Introduction to Economic Fluctuations:

Introduction to the Short-run Model

CHAPTER

1

Chapter 10 - selected sections!

The Short Run Economic Fluctuations– Business cycle

• real GDP fluctuates around an overall upward trend

– Recessions• Output declines, employment falls and

unemployment increases

– Expansions • Output rises faster than potential output,

employment rises and unemployment falls

2

Economic Fluctuations• Boom

– A period of time during which real GDP is above potential GDP

• Slump – A period during which real GDP is below

potential and/or the employment rate is below normal (unemployment rate above normal)

3

Over time, real GDP fluctuates around an overall upward trend. Such fluctuations are called business cycles. When output rises, we are in the expansion phase of the cycle; when output falls, we are in a recession.

The Business Cycle

Slump

Log-run trend in potential GDP

Boom

Potential and Actual Real GDP and Employment, quarterly, 1979–2011 (a)

5

Economic Fluctuations - Facts• The shift from a strong expansion to a

serious recession can occur suddenly

• Recessions and the resulting slumps don’t last forever

• The recession phase can be relatively brief• Slumps can be long and painful

6

U.S. Employment Rate (percent employed): Workers Aged 25 to 54, 1979–2011

7

Economic Fluctuations• Three things to explain about economic

fluctuations

– Why they occur in the first place

– Why they sometimes last so long

– Why they do not last forever

8

Can the Classical Model ExplainEconomic Fluctuations?

• Remember - The Classical model is supply oriented. Fluctuations would occur when something affects the supply side of the economy in the labor market, capital market or productivity

9

Can the Classical Model ExplainEconomic Fluctuations?

• Recession– We would have to experience a sudden

leftward shift of the labor supply curve?– Think about what this means: people

prefer to work less and the level of employment and output would fall

10

In fact, shifts in labor supply occur very slowly, so they cannot explain economic fluctuations.

A Recession Caused by Declining Labor Supply?

11

Employment

Real Wage Rate

$30

100

Million

$25

Normal Labor Supply

Labor

Demand

90

Million

E

Recession Labor Supply?

G

Sudden shifts in the labor supply curve are unlikely to occur

– Why would people want to work less?

– Why would unemployment increase if people want to work less?

– Conclusion: the classical model cannot explain fluctuations through shifts in the supply of labor

12

Can the Classical Model Explain Economic Fluctuations?

• Recession– Can it be caused by a leftward shift of the

labor demand curve?• Leftward shift in the labor demand

– The level of employment would fall– The real wage rate would fall– with flexible prices the market clears.– there is no rise in unemployment

contradicting the facts of actual recessions . 13

In theory, a recession could be caused by a sudden leftward shift in the labor demand curve, causing employment to fall. But in panel with flexible wages, the labor market clears, so there would be no rise in unemployment, contradicting the facts of actual recessions.

A Recession Caused by Declining Labor Demand? (a)

14

Employment

Real Wage Rate

20

100

Million

$25

Labor Supply

Normal Labor Demand

90

Million

E

Recession Labor Demand?

F

Sticky Wages and Leftward Shift in Labor Demand

– With sticky wages (real wage rate remains unchanged)

– you get unemployment !

– this seems to fit what happens in real-world recessions

15

Downward wage rigidity prevents the labor market from clearing. This could, in theory, explain the rise in unemployment during a recession.

A Recession Caused by Declining Labor Demand? Wage rate rigid at $25

16

Employment

Real Wage Rate

20

100

Million

$25

Labor Supply

Normal Labor Demand

90

Million

E

Recession Labor Demand?

F

H

80

Million

What is the level of unemployment in this graph?

How many people want to work in this graph?

• They seem to be.

• Institutional factors such as unions and minimum wage.

• Employers are hesitant to lower wages - negative effect on worker morale and productivity

Are Wages Rigid and WHY?

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What Causes Labor Demand to Shift Leftward?

– Decrease in labor productivity

– Decrease in total spending

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Decrease in Labor Productivity• Labor becomes less productive and thus

less valuable to firms– For example, labor has less

capital(equipment) to work with– Really need to ask why would labor

become less productive.

• Does not occur rapidly enough to explain real-world economic fluctuations

19

Decrease in Total Spending

– Plays an important role in real-world economic fluctuations

– But, the classical model rules this out as an initial cause because of the flexible price assumption and Say’s law.

20

Verdict!

• The classical model cannot explain economic fluctuations

• Once we step away from the classical model and the assumption that all markets clear, a combination of a sudden drop in spending combined with wage rigidity can explain economic fluctuations

21

Expansions and Recessions in the Last 50 Years

22© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Expansions and Recessions in the Last 50 Years

23© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

• The classical model cannot explain booms and recessions because it assumes that markets respond very quickly to changes in spending so that the economy remains at full employment - labor markets always clear.

• Evidence suggests that this assumption is not valid over short time periods - rigid wages

• The alternative view - the short-run macro view, is that markets respond slowly to shocks - rigidity.

Summary

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• The major difference in these two views is in the speed of adjustment.

• Because the short-run macro view concentrates on the period during which adjustment is less than complete, it places the focus on spending.

25

Summary