Let’s consider an example. Suppose you own a small chocolate factory in India. Most of the major festivals – Diwali, Eid, Dussehra, Christmas etc. lie during the second half of the year. During this festive season, lot of people buy your chocolate boxes to gift their loved ones. So every year, as the second half approaches, your weekly sales start increasing with more and more people buying chocolate boxes. Your weekly sales peak’s sometime in the middle of the second half of the year and then again starts decreasing slowly, as the first half of the next year approaches. It bottoms out during the middle of the first half of the next year and again starts increasing, as the festive half of the year approaches. If you try and plot your weekly sales, it might look something like the chart below. But this chart assumes that you are not growing and on an average, are producing the same number of chocolate boxes every year.
Now suppose, your company is experiencing rapid growth and producing and selling more and more chocolate boxes every year. You are opening new plants and rapidly expanding your operations. So average number of chocolate boxes produced by your firm, in a year, keeps on increasing with time, but you will still be facing same seasonal fluctuation in sales due to festivals. Now in this case, if you plot your weekly sales, it will look something like the chart below.
You can easily extend this concept to the whole economy. In this case we will plot GDP, instead of weekly sales. Now the time period might not be a fixed one, like one year in our example. It could be several years, and cycles could be smaller or bigger. Actual GDP during a period could fluctuate due to reasons like increased investments, reform oriented government, rising consumer spending etc.
During expansionary phase – GDP growth increases, unemployment rate is low and inflation increases. As explained in demand pull inflation, growth in GDP leads to higher income, resulting in higher spending. Increased spending drives prices higher, hence higher inflation. While in the case of contraction – GDP growth decreases (sometimes even becomes negative), unemployment rate increases and inflation decreases. Generally, when an economy enters the contraction phase and experiences two consecutive quarters of negative GDP growth, it is termed as recession.