McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 17: Short-term Economic Fluctuations

1. Identify the four phases of the business cycle

2. Explain the primary characteristics of recessions and expansions

3. Define potential output, measure the output gap, and analyze an economy's position in the business cycle

4. Define the natural rate of unemployment and relate it to cyclical unemployment

5. Apply Okun's law to analyze the relationship between the output gap and cyclical unemployment

6. Discuss the differences between how the economy operates in the short run and the long run

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Recessions and Expansions

• Business Cycles are short-term fluctuations in GDP and other variables

• A recession (or contraction) is a period in which the economy is growing at a rate significantly below normal– A period during which real GDP falls for two or more

consecutive quarters– A period during which real GDP growth is well below

normal, even if not negative– A variety of economic data are examined

• A depression is a particularly severe recession

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Recessions and Expansions

• A peak is the beginning of a recession– High point of the business cycle

• A trough is the end of a recession– Low point of the business cycle

• An expansion is a period in which the economy is growing at a rate significantly above normal

• A boom is a strong and long lasting expansion

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Calling the 2007 Recession• NBER declared a recession December 2007

– Previous recession ended November 2001– 73 month expansion

• Four important monthly indicators used to date recessions:– Industrial production– Total sales in manufacturing, wholesale, and retail– Non-farm employment– Real after-tax household income

• Coincident indicators move with overall economy

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Short-Term Economic Fluctuations

• Economists have studied business cycles for at least a century– Recessions and expansions are irregular in their

length and severity– Contractions and expansions affect the entire

economy• May have global impact

– Great Depression of the 1930s was worldwide– US recessions of 1973 – 1975 and 1981 – 1982– US recession that began in 2007

17-6

Symptoms of Business Cycles

• Cyclical unemployment rises sharply during recessions– Decrease in unemployment lags the recovery– Real wages grow more slowly for those employed– Promotions and bonuses are often deferred– New labor market entrants have difficulty finding

work

• Production of durable goods is more volatile than services and non-durable goods– Cars, houses, capital equipment less stable

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Potential Output

• Potential output, Y* , is the maximum sustainable amount of output that an economy can produce– Also called full-employment output

– Use capital and labor at greater than normal rates and exceed Y* – for a period of time

• Potential output grows over time

• Actual output grows at a variable rate– Reflects growth rate of Y*

• Variable rates of technical innovation, capital formation, weather conditions, etc.

– Actual output does not always equal potential output

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Output Gaps• The output gap is the difference between the

economy’s actual output and its potential output, relative to potential output, at a point in time

Output gap = [(Y – Y*)/Y*]x100– Recessionary gap is a negative output gap; Y* > Y

– Expansionary gap is a positive output gap; Y* < Y

• Policy makers consider stabilization policies when there are output gaps– Recessionary gaps mean output and employment are

less than their sustainable level

– Expansionary gaps lead to inflation

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Natural Rate of Unemployment

• Recessionary gaps have high unemployment rates– Expansionary gaps have low unemployment rates

• The natural rate of unemployment, u*, is the sum of frictional and structural unemployment– Unemployment rate when cyclical unemployment is 0– Occurs when Y is at Y*

• Cyclical unemployment is the difference between total unemployment, u, and u*– Recessionary gaps have u > u*– Expansionary gaps have u < u*

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Okun’s Law

• Okun's law relates cyclic unemployment changes to changes in the output gap– One percentage point increase in cyclical

unemployment means a 2 percentage point increase in the output gap

• Suppose the economy begins with 1% cyclical unemployment and an recessionary gap of 2% of potential GDP– If cyclical unemployment increases to 2%, the

recessionary gap increases to 4% of Y*

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Importance of the Output Gap

• The 1982 output gap was $402 billion• US population was 230 million

– $402 billion/230 million = $1,748 for a family of four– In 2000 dollars it equals $7,000 for a family of four

• Policy makers pay attention to output gaps because of the impact it has on our standard of living– While average impact is $7,000 for a family of four,

the distribution of costs are not even• Concentrated in households of workers laid off

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Causes of Short-Term Fluctuations

• The economy has self-correcting mechanisms– Firms eventually adjust to output gaps

• If spending is less than potential output, firms will slow the increase of their prices

• If spending is more than potential output, firms increase prices– Potential inflationary pressure

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Causes of Short-Term Fluctuations

• The economy has self-correcting mechanisms– Eventually, prices reach equilibrium and eliminate

output gaps– Production is at potential output levels

• Output is determined by productive capacity

• Spending influences only price levels and inflation