ISA, Grade 11 Economics Standard and Higher level, March 2024

UNIT 3: MACROECONOMICS
3.1 Measuring economic activity
Business Cycle

Real-world issue 1:
Why does economic activity vary over time and why does this matter?

Content:
● business cycle
○ short term fluctuations
○ long term growth trend (potential output)

Diagram / calculation
● Business cycle showing short term term fluctuations and long-term growth trend
(potential output)

Dept of command terms

● AO2 and AO4

Also see:
●

Learning objectives:
● Define the following terms: business cycle, potential output, boom, downturn, recession,
recovery, trough, expansion, contraction, actual output, long-term growth trend;
● Know that economies typically tend to go through a cyclical pattern characterised by the
phases of the business cycle;
● Distinguish between short-term fluctuations and long-term trend;
● Aware that economic growth is not constant in the short run;
● Using a business cycle, explain how economies go through a cyclical pattern of different
phases;
● Explain the long-term growth trend in the business cycle as the potential output of a
country;
● Distinguish between a decrease in GDP and a decrease in GDP growth;
● Aware that business cycle theories are heavily criticised;

GLOSSARY
Business cycle
The short-term fluctuations of real GDP around its long-term trend (or potential output).

Long-term growth
Growth over long periods of time. In the PPC model this is shown by outward shifts of the
PPC. When shown in the AD–AS model (the AD–AS model considers the AD and AS
curves together), it is shown by rightward shifts in the LRAS curve.

Long-term growth trend

1
Refers to average growth over long periods of time shown in the business cycle diagram as
the line that runs through short-term fluctuations, indicating changes in potential output

Potential output
Output produced by an economy when it is at full employment equilibrium, or long-run
equilibrium according to the monetarist/new classical model.

Growth in production possibilities

When the production possibilities of a country increase because of more/better resources
and/or better technology becoming available; illustrated by a shift outwards of the PPC.

Actual growth
Occurs when real output (real GDP) increases through time and is a result of greater or
better use of existing resources. In the PPC model it can be illustrated by a movement from
a point inside a PPC to another point in the northeast direction.

Economic growth
Refers to increases in real GDP over time.

Short-term fluctuations of economic activity

Periods of growth of real GDP followed by periods of contraction, which are part of the
business cycle.

Long run in microeconomics

The period of time when all factors of production are variable.

Long run in macroeconomics

The period of time when the prices of all factors of production, especially wages, change to
match changes in the price level.

Short run in macroeconomics

The period of time when the prices of factors of production, especially wages, are
considered fixed.

Short run in microeconomics

The period of time when at least one factor of production is fixed.

Recession
Occurs when real GDP falls for at least two consecutive quarters.

Automatic stabilisers
Institutionally built-in features (like unemployment benefits and progressive income
taxation) that tend to decrease the short-term fluctuations of the business cycle without the
need for governments to intervene.

2
Through the circular flow of income, you realise that in an economy which is in equilibrium
the total value of output would equal the total value of expenditures (spending) which would
equal the total value of income.

The circular flow of income makes clear that the total value of output, GDP, can change from
one period to the next. These changes are impacted by the relative sizes of the leakages and
injections. This is why GDP changes over time. Over time, certain economists have observed
an economy to go through certain patterns in growth rates. These theories are referred to as
business cycle theories. You do not need to know the different types which exist, but just the
general idea that economies go through a cyclical pattern of different phases in the short-run.

ASSIGNMENT 1
Complete the blanks below:
Most economies experience long-run economic growth. Many models assume this growth
rate to be consistent. Over time, this would be illustrated by a ________________ curve
when plotting GDP against time.

However in the short-run, economies grow at different rates from quarter to quarter. We could
therefore, distinguish different phases along a business cycle:
___________________ when the economy growth is above long-term trend growth;
___________________ when the economy starts to experience faster economic growth;
___________________ when the economy shrinks for at least two consecutive quarters;
___________________ when (negative) economic growth has reached it lowest value;
___________________ when the economic growth has reached its highest value.

ASSIGNMENT 2
Illustrate a business cycle identifying the following phases correctly along the cycle: boom,
peak, trough, recession, expansion, contraction, recovery, slump / depression, slow down.

Different values of economic growth

It is important to note the difference between rising growth and slowing (economic) growth.
In both cases, the total value of an economy is still increasing from one period to the next
(e.g. the economy has grown 0.8% compared to the previous quarter), but in the first case the
percentage growth is increasing (first quarter growth was 1.2% and second quarter growth is
higher at 1.6%) while in the second case the growth percentage is lower than it was before
(first quarter growth was 1.2% and second quarter growth is only 1.1%).

It is also possible for the growth rate to be a negative value. This means that the economy has
shrunk in size. The total value of the spending / income / production over a particular period
of time fell in that case. A decrease in output is not the same as a decrease in GDP growth. A
slowdown in growth is less of a negative than a fall in output.

It is clear that output and economic growth are not constant values. There will be periods in
which an economy grows fast (above the long-term trend, at a relatively high percentage),
while in other periods it may be that economic growth slows down, or is even negative.

3
Business cycle
A business cycle represents the changing levels of economic activity that an economy
experiences over time, measured by changes in real GDP (in billions or trillions of the local
currency) or real GDP growth figures (percentage). Each textbook names the different stages
of the business cycle slightly differently. In general, these are several of the different phases
along a business cycle: recovery, expansion (growth), boom, peak (overheating), downturn,
contraction, slump (recession), and trough.

A business cycle fluctuates around potential output or the so-called long-term trend growth of
a country. As a country increases its potential output over time as factors of production
increase in quantity and quality, there should be an upwards slope of the long-term business
cycle. In the short-run, however, there may be fluctuations below this growth rate.

In the past, business cycles were thought (and proven) to be extremely regular, with
predictable durations, but today they are widely believed to be irregular, varying in frequency,
magnitude and duration, if they already exist at all. However, economic growth does tend to
go through patterns, even though these may not be purely predictable. Economies recover
from a recession eventually, but the length of a recession may be different from country to
country and from time period to time period.

The long-term trend growth can be linked to the potential output of a country. However, an
economy does not have to be producing at potential output. There can be many reasons why
the quantity and quality of the available resources are not fully used. We will look at these in
more detail, when we look at the difference between the short-run and long-run aggregate
supply curves. Actual GDP growth can be compared with potential GDP growth or a trend
growth. This can be represented as follows as a simple business cycle.

Overheating economy
● Period of high economic growth resulting in high levels of inflation and peak;
● The central bank will usually raise the main interest rates;
Recession
● A period of two consecutive quarters in
which GDP falls (negative growth rate).
This means that production, employment
and real income all fall;
● Most recessions tend to have a length of
between 6 to 18 months;

Expansion
● Gross domestic product (GDP) is increasing and unemployment falls;
● Economy moves from a trough to a peak. It is a period when business activity
increases and gross domestic product expands until it reaches a peak;
● The start of the expansion phase is also known as "economic recovery".
For international economic growth rates see:
EU: https://ec.europa.eu/eurostat/tgm/table.do?tab=table&init=1&language=en&pcode=tec00115&plugin=1
USA: https://www.bea.gov/news/glance
World Bank: https://ec.europa.eu/eurostat/web/products-datasets/-/tec00115