Frank & Bernanke 3rd edition, 2007 Ch. 12: Short-Term Economic Fluctuations: An Introduction

Recessions and Expansions A person can drown in a lake of 3 ft average depth. An economy can go through spurts of fast growth and stagnation that will affect the people deeply. NBER defines a recession as two quarters of shrinking GDP (negative growth). Even if there was positive growth, slower growth of GDP than population growth or work force growth will cause major discontent.

Recessions and Expansions Growth rates of GDP show peaks and troughs. A peak is the onset of slowdown, perhaps the beginning of a recession. A trough is the end of a slowdown or a recession. Expansions and slowdowns are irregular, though they are called business cycles.

Definitions Recession (or contraction): A period in which the economy is growing at a rate significantly below normal. Depression: A particularly severe or protracted recession. Peak: The beginning of a recession, the high point of economic activity prior to a downturn. Trough: The end of a recession, the low point of economic activity prior to a recovery. Expansion: A period in which the economy is growing at a rate significantly above normal. Boom: A particularly strong and protracted expansion.

Fluctuations in U.S. Real GDP, 1920-2004

Calling the 2001 recession Indicators of the business cycle Industrial production Total sales in manufacturing, wholesale trade, and retail trade Nonfarm employment Real after-tax income of households excluding transfers

U.S. Recessions Since 1929 Peak date (beginning) Trough date (end) Duration (months) Highest unemployment rate (%) Change in real GDP (%) Duration of subsequent expansion (months) Aug. 1929 Mar. 1933 43 24.9 -28.8 50 May 1937 June 1938 13 19.0 -5.5 80 Feb. 1945 Oct. 1945 8 3.9 -8.5 37 Nov. 1948 Oct. 1949 11 5.9 -1.4 45 July 1953 May 1954 10 5.5 -1.2 39 Aug. 1957 Apr. 1958 8 6.8 -1.7 24 Apr. 1960 Feb. 1961 10 6.7 2.3 106 Dec. 1969 Nov. 1970 11 5.9 0.1 36 Nov. 1973 Mar. 1975 16 8.5 -1.1 58 Jan. 1980 July 1980 6 7.6 -0.3 12 July 1981 Nov. 1982 16 9.7 -2.1 92 July 1990 Mar. 1991 8 7.5 -0.9 120 Mar. 2001 Nov. 2001 8 5.8 0.8

Unemployment During recessions unemployment rate rises sharply. Usually unemployment rates are lagging indicators: they start to rise after the economy has passed the peak. During expansions unemployment rate falls, rather slowly.

Durable Industries During recessions, durable industries, like construction, cars, machines are more affected by recessions than service and non-durable industries because basic consumption expenditures continue.

Inflation Inflation rate drops during recessions. Usually, inflation rates would be rising before recessions. In late nineties many East Asian, Latin American and European newly industrializing countries experienced recessions because of exchange rate crisis. US is a relatively closed economy, somewhat insulated from global shocks compared to others.

U.S. Inflation, 1960-2004

Measuring Fluctuations In order to claim a recession is big or small, an unemployment rate is too high or too low, one needs to have a standard to measure against. The “normal” or “trend” or “potential” or “full employment” output is the standard to compare expansions or recessions. Long run average unemployment rate is the “natural” or “full employment” rate of unemployment.

Output Gaps and Cyclical Unemployment Potential Output and the Output Gap Changes in the rate at which the country’s potential output is increasing Actual output does not always equal potential output Y* (potential output) - Y (actual output) The difference between the economy’s potential output and its actual output at a point in time

Output Gaps Recessionary Gap Y* > Y A positive output gap, which occurs when potential output exceeds actual output Capital and labor resources are not fully utilized Output and employment are below normal levels

Output Gaps Expansionary Gap Y > Y* A negative output gap, which occurs when actual output is higher than potential output Higher output and employment than normal Demand for goods exceed the capacity to produce them and prices rise High inflation reduces economic efficiency

Natural rate of unemployment, u* U* is attributable to frictional and structural unemployment Cyclical unemployment equals zero No recessionary or expansionary gap Cyclical unemployment = u - u*

What Can Cause Slow Growth? If the potential growth of the economy slows, the society would experience a recession. Capital Technology Labor The experience of US in the second half of the nineties was an acceleration of the potential growth rate of the economy. The experience of Japan was that the rate of growth of potential output slowed from 3.6% in the eighties to 2.2% in the nineties.

What Can Cause Slow Growth? If the economy produces less than its potential amount, the “positive output gap” will also be responsible for slow growth and recession. If the economy produces more than its potential amount because labor and/or capital is overworked, the “negative output gap” will be responsible for fast growth. Output gap: Y* - Y. Potential GDP – Actual GDP.

Natural Rate of Unemployment Cyclical unemployment is zero: there is no recessionary or expansionary output gap. Frictional and structural unemployment add to the natural rate of unemployment. If u>u*, there is positive cyclical unemployment and the economy is in a recessionary mode. If u<u*, there is negative cyclical unemployment, labor is being used more intensively than normal.

Natural Rate of Unemployment Why has the natural rate of unemployment in the United States apparently declined? Aging labor force More efficient labor market

Okun’s Law Arthur Okun in the sixties observed that every time unemployment rate in the US rose one percentage point above the natural rate, GDP fell 3 percentage points below the potential GDP. Recent data indicate that the relationship is now one percent deviation of unemployment rate implies two percentage point deviation in GDP.

Okun’s Law Year u u* Y* 1982 9.7% 6.1% 5,584 1991 6.8 5.8 7,305 1982 9.7% 6.1% 5,584 1991 6.8 5.8 7,305 1998 4.5 5.2 8,950 2002 5.8 5.2 10,342 1982 u - u* = cyclical unemployment 9.7 - 6.1 = 3.6% Output gap = 2 x 3.6 = 7.2% Output gap = 5,584 x .072 = $402 billion 1991 6.8 - 5.8 = 1% Output gap = 7,305 x .02 = $146 billion 2002 u - u* = 5.8 - 5.2 = 0.6 Output gap = 2 x .06 = .12 Y* - Y = 10,342 x .12 = $124 billion 1998 4.5 - 5.2 = -0.7 Output gap = 8,563 x -.014 = -$120 billion

Significance of Output Gaps The 1982 output gap per capita $402 billion/230 million = $1,748 for a family of four In 2000 dollars it equals $7,000 for a family of four

Problem #5, p. 341

Why Do Output Gaps Occur? If prices in every market adjusted immediately to demand shifts, there would not have been any output gaps. Firms do not change their prices every day: contracts, menu costs keep prices constant for a period of time. Show a partial equilibrium, market supply and demand case to indicate the above. Coke example.

Why Do Output Gaps Occur? If some markets are experiencing positive output gaps and others negative output gaps, the net outcome might be no change. For the economy as whole to experience positive or negative output gaps, total spending in the economy has to be below or above the total output produced.

Why Do Output Gaps Occur? It is the total spending (aggregate demand) that determines the gaps in the short run. Total spending is C+I+G+NX.

Why Output Gaps Don’t Last? In the long run firms will adjust prices upward if total spending is more than the potential output, eliminating the gap. Likewise, if total spending is less than the potential output, firms will reduce prices. In the long run, the economy settles at the potential output. Chronic excess total spending will create chronic inflation but not an increase in output.