On a graph with real GDP on the y-axis and time on the x-axis, the line representing GDP growth is not a straight line. The line is constantly going up and down.
Most people hope for the line to be straight, because that would show strong and sustained growth. The straight line shows the potential growth and the trend growth. The curvy line shows the actual GDP growth. Both lines are rising, but the actual growth is fluctuating. This constant fluctuation of GDP growth is the economic cycle.
The four stages in the economic cycle are the boom, recession, trough and recovery.
Boom: Here, growth is very strong, the economy is at the peak, employment levels are high and animal spirits are high. Firms are usually making high profits, there is lots of consumption, workers are being paid for overtime work, income is higher, there is a bigger demand for imports, tax revenue is very high and inflation is occurring. There is demand-pull inflation. The actual growth is greater than the potential/trend growth and there is a positive output gap. This can be visualised as the gap between the trend growth line and the actual growth line. Overall the rise of investment and consumerism means rising prices and production.
Trough: This is known as rock bottom. There is high unemployment, low animal spirits, low demand for imports, and the economy has just experienced a recession. The actual GDP growth is lower than the trend growth and therefore there is a negative output gap, seen on the graph as the gap between the actual growth line and the trend growth line. Firms begin destocking and lower prices to lure consumerism to try to maintain profits. There will be loose policy(eg lower interest rates) to stimulate growth. Overall the fall of investment and consumerism means falling prices and production.
Recovery: Investors believe that the economy has reached a trough, and it can’t get worse. They use the chance to buy shares and invest in companies as share prices are low. Since they believe the only way is up, they believe they will get very high returns on these investments. These investments lead to higher income, higher production and a rising Aggregate Demand. Consumer spending is increasing, house prices are rising and animal spirits begin to rise with employment. Loose policy is kept so that the economy doesn’t slip back into recession. This stage usually leads to the boom stage.
Recession: A recession is defined as two successive quarters of GDP decline. Usually the boom stage becomes unsustainable as the prices become too high and they don’t represent the real value of the assets. This means that some firms over-invest and get lower returns. Businessmen and women start to worry and pull out of investing. Prices then fall and profits fall. Income falls, employments falls due to lack of investment and confidence in consumerism falls. With this decline, aggregate demand is reduced as well, and the GDP is falling, leading to a trough.
One other major reason for fluctuations in GDP growth is the occurrence of shocks: events few can foresee. These are usually events that are bad for the economy and can lead to recession. They can be on the demand side or the supply side.
Demand-side shocks: Factors that end up reducing aggregate demand. Eg sudden increase in interest rates, sudden cut in government spending, sudden crisis(housing, banking, financial market), sudden increase in tax or a sudden strengthening in the exchange rates(therefore less net exports).
Supply-side shocks: Factors that reduce long run aggregate supply. Eg natural disasters. Factors that reduce short run aggregate supply. Eg sudden increase in wages, sudden increase in prices, sudden increase in VAT, sudden weakening of exchange rates(leads to imports being more expensive).