Business Cycle Graph

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.

1. 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).
2. 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.
3. 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.
4. 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.

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.

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.

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.

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!