Transcript Slide 1

Frank & Bernanke
3rd edition, 2007
Ch. 12: Short-Term Economic
Fluctuations: An Introduction
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Recessions and Expansions

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A person can drown in a lake of 3 ft average
depth. An economy can go through spurts of
fast growth and stagnation that will affect the
people deeply.
NBER defines a recession as two quarters of
shrinking GDP (negative growth).
Even if there was positive growth, slower growth
of GDP than population growth or work force
growth will cause major discontent.
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Recessions and Expansions

Growth rates of GDP show peaks and
troughs.
A peak is the onset of slowdown, perhaps
the beginning of a recession.
 A trough is the end of a slowdown or a
recession.

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Expansions and slowdowns are
irregular, though they are called
business cycles.
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Definitions

Recession (or contraction): A period in which the economy is
growing at a rate significantly below normal.
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Depression: A particularly severe or protracted recession.
Peak: The beginning of a recession, the high point of economic
activity prior to a downturn.

Trough: The end of a recession, the low point of economic activity
prior to a recovery.

Expansion: A period in which the economy is growing at
a rate significantly above normal.

Boom: A particularly strong and protracted expansion.
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Fluctuations in U.S. Real GDP,
1920-2004
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6
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Calling the 2001 recession
 Indicators
of the business cycle
 Industrial
production
 Total sales in manufacturing, wholesale
trade, and retail trade
 Nonfarm employment
 Real after-tax income of households
excluding transfers
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U.S. Recessions Since 1929
Peak date
(beginning)
Trough date
(end)
Duration
(months)
Highest
unemployment
rate (%)
Change in real
GDP (%)
Duration of
subsequent
expansion (months)
Aug. 1929
Mar. 1933
43
24.9
-28.8
50
May 1937
June 1938
13
19.0
-5.5
80
Feb. 1945
Oct. 1945
8
3.9
-8.5
37
Nov. 1948
Oct. 1949
11
5.9
-1.4
45
July 1953
May 1954
10
5.5
-1.2
39
Aug. 1957
Apr. 1958
8
6.8
-1.7
24
Apr. 1960
Feb. 1961
10
6.7
2.3
106
Dec. 1969
Nov. 1970
11
5.9
0.1
36
Nov. 1973
Mar. 1975
16
8.5
-1.1
58
Jan. 1980
July 1980
6
7.6
-0.3
12
July 1981
Nov. 1982
16
9.7
-2.1
92
July 1990
Mar. 1991
8
7.5
-0.9
120
Mar. 2001
Nov. 2001
8
5.8
0.8
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Unemployment
During recessions unemployment rate
rises sharply.
 Usually unemployment rates are lagging
indicators: they start to rise after the
economy has passed the peak.
 During expansions unemployment rate
falls, rather slowly.

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Durable Industries

During recessions, durable industries,
like construction, cars, machines are
more affected by recessions than
service and non-durable industries
because basic consumption
expenditures continue.
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Inflation
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Inflation rate drops during recessions.
Usually, inflation rates would be rising before
recessions.
In late nineties many East Asian, Latin
American and European newly industrializing
countries experienced recessions because of
exchange rate crisis.
US is a relatively closed economy, somewhat
insulated from global shocks compared to
others.
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U.S. Inflation, 1960-2004
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Measuring Fluctuations
In order to claim a recession is big or
small, an unemployment rate is too high
or too low, one needs to have a
standard to measure against.
 The “normal” or “trend” or “potential” or
“full employment” output is the standard
to compare expansions or recessions.
 Long run average unemployment rate is
the “natural” or “full employment” rate of
unemployment.
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Output Gaps and
Cyclical Unemployment

Potential Output and the Output Gap
 Changes
in the rate at which the
country’s potential output is increasing
 Actual output does not always equal
potential output
 Y* (potential output) - Y (actual output)
 The difference between the economy’s
potential output and its actual output at a
point in time
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Output Gaps

Recessionary Gap
Y* > Y
 A positive output gap, which occurs when
potential output exceeds actual output
 Capital and labor resources are not fully
utilized
 Output and employment are below normal
levels
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Output Gaps

Expansionary Gap
Y > Y*
 A negative output gap, which occurs when
actual output is higher than potential output
 Higher output and employment than normal
 Demand for goods exceed the capacity to
produce them and prices rise
 High inflation reduces economic efficiency
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Natural rate of unemployment, u*
 U*
is attributable to frictional and
structural unemployment
 Cyclical unemployment equals zero
 No recessionary or expansionary
gap
 Cyclical unemployment = u - u*
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What Can Cause Slow Growth?

If the potential growth of the economy slows, the
society would experience a recession.
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Capital
Technology
Labor
The experience of US in the second half of the
nineties was an acceleration of the potential
growth rate of the economy.
The experience of Japan was that the rate of
growth of potential output slowed from 3.6% in the
eighties to 2.2% in the nineties.
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What Can Cause Slow Growth?
If the economy produces less than its
potential amount, the “positive output
gap” will also be responsible for slow
growth and recession.
 If the economy produces more than its
potential amount because labor and/or
capital is overworked, the “negative
output gap” will be responsible for fast
growth.
 Output gap: Y* - Y. Potential GDP –
Actual GDP.
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Natural Rate of Unemployment
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Cyclical unemployment is zero: there is no
recessionary or expansionary output gap.
Frictional and structural unemployment add to
the natural rate of unemployment.
If u>u*, there is positive cyclical
unemployment and the economy is in a
recessionary mode.
If u<u*, there is negative cyclical
unemployment, labor is being used more
intensively than normal.
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Natural Rate of Unemployment

Why has the natural rate of unemployment in
the United States apparently declined?
 Aging
labor force
 More efficient labor market
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Okun’s Law
Arthur Okun in the sixties observed that
every time unemployment rate in the US
rose one percentage point above the
natural rate, GDP fell 3 percentage
points below the potential GDP.
 Recent data indicate that the
relationship is now one percent
deviation of unemployment rate implies
two percentage point deviation in GDP.
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Okun’s Law
Year
u
u*
Y*
1982
9.7%
6.1%
5,584
1991
6.8
5.8
7,305
1998
4.5
5.2
8,950
2002
5.8
5.2
10,342
1982
• u - u* = cyclical unemployment
• 9.7 - 6.1 = 3.6%
• Output gap = 2 x 3.6 = 7.2%
• Output gap = 5,584 x .072
= $402 billion
1998
4.5 - 5.2 = -0.7
Output gap = 8,563 x -.014
= -$120 billion
1991
• 6.8 - 5.8 = 1%
• Output gap = 7,305 x .02 = $146 billion
2002
u - u* = 5.8 - 5.2 = 0.6
Output gap = 2 x .06 = .12
Y* - Y = 10,342 x .12
= $124 billion
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Significance of Output Gaps
 The
1982 output gap per capita
$402
billion/230 million = $1,748 for a
family of four
In 2000 dollars it equals $7,000 for a
family of four
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Problem #5, p. 341
Year
1
2
3
4
Y
7840
8100
8415
Y*
8000
8200
8250
u*
5%
4.5%
5%
u
6%
5%
4%
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Why Do Output Gaps Occur?
If prices in every market adjusted
immediately to demand shifts, there would
not have been any output gaps. Firms do
not change their prices every day: contracts,
menu costs keep prices constant for a
period of time.
 Show a partial equilibrium, market supply
and demand case to indicate the above.
 Coke example.
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Why Do Output Gaps Occur?
If some markets are experiencing positive
output gaps and others negative output
gaps, the net outcome might be no
change.
 For the economy as whole to experience
positive or negative output gaps, total
spending in the economy has to be below
or above the total output produced.
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Why Do Output Gaps Occur?
It is the total spending (aggregate
demand) that determines the gaps in the
short run.
 Total spending is C+I+G+NX.
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Why Output Gaps Don’t Last?
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In the long run firms will adjust prices upward
if total spending is more than the potential
output, eliminating the gap.
Likewise, if total spending is less than the
potential output, firms will reduce prices.
In the long run, the economy settles at the
potential output.
Chronic excess total spending will create
chronic inflation but not an increase in output.
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