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Economic Fluctuations © 2003 South-Western/Thomson Learning Can the Classical Model Explain Economic Fluctuations? Shifts in Labor Demand Shifts in Labor Supply Shifts in Labor Demand Shifts in labor demand not very large from year to year

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economic fluctuations

Economic Fluctuations

© 2003 South-Western/Thomson Learning

can the classical model explain economic fluctuations

Can the Classical Model Explain Economic Fluctuations?

  • Shifts in Labor Demand
  • Shifts in Labor Supply
shifts in labor demand

Shifts in Labor Demand

  • Shifts in labor demand not very large from year to year
  • Classical model cannot explain real-world economic fluctuations through shifts in labor demand
shifts in labor demand4

Labor

Supply

E

F

Normal

Labor

Demand

Recession

Labor

Demand?

Shifts in Labor Demand

Real

Wage

Rate

$15

12

70

100

Employment

Million

Million

a

a

a

a

shifts in labor supply

Shifts in Labor Supply

  • Sudden shifts in labor supply are unlikely
  • Thus, the classical model cannot explain real-world economic fluctuations through shifts in labor supply.
shifts in labor supply6

Recession

Labor

Supply?

G

Normal

Labor

E

Supply

Labor

Demand

Shifts in Labor Supply

Real

Wage

Rate

$18

15

70

100

Employment

Million

Million

a

a

a

classical model cannot explain economic fluctuations

Classical Model Cannot Explain Economic Fluctuations

  • We cannot explain the facts of short-run economic fluctuations with a model useful for the long-run
  • The classical model assumes the market always clears,
    • it does a poor job of explaining the economy in the short run
economic fluctuations a more realistic view

Economic Fluctuations: A More Realistic View

  • Opportunity Costs and Labor Supply
  • Firms’ Benefits from Hiring: The Labor Demand Curve
  • The Meaning of Labor Market Equilibrium
  • The Labor Market When Output Is Below Potential
  • The Labor Market When Output Is Above Potential
economic fluctuations a more realistic view9

Economic Fluctuations: A More Realistic View

Disequilibrium

A situation in which a market does not clear - quantity supplied is not equal to quantity demanded.

opportunity cost and labor supply

Opportunity Cost and Labor Supply

At every point along the labor supply curve, the wage rate tells us the opportunity cost of working for the last worker to enter the labor force.

firms benefits from hiring the labor demand curve

Firms’ Benefits from Hiring: The Labor Demand Curve

At every point along the labor demand curve, the wage rate tells us the benefit obtained by some firm from the last worker hired.

the meaning of labor market equilibrium

The Meaning of Labor Market Equilibrium

At the equilibrium level of employment, all opportunities for mutually beneficial trade in the labor market have been exploited.

the meaning of labor market equilibrium15

Real

Wage

S

L

Rate

G

J

$18

E

15

F

K

12

D

L

Employment

Employment

in a recession

in a boom

70

100

130

Employment

Million

Million

Million

The Meaning of Labor Market Equilibrium

the labor market output below potential

The Labor Market: Output Below Potential

During a recession, the labor market is in disequilibrium, and the benefit from hiring another worker exceeds the opportunity cost to that worker.

the labor market output below potential17

The Labor Market: Output Below Potential

  • In recessions, there are incentives to increase the level of employment because
  • the benefit to firms from additional employment exceeds the opportunity cost to workers
  • these incentives help explain why recessions do not last forever
the labor market output above potential

The Labor Market: Output Above Potential

  • In booms, there are incentives to decrease the level of employment because
  • the benefit to firms from some who have been hired is smaller than the opportunity cost to those workers.
  • These incentives help explain why booms do not last forever.
what triggers economic fluctuations

What Triggers Economic Fluctuations?

  • A Very Simple Economy vs.
  • The Real-World Economy
  • Shocks That Push the Economy Away from Equilibrium
    • Spending shock: a change in spending that ultimately affects the entire economy
what triggers economic fluctuations20

What Triggers Economic Fluctuations?

In the short run, we need to look carefully at the problems of coordinating production, trade, and consumption in an economy with hundreds of millions of people and tens of millions of businesses.

the economics of slow adjustment

The Economics of Slow Adjustment

  • Adjustment in a Boom
  • Adjustment in a Recession
  • The Speed of Adjustment
adjustment in a boom

Adjustment in a Boom

  • When a positive shock causes a boom, firms operate - temporarily - at above-normal rates of utilization. As a consequence
  • employment rises above its normal, full- employment level.
adjustment in a boom23

Adjustment in a Boom

Over time, firms that have experienced an increase in demand will return to normal utilization rates, and employment will fall back to its normal, full-employment level.

adjustment in a recession

Adjustment in a Recession

  • When an adverse shock causes a recession, firms operate - temporarily - at below-normal rates of utilization. As a consequence
  • employment drops below its normal, full- employment level.
adjustment in a recession25

Adjustment in a Recession

Over time, firms that have experienced a decrease in demand will return to normal utilization rates, and employment will rise back to its normal, full-employment level.

the speed of adjustment

The Speed of Adjustment

Job-searching behavior by firms and workers is just one explanation for the slow pace of adjustment back to full employment.

where do we go from here

Where Do We Go from Here?

  • In the short run, we have seen that spending shocks to the economy affect production - usually in a specific sector.
  • If we want to understand fluctuations, we need to take a close look at spending.