Transcript Economics Principles and Applications

Economic Fluctuations
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
Economic Fluctuations
• Neither output nor employment grows as smoothly
and steadily as classical model predicts
– As far back as we have data, United States and similar
countries have experienced economic fluctuations
• During recessions, output declines—occasionally
sharply
– During expansions output rises quickly—usually faster
than potential output is rising
– In later stages of an expansion, output often exceeds
potential output
• Called a boom
• Why do economic fluctuations
• Occur in the first place?
• Sometimes last so long?
• Not last forever?
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Figure 1: Potential and Actual Real
GDP and Employment, 1960-2001
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Figure 2: U.S. Unemployment Rate,
1960-2003
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Shifts in Labor Demand
• Can classical model explain why GDP and
employment typically fall below potential during a
recession and often rise above it in an expansion?
• One idea is that a recession might be caused by a
leftward shift of labor demand curve
• Is this a reasonable explanation for recessions?
– Most economists feel that the answer is no
• If we want to explain a leftward shift in the labor
demand curve using the classical model
– Must look for some explanation other than a sudden
change in spending
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Shifts in Labor Demand
• Another possibility is that labor demand curve shifts
leftward
– Because workers have become less productive and therefore less
valuable to firms
• A leftward shift of labor demand curve is an unlikely explanation for
recessions
• What about booms?
– Could a rightward shift of labor demand curve explain them?
– A change in total spending cannot be the answer
– A sudden rightward shift of labor demand curve is an unlikely
explanation for an expansion that pushes us beyond potential
output
• Because shifts in labor demand curve are not very large
from year to year
– Classical model cannot explain real-world economic fluctuations
through shifts in labor demand
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Figure 3: A Recession Caused By
Declining Labor Demand?
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Shifts in Labor Supply
• A second way classical model might explain a recession is through a shift
in labor supply curve
• Explanation of recessions has almost no support among economists
– Remember that labor supply schedule tells us number of people who would
like to work
• At each real wage rate
– Even if such a shift in preferences did occur, it could not explain facts of realworld downturns
• Same arguments could be made about expansions
– To explain them with labor supply shifts, would have to believe that
preferences suddenly change toward market work and away from other
activities—an unlikely occurrence
• Because sudden shifts of labor supply curve are unlikely to occur, and
– Because they could not accurately describe facts of economic cycle
• Classical model cannot explain fluctuations through shifts in supply of labor
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Figure 4: A Recession Caused By
Declining Labor Supply?
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Verdict: The Classical Model Cannot
Explain Economic Fluctuations
• Earlier chapters stressed that classical
model works well in explaining movements
of economy in longer run
– Does a rather poor job of explaining economy
in short-run
• Cannot explain facts of short-run economic
fluctuations with a model in which the labor
market always clears
– Classical model assumes market always clears
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What Triggers Economic
Fluctuations?
• In a recession, millions of qualified people want to
work at the going wage rate
– But firms won’t hire them
• In a boom, unemployment rate is so low normal
job-search activity—which accounts for frictional
unemployment—is short-circuited
– Firms are less careful about whom they hire
• Desperate to hire workers because production is so high
• Booms and recessions are periods during which
economy deviates from normal, full-employment
equilibrium of classical model
– Why do such deviations occur?
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A Very Simple Economy
• Imagine an economy with just two people
• Suppose there is a breakdown in communication
– Total production in economy declines
• Two traders will lose some of benefits of trading
• Corresponds to a recession
• Or, total output in economy rises
– Corresponding to an expansion
• A breakdown in communication and a sudden
change would be extremely unlikely… in a simple
economy with just two people
– And therein lies the problem
• Real-world economy is much more complex
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The Real-World Economy
• Think about U.S. economy, with its millions of businesses
producing goods and services for hundreds of millions of
people
• When people spend their incomes, they give firms the
revenue they need to hire workers…and pay them income
– If any link in this chain is broken, output and income may both
decline
• Classical model, however, waves these potential problems
aside
– Assumes workers and firms, with aid of markets, can work things
out and enjoy the benefits of producing and trading
– Classical model is right
• People will work things out…eventually
• A boom can arise in much the same way as a recession
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Shocks That Push the Economy
Away From Equilibrium
• Spending Shock
– Change in spending that ultimately affects entire
economy
• In real world, economy is constantly buffeted by
shocks
– Often cause full-fledged macroeconomic fluctuations
• Economy is buffeted by other shocks whose
origins are harder to spot
• Each shock has momentum
– Economy can continue sliding downward, and remain
below potential output, for a year or longer
– Same processes work in reverse during an expansion
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Shocks That Push the Economy
Away From Equilibrium
• Booms and recessions do not last forever
– Often, a change in government macroeconomic
policy helps adjustment process along
• Speeding return to full employment
– Other times, a policy mistake thwarts
adjustment process
• Prolonging or deepening a costly recession, or
exacerbating a boom and overheating economy
even more
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Where Do We Go From Here?
• Classical model is useful
– Helps us understand economic growth over time
• How economic events and economic policies affect economy
over long-run
– But in trying to understand expansions and recessions
we’ve had to depart from strict framework of classical
model
• But in short-run, we’ve seen that spending shocks
to economy affect production
– If we want to understand fluctuations need to take a
close look at spending
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