1. Introduction to Economic Fluctuations:
CHAPTER
Introduction to Economic Fluctuations:
Introduction to the Short-run Model
Chapter 10 - selected sections!

2. The Short Run Economic Fluctuations
Business cycle
real GDP fluctuates around an overall upward trend
Recessions
Output declines, employment falls and unemployment increases
Expansions
Output rises faster than potential output,
employment rises and unemployment falls

3. 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 (unemployment rate above normal)

4. Log-run trend in potential GDP
The Business Cycle
Log-run trend in potential GDP
Boom
Slump
Over time, real GDP fluctuates around an overall upward trend. Such fluctuations are called business cycles. When output rises, we are in the expansion phase of the cycle; when output falls, we are in a recession.

5. Potential and Actual Real GDP and Employment, quarterly, 1979–2011 (a)

6. Economic Fluctuations - Facts
The shift from a strong expansion to a serious recession can occur suddenly
Recessions and the resulting slumps don’t last forever
The recession phase can be relatively brief
Slumps can be long and painful

7. U.S. Employment Rate (percent employed): Workers Aged 25 to 54, 1979–2011

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

9. Can the Classical Model Explain Economic Fluctuations?
Remember - The Classical model is supply oriented. Fluctuations would occur when something affects the supply side of the economy in the labor market, capital market or productivity

10. Can the Classical Model Explain Economic Fluctuations?
Recession
We would have to experience a sudden leftward shift of the labor supply curve?
Think about what this means: people prefer to work less and the level of employment and output would fall

11. A Recession Caused by Declining Labor Supply?
Employment
Real Wage Rate
Recession
Labor Supply?
Labor
Demand G
$30
Normal Labor Supply 90
Million E
$25
100
Million
In fact, shifts in labor supply occur very slowly, so they cannot explain economic fluctuations.

12. Sudden shifts in the labor supply curve are unlikely to occur
Why would people want to work less?
Why would unemployment increase if people want to work less?
Conclusion: the classical model cannot explain fluctuations through shifts in the supply of labor

13. Can the Classical Model Explain Economic Fluctuations?
Recession
Can it be caused by a leftward shift of the labor demand curve?
Leftward shift in the labor demand
The level of employment would fall
The real wage rate would fall
with flexible prices the market clears.
there is no rise in unemployment contradicting the facts of actual recessions .

14. A Recession Caused by Declining Labor Demand? (a)
Employment
Real Wage Rate
Normal Labor Demand
Labor Supply
Recession Labor Demand? E
$25
100
Million F 20 90
Million
In theory, a recession could be caused by a sudden leftward shift in the labor demand curve, causing employment to fall. But in panel with flexible wages, the labor market clears, so there would be no rise in unemployment, contradicting the facts of actual recessions.

15. Sticky Wages and Leftward Shift in Labor Demand
With sticky wages (real wage rate remains unchanged)
you get unemployment !
this seems to fit what happens in real-world recessions

16. A Recession Caused by Declining Labor Demand? Wage rate rigid at $25
Employment
Real Wage Rate
Normal Labor Demand
What is the level of unemployment in this graph?
How many people want to work in this graph?
Labor Supply
Recession Labor Demand? H E
$25 80
Million
100
Million 20 F 90
Million
Downward wage rigidity prevents the labor market from clearing. This could, in theory, explain the rise in unemployment during a recession.

17. Institutional factors such as unions and minimum wage.
Are Wages Rigid and WHY?
They seem to be.
Institutional factors such as unions and minimum wage.
Employers are hesitant to lower wages - negative effect on worker morale and productivity

18. What Causes Labor Demand to Shift Leftward?
Decrease in labor productivity
Decrease in total spending

19. Decrease in Labor Productivity
Labor becomes less productive and thus less valuable to firms
For example, labor has less capital(equipment) to work with
Really need to ask why would labor become less productive.
Does not occur rapidly enough to explain real-world economic fluctuations

20. Decrease in Total Spending
Plays an important role in real-world economic fluctuations
But, the classical model rules this out as an initial cause because of the flexible price assumption and Say’s law.

21. Verdict! The classical model cannot explain economic fluctuations
Once we step away from the classical model and the assumption that all markets clear, a combination of a sudden drop in spending combined with wage rigidity can explain economic fluctuations

22. Expansions and Recessions in the Last 50 Years
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23. Expansions and Recessions in the Last 50 Years
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24. Summary
The classical model cannot explain booms and recessions because it assumes that markets respond very quickly to changes in spending so that the economy remains at full employment - labor markets always clear.
Evidence suggests that this assumption is not valid over short time periods - rigid wages
The alternative view - the short-run macro view, is that markets respond slowly to shocks - rigidity.

25. Summary
The major difference in these two views is in the speed of adjustment.
Because the short-run macro view concentrates on the period during which adjustment is less than complete, it places the focus on spending.