SHORT-RUN ECONOMIC FLUCTUATIONS

Aggregate Demand and Aggregate Supply

Short-Run Economic Fluctuations What causes short-run fluctuations in economic activity? What, if anything, can the government do to stop GDP from falling and unemployment from rising? And if the government can’t stop the occurrence of bad times, can it at least make them less damaging in terms of duration and severity?

Short-Run Economic Fluctuations Economic activity fluctuates from year to year. Real GDP increases in most years. On average over the past 50 years, real GDP in the U.S. economy has grown by about 3 percent per year. In some years normal growth does not occur, causing a recession.

Short-Run Economic Fluctuations A recession is a period of declining real incomes, and rising unemployment. A depression is a severe recession. An expansion is a period of increasing real incomes, and falling unemployment.

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Economic fluctuations are irregular and unpredictable. Fluctuations in the economy are often called the business cycle. Most macroeconomic variables fluctuate together. As output falls, unemployment rises.

Three Facts About Economic Fluctuations FACT 1: Economic fluctuations are irregular and unpredictable. $ U.S. real GDP, billions of 2000 dollars The shaded bars are recessions On some displays, the numbers along the axes appear grainy. This is due to a quirk with PowerPoint, that often occurs when animation is added on a slide with a graph imported from Excel. If the graininess looks especially bad on the display in your classroom, you can make it go away by turning off the animation effects on this slide. (You’ll have to do the same for the following two slides, as well.) Point out to students that the recessions (represented by the shaded bars) are of different durations and do not occur with any regularity. Hence, the common term “business cycle” is a bit misleading, as “cycle” implies something more regular and predictable. UNITS: Billions of chained 2000 dollars ORIGINAL SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis WEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/ series “GDPC1”

Economic fluctuations are irregular and unpredictable Recessions start at the peak of a business cycle and end at the trough. The length of a business cycle may be measured by the time between one peak and the next or the time between one trough and the next. The peaks and troughs of the US business cycle are officially registered by the NBER. During 1945-2001, there have been 10 cycles in the US. The average recession lasted 10 months and the average expansion lasted 57 months, thereby making the average cycle 67 months long.

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Most macroeconomic variables fluctuate together. When real GDP falls in a recession, so do personal income, corporate profits, consumption spending, investment spending, industrial production, retail sales, home sales, auto sales, and so on. However, investment fluctuates a lot more than other variables. Even though investment is about one-seventh of GDP, much of the fall in GDP during recessions is due to the fall in investment spending.

Three Facts About Economic Fluctuations FACT 2: Most macroeconomic quantities fluctuate together. $ Investment spending, billions of 2000 dollars Point out that investment falls during each recession (each shaded bar). This is true of other variables, as well: When the economy is in recession, incomes fall, consumer spending falls, profits fall, many stock prices fall, tax revenue falls (causing the budget deficit to rise), and spending on imports falls (causing the trade deficit to shrink). UNITS: Billions of chained 2000 dollars ORIGINAL SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis WEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/ series “GPDIC1”

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS As output falls, unemployment rises. Changes in real GDP are inversely related to changes in the unemployment rate. During times of recession, unemployment rises substantially. The unemployment rate never approaches zero; instead it fluctuates around its natural rate of about 5 or 6 percent.

Three Facts About Economic Fluctuations FACT 3: As output falls, unemployment rises. Unemployment rate, percent of labor force During each recession, the unemployment rate rises. When firms cut back on production, they don’t need as many workers. Similarly, during expansions, we see the unemployment rate falling – as firms increase their output, they need more workers. UNITS: Percent of labor force (seasonally adjusted) ORIGINAL SOURCE: U.S. Department of Labor, Bureau of Labor Statistics WEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/ series “UNRATE” Note: The source data was monthly. To be consistent with Figure 1c of the text, I graphed quarterly data, where each quarterly value is a simple average of the three monthly values.