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Introduction to Economic Fluctuations
Chapter 10
Short-Run Fluctuations
• In chapter 3, we have discussed the behavior of an economy in the long run
• In the short run, the economy fluctuates around its long-run path
• We need to understand why these fluctuations happen
– what can be done to stabilize the economy when fluctuations occur
BUSINESS-CYCLE FACTS
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Some facts about the business cycle
• RGDP growth averages 3 to 3.5 percent per year in the US over the long run
• But there are large fluctuations in the short run.
• Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP.
• Unemployment rises during recessions and falls during expansions. – Okun’s Law: there is a reliable negative relationship
between the GDP growth rate and changes in the unemployment rate.
-4
-2
0
2
4
6
8
10
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Growth rates of real GDP, consumption
Percent
change
from 4
quarters
earlier
Average growth
rate
Real GDP growth rate
Consumption growth rate
-30
-20
-10
0
10
20
30
40
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Growth rates of real GDP, consumption, investment
Investment growth rate
Real GDP growth rate
Consumption growth rate
Percent
change
from 4
quarters
earlier
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3
0
2
4
6
8
10
12
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Unemployment
Percent
of labor
force
-4
-2
0
2
4
6
8
10
-3 -2 -1 0 1 2 3 4
Okun’s Law
Percentage
change in
real GDP
Change in unemployment rate
3 2Y
uY
1975
1982 1991
2001
1984
1951 1966
2003
1987
2008
1971
2009
Okun’s Law - what this equation says:
3 2Y
uY
At “steady state”, when ΔU = 0…
the growth rate in RGDP is equal to 3%.
One extra percentage point of unemployment cost 2 percentage points in RGDP growth.
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Okun’s Law 3 2
Yu
Y
Can solve for ∆𝑌
𝑌 needed to reduce U by a stated
amount.
Suppose you want to reduce unemployment by 1 percentage point in one year, i.e., ΔU = - 1:
∆𝒀
𝒀 = 3 – 2(-1) = 5%
For ΔU = - 2: ∆𝒀
𝒀 = 3 – 2(-2) = 7%
Okun’s Law Can also look at Okun’s Law as relating the change of
the unemployment rate to the growth rate of GDP relative to the trend or “natural” rate of growth, where trend = 3%.
Ut – Ut-1 = -0.5(∆𝑌
𝑌 - 3%)
If ∆𝑌
𝑌 < 3% => U increases.
∆𝑌
𝑌 = 1% => ΔU = +1 percentage point
In today’s world the constant term (trend GDP
growth) is estimated to be around 2.2%.
Index of Leading Economic Indicators
• Published monthly by the Conference Board.
• Aims to forecast changes in economic activity 6-9 months into the future.
• Used in planning by businesses and government, even though ILEI is not a perfect predictor.
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Components of the ILEI
• Average workweek in manufacturing
• Initial weekly claims for unemployment insurance (–)
• New orders for consumer goods and materials
• New orders for nondefense capital goods
• ISM new orders index
• Building permits issued for private housing units
• Index of stock prices
• Leading Credit Index
• Interest rate spread (yield on 10-year Treasury bonds minus the federal funds rate)
• Index of consumer expectations
Index of Leading Economic Indicators, 1970-2012
Source:
Conference
Board
0
10
20
30
40
50
60
70
80
90
100
110
120
1970 1975 1980 1985 1990 1995 2000 2005 2010
200
4 =
100
SHORT-RUN PRICE STICKINESS IS THE ROOT CAUSE OF FLUCTUATIONS
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Time horizons in macroeconomics
• Long run Prices are flexible, respond to changes in supply or demand.
• Short run Many prices are “sticky” at a predetermined level.
The economy behaves very
differently when prices are sticky.
Recap of classical macro theory
• Output is determined by the supply side: – supplies of capital, labor
– Technology
– Y = F(K, L)
• Changes in demand for goods and services (C, I, G) only affect prices (r), not output.
• Assumes complete flexibility of overall price level (P).
• Applies to the long run.
When prices are sticky…
… output and employment also depend on demand,
And demand is affected by:
– fiscal policy (G and T)
– monetary policy (M)
– other factors, like exogenous changes in C (e.g., change in wealth) or I (e.g., change in expected profit)
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The role of price stickiness
• When P is flexible, recessions would not occur – Under price and wage flexibility, if a recession did
occur it would quickly be over …
– … because unemployed workers would accept lower and lower wages, prices would drop, and customers would flock to the malls, thereby ending the recession
• To explain why recessions do in fact occur, we therefore need to assume that prices are sticky or rigid
“Price Stickiness”
• Price stickiness does not necessarily mean that the overall level of prices (P) is constant
• All that price stickiness means is that P has stopped responding to the economic factors that you would expect to affect P
The model of aggregate demand and supply
• Shows how the price level and aggregate output are determined
• Shows how the economy’s behavior is different in the short run and long run
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Aggregate demand
• The aggregate demand curve shows the relationship between the price level and the quantity of output demanded.
• Chapters 11-13 develop the theory of aggregate demand in more detail.
Y
P
AD
Aggregate supply in the long run
• Recall from Chapter 3: In the long run, output is determined by factor supplies and technology
, ( )Y F K L
is the full-employment or natural level of
output, at which the economy’s resources are
fully employed.
Y
The long-run aggregate supply curve
Y
P LRAS
does not depend on P, so LRAS is vertical.
Y
( ) ,
Y
F K L
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Aggregate supply in the short run
• Many prices are sticky in the short run.
• For now (and through Chap. 12), we assume
– all prices are stuck at a predetermined level in the short run.
– firms are willing to sell as much at that price level as their customers are willing to buy.
• Therefore, the short-run aggregate supply (SRAS) curve is horizontal:
The short-run aggregate supply curve
Y
P
PSRAS
The SRAS curve is horizontal:
The price level is fixed at a predetermined level, and firms sell as much as buyers demand.
The short-run aggregate supply curve
Y
P In Chapter 13 the SRAS curve is upward sloping
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The aggregate supply curve
Y
P LRAS
( ) ,
Y
F K L
SRAS
SRAS’
The role of shocks
• Price stickiness helps us explain why an economy that has fallen into a recession may continue in a recession
• But price stickiness does not explain why the economy got into trouble in the first place
• For that we need shocks that can explain why businesses may suddenly see there customers stop buying
The role of shocks Demand Shocks • Consumption function: C = C0 + mpc(Y – T) • Investment function: I = Io − Irr • Fiscal policy (G and T) • Monetary policy (M)
Supply Shocks • Input costs (Business costs). For example, costlier
imported oil.
These shocks can throw an economy off its long-run path • Price stickiness then impedes a quick bounce back to the
long-run path
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STABILIZATION POLICY
Fiscal and Monetary Policy • We saw in chapter 3 that, in the long run, changes
in G and T have no effect on Y
• In the short run, G and T can affect Y
• We have seen that, in the long run, changes in M affect only P and have no effect on Y – Recall “classical dichotomy” and “monetary neutrality”
from chapter 5
• In the short run, M cannot affect P, which is sticky, but it can affect Y
• Therefore, G, T and M can be used to stabilize Y and other economic variables
CASE STUDY: SHOCKS TO BUSINESS COSTS
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Supply shocks • A supply shock alters production costs, affects the prices
that firms charge. (also called price shocks)
• Examples of adverse supply shocks:
– Bad weather reduces crop yields, pushing up food prices.
– Workers unionize, negotiate wage increases.
– New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance.
• Favorable supply shocks lower costs and prices.
CASE STUDY:
The 1970s oil shocks
• Early 1970s: OPEC coordinates a reduction in the supply of oil.
• Oil prices rose 11% in 1973 68% in 1974 16% in 1975
• Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.
CASE STUDY:
The 1970s oil shocks
Predicted effects of the oil shock:
• inflation
• output
• unemployment
…and then a gradual recovery.
0%
10%
20%
30%
40%
50%
60%
70%
1973 1974 1975 1976 1977
4%
6%
8%
10%
12%
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
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CASE STUDY:
The 1970s oil shocks
Late 1970s:
As economy was recovering, oil prices shot up again, causing another huge supply shock!!!
0%
10%
20%
30%
40%
50%
60%
1977 1978 1979 1980 1981
4%
6%
8%
10%
12%
14%
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
CASE STUDY:
The 1980s oil shocks
1980s:
A favorable supply shock-- a significant fall in oil prices.
As the model predicts, inflation and unemployment fell:
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
1982 1983 1984 1985 1986 1987
0%
2%
4%
6%
8%
10%
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
