ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing Slides by: John & Pamela Hall Economic Fluctuations

2 Neither output nor employment grows as smoothly and steadily as classical model predicts –As far back as we have data, United States and similar countries have experienced economic fluctuations During recessions, output declines—occasionally sharply –During expansions output rises quickly—usually faster than potential output is rising –In later stages of an expansion, output often exceeds potential output Called a boom Why do economic fluctuations Occur in the first place? Sometimes last so long? Not last forever?

3 Figure 1: Potential and Actual Real GDP and Employment,

4 Figure 2: U.S. Unemployment Rate,

5 Shifts in Labor Demand Can classical model explain why GDP and employment typically fall below potential during a recession and often rise above it in an expansion? One idea is that a recession might be caused by a leftward shift of labor demand curve Is this a reasonable explanation for recessions? –Most economists feel that the answer is no If we want to explain a leftward shift in the labor demand curve using the classical model –Must look for some explanation other than a sudden change in spending

6 Shifts in Labor Demand Another possibility is that labor demand curve shifts leftward –Because workers have become less productive and therefore less valuable to firms A leftward shift of labor demand curve is an unlikely explanation for recessions What about booms? –Could a rightward shift of labor demand curve explain them? –A change in total spending cannot be the answer –A sudden rightward shift of labor demand curve is an unlikely explanation for an expansion that pushes us beyond potential output Because shifts in labor demand curve are not very large from year to year –Classical model cannot explain real-world economic fluctuations through shifts in labor demand

7 Figure 3: A Recession Caused By Declining Labor Demand?

8 Shifts in Labor Supply A second way classical model might explain a recession is through a shift in labor supply curve Explanation of recessions has almost no support among economists –Remember that labor supply schedule tells us number of people who would like to work At each real wage rate –Even if such a shift in preferences did occur, it could not explain facts of real- world downturns Same arguments could be made about expansions –To explain them with labor supply shifts, would have to believe that preferences suddenly change toward market work and away from other activities—an unlikely occurrence Because sudden shifts of labor supply curve are unlikely to occur, and –Because they could not accurately describe facts of economic cycle Classical model cannot explain fluctuations through shifts in supply of labor

9 Figure 4: A Recession Caused By Declining Labor Supply?

10 Verdict: The Classical Model Cannot Explain Economic Fluctuations Earlier chapters stressed that classical model works well in explaining movements of economy in longer run –Does a rather poor job of explaining economy in short-run Cannot explain facts of short-run economic fluctuations with a model in which the labor market always clears –Classical model assumes market always clears

11 What Triggers Economic Fluctuations? In a recession, millions of qualified people want to work at the going wage rate –But firms won’t hire them In a boom, unemployment rate is so low normal job-search activity—which accounts for frictional unemployment—is short-circuited –Firms are less careful about whom they hire Desperate to hire workers because production is so high Booms and recessions are periods during which economy deviates from normal, full-employment equilibrium of classical model –Why do such deviations occur?

12 A Very Simple Economy Imagine an economy with just two people Suppose there is a breakdown in communication –Total production in economy declines Two traders will lose some of benefits of trading Corresponds to a recession Or, total output in economy rises –Corresponding to an expansion A breakdown in communication and a sudden change would be extremely unlikely… in a simple economy with just two people –And therein lies the problem Real-world economy is much more complex

13 The Real-World Economy Think about U.S. economy, with its millions of businesses producing goods and services for hundreds of millions of people When people spend their incomes, they give firms the revenue they need to hire workers…and pay them income –If any link in this chain is broken, output and income may both decline Classical model, however, waves these potential problems aside –Assumes workers and firms, with aid of markets, can work things out and enjoy the benefits of producing and trading –Classical model is right People will work things out…eventually A boom can arise in much the same way as a recession

14 Shocks That Push the Economy Away From Equilibrium Spending Shock –Change in spending that ultimately affects entire economy In real world, economy is constantly buffeted by shocks –Often cause full-fledged macroeconomic fluctuations Economy is buffeted by other shocks whose origins are harder to spot Each shock has momentum –Economy can continue sliding downward, and remain below potential output, for a year or longer –Same processes work in reverse during an expansion

15 Shocks That Push the Economy Away From Equilibrium Booms and recessions do not last forever –Often, a change in government macroeconomic policy helps adjustment process along Speeding return to full employment –Other times, a policy mistake thwarts adjustment process Prolonging or deepening a costly recession, or exacerbating a boom and overheating economy even more

16 Where Do We Go From Here? Classical model is useful –Helps us understand economic growth over time How economic events and economic policies affect economy over long-run –But in trying to understand expansions and recessions we’ve had to depart from strict framework of classical model But in short-run, we’ve seen that spending shocks to economy affect production –If we want to understand fluctuations need to take a close look at spending