Booms and recessions
Economies do not grow smoothly. They move through periods of expansion and contraction known as business cycles.
The business cycle
The business cycle is the pattern of fluctuations in real GDP around its long-run trend. It has four phases: expansion (output and jobs rising), peak (the high point), contraction or recession (output falling), and trough (the low point before recovery). Cycles are irregular in length and depth.
Defining a recession
A common rule of thumb defines a recession as two consecutive quarters of falling real GDP. In the US, the National Bureau of Economic Research (NBER) officially dates recessions using a broader set of indicators, including employment, income, and industrial production, defining a recession as a significant, widespread decline lasting more than a few months.
Recent recessions
Major recent US recessions include the 2001 recession after the dot-com bust, the Great Recession of December 2007 to June 2009, the longest since World War II, and the very short but deep COVID-19 recession from February to April 2020. The Great Depression of the 1930s remains the most severe, with US output falling by about a quarter.
Potential output and the output gap
Potential output is the level of real GDP the economy can produce when resources are fully employed without rising inflation. The output gap is actual minus potential output. In a recession, the gap is negative (spare capacity, high unemployment); in a boom, positive (overheating, rising inflation).
Okun's law
Okun's law is an empirical relationship between output and unemployment: roughly, each 1% that real GDP falls below potential is associated with about half a percentage point higher unemployment in the US. It explains why recessions bring rising joblessness.
Economic indicators
Leading indicators tend to change before the economy as a whole: stock prices, building permits, new orders, consumer expectations, and the slope of the yield curve. Coincident indicators move with the economy, such as industrial production and employment. Lagging indicators change afterward, such as the unemployment rate and inflation.
The yield curve
The yield curve shows interest rates on government bonds of different maturities. Normally long-term rates are higher than short-term ones. When short-term rates rise above long-term rates (an inverted yield curve), it has historically often preceded US recessions, though not perfectly; the inversion of 2022-2023 was not followed by a recession in that period.
Worked example
Potential GDP is 20 trillion dollars, but actual GDP falls to 19.4 trillion, an output gap of -3%. Using Okun's law with a coefficient of 0.5, unemployment would be about 1.5 percentage points above its natural rate: if the natural rate is 4.5%, unemployment would be near 6%.
Key takeaways
Business cycles move through expansion, peak, contraction, and trough. A recession is a significant, widespread decline in activity; the NBER dates US recessions. Recent major recessions include 2007-2009 and the brief COVID-19 recession. The output gap compares actual and potential output. Okun's law links output gaps to unemployment. Leading indicators, including the yield curve, can signal turning points.
Flashcard
Fluctuations of GDP around trend
Check your understanding
Which of these is a lagging indicator?