Trend growth and short-term swings
Real GDP is the value of all goods and services a country makes in a year, adjusted for price changes. Over the long run it usually grows: this is the trend (or potential growth), driven by more workers, more machines and better technology.
In the short run, real GDP does not grow smoothly. It rises faster than trend for a while, then slower or even falls. These ups and downs are called the business cycle (or economic cycle, or trade cycle). A cycle usually lasts a few years, but no two cycles are the same length.
The output gap = actual GDP − trend GDP. Positive gap: the economy is running hot. Negative gap: it is running below capacity.
The four phases: boom and recession
- Expansion (recovery): output, jobs and spending grow.
- Peak (boom): output is at its highest, above trend. Firms find it hard to get workers and materials.
- Contraction: output growth slows or falls; firms cut orders.
- Trough: the lowest point. A recession is often defined as two quarters in a row of falling real GDP. A deep, long recession is a depression.
Why do cycles happen?
- Changes in confidence: households and firms spend more when hopeful, less when worried.
- Changes in investment and stock building.
- Shocks: oil price jumps, pandemics, financial crises, harvest failures.
- Changes in exports when trading partners boom or slump.
Economists watch indicators: leading ones (orders, business confidence) move before the cycle, lagging ones (unemployment) move after.
Effects on inflation and unemployment
| Boom | Recession | |
|---|---|---|
| Unemployment | low (firms hire) | high (cyclical unemployment) |
| Inflation | rising (demand-pull) | low, maybe deflation |
| Profits and wages | rising | falling |
| Government budget | tax income up, deficit shrinks | tax income down, benefits up, deficit grows |
The changes in the budget happen by themselves: these are called automatic stabilisers.
Stabilisation policy: fiscal and monetary
Fiscal policy (government)
In a recession: raise government spending or cut taxes (expansionary) to lift demand. In a boom: cut spending or raise taxes (contractionary) to cool demand.
Monetary policy (central bank)
In a recession: cut the policy interest rate, so borrowing is cheaper and people spend and invest more. In a boom: raise interest rates to slow borrowing and inflation.
Limits
- Time lags: policy can take a year or more to work.
- Interest rates cannot go much below zero.
- Bigger deficits mean more government debt.
The goal is not to stop the cycle but to make the swings smaller ('lean against the wind').
Try it: spot the phase
Find news about your country's economy. Look for three clues: is GDP growth up or down? Is unemployment rising or falling? Is the central bank raising or cutting rates? Decide which phase of the cycle your country is in, then check it on the 3D time slider.
Key formulas and definitions
- Output gap = actual real GDP − trend (potential) real GDP
- Growth rate = (GDP this year − GDP last year) ÷ GDP last year × 100
- Recession ≈ 2 quarters in a row of falling real GDP
- Phases: expansion → peak → contraction → trough
- Recession policy: G ↑, T ↓, interest rate ↓ · Boom policy: the opposite
Worked examples
1. Real GDP is 2.06 trillion this year and 2.00 trillion last year. Find the growth rate.
(2.06 − 2.00) ÷ 2.00 × 100 = 3%.
2. Trend GDP is 500 billion and actual GDP is 480 billion. Find the output gap and say what it means.
480 − 500 = −20 billion. A negative gap: the economy is below capacity, likely with higher unemployment.
3. Quarterly real GDP growth: +0.5%, −0.3%, −0.4%, +0.2%. Was there a recession?
Yes: two quarters in a row (−0.3% and −0.4%) of falling real GDP.
4. Inflation is 7% and unemployment is very low. Which phase, and what should the central bank do?
A boom (peak). It should raise interest rates to cool spending and bring inflation down.
5. In a recession, tax income falls and benefit spending rises without any new law. What is this called and why does it help?
Automatic stabilisers. People keep more money and receive benefits, which supports spending and softens the fall.
6. Give one reason why a government might not cut taxes in a recession.
Government debt may already be high, or the cut may take too long to work (time lag).
Common mistakes
- Thinking a recession means GDP is zero: it means GDP is falling, from a high level.
- Mixing up the trend (long run) with the cycle (short run).
- Saying monetary policy is done by the government: it is set by the central bank.
- Believing policy can remove cycles completely: it can only make them smaller.