1. Frank & Bernanke Ch. 12: Short-Term Economic Fluctuations: An Introduction

2. Recessions and Expansions A person can drown in a lake of 3 ft average depth. An economy can go through spurts of fast growth and stagnation that will affect the people deeply. NBER defines a recession as two quarters of shrinking GDP (negative growth). Even if there was positive growth, slower growth of GDP than population growth or work force growth will cause major discontent.

3. Recessions and Expansions Growth rates of GDP show peaks and troughs. – A peak is the onset of slowdown, perhaps the beginning of a recession. – A trough is the end of a slowdown or a recession. Expansions and slowdowns are irregular, though they are called business cycles.

6. Unemployment During recessions unemployment rate rises sharply. Usually unemployment rates are lagging indicators: they start to rise after the economy has passed the peak. During expansions unemployment rate falls, rather slowly.

7. Inflation Inflation rate drops during recessions. Usually, inflation rates would be rising before recessions. In late nineties many East Asian, Latin American and European newly industrializing countries experienced recessions because of exchange rate crisis. US is a relatively closed economy, somewhat insulated from global shocks compared to others.

8. Calculated from: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

9. Durable Industries During recessions, durable industries, like construction, cars, machines are more affected by recessions than service and non- durable industries because basic consumption expenditures continue.

10. Measuring Fluctuations In order to claim a recession is big or small, an unemployment rate is too high or too low, one needs to have a standard to measure against. The “normal” or “trend” or “potential” or “full employment” output is the standard to compare expansions or recessions. Long run average unemployment rate is the “natural” or “full employment” rate of unemployment.

11. What Can Cause Slow Growth? If the potential growth of the economy slows, the society would experience a recession. – Capital – Technology – Labor The experience of US in the second half of the nineties was an acceleration of the potential growth rate of the economy. The experience of Japan was that the rate of growth of potential output slowed from 3.6% in the eighties to 2.2% in the nineties.

12. What Can Cause Slow Growth? If the economy produces less than its potential amount, the “positive output gap” will also be responsible for slow growth and recession. If the economy produces more than its potential amount because labor and/or capital is overworked, the “negative output gap” will be responsible for fast growth. Output gap: Y* - Y. Potential GDP – Actual GDP.

13. Natural Rate of Unemployment Cyclical unemployment is zero: there is no recessionary or expansionary output gap. Frictional and structural unemployment add to the natural rate of unemployment. If u>u*, there is positive cyclical unemployment and the economy is in a recessionary mode. If u<u*, there is negative cyclical unemployment, labor is being used more intensively than normal.

14. Okun’s Law Arthur Okun in the sixties observed that every time unemployment rate in the US rose one percentage point above the natural rate, GDP fell 3 percentage points below the potential GDP. Recent data indicate that the relationship is now one percent deviation of unemployment rate implies two percentage point deviation in GDP.

15. Problem #5, p. 325

16. Significance of Output Gaps In 1982, u=9.7%, u*=6.1%, Y*=$4,957b, Y=$4,600b (in 1992 dollars). The loss of output, output gap, was therefore, $357b. The population of the US at the time was 230 million. Per capita loss was, therefore, $1,550 in 1992 dollars or about $1,925 in 2001 dollars. For a family of four, that one year impoverishment was $7,800!

17. Why Do Output Gaps Occur? If prices in every market adjusted immediately to demand shifts, there would not have been any output gaps. Firms do not change their prices every day: contracts, menu costs keep prices constant for a period of time. Show a partial equilibrium, market supply and demand case to indicate the above.

18. Why Do Output Gaps Occur? If some markets are experiencing positive output gaps and others negative output gaps, the net outcome might be no change. For the economy as whole to experience positive or negative output gaps, total spending in the economy has to be below or above the total output produced.

19. Why Do Output Gaps Occur? It is the total spending (aggregate demand) that determines the gaps in the short run. Total spending is C+I+G+NX.

20. Why Output Gaps Don’t Last? In the long run firms will adjust prices upward if total spending is more than the potential output, eliminating the gap. Likewise, if total spending is less than the potential output, firms will reduce prices. In the long run, the economy settles at the potential output. Chronic excess total spending will create chronic inflation but not an increase in output.