Week 6 · Chapter

Chapter 6 — Business Cycles & Short-Run Fluctuations

Principles of Macroeconomics Free sample edition

The module's primary reading · ~35–45 minutes · Objective 5 (use the aggregate-demand and aggregate-supply model to analyze short-run fluctuations and the business cycle — name which curve shifts, in which direction, and what happens to the price level and real output — and measure recessionary and inflationary gaps), with Objective 3 (measure the price level and the labor market — compute and interpret the CPI, the inflation rate, a real wage change, the unemployment rate, and the labor-force participation rate — and classify frictional, structural, and cyclical unemployment) · Read it first this week; the lecture, the slides, the tutorial, the quiz, and the Model Workshop all build on it.

In plain language

The economy does not grow in a straight line. It speeds up, slows down, and sometimes shrinks for a while before it grows again, and that up-and-down pattern is called the business cycle (the repeated rise and fall of the economy's output around its long-run path). This week you learn to measure how far the economy has drifted from normal with an output gap (the distance between what the economy is producing and what it could produce at normal, full use). A gap below normal means idle workers and empty shifts; a gap above normal means stretched workers and rising prices. You will also learn how recessions are officially dated, and why two economists can look at the same gap and disagree about whether to wait it out or act.

Why you already care about this

Think about a line cook at a busy restaurant, an illustrative case. In a strong year, the restaurant adds a second dinner shift, the owner raises wages to keep staff, and the menu prices creep up. In a weak year, the same restaurant cuts the cook to three nights a week and runs specials to bring customers in. The cook did not change. The kitchen did not change. What changed was the whole economy around them.

You have probably lived through both kinds of year, or heard about them from someone who did. A parent's overtime vanishes. A friend's job search takes months instead of weeks. Then, a year or two later, help-wanted signs are back and employers are offering signing bonuses. That rhythm is the business cycle, and it touches your hours, your rent, and how easy it is to land the job you want.

In this chapter you will follow an illustrative economy that could produce 1,000 billion dollars of real output at normal, full use. In one year it produces only 950 billion, a shortfall of 50 billion dollars. In another year it produces 1,040 billion, 40 billion dollars beyond normal. You will learn to report each of those gaps two ways, read each one off the AD–AS diagram, and explain why a gap can last.

By the end of this chapter you will be able to:

name the four phases of the business cycle and place an episode in the right one;
locate potential output as the vertical long-run aggregate supply line and actual output as the crossing of aggregate demand and short-run aggregate supply;
compute a recessionary gap and an inflationary gap in billions of dollars and as a percentage of potential;
read a gap off a described AD–AS diagram and keep "where the economy sits" separate from "which curve moved it there";
explain how expected inflation shifts short-run aggregate supply and why a gap can persist;
explain how the Business Cycle Dating Committee dates a recession and why the two-negative-quarters rule of thumb is not its definition;
state the self-correction view and the intervention view at full strength without picking a winner.

Carry this line with you: a gap is where you are — not how you got there.

Where we are

Already covered: Week 1, The Macro Perspective, showed an inside point on the frontier as idle resources. Week 2, Measuring Output, taught real GDP. Week 3, Measuring Inflation & Unemployment, taught the three types of unemployment, including cyclical unemployment. Week 4, Economic Growth & Productivity, named potential output. Week 5, Aggregate Demand & Aggregate Supply, built the AD–AS diagram and the habit of naming which curve shifts.
This week: the business cycle, the two kinds of output gap, how expectations can make a gap last, how recessions are dated, and the debate over whether to wait or act.
How they connect: a gap is Week 4's potential output compared with Week 5's crossing, measured in Week 2's real GDP, and its human face is Week 3's cyclical unemployment.
Where we're going next: Week 7, Fiscal Policy, gives you the government's spending and tax tools and the multiplier, so you can test the intervention side of this week's debate.

Five earlier ideas carry this chapter. From Week 1, a point inside the production possibilities frontier is attainable but wasteful, because some resources sit idle. From Week 2, real GDP measures output with price changes stripped out. From Week 3, cyclical unemployment is the extra joblessness of a recession. From Week 4, potential output is the real output an economy can produce when its labor, capital, and technology are in normal, full use. From Week 5, the vertical long-run aggregate supply line stands at potential output, and the crossing of aggregate demand and short-run aggregate supply sets the price level and real output. This week puts the crossing and the vertical line side by side and measures the distance between them.

1. Trace the business cycle: four phases

Picture a coastal town whose harbor is busy every summer and quiet every winter. That swing is seasonal, and everyone plans for it. Now picture a different swing, one that nobody can schedule. For two or three years, the whole town's businesses add workers. Then, over a few months, orders fall almost everywhere at once, and the layoffs spread from the harbor to the hardware store to the dentist. A year later, hiring starts again. That second swing, across the whole economy and with no fixed timetable, is the business cycle.

The business cycle is the repeated rise and fall of real output around its long-run path, moving through four phases: an expansion, a peak, a recession, and a trough.

Each phase has a name of its own.

An expansion is the phase of the business cycle in which real output, jobs, and incomes rise, running from a trough up to the next peak.
A peak is the high point of economic activity at the end of an expansion, the month after which activity starts to fall.
A recession is a significant decline in economic activity that is spread across the economy and lasts more than a few months, running from a peak down to a trough.
A trough is the low point of economic activity at the end of a recession, the month after which a new expansion begins.

Picture the cycle as a wavy line drawn over a gently rising straight line. The straight line is potential output, climbing year after year as Week 4's growth adds workers, capital, and better ideas. The wavy line is actual real output. It climbs above the straight line in some years and dips below it in others. A peak is a crest of the wave, a trough is a dip, and the stretches between them are expansions and recessions.

Worked example — placing four moments in the cycle. These moments come from an illustrative economy constructed for this course.

Real output has risen for eight straight quarters, and hiring is broad. Output is climbing, so this is an expansion.
Activity reaches its highest level, and the next month it starts to fall. That turning month is the peak.
For the next nine months, output, jobs, and spending fall in most industries. A significant, widespread decline lasting more than a few months is a recession.
Activity hits its lowest level, and the next month it starts to rise. That turning month is the trough, and a new expansion begins.

In words: an expansion runs up to a peak, a recession runs down to a trough, and then the cycle starts again.

Misconception check. Students often think the business cycle is regular, like the seasons, so a recession is "due" every few years. The word "cycle" makes it sound like a clock. It is not one. Expansions and recessions vary a great deal in length and depth, and nobody can schedule the next peak. The cure: read "cycle" as "repeated ups and downs," not "a fixed rhythm."

2. Locate potential output: the LRAS line and the crossing

Think about an illustrative hospital with 100 nurses on staff. On a normal week, they cover every shift with ordinary overtime. That normal, sustainable level of care is the hospital's potential. In a slow month, some nurses are sent home early, and the hospital provides less care than it could. In a flu surge, nurses work double shifts, and the hospital provides more than its normal level, for a while, at a cost. The economy works the same way.

You already know potential output from Week 4: the real output an economy can produce when its labor, capital, and technology are in normal, full use. In Week 5 it became a line on a graph. The long-run aggregate supply line, LRAS, is vertical at potential output. This course writes potential output as Y* and actual output as Y.

Actual output is the real output an economy is producing right now, shown on the AD–AS diagram where aggregate demand crosses short-run aggregate supply.

So the diagram holds three lines and two outputs. Aggregate demand slopes down. Short-run aggregate supply slopes up. Where those two cross is actual output, Y. The vertical LRAS line stands at potential output, Y*. The two do not have to match.

An output gap is the distance between actual output and potential output, reported in units of real output and as a percentage of potential output.

Here is the diagram in words. The horizontal axis is real output in billions of dollars. The vertical axis is the price level. A vertical line, LRAS, rises from the horizontal axis at potential output. Somewhere on the diagram, the downward-sloping aggregate demand line crosses the upward-sloping short-run aggregate supply line. Drop a line straight down from that crossing to the horizontal axis, and you have actual output. The horizontal distance between the crossing and the LRAS line is the output gap.

Misconception check. Students often think the economy always sits on the LRAS line, because "long-run" sounds like "normal." But LRAS shows where output settles once every price and wage has adjusted, and that can take a long time. In the short run, the crossing can sit to the left or right of LRAS. The cure: always find the crossing first, then compare it with the vertical line.

3. Measure a recessionary gap: below potential, in units and percent

Imagine an illustrative construction company that owns 20 excavators but has work for only 15 of them this season. Five machines sit in the yard. Their drivers are laid off or put on short weeks. The company could build more; nobody is paying it to. That is what a recessionary gap looks like from the inside.

A recessionary gap is the shortfall of actual output below potential output, found as potential output minus actual output; workers and machines sit idle, and cyclical unemployment is above zero.

As a formula on one line: recessionary gap = potential output − actual output. Then turn the gap into a share of potential: gap ÷ potential output × 100.

Worked example — the illustrative output-gap economy, recession case. This economy is constructed for this course, not real data. Output is in billions of dollars of real GDP.

Potential and actual output in the recession case of the illustrative output-gap economy, in billions of dollars
Measure	Billions of dollars
Potential output	1,000
Actual output	950

Subtract actual output from potential output. 1,000 − 950 = 50 billion dollars.
Divide by potential output. 50 ÷ 1,000 = 0.05.
Turn it into a percent. 0.05 × 100 = 5% of potential.

In words: this economy is producing 50 billion dollars less than it could at normal, full use, a recessionary gap of 5 percent of potential. On the diagram, its crossing sits 50 billion dollars to the left of the vertical LRAS line at 1,000.

Why report the percentage too? A gap of 50 billion dollars means something very different in a 1,000-billion economy than in a hypothetical 20,000-billion economy. The percentage puts every gap on the same footing, the way a growth rate did in Week 4.

What does the gap mean for people? Week 3 split unemployment into three types. Frictional unemployment is the ordinary time it takes to match with a job. Structural unemployment is a lasting mismatch of skills or places. Cyclical unemployment is the extra joblessness that appears when spending across the economy falls in a recession and that shrinks again in an expansion. In a recessionary gap, unemployment sits above its frictional-plus-structural level, so cyclical unemployment is positive. The idle excavators have idle drivers.

Misconception check. Students often read a recessionary gap as "the economy cannot produce more." It is tempting, because output is low. But the gap is measured against what the economy can produce. The workers, machines, and know-how are still there; they are idle. That is the Week 1 inside point again: attainable, and wasteful. The cure: say "could produce, is not producing."

Misconception check — the flipped sign. Students often subtract the other way, 950 − 1,000 = −50, and report a gap of "minus 50." The size is right, but a bare negative number hides which kind of gap it is. The cure: for a recessionary gap, subtract actual output from potential output, so the gap is a positive shortfall, and then name it in words: "a recessionary gap of 50 billion dollars."

In practice (your tools). In Google Sheets, type "Potential output" in A2 and 1000 in B2, then "Actual output" in A3 and 950 in B3. In B4, type =B2-B3; it shows 50. In B5, type =B4/B2*100; it shows 5. The formula in B5 divides by B2, potential output, never by actual output.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Describe a workplace you know, from a job you have held or watched closely, that had people or equipment sitting idle during a slow stretch. Explain in two sentences why that is a sign the business could produce more.
(b) Describe a stretch when someone you know looked for work for much longer than usual. Explain in two sentences whether that sounds more like frictional, structural, or cyclical unemployment, and why.

4. Measure an inflationary gap: above potential, in units and percent

Now flip the picture. An illustrative furniture factory normally runs one long shift. Orders pour in, so it adds a weekend shift, pays overtime, and runs its machines without the usual maintenance breaks. Output rises above normal. It cannot last forever. Workers tire, machines wear out, and the factory starts paying more for everything it buys, so it raises its own prices.

An inflationary gap is the excess of actual output above potential output, found as actual output minus potential output; workers and machines are stretched past normal, full use, and price pressure builds.

As a formula on one line: inflationary gap = actual output − potential output. Then divide by potential output and multiply by 100, the same second step as before.

Worked example — the illustrative output-gap economy, boom case. The same constructed economy, in a different year. Potential output is still 1,000 billion dollars.

Potential and actual output in the boom case of the illustrative output-gap economy, in billions of dollars
Measure	Billions of dollars
Potential output	1,000
Actual output	1,040

Subtract potential output from actual output. 1,040 − 1,000 = 40 billion dollars.
Divide by potential output. 40 ÷ 1,000 = 0.04.
Turn it into a percent. 0.04 × 100 = 4% of potential.

In words: this economy is producing 40 billion dollars beyond normal, full use, an inflationary gap of 4 percent of potential. On the diagram, its crossing sits 40 billion dollars to the right of the LRAS line.

Notice the two subtractions point in opposite directions. For a recessionary gap you take potential minus actual; for an inflationary gap you take actual minus potential. Either way, you get a positive distance, and the gap's name tells you which side of potential the economy is on.

Misconception check. Students often report a gap as a bare number: "the gap is 40." That leaves out half the story. A 40-billion-dollar gap is 4 percent of a 1,000-billion economy but a tiny fraction of a much larger one. The cure: report every gap twice, in billions of dollars and as a percentage of potential, and name its type.

In practice (your tools). In the same sheet, type "Actual output, boom" in A6 and 1040 in B6. In B7, type =B6-B2; it shows 40. In B8, type =B7/B2*100; it shows 4. Both percentage formulas divide by B2, so both gaps are measured against the same potential output.

5. Read a gap off the diagram: where versus which

Suppose you hear that a city's unemployment rate is high. That tells you where the city is. It does not tell you how it got there. Maybe its biggest employer closed. Maybe people stopped spending. Maybe fuel costs soared. The location and the cause are two separate questions. The AD–AS diagram keeps them separate too.

Where the economy sits is read from one comparison: is the crossing of aggregate demand and short-run aggregate supply to the left of the LRAS line, on it, or to the right?

Left of LRAS: actual output is below potential, a recessionary gap.
On LRAS: actual output equals potential, no gap.
Right of LRAS: actual output is above potential, an inflationary gap.

Which curve moved it there is a different question, answered with Week 5's habit: name the curve, name the direction, read the new P and Y.

Worked example — where, in the illustrative output-gap economy. Draw a vertical LRAS line at 1,000 billion dollars.

Recession case. The crossing is at 950. 950 is less than 1,000, so the crossing sits to the left of LRAS: a recessionary gap of 50 billion dollars, 5% of potential.
Boom case. The crossing is at 1,040. 1,040 is more than 1,000, so the crossing sits to the right of LRAS: an inflationary gap of 40 billion dollars, 4% of potential.

In words: the horizontal distance from the crossing to the vertical line is the gap, and the side it falls on is the gap's type.

Now the "which" question, described as a picture. In Week 5's illustrative linear pair, government spending rose, aggregate demand shifted right, and the crossing walked up the short-run aggregate supply line from (800, 12) to (900, 13). That pair has its own scale, separate from this chapter's economy, and Week 5 never placed its LRAS line. So you cannot say from the numbers alone whether that move opened a gap or closed one. If LRAS stood to the right of 900, the shift shrank a recessionary gap. If LRAS stood to the left of 800, the shift widened an inflationary gap. Where the economy sits depends on where LRAS stands.

Two very different causes can also put the economy in the same place. Picture two crossings, both to the left of LRAS.

In the first, aggregate demand shifted left, perhaps because households grew nervous and cut spending. Output and the price level both fell, together.
In the second, short-run aggregate supply shifted left, perhaps because of a jump in oil prices. Output fell, but the price level rose: Week 5's stagflation.

Both are recessionary gaps. The first came with falling prices and the second with rising prices. The gap tells you where; the price level helps tell you which.

Misconception check. Students often assume every recessionary gap comes from a fall in demand. It is a natural guess, because weak spending is the most familiar story. But a supply shock can open the same gap with rising prices instead of falling ones. The cure: read the gap's position first, then ask separately which curve moved, and check which way the price level went.

In practice (your tools). In Desmos, type x=1000 to draw a vertical LRAS line at potential output. Then type x=950 and x=1040 on two more lines to mark the two crossings. The first sits to the left of LRAS and the second to the right. Reading the horizontal distance between each line and x=1000 gives the two gaps, 50 and 40.

6. Explain why gaps last: expectations and SRAS

Think about an illustrative dental office that signed one-year contracts with its hygienists last spring, expecting prices to rise about 3 percent. Then the economy slows. Patients postpone cleanings. The office cannot cut the agreed pay this year, and when it renews the contracts, it will base the new raise on what it now expects prices to do. Those expectations shape the office's costs, and costs shape its prices.

Expected inflation is the rate of price increase that workers and firms anticipate and build into the wages and prices they set; a change in it shifts the short-run aggregate supply curve.

Week 5 listed expected inflation as one of the three shifters of short-run aggregate supply, along with input costs and productivity. This week you see why it matters so much: it is the force that can close a gap on its own, slowly, or keep a gap open.

Here is the slow, self-correcting story in words.

In a recessionary gap, many workers want jobs and many firms have spare capacity. Over time, wage demands soften and expected inflation comes down. Lower expected costs shift short-run aggregate supply to the right. The crossing slides down the aggregate demand line toward LRAS. Output drifts back toward potential, at a lower price level.
In an inflationary gap, workers are scarce and firms are straining. Wage demands rise and expected inflation goes up. Higher expected costs shift short-run aggregate supply to the left. The crossing slides up the aggregate demand line toward LRAS. Output returns toward potential, at a higher price level.
Self-correction is the process by which wages, prices, and expected inflation adjust over time and shift short-run aggregate supply until real output returns to potential output with no new policy.

Worked example — the direction of self-correction, in the illustrative output-gap economy. No new numbers; read the directions.

Recession case, actual output 950. The gap is recessionary, so expected inflation and wage demands fall over time. Short-run aggregate supply shifts right. Output rises toward 1,000; it needs to rise by 50, since 950 + 50 = 1,000. The price level falls.
Boom case, actual output 1,040. The gap is inflationary, so expected inflation and wage demands rise. Short-run aggregate supply shifts left. Output falls toward 1,000; it needs to fall by 40, since 1,040 − 40 = 1,000. The price level rises.

In words: in both cases the curve that does the correcting is short-run aggregate supply, and it moves toward the side that closes the gap.

So why can a gap last? Because the adjustment runs through sticky wages and prices and through expectations, and all of them move slowly. A worker on a one-year contract keeps last year's raise all year. A firm that expects 3 percent inflation keeps setting prices as if it will happen. If people keep expecting the same inflation, short-run aggregate supply does not move, and the gap stays open. Here is a caveat for you: how long "slowly" means is one of the big open questions in this course, and Section 8 shows why economists disagree about it.

Misconception check. Students often think that during self-correction, aggregate demand is the curve that moves back. It is tempting, because a fall in demand may have opened the gap. But in the self-correction story, nobody changes spending on purpose; wages and expectations adjust instead, and that is a shift of short-run aggregate supply. The cure: when the story is "wages and expectations adjust," name short-run aggregate supply as the curve that shifts.

7. Date a recession: the committee versus the rule of thumb

You may have heard a news anchor say, "Two straight quarters of shrinking GDP means we are officially in a recession." It sounds precise. It is a handy shortcut, and it is not how recessions in the United States are actually dated.

In the United States, recessions are dated by the National Bureau of Economic Research, a private research organization. It does the job through a committee. The Business Cycle Dating Committee is the group of economists at the National Bureau of Economic Research who decide the months of U.S. business-cycle peaks and troughs by weighing several monthly indicators of economic activity.

The committee calls a recession a significant decline in economic activity that is spread across the economy and lasts more than a few months. It weighs three things:

Depth: how far activity falls.
Diffusion: how widely the decline spreads across industries and regions.
Duration: how long the decline lasts.

It looks at several monthly indicators, not GDP alone, and it dates each peak and each trough by month.

The two-negative-quarters rule of thumb is a popular shortcut that calls a recession two quarters in a row of falling real GDP; it is not the official way U.S. recessions are dated.

Worked example — testing the rule of thumb on an illustrative quarter-by-quarter record. This record is constructed for this course.

Quarterly growth of real GDP and the state of other indicators in an illustrative economy
Quarter	Real GDP growth	Jobs, income, and spending
Quarter 1	−0.1%	rising in most industries
Quarter 2	−0.2%	rising in most industries

Apply the rule of thumb. Real GDP fell in two quarters in a row, so the rule of thumb says "recession."
Apply the committee's three questions. The decline in GDP is small, so its depth is slight. Jobs, income, and spending are still rising in most industries, so the decline is not spread across the economy. The committee would weigh all of that, not GDP alone.
Conclude. The rule of thumb and the committee's approach can disagree, and only the committee's judgment dates an official recession.

In words: two negative quarters is a signal worth watching, but a recession is judged by depth, diffusion, and duration across many indicators.

The reverse can happen too. A sharp, widespread decline in jobs and spending that lasts more than a few months can count as a recession even if quarterly GDP does not fall twice in a row. One more honesty note: the committee dates peaks and troughs only after the fact, once enough data are in to judge. That is why this course does not try to date any current episode in real time.

Misconception check. Students often state "two negative quarters" as the official definition of a recession. It is tempting, because it is short and you hear it everywhere. But it is a rule of thumb. The cure: say "a significant decline in activity, spread across the economy, lasting more than a few months, judged across several indicators," and call two negative quarters what it is, a shortcut.

8. Weigh self-correction versus intervention: two views at full strength

Suppose the illustrative economy sits in its recessionary gap, producing 950 billion dollars against a potential of 1,000. Cyclical unemployment is positive. Section 6 showed that self-correction will, in time, bring output back to potential. The question every recession raises is the next one: should the government or the central bank wait for that, or act to close the gap sooner?

Stabilization policy is deliberate action by a government or a central bank to shrink a recessionary or inflationary gap by shifting aggregate demand, instead of waiting for self-correction.

Economists answer the question from two traditions. Both use the same diagram. Each is stated here at full strength.

The Keynesian view. Wages and prices are sticky, so the adjustment in Section 6 can be very slow. While the economy waits, real people stay out of work and real output is lost for good. Aggregate demand drives short-run fluctuations, so a government or central bank that shifts aggregate demand to the right can close a recessionary gap far sooner than self-correction would. Positive claim: sticky wages and prices can keep an economy in a gap for a long time. Normative judgment: the cost of that lost output and those lost jobs is high enough to justify acting.

The classical and monetarist view. In the long run, prices are flexible, and potential output is the economy's anchor; the economy corrects itself. Policy that tries to fine-tune the cycle can arrive late, after the economy has already begun to recover, and can push it into the opposite gap. Predictable rules serve better than discretion. Positive claim: prices adjust and output returns to potential without new policy. Normative judgment: the risk of mistimed policy is high enough to justify restraint.

Here is what both sides agree on, stated plainly: the short run and the long run behave differently, and in the long run output returns to potential. What they dispute is how long the short run lasts and whether policy shortens it or makes it worse. Those are partly empirical questions and partly questions of values, and this course does not hand down a verdict. Next week gives you the government's tools so you can test both arguments with numbers.

Misconception check. Students often think one of these views is "right" and the other "outdated." Both are live traditions, and modern macroeconomics draws on each. The cure: for every claim, ask "Is this positive, something evidence can test, or normative, a judgment about what we ought to do?" Then give each side its strongest version before you weigh them.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Imagine you are a worker laid off in a recessionary gap. Write two sentences giving the strongest case for waiting for self-correction, and two giving the strongest case for intervention, each in that worker's own voice.
(b) Imagine you run a small business in a recessionary gap. Write two sentences on what you would want to know about how long self-correction takes, and two on what could go wrong if policy acted too late.

Key terms

Business cycle — The repeated rise and fall of real output around its long-run path, moving through four phases: an expansion, a peak, a recession, and a trough. (first used: 1. Trace the business cycle: four phases)
Expansion — The phase of the business cycle in which real output, jobs, and incomes rise, running from a trough up to the next peak. (first used: 1. Trace the business cycle: four phases)
Peak — The high point of economic activity at the end of an expansion, the month after which activity starts to fall. (first used: 1. Trace the business cycle: four phases)
Recession — A significant decline in economic activity that is spread across the economy and lasts more than a few months, running from a peak down to a trough. (first used: 1. Trace the business cycle: four phases)
Trough — The low point of economic activity at the end of a recession, the month after which a new expansion begins. (first used: 1. Trace the business cycle: four phases)
Actual output — The real output an economy is producing right now, shown on the AD–AS diagram where aggregate demand crosses short-run aggregate supply. (first used: 2. Locate potential output: the LRAS line and the crossing)
Output gap — The distance between actual output and potential output, reported in units of real output and as a percentage of potential output. (first used: 2. Locate potential output: the LRAS line and the crossing)
Recessionary gap — The shortfall of actual output below potential output, found as potential output minus actual output; workers and machines sit idle, and cyclical unemployment is above zero. (first used: 3. Measure a recessionary gap: below potential, in units and percent)
Inflationary gap — The excess of actual output above potential output, found as actual output minus potential output; workers and machines are stretched past normal, full use, and price pressure builds. (first used: 4. Measure an inflationary gap: above potential, in units and percent)
Expected inflation — The rate of price increase that workers and firms anticipate and build into the wages and prices they set; a change in it shifts the short-run aggregate supply curve. (first used: 6. Explain why gaps last: expectations and SRAS)
Self-correction — The process by which wages, prices, and expected inflation adjust over time and shift short-run aggregate supply until real output returns to potential output with no new policy. (first used: 6. Explain why gaps last: expectations and SRAS)
Business Cycle Dating Committee — The group of economists at the National Bureau of Economic Research who decide the months of U.S. business-cycle peaks and troughs by weighing several monthly indicators of economic activity. (first used: 7. Date a recession: the committee versus the rule of thumb)
Two-negative-quarters rule of thumb — A popular shortcut that calls a recession two quarters in a row of falling real GDP; it is not the official way U.S. recessions are dated. (first used: 7. Date a recession: the committee versus the rule of thumb)
Stabilization policy — Deliberate action by a government or a central bank to shrink a recessionary or inflationary gap by shifting aggregate demand, instead of waiting for self-correction. (first used: 8. Weigh self-correction versus intervention: two views at full strength)

Summary

The business cycle runs expansion, peak, recession, trough, and around again.
Potential output is the vertical LRAS line; actual output is the AD–SRAS crossing.
A recessionary gap is potential minus actual; an inflationary gap is actual minus potential.
Report every gap in billions of dollars and as a percentage of potential.
In a recessionary gap, cyclical unemployment is positive and resources sit idle.
Read where the economy sits first, then ask which curve moved it there.
Expected inflation shifts short-run aggregate supply, and slow expectations let a gap last.
A recession is dated by depth, diffusion, and duration, not by two negative quarters alone.
Self-correction versus intervention is argued from both sides; this course gives no verdict.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

An illustrative regional economy has potential output of 250 billion dollars and actual output of 240 billion dollars. Name the type of gap, compute it in billions of dollars and as a percentage of potential, and say what a student who subtracted the other way would write.
An illustrative island economy has potential output of 2,000 billion dollars and actual output of 2,060 billion dollars. Name the type of gap, compute it both ways, and say where the crossing sits relative to the LRAS line.
In an illustrative economy, real GDP shrinks by 0.3% in one quarter and grows by 0.1% the next, while jobs, income, spending, and production fall sharply in nearly every industry for seven months. Does the two-negative-quarters rule of thumb call this a recession? Explain why the Business Cycle Dating Committee's approach could reach a different conclusion.
An illustrative economy sits in an inflationary gap, and no new policy is used. Which curve shifts during self-correction, in which direction, and what happens to the price level and real output?

Answers (worked reasoning — read after attempting)

Actual output, 240, is below potential, 250, so this is a recessionary gap. Subtract actual from potential: 250 − 240 = 10 billion dollars. Divide by potential: 10 ÷ 250 = 0.04, and 0.04 × 100 = 4% of potential. The region is producing 10 billion dollars less than it could, a recessionary gap of 4 percent of potential. A student who subtracted the other way would write 240 − 250 = −10, a bare negative number that hides the gap's type; the fix is to subtract potential minus actual and name the gap.
Actual output, 2,060, is above potential, 2,000, so this is an inflationary gap. Subtract potential from actual: 2,060 − 2,000 = 60 billion dollars. Divide by potential: 60 ÷ 2,000 = 0.03, and 0.03 × 100 = 3% of potential. The crossing of aggregate demand and short-run aggregate supply sits 60 billion dollars to the right of the vertical LRAS line, so workers and machines are stretched past normal, full use and price pressure is building.
No. Real GDP fell in only one quarter, so the rule of thumb's test of two quarters in a row is not met. The committee asks about depth, diffusion, and duration across several monthly indicators. Here the decline is sharp, spread across nearly every industry, and lasts seven months, which is more than a few months. So the committee's approach could call it a recession even though the rule of thumb does not; the rule of thumb looks at GDP alone and misses the rest.
Short-run aggregate supply shifts left. In an inflationary gap, workers are scarce, so wage demands and expected inflation rise, and higher expected costs shift short-run aggregate supply to the left. The crossing slides up the aggregate demand line toward LRAS: the price level rises and real output falls back toward potential. It is not aggregate demand that moves, because in self-correction nobody changes spending on purpose; wages and expectations do the adjusting.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week fiscal policy and the spending multiplier give you the tools to test whether intervention can close a gap.

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