©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 20: Short-term Economic Fluctuations

©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Identify the four phases of the business cycle 2.Explain the primary characteristics of recessions and expansions 3.Define potential output, measure the output gap, and analyze an economy's position in the business cycle 4.Define the natural rate of unemployment and relate it to cyclical unemployment 5.Use Okun's law to analyze the relationship between the output gap and cyclical unemployment 6.Discuss the differences between how the economy operates in the short run and the long run

©2012 The McGraw-Hill Companies, All Rights Reserved 3 The Economy in the Short Run Short-Run Fluctua- tions Aggregate Spending Monetary Policy Inflation Policy Analysis

©2012 The McGraw-Hill Companies, All Rights Reserved 4 Recessions and Expansions Recession (or contraction) is a period in which the economy is growing at a rate below normal Depression a particularly severe recession Commonly held to be 2 or more consecutive quarters of negative GDP growth A variety of economic data are consulted

©2012 The McGraw-Hill Companies, All Rights Reserved 5 Fluctuations in Egyptian Real GDP, : Six-day war : Yom Kippur war 1991: Persian Gulf crisis

©2012 The McGraw-Hill Companies, All Rights Reserved 6 Fluctuations in Moroccan Real GDP, s: Post-independence political tensions including war with Algeria (Sand War – La guerre des sables) 1980s: Social unrest, drought, plummeting phosphate prices

©2012 The McGraw-Hill Companies, All Rights Reserved 7 Fluctuations in Turkish Real GDP, : Oil shocks of the 1970s : Global financial crisis

©2012 The McGraw-Hill Companies, All Rights Reserved 8 Recessions and Expansions A peak is the beginning of a recession High point of the business cycle A trough is the end of a recession Low point of the business cycle

©2012 The McGraw-Hill Companies, All Rights Reserved 9 Recessions and Expansions

©2012 The McGraw-Hill Companies, All Rights Reserved 10 Some Facts About Short-Term Economic Fluctuations Economists have studied business cycles for at least a century Recessions and expansions are irregular in their length and severity Contractions and expansions affect the entire economy May have global impact Great Depression of the 1930s was worldwide US recessions of 1973 – 1975 and 1981 – 1982 East Asian slowdown in the late 1990s

©2012 The McGraw-Hill Companies, All Rights Reserved 11 Symptoms of Business Cycles Cyclical unemployment rises sharply during recessions Decrease in unemployment lags the recovery Real wages grow more slowly for those employed Promotions and bonuses are often deferred New labor market entrants have difficulty finding work Production of durable goods is more volatile than services and non-durable goods Cars, houses, capital equipment less stable

©2012 The McGraw-Hill Companies, All Rights Reserved 12 Egyptian Recessions since 1960

©2012 The McGraw-Hill Companies, All Rights Reserved 13 Moroccan Recessions since 1960

©2012 The McGraw-Hill Companies, All Rights Reserved 14 Turkish Recessions since 1960

©2012 The McGraw-Hill Companies, All Rights Reserved 15 Output Gaps and Cyclical Unemployment: Potential Output and The Output Gap Potential output, Y*, is the maximum sustainable amount of real GDP that an economy can produce Also called full-employment GDP Use capital and labor at greater than normal rates and exceed Y* -- for a period of time Potential output grows over time Actual output grows at a variable rate Reflect growth rate of Y* Variable rates of technical innovation, capital formation, weather conditions, etc. Actual output does not always equal potential output

©2012 The McGraw-Hill Companies, All Rights Reserved 16 Egyptian, Moroccan, and Turkish Recessions Unemployment increases in Egypt from 1.5 to 1.6 percent during the 1972–1973 recession and to 9.6 percent during the 1991 recession. As for Morocco, unemployment is high by international standards and peaks at 22.9 percent during the 1995 recession and at 22 percent during the 1999 recession. As the Moroccan economy improves in 2000 by growing at 1.59 percent (versus 0.52 in 1999), unemployment also improves to 21.5 percent. It is important to note that the high level of unemployment observed in countries like Egypt and Morocco is not only associated with economic activity but also with other demographic and political factors - factors deemed largely responsible for the Arab uprisings of 2011.

©2012 The McGraw-Hill Companies, All Rights Reserved 17 Egyptian, Moroccan, and Turkish Recessions Like unemployment, inflation follows a typical pattern in recessions and expansions, though it is not so sharply defined. Recessions tend to be followed soon after by a decline in the rate of inflation. Inflation decreased from 9.04 percent to 0.70 percent during the Egyptian recession of 1966–1967. Inflation decreased from 4.02 percent to 3.48 percent and to 1.01 percent during the Moroccan recession of 1964–1966. Turkey faced unique circumstances (i.e. hyperinflation) that did not necessarily translate into lower inflation during recessions. Furthermore, manythough not allrecessions have been preceded by increases in inflation. Inflation in Egypt reached percent in 1965 before declining to 9.04 percent during the 1966 recession.

©2012 The McGraw-Hill Companies, All Rights Reserved 18 Output Gaps Output gap is the difference between potential output and actual output at a point in time Output gap = Y* – Y Recessionary gap is a negative output gap; Y* > Y Expansionary gap is a positive output gap; Y* < Y Policymakers consider stabilization policies when there are output gaps Recessionary gaps mean output and employment are less than their sustainable level Expansionary gaps lead to inflation to ration output

©2012 The McGraw-Hill Companies, All Rights Reserved 19 The Natural Rate of Unemployment and Cyclical Unemployment Recessionary gaps have high unemployment rates Expansionary gaps have low unemployment rates The natural rate of unemployment, u*, is the sum of frictional and structural unemployment Unemployment rate when cyclical unemployment is 0 Occurs when Y = Y* Cyclical unemployment is the difference between total unemployment, u, and u* Recessionary gaps have u > u* Expansionary gaps have u < u*

©2012 The McGraw-Hill Companies, All Rights Reserved 20 What Would Cause The Natural Rate of Unemployment to Decline? Possible explanations Frictional unemployment decreased Structural unemployment decreased Change in the age structure of the population Decline in the share of working population ages This group has higher unemployment than older workers Short-term jobs / Interrupt work for school Frequent job changes increases frictional unemployment Lower skills means more structural unemployment

©2012 The McGraw-Hill Companies, All Rights Reserved 21 What Would Cause The Natural Rate of Unemployment to Decline? Labor markets may be more efficient at matching job openings and workers Reduces frictional and structural unemployment Temporary agencies Temp work can lead to permanent position Online job boards Less time between jobs

©2012 The McGraw-Hill Companies, All Rights Reserved 22 Okuns Law Okun's law relates cyclic unemployment changes to changes in the output gap One percentage point increase in cyclical unemployment means a 2 percentage point increase in the output gap Suppose the economy begins with 1% cyclical unemployment and a recessionary gap of 2% of potential GDP If cyclical unemployment increases to 2%, the recessionary gap increases to 4% of Y*

©2012 The McGraw-Hill Companies, All Rights Reserved 23 Output Gap in the US, Egypt, Morocco, and Turkey

©2012 The McGraw-Hill Companies, All Rights Reserved 24 Output Gap in the US, Egypt, Morocco, and Turkey All years listed for Egypt, Morocco, and Turkey were recession years, so the output gaps are expected to be recessionary gaps. Contrary to expectations, recessionary gaps only took place in 1991 in Egypt, 1987, 1995, and 2000 in Morocco, and 1994 and 2008 in Turkey. Despite the year 1992 being a recession year for Morocco, the natural rate of unemployment exceeds the actual unemployment rate.

©2012 The McGraw-Hill Companies, All Rights Reserved 25 Output Gap in the US, Egypt, Morocco, and Turkey Such inconsistencies, also observed for Egypt and Turkey, cast doubt on the reliability of the data and impose serious limitations on the public and policymakers ability to deal effectively with recessions. It is common knowledge, at least in the academic world, that one of the most daunting tasks in conducting research about countries in the developing world is the lack of reliable data. This problem is likely due to various factors, including but not limited to data imperfections (i.e., missing observations), a lack of resources (i.e., human capital), the reluctance of various (primarily governmental) organizations to collect and disseminate data, or just a lack of interest.

©2012 The McGraw-Hill Companies, All Rights Reserved 26 Why Do Short-Term Fluctuations Occur? A Preview and A Parable Output gaps arise for two main reasons 1. Growth in potential output itself may slow down or speed up, reflecting changes in the growth rates of available capital, labor, and technology. 2. Actual output may be higher or lower than potential output despite normal growth in potential output.

©2012 The McGraw-Hill Companies, All Rights Reserved 27 Markets require time to reach equilibrium price and quantity Firms change prices infrequently Quantity produced is not at equilibrium during the adjustment period Firms produce to meet the demand at current prices Why Do Short-Term Fluctuations Occur? A Preview and A Parable

©2012 The McGraw-Hill Companies, All Rights Reserved 28 Changes in total spending at preset prices affects output levels When spending is low, output will be below potential output Changes in economywide spending are the primary causes of output gaps Policy: adjust government spending to close the output gap Why Do Short-Term Fluctuations Occur? A Preview and A Parable

©2012 The McGraw-Hill Companies, All Rights Reserved 29 Why Do Short-Term Fluctuations Occur? A Preview and A Parable The economy has self-correcting mechanisms Firms eventually adjust to output gaps If spending is less than potential output, firms will slow the increase of their prices If spending is more than potential output, firms increase prices Potential inflationary pressure

©2012 The McGraw-Hill Companies, All Rights Reserved 30 Why Do Short-Term Fluctuations Occur? A Preview and A Parable The economy has self-correcting mechanisms Eventually, prices reach equilibrium and eliminate output gaps Production is at potential output levels Output is determined by productive capacity Spending influences only rate of inflation

©2012 The McGraw-Hill Companies, All Rights Reserved 31 Alaa's Ice Cream – Production Capacity Daily output of the store is determined by Production capacity Amount of capital Labor employed (includes hours worked) Productivity of capital and labor Capacity changes slowly, but periodic disruptions happen Machine failure Workers fail to report for work Power outage Supplies not delivered

©2012 The McGraw-Hill Companies, All Rights Reserved 32 Alaa's Ice Cream – Demand Fluctuations Predictable changes hour by hour Day of the week patterns Annual cycles of demand Unpredictable changes in demand Weather Community events Increase sales or divert customers elsewhere Demand for specific flavors

©2012 The McGraw-Hill Companies, All Rights Reserved 33 Alaa's Ice Cream – Setting Prices Fully flexible prices are unrealistic Minute-by-minute pricing is confusing to customers Costs of an auction exceed Alaa's benefits Continuous purchases in low volumes by different customers Alaa sets prices Survey of competitors Product strengths and weaknesses Analyzes sales over time to see if adjustments are needed Alaa meets demand in the short run

©2012 The McGraw-Hill Companies, All Rights Reserved 34 Alaa's Ice Cream – Long Run Alaa observes consistently strong demand for his products Waiting lines Low inventory Fully utilized production capacity Alaa's first response is to raise prices Implemented quickly Alaa evaluates expanding capacity If expansion does not raises average costs, Alaa will expand and return to original prices

©2012 The McGraw-Hill Companies, All Rights Reserved 35 Alaa's Ice Cream – Macroeconomic Lessons In the short run, producers meet demand at existing prices Total spending drives output levels Gather data and analyze business opportunities In the long run, prices reach equilibrium levels Output is at its potential level

©2012 The McGraw-Hill Companies, All Rights Reserved 36 Dynamic Pricing Coca-Cola tested machines that could modify prices according to demand Temperature sensors triggered higher prices on hot days Machines could raise prices for periods of high demand Justified as a response to consumer demand Barriers to flexible pricing Sophisticated vending machines increase costs Consumers reacted negatively to change in pricing practices