Transcript Chapter 21 - Economic Fluctuations

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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Actual and Potential Real GDP
(Billions of 1996 Dollars)
Figure 1a: Potential and Actual Real
GDP and Employment, 1960-2001
9,000
8,000
The orange line shows fullemployment or potential output.
7,000
6,000
5,000
4,000
3,000
The green line shows
actual output.
During recessions,
output declines.
During expansions, output
rises—sometimes rapidly.
2,000
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Figure 1b: Potential and Actual Real
GDP and Employment, 1960-2001
140
Employment
(Millions)
Employment falls in recessions . . .
120
100
80
and rises in expansions.
60
4
Unemployment Rate (Percent)
Figure 2: U.S. Unemployment Rate,
1960-2003
12
10
8
The unemployment
rate rises during
recessions . . .
and generally falls
during expansions.
6
4
2
5
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?
Real Wage
Rate
Labor
Supply
E
$15
12
F
Normal Labor
Demand
Recession Labor
Demand ?
70 Million 100 Million
Employment
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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?
Real Wage
Rate
$18
15
Recession Labor Supply?
G
Normal Labor Supply
E
Labor Demand
70 Million 100 Million
Employment
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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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