The business cycle describes the recurring fluctuations of an economy around its long-run trend, moving through four phases. During expansion, output, employment, and income grow. The peak marks the upper turning point, after which the economy enters contraction, also called a recession when sufficiently severe. The trough is the lowest point, after which a new expansion begins. A recession is commonly identified by two consecutive quarters of declining real GDP, though the U.S. National Bureau of Economic Research defines it more broadly as a significant decline in economic activity spread across the economy and lasting more than a few months. A depression is a particularly severe and prolonged recession, characterized by very large declines in GDP, extremely high unemployment, and often deflation.
Economists track leading economic indicators, such as stock market returns, building permits, consumer confidence, and new manufacturing orders, which tend to change before the broader economy turns. Lagging indicators, such as the unemployment rate and corporate profits, move after the economy has already shifted, confirming trends rather than predicting them.
Aggregate demand (AD) is the total quantity of goods and services demanded across the economy at a given overall price level and equals C + I + G + (X − M). The AD curve slopes downward for three reasons. The wealth effect holds that higher prices reduce the real value of money holdings, dampening consumption. The interest rate effect notes that higher prices increase money demand, pushing up interest rates and reducing interest-sensitive spending. The exchange rate effect observes that higher domestic prices make exports less competitive abroad while imports become relatively cheaper, reducing net exports.
Aggregate supply (AS) describes the total output firms are willing to produce at a given price level. In the short run, the SRAS curve slopes upward because wages and input prices are sticky, so a higher overall price level makes production more profitable and firms expand output. In the long run, the LRAS curve is vertical at potential output, reflecting that real output is determined by resources, technology, and institutions rather than the price level. Macroeconomic equilibrium occurs where AD intersects AS, determining both the equilibrium price level and real GDP.
Shifts in AD arise from changes in consumption, investment, government spending, net exports, or the money supply; for example, a tax cut shifts AD to the right. Shifts in SRAS result from changes in input prices, productivity, technology, or supply shocks: a spike in oil prices shifts SRAS leftward, while a productivity breakthrough shifts it rightward. Sudden, unexpected events, called demand shocks or supply shocks, can push the economy away from equilibrium, producing booms, recessions, or stagflation depending on which curve shifts and in which direction.