ECN 506 Chapter 12: Chapter 12

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4 Aug 2016
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Chapter 12: Short-Run Economic Fluctuation
Business cycle: short run (year-to-year) fluctuations in an economy’s output and unemployment
-firms will adjust their workforces as their output changes
-output is determined by total spending on goods and services by people, firms and governments
-spending and output shift because of the monetary policy and other factors
-the central bank can raise output in the short run by reducing interest rates or lower output by
raising rate
12.1 The Business Cycle
An economy’s output is the level of real gross domestic product (real GDP).
The unemployment rate (U) is the percentage of the labor force without jobs.
The business cycle is the short-run movements of real GDP and U around their normal
levels.
Long-Run Output and Unemployment
Output
Potential output (Y*) is the normal or average level of output, as determined by
resources and technology.
Potential output is determined by the number of workers and the amount of physical
capital and also the available technologies.
Potential output is the amount that can be produced with normal, not maximum,
utilization of resources.
Potential output grew at a rate of 1–2% annually in the 1970s and 1980s, but has
increased to 3% since the mid-1990s.
The growth rate of potential output fell in 2007 after the financial crisis and deep
recession.
Unemployment
The natural rate of unemployment (U*) is the normal or average rate of
unemployment.
Unemployment is at the natural rate when output equals potential output, and workers are
working at normal intensity.
There is always some unemployment because some workers are looking for jobs and
others lack necessary skills or live where few jobs are available.
Case Study
Since the natural rate cannot be observed, economists estimate it.
The estimated natural rate rose from 1960 to 1983 and then fell until 2002. Since then,
the natural rate began to rise again.
The entry of the baby boom generation into the labor force in the 1960s and 1970s
increased the natural rate since young workers have less training and experience more
frequent unemployment.
When productivity growth slowed in the 1970s firms could not afford to increase wages
as much as workers demanded, thereby increasing unemployment.
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Firms were able to raise wages more quickly than workers demanded when productivity
growth accelerated in the 1990s due to computers and technology, reducing
unemployment.
An aging workforce has lower unemployment since the percentage of younger workers
declined.
Is the increase in unemployment in 2008-2009 temporary or permanent or some of both?
If some of the increase is permanent, the natural rate, U*, has increased.
Hysteresis is the idea that a recession affects workers in ways that permanently increase
the natural rate.
-go to page 350, slide 11
Booms and Recessions
Potential output grows smoothly over time while actual output fluctuates erratically.
Unemployment also fluctuates from year to year, while the natural rate changes
gradually.
These short-run fluctuations around the long-run trends define the business cycle.
Output Fluctuations
An economic boom is a period when actual output exceeds potential output.
A recession is a period when actual output falls below potential output.
The size of booms and recessions is measured by the output gap.
The output gap is the percentage difference between actual and potential output:
Output gap = Ỹ = (Y-Y*)/Y*
The output gap is positive in booms and negative in recessions.
Slide 14, page 352
-5 percent means a recession with actual output of 5 percent
Unemployment Fluctuations
Unemployment rises above the natural rate in recessions and falls below it in booms.
In booms output is high and unemployment is low and in recessions unemployment is
high and output is low.
Firms hire more workers to produce a higher level of output and lay off workers when
output falls.
Okun’s Law
Okun’s Law is the relation between output and unemployment over the business cycle:
the output gap falls by 2 percentage points when unemployment rises 1 point above the
natural rate.
( YY* )/ Y* = –2( UU* )
If the natural rate (U*) is 6% and U increases to 8%, there is a negative output gap of
4%, indicating a recession:
( YY* )/ Y* = –2( UU* )
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= –2 ( 8% – 6%)
= –4%
If unemployment falls to 4%, the output gap is 4%, indicating a boom:
( YY* )/ Y* = –2( UU* )
= –2 ( 4% – 6%)
= 4%
-positive gap indicates a boom: output is 4 percent above potential
Slide 18
Case Study
What is a Recession?
The National Bureau of Economic Research (NBER), a private organization, has a
Business Cycle Dating Committee that sets the “official” dates for the beginning and end
of recessions.
The NBER recession is a period when output falls substantially, and all nonrecessionary
periods are expansions.
The NBER definition differs from the definition of “recession” in this book, but the
difference is not enormous.
The NBER has identified seven recession between 1960 and 2006 with an average length
of 11 months.
The most recent recession began in December 2007 and ended in June 2009, a recession
lasting 18 months.
As depicted in figure 12.5, more than one year after the recent recession ended, output
remained far below potential and unemployment exceeded the natural rate.
Aggregate Expenditure
Aggregate expenditure (AE) is total spending on an economy’s goods and services by
people, firms, and governments.
Total spending varies over time, causing the business cycle
A rise in spending means higher sales for firms, this leads to higher production(higher
output)
Increases in AE increase output and reduce unemployment, and vice versa.
The effects of AE on the economy were developed by John Maynard Keynes in his
famous book The General Theory of Employment, Interest, and Money.
He wrote during the Great Depression when output fell by more than 30%, and
potential output had not decreased sharply.
Effects of aggregate expenditure, page 356, slide 23
12.2 What Determines Aggregate Expenditure?
The Components of Expenditure
Aggregate expenditure has four components:
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