The Business Cycle

Define the business cycle

The expansion and contraction in real GDP that occurs around the long term growth path of potential GDP

Define the expansion phase

The phase between the trough and peak of the cycle where real GDP increases - also known as the ‘recovery phase’ in the beginning

Characteristics of the expansion phase

• Consumer confidence rises (higher consumer spending)

• Business confidence rises (higher investment spending)

• Production rises

• Employment rises (unemployment rate decreases)

• Share prices increase as expected profits rise

• House prices rise

• Real GDP increases

• Rate of inflation rises

Define the peak phase

The upper turning point of the cycle where economy is operating above capacity - meaning GDP growth has slowed and the unemployment rate is below the natural rate.

• Limited new investment opportunities

• High inflation reduces spending

Define the contraction phase

The phase following a peak where real GDP falls

Define a recession

Two or more consecutive quarters of negative economic growth

Contraction phase features

• Production and employment decline

• Investment falls

• Consumption falls and savings increase

• Unemployment rate increases

• Inflation rate decreases

Define the trough phase

Marks the end of the contraction and the beginning of the expansion

Trough phase features

• Low demand for G+S

• High unemployment rate

• Low profitability

• Very low business and consumer confidence

• Expansionary fiscal and monetary policy

• Bankruptcies are likely to be high

Define economic shock

An unexpected event that causes a significant change with an economy

Economic shock examples

• Natural events (e.g. drought)

• Political events (e.g. Ukraine War)

• Health crises (e.g. COVID-19)

• A mining boom

Positive vs negative economic shocks

Positive: increase economic activity by an increase in production, employment, and income (e.g. an increase in China’s growth rate, a share market boom)

Negative: decrease economic activity by a decrease in production, employment, and income (e.g. a natural disaster, pandemic, share market crash)

External shocks

In the short term, they would impact on production in a specific area of the economy and could result in shortages, price changes, and lower income. These results flow onto other sectors

Positive output gap

Actual GDP > Potential GDP - unemployment rate falls below the natural rate

Negative output gap

Actual GDP < Potential GDP - unemployment above the natural rate

Real GDP as an indicator

A summary statistic measuring the aggregate level of economic activity which helps confirm the position of the economy in the business cycle

Define procyclical variable and examples

A variable that increases during an expansion and falls during a contraction

• Consumer spending

• Investment

• Employment

• Household confidence

Define countercyclical variable and examples

A variable that decreases during an expansion and increases during a contraction

• Unemployment

• Business failures

• Gov welfare spending

Leading indicators definition

Change before a direction becomes evident in the rest of the economy - e.g. it will increase before the level of economic activity actually increases

Coincidental indicators definition

Move in line with the level of economic activity, changing simultaneously with economic conditions - used to identify the current state of the economy

Lagging indicators definition

Change sometime after the level of economic activity changes - represent the truth by confirming where the economy has been

Leading indicator examples

• Share prices

• Building approvals

• Inventory of retail firms

• Manufacturers’ new orders

• Business and consumer confidence

• New employment vacancies

• New business start-ups

Coincidental indicator examples

• GDP

• Manufacturing output

• Sales of consumer durables

• Industrial production

• Retail sales

• Job advertisements

• Motor vehicle sales

• Saving ratio

• Household income

Lagging indicator examples

• Unemployment rate

• wages

• Inflation rate

• Interest rates

• Consumer debt

• Business profit

• Bankruptcies