Lecture Principles of economics (Brief edition, 2e): Chapter 17 - Robert H. Frank, Ben S. Bernanke

This chapter identify the four phases of the business cycle; explain the primary characteristics of recessions and expansions; define potential output, measure the output gap, and analyze an economy''s position in the business cycle; define the natural rate of unemployment and relate it to cyclical unemployment; apply okun''s law to analyze the relationship between the output gap and cyclical unemployment; discuss the differences between how the economy operates in the short run and the long run.

Chapter 17: Short-term Economic

Fluctuations

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 Apply Okun's law to analyze the relationship

between the output gap and cyclical unemployment

Recessions and Expansions

• Business Cycles are short-term fluctuations in

GDP and other variables

• A recession (or contraction) is a period in

which the economy is growing at a rate

significantly below normal

– A period during which real GDP falls for two or more consecutive quarters

– A period during which real GDP growth is well

below normal, even if not negative

– A variety of economic data are examined

• A depression is a particularly severe recession

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

• An expansion is a period in which the economy

is growing at a rate significantly above normal

• A boom is a strong and long lasting expansion

Calling the 2007 Recession

• NBER declared a recession December 2007

– Previous recession ended November 2001

– 73 month expansion

• Four important monthly indicators used to date recessions:

– Industrial production

– Total sales in manufacturing, wholesale, and

retail

– Non-farm employment

– Real after-tax household income

• Coincident indicators move with overall

economy

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 – US recession that began in 2007

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

Potential Output

• Potential output, Y* , is the maximum sustainable

amount of output that an economy can produce

– Also called full-employment output

– 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

– Reflects growth rate of Y*

• Variable rates of technical innovation, capital formation, weather conditions, etc.

Output Gaps

• The output gap is the difference between the

economy’s actual output and its potential output, relative to potential output, at a point in time

Output gap = [(Y – Y*)/Y*]x100

– Recessionary gap is a negative output gap; Y* > Y – Expansionary gap is a positive output gap; Y* < Y

• Policy makers 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

Natural Rate of 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 is at Y*

• Cyclical unemployment is the difference between total unemployment, u, and u*

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 an recessionary gap of 2%

of potential GDP

– If cyclical unemployment increases to 2%, the

recessionary gap increases to 4% of Y*

Importance of the Output Gap

• The 1982 output gap was $402 billion

• US population was 230 million

– $402 billion/230 million = $1,748 for a family of four – In 2000 dollars it equals $7,000 for a family of four

• Policy makers pay attention to output gaps

because of the impact it has on our standard of

living

– While average impact is $7,000 for a family of four, the distribution of costs are not even

Causes of Short-Term

Fluctuations

• 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

Causes of Short-Term

Fluctuations

• 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 price levels and inflation