Transcript PPT chapter 04 - McGraw Hill Higher Education

Chapter 4
Short-term economic
fluctuations
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Learning objectives
1. How do economists decide whether the economy is
in recession?
2. What typically happens to the unemployment rate in
recessions?
3. What caused the early 1990s recession in Australia?
4. What features seem to be common to most business
cycle fluctuations in the economy?
5. How are output gaps and cyclical unemployment
related?
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Chapter organisation
4.1
Contractions and expansions
4.2
Output gaps and cyclical unemployment
4.3
Why do short-term fluctuations occur?
Summary
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4.1 Contractions and expansions
• In the long run, real gross domestic product (GDP)
grows steadily for most countries.
• The short run is characterised by volatile contractions
and expansions in growth of real GDP.
• The business cycle refers to short-term fluctuations in
growth of real GDP.
• The growth cycle is a different way of representing
the business cycle.
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The business cycle
Figure 4.1 Stylised characteristics of the business cycle
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The business cycle in Australia:
1960–2008
Figure 4.2 Real GDP growth, unemployment and contractions, Australia
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Recession dates in Australia
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The early 1990s recession
Figure 4.3 Investment and the interest rate
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Unemployment during the 1990s
recession
Figure 4.4 Unemployment during the 1990s recession
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Some facts about short-term economic
fluctuations
• Economic fluctuations are irregular both in their
length and severity.
• Global economic fluctuations often have significant
impacts on Australia.
• Unemployment usually increases in a recession.
• Inflation usually decreases in a recession.
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Inflation and the business cycle
Figure 4.5 Inflation, 1960–2010
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The 2008 global financial crisis
• Though the 2008 global financial crisis (GFC) began
in the US it quickly spread to the rest of the world.
• Some stylised facts about the GFC in the US:
– Sharp decline in real GDP
– Sharp rise in unemployment
– Sharp decline in inflation
• Australia was relatively unaffected by the GFC.
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Chapter organisation
4.1
Contractions and expansions
4.2
Output gaps and cyclical unemployment
4.3
Why do short-term fluctuations occur?
Summary
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Potential output
• Potential output is the amount of output (or real GDP)
the economy is capable of producing when using
resources such as:
– labour, under normal weekly hours of work, at normal rates
– capital, at normal rates.
• This is less than the physical maximum, which would
involve overtime.
– Actual output can exceed potential output.
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Potential output (cont.)
• Potential output can grow over time with increases in
the number of labour and capital resources available,
and increases in their productivity.
• One reason for economic fluctuations are changes in
the level of potential output, signified by y*:
– An extensive drought could cause a significant fall in
potential output growth, leading to a contraction or
recession.
– A period of particularly rapid innovation could cause
unusually large growth in potential output, leading to an
expansion or boom.
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Output gaps
• If economic fluctuations are usual and require a
policy response, some way to identify the size of the
fluctuation is needed.
• The output gap measures how far actual output is
from its normal level at a particular time.
– The normal level of output is called the potential output, or
potential GDP, which is also equal to full employment output.
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Output gaps (cont.)
• Economic fluctuations arise when actual output does
not always equal potential output:
– When (y – y*) < 0: There is an underutilisation of resources; a
recessionary gap.
– When (y – y*) > 0: There is an overutilisation of resources; an
inflationary gap.
• Both cause problems in the economy
– A rise in unemployment in recession
– A rise in inflation in booms
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Natural rate of unemployment
• An important measure of the utilisation of resources
in the economy is the unemployment rate.
• Frictional and structural unemployment are always
present in the labour market, even when the
economy is operating normally.
• Cyclical unemployment is the extra unemployment
that occurs during a recession.
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Natural rate of unemployment (cont.)
• The natural rate of unemployment is equal to
frictional plus structural unemployment.
• Natural rate of unemployment (u*) occurs when the
cyclical unemployment rate is zero, and neither a
recessionary nor an expansionary gap exists:
– (u – u*) > 0: A recessionary gap
– (u – u*) < 0: An inflationary gap
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Replacement ratio and unemployment
rate in Australia, 1964 –2003
Figure 4.9 Australia’s replacement rate and unemployment rate,
June 1964–June 2003
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Okun’s law
• How much output is forgone with cyclical
unemployment?
• Okun’s law: each extra percentage point in
unemployment is associated with about a 2%
increase in the output gap (US figure).
• For Australia, the relationship has been calculated
using real GDP and unemployment data. It was found
that an unemployment rate which is 1% above the
natural rate of unemployment will cause GDP to fall
below potential by 1.5%.
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Okun’s law (cont.)
In symbols:
y – y*
= –β (u – u*)
y*
where y is the actual output and y* is the full-employment
level of output and where β is 2 for the US and 1.5
for Australia.
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Okun’s law (cont.)
Example: June 1983
Australia u = 10.3%, u* = 8.08%,
y* = $108 213.6 million.
–β (u – u*) = –1.5 (0.103 – 0.0808) = –0.0333
Therefore, the output gap was –3.33% of y*
= 3.33% x $108 213.6 million
= $3603.51 million
This is a recessionary gap (negative sign).
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Chapter organisation
4.1
Contractions and expansions
4.2
Output gaps and cyclical unemployment
4.3
Why do short-term fluctuations occur?
Summary
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Why do short-term fluctuations occur?
• Two reasons for changes in real GDP growth:
– Growth in potential output itself differs to normal.
– Potential output is growing at the normal rate, but actual
output is above or below potential output.
• Later, we will look at changes in potential output.
– For now, let’s focus on fluctuations in actual output when we
assume that potential output is constant.
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Why do short-term fluctuations occur?
(cont.)
• In the next chapter, we will see that when potential
output remains constant, actual output may mean we
have a recessionary or expansionary gap.
• Firms adjust to short-run changes in demand by
simply expanding their output, keeping constant
prices.
• This means that firms change output in response to
demand. In the short run, deficient demand leads to
contractionary output gaps; too much demand leads
to expansionary output gaps.
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Why do short-term fluctuations occur?
(cont.)
• Governments can help to eliminate output gaps by
influencing total spending.
• If demand continues to differ from potential output,
firms will eventually adjust their prices to eliminate
output gaps.
• Over the long run, changes in prices will bring the
economy back to potential output.
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What caused the global financial
crisis?
Figure 4.10 Index of US house prices, 1890–2009
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Chapter organisation
4.1
Contractions and expansions
4.2
Output gaps and cyclical unemployment
4.3
Why do short-term fluctuations occur?
Summary
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Summary
• Every economy goes through the business cycle in
the short run.
• The natural rate of unemployment consists of only
frictional and structural unemployment.
• The level of output associated with the natural rate of
unemployment is called potential output.
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Summary (cont.)
• Output gap is the difference between the actual level
of output and the potential output.
• Okun’s law describes the trade-off between cyclical
unemployment and output level.
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