Transcript The Short Run

We turn to short-run output, the gap between actual GDP and potential GDP
 Fluctuations in economic activity can be costly
 The rate of inflation tends to decline when the economy is in a recession
 We study a simple model to understand these short-run patterns
 Our long-run model: how the economy behaves on average.
 The long-run model determines potential output and long-run inflation
Potential output is what the economy would produce if all inputs were
utilized at their long-run, sustainable levels
 The short-run model determines current output and current inflation
 Potential output and the long-run inflation rate are exogenous
 Output deviates from potential output because the economy can be hit by shocks
» The short run is the length of time over which these shocks and
deviations can occur.
 In short-run models, we assume that the long run is given (it is determined
by the long-run model, which is outside of the short-run model)
Trends and Fluctuations
 Output is equal to the long-run trend plus short-run fluctuations:
 the long-run trend is potential output
 short-run fluctuations are percent deviations from potential GDP
 A short-run fluctuation is the difference between actual and potential output,
expressed as a percentage of potential output
 this short-run deviation,
, is called detrended output or short-run output
 Fluctuations in U.S. GDP are relatively hard to see when graphed over a long period
 The Great Depression was the large negative gap of the 1930s: output was well below potential
 A recession begins when actual output falls below potentialshort-run output becomes
negative
» The Great Recession began December 2007.
 A recession is over when short-run output starts to rise and become less negative
» The Great Recession “ended” June 2009
 since 1950, fluctuations in real GDP have mostly
been between plus or minus four percent
 Real GDP was 7¼ below potential in 2009III
 Real GDP was 5+% below potential in 2010IV
 during a recession, output is usually below
potential for approximately two years, which
results in a loss of about $2,400 per person
 Output is still below potential after three
years since the Great Recession began
 during a recession, between 1.5 million and 3
million jobs are lost
Estimating Potential Output
 assume a perfectly smooth trend passes
through movements of real GDP
 Compared to the employment trend of the
2000s, over 10 million jobs were lost in the
Great Recession
 Thru January 2011, the number is 11.4 mil
 take averages of the surrounding actual GDP  the costs of short-term fluctuations are much less
than these numbers suggest because they do not
numbers
incorporate the benefits of a boom
 consult a variety of indicators
 The benefits of the construction boom are
evident on the Las Vegas skyline
The Great Moderation: 1 9 8 3 -- 2 0 0 7
 the rate of inflation typically peaks at the start of a recession and then falls during the
recession
The Short-Run Model
 the short-run model features an open economy:
 booms and recessions in the rest of the world impact the economy at home
 the economy exhibits long-run growth and fluctuations
 the central bank manages monetary policy to smooth fluctuations
The short-run model is based on three premises:
1. the economy is constantly hit by economic shocks:
 changes in oil prices, technologies, spending, or disasters that cause
fluctuations in output or inflation
2. monetary and fiscal policies affect output:
 policymakers may be able to neutralize shocks to the economy
3. there is a dynamic trade-off between output and inflation:
 the government does not want to keep actual GDP as high as possible
because a booming economy leads to an increase in the inflation rate
 if inflation is high, a recession is usually required to lower it
 the Phillips curve is the dynamic trade-off between output and inflation
 The Phillips Curve: a boom increases inflation and a recession decreases inflation
 A positive relationship between the change in inflation and short-run output
Demand and output up  Employment up  Unemployment down  Wages up faster
 Costs up faster Prices up faster
Phillips Curve as Inflation-Unemployment Tradeoff Circa 1960
1970s Stagflation: Why did the Phillips curve vanish?
Is there no inflation – unemployment tradeoff?
Inflation & Expectations: Natural rate hypothesis
•1970-1998:
 t – t-1 = 6.5% – 1.0ut = -1 (ut - 6.5%)
NAIRU: Non-accelerating inflation rate of unemployment
 empirically, the slope of the relationship between the change in inflation and shortrun output is approximately one-half
 if output exceeds potential by 2 percent, the inflation rate increases 1 percentage point
 a booming economy  the inflation rate increases
 a slumping economy the inflation rate falls
Okun’s Law: Output and Unemployment
 In recession: output low and unemployment high
 Cyclical unemployment: the difference between current unemployment and the
natural rate of unemployment
 natural rate of unemployment: the rate of unemployment that prevails in the long run
 plotting data for cyclical unemployment and short-run output yields Okun’s law:
 the difference between the unemployment rate and the natural rate of
unemployment is equal to negative one-half times short-run output
the unemployment
rate
the natural rate of unemployment
CHAPTER 9 An Introduction to the Short Run
9.5 Filling in the Details
 the IS curve says that an economy’s output in the
short run depends negatively on the real interest rate
 the MP curve shows how monetary policy affects the
real interest rate
Summary
1. The long-run model determines potential output and the
long-run rate of inflation. The short-run model determines
current output and current inflation.
2. In any given year, output consists of two components: the
long-run component associated with potential output Yt , and
a short-run component associated with economic
fluctuations . The latter component is called short-run
output and is a key variable in our short-run model.
CHAPTER 9 An Introduction to the Short Run
3. Another way of viewing
is that it is the percentage
difference between actual and potential output. It’s
positive when the economy is booming, and negative
when the economy is slumping. A recession is a
period when actual output falls below potential, so
that short-run output becomes negative.
4. In the slump associated with a recession, the
cumulative loss in output is typically about 6 percent
of GDP – about $2,400 per person or $10,000 per
family of four. The gains from eliminating
fluctuations in short-run output are smaller than this,
however, because of the benefits associated with a
booming economy.
CHAPTER 9 An Introduction to the Short Run
5. An important stylized fact of economic fluctuations
is that the inflation rate usually falls during a
recession. This fact lies at the heart of our short-run
model in the form of the Phillips curve. The Phillips
curve captures the dynamic trade-off between output
and inflation: a booming economy leads to a rising
inflation rate, and a slumping economy to a declining
inflation rate.
CHAPTER 9 An Introduction to the Short Run
6. The essence of the short-run model is that the
economy is hit with shocks, which policymakers may
be able to mitigate, and inflation evolved according
to the Phillips curve. Policymakers use monetary and
fiscal policy in an effort to stabilize output and keep
inflation low and steady. This task is made difficult
by the fact that potential output is not readily
observed, and the economy is always being hit by
new shocks whose effects are not immediately
obvious.
CHAPTER 9 An Introduction to the Short Run
7. Okun’s law, which allows us to go back and forth
between short-run output and the unemployment rate,
says that a one percentage point decline in output
below potential corresponds to a half percentage
point increase in the unemployment rate.
CHAPTER 9 An Introduction to the Short Run