Economies do not grow in a neat straight line. They surge, they stall, they shrink, they pick themselves up again. Plot real GDP over twenty years and you get a wave wrapped around a rising trend — and every point on that wave has a name the examiner expects you to use.
📘 What you need to know
The business cycle shows changes in real GDP over time — this is actual growth.
The straight line through the middle is trend growth — the economy’s long-run potential.
The four phases are boom, slowdown, recession and recovery.
A recession is two consecutive quarters (six months) of negative economic growth.
Actual output above trend is a positive output gap; below trend is a negative output gap.
Governments try to smooth the cycle — cooling a boom, supporting a recession.
Actual growth vs trend growth
Two different lines are on the same diagram, and mixing them up costs marks.
Actual growth is what really happened to real GDP this year. It is the wobbly line. It depends mostly on demand: how much households, firms, governments and foreigners are spending right now.
Trend growth is the average rate the economy can sustain over the long run, given its workers, machines, skills and technology. It is the straight line. It depends on the supply side of the economy, and it moves slowly.
The whole business cycle is just actual growth swinging above and below trend growth.
The blue line is where the economy actually is. The green line is where it could be if every resource were fully used.
When you draw this in an exam, draw the straight trend line first, then wrap the wave around it. Students who draw the wave first almost always end up with a trend line that does not sit in the middle.
The four phases, in order
🧩 Going round the cycle
Boom (peak) — growth is fast, unemployment is low, confidence is high, spare capacity has run out and prices are being bid up.
Slowdown (downturn) — growth is still positive but getting weaker. Firms grow cautious and delay investment.
Recession (trough) — real GDP is actually falling. Firms cut output, lay off workers and unemployment climbs.
The official definition
A recession = two consecutive quarters of negative real GDP growth
By Q5 growth is positive again, so the economy has entered recovery even though output is still below where it was in Q2.
What a boom and a recession actually feel like
Indicator
In a boom
In a recession
Real GDP growth
High and rising
Negative
Unemployment
Low, with lots of vacancies
High and climbing
Inflation
Rising, usually demand-pull
Low, sometimes deflation
Spare capacity
Almost none; positive output gap
Plenty; negative output gap
Confidence
High, so firms take risks and invest
Low, so investment is delayed
Government budget
Improves — tax revenue up, benefits down
Worsens — tax revenue down, benefits up
Not everyone suffers equally. Discount supermarkets, repair shops and second-hand retailers often do better in a recession, because households switch to inferior goods. Dropping that point into an evaluation shows the examiner you can think past the model.
Output gaps
An output gap is the difference between actual real GDP and the potential output the economy could manage if every resource were fully employed.
Positive output gap — actual is above potential. Workers are doing overtime, factories are running flat out. It cannot last, and it pushes prices up.
Negative output gap — actual is below potential. There are idle workers and idle machines. Wasteful, but it does keep inflation down.
Output gaps are genuinely hard to measure, because nobody can see potential output directly. Economists infer it: rapidly rising prices hint at a positive gap; rising unemployment hints at a negative one.
WORKED EXAMPLE
Measuring an output gap
An economy’s actual real GDP is $620 billion. Its estimated potential output is $650 billion. Calculate the output gap in dollars and as a percentage of potential output, and state which type of gap it is. [3]
Step 1: Actual minus potential620 − 650 = −30Step 2: As a percentage of potential(−30 ÷ 650) × 100 = −4.615…A negative output gap of $30bn, or 4.62% of potentialnegative gap means spare capacity, so unemployment will be above its natural rate
WORKED EXAMPLE
Naming the phase from data
Real GDP growth over four quarters was: +0.5%, +0.1%, −0.4%, −0.6%. Identify the phase the economy is in by the fourth quarter and explain your answer. [3]
Step 1: Read the direction, not just the sign
Growth fell from +0.5 to +0.1 while still positive — that is a slowdown.
Step 2: Check the recession rule
Q3 and Q4 are both negative and consecutive.
The economy is in recession by Q4expect rising unemployment, falling confidence and a widening negative output gap
💡 Exam tip
Label both lines on your diagram. An unlabelled trend line throws away an easy mark.
Falling growth is not the same as falling GDP. Only negative growth means output is shrinking.
Give the recession definition in full: two consecutive quarters of negative real GDP growth.
Link each phase to unemployment and inflation. Questions almost always want those consequences.
Governments smooth the cycle: raise taxes or cut spending in a boom, do the opposite in a recession.
For evaluation, mention that output gaps cannot be measured precisely, so policy is often based on estimates.
⚠️ Common mix-up
Drawing the trend line going flat. Trend growth is positive, so the line slopes upwards.
Calling one negative quarter a recession. You need two in a row.
Saying a boom is always good. It brings inflation, shortages and unsustainable borrowing.
Mixing up an inflationary output gap with inflation itself. The gap is about output being above potential, not about the price level.
Assuming the phases last a set length. Some recoveries take months, some take years.
Forgetting the components of AD move at different speeds. In a recovery, consumption usually picks up well before firms start investing again.
Up next: Does GDP or GNI Capture Well-being? — we have spent two pages calculating these numbers, so now it is fair to ask what they leave out.
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