Economic Fluctuations

1. Economic Fluctuations • Neither output nor employment grows as smoothly and steadily as classical model predicts • As far back as we have data, United States and similar countries have experienced economic fluctuations • During recessions, output declines—occasionally sharply • During expansions output rises quickly—usually faster than potential output is rising • In later stages of an expansion, output often exceeds potential output • Called a boom • Why do economic fluctuations • Occur in the first place? • Sometimes last so long? • Not last forever?

2. Figure 1: Potential and Actual Real GDP 1950-2009

3. Figure 2: U.S. Unemployment Rate, 1960-2003

4. Can the Classical Model explain recessions? • Can the classical model explain • Why output falls in a recession? • Why employment falls in a recession? • Two potential explanations: • Labor demand curve shifts in. This will reduce employment and output. • Labor supply curve shifts in. This will also reduce employment and output. • Are either of these plausible explanations for recessions?

5. Figure 3: A Recession Caused By Declining Labor Demand?

6. Shifts in Labor Demand • Labor demand curve shifts leftward • Two potential explanations? • Workers become less productive and therefore less valuable to firms • What would make workers suddenly less productive? War that destroys equipment? • Firms want to produce less • Because they cannot sell all they produce • Classical model predicts that generalized overproduction does not occur (Say’s Law)

7. Shifts in Labor Demand • Neither explanation is plausible • Shifts in Labor Demand cannot explain recessions

8. Shifts in Labor Demand • What about booms? • Could a rightward shift of labor demand curve explain them? • A sudden increase in demand for output? • Not possible in the classical model. • Demand for output increases because of an increase in employment and output. • Not the other way round. • Workers suddenly become more productive? • This happens at a very slow pace.

9. Shifts in Labor Demand • Because shifts in labor demand curve are not very large from year to year • Classical model cannot explain real-world economic fluctuations through shifts in labor demand

10. Figure 4: A Recession Caused By Declining Labor Supply?

11. Shifts in Labor Supply • Explanation of recessions through shifts in labor supply has almost no support among economists • Remember that labor supply schedule tells us number of people who would like to work so an inward shift in labor supply means that fewer people want to work. • But in a recession unemployment rate goes UP. So more people are looking for a job, not fewer!

12. Shifts in Labor Supply • Same arguments could be made about expansions • We would have to believe that preferences suddenly change toward market work and away from other activities—an unlikely occurrence • But in an expansion fewer people are looking for work, unemployment is LOW! • Because sudden shifts of labor supply curve are unlikely to occur, and • Because they could not accurately describe facts of economic cycle • Classical model cannot explain fluctuations through shifts in supply of labor

13. Verdict: The Classical Model Cannot Explain Economic Fluctuations • Earlier chapters stressed that classical model works well in explaining movements of economy in longer run • Does a rather poor job of explaining economy in short-run • Cannot explain facts of short-run economic fluctuations with a model in which the labor market always clears • Classical model assumes market always clears

14. What Triggers Economic Fluctuations? • In a recession, millions of qualified people want to work at the going wage rate • But firms won’t hire them • In a boom, unemployment rate is so low normal job-search activity—which accounts for frictional unemployment—is short-circuited • Firms are less careful about whom they hire • Desperate to hire workers because production is so high • Booms and recessions are periods during which economy deviates from normal, full-employment equilibrium of classical model • Why do such deviations occur?

15. A Very Simple Economy • Imagine an economy with just two people; one that makes popcorn (P) and the other yoghurt (Y) and trade with each other. • Suppose there is a breakdown in communication • Y gets the impression that P wants less yoghurt so she reduces her production of yoghurt. P is offered less yoghurt so he reduces the popcorn he makes. • Total production in economy declines • Two traders will lose some of benefits of trading • Corresponds to a recession • Or, total output in economy rises if P believes Y wants more popcorn. • Corresponding to an expansion (even if Y doesn’t want more popcorn it has been produced).

16. A Very Simple Economy • Communication failure causes booms or recessions. • In an economy with just two people this is not very plausible but in the US economy with hundreds of millions of players, it is very probable.

17. The Real-World Economy • U.S. economy, has millions of businesses producing goods and services for hundreds of millions of people • When people spend their incomes, they give firms the revenue they need to hire workers…and pay them income • If any link in this chain is broken, output and income may both decline • Classical model, however, waves these potential problems aside • Assumes workers and firms, with aid of markets, can work things out and enjoy the benefits of producing and trading • Classical model is right • People will work things out…eventually • But in the meantime the economy could experience a recession. • A boom can arise in much the same way as a recession

18. Shocks • Economy is constantly buffeted by shocks. • A shock is an event that affects one sector • Which causes ripples in the rest of the economy • Spending shocks • Defense Spending • Oil Price Shock

19. Shocks That Push the Economy Away From Equilibrium • Each shock has momentum • Economy can continue sliding downward, and remain below potential output, for a year or longer • Same processes work in reverse during an expansion • Why doesn’t Say’s Law bring the economy back to Equilibrium? • Why can’t Say’s Law prevent recessions?

20. When Say’s Law Holds • Households save and supply these funds to the loanable funds market. • Spending shocks have no real effects

21. Households do not supply funds • Households increase savings, but do not supply it to the loanable funds markets • Worried about bank stability?

22. Banks do not loan out funds • Households put money in banks • Banks do not lend it out • Worried about repayments • Pessimistic about the future

23. Shocks That Push the Economy Away From Equilibrium • Booms and recessions do not last forever • Often, a change in government macroeconomic policy helps adjustment process along • Speeding return to full employment • Other times, a policy mistake thwarts adjustment process • Prolonging or deepening a costly recession, or exacerbating a boom and overheating economy even more

24. Where Do We Go From Here? • Classical model is useful • Helps us understand economic growth over time • How economic events and economic policies affect economy over long-run • But in trying to understand expansions and recessions we’ve had to depart from strict framework of classical model • But in short-run, we’ve seen that spending shocks to economy affect production • If we want to understand fluctuations need to take a close look at spending

25. Recent Expansions and Recessions