ECO 3311 Ch 7: Overview of the Short Run

1. ECO 3311 Ch 7: Overview of the Short Run

2. Introduction • In this chapter, we learn: • how the gap between actual GDP and potential GDP—a gap we call short-run output—is a key measure of the economy’s performance in the short run • how costly fluctuations in economic activity can be • that the rate of inflation tends to decline when the economy is in a recession • a simple version of the short-run model that will help us understand these patterns

3. the long-run model is a guide to how the economy behaves on average. • at any given time, the economy is unlikely to exactly equal the long-run average

4. The Long Run, the Short Run, and Shocks • the long-run model determines potential output and long-run inflation • the short-run model determines current output and current inflation • potential output is the amount the economy would produce if all inputs were utilized at their long-run, sustainable levels

5. output may deviate from potential output because the economy can be hit by shocks • the short run is the length of time over which these shocks and deviations can occur. • in short-run models, we assume that the long run is given (it is determined by the long-run model, which is outside of the short-run model) • Potential output and the long-run inflation rate are exogenous

6. the current level of output and the current inflation rate are endogenous in the short-run model Trends and Fluctuations • output is equal to the long-run trend plus short-run fluctuations:

7. the long-run trend is potential output • the short-run fluctuations are the percentage change of deviations from potential GDP • fluctuation is equal to the difference in actual and potential output, expressed as a percentage of potential output • this short-run deviation, , is referred to as detrended output or short-run output:

9. Short-Run Output in the United States • fluctuations in U.S. GDP are relatively hard to see when graphed over a long period of time • The Great Depression was the large negative gap of the 1930s when actually output was well below potential • a recession begins when actual output falls below potential, that is, when short-run output becomes negative • a recession is over when short-run output starts to rise and become less negative

10. fluctuations in real GDP have mostly been between plus or minus four percent, since 1950 • during a recession, output is usually below potential for approximately two years, which results in a loss of about $2,400 per person • during a recession, between 1.5 million and 3 million jobs are lost • the costs of short-term fluctuations are much less than these numbers suggest because they do not incorporate the benefits of a boom

13. Measuring Potential Output • there is no directly observable measure of potential output in an economy • one way to measure it is to assume a perfectly smooth trend passes through quarterly movements of real GDP • an alternative is to take averages of the surrounding actual GDP numbers

14. an annualized rate is the rate of change that would apply if the growth rate persisted for an entire year • absent any way to measure potential output, economists must consult a variety of indicators The Inflation Rate • the rate of inflation typically peaks at the start of a recession and then falls during the recession

16. The Short-Run Model • the short-run model features an open economy where booms and recessions in the rest of the world impact the economy at home • the economy will exhibit long-run growth and fluctuations • central bank manages monetary policy to smooth fluctuations

17. The short-run model is based on three premises: 1. the economy is constantly being hit by shocks: • economic shocks are things such as changes in oil prices, technologies, spending, or disasters that cause fluctuations in output or inflation 2. monetary and fiscal policies affect output: • policymakers may be able to neutralize shocks to the economy

18. 3. there is a dynamic trade-off between output and inflation: • the government does not want to keep actual GDP as high as possible because a booming economy leads to an increase in the inflation rate • if inflation is high, a recession is usually required to lower it • the Phillips curve is the dynamic trade-off between output and inflation

19. A Graph of the Short-Run Model • the Phillips curve implies that a boom increases inflation and a recession decreases inflation • this implies a positive relationship between the change in inflation and short-run output

20. when an economy is booming, all firms are producing above potential • in order to do this, the firms must raise wages and perhaps delay maintenance on machines • firms are thus required to raise prices above the prevailing inflation rate for two reasons: 1. production is more costly 2. demand is higher because the economy is booming

21. because all firms are doing this, the inflation rate increases • firms cut costs and lay off workers because there is less demand for their products • thus the inflation rate will fall when all firms are cutting costs and demand is low

23. How the Short-Run Model Works • assume policymakers can select short-run output through an appropriate monetary policy • in 1979, inflation was increasing because of oil prices, so the Federal Reserve tightened monetary policy by raising interest rates • the policy induces a recession because higher interest rates discourage investment • as output declines, firms face lower demand and reduce costs • inflation falls dramatically

24. The Empirical Fit of the Phillips Curve • empirically, the slope of the relationship between the change in inflation and short-run output is approximately one-half • if output exceeds potential by 2 percent, the inflation rate increases one percentage point

26. Summary • the short-run model says that a booming economy leads the inflation rate to increase, and a slumping economy leads the inflation rate to fall

27. Okun’s Law: Output and Unemployment • in a recession, output is low and thus unemployment is high • Okun’s law provides a way to relate output and unemployment • cyclical unemployment is the difference between current unemployment and the natural rate of unemployment • the natural rate of unemployment is the rate of unemployment that prevails in the long run

28. plotting data for cyclical unemployment and short-run output yields Okun’s law, which says that the difference between the unemployment rate and the natural rate of unemployment is equal to negative one-half times short-run output: is the natural rate of unemployment u is the unemployment rate

30. Filling in the Details • the IS curve says that an economy’s output in the short run depends negatively on the real interest rate • the MP curve shows how monetary policy affects the real interest rate

31. Summary 1. The long-run model determines potential output and the long-run rate of inflation. The short-run model determines current output and current inflation. 2. In any given year, output consists of two components: the long-run component associated with potential output , and a short-run component associated with economic fluctuations . The latter component is called short-run output and is a key variable in our short-run model.

32. 3. Another way of viewing is that it is the percentage difference between actual and potential output. It’s positive when the economy is booming, and negative when the economy is slumping. A recession is a period when actual output falls below potential, so that short-run output becomes negative. 4. In the slump associated with a recession, the cumulative loss in output is typically about 6 percent of GDP – about $2,400 per person or $10,000 per family of four. The gains from eliminating fluctuations in short-run output are smaller than this, however, because of the benefits associated with a booming economy.

33. 5. An important stylized fact of economic fluctuations is that the inflation rate usually falls during a recession. This fact lies at the heart of our short-run model in the form of the Phillips curve. The Phillips curve captures the dynamic trade-off between output and inflation: a booming economy leads to a rising inflation rate, and a slumping economy to a declining inflation rate.

34. 6. The essence of the short-run model is that the economy is hit with shocks, which policymakers may be able to mitigate, and inflation evolved according to the Phillips curve. Policymakers use monetary and fiscal policy in an effort to stabilize output and keep inflation low and steady. This task is made difficult by the fact that potential output is not readily observed, and the economy is always being hit by new shocks whose effects are not immediately obvious.

35. 7. Okun’s law, which allows us to go back and forth between short-run output and the unemployment rate, says that a one percentage point decline in output below potential corresponds to a half percentage point increase in the unemployment rate.