Short-Term Economic Fluctuations - PowerPoint Presentation

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Short-Term Economic Fluctuations

Chapter 21

McGraw-Hill/Irwin

Copyright ©

2015

by

McGraw-Hill Education (Asia).

All rights reserved.Slide2

Learning Objectives

Identify the four phases of the business cycle and explain the primary characteristics of recessions and expansionsUse potential output and the output gap to analyze an economy's position in the business cycleDefine the natural rate of unemployment and show how it is related to cyclical unemploymentApply Okun's law to analyze the relationship between the output gap and cyclical unemploymentDiscuss the differences between how the economy operates in the short run and the long runSlide3

Headlines from The New York Times

“Home Sales and Prices Continue to Plummet”“As Jobs Vanish, Motel Rooms Become Home”“Global Stock Markets Plummet”“Energy Prices Surge, and Stocks Fall Again”“Steep Slide in Economy as Unsold Goods Pile Up”“Fed Plans to Inject Another $1 Trillion to Aid Economy”“World Bank Says Global Economy Will Shrink in ‘09”U.S. economy has passed through its worst recession in 25 yearsSlide4

Recessions and Expansions

Business Cycles are short-term fluctuations in GDP and other variablesA recession (or contraction) is a period in which the economy is growing at a rate significantly below normalA period during which real GDP falls for two or more consecutive quartersA period during which real GDP growth is well below normal, even if not negativeA variety of economic data are examinedA depression is a particularly severe recessionSlide5

Recessions and Expansions

A peak is the beginning of a recessionHigh point of the business cycleA trough is the end of a recessionLow point of the business cycleAn expansion is a period in which the economy is growing at a rate significantly above normalA boom is a strong and long lasting expansionSlide6

Fluctuations in US Real GDP, 1920-2010Slide7

Peak

Trough

Months

U. Rate (high)

Change RGDP

Next Expansion

8/29

3/33

43

24.9%

–

28.8%

50 months

5/37

5/38

12

19.0

–

5.5

80

2/45

10/45

8 3.9 –8.53711/4810/4911 5.9 –1.4457/535/5410 5.5 –1.2398/574/588 6.8 –1.7244/602/6110 6.7 2.310612/6911/7011 5.9 0.13611/733/7516 8.5 –1.1581/807/806 7.6 –0.3127/8111/8216 9.7 –2.1927/903/918 7.5 –0.91203/0111/018 5.8 0.87312/076/091810.0 -4.1Slide8

Calling the 2007 Recession in the United States

NBER declared a recession December 2007Previous recession ended November 200173 month expansionFour important monthly indicators used to date recessions:Industrial productionTotal sales in manufacturing, wholesale, and retailNon-farm employmentReal after-tax household incomeCoincident indicators move with overall economySlide9

Short-Term Economic Fluctuations

Economists have studied business cycles for at least a centuryRecessions and expansions are irregular in their length and severityContractions and expansions affect the entire economyMay have global impactGreat Depression of the 1930s was worldwideU.S. recessions of 1973 – 1975 and 1981 – 1982U.S. recession that began in 2007Slide10

Real GDP Growth, 2002–2012Slide11

Symptoms of Business Cycles

Cyclical unemployment rises sharply during recessionsDecrease in unemployment lags the recoveryReal wages grow more slowly for those employedPromotions and bonuses are often deferredNew labor market entrants have difficulty finding workProduction of durable goods is more volatile than services and non-durable goodsCars, houses, capital equipment less stableSlide12

Symptoms of Business Cycles

Inflation generally decreases during a business cycleDecreases at other times as wellSlide13

Potential Output

Potential output, Y* , is the maximum sustainable amount of output that an economy can produceAlso called full-employment outputUse capital and labor at greater than normal rates and exceed Y* – for a period of timePotential output grows over timeActual output grows at a variable rateReflects growth rate of Y*Variable rates of technical innovation, capital formation, weather conditions, etc.Actual output does not always equal potential outputSlide14

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 timeOutput gap = [(Y – Y*)/Y*]x100Recessionary gap is a negative output gap; Y* > YExpansionary gap is a positive output gap; Y* < YPolicy makers consider stabilization policies when there are output gapsRecessionary gaps mean output and employment are less than their sustainable levelExpansionary gaps lead to inflation Slide15

Natural Rate of Unemployment

Recessionary gaps have high unemployment ratesExpansionary gaps have low unemployment ratesThe natural rate of unemployment, u*, is the sum of frictional and structural unemploymentUnemployment rate when cyclical unemployment is 0Occurs when Y is at Y*Cyclical unemployment is the difference between total unemployment, u, and u*Recessionary gaps have u > u*Expansionary gaps have u < u*Slide16

U.S. Natural Rate of Unemployment

From 6.3% in 1979 to 4.8% in 2007Unemployment stayed close to 4% for several yearsNatural rate of unemployment could be 4.5% or lessPossible explanationsFrictional unemployment decreasedStructural unemployment decreasedSlide17

U.S. Natural Rate of Unemployment

Age structure of the population has changedShare of working age population ages 16 – 24 has declined from 25% to 15%This group has higher unemployment than older workersShort-term jobsCareer shoppingInterrupt work for school or military serviceFrequent job changes increases frictional unemploymentLower skills means more structural unemploymentSlide18

U.S. Natural Rate of Unemployment

Labor markets may be more efficient at matching job openings and workersReduces frictional and structural unemploymentTemporary agencies Temp work can lead to permanent positionOnline job boardsLess time between jobsSlide19

Okun’s Law

Okun's law relates cyclic unemployment changes to changes in the output gapOne percentage point increase in cyclical unemployment means a 2 percentage point increase in the output gapSuppose the economy begins with 1% cyclical unemployment and an recessionary gap of 2% of potential GDPIf cyclical unemployment increases to 2%, the recessionary gap increases to 4% of Y*Slide20

U.S. Output Gap

According to Okun's LawOutput gap = -2 x (u – u*) In 1995, 2005, and 2010, the economy had a recessionary gapIn 2000, there was an expansionary gapYear

u

u*

Y* ($B)

1995

5.6%

5.3%

$9,216.4

2000

4.0

5.0

10,880.7

2005

5.1

5.0

12,576.3

2010

9.6

5.2

14,017.1

Output Gap ($B)

-$55.3

271.6-25.2 - 1,233.5 Slide21

Importance of the Output Gap

The 2010 output gap was -$1.2 trillionU.S. population was 309 million$1.2 trillion/309 million = $4,000 for a family of fourIn 2010 dollars it equals $16,000 for a family of fourPolicy makers pay attention to output gaps because of the impact it has on our standard of livingWhile average impact is $8,000 for a family of four, the distribution of costs are not evenConcentrated in households of workers laid offSlide22

Macroeconomic Policy 1999-2000

Federal Reserve applied the brakes in 1999 and 2000About 1997, cyclical unemployment rates became negativeFor 1997 and 1998, Fed saw the inflationary pressure as low due to Gains in productivityInternational competitionExpansionary gap increased in 1999 and 2000Fed grew more concerned about inflation and began to slow the economyRecession in early 2001 caused Fed to reverse courseSlide23

Short-Term Fluctuations

Output gaps arise for two main reasonsMarkets require time to reach equilibrium price and quantityFirms change prices infrequentlyQuantity produced is not at equilibrium during the adjustment periodFirms produce to meet the demand at current pricesSlide24

Short-Term Fluctuations

Output gaps arise for several reasonsChanges in total spending at preset prices affects output levelsWhen spending is low, output will be below potential outputChanges in economy-wide spending are the primary causes of output gapsPolicy: adjust government spending to close the output gapSlide25

Causes of Short-Term Fluctuations

The economy has self-correcting mechanismsFirms eventually adjust to output gapsIf spending is less than potential output, firms will slow the increase of their pricesIf spending is more than potential output, firms increase pricesPotential inflationary pressureSlide26

Causes of Short-Term Fluctuations

The economy has self-correcting mechanismsEventually, prices reach equilibrium and eliminate output gapsProduction is at potential output levelsOutput is determined by productive capacity Spending influences only price levels and inflationSlide27

Al's Ice Cream – Production Capacity

Daily output of the store is determined byProduction capacityAmount of capitalLabor employed (includes hours worked)Productivity of capital and laborCapacity changes slowly, but periodic disruptions happenMachine failureWorkers fail to report for workPower outageSupplies not deliveredSlide28

Al's Ice Cream – Demand Fluctuations

Predictable changes hour by hourDay of the week patternsAnnual cycles of demandUnpredictable changes in demandWeatherCommunity eventsIncrease sales or divert customers elsewhereDemand for specific flavorsSlide29

Al's Ice Cream – Setting Prices

Fully flexible prices are unrealisticMinute-by-minute pricing is confusing to customersCosts of an auction exceed Al's benefitsContinuous purchases in low volumes by different customersAl sets pricesSurvey of competitorsProduct strengths and weaknessesAnalyzes sales over time to see if adjustments are neededAl meets demand in the short runSlide30

Al's Ice Cream – Long Run

Al observes consistently strong demand for his productsWaiting lines Low inventoryFully utilized production capacityAl's first response is to raise pricesImplemented quicklyAl evaluates expanding capacityIf expansion does not raises average costs, Al will expand and return to original pricesSlide31

Al's Ice Cream – Macroeconomic Lessons

In the short run, producers meet demand at existing pricesTotal spending drives output levelsGather data and analyze business opportunitiesIn the long-run, prices reach equilibrium levels Output is at its potential levelSlide32

Dynamic Pricing

Coca-Cola tested machines that could modify prices according to demandTemperature sensors triggered higher prices on hot daysMachines could raise prices for periods of high demandJustified as a response to consumer demandBarriers to flexible pricingSophisticated vending machines increase costsConsumers reacted negatively to change in pricing practicesSlide33

Short-Term Economic Fluctuations

Short-Term Economic FluctuationsBusiness Cycles4 Phases of Business CyclesSymptoms

Causes

Potential Output

Output Gaps

Natural Rate of Unemployment