ECON1002 · Introductory Macroeconomics
The Business Cycle & Output Gaps
The business cycle is the irregular fluctuation of real GDP around its trend — expansions and contractions punctuated by peaks and troughs — and a technical recession is two consecutive quarters of falling real GDP. The chapter formalises slack with potential output y* and the output gap = 100 × (Y − Y*)/Y*, distinguishing recessionary (Y < Y*) from expansionary (Y > Y*) gaps.
It is examined as an Okun's-Law calculation linking the output gap to the deviation of unemployment from its natural rate, and as concept MCQ on recession definitions and reading growth as the slope of a log-GDP plot.
What this chapter covers
- 011. Short-run fluctuations around trend: expansions & contractions, peaks & troughs (not periodic)
- 022. Technical recession = 2 consecutive quarters of negative real-GDP growth; growth recession = growth below trend
- 033. Logs & growth rates: growth ≈ log(yₜ₊₁) − log(yₜ); slope of a log-GDP plot = the growth rate
- 044. Potential output y* = output at normal resource use
- 055. Output gap = 100 × (Y − Y*)/Y*
- 066. Recessionary gap (Y < Y*): under-use, rising unemployment, falling inflation
- 077. Expansionary gap (Y > Y*): over-use, falling unemployment, rising inflation
- 088. Okun's Law: (Y − Y*)/Y* × 100 = −β(u − u*), β ≈ 2 in Australia
Okun's Law — output gap to unemployment
- 1 markWrite Okun's Law linking the output gap to the unemployment deviation: (Y − Y*)/Y* × 100 = −β(u − u*).
- 1 markSubstitute the gap and β: +4 = −2(u − u*) ⇒ (u − u*) = −2%. So unemployment is 2 percentage points BELOW the natural rate.
Key terms
- Business cycle
- The recurring but irregular pattern of expansions and contractions in real GDP around its long-run trend, marked by peaks (the top of an expansion) and troughs (the bottom of a contraction). Cycles vary in length and depth and are not periodic.
- Technical vs growth recession
- A technical recession is two consecutive quarters of negative real-GDP growth. A growth recession is a period when output grows but more slowly than trend/potential, so slack still rises even though GDP is not falling.
- Potential output (y*)
- The level of real GDP the economy produces when labour and capital are used at normal (full-employment) rates. It is a moving benchmark, not a ceiling — actual output can temporarily exceed it in a boom.
- Output gap
- The percentage deviation of actual from potential output: 100 × (Y − Y*)/Y*. Negative = recessionary gap (spare capacity, rising unemployment); positive = expansionary gap (over-heating, inflation pressure).
- Okun's Law
- An empirical link between the output gap and unemployment: (Y − Y*)/Y* × 100 = −β(u − u*), with β ≈ 2 in Australia. A 1-point rise in unemployment above the natural rate is associated with about a β-point negative output gap.
- Growth as a log slope
- Because log(yₜ₊₁) − log(yₜ) ≈ the growth rate of y, plotting GDP on a log scale turns a constant growth rate into a straight line, so the slope of a log-GDP graph reads off the growth rate directly.
The Business Cycle & Output Gaps FAQ
How is the business cycle examined in ECON1002?
Mostly as an Okun's-Law calculation — given the output gap and β, find how far unemployment is from its natural rate (or vice versa) — plus concept MCQ on the definitions: technical vs growth recession, peaks and troughs, and reading a growth rate as the slope of a log-GDP plot. Knowing the sign convention on the output gap is what wins the marks.
What is the difference between a recessionary and an expansionary output gap?
A recessionary gap is Y < Y* (a negative output gap): the economy is under-using resources, unemployment rises above the natural rate, and inflation tends to fall. An expansionary gap is Y > Y* (a positive gap): resources are over-used, unemployment falls below the natural rate, and inflation pressure builds. The sign of the gap drives both the unemployment and the inflation story.
Why is two quarters of falling GDP called a 'technical' recession?
Because it is a simple, mechanical rule of thumb — two consecutive quarters of negative real-GDP growth — rather than an official dating. Real recessions are judged on broader evidence (employment, income, spending), and an economy can have a 'growth recession' (growth below trend, rising slack) without ever meeting the two-quarter technical definition.
How does Okun's Law connect output and unemployment?
It says deviations of output from potential move opposite to deviations of unemployment from its natural rate: (Y − Y*)/Y* × 100 = −β(u − u*). With β ≈ 2, a 1-point rise in unemployment above u* corresponds to roughly a 2% recessionary output gap. It is the bridge that lets you translate a labour-market number into an output number and back.
Exam move
The decisive skill is the sign convention. Write Okun's Law with the minus on β every time — (Y − Y*)/Y* × 100 = −β(u − u*) — so a positive output gap always lands unemployment below u* and a negative gap above. Practise solving it both directions (gap → unemployment deviation and back). Memorise the recession definitions (technical = two negative quarters; growth recession = below-trend growth) and the peak/trough vocabulary for the concept MCQ, and remember that on a log-GDP plot the slope is the growth rate. Finally, pair the gap with its consequences — recessionary gap → rising u, falling inflation; expansionary gap → falling u, rising inflation — because that link feeds straight into the AD-AS chapter.
