CHAPTER 3

ECONOMIC PERFORMANCE AND BUSINESS CYCLE

Introduction: Definition and concepts of the Business Cycle
One of the major concerns of macroeconomics is the upswing and downswings in the level of
real output called business cycle. Therefore, business cycle can be defined as a more or less
regular pattern of path or line fluctuating with the level of economic activity of a country or an
economy around the trend path. It shows alternating periods of economic growth and
contraction, which can be measured by the changes in real Gross Domestic Product (RGDP). The
total national output of a country changes from time to time depending on different negative and
positive factors.
Negative factors are factors that adversely affect total national output. For instance, drought
reduced agricultural output; civil wars or war between countries divert resources from production
to war and inappropriate economic policies mislead countries economic growth path. Thereby
leading to reduction or fall in total national output. The fall in total output is represented by
downward moving curve or path of the business cycle.
Positive factors increase the total national output. For instance, favorable climate conditions
increases agricultural output; political stability also helps people concentrate on production and
government use resources for production and good trade polices enable a country to get more
foreign exchange. These all increases total output (values of goods and services) of a country.
This increase in economic performance is depicted by increasing the path of the business cycle.
Since economic variables are related, any change in real Gross Domestic Product (RGDP)
brings similar changes in employment, trade and other key indicators of the economy. In other
words, all other aggregate economic activities get affected. The upswing and downswing in the
level of real output are cyclical in nature and move around its trend path. The trend path is given
by straight-line that shows the movement of the economy if is in full employment. In other
words, the trend path of aggregate economic activities is the normal path the indicators. (GDP,
employment, trade, Growth etc.) would take if factors of production were fully employed.
Phases of the Business Cycle
These phases are stages through which an economy passes to complete the business cycle (to
complete one cycle). These phases are Peak (Room), Contraction (Recession), Trough
(bottom) and Expansion (Recovery). Once completed, these phases repeat themselves. That
means, the sequence of changes is recurrent (is repeating itself), but not periodic and varies in
duration. The duration depends on factors like good or bad economic policies and favorable
or unfavorable natural conditions.

Sequence repeats itself in different length of period for different economies or different
countries. From “A” to ‘B’, to ‘C’ and the from ‘C’ to ‘D’, from the ‘D’ to ‘A’ to ‘B’ and so on.
Normal business cycles vary from one year to ten or twelve years. They represents a rise and fall
of a nation’s economic activities, such as GDP or GNP, inflation, growth and unemployment.
Contraction or recession follows bad economic policy (national or international) and bad natural
or social factors likes drought or conflict whereas expansion or recovery follows the opposite
factors like good economic policies or favorable natural factors.
During peak, economic activities reach their maximum after rising during a recovery. In
recession or contraction, generally economy witnesses a downturn in the business cycle during
which real GDP declines. During trough economic activities reach its minimum after falling
during recession. Recovery represents an upturn in the business cycle during which real GDP
rises. One can observe similar patterns in other economic indicators such as inflation, growth,
unemployment etc. The business cycle is depicted in the following figure (Figure 3.1).
We can see or understand from the figure on the next page (Figure 3.1) that economic activities
fluctuates from time to time leading to output fluctuations in the economy. In the figure, X-axis
represents the time period and Y-axis represents the aggregate economic activities. Trend Line is
indicated by the straight dotted line and business cycle which passes through points of actual
economic activity measured by GDP is shown by bold line.

Figure3.1Business Cycle
From ‘O’ to ‘P1’ in the figure, one can find that economy is above the trend line. This phase
is therefore, known as Expansion phase. Economy reaches its peak, which is at point ’P 1’.
From ‘P1’ to ‘T’ economy is in recession, which means economic activities are slowing
down. This trend is shown by the downward movement of the cycle. This phase is known as
Contraction phase. The figure depicts that contraction phase brings or leads to the bottom of
the economic activities, which is known as trough represented by pint ‘T’. From the figure
one perceives that from bottom point the economy again starts recovering because of some
corrective measures or favorable conditions created for the economy; i.e. expansion phase
begins. This process continues again that is by reaching peak followed by trough.
Sources of Economic Fluctuations: Sources and Characteristics of different phases of the
business cycle
 Why GDP moves from its trend path?
Over time, real GDP (which is a measure of aggregate economic activities) changes from two
reasons. First, more resources become available which allow the economy to produce more
goods and service, thereby resulting in rise of the trend level of output. Second, factors are
not fully employed all the time due to many reasons. Hence, economy produces below its
capacity and deviates from its trend path.
Each phase of the business cycle has its own sources or factors leading the economy to
take that phase. These phases have also some characteristics. Economic variables like total
output, employment or unemployment, aggregate demand for commodities and factors of
production have different values throughout the different phases of the business cycle.
For instance, economic recessions (or contractions) and economic troughs are the result of
the following major factors:
 Natural factors such as drought caused by shortage of rainfall;
 War which diverts resources from production;
 Inappropriate economic policies
 Underemployment of the existing economic resources or factors of production;
 And so on.

These phases are again characterized by the following cyclical recession or cyclical trough:
 Low output or GDP;
 High unemployment (or low employment);
 Low aggregate demand for both products and factors of production;
 Low per-capita income (PCI);
 And so on.

On the other hand, economic expansion (or recovery) and peak are the result of the following
major factors which are opposite to the factors that lead to cyclical recession and cyclical trough.
 Political stability;
 Use of appropriate economic or macroeconomic policies;
 Discovery and use of new economic resources of factors of production such as
minerals like petroleum or oil and deposits of precious metals like gold.
 Utilization of idle resources or factors of production such as labour;
 Use of improved quality workers through training and so on.
These phases of cyclical expansion or recovery and peak are characterized by:
 Higher aggregate output or GDP;
 Low unemployment (or high employment) of factors of production such as labour and
capital:
 High aggregate demand for products and factors of production:
 Larger percapita income (PCI); and so on
  The phases of business cycle show the movement of the economy at different periods.
Economy sometimes performs well and sometimes it lags behind from its trend path
which is nothing but the average performance of the economy. The deviation from the
trend path creates gap in the output which we are going to discuss now.

Business Cycle and Output Gap

Trend path is the level corresponding to full employment of the factors of production but actual
output fluctuates around the trend level. During expansion or recovery) the employment of
factors of production increases, and that is a source of increased production. Conversely, during
recession, unemployment increases and the output produced is below its capacity. Deviation of
output from trend is known as output gap. The output gap measures the gap between the
output the economy could produce at full employment (trend line) given the existing resources
and actual output (cyclical line). Full employment output is called potential output. Output gap
is the difference between potential output and actual output.
Output Gap = Potential Output (Trend) – Actual Output (Cyclical)
= Y1 - Ya
Where; Yt: is trend or potential output
Ya: is actual output or cyclical output

There are three possibilities of output gaps. That means the output gap can take three different
values.
Possibility 1: From A to B in the above figure, (Figure 3.1), when Actual output is
greater than the potential output which is given by the straight dotted line in the
figure. Here output gap is Negative.
Possibility 2: From B to C in the above figure, (Figure 3.1), when Actual output is less
than the potential output (the value on the straight line). Here output gap is
positive.
Possibility 3: At point A, B and C in the above figure when Actual output is exactly
equal to potential output. The two curves have equal values at the point of their
intersection. Here output gap is Zero.
Output gap allows us to measure the size of the cyclical derelictions deviations of output from
the potential output or trend output (deviation from the potential output that the economy can
produce with full capacity utilization of the existing resources).
a) A negative gap indicates that there is over employment, overtime for workers, more
utilization of the capacity of the machineries and so on.
b) A positive output gap indicates unemployment, underutilization of capacity and actual
out falls below the potential output.
c) A zero output gap indicate that we are or the economy is at full employment of existing
resources or factors of production.