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Lesson 1 of 7 · 13 min

What a business cycle is: classical, growth and growth rate cycles

A business cycle is a recurring but irregular swing in broad economic activity, and whether you date its peaks and troughs by the level of output, its gap to trend, or its growth rate changes when the turning points appear.

In short

Business cycles are recurrent expansions and contractions in economic activity that hit many sectors at about the same time.
They are recurrent but not periodic: they keep happening, but with different lengths (from about one year to over a decade) and intensities.
Classical cycle: swings in the level of activity (e.g. real GDP). Contractions are short, expansions long; outright falls in output are fairly rare.
Growth cycle: swings of actual output around its trend (potential), i.e. the output gap. This is how most economists think about the cycle.
Growth rate cycle: swings in the growth rate of activity. No trend estimate needed, and turning points show up earliest.
Order of peaks: growth rate cycle first, then growth cycle, then classical cycle. Growth cycle troughs come later than classical troughs.

A working definition

Output in a market economy does not grow in a straight line. It speeds up and slows down around a long-run path set by population, technology and capital. Business cycles are the recurring upswings and downswings in that output, broad enough to affect most of the economy rather than one industry.

Four features define them. They belong to economies organised mainly around business enterprises, not subsistence farming or central planning. They follow a sequence of phases, alternating upswings and downturns. The phases happen at about the same time across many activities. And they are recurrent but not periodic: no two cycles have the same length or depth, typically ranging from a little over a year to around ten or twelve years.

Short-run swings are driven by forces that shift aggregate demand and supply: expectations, politics, natural disasters and fiscal or monetary policy. History never repeats exactly, but the patterns are regular enough to be useful for analysis and forecasting.

Exam wording: cycles are recurrent, not periodic. If an option says cycles repeat at regular intervals or have similar durations, it is wrong.

Three ways to define the cycle

Because output usually trends upward, there is more than one way to say when it 'peaks'. Analysts use three cycle concepts, and mixing them up causes most of the confusion about timing.

The classical cycle tracks the level of activity, such as real GDP. A peak is the highest level before an outright fall; a trough is the lowest level before output rises again. Contractions are usually short and expansions long. It is little used in practice, because it does not separate short-run swings from the long-run trend and absolute declines in output are not that frequent.

The growth cycle tracks how far actual output sits above or below its trend (potential). Its peak is the largest positive output gap; its trough the largest negative gap. Time spent above and below trend is roughly equal. This view splits activity into a trend part and a cyclical part, which is how mainstream economists think, and it is the definition this module uses from here on.

The growth rate cycle tracks the growth rate of activity (e.g. quarterly GDP growth). It needs no estimate of potential output, and its peaks and troughs appear earliest of the three.

The three cycle concepts
Concept	What is measured	Peak means	Practical notes
Classical	Level of activity (real GDP)	Highest level before an absolute fall	Short contractions, long expansions; rarely used
Growth	Gap between actual and trend output	Largest positive output gap	Mainstream view; above- and below-trend spells of similar length
Growth rate	Growth rate of activity	Highest growth rate	No trend estimate needed; turns first

Trend output grows 0.5% a quarter and actual output swings 3% around it. The gap is largest in quarter 6 (growth cycle peak) but the level keeps rising until about quarter 8.7 (classical peak); the level bottoms around quarter 15.5, before the gap does in quarter 18. The classical contraction (about 7 quarters) is much shorter than the classical expansion that follows.

Why the turning points differ

Trend output keeps rising, so actual output can grow and still lose ground against trend. The gap stops widening as soon as actual growth drops to trend growth, which happens while output is still climbing. That is why a growth cycle peak comes before the classical peak: in the chart, the gap is largest in quarter 6, but the level keeps rising until about quarter 8.7.

At the bottom the logic reverses. Output can start rising (classical trough) while still growing more slowly than trend, so the gap keeps widening. The growth cycle trough comes after the classical trough: about quarter 15.5 for the level against quarter 18 for the gap.

The growth rate turns even earlier. Growth is fastest when the gap is closing at full speed, well before the gap itself is largest. So for peaks the order is: growth rate cycle, then growth cycle, then classical cycle.

In practice, people use the three definitions interchangeably, and the classical one rarely. When someone says growth is 'above potential', they are speaking growth-rate language about a growth-cycle idea. Always check which concept a statement assumes.

Same economy as above. Quarterly growth peaks around quarter 24, while the gap keeps widening until quarter 30, when growth has fallen back to the 0.5% trend. The growth rate cycle turns first.

Formula

Output gap (growth cycle measure): $\text{Output gap} = \frac{\text{Actual output} - \text{Potential output}}{\text{Potential output}}$
Positive: economy above trend (expansion/slowdown). Negative: below trend (contraction/recovery). The gap narrows whenever actual growth differs from potential growth in the direction of closing it.

Worked examples

Example 1 Is the gap closing?

Potential GDP of a euro area country is EUR 800bn and actual GDP is EUR 776bn. Next year potential grows 2.0% and actual GDP grows 3.5%. What are the output gaps in both years, and what does the change suggest?

Example 2 Which cycle has turned?

Quarterly real GDP growth in Norway has slowed from 1.2% to 0.6% over three quarters. Trend growth is 0.5% a quarter. Which of the three cycles has already passed a peak?

On the exam

Expect definition questions (recurrent vs periodic, which concept measures what) and timing questions: which cycle peaks first, and what a growth cycle peak or trough represents.

Calling business cycles periodic or of similar length. They are recurrent but irregular.
Treating any slowdown in growth as a growth cycle peak. The gap only starts closing once growth falls below trend.
Assuming the classical cycle is the standard. Most economists use the growth cycle (deviations from potential).
Getting the order of turning points backward: growth cycle peaks come before classical peaks, but growth cycle troughs come after classical troughs.

Check yourself

Q1The pattern of expansions and contractions in a business cycle is best described as:
Q2A business cycle defined as fluctuations of actual output around its long-term potential is a:
Q3Potential GDP is NOK 4,500bn and actual GDP is NOK 4,350bn. The output gap is closest to:
Q4Which cycle concept most likely identifies a cyclical peak first?
Q5A main advantage of the growth rate cycle over the growth cycle is that it:

0/5Check yourself

Answer the 5 questions: +10 XP for each one you get right first time.

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