Short-Term Economic Fluctuations: An Introduction

1. Short-Term Economic Fluctuations: An Introduction

2. Long Run vs. Short Run • The economic “climate” • Long-run economic conditions are the ultimate determinant of living standards • Changes in the economic “weather” • Short-run fluctuations are important to our day-to-day existence

3. Recessions • Recession [or Contraction] • A period in which the economy is growing at a rate significantly below normal • A period during which real GDP falls for at least 6 consecutive months • Recent recessions have lasted between 6 and 16 months • Depression • A particularly severe or protracted recession

4. Recessions • Duration • Length of recessions • Peak • The beginning of a recession • The high point of economic activity prior to a downturn • Trough • The end of a recession • The low point of economic activity prior to a recovery

5. Fig. 12.1Fluctuations in U.S. Real GDP,1920-1999

6. Expansions • Expansion • A period in which the economy is growing at a rate significantly above normal • Normally lasts longer than recessions • Boom • A particularly strong and protracted expansion

7. Cyclical? • Cyclical fluctuations • Business cycles • Might imply that economic fluctuations are regular • However, economic fluctuations are quite irregular in their length and severity

8. Fig. 12.2U.S. Inflation, 1960-1999

9. Characteristics of SR Fluctuations • Expansions and recessions are • Felt throughout the economy and often globally • Felt not just in a few industries • The unemployment rate • Typically rises sharply during recessions • Rises because of cyclical unemployment

10. Characteristics of SR Fluctuations • Recessions • Tend to be preceded by inflation • Tend to bring lower inflation rates • Durable goods • Cars, houses, capital equipment • Sensitive to fluctuations • Services and nondurables • Food • Much less sensitive to fluctuations

11. Potential Output • Potential output or Potential real GDP • Full employment output • The amount of output (real GDP) that an economy can produce when using its resources, such as capital and labor, at normal rates • Grows over time • Y*

12. Causes of Recession • A recession occurs when the economy is growing significantly below its normal rate • Two possibilities • Actual output equals potential output, but potential output is growing slowly • Appropriate policy responses include long-run solutions (Part VI) • Promote saving, investment, technological innovation, human capital formation • Actual output does not always equal potential output (i.e., a recessionary gap)

13. Output Gaps • Output gap (Y* - Y) • The difference between the economy’s potential output and its actual output at a given point in time • Y is actual real GDP • Y* is potential real GDP

14. Gaps • Recessionary gap (Y* > Y) • A positive output gap, which occurs when potential output exceeds actual output • A condition when an economy’s capital and labor resources may not be fully utilized • Expansionary gap (Y* < Y) • A negative output gap, which occurs when actual output is higher than potential output • A condition when an economy’s resources are being over-utilized

15. Fig. 12.3Actual and Potential Output in Japan, 1980-2000

16. Unemployment and Gaps • During a recessionary gap • Low utilization of resources occurs • A high unemployment rate causes output to fall below potential • During an expansionary gap • Over utilization of resources occurs • Low unemployment rate • Hence, output is higher than potential

17. Types of Unemployment • Frictional • Short-term matching of workers and jobs • Always present • Structural • Long-term chronic—mismatch of skills of workers and skills required for jobs • Always present • Cyclical • Extra unemployment during periods of recession • Only present during recessions

18. Natural Rate of Unemployment • Natural rate of unemployment [u*] • The part of the total unemployment rate that is attributable to frictional and structural unemployment • The unemployment rate that prevails when cyclical unemployment equals zero • The unemployment rate that exists when an economy has neither an expansionary gap nor a recessionary gap

19. Cyclical Unemployment • Cyclical unemployment: u - u* • Actual unemployment rate: u • Natural rate of unemployment: u* • Recession • u – u* is positive (u > u*) • Positive cyclical unemployment • Expansion • u – u* is negative (u < u*) • Negative cyclical unemployment: Labor is being used more intensively than normal

20. Okun’s Law • Okun’s Law • Each extra percentage point of cyclical unemployment is associated with about a 2 percentage point increase in the output gap • Measured in relation to potential output

21. Significant Costs • Output gaps and cyclical unemployment have significant costs • 1982 recessionary gap = $357 billion, in 1992 dollars • 1982 U.S. population = 230 million • Hence, the output loss was around $1,550 per person or about $6,000 per family

22. Reasons for Output Gaps • 1. Some prices adjust slowly • Firms “meet the demand” at a preset price in the short run • 2. Economy-wide spending changes • Major cause of output gaps • 3. Firms change prices • Raise prices in response to expansionary gaps • Lower prices in response to recessionary gaps • 4. Economy self-corrects • Tends to eliminate output gaps in the long run