MacroeconomicsI_working_version (1)

38
Chapter 5
The business cycle could be described as the more or less regular pattern of expansion
(recovery) and contraction (recession) in economic activity around the path of trend
growth (potential output).
We can distinguish among four distinct phases of the cycle. Unemployment, inflation and
growth all have clear cyclical patterns. At a point of cyclical peak, economic activity is
high relative to trend. Conversely, at a cyclical trough, economic activity is weak relative to
trend path of potential output. Inflation, growth and unemployment all have clear cyclical
patterns.
Peak
Output
Reccesion
Recovery
Trend
(Potential Output)
Trough
Figure 5.1 The business cycle.
The trend line in Figure 5.1 shows the trend path of real GDP. The trend path of GDP
corresponds to full-employment output when factors of production are fully employed.
Output does not always operate at its trend level, that is, the level corresponding to full
employment of the factors of production. Rather, output fluctuates around the trend path.
During an expansion (or recovery) the employment of factors of production increases,
which is a source of increased production. Output can rise above trend because people
work overtime and machinery is used for several shifts. Conversely, during a recession
unemployment declines and less output is produced than could be in fact produced with the
existing resources and technology. The cyclical deviations of output from trend are
represented by the wavy line in the figure. Departures of output from trend are referred to
as the output gap.
The output gap measures the difference between actual output and output the economy
could produce at full employment given the existing resources. Full employment output is
also called potential output.
Output gap ≡ potential output – actual output