Chances are that you know what a business cycle is; you just do not know that you know it. Remember any time when there was widespread unemployment? Or a time when prices were just skyrocketing, and people were complaining all over about how things were more expensive? These are all signs of the business cycle. The business cycle refers to short-term fluctuations in economic activity. Economists use the business cycle graph to represent the business cycle and show all of its stages. This is the main reason why we are here - to explain the business cycle graph. Read on, and enjoy!
Business Cycle Graph Definition
We'll provide the definition of the business cycle graph. But first, let's understand what the business cycle is. The business cycle refers to the fluctuations in business activity that happen in the short term in an economy. The short term mentioned here does not refer to any specific amount of time but the time within which fluctuations occur. So, the short term could be as short as a few months or as long as ten years!
If you'd like a little bit more help with exploring the topic of the business cycle, check out our article: Business Cycle.
The business cycle refers to the short-term fluctuations in economic activity.
Now that we know what the business cycle is, what is the business cycle graph? The business cycle graph illustrates the business cycle. Take a look at Figure 1 below, and let's continue with the explanation.
The business cycle graph is the graphical illustration of short-term fluctuations in economic activity
Fig. 1 - Business Cycle Graph
The business cycle graph plots the real GDP against time. The real GDP is on the vertical axis, whereas time is on the horizontal axis. From Figure 1, we can see the trend output or the potential output, which is the level of output that can be achieved by the economy if it uses all of its resources optimally. The actual output shows how the economy actually progresses and represents the business cycle.
Potential output refers to the level of output the economy can achieve if all economic resources are employed optimally.
Actual output refers to the total output produced by the economy.
Business Cycle Graph Economics
Now, let's look at the economics of the business cycle graph. What does it actually show? Well, it shows the phases of the business cycle. Take a moment to look at Figure 2 below, then we proceed.
Fig. 2 - Detailed Business Cycle Graph
The business cycle consists of the expansion phase and the recession or contraction phase. In between these, we have the peak and trough phases. Therefore, there are four phases in the business cycle. Let's explain these four phases briefly.
- Expansion - In the expansion phase, there is a rise in economic activity, and the output of the economy is rising temporarily. During this phase, there is an increase in employment, investment, consumer spending, and economic growth (real GDP).
- Peak - The peak phase refers to the highest point reached in the business cycle. This follows the expansion phase. During this phase, economic activity has reached its highest point, and the economy has reached or has almost reached full employment.
- Contraction or Recession - The contraction or recession comes after the peak and represents a period when the economy is declining. Here, there is a decline in economic activity, and this means that there is a reduction in output, employment, and spending.
- Trough - This is the lowest point reached in the business cycle. While the peak is where the expansion ends, the trough is where the contraction ends. The trough represents when economic activity is at its lowest. From the trough, the economy can only go back into an expansion phase.
Figure 2 clearly marks these phases as described above.
Business Cycle Graph Inflation
The expansion phase of the business cycle graph is associated with inflation. Let's consider an expansion that was fueled by the creation of more money by the central bank. When this happens, consumers have more money to spend. However, if the output of producers does not increase to match the sudden increase in money supply, producers will begin to increase the prices of their products. This raises the price level in the economy, phenomenon economists refer to as inflation.
Inflation is the increase in the general price level in an economy.
The expansion phase is often accompanied by inflation. Here, the currency loses its purchasing power to an extent because the same amount of money is unable to purchase a number of products it was able to purchase before. Take a look at the example below.
In year 1, a bag of chips was sold for $1; however, due to inflation, the chip producers began to sell a bag of chips for $1.50 in year 2.
This means that your money is unable to purchase the same value of chips in year 2 as it used to purchase in year 1.
Read our article on Inflation for a more thorough understanding of this concept.
Business Cycle Graph Contraction
The business cycle is said to be in the contraction phase when economic activity begins to go down. In this phase, the economy experiences declines in employment, investment, consumer spending, and real GDP or output. An economy that contracts for a prolonged period of time is said to be in a depression. The contraction phase ends at the trough and is followed by a recovery (or an expansion), as labeled on the business cycle graph in Figure 3.
Fig. 3 - Detailed Business Cycle Graph
During a contraction, there is likely to be a negative GDP gap, which is the difference between the potential GDP of the economy and the actual GDP of the economy. This is because a recession means that a significant portion of the economy's labor force is unemployed, and potential production is going to waste.
Unemployment can be quite costly to the economy. Learn more in our article on Unemployment.
Business Cycle Example
A typical example of a business cycle is the emergence of the COVID-19 virus in 2019, causing a global pandemic. During the height of the pandemic, businesses closed down, and there was a widespread drop in production. It also resulted in widespread unemployment as businesses struggled to keep employees on their payrolls. This widespread unemployment also meant a reduction in consumption spending.
This describes the triggering of the contraction phase of the business cycle. Recovery begins after this, once prices drop low enough for consumers to regain their interest in consumption and increase their demand.
Figure 4 shows the business cycle of the U.S. from 2001 to 2020.
Fig. 4 - U.S. Business Cycle from 2001 to 2020. Source: Congressional Budget Office1
The GDP of the U.S. has seen periods of both positive and negative GDP gaps. The positive gap is the period where the actual GDP is above the potential GDP line, and the negative gap is the period where the actual GDP is below the potential GDP line. Also, notice how the actual GDP dips rapidly around 2019 to 2020? That is also the period when the COVID-19 pandemic hit!
Congrats on completing the article! Our articles on Business Cycle, Macroeconomic Issues, and Unemployment provide more insights into the concepts discussed here.
Business Cycle Graph - Key takeaways
- The business cycle refers to short-term fluctuations in economic activity.
- The business cycle graph is a graphical illustration of short-term fluctuations in economic activity.
- Potential output refers to the level of output the economy can achieve if all economic resources are employed optimally.
- Actual output refers to the total output produced by the economy.
- The four phases of the business cycle illustrated on the business cycle graph include the expansion, peak, contraction, and trough phases.
References
- Congressional Budget Office, Budget and Economic Data, https://www.cbo.gov/system/files/2021-07/51118-2021-07-budgetprojections.xlsx
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