The Business Cycle

Economists often observe how output, the goods and services produced in an economy, change as time progresses to track the health of an economy. Economists have noticed that as time progresses, output generally increases. Economists reasoned that this trend is a result of an increasing population and an accelerating productivity. Recall that productivity accelerates as a result of technological advancements, an increase in human capital, or a discovery of a new resource. Economists graphed this trend between the changes in output over time.

From this graph, we see real GDP being measured over time. Recall the real GDP adjusts for changes in prices. This allows us to measure purely the changes in the output levels of an economy. Measuring the nominal GDP would allow us to measure price changes in an economy which does not reflect on the output levels of an economy and therefore real GDP would give the most accurate measurement. From this graph, we see an upwards sloping line demonstrating that as time increases, output also increases at a constant rate. However, though output does increase over time, it does not increase at an exactly steady rate. Therefore, this graph does not give a precise representation of how output changes over time and rather provides only a general idea. So, we will call this line a “trend line” as it gives an idea of the general trend between the changes in output over time. The changes in output of an economy face constant fluctuations as time progresses; sometimes an economy’s real GDP may be slightly under or over the upwards trend line. To account for these deviations from our trend line we can update our graph of real GDP vs time.

We have updated the graph with a curve accounting for the slight deviations from our trend line. To simply put it, the trend line can be thought of as a line of best fit which gives a general idea of how real GDP changes over time. This new curve drawn in can be thought of as the exact or actual change in real GDP over time as it provides a more precise representation. Looking at the characteristics of this curve, we can see that it oscillates. First it goes slightly over the trend line, then goes under the trend line and the pattern continues. What exactly causes the fluctuations and the deviations from the trend line? First, let’s clarify two important terms. The actual real GDP or actual output states the current value of real GDP or the current amount of output in the economy. The potential real GDP or potential output states the real GDP values and output levels which keep the economy at a healthy state. In other words the potential real GDP/output represents the production levels where an economy ideally wants to be. We will later understand why the trend line represents the potential output. Now looking at our graph, the curve represents the actual output levels while the trend line represents the potential output levels. Starting at the very beginning of this graph, we see that the actual level of output and the potential output are equal. Moving from left to right, we reach the “expansion phase”. A small jump in production levels begins the expansion phase. This increase in production levels causes prices to rise. Due to the rise in prices, consumers predict that prices will continue to rise and therefore assume that future prices will far exceed the current prices. As a result, consumers begin increasing their purchases of goods and services in an attempt to buy these commodities before their prices rise. Due to the increase in consumer purchases, businesses earn great profits and begin hiring more workers to further increase productivity. Ultimately, this leads to an increasing real GDP. As prices continue to rise, consumers continue to buy and real GDP continues to increase. As a consequence of these constant increases in real GDP, people within the economy become very optimistic and are willing to take major risks in investments and purchases without being sceptical of any form of downfall in the economy. At this point, the economy has reached the “peak” or the highest point attainable in terms of output levels and productivity. The optimistic atmosphere in the economy causes prices to further increase past a “breaking point” which triggers events such as a crash in the stock market to occur. This begins the “contraction” phase. Consumers start holding back on purchases and businesses begin receiving less profits and start laying off workers to lower costs causing the real GDP to fall. As real GDP continues to fall the economy reaches the “trough” phase. This phase is the lowest point for the economy and is also often referred to as a period of depression. From this point, though they remain skeptical, consumers once again slowly start purchasing more goods and services. From here, consumers begin seeing a positive sign in the state of the economy and the purchasing continues putting the economy back in the expansion phase. As we noticed, the economy went around in a cycle. This cycle is called the “Business Cycle”. It is important to note that though this term uses the phrase “cycle”, it could be misinterpreted that there is no net gain or net loss in real GDP. However, we can see from the trend line that as time progresses, despite this constant cycle which an economy faces, there is an overall net increase in real GDP. We noticed that though it is natural, it is unhealthy for an economy to go very above the trend line or very below the trend line. In between these fluctuations is the most healthy state for an economy as going too above will crash the economy and going to below will lead the economy into a depression. This is why the trend line represents potential output levels. In this article, we looked at how this cycle naturally operates without any government interventions. It should be noted that the cycle does not have to happen naturally as the government can intervene to stimulate certain phases of the cycle to bring the economy back to healthy production levels. Why doesn’t the government always intervene when the economy is in a miserable state? This is because the cycle is very unpredictable. Some phases can last longer than others and sudden phase changes can also occur, making it hard for economists to understand when an economy is heading towards a recession or inflation. We will further investigate how the government intervenes within the cycle in future articles.

Lastly, let’s note an observation regarding unemployment and the business cycle. Recall that in previous articles, we categorized unemployment into three categories, cyclical unemployment, structural unemployment and frictional unemployment, and stated that every economy has an inevitable unemployment rate called the natural rate of unemployment which consists of structural unemployment and frictional unemployment. In the business cycle, the trend line represents the natural rate of unemployment. As an economy expands, cyclical unemployment falls causing unemployment to fall. As an economy contracts, cyclical unemployment rises causing unemployment to also rise. It is important to note that cyclical unemployment is what changes during this economic cycle and that the natural rate of unemployment does not. The natural rate of unemployment in fact can change, but that is under different circumstances which we will explore in future articles. The business cycle is a fundamental topic in macroeconomics and we will revisit this economic cycle often in future articles.