Nominal and Real GDP does not grow smoothly. It rises for a while, then falls, then rises again. These swings change jobs (cyclical unemployment) and are called the business cycle. On a production possibilities curve, a recession is like moving to a point inside the curve.
Key idea
The business cycle has four phases: expansion (real GDP rises), peak (the high point), contraction (real GDP falls; a recession when it is large and lasting), and trough (the low point). Over the long run, real GDP moves around a rising trend of potential output, what the economy can produce with its resources fully employed.
Why it works
Spending, hiring and production feed one another: when spending rises, firms hire, and new paychecks raise spending again; when spending falls, the same loop runs in reverse. Meanwhile the economy's capacity grows steadily with more capital, workers and better technology. Real GDP can run below potential (a recessionary gap) or, for a while, above it (an inflationary gap), when workers and factories are pushed past their normal pace.
A worked example
Worked example: Reading the phases
Real GDP (billions of base-year dollars) for six years: 100, 103, 106, 104, 102, 105. Name the phase in each part.
- Years 1 to 3: real GDP rises, an expansion.
- Year 3 (106) is higher than the years on either side: the peak.
- Years 3 to 5: real GDP falls, a contraction.
- Year 5 (102) is the lowest point: the trough. After it, a new expansion begins.
Answer: Expansion, peak (year 3), contraction, trough (year 5)
In the United States, the National Bureau of Economic Research dates recessions. It looks for a significant decline in activity spread across the economy and lasting more than a few months, using jobs, income and spending as well as GDP. "Two quarters in a row of falling real GDP" is a common rule of thumb, not the official definition.
Common mistake
Confusing slower growth with a recession, or thinking potential output is the most an economy could ever produce. If real GDP grows 1% after growing 3%, the economy is still expanding. And output can run above potential for a while, with overtime and extra shifts. Check: is real GDP actually falling?
See it with real data: the growth rate of U.S. real GDP, quarter by quarter, on the Economic Data page, with recessions shaded.