Lecture: Business Cycles & Short-Run Fluctuations
Lecture script · about 15–20 minutes spoken · Week 6
Opening
Here's a question for this lecture. What is a recession, on the diagram and in your own life?
Think about a line cook at a busy restaurant. In a strong year, the restaurant adds a second dinner shift and raises wages to keep staff. In a weak year, the same cook is down to three nights a week. Or think about a construction crew waiting on the next contract, or a hospital billing office where overtime piles up. Whether those hours grow or shrink depends on where the whole economy sits, and one number tells you which side of normal it's on.
Here's where we are. In Week 3, Measuring Inflation & Unemployment, you met cyclical unemployment. In Week 4, Economic Growth & Productivity, you met potential output. In Week 5, Aggregate Demand & Aggregate Supply, you built the diagram and learned to name which curve shifts. In this lecture we put the crossing of the curves next to potential output and measure the distance.
Here's the plan. I'll walk you through the four phases of the business cycle, then place potential output on the diagram. We'll measure a recessionary gap and an inflationary gap, read each one off the picture, and see why a gap can last. Then we'll look at how recessions are officially dated, and end on a debate that Week 7, Fiscal Policy, picks up.
1. The business cycle has four phases
Picture a coastal town. For two or three years, almost every business adds workers. Then, over a few months, orders fall nearly everywhere at once, from the harbor to the hardware store. A year later, hiring starts again. Nobody scheduled any of it.
That's the idea. Here's the term. 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.
Let me name the four. 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. And a trough is the low point of economic activity at the end of a recession, the month after which a new expansion begins.
Here's a picture to hold in your head. Draw a straight line that rises gently from left to right. That's potential output, climbing as the economy grows. Now draw a wavy line that snakes above and below it. That's actual real output. The crests are peaks, the dips are troughs, and the climbs and falls between them are expansions and recessions.
One warning. The word "cycle" makes it sound like a clock. It isn't. Expansions and recessions differ a lot in length and depth.
Pause and try this. Activity reaches its highest level, and the next month it starts to fall. Which phase is that turning month?
Picture the crest of the wave.
Here's the answer. It's the peak. The peak is the high point at the end of an expansion, right before the decline starts.
2. Potential output is the LRAS line
Think about an illustrative hospital with 100 nurses. In a normal week, they cover every shift with ordinary overtime. That's the hospital's potential. In a slow month, some nurses go home early. In a flu surge, nurses work double shifts. For a while, the hospital runs above normal, at a cost.
The economy works the same way. You 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 the long-run aggregate supply line, a vertical line standing at potential output.
Now here's the new term. 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 picture the diagram. Real output runs along the bottom. The price level runs up the side. A vertical line rises from the bottom at potential output. Somewhere on the diagram, the downward-sloping aggregate demand line crosses the upward-sloping short-run aggregate supply line. Drop straight down from that crossing, and you've found actual output.
The two don't 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.
Pause and try this. On the diagram, which line shows potential output, and which point shows actual output?
Think vertical line versus crossing.
Here's the answer. The vertical long-run aggregate supply line shows potential output. Actual output is where aggregate demand crosses short-run aggregate supply.
3. A recessionary gap: below potential
Imagine an illustrative construction company that owns 20 excavators but has work for only 15 of them. Five machines sit in the yard, and their drivers are on short weeks. The company could build more. Nobody is paying it to.
That's the idea. Here's the term. 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.
Let's measure one. Our illustrative output-gap economy is built for this course, and it's measured in billions of dollars of real output. Its potential output is 1,000. In the recession case, its actual output is 950. Step one, subtract actual from potential: 1,000 minus 950 is 50, in billions of dollars. Step two, divide by potential: 50 divided by 1,000 is 0.05. Step three, multiply by 100. That's 5 percent of potential. In words, this economy is producing 50 less than it could, counted in billions of dollars, a recessionary gap of 5 percent of potential.
Why the percentage? Because a gap of 50, in billions of dollars, means something very different in a small economy than in a huge one. The percentage puts every gap on the same footing.
And here's the human side. Unemployment now sits above its frictional-plus-structural level. That extra joblessness is cyclical unemployment, from Week 3. The idle excavators have idle drivers.
One more trap. Some students subtract the other way, 950 minus 1,000, and write minus 50. Subtract potential minus actual, and name the gap in words.
Pause and try this. In the recession case, is the economy unable to produce more?
Think about where the workers and machines went.
Here's the answer. No, it can produce more. The workers and machines are still there, sitting idle, so the economy is producing less than it could.
4. An inflationary gap: above potential
Now flip it. An illustrative furniture factory normally runs one long shift. Orders pour in, so it adds a weekend shift, pays overtime, and skips maintenance breaks. Output goes above normal, and so do its costs, so its prices start to climb.
That's the idea. Here's the term. 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.
Back to the illustrative economy, in a boom year. Potential output is still 1,000. Actual output is 1,040. Step one, subtract potential from actual: 1,040 minus 1,000 is 40, in billions of dollars. Step two, divide by potential: 40 divided by 1,000 is 0.04. Step three, multiply by 100. That's 4 percent of potential. In words, this economy is producing 40 beyond normal, full use, counted in billions of dollars, an inflationary gap of 4 percent of potential.
Notice that the two subtractions point opposite ways. For a recessionary gap, it's potential minus actual. For an inflationary gap, it's actual minus potential. Either way you get a positive distance, and the name tells you the side.
And please, report every gap twice: in billions of dollars and as a percentage of potential. A bare "the gap is 40" leaves out half the story.
Pause and try this. Someone says, "The gap is 40." What two things are missing?
Think about units, percent, and type.
Here's the answer. The percentage of potential and the gap's type are missing. Say it in full: an inflationary gap of 40, in billions of dollars, and 4 percent of potential.
5. Where versus which
Suppose you hear that a city's unemployment rate is high. That tells you where the city is. It doesn't tell you how it got there. Maybe a big employer closed. Maybe people stopped spending. Maybe fuel costs soared. Location and cause are two separate questions.
On the diagram, "where" is one comparison. Is the crossing to the left of the vertical long-run aggregate supply line, on it, or to the right? Left means a recessionary gap. Right means an inflationary gap. In our illustrative economy, a crossing at 950 sits left of the line at 1,000, and a crossing at 1,040 sits to the right.
"Which" is Week 5's habit: name the curve, name the direction, read the new price level and output. Here's why the two questions need to stay apart. Two different shifts can land the economy in the same place. If aggregate demand shifts left, output and the price level both fall. If short-run aggregate supply shifts left, say after an oil-price jump, output falls but the price level rises. That's stagflation. Both crossings can sit left of the line. Same gap, two causes.
Here's another twist. In Week 5's illustrative pair, aggregate demand shifted right and the crossing walked from 800 to 900. Did that open a gap or close one? You can't tell until you know where the vertical line stands.
Pause and try this. A crossing sits left of the vertical line, and the price level has risen. Which curve most likely moved?
Think about which shift moves the price level and output apart.
Here's the answer. Short-run aggregate supply shifted left. An aggregate supply shift moves the price level and output in opposite directions, while an aggregate demand shift moves them together.
6. Why a gap can last: expectations
Think about an illustrative dental office that signed one-year contracts with its hygienists, expecting prices to rise about 3 percent. Then the economy slows. The office can't cut the agreed pay this year. When it renews the contracts, the new raise depends on what it now expects prices to do.
That's the idea. Here's the term. 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.
Here's the slow, self-correcting story. In a recessionary gap, many workers want jobs. Over time, wage demands soften and expected inflation falls. Short-run aggregate supply shifts right, and output drifts back toward potential at a lower price level. In an inflationary gap, it runs the other way. Expected inflation rises, short-run aggregate supply shifts left, and output returns toward potential at a higher price level.
That process has a name. 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.
So why can a gap last? Because wages and prices are sticky, and expectations move slowly. If people keep expecting the same inflation, short-run aggregate supply doesn't move, and the gap stays open.
Pause and try this. Our illustrative economy sits at 950 against a potential of 1,000. During self-correction, which curve shifts, and which way?
Think about what wages and expectations do when workers are idle.
Here's the answer. Short-run aggregate supply shifts right. Wage demands and expected inflation come down, so output rises back toward 1,000 and the price level falls.
7. How recessions are dated
You've probably heard someone say, "Two straight quarters of shrinking GDP means we're officially in a recession." It sounds precise. It isn't the official rule.
In the United States, recessions are dated by the 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.
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 depth, which is how far activity falls. It weighs diffusion, which is how widely the fall spreads. And it weighs duration, which is how long it lasts. It looks at several monthly indicators, not GDP alone, and it dates each peak and trough by month.
So what's the popular version? 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. It's a signal worth watching. It's not the definition.
One honest caveat. The committee dates turning points after the fact, once enough data are in. That's why this course never tries to date a current episode in real time.
Pause and try this. Real GDP falls two quarters in a row, but jobs, income, and spending keep rising in most industries. Does that settle the question?
Think about depth, diffusion, and duration.
Here's the answer. No, it doesn't settle it. The rule of thumb says recession, but the committee weighs many indicators, and here the decline isn't spread across the economy.
8. Wait, or act?
Let's go back to our illustrative economy, stuck at 950 against a potential of 1,000. Self-correction will bring it back, in time. So here's the question every recession raises. Should a government or a central bank wait, or act to close the gap sooner?
Here's the term for acting. 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 from two traditions, and I want you to hear each one at full strength. The Keynesian view says wages and prices are sticky, so self-correction can be very slow. While the economy waits, people stay out of work and output is lost for good. Shifting aggregate demand to the right can close the gap far sooner.
The classical and monetarist view says prices are flexible in the long run and potential output is the anchor, so the economy corrects itself. Policy that tries to fine-tune the cycle can arrive late and push the economy into the opposite gap. Predictable rules serve better than discretion.
Both sides agree that the short run and the long run behave differently. They disagree about how long the short run lasts, and whether policy shortens it. Part of that is evidence, which is positive. Part of it is values, which is normative. This course doesn't hand down a verdict.
Pause and try this. "Sticky wages can keep an economy in a gap for a long time." Is that a positive or a normative claim?
Ask whether evidence could test it.
Here's the answer. It's positive. Evidence can test how slowly wages adjust, while "we ought to act" would be normative.
Closing
Let me pull it together, in the order we built it. The business cycle runs expansion, peak, recession, trough, and around again. Potential output is the vertical long-run aggregate supply line, and actual output is the crossing. A recessionary gap is potential minus actual, like 1,000 minus 950, which is 50 in billions of dollars, or 5 percent of potential. An inflationary gap is actual minus potential, like 40 in billions of dollars, or 4 percent. Where the economy sits is one question, and which curve moved it there is another. Expected inflation shifts short-run aggregate supply, and slow expectations let a gap last. Recessions are dated by depth, diffusion, and duration, not by two negative quarters alone. And whether to wait or act is argued from both sides.
Next in this module come the slide deck, the Readings & Resources page, the lecture tutorial, the practice set, and the quiz. In Week 7, Fiscal Policy, you'll get the government's spending and tax tools, and the multiplier, so you can test the case for acting with numbers.
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