1 The Short Term

2 We have seen in the long run that the US economy has had an upward trend of economic activity in terms of producing goods and services. We now want to switch our attention and study the short term fluctuations around that long term trend. Words and phrases you hear associated with the short term are the business cycle, cyclical fluctuations, expansions, recessions, booms and busts. In this section we begin the study of the economy in the short term and we will build a model of the short term where we will consider the actions of the 4 sectors of the economy (households, businesses, governments and the rest of the world). We will also add how monetary and fiscal policy are tools that can be used to influence the economic system.

3 Time in years RGDP This is an imaginary business cycle. But, note the long term upward trend. IN the short term we have ups and downs. Note that for a while on the time line we could have a peak of economic activity. This means that before and after this time the level of activity is lower than at the peak. Troughs are just the opposite in that they are periods of lowest activity. peak trough One business cycle is typically thought of as occurring from peak to peak. The time period where the economy is moving from peak to trough is called a recession and the movement from the trough to the next peak is called an expansion.

4 A rule of thumb about a recession is that RGDP needs to fall for 2 consecutive quarters, or more. But, more formally, a recession is a period of time when RGDP growth is well below normal (and may not even be negative). Note a depression, like the one that occurred in the 1930’s, is really just a sever recession. A boom is just an extra big expansion. In the formal definition of recession we say output growth is below normal. This implies there is a natural level of output at which the economy could produce. Another name for this is the potential output or potential GDP or the full-employment level of output. Let’s call Y* the potential output and recognize this is the maximum sustainable amount of output capable of being produced in an economy at a certain time given the resource base and technology available in the economy.

5 Analogy: When jogging for exercise many folks do not sprint the whole time. Sprinting is a persons maximum speed, but not their maximum sustainable speed. The potential GDP is analogous to your jogging pace. Note that the better shape you are in the faster is your jogging pace and the same can be said about potential GDP. Let’s define Y - Y* = Actual GDP minus potential GDP = output or GDP gap. If Y – Y* > 0 the output gap is positive. If Y – Y* < 0 the output gap is negative. Let u = the unemployment rate and we saw before this includes folks unemployed for frictional, structural and cyclical reasons. If we could eliminate the business cycle we would have the natural rate of unemployment u* = frictional and structural unemployment.

6 u* is the unemployment that would be consistent with potential output, and so u – u* = cyclical unemployment. The point to think about here is that part of the actual unemployment is the natural unemployment that would occur, u*, and the cyclical component. Now, If Y – Y* 0. This means we have more than just the natural unemployment. We also have cyclical unemployment. The idea is that if output is less than potential then some resources will also be idle, including labor. If Y – Y* > 0 we have a positive gap and u – u* < 0. This means we have less than the natural unemployment, and certainly no cyclical unemployment. The idea is that if output is more than potential then some resources are being used very intensively, including labor.

7 If Y* - Y = 0 we have no gap and u – u* = 0. This means we have just the natural unemployment. We have no cyclical unemployment. The idea is that if output is equal to potential then resources are being used to their fullest, including labor. Okun’s Law (Y – Y*)/Y* = 2(u – u*). Okun’s law is based on observations made by Authur Okun. The way to read this equation is start on the left and say 1) For every extra % point in cyclical unemployment u – u*, 2) There is a 2 % point increase in the output gap as a % of the potential output.