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Economic Fluctuations Neither output nor employment grows as smoothly and steadily as classical model predicts As far back as we have data, United States and similar countries have experienced economic fluctuations During recessions, output declines — occasionally sharply

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Economic Fluctuations

  • Neither output nor employment grows as smoothly and steadily as classical model predicts

    • As far back as we have data, United States and similar countries have experienced economic fluctuations

  • During recessions, output declines—occasionally sharply

    • During expansions output rises quickly—usually faster than potential output is rising

    • In later stages of an expansion, output often exceeds potential output

      • Called a boom

  • Why do economic fluctuations

    • Occur in the first place?

    • Sometimes last so long?

    • Not last forever?




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Can the Classical Model explain recessions?

  • Can the classical model explain

    • Why output falls in a recession?

    • Why employment falls in a recession?

  • Two potential explanations:

    • Labor demand curve shifts in. This will reduce employment and output.

    • Labor supply curve shifts in. This will also reduce employment and output.

  • Are either of these plausible explanations for recessions?



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Shifts in Labor Demand

  • Labor demand curve shifts leftward

  • Two potential explanations?

    • Workers become less productive and therefore less valuable to firms

      • What would make workers suddenly less productive? War that destroys equipment?

    • Firms want to produce less

      • Because they cannot sell all they produce

      • Classical model predicts that generalized overproduction does not occur (Say’s Law)


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Shifts in Labor Demand

  • Neither explanation is plausible

  • Shifts in Labor Demand cannot explain recessions


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Shifts in Labor Demand

  • What about booms?

    • Could a rightward shift of labor demand curve explain them?

    • A sudden increase in demand for output?

      • Not possible in the classical model.

      • Demand for output increases because of an increase in employment and output.

        • Not the other way round.

    • Workers suddenly become more productive?

      • This happens at a very slow pace.


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Shifts in Labor Demand

  • Because shifts in labor demand curve are not very large from year to year

    • Classical model cannot explain real-world economic fluctuations through shifts in labor demand



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Shifts in Labor Supply

  • Explanation of recessions through shifts in labor supply has almost no support among economists

    • Remember that labor supply schedule tells us number of people who would like to work so an inward shift in labor supply means that fewer people want to work.

    • But in a recession unemployment rate goes UP. So more people are looking for a job, not fewer!


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Shifts in Labor Supply

  • Same arguments could be made about expansions

    • We would have to believe that preferences suddenly change toward market work and away from other activities—an unlikely occurrence

    • But in an expansion fewer people are looking for work, unemployment is LOW!

  • Because sudden shifts of labor supply curve are unlikely to occur, and

    • Because they could not accurately describe facts of economic cycle

      • Classical model cannot explain fluctuations through shifts in supply of labor


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Verdict: The Classical Model Cannot Explain Economic Fluctuations

  • Earlier chapters stressed that classical model works well in explaining movements of economy in longer run

    • Does a rather poor job of explaining economy in short-run

  • Cannot explain facts of short-run economic fluctuations with a model in which the labor market always clears

    • Classical model assumes market always clears


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What Triggers Economic Fluctuations? Fluctuations

  • In a recession, millions of qualified people want to work at the going wage rate

    • But firms won’t hire them

  • In a boom, unemployment rate is so low normal job-search activity—which accounts for frictional unemployment—is short-circuited

    • Firms are less careful about whom they hire

      • Desperate to hire workers because production is so high

  • Booms and recessions are periods during which economy deviates from normal, full-employment equilibrium of classical model

    • Why do such deviations occur?


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A Very Simple Economy Fluctuations

  • Imagine an economy with just two people; one that makes popcorn (P) and the other yoghurt (Y) and trade with each other.

  • Suppose there is a breakdown in communication

    • Y gets the impression that P wants less yoghurt so she reduces her production of yoghurt. P is offered less yoghurt so he reduces the popcorn he makes.

    • Total production in economy declines

      • Two traders will lose some of benefits of trading

      • Corresponds to a recession

  • Or, total output in economy rises if P believes Y wants more popcorn.

    • Corresponding to an expansion (even if Y doesn’t want more popcorn it has been produced).


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A Very Simple Economy Fluctuations

  • Communication failure causes booms or recessions.

  • In an economy with just two people this is not very plausible but in the US economy with hundreds of millions of players, it is very probable.


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The Real-World Economy Fluctuations

  • U.S. economy, has millions of businesses producing goods and services for hundreds of millions of people

  • When people spend their incomes, they give firms the revenue they need to hire workers…and pay them income

    • If any link in this chain is broken, output and income may both decline

  • Classical model, however, waves these potential problems aside

    • Assumes workers and firms, with aid of markets, can work things out and enjoy the benefits of producing and trading

    • Classical model is right

      • People will work things out…eventually

  • But in the meantime the economy could experience a recession.

  • A boom can arise in much the same way as a recession


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Shocks Fluctuations

  • Economy is constantly buffeted by shocks.

    • A shock is an event that affects one sector

    • Which causes ripples in the rest of the economy

  • Spending shocks

    • Defense Spending

  • Oil Price Shock


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Shocks That Push the Economy Away From Equilibrium Fluctuations

  • Each shock has momentum

    • Economy can continue sliding downward, and remain below potential output, for a year or longer

    • Same processes work in reverse during an expansion

  • Why doesn’t Say’s Law bring the economy back to Equilibrium?

    • Why can’t Say’s Law prevent recessions?


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When Say’s Law Holds Fluctuations

  • Households save and supply these funds to the loanable funds market.

  • Spending shocks have no real effects


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Households do not supply funds Fluctuations

  • Households increase savings, but do not supply it to the loanable funds markets

    • Worried about bank stability?


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Banks do not loan out funds Fluctuations

  • Households put money in banks

    • Banks do not lend it out

    • Worried about repayments

    • Pessimistic about the future


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Shocks That Push the Economy Away From Equilibrium Fluctuations

  • Booms and recessions do not last forever

    • Often, a change in government macroeconomic policy helps adjustment process along

      • Speeding return to full employment

    • Other times, a policy mistake thwarts adjustment process

      • Prolonging or deepening a costly recession, or exacerbating a boom and overheating economy even more


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Where Do We Go From Here? Fluctuations

  • Classical model is useful

    • Helps us understand economic growth over time

      • How economic events and economic policies affect economy over long-run

    • But in trying to understand expansions and recessions we’ve had to depart from strict framework of classical model

  • But in short-run, we’ve seen that spending shocks to economy affect production

    • If we want to understand fluctuations need to take a close look at spending



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