Short-Term Economic Fluctuations: An Introduction : Short-Term Economic Fluctuations: An Introduction Jenny Xu, Department of Economics, SFU chapter 11 PART 4
The Economy in the Short Run
Long Run vs. Short Run Climate Change vs. Daily Weather : Long Run vs. Short Run Climate Change vs. Daily Weather Economic “climate”
Long-run economic trends are the ultimate determinants of living standards
Economic “weather”
Short-run fluctuations determine our day-to-day experience
Long-run = a succession of short-runs
So “short run” economic policy matters for the long run
“Short Run” also matters for Well-Being
Canadians can still freeze in blizzards, even if the Global Climate has a long run warmer trend
I. Recessions and Expansions : I. Recessions and Expansions How much does economic activity fluctuate?
Business Cycle : Business Cycle All market economies have had fluctuations in economic growth – periods of expansion followed by periods of recession
Recessions can be very costly
Loss of potential output can be several hundred billion $
Historically – some depressions produced bad political changes
Example: Germany in 1930s
Public policy aim: minimize frequency & length of recessions
Peak
The high point of economic activity (GDP) prior to a downturn
Trough
The low point of economic activity (GDP) prior to a recovery
Recessions : Recessions How to define “recession” ?
General Idea: a period in which the economy is growing at a rate significantly below normal
Technical Definition: when GDP has fallen for at least 6 consecutive months
Some debates exist on particular events
Early 1990s – was it a long recession or a slow recovery ?
Depression
A particularly severe or protracted recession
Great Depression
FIGURE 11.1 : FIGURE 11.1 Fluctuations in Canadian Real GDP, 1926-2003
Expansions : Expansions Expansion
A period in which the economy is growing at a rate significantly above normal
Normally lasts longer than a recession
Boom
A particularly strong & protracted expansion
A term often very loosely used by journalists
“Cyclical” Fluctuations of economic activity : “Cyclical” Fluctuations of economic activity The term “Business Cycle” should not be read to imply that economic fluctuations are regular or inevitable
Irregular in length and severity
Reducing frequency and length of recessions was and is the major objective of macro-economic policy
HUGE payoffs, since 1% of GDP = $13 Billion
Fortin: early 1990s recession cost Canadians $ 475 Billion in lost output
FIGURE 11.2 : Canada’s Real GDP Per Capita Growth Rate, 1927–2003 FIGURE 11.2 Average growth rate, 1940-1944 (9.1 percent) Growth rate of real
GDP per capita Average growth rate,
1962-1979
(3.3 percent) Long-term average growth rate,
1927-2003
(2.3 percent) Average growth
rate, 1980-1996 (1.2 percent) Average growth rate, 1929-1938
(-1.1 percent)
Some facts about Short-term Fluctuations: http://www.ny.frb.org/research/directors_charts/capage.pdf : Some facts about Short-term Fluctuations: http://www.ny.frb.org/research/directors_charts/capage.pdf Expansions and recessions are
Felt throughout the economy - not just some industries
Positively correlated across countries
The unemployment rate
Lags slowdown in GDP
Typically rises sharply during recessions
Layoffs + longer search times to find jobs
But - jobless workers may also stop searching
Cyclical unemployment
Also known as “Demand-deficient”
Characteristics of Short-run Fluctuations : Characteristics of Short-run Fluctuations Recessions - may be “policy induced” in order to prevent higher inflation or lower inflation rates
Uneven in industrial impact
Durable goods are much more sensitive to income and interest rate fluctuations
Households can postpone purchases ?
E.g., cars, houses, capital equipment
Services and nondurables output is much less sensitive to fluctuations
Hard to postpone consumption
E.g., Food, hospitals, schools
II. Measuring Fluctuations : II. Measuring Fluctuations How much could the economy produce, compared to what it does produce?
Potential Output : Potential Output Potential output, Potential real GDP, or Full employment output
The amount of output (real GDP) that an economy could produce when using all its resources, such as capital and labour, at normal rates
Potential output grows over time
Capital & labor inputs increase + technology improves
Usually denoted by Y*
Always estimated with some uncertainty
Recessions and Potential Output : Recessions and Potential Output Why might the economy grow at less than its normal rate? – 2 possibilities
Maybe actual output (Y) equals potential output (Y*), but potential output is now growing more slowly ??
Appropriate policy responses - Promote saving, investment, technological innovation, human capital formation (all of which have long run impacts)
Actual output (Y) is less than potential output (Y*)
i.e., a recessionary gap
the usual explanation for short-term fluctuations
Output gap (Y* - Y)
The difference between the economy’s potential output and its actual output at a given point in time
Y* is potential real GDP
Y is actual real GDP
Gaps : Gaps Recessionary gap (Y* > Y)
A positive output gap - when potential output exceeds actual output
Capital & labour resources are not fully utilized
WASTE
Expansionary gap (Y* < Y)
A negative output gap - when actual output is higher than potential output
Resources are being “over-utilized”
FIGURE 11.5 : FIGURE 11.5 Actual Output and IMF Estimates of Potential Output, Canada, 1985-2003
Unemployment and Gaps : Unemployment and Gaps Recessionary gap = under-utilization of resources: Output < potential
Indicator - high unemployment rate
Many people looking for jobs, but few are available
Expansionary gap = “over-utilization”
Economy cannot continue to grow at this rate without increasing inflation
Low unemployment rate
Output > potential
Types of Unemployment : Types of Unemployment Frictional
Associated with short-term matching of workers and jobs
Always present – but longer in recessions
Structural
Long-term chronic—mismatch of skills which workers have & skills required for jobs
Very often present, but not a large % of labour force
Seasonal
Predictable fluctuations in jobs & job search due to weather, Xmas, etc.
Recurring every year
Unemployment and Aggregate Demand : Unemployment and Aggregate Demand Cyclical Unemployment
Also known as “Demand – deficient” unemployment
Firms hire workers when they expect to be able to sell what workers will produce
When expected sales decrease, jobs are lost
Extra unemployment occurs during recession because of:
LAY-OFFS at continuing firms +
Bankruptcies & firm closures cost jobs +
Fewer new firms opening means less new hiring = fewer jobs
Cyclical Unemployment is characteristic of recessions
Natural Rate of Unemployment : Natural Rate of Unemployment Natural rate of unemployment [u*]
Frictional + structural + seasonal unemployment
The unemployment rate
when cyclical unemployment equals zero
when an economy has neither an expansionary gap nor a recessionary gap
“Natural” does not equal “Good”
Well designed public policies can change the “natural rate”
Large payoffs to policies which reduce u*
Example: policies which reduce frictional unemployment by reducing job search time, by publicizing vacancies
Cyclical Unemployment : 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 gap
Expansion
u – u* is negative (u < u*)
Negative cyclical unemployment: Labour is being used more intensively than normal
GDP growth & unemployment : GDP growth & unemployment Okun’s Law- the quantitative relationship between cyclical unemployment and the output gap.
When unemployed workers get a job, they put unemployed capital to work
– hence output increases
A rule of thumb to describe the quantitative relationship between cyclical unemployment and the output gap, after Arthur Okun.
Each extra percentage point of cyclical unemployment is associated with a 2 percentage point increase change in output
[Some estimates are higher - 2.5%]
Can be used to calculate Natural rate of unemployment, see Example 11.1
Output Gap has Significant Costs in lost output : Output Gap has Significant Costs in lost output 1994 – estimates of cost of recessionary gap range from $37 to $109 billion, for that one year
1994 Canadian population = 29 million
Even according to the lowest estimate, the output loss was around $1,276 per person or about $5,100 per family (1994 dollars)
Total cost of 1990s recession must be summed over entire period 1990-96
IV. Why do Output Gaps occur? : IV. Why do Output Gaps occur? In the short-run, only a few prices adjust instantly
Most firms “meet the demand” at a preset price
Because of this slow adjustment of prices, economy-wide spending changes are the major cause of output gaps
Governments can and often do attempt to manage economy-wide spending by policy
If gaps persist, firms may eventually respond (and gaps may then be eliminated)
Firms may raise prices aggressively in response to expansionary gaps (inflation)
Firms may increase prices by less (or even cut them) to increase sales, in response to recessionary gaps
If gaps would otherwise persist too long, society is better off if policy-makers take action to speed up the correction