Business (Trade) Cycle
Diagram of the economic business cycle showing boom, recession, trough, and recovery phases relative to trend GDP growth, along with output gap fluctuations.
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The diagram shows actual real GDP fluctuating around trend GDP, the navy straight line that rises steadily over time. Actual GDP is drawn in four colours, one for each phase of the cycle: red for boom, amber for slowdown, blue for recession and green for recovery, and two full cycles are shown. The grey hatched areas between the two lines are output gaps, hatched one way where actual GDP is above trend (a positive output gap) and the opposite way where it is below trend (a negative output gap). Technically, a recession is two consecutive quarters of negative economic growth; on the diagram each recession is the stretch from the peak down to the trough where real GDP falls, before recovery begins.
Key points
- Boom (red): actual GDP is above trend and growing faster than trend.
- Slowdown (amber): actual GDP is still above trend and still growing, but no faster than trend.
- Recession (blue): technically, a recession is two consecutive quarters of negative economic growth (falling real GDP). On the diagram it is the stretch from the peak to the trough where real GDP falls, starting above trend and ending below it.
- Recovery (green): real GDP grows again while it is at or below trend; once it rises back above trend, the next boom begins.
- A positive output gap (actual GDP above trend) is often linked with inflationary pressure, and a negative output gap (actual GDP below trend) with spare capacity and higher unemployment. The diagram keeps the size of each swing the same; real cycles vary in length and size.
Exam tip
Name each phase from what actual GDP is doing, not only from which side of trend it is on. A recession is two consecutive quarters of negative economic growth: on the diagram it starts at the peak, while actual GDP is still above trend, and ends at the trough, below trend. A slowdown is not a recession, because real GDP is still rising, just no faster than trend.
Common mistakes
Treating a slowdown as a recession: in a slowdown real GDP is still rising, only more slowly than trend, whereas in a recession it actually falls. Calling one quarter of falling real GDP a recession: it needs two consecutive quarters of negative growth. Assuming the output gap changes sign at the peak or the trough: as drawn, the gap stays positive from the start of the boom until actual GDP falls back through trend part-way through the recession, and stays negative until actual GDP rises back above trend.
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