1. 1 Frank & Bernanke 4 th edition, 2009 Ch. 10: Short-Term Economic Fluctuations

2. 2 Definitions Recession (or contraction): A period in which the economy is growing at a rate significantly below normal. Recession (or contraction): A period in which the economy is growing at a rate significantly below normal. Depression: A particularly severe or protracted recession. Depression: A particularly severe or protracted recession. Peak: The beginning of a recession, the high point of economic activity prior to a downturn. 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. Trough: The end of a recession, the low point of economic activity prior to a recovery. Expansion : A period in which the economy is growing at a rate significantly above normal. Expansion : A period in which the economy is growing at a rate significantly above normal. Boom : A particularly strong and protracted expansion. Boom : A particularly strong and protracted expansion.

3. 3 http://www.dallasfed.org/research/swe/2005/swe0502.pdf

4. 4 http://www. nber.org/cy cles/cycles main.html

5. 5

6. 6 http://research.stlouisfed.org/publications/net/page4.pdf

7. 7 Fluctuations in U.S. Real GDP, 1920-2004

8. 8 Recessions and Expansions Growth rates of GDP show peaks and troughs. Growth rates of GDP show peaks and troughs. A peak is the onset of slowdown, perhaps the beginning of a recession. A peak is the onset of slowdown, perhaps the beginning of a recession. A trough is the end of a slowdown or a recession. A trough is the end of a slowdown or a recession. Expansions and slowdowns are irregular, though they are called business cycles. Expansions and slowdowns are irregular, though they are called business cycles.

9. 9

10. 10 Calling the 2001 recession Indicators of the business cycle Indicators of the business cycle Industrial production Industrial production Total sales in manufacturing, wholesale trade, and retail trade Total sales in manufacturing, wholesale trade, and retail trade Nonfarm employment Nonfarm employment Real after-tax income of households excluding transfers Real after-tax income of households excluding transfers

11. 11 U.S. Recessions Since 1929 Peak date (beginning) Trough date (end) Duration (months) Highest unemployment rate (%) Change in real GDP (%) Duration of subsequent expansion (months) Aug. 1929Mar. 19334324.9-28.850 May 1937June 19381319.0-5.580 Feb. 1945Oct. 194583.9-8.537 Nov. 1948Oct. 1949115.9-1.445 July 1953May 1954105.5-1.239 Aug. 1957Apr. 195886.8-1.724 Apr. 1960Feb. 1961106.72.3106 Dec. 1969Nov. 1970115.90.136 Nov. 1973Mar. 1975168.5-1.158 Jan. 1980July 198067.6-0.312 July 1981Nov. 1982169.7-2.192 July 1990Mar. 199187.5-0.9120 Mar. 2001Nov. 2001 85.80.8

12. 12 Unemployment During recessions unemployment rate rises sharply. During recessions unemployment rate rises sharply. Usually unemployment rates are lagging indicators: they start to rise after the economy has passed the peak. Usually unemployment rates are lagging indicators: they start to rise after the economy has passed the peak. During expansions unemployment rate falls, rather slowly. During expansions unemployment rate falls, rather slowly.

13. 13 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. During recessions, durable industries, like construction, cars, machines are more affected by recessions than service and non-durable industries because basic consumption expenditures continue.

14. 14 Inflation Inflation rate drops during recessions. Inflation rate drops during recessions. Usually, inflation rates would be rising before 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. 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. US is a relatively closed economy, somewhat insulated from global shocks compared to others.

15. 15 U.S. Inflation, 1960-2004

16. 16 CPI http://data.bls.gov/PDQ/servlet/SurveyOutputServlet

17. 17 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. 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. 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. Long run average unemployment rate is the “natural” or “full employment” rate of unemployment.

18. 18 Output Gaps and Cyclical Unemployment Potential Output and the Output Gap Potential Output and the Output Gap Changes in the rate at which the country’s potential output is increasing Changes in the rate at which the country’s potential output is increasing Actual output does not always equal potential output Actual output does not always equal potential output Y (actual output) - Y* (potential output) Y (actual output) - Y* (potential output) The difference between the economy’s actual output and its potential output at a point in time The difference between the economy’s actual output and its potential output at a point in time

19. 19 Output Gaps Recessionary Gap: Y-Y* < 0 Recessionary Gap: Y-Y* < 0 Y* > Y Y* > Y A negative output gap, which occurs when potential output exceeds actual output A negative output gap, which occurs when potential output exceeds actual output Capital and labor resources are not fully utilized Capital and labor resources are not fully utilized Output and employment are below normal levels Output and employment are below normal levels

20. 20 Output Gaps Expansionary Gap: Y-Y* > 0 Expansionary Gap: Y-Y* > 0 Y > Y* Y > Y* A positive output gap, which occurs when actual output is higher than potential output A positive output gap, which occurs when actual output is higher than potential output Higher output and employment than normal Higher output and employment than normal Demand for goods exceed the capacity to produce them and prices rise Demand for goods exceed the capacity to produce them and prices rise High inflation reduces economic efficiency High inflation reduces economic efficiency

21. 21 Natural rate of unemployment, u* U* is attributable to frictional and structural unemployment U* is attributable to frictional and structural unemployment Cyclical unemployment equals zero Cyclical unemployment equals zero No recessionary or expansionary gap No recessionary or expansionary gap Cyclical unemployment : u - u* > 0 Cyclical unemployment : u - u* > 0 If u<u*, there is negative cyclical unemployment, labor is being used more intensively than normal. If u<u*, there is negative cyclical unemployment, labor is being used more intensively than normal.

22. 22 What Can Cause Slow Growth? If the potential growth of the economy slows, the society would experience a recession. If the potential growth of the economy slows, the society would experience a recession. Capital Capital Technology Technology Labor 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 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. 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.

23. 23 What Can Cause Slow Growth? If the economy produces less than its potential amount, the “negative output gap” will also be responsible for slow growth and recession. If the economy produces less than its potential amount, the “negative 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 “positive output gap” will be responsible for fast growth. If the economy produces more than its potential amount because labor and/or capital is overworked, the “positive output gap” will be responsible for fast growth.

24. 24 Natural Rate of Unemployment Why has the natural rate of unemployment in the United States apparently declined in the nineties? Why has the natural rate of unemployment in the United States apparently declined in the nineties? Aging labor force Aging labor force More efficient labor market More efficient labor market

25. 25 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. 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. Recent data indicate that the relationship is now one percent deviation of unemployment rate implies two percentage point deviation in GDP.

26. 26 Okun’s Law Yearuu*Y* 19829.7%6.1%5,584 19916.85.87,305 19984.55.28,950 20025.85.210,342 1982 u - u* = cyclical unemployment 9.7 - 6.1 = 3.6% Output gap = 2 x 3.6 = 7.2% Output gap = 5,584 x.072 = $402 billion 1991 6.8 - 5.8 = 1% Output gap = 7,305 x.02 = $146 billion 1998 4.5 - 5.2 = -0.7 Output gap = 8,563 x -.014 = -$120 billion 2002 u - u* = 5.8 - 5.2 = 0.6 Output gap = 2 x.06 =.12 Y* - Y = 10,342 x.12 = $124 billion

27. 27 http://www.econ.yale.edu/alumni/conf2011/shiller-presentation.pdf

28. 28 Significance of Output Gaps The 1982 output gap per capita The 1982 output gap per capita $402 billion/230 million = $1,748 for a family of four $402 billion/230 million = $1,748 for a family of four In 2000 dollars it equals $7,000 for a family of four In 2000 dollars it equals $7,000 for a family of four

29. 29 Problem #5, p. 341

30. 30 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. 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. Show a partial equilibrium, market supply and demand case to indicate the above. Coke example. Coke example.

31. 31 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. 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. 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.

32. 32 Why Do Output Gaps Occur? It is the total spending (aggregate demand) that determines the gaps in the short run. It is the total spending (aggregate demand) that determines the gaps in the short run. Total spending is C+I+G+NX. Total spending is C+I+G+NX.

33. FIRMS GOVERNMENT FINANCIAL SYSTEM HOUSEHOLDS REST OF THE WORLD Y=wages+salaries+rent+profits+inter est C S pri T>TR+INT+G : S gov TTR+INT I NX<0 S for EX IM G GDP NX>0 -S for -S gov

34. 34 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. 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. 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. 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. Chronic excess total spending will create chronic inflation but not an increase in output.