Transcript Output gap - McGraw Hill Higher Education

Chapter 20: Short-term
Economic Fluctuations
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Learning Objectives
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. Use 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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The Economy in the Short Run
Policy
Analysis
Short-Run
Fluctuations
Aggregate
Spending
Inflation
Monetary
Policy
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Recessions and Expansions
Recession (or contraction) is a period in
which the economy is growing at a rate
below normal
 Depression
a particularly severe recession
 Commonly held to be 2 or more consecutive
quarters of negative GDP growth

A variety of economic data are consulted
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Fluctuations in Egyptian Real GDP, 1960-2009
 1966-1967: Six-day war
 1972-1973: Yom Kippur war
 1991: Persian Gulf crisis
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Fluctuations in Moroccan Real GDP, 19602009
 1960s: Post-independence political tensions including war with
Algeria (Sand War – La guerre des sables)
 1980s: Social unrest, drought, plummeting phosphate prices
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Fluctuations in Turkish Real GDP, 1960-2009
 1978-1980: Oil shocks of the 1970s
 2008-2009: Global financial crisis
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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
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Recessions and Expansions
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Some Facts About 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
• East Asian slowdown in the late 1990s
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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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Egyptian Recessions since 1960
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Moroccan Recessions since 1960
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Turkish Recessions since 1960
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Output Gaps and Cyclical Unemployment:
Potential Output and The Output Gap
 Potential output, Y* , is the maximum sustainable
amount of real GDP that an economy can produce


Also called full-employment GDP
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

Reflect 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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Egyptian, Moroccan, and Turkish Recessions
 Unemployment increases in Egypt from 1.5 to 1.6 percent
during the 1972–1973 recession and to 9.6 percent during
the 1991 recession.
 As for Morocco, unemployment is high by international
standards and peaks at 22.9 percent during the 1995
recession and at 22 percent during the 1999 recession.
 As the Moroccan economy improves in 2000 by growing
at 1.59 percent (versus 0.52 in 1999), unemployment also
improves to 21.5 percent.
 It is important to note that the high level of unemployment
observed in countries like Egypt and Morocco is not only
associated with economic activity but also with other
demographic and political factors - factors deemed largely
responsible for the Arab uprisings of 2011.
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Egyptian, Moroccan, and Turkish Recessions
 Like unemployment, inflation follows a typical pattern in
recessions and expansions, though it is not so sharply defined.
 Recessions tend to be followed soon after by a decline in the
rate of inflation.
 Inflation decreased from 9.04 percent to 0.70 percent during
the Egyptian recession of 1966–1967.
 Inflation decreased from 4.02 percent to 3.48 percent and to
−1.01 percent during the Moroccan recession of 1964–1966.
 Turkey faced unique circumstances (i.e. hyperinflation) that
did not necessarily translate into lower inflation during
recessions.
 Furthermore, many—though not all—recessions have been
preceded by increases in inflation.

Inflation in Egypt reached 14.84 percent in 1965 before declining to
9.04 percent during the 1966 recession.
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Output Gaps
 Output gap is the difference between potential
output and actual output at a point in time
Output gap = Y* – Y
Recessionary gap is a negative output gap; Y* > Y
 Expansionary gap is a positive output gap; Y* < Y

 Policymakers 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 to ration output
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The Natural Rate of Unemployment and
Cyclical 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 = 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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What Would Cause The Natural Rate of
Unemployment to Decline?
Possible explanations
 Frictional
unemployment decreased
 Structural unemployment decreased
Change in the age structure of the population
 Decline

in the share of working population ages 16-24
This group has higher unemployment than older workers
• Short-term jobs / Interrupt work for school


Frequent job changes increases frictional unemployment
Lower skills means more structural unemployment
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What Would Cause The Natural Rate of
Unemployment to Decline?
Labor markets may be more efficient at
matching job openings and workers
 Reduces

frictional and structural unemployment
Temporary agencies
• Temp work can lead to permanent position


Online job boards
Less time between jobs
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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 a 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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Output Gap in the US, Egypt, Morocco, and
Turkey
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Output Gap in the US, Egypt, Morocco, and
Turkey
 All years listed for Egypt, Morocco, and
Turkey were recession years, so the output
gaps are expected to be recessionary gaps.
 Contrary to expectations, recessionary gaps
only took place in 1991 in Egypt, 1987, 1995,
and 2000 in Morocco, and 1994 and 2008 in
Turkey.
 Despite the year 1992 being a recession year
for Morocco, the natural rate of
unemployment exceeds the actual
unemployment rate.
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Output Gap in the US, Egypt, Morocco, and
Turkey
 Such inconsistencies, also observed for Egypt and Turkey,
cast doubt on the reliability of the data and impose
serious limitations on the public and policymakers’ ability
to deal effectively with recessions.
 It is common knowledge, at least in the academic world,
that one of the most daunting tasks in conducting
research about countries in the developing world is the
lack of reliable data.
 This problem is likely due to various factors, including
but not limited to data imperfections (i.e., missing
observations), a lack of resources (i.e., human capital),
the reluctance of various (primarily governmental)
organizations to collect and disseminate data, or just a
lack of interest.
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Why Do Short-Term Fluctuations Occur? A
Preview and A Parable
Output gaps arise for two main reasons
Growth in potential output itself may slow
down or speed up, reflecting changes in the
growth rates of available capital, labor, and
technology.
2. Actual output may be higher or lower than
potential output despite normal growth in
potential output.
1.
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Why Do Short-Term Fluctuations Occur? A
Preview and A Parable
Markets require time to reach equilibrium
price and quantity



Firms change prices infrequently
Quantity produced is not at equilibrium during the
adjustment period
Firms produce to meet the demand at current prices
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Why Do Short-Term Fluctuations Occur? A
Preview and A Parable
Changes in total spending at preset prices
affects output levels



When spending is low, output will be below potential
output
Changes in economywide spending are the primary
causes of output gaps
Policy: adjust government spending to close the output
gap
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Why Do Short-Term Fluctuations Occur? A
Preview and A Parable
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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Why Do Short-Term Fluctuations Occur? A
Preview and A Parable
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 rate of inflation
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Alaa's Ice Cream – Production Capacity
Daily output of the store is determined by
 Production



capacity
Amount of capital
Labor employed (includes hours worked)
Productivity of capital and labor
 Capacity
changes slowly, but periodic
disruptions happen




Machine failure
Workers fail to report for work
Power outage
Supplies not delivered
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Alaa's Ice Cream – Demand Fluctuations
Predictable changes hour by hour
 Day
of the week patterns
 Annual cycles of demand
Unpredictable changes in demand
 Weather
 Community

events
Increase sales or divert customers elsewhere
 Demand
for specific flavors
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Alaa's Ice Cream – Setting Prices
 Fully flexible prices are unrealistic
 Minute-by-minute
pricing is confusing to
customers
 Costs of an auction exceed Alaa's benefits

Continuous purchases in low volumes by different
customers
 Alaa sets prices
 Survey
of competitors
 Product strengths and weaknesses
 Analyzes sales over time to see if adjustments are
needed
 Alaa meets demand in the short run
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Alaa's Ice Cream – Long Run
Alaa observes consistently strong demand
for his products
 Waiting
lines
 Low inventory
 Fully utilized production capacity
Alaa's first response is to raise prices
 Implemented
quickly
Alaa evaluates expanding capacity
 If
expansion does not raises average costs, Alaa
will expand and return to original prices
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Alaa's Ice Cream – Macroeconomic Lessons
In the short run, producers meet demand
at existing prices
 Total
spending drives output levels
 Gather data and analyze business opportunities
In the long run, prices reach equilibrium
levels
 Output
is at its potential level
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Dynamic Pricing
 Coca-Cola tested machines that could modify
prices according to demand
 Temperature
sensors triggered higher prices on
hot days
 Machines could raise prices for periods of high
demand
 Justified as a response to consumer demand
 Barriers to flexible pricing
 Sophisticated
vending machines increase costs
 Consumers reacted negatively to change in pricing
practices
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