1. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 0 Short-Term Economic Fluctuations: An Introduction

2. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 1 Long Run vs. Short Run  The economic “climate”  Long-run economic conditions are the ultimate determinant of living standards  Changes in the economic “weather”  Short-run fluctuations are important to our day-to-day existence

3. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 2 Recessions  Recession [or Contraction]  A period in which the economy is growing at a rate significantly below normal  A period during which real GDP falls for at least 6 consecutive months  Recent recessions have lasted between 6 and 16 months  Depression  A particularly severe or protracted recession

4. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 3 Recessions  Duration  Length of recessions  Peak  The beginning of a recession  The high point of economic activity prior to a downturn  Trough  The end of a recession  The low point of economic activity prior to a recovery

5. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 4 Fig. 12.1 Fluctuations in U.S. Real GDP, 1920-1999

6. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 5 Expansions  Expansion  A period in which the economy is growing at a rate significantly above normal  Normally lasts longer than recessions  Boom  A particularly strong and protracted expansion

7. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 6 Cyclical?  Cyclical fluctuations  Business cycles  Might imply that economic fluctuations are regular  However, economic fluctuations are quite irregular in their length and severity

8. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 7 Fig. 12.2 U.S. Inflation, 1960-1999

9. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 8 Characteristics of SR Fluctuations  Expansions and recessions are  Felt throughout the economy and often globally  Felt not just in a few industries  The unemployment rate  Typically rises sharply during recessions  Rises because of cyclical unemployment

10. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 9 Characteristics of SR Fluctuations  Recessions  Tend to be preceded by inflation  Tend to bring lower inflation rates  Durable goods  Cars, houses, capital equipment  Sensitive to fluctuations  Services and nondurables  Food  Much less sensitive to fluctuations

11. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 10 Potential Output  Potential output or Potential real GDP  Full employment output  The amount of output (real GDP) that an economy can produce when using its resources, such as capital and labor, at normal rates  Grows over time  Y*

12. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 11 Causes of Recession  A recession occurs when the economy is growing significantly below its normal rate  Two possibilities  Actual output equals potential output, but potential output is growing slowly  Appropriate policy responses include long-run solutions (Part VI)  Promote saving, investment, technological innovation, human capital formation  Actual output does not always equal potential output (i.e., a recessionary gap)

13. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 12 Output Gaps  Output gap (Y* - Y)  The difference between the economy’s potential output and its actual output at a given point in time  Y is actual real GDP  Y* is potential real GDP

14. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 13 Gaps  Recessionary gap (Y* > Y)  A positive output gap, which occurs when potential output exceeds actual output  A condition when an economy’s capital and labor resources may not be fully utilized  Expansionary gap (Y* < Y)  A negative output gap, which occurs when actual output is higher than potential output  A condition when an economy’s resources are being over-utilized

15. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 14 Fig. 12.3 Actual and Potential Output in Japan, 1980-2000

16. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 15 Unemployment and Gaps  During a recessionary gap  Low utilization of resources occurs  A high unemployment rate causes output to fall below potential  During an expansionary gap  Over utilization of resources occurs  Low unemployment rate  Hence, output is higher than potential

17. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 16 Types of Unemployment  Frictional  Short-term matching of workers and jobs  Always present  Structural  Long-term chronic—mismatch of skills of workers and skills required for jobs  Always present  Cyclical  Extra unemployment during periods of recession  Only present during recessions

18. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 17 Natural Rate of Unemployment  Natural rate of unemployment [u*]  The part of the total unemployment rate that is attributable to frictional and structural unemployment  The unemployment rate that prevails when cyclical unemployment equals zero  The unemployment rate that exists when an economy has neither an expansionary gap nor a recessionary gap

19. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 18 Cyclical Unemployment  Cyclical unemployment: u - u*  Actual unemployment rate: u  Natural rate of unemployment: u*  Recession  u – u* is positive (u > u*)  Positive cyclical unemployment  Expansion  u – u* is negative (u < u*)  Negative cyclical unemployment: Labor is being used more intensively than normal

20. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 19 Okun’s Law  Okun’s Law  Each extra percentage point of cyclical unemployment is associated with about a 2 percentage point increase in the output gap  Measured in relation to potential output

21. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 20 Significant Costs  Output gaps and cyclical unemployment have significant costs  1982 recessionary gap = $357 billion, in 1992 dollars  1982 U.S. population = 230 million  Hence, the output loss was around $1,550 per person or about $6,000 per family

22. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 12 - 21 Reasons for Output Gaps  1. Some prices adjust slowly  Firms “meet the demand” at a preset price in the short run  2. Economy-wide spending changes  Major cause of output gaps  3. Firms change prices  Raise prices in response to expansionary gaps  Lower prices in response to recessionary gaps  4. Economy self-corrects  Tends to eliminate output gaps in the long run