Transcript Potential GDP

Chapter 10
Business Cycles,
Unemployment, and
Inflation
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
• Compare and contrast potential GDP and
real GDP.
• Define the unemployment rate and
distinguish between the different types of
unemployment.
• Explain the tradeoff between unemployment
and inflation.
• Define recessions and discuss the impact of
recessions on workers and businesses.
• List the possible causes of recession.
10-2
Potential versus Real GDP
• Potential GDP is the output of the
economy assuming no strains on
production or unused resources.
– Potential and actual GDP can be
different.
– The economy normally operates at levels
above or below potential.
• The rate at which potential GDP rises
is the potential growth rate.
10-3
Potential Growth
• The potential growth rate in the
economy is a combination of the longterm growth rate of the labor force plus
the long-term growth rate of
productivity.
• The estimated growth rate in potential
GDP for the U.S. is around 3% per
year.
• Projections of potential GDP are made
to forecast the sustainable growth path
for the economy.
10-4
The Path of Potential GDP
10-5
The Output Gap
• As noted previously, the actual level of
real GDP may be higher or lower than
potential GDP.
• The output gap is the difference
between actual and potential GDP.
• The output gap is negative when
actual GDP is less than potential, and
positive when the output is greater
than potential.
10-6
The Output Gap
10-7
Unemployment
• Unemployment is a key measure of the
health of the economy.
• The unemployment rate is the percentage
of the labor force who are unemployed.
– The labor force is the sum of the employed
workers and the unemployed workers.
• Unemployment occurs when actual GDP is
below potential GDP, and the economy
slows.
10-8
Unemployment Rate, 1960-2010
10-9
Types of Unemployment
• Unemployment can be classified into 3
categories:
– Frictional unemployment arises due to the job
search process.
– Structural unemployment comes when there is
a mismatch between the skills of unemployed
workers and the needs of employers with
unfilled jobs.
– Cyclical unemployment is caused by a lack of
demand for the products sold by the employer.
10-10
The Unemployment Puzzle
• Wages are the price of labor.
• Thus, one would expect wages to fall
when unemployment is high.
– This does not occur because wages are
sticky.
• Sticky wages mean that is difficult to change
wages in the short run.
• One reason wages are sticky is due to the
presence of unions.
10-11
Trade-off between
Unemployment and Inflation
• The unemployment rate rises when
actual GDP is below potential GDP.
• In contrast, the unemployment rate
falls when actual GDP is above
potential GDP.
– But then wages and inflation begin to rise.
• Thus, low unemployment is linked to
higher inflation.
10-12
Trade-off between
Unemployment and Inflation
• If the economy grows too fast – that is,
if actual GDP is too high relative to
potential GDP – we get rising inflation.
• If the economy grows too slowly - if
actual GDP is too low relative to
potential GDP – we get unemployment.
• The job for policymakers is to find the
right balance between inflation and
unemployment.
10-13
Inflation and Potential GDP
• Given the link between GDP, inflation,
and unemployment:
– We can define potential GDP as the
maximum amount of economic output an
economy can sustain at any moment
without inducing an increase in the
inflation rate.
• Potential GDP is effectively the “speed limit”
for the economy.
10-14
Natural Rate of Unemployment
• The natural rate of unemployment is
defined as the level of unemployment where
inflation is more or less stable.
– When the unemployment rate is below
the natural rate, the inflation rate
increases.
– When the unemployment rate is above
the natural rate, the inflation rate falls.
• The natural rate of unemployment is also
called the “non-accelerating inflation rate of
unemployment,” or NAIRU for short.
10-15
Recessions
• A recession is defined as a significant
decline in economic activity spread across
the economy, lasting more than a few
months.
• In a recession, GDP is running below its
potential and the unemployment rate is high.
During a recession:
–
–
–
–
It’s harder to find a job.
Profits aren’t as high.
Malls are empty.
Tax revenues fall short of predictions.
10-16
The Business Cycle
• The peak is the date the recession
starts.
• The trough is the date the recession
ends.
• The expansion is the period of time
from the trough, through recovery, and
all the way to the next peak.
• The pattern of recession, recovery,
and expansion is the business cycle.
10-17
The Typical Business Cycle
10-18
The Impact of
Recession on Workers
• Unemployed workers and their families
suffer the most from a recession.
• During a recession, it is hard to find a job as
the economy shrinks and companies stop
hiring.
• The labor market typically doesn’t fully
recover until well after the recession has
ended.
10-19
The Impact of
Recession on Businesses
• Recessions negatively impact
businesses, as the demand for their
product declines.
• This results in a downward shift in the
demand curve for their product.
• Demand falls because consumers have
less income to spend.
• Businesses also cut back on expansion
plans and investment in new equipment.
10-20
The Impact of
Recession on Businesses
Price
of cars
Supply curve for
cars
A
P
B
P1
Demand curve for
cars pre-recession
Demand curve for
cars during the
recession
Q1
Q
Quantity of cars demanded/supplied
10-21
What Happens in a Recession
Aspect of the Economy
What Happens
Employment
Businesses lay off workers and
cut back on hiring.
Retail sales
Stores see falling sales, and
some close.
Home construction
Fewer homes are built.
Household income, adjusted for
inflation
Many households see their real
incomes drop.
Business profits
Businesses make less money.
Business investment
Businesses cut spending.
Industrial production
Factories produce less.
Tax revenues
Governments collect less taxes.
10-22
The Great Recession:
Real GDP
10-23
The Great Recession:
Private-Sector Jobs
10-24
Why Do Recessions Happen?
• The cause of recessions is a
controversial issue among economists.
• But there are certain triggers that may
set the stage for a recession.
• One potential trigger is problems in the
financial markets.
• The Great Recession was largely
caused by problems in the financial
markets.
10-25
Problems in Financial Markets
• Individuals and businesses borrow money
from the financial markets to finance various
types of expenditures.
• When financial markets stop working, it
becomes harder to borrow and the economy
slows.
• Banks tighten lending standards so
consumers have less money available to buy
homes and cars.
• Small businesses also find it difficult to
borrow.
10-26
Why Do Recession Happen?
• Another cause is an unexpected negative
supply shift.
• An example would be a sudden rise in the
price of oil.
• The higher price of oil causes the supply
schedule in many individual industries to
shift left.
• Another example of a negative supply shift
is a terrorist attack that forces the
government and businesses to adopt tighter
security measures.
10-27
Impact of a Negative
Supply Shift
Supply curve
with higher oil
prices
Price of
groceries
Original supply
curve
P1
P
Demand curve
Q1
Q
Quantity of groceries demanded/supplied
10-28
Negative Demand Shifts
• A final trigger for a recession is a
negative demand shift.
– Recession is caused by a large drop in
demand.
– A good example of a demand-driven
recession was the recession of 2001,
which was primarily caused by a decline in
business spending on computers,
communications equipment, and other
information technology gear.
– The decline in demand results in an
increase in the unemployment rate.
10-29
Inflation Fighting
• A third trigger for a recession is that
the economy gets overheated and
inflation rises.
– Policymakers must slow it down to curb
the inflationary threat.
– They may slow growth so much that it
results in a recession.
– A good example is the recession of 1980
and 1981.
10-30