The Business Cycle What are recessions? Expansions? POTENTIAL GDP, Actual GDP and the GDP GAP Unemployment and the NAIRU Okun’s Law.

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The Business Cycle What are recessions? Expansions? POTENTIAL GDP, Actual GDP and the GDP GAP Unemployment and the NAIRU Okun’s Law

National Bureau of Economic Research and the dating of the business cycle The NBER (a private organization in Boston) produces the most widely accepted business cycle dates. It looks at several indicators: –industrial production –employment –real income –wholesale/retail trade Recessions are the period from PEAK to TROUGH Expansions are the period from TROUGH to PEAK Web site:

The Congressional Budget Office Estimates POTENTIAL GDP on basis of available capital, labor force and technology. Uses those estimates in long-run planning -- for example, can we still fund Social Security and have a tax cut? Permits a definition of RECESSION as a period in which the economy is BELOW POTENTIAL. GDP GAP = (POTENTIAL GDP - ACTUAL GDP) divided by POTENTIAL GDP. Textbook notation: (Y* - Y) / Y*

Actual GDP and Potential GDP 1953.Q1 to 2000.Q2 Source: Congressional Budget Office

GDP gap = (potential - actual) / potential Gap greater than 0 ==> RECESSION

GDP gap Gap < 0 indicates EXPANSION

The NAIRU (Natural Rate of Unemployment) NAIRU literally stands for “The Non-Accelerating Inflation Rate of Unemployment” -- the level of unemployment which cannot be reduced by monetary policy without a higher and accelerating inflation rate. The “Natural Rate” = “non-cyclical rate” Estimates of the NAIRU have changed –because of the changing composition of the labor force –new entrants into the labor force change jobs more frequently, and therefore have higher rates of unemployment

The NAIRU estimated by the CBO NAIRU = Non-Accelerating Inflation Rate of Unemployment

Percentage composition of the labor force YEAR Under 24Over 24Female

Unemployment rate and the NAIRU to

GDP gap and unemployment gap Note that they move together, but GDP moves more

Okun’s Law -- scatterplot Unemployment gap on X-axis GDP gap on Y-axis

Okun’s Law - regression line GDP GAP = 1.77 UGAP