Explaining the relationship between GDP and the business cycle can be quite difficult since it requires understanding both these terms individually. Both these terms are dependent on each other, though, and are a reflection of the nation’s economic health.
With regards to the aforementioned query and the following answer, we would be covering four broad spectrum’s of economic theory and thought. Adam Smith, Alfred Marshall’s logic, Keynesian thought for the demand and supply analysis, and the overall logic of macro and micro economics. To understand the relationship between GDP and business cycle, it is first necessary to understand the meaning of each of them and how they have an influence on each other.
Definitions and Meaning of GDP and Business Cycle
In this answer, it must be noted that no complex incomprehensible theories have been used, instead a simple logic has been used to back up the relationship in the two concepts. However before we take a look at how and why these conditions affect each other, it is essential to know the definition of the two concepts.
Gross Domestic Product
A gross domestic product is principally the total of all the goods and services which have been produced within a nation’s borders in one accounting year. The common formula for GDP goes as follows:
C + G + I + NX
Where C is the private consumption and spending, G is the government spending, I is the spending for business and NX is the difference between imports and exports. On the whole a GDP provides a great overview and indication of the production, spending and income earning capacity of the economy.
While reading the answer to the question, what is the relation between GDP and business cycle, note that here we will be dealing with 4 business cycles that affect the economic indicators and not the 5 classifications of business cycles that are based upon the time duration of cycle. The 4 business cycles include the following:
The economy of each and every nation goes through these changes continually, and there is no economy that has not experienced this cycle. These cycles are triggered by several factors such a lack of resources, laws, foreign policy, politics, war, economic health of the private sector, etc. The factors may affect the economic situation either collectively in individually. The change of cycle in a negative gear indicates that the balanced equilibrium of the economy has been disturbed and the economic machinery is not functioning in proper manner, and there is need for change.
Relation Between GDP and the Business Cycle
The aforementioned business cycles have a profound effect on the GDP. There is no specified theory or equation or rational formula that establishes the relation between the GDP and the business cycle, or the effect that a business cycle on a GDP. Also it must be noted every cycle, GDP and the status of the economy which it represents, is unique and every cycle has to be dealt with a different approach.
Here is what exactly happens with each cycle. Now to understand the table, imagine a fat ‘U’ that is the letter ‘U’ not ‘U’ as in ‘you’. Sorry ladies, for the rude shock. The left upper section of the U is ‘slump’. The tapering downward slope is a recession. The upward going slope is the ‘recovery’, and the portion above it is a ‘boom’.
|Business Cycle||Meaning||Characteristics and Merits||Demerits||Effect on GDP and National Economy|
|Slump||A slump is a time period where the equating balance of the equilibrium of the economy degrades due to some cause resulting into the drop in output and growth of the economy.||Common characteristics of the slump period includes a reduction in output which leads to reduction in demand. As customers start to spend lesser and save more as they ready themselves for a recession, an even greater drop in output is witnessed.||The confidence of the economy is shaken due to the slump and in this period, some businesses start to incur losses, bad debts and drop in the inward cash flow is observed. The comprehensive is accumulated in places such as savings accounts and the net drop in all outflow of goods occurs.||In this cycle, the GDP of the nation starts dropping and the key initiative of the people is to save and lessen spending. In this cycle, a distinctive rise in the imports is observed. So basically the GDP of the nation drops down as a result of decreased economic activity and lack in resource input and output sales values.|
|Recession||The grave follow-up of the slump cycle is the recession, where an acute and drastic drop in the level of total goods and products manufactured is seen. The only merit, per se being that the consumers in the economy go into a relatively healthy cycle of lots of savings and the less demand leads to a substantial drop down in the general price levels.||Negative aspects are not just substantial in number, but they also tend to have a substantial effect on the economy. The prominent effect is that the employment levels and the levels of production drop. Lack of proper resource supply, bankruptcy and high government spending are some of other important aspects of a recession||In this stage, the GDP drops down substantially due to decreased spending, unemployment and bankruptcy, a further decrease in the demand, decreases the level of production, together affect the GDP.||During the periods of recession the levels of GDP rapidly drop, often at alarming rates.|
|Recovery||Recovery is the process where the economy starts to recover from the reduced GDP and comes back to a normal status.||The principle characteristic of such an economic situation is that the production and economic activities are renewed and some of the crucial negative aspects of economy such as bankruptcy and unemployment are significantly curtailed, exports start increasing and imports are controlled or eliminated to the extent of achieving self sufficiency.||There are almost no or few potential demerits of such a state of the economy, a prominent problem being that this very state of the economy can lead out into a recessionary cycle.||A slow, steady and gradual rise in the GDP would be observed in such a recovery stage.|
|Boom||A boom is a period of substantial rise in the output and manufacturing volumes. In such a case the growth or the amount of inward cash flow goes on increasing and so does the volume of export.||This cycle results in a rapid growth, in monetary terms, quick profits, self-reliance, favorable trade and a drastic rise in overall income level of the population.||There is a strong chance of rise in the level of general inflation and there is also a substantial risk of facing what is known as overspending.||The GDP of the nation increases substantially in this time period.|
Apart from these aforementioned facts and effects there are several other factors that are bound to influence the GDP at the same time.