1. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-1 Chapter 4 Short-term economic fluctuations

2. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-2 Learning objectives 1.How do economists decide whether the economy is in recession? 2.What typically happens to the unemployment rate in recessions? 3.What caused the early 1990s recession in Australia? 4.What features seem to be common to most business cycle fluctuations in the economy? 5.How are output gaps and cyclical unemployment related?

3. Chapter organisation 4.1Contractions and expansions 4.2Output gaps and cyclical unemployment 4.3Why do short-term fluctuations occur? Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-3

4. 4.1 Contractions and expansions In the long run, real gross domestic product (GDP) grows steadily for most countries. The short run is characterised by volatile contractions and expansions in growth of real GDP. The business cycle refers to short-term fluctuations in growth of real GDP. The growth cycle is a different way of representing the business cycle. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-4

5. The business cycle Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-5 Figure 4.1 Stylised characteristics of the business cycle

6. The business cycle in Australia: 1960–2008 Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-6 Figure 4.2 Real GDP growth, unemployment and contractions, Australia

7. Recession dates in Australia Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-7

8. The early 1990s recession Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-8 Figure 4.3 Investment and the interest rate

9. Unemployment during the 1990s recession Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-9 Figure 4.4 Unemployment during the 1990s recession

10. Some facts about short-term economic fluctuations Economic fluctuations are irregular both in their length and severity. Global economic fluctuations often have significant impacts on Australia. Unemployment usually increases in a recession. Inflation usually decreases in a recession. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-10

11. Inflation and the business cycle Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-11 Figure 4.5 Inflation, 1960–2010

12. The 2008 global financial crisis Though the 2008 global financial crisis (GFC) began in the US it quickly spread to the rest of the world. Some stylised facts about the GFC in the US: –Sharp decline in real GDP –Sharp rise in unemployment –Sharp decline in inflation Australia was relatively unaffected by the GFC. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-12

13. Chapter organisation 4.1Contractions and expansions 4.2Output gaps and cyclical unemployment 4.3Why do short-term fluctuations occur? Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-13

14. Potential output Potential output is the amount of output (or real GDP) the economy is capable of producing when using resources such as: –labour, under normal weekly hours of work, at normal rates –capital, at normal rates. This is less than the physical maximum, which would involve overtime. –Actual output can exceed potential output. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-14

15. Potential output (cont.) Potential output can grow over time with increases in the number of labour and capital resources available, and increases in their productivity. One reason for economic fluctuations are changes in the level of potential output, signified by y* : –An extensive drought could cause a significant fall in potential output growth, leading to a contraction or recession. –A period of particularly rapid innovation could cause unusually large growth in potential output, leading to an expansion or boom. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-15

16. Output gaps If economic fluctuations are usual and require a policy response, some way to identify the size of the fluctuation is needed. The output gap measures how far actual output is from its normal level at a particular time. –The normal level of output is called the potential output, or potential GDP, which is also equal to full employment output. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-16

17. Output gaps (cont.) Economic fluctuations arise when actual output does not always equal potential output: –When (y – y*) < 0 : There is an underutilisation of resources; a recessionary gap. –When (y – y*) > 0 : There is an overutilisation of resources; an inflationary gap. Both cause problems in the economy –A rise in unemployment in recession –A rise in inflation in booms Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-17

18. Natural rate of unemployment An important measure of the utilisation of resources in the economy is the unemployment rate. Frictional and structural unemployment are always present in the labour market, even when the economy is operating normally. Cyclical unemployment is the extra unemployment that occurs during a recession. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-18

19. Natural rate of unemployment (cont.) The natural rate of unemployment is equal to frictional plus structural unemployment. Natural rate of unemployment ( u* ) occurs when the cyclical unemployment rate is zero, and neither a recessionary nor an expansionary gap exists: – (u – u*) > 0 : A recessionary gap – (u – u*) < 0 : An inflationary gap Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-19

20. Replacement ratio and unemployment rate in Australia, 1964 –2003 Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-20 Figure 4.9 Australia’s replacement rate and unemployment rate, June 1964–June 2003

21. Okun’s law How much output is forgone with cyclical unemployment? Okun’s law: each extra percentage point in unemployment is associated with about a 2% increase in the output gap (US figure). For Australia, the relationship has been calculated using real GDP and unemployment data. It was found that an unemployment rate which is 1% above the natural rate of unemployment will cause GDP to fall below potential by 1.5%. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-21

22. Okun’s law (cont.) In symbols: y – y* = –β (u – u*) y* where y is the actual output and y* is the full-employment level of output and where β is 2 for the US and 1.5 for Australia. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-22

23. Okun’s law (cont.) Example: June 1983 Australia u = 10.3%, u* = 8.08%, y* = $108 213.6 million. –β (u – u*) = –1.5 (0.103 – 0.0808) = –0.0333 Therefore, the output gap was –3.33% of y* = 3.33% x $108 213.6 million = $3603.51 million This is a recessionary gap (negative sign). Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-23

24. Chapter organisation 4.1Contractions and expansions 4.2Output gaps and cyclical unemployment 4.3Why do short-term fluctuations occur? Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-24

25. Why do short-term fluctuations occur? Two reasons for changes in real GDP growth: –Growth in potential output itself differs to normal. –Potential output is growing at the normal rate, but actual output is above or below potential output. Later, we will look at changes in potential output. –For now, let’s focus on fluctuations in actual output when we assume that potential output is constant. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-25

26. Why do short-term fluctuations occur? (cont.) In the next chapter, we will see that when potential output remains constant, actual output may mean we have a recessionary or expansionary gap. Firms adjust to short-run changes in demand by simply expanding their output, keeping constant prices. This means that firms change output in response to demand. In the short run, deficient demand leads to contractionary output gaps; too much demand leads to expansionary output gaps. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-26

27. Why do short-term fluctuations occur? (cont.) Governments can help to eliminate output gaps by influencing total spending. If demand continues to differ from potential output, firms will eventually adjust their prices to eliminate output gaps. Over the long run, changes in prices will bring the economy back to potential output. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-27

28. What caused the global financial crisis? Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-28 Figure 4.10 Index of US house prices, 1890–2009

29. Chapter organisation 4.1Contractions and expansions 4.2Output gaps and cyclical unemployment 4.3Why do short-term fluctuations occur? Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-29

30. Summary Every economy goes through the business cycle in the short run. The natural rate of unemployment consists of only frictional and structural unemployment. The level of output associated with the natural rate of unemployment is called potential output. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-30

31. Summary (cont.) Output gap is the difference between the actual level of output and the potential output. Okun’s law describes the trade-off between cyclical unemployment and output level. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 4-31