The Business Cycle & Output Gaps
- Identify the phases of the business cycle and the indicators that move in each
- Distinguish a recessionary from an inflationary output gap
- Explain why potential output is a trend rather than a ceiling
Four phases, one trend line
Real GDP fluctuates around a rising long-run trend of potential output. The expansion phase has output growing and unemployment falling; the peak is where the expansion tops out; the contraction or recession has output falling and unemployment rising; the trough is the bottom before recovery begins. The conventional shorthand for a recession is two consecutive quarters of falling real GDP, though official determinations look at a broader set of indicators.
Two gaps, and which policy each calls for
Compare actual to potential output. Below potential is a recessionary gap: cyclical unemployment above zero, unemployment above the natural rate, and downward pressure on prices. Above potential is an inflationary gap: unemployment below the natural rate, labor and capital stretched past sustainable use, and upward pressure on prices. Recessionary gaps call for expansionary policy, inflationary gaps for contractionary. Naming the gap correctly is the first step in every AD–AS free response, and getting it wrong costs every subsequent part.
Potential output is not a hard ceiling
An economy can produce above potential for a while — overtime, deferred maintenance, drawing down inventories, pulling in workers who would otherwise be out of the labor force. What makes it unsustainable is not physical impossibility but that it bids up wages and input prices, shifting SRAS left and pushing output back toward potential at a higher price level. So potential is the level output returns to, not the level it cannot exceed. LRAS is vertical there for that reason.
Leading, lagging and coincident
Indicators differ in timing, which matters for policy. Leading indicators turn before the economy does — new building permits, new orders for capital goods, stock prices, consumer expectations. Coincident indicators move with it, most obviously real GDP itself. Lagging indicators turn after, and unemployment is the classic lagging indicator: firms wait until a recovery looks durable before hiring, so unemployment can keep rising for months after output has bottomed out. That lag is why a recovery so often feels like a continuing recession.
Potential real GDP is $20 trillion and actual real GDP is $19.2 trillion, with unemployment at 7.5% and a natural rate of 5%. Identify the gap, compute it, and state the appropriate policy.
- 1.Actual is below potential, so this is a recessionary gap.
- 2.Output gap = (19.2 − 20)/20 × 100 = −4.0%.
- 3.Cyclical unemployment = 7.5% − 5% = 2.5 percentage points.
- 4.The policy response is expansionary — increase government spending, cut taxes, or lower the federal funds rate — to shift AD right.
Full employment does not mean zero unemployment. It means cyclical unemployment is zero and the rate equals the natural rate, which includes frictional and structural unemployment. An exam answer claiming zero unemployment at full employment loses the point.
Actual real GDP is above potential real GDP. The economy has:
Unemployment is described as a lagging indicator because:
Which is a leading indicator of the business cycle?
Every AD–AS free response starts by naming the gap. Write "output is below potential, so there is a recessionary gap" explicitly — it is usually its own rubric point and it fixes the direction of every shift you draw afterward.
Answer the 3 checkpoints as you read.
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