Essential definitions

Business cycle

Fluctuations in real economic activity around its longer-run trend.

Recession

A substantial decline in economic activity; two consecutive quarters of falling real GDP is a common technical convention.

Potential output

The sustainable level of real output when productive resources are normally employed.

Follow actual output over time

The business cycle is the uneven movement of economic activity. In an expansion, real output rises. A peak is a turning point before output falls; contraction is the fall, and a trough precedes recovery. Slower positive growth is still growth. A common technical recession convention uses two quarterly falls in real GDP, while broader assessments consider employment, income and production too.

Imagine that households become less confident and postpone purchases. Firms sell less, cut production and hire fewer workers. Lower household income can weaken spending further. Better confidence can reverse the chain. Credit changes, inventories and external shocks can also start or amplify a cycle, so it does not follow a fixed timetable.

Read the business-cycle diagram

Time is on the horizontal axis and real GDP on the vertical axis. The wavy line is actual output. Follow it upwards for expansion and downwards for contraction. Its peak need not occur where it crosses the smoother trend line.

Potential output is the amount the economy can sustainably produce with its available resources. An output gap compares actual output with this capacity. A point below potential indicates spare capacity, even if the actual-output line is rising. A point above potential suggests unusually intensive use of workers and machinery. A trend is a useful guide, but estimates of potential can change.

Distinguish recovery from full recovery

If output falls from 500 to 490 billion and then rises 1%, it reaches 494.9 billion. Activity is recovering but remains below 500. This is why a positive growth rate alone does not show that a downturn's losses have been recovered.

Long downturns may also damage future capacity: workers lose skills and firms cancel investment. To diagnose weakness, compare output with employment, use of capacity and inflation. A supply disruption can reduce output while raising prices, unlike a simple fall in spending. The aggregate-demand and supply lessons next explain that distinction.

Apply and evaluate

• Output data arrive with delays and revisions, so policy decisions use incomplete evidence.
• A trend fitted to past data is not automatically a reliable measure of sustainable future capacity.

Real-world application