Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 0 Short-Term...

Slide 12 - 1

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Short-Term Economic Fluctuations: An

Introduction

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Long Run vs. Short Run

The economic “climate” Long-run economic conditions are the

ultimate determinant of living standardsChanges in the economic “weather”

Short-run fluctuations are important to our day-to-day existence

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RecessionsRecession [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

DepressionA particularly severe or protracted recession

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RecessionsDuration

Length of recessionsPeak

The beginning of a recessionThe high point of economic activity prior to a

downturnTrough

The end of a recessionThe low point of economic activity prior to a

recovery

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Fig. 12.1Fluctuations in U.S. Real GDP,

1920-1999

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Expansions

ExpansionA period in which the economy is growing

at a rate significantly above normalNormally lasts longer than recessions

BoomA particularly strong and protracted

expansion

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Cyclical?

Cyclical fluctuationsBusiness cycles

Might imply that economic fluctuations are regular

However, economic fluctuations are quite irregular in their length and severity

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

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Characteristics of SR Fluctuations

Expansions and recessions areFelt throughout the economy and often

globallyFelt not just in a few industries

The unemployment rate Typically rises sharply during recessionsRises because of cyclical unemployment

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Characteristics of SR Fluctuations

RecessionsTend to be preceded by inflationTend to bring lower inflation rates

Durable goodsCars, houses, capital equipmentSensitive to fluctuations

Services and nondurablesFoodMuch less sensitive to fluctuations

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Potential Output

Potential output or Potential real GDPFull 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 timeY*

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Causes of RecessionA recession occurs when the economy is

growing significantly below its normal rateTwo possibilities

Actual output equals potential output, but potential output is growing slowlyAppropriate policy responses include long-run solutions

(Part VI)Promote saving, investment, technological innovation,

human capital formationActual output does not always equal

potential output (i.e., a recessionary gap)

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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 GDPY* is potential real GDP

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GapsRecessionary 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 outputA condition when an economy’s resources are

being over-utilized

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Fig. 12.3Actual and Potential Output

in Japan, 1980-2000

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Unemployment and Gaps

During a recessionary gapLow utilization of resources occurs

A high unemployment rate causes output to fall below potential

During an expansionary gapOver utilization of resources occurs

Low unemployment rateHence, output is higher than potential

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Types of UnemploymentFrictional

Short-term matching of workers and jobsAlways present

StructuralLong-term chronic—mismatch of skills of

workers and skills required for jobsAlways present

CyclicalExtra unemployment during periods of recessionOnly present during recessions

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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

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Cyclical UnemploymentCyclical unemployment: u - u*

Actual unemployment rate: uNatural rate of unemployment: u*

Recessionu – u* is positive (u > u*)Positive cyclical unemployment

Expansionu – u* is negative (u < u*)Negative cyclical unemployment: Labor is being

used more intensively than normal

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Okun’s Law

Okun’s LawEach 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

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Significant Costs

Output gaps and cyclical unemployment have significant costs1982 recessionary gap = $357 billion, in

1992 dollars1982 U.S. population = 230 millionHence, the output loss was around $1,550

per person or about $6,000 per family

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Reasons for Output Gaps1. Some prices adjust slowly

Firms “meet the demand” at a preset price in the short run

2. Economy-wide spending changesMajor cause of output gaps

3. Firms change pricesRaise 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

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