📈 What Is the Business Cycle?
Definition: The business cycle.
Four phases
- Expansion (recovery/boom) — real GDP is rising, unemployment falls, spending increases, confidence is high.
- Peak — the highest point before the economy starts to slow down.
- Contraction (recession/downturn) — real GDP is falling (a recession is technically two consecutive quarters of negative growth), unemployment rises.
- Trough — the lowest point before the economy starts recovering.
Draw the business cycle as a wave-like curve oscillating around an upward-sloping long-run trend line (potential GDP). Label the four phases clearly.
📐 Output Gaps
Definition: An output gap.
Two types
- Inflationary gap (positive output gap).
- Deflationary/recessionary gap (negative output gap).
On a business-cycle diagram: the wave above the trend line = inflationary gap. The wave below = deflationary gap. On an AD/AS diagram: equilibrium to the right of LRAS = inflationary gap; to the left = deflationary gap.
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🔧 What Drives Business Cycle Fluctuations?
- Demand-side shocks — changes in consumer confidence, investment, government spending, or exports that shift aggregate demand.
- Supply-side shocks — changes in oil prices, technology, natural disasters, or input costs that shift aggregate supply.
- Financial factors — credit availability, interest rate changes, asset price bubbles and crashes.
- External shocks — global recessions, pandemics, trade wars, geopolitical events.
Recent examples: The 2020 COVID recession was triggered by a supply shock (lockdowns) and a demand shock (collapsed spending) simultaneously. The 2022–23 inflation surge was driven by supply-side factors (energy prices, supply chain disruptions) combined with strong demand from stimulus spending.
Business cycles are not regular or predictable. The IB doesn't expect you to forecast them — just explain the phases, output gaps, and link cause → effect using AD/AS analysis.