Real GDP does not grow in a straight line. It rises and falls around potential output, moving through expansion, peak, contraction, and trough. Drag the time slider or press play to walk through ten years of a made-up economy, then test yourself by naming the phase behind each news report.
The green line is potential output, which grows steadily as the economy gains resources and technology. The blue line is actual real GDP. Blue shading marks a recessionary gap and red shading marks an inflationary gap. All numbers are hypothetical.
The short-run ups and downs of real GDP around its long-run trend. Expansion rises to a peak, contraction falls to a trough, and a new expansion begins. Cycles are irregular: no two have the same length or depth.
The real GDP the economy produces when unemployment equals the natural rate. It is also called full-employment output. On the cycle graph it is the upward-sloping trend line; on the AD–AS graph it is where LRAS sits.
Output gap = actual real GDP − potential real GDP. As a percent: (actual − potential) ÷ potential × 100. A negative gap is a recessionary gap. A positive gap is an inflationary gap.
In a recessionary gap, cyclical unemployment pushes unemployment above the natural rate and inflation slows. In an inflationary gap, unemployment falls below the natural rate and inflation speeds up.
A recession is commonly described as two consecutive quarters of falling real GDP. That is a rule of thumb, not an official definition. In the United States, a committee at the National Bureau of Economic Research dates recessions using a broad set of indicators, including employment, income, sales, and production.
A recession is a point inside the PPC: resources such as workers and machines sit idle. Full employment is a point on the PPC. A recession does not shift the PPC, because the economy's resources and technology have not changed.
Memorize this table. Most multiple-choice questions on business cycles test one row of it.
| Phase | Real GDP | Unemployment | Inflation | Output gap | On the PPC |
|---|---|---|---|---|---|
| Expansion | Rising | Falling | Tends to rise as output passes potential | Recessionary early, can turn inflationary late | Moving out toward the curve |
| Peak | At its highest point, about to fall | At or near its lowest, often below the natural rate | Upward pressure is strongest | Usually inflationary (positive) | On the curve, resources stretched |
| Contraction (recession) | Falling | Rising, with more cyclical unemployment | Slows (disinflation), and the price level may fall | Shrinks and turns recessionary | Moving inside the curve |
| Trough | At its lowest point, about to rise | At or near its highest, above the natural rate | Downward pressure | Recessionary (negative) | Well inside the curve |
| Full employment | Equal to potential output | Equal to the natural rate (no cyclical unemployment) | Steady at the expected rate | Zero | On the curve |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 2.7. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 2 terminology guide.