Economic Fluctuations © 2003 South-Western/Thomson Learning

Can the Classical Model Explain Economic Fluctuations? Shifts in Labor Demand Shifts in Labor Supply

Shifts in Labor Demand Shifts in labor demand not very large from year to year Classical model cannot explain real-world economic fluctuations through shifts in labor demand

Shifts in Labor Demand Real Wage Normal Labor Demand Labor Supply Rate Recession Labor Demand? E $15 F 12 70 100 Employment Million Million a a a a

Shifts in Labor Supply Sudden shifts in labor supply are unlikely Thus, the classical model cannot explain real-world economic fluctuations through shifts in labor supply.

Shifts in Labor Supply Real Recession Labor Supply? Wage Rate Labor Demand G Normal Labor Supply $18 E 15 70 100 Employment Million Million a a a

Classical Model Cannot Explain Economic Fluctuations We cannot explain the facts of short-run economic fluctuations with a model useful for the long-run The classical model assumes the market always clears, it does a poor job of explaining the economy in the short run

Economic Fluctuations: A More Realistic View Opportunity Costs and Labor Supply Firms’ Benefits from Hiring: The Labor Demand Curve The Meaning of Labor Market Equilibrium The Labor Market When Output Is Below Potential The Labor Market When Output Is Above Potential

Economic Fluctuations: A More Realistic View Disequilibrium A situation in which a market does not clear - quantity supplied is not equal to quantity demanded.

Opportunity Cost and Labor Supply At every point along the labor supply curve, the wage rate tells us the opportunity cost of working for the last worker to enter the labor force.

Opportunity Cost and Labor Supply

Firms’ Benefits from Hiring: The Labor Demand Curve At every point along the labor demand curve, the wage rate tells us the benefit obtained by some firm from the last worker hired.

Firms’ Benefits from Hiring: The Labor Demand Curve

The Meaning of Labor Market Equilibrium At the equilibrium level of employment, all opportunities for mutually beneficial trade in the labor market have been exploited.

The Meaning of Labor Market Equilibrium Real Wage Rate J 70 Million G $18 15 12 100 130 Employment E F K L S D in a boom in a recession

The Labor Market: Output Below Potential During a recession, the labor market is in disequilibrium, and the benefit from hiring another worker exceeds the opportunity cost to that worker.

The Labor Market: Output Below Potential In recessions, there are incentives to increase the level of employment because the benefit to firms from additional employment exceeds the opportunity cost to workers these incentives help explain why recessions do not last forever

The Labor Market: Output Above Potential In booms, there are incentives to decrease the level of employment because the benefit to firms from some who have been hired is smaller than the opportunity cost to those workers. These incentives help explain why booms do not last forever.

What Triggers Economic Fluctuations? A Very Simple Economy vs. The Real-World Economy Shocks That Push the Economy Away from Equilibrium Spending shock: a change in spending that ultimately affects the entire economy

What Triggers Economic Fluctuations? In the short run, we need to look carefully at the problems of coordinating production, trade, and consumption in an economy with hundreds of millions of people and tens of millions of businesses.

The Economics of Slow Adjustment Adjustment in a Boom Adjustment in a Recession The Speed of Adjustment

Adjustment in a Boom When a positive shock causes a boom, firms operate - temporarily - at above-normal rates of utilization. As a consequence employment rises above its normal, full- employment level.

Adjustment in a Boom Over time, firms that have experienced an increase in demand will return to normal utilization rates, and employment will fall back to its normal, full-employment level.

Adjustment in a Recession When an adverse shock causes a recession, firms operate - temporarily - at below-normal rates of utilization. As a consequence employment drops below its normal, full- employment level.

Adjustment in a Recession Over time, firms that have experienced a decrease in demand will return to normal utilization rates, and employment will rise back to its normal, full-employment level.

The Speed of Adjustment Job-searching behavior by firms and workers is just one explanation for the slow pace of adjustment back to full employment.

Where Do We Go from Here? In the short run, we have seen that spending shocks to the economy affect production - usually in a specific sector. If we want to understand fluctuations, we need to take a close look at spending.