Introduction

In the last few articles, we looked at aggregate demand (“AD”), aggregate supply (“AS”), and how interaction between the two determines GDP within an economy. We explored in depth the differing opinions economists have on the shape of the long-run AS (“LRAS”) curve, and therefore whether an increase in AD will have an impact on price, output, or both (and in what proportions). This impacts on the type of policy used to grow GDP.

The shape of the LRAS curve at a particular point in time may correspond to the stage of an economy's business cycle, which we discuss further in this article.

Business cycles

Economies go through periods in which they experience growth and declines in GDP. The length and magnitude of each such period will vary depending on a number of factors.

This pattern of growth and decline - or boom and bust as you may have heard it called - is know as the business cycle.

There are debates about whether it can truly be called a cycle, because recessions may be caused by a multitude of factors, such as shocks to the economy (take the Covid-19 pandemic, or the Ukraine war and the impact on oil and gas prices, for example), which are not really cyclical. However, the term acts as a useful tool to understand the trajectory of an economy.

Depending on who you ask, there are 4 to 6 stages of a business cycle. We describe the cycle in 5 stages here.

1. The recovery  / upturn - this is the phase in which a contracting or stagnant (zero growth) economy starts to recover. As you will see, this period comes after a recession and trough, where there is likely to be spare capacity within an economy;
2. Expansion - the economy starts to grow at a faster rate, and the spare capacity starts to get used up. This leads to rising output (GDP), employment, and income levels. Consumer and business confidence typically improve, leading to increased spending, investment, and borrowing;
3. Peaking out - the rate of growth starts to slow or even stops. This could be caused by a growth in AD and the economy reaching near full employment (the AD intersects the LRAS curve at a point it is close to vertical), or there is no growth in AD despite there being spare capacity within an economy. At this point, signs of overheating may emerge, such as inflationary pressures, tight labour markets, and capacity constraints. Consumer and business confidence may plateau or start to decline as concerns about sustainability arise. Governments and central banks may also enact policy to control AD growth and reduce inflation;‍
4. Recession - the economy ceases to grow and goes into decline. This could be due to contractions in AS (a supply side recession) or AD (a demand deficient recession) or both. If the recession is caused by contractions in AD, spare capacity within an economy is likely to increase. Output, employment, and income levels begin to decline as demand weakens. Governments and central banks may enact policy in an effort to stem the recession and simulate growth;‍
5. Trough - the rate of decline within an economy bottoms out, ready for the recovery phase to start again. The decline of an economy may come to a halt because there is usually a minimum level of supply and consumption within an economy. Governments and central banks may also have changed policy as a result of seeing a decline, which could cause the decline to halt.

Below, we show the 5 stages on figure 1 - plotting GDP growth in each stage over time.

In figure 2, we show how a cycle could be caused by shifts in AD (using the Keynesian concept of LRAS). An increase in AD may cause an increase in GDP. However, as an economy reaches full capacity, an increase in GDP will cause a disproportionate increase in price compared to GDP (inflation). Accordingly, if AD continues to increase, citizens may be worse off.

An expansion or recession can also be caused by shifts in AS. We don’t model this here due to the disagreements between economists about the shape of the AS curve/s. However, it suffices to say that an increase in AS may cause growth, whereas a decrease in AS may cause a recession.

In reality, both shifts in AD and SRAS / LRAS may be working in tandem as a result of ordinary market forces, shocks to the economy, and/or government and central bank policy.

Conclusion

In this article, we’ve discussed the 5 stages of a business cycle, what is happening at each stage, and the supply and demand-side forces that could be causing each stage (either natural market forces, shocks to the economy, or government and central bank policy).

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