Learning Outcomes
After studying this article, you will be able to: explain the phases and characteristics of business cycles; distinguish between business and credit cycles; evaluate economic indicators across the cycle; and analyze the significance of output gaps for economic growth. You will be able to apply these concepts in assessing macroeconomic conditions relevant to CFA Level 1 exam requirements.
CFA Level 1 Syllabus
For CFA Level 1, you are required to understand macroeconomic cycles, indicators, and output gaps and their implications for economic growth. Focus your revision on:
- Describing the business cycle and its phases
- Explaining the significance of output gaps and their measurement
- Interpreting economic indicators used to identify and track business cycles
- Comparing business and credit cycles and understanding their interactions
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What are the four phases of the business cycle, and what is the key characteristic of each?
- Which indicators are considered leading, coincident, and lagging in identifying business cycle phases?
- How is an output gap defined, and what does a negative output gap indicate?
- How do credit cycles interact with business cycles?
Introduction
Business cycles—alternating periods of economic expansion and contraction—are central to macroeconomics and practical analysis for the CFA exam. Understanding their phases, how to measure them, and the implications of an output gap is essential for interpreting macroeconomic conditions, growth prospects, and risks for investment decisions.
Key Term: business cycle
The recurring sequence of expansion (growth), peak, contraction (recession), and trough phases in aggregate economic activity, typically measured by changes in real GDP.Key Term: output gap
The difference between actual output (real GDP) and potential output (the level the economy can produce at full employment), indicating whether the economy is operating above or below its sustainable capacity.
The Phases of the Business Cycle
A standard business cycle consists of four main phases:
- Expansion – Rising output and employment, actual GDP grows faster than potential GDP, generally accompanied by improving confidence, investment, and sometimes rising inflation.
- Peak – The high point of the cycle where growth rate slows and economic activity reaches its maximum relative to potential output.
- Contraction (Recession) – Falling output and employment, actual GDP grows slower than (or falls below) potential GDP. Confidence, investment, and consumption typically drop, with unemployment rising.
- Trough – Lowest point in the cycle; economic decline ends and an upturn (recovery) begins.
The cycle is recurrent (keeps happening) but not strictly periodic—duration and magnitude vary.
Key Term: potential output
The level of real GDP that an economy can produce at full employment of resources, without generating inflationary pressure.
Output Gaps: Definition and Significance
The output gap signals the difference between actual GDP and potential output (full-employment output):
- Positive output gap (inflationary gap): Actual output exceeds potential, resources are overutilized, higher inflation pressure.
- Negative output gap (recessionary gap): Actual output is below potential, unemployment rises, lower inflation or deflation risk.
Monitoring the output gap is essential, as persistent gaps can indicate macroeconomic imbalances, inform policy decisions, and affect corporate performance and asset prices.
Worked Example 1.1
A country's actual real GDP is $950 billion. Economists estimate potential GDP at $1,000 billion. What is the output gap, and what could this imply?
Answer:
The output gap = $950b - $1,000b = –$50b (negative output gap). The economy is producing below capacity, suggesting higher unemployment and little inflation pressure.
Economic Indicators Across the Cycle
Recognizing which phase an economy is in relies on economic indicators:
- Leading indicators: Turn before the economy (e.g., new orders, stock market returns, building permits).
- Coincident indicators: Move with the economy (e.g., real GDP, employment, personal income).
- Lagging indicators: Change after the economy (e.g., unemployment rate, unit labor cost, business inventories).
Analysts monitor combinations of these to identify turning points, forecast trends, and assess risks.
Key Term: economic indicator
A statistic or data series (e.g., GDP, unemployment, new orders) used to assess the current phase and trends in the business cycle.
Business Cycles Versus Credit Cycles
While the business cycle focuses on output, the credit cycle tracks changes in the growth and availability of credit (loans and financing). Credit cycles can magnify expansions and recessions, as easy credit fuels booms and tightening credit exacerbates downturns. Severe credit contractions often lead to longer, deeper recessions and impair recoveries.
Worked Example 1.2
Suppose banks increase lending aggressively, spurring a boom in housing and investment. However, defaults later spike and banks sharply restrict new loans. What is the likely effect on the business and credit cycles?
Answer:
The initial credit expansion may magnify economic growth (and the boom), but the subsequent credit contraction may lead to a sharp, prolonged recession, deeper than if credit had been stable.
Exam Warning
Many candidates incorrectly associate "recession" only with two quarters of negative GDP growth. For CFA exam purposes, remember that a recession is best defined as a broad, significant decline in economic activity, as measured by several indicators, not just real GDP.
Output Gap Measurement and Policy Implications
Estimating potential output and the output gap requires judgment and is subject to revision. Policymakers use output gap estimates to guide monetary and fiscal interventions:
- Negative gap: Policy may be eased (stimulus) to boost growth and employment.
- Positive gap: Policy may be tightened to control inflationary pressures.
Persistent, large gaps may signal structural problems and justify targeted reforms or longer-term adjustments.
Key Term: recession
A significant decline in economic activity across the economy, lasting more than a few months and visible in real GDP, income, employment, and production.
Interpreting Indicators and Output Gaps for Growth
- Short-term: Large positive output gaps often precede periods of high inflation, while large negative gaps are linked to disinflation or deflation and rising unemployment.
- Long-term: Sustained large negative output gaps may reduce potential output, as lost investment, productivity, or labor force skills erode future growth.
Worked Example 1.3
An analyst observes unemployment rising and inflation falling, while real GDP is well below trend. What does this likely indicate about the output gap and current business cycle position?
Answer:
This likely indicates a large negative output gap and a contraction (recession) phase. Policy stimulus may be warranted to reduce unemployment and bring output closer to potential.
Summary
Business cycles describe the recurrent pattern of expansion, peak, contraction, and trough in aggregate economic activity. The output gap measures the difference between actual and potential GDP, identifying whether the economy is overheating or underperforming. Economic indicators—leading, coincident, and lagging—are essential for diagnosing the cycle phase and output gap, which are critical for growth and policy analysis in the CFA exam context.
Key Point Checklist
This article has covered the following key knowledge points:
- Describe the four phases of the business cycle and their characteristics.
- Define and interpret the output gap and its macroeconomic implications.
- Identify and classify economic indicators as leading, coincident, or lagging.
- Explain the difference between business cycles and credit cycles.
- Recognize the significance of output gaps for monetary and fiscal policy decisions.
Key Terms and Concepts
- business cycle
- output gap
- potential output
- economic indicator
- recession