1. Economic Fluctuations
CHAPTER
Economic Fluctuations
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2. Economic Fluctuations
Recessions
Output declines, occasionally sharply
Employment falls
Expansions
Output rises faster than potential output
Employment rises
Employment and output move very close together
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3. 1
Potential and Actual Real GDP and Employment, quarterly, 1979–2011 (a)
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4. 1
Potential and Actual Real GDP and Employment, quarterly, 1979–2011 (b)
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5. 2 U.S. Employment Rate for Workers Aged 25 to 54, 1979–2011
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6. Economic Fluctuations
The shift from a strong expansion to a serious recession can occur rather suddenly
Recessions and the resulting slumps don’t last forever
The recession phase can be relatively brief
Slumps can be long and painful
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7. Economic Fluctuations
Boom
A period of time during which real GDP is above potential GDP
Slump
A period during which real GDP is below potential and/or the employment rate is below normal
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8. Economic Fluctuations
Three things to explain about economic fluctuations
Why they occur in the first place
Why they sometimes last so long
Why they do not last forever
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9. Can the Classical Model Explain Economic Fluctuations?
Recession
Can be caused by a leftward shift of the labor supply curve?
Leftward shift in the labor supply
Equilibrium would move up and to the left along the labor demand curve
The level of employment would fall
Output would fall with it
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10. 3 A Recession Caused by Declining Labor Supply? Real Wage Rate
Employment
Real Wage Rate
Recession
Labor Supply?
Labor
Demand G
$30
Normal Labor Supply 90
Million E
$25
100
Million
In theory, a recession could be caused by a sudden leftward shift in the labor supply curve, causing employment to fall. In fact, shifts in labor supply occur very slowly, so they cannot explain economic fluctuations.
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11. Can the Classical Model Explain…
Sudden shifts in the labor supply curve
Are unlikely to occur
Could not accurately describe the facts of the economic cycle
The classical model cannot explain fluctuations through shifts in the supply of labor
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12. Can the Classical Model Explain…
Recession
Can be caused by a leftward shift of the labor demand curve?
Leftward shift in the labor demand
Move us down and to the left along the labor supply curve
The level of employment would fall
The real wage rate would fall
Will the market clear? Probably not
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13. 4 A Recession Caused by Declining Labor Demand? (a) Real Wage Rate
Employment
Real Wage Rate
Normal Labor Demand
Labor Supply
Recession Labor Demand? E
$25
100
Million F 20 90
Million
Panel (a) shows how, in theory, a recession could be caused by a sudden leftward shift in the labor demand curve, causing employment to fall. But in panel (a), the labor market clears, so there would be no rise in unemployment, contradicting the facts of actual recessions.
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14. Can the Classical Model Explain…
Leftward shift in the labor demand
With sticky wages (real wage rate remains unchanged)
Unemployment
Seem to fit what happens in real-world recessions
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15. 4 A Recession Caused by Declining Labor Demand? (b) Employment
Real Wage Rate
Normal Labor Demand
Labor Supply
Recession Labor Demand? H E
$25 80
Million
100
Million 20 F 90
Million
In panel (b), downward wage rigidity prevents the labor market from clearing. This could, in theory, explain the rise in unemployment during a recession. But the classical model does not explain how such sudden leftward shifts in labor demand could realistically occur.
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16. Can the Classical Model Explain…
Why does labor demand shifts leftward?
Change in productivity
Change in total spending
Changes in labor productivity
Can shift the labor demand curve
They do not occur rapidly enough to explain real-world economic fluctuations
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17. Can the Classical Model Explain…
Changes in spending
Play an important role in real-world economic fluctuations
The classical model rules them out as an initial cause
Verdict
The classical model cannot explain economic fluctuations
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18. What Triggers Economic Fluctuations?
In a recession: high unemployment rate
Millions of qualified people want to work, but firms won’t hire them
Managers would like to hire them, but they aren’t selling enough output
In part because so many people are unemployed
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19. What Triggers Economic Fluctuations?
In a boom: very low unemployment rate
Firms: desperate to hire workers
Are less careful about whom they hire
Poorer-than- normal match between workers and their jobs
Drives up wage rates in the economy, raises production costs for firms, and ultimately causes firms to raise their prices
The overheating of the economy that occurs in a boom can lead to inflation
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20. A Very Simple Economy Yasmin and Pepe If things are going well
Yasmin makes yogurt, but she eats popcorn
Pepe makes popcorn, but he eats yogurt
If things are going well
Specialize and trade
Gains from trade
Full employment
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21. A Very Simple Economy Breakdown in communications
Yasmin makes less yogurt
Next round, Pepe makes less popcorn
Lower total production
Recesion
Yasmin makes more yogurt
Higher total production
Boom
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22. The Real-World Economy
A change in production
A firm reduces production (Ford Motors)
Unemployment
Less consumption spending
Lower production
More unemployment
And so on
Can also trigger a boom
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23. The Real-World Economy
A change in spending
A large number of consumers believe a recession is likely in the near future
Save more and spend less
Firms: lower production
Unemployment
Lower spending
And so on
Can also trigger a boom
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24. Say’s Law Doesn’t Prevent Recessions
Critical assumption of the classical model
The interest rate adjusts until saving is equal to business and government borrowing
Households spend less (save more)
But do not supply all of their additional saving to the loanable funds market
Total spending will drop below total income, violating Say’s law
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25. 5 Two Destinations for Additional Household Saving (a)
In panel (a), the loanable funds market behaves according to the classical model. Households cut their spending (increase their saving) by $100 billion per year, and supply it all to the loanable funds market. The funds are loaned out to business firms, and planned investment rises by $100 billion. Consumption falls by $100 billion and planned investment rises by $100 billion, so there is no change in total spending.
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26. 5 Two Destinations for Additional Household Saving (b)
Panel (b) deviates from the classical model. As in panel (a), households cut their spending (increase their saving) by $100 billion per year, but now they supply none of it to the loanable funds market. The additional saving is not loaned out to business firms, and planned investment does not change. Consumption falls by $100 billion and planned investment does not change, so total spending drops by $100 billion.
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27. Say’s Law Doesn’t Prevent Recessions
Households save more (spend less)
But financial intermediaries do not lend out all of the additional saving
Total spending will drop below total income, violating Say’s law
But other factors prevent the interest rate from falling to its market-clearing level
Then some of the additional saving will not be borrowed and spent by others
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28. 6 Additional Saving Supplied to the Market but Not Loaned Out
Households cut their spending (increase their saving) by $100 billion per year, and supply all of the additional funds to the loanable funds market. But if pessimistic financial intermediaries in the loanable funds market do not lend out the funds, there is no additional borrowing by business firms. Because consumption falls by $100 billion and planned investment does not change, total spending falls by $100 billion.
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29. Say’s Law Doesn’t Prevent Recessions
Interest rates
Can be influenced by events outside the loanable funds market
Interest-rate changes
Can cause economic fluctuations
A rise in the interest rate
Causes both household and business spending to drop
Decrease in total spending
Downward spiral
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30. 1 Expansions and Recessions in the Last 50 Years
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31. 1 Expansions and Recessions in the Last 50 Years
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