Economic Fluctuations

1. Economic Fluctuations

2. 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?

3. Figure 1: Potential and Actual Real GDP and Employment, 1960-2001

4. Figure 2: U.S. Unemployment Rate, 1960-2003

5. Shifts in Labor Demand • Can classical model explain why GDP and employment typically fall below potential during a recession and often rise above it in an expansion? • One idea is that a recession might be caused by a leftward shift of labor demand curve • Is this a reasonable explanation for recessions? • Most economists feel that the answer is no • If we want to explain a leftward shift in the labor demand curve using the classical model • Must look for some explanation other than a sudden change in spending

6. Shifts in Labor Demand • Another possibility is that labor demand curve shifts leftward • Because workers have become less productive and therefore less valuable to firms • A leftward shift of labor demand curve is an unlikely explanation for recessions • What about booms? • Could a rightward shift of labor demand curve explain them? • A change in total spending cannot be the answer • A sudden rightward shift of labor demand curve is an unlikely explanation for an expansion that pushes us beyond potential output • 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

7. Figure 3: A Recession Caused By Declining Labor Demand?

8. Shifts in Labor Supply • A second way classical model might explain a recession is through a shift in labor supply curve • Explanation of recessions has almost no support among economists • Remember that labor supply schedule tells us number of people who would like to work • At each real wage rate • Even if such a shift in preferences did occur, it could not explain facts of real-world downturns • Same arguments could be made about expansions • To explain them with labor supply shifts, would have to believe that preferences suddenly change toward market work and away from other activities—an unlikely occurrence • 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

9. Figure 4: A Recession Caused By Declining Labor Supply?

10. 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

11. What Triggers Economic 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?

12. A Very Simple Economy • Imagine an economy with just two people • Suppose there is a breakdown in communication • Total production in economy declines • Two traders will lose some of benefits of trading • Corresponds to a recession • Or, total output in economy rises • Corresponding to an expansion • A breakdown in communication and a sudden change would be extremely unlikely… in a simple economy with just two people • And therein lies the problem • Real-world economy is much more complex

13. The Real-World Economy • Think about U.S. economy, with its 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 • A boom can arise in much the same way as a recession

14. Shocks That Push the Economy Away From Equilibrium • Spending Shock • Change in spending that ultimately affects entire economy • In real world, economy is constantly buffeted by shocks • Often cause full-fledged macroeconomic fluctuations • Economy is buffeted by other shocks whose origins are harder to spot • 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

15. Shocks That Push the Economy Away From Equilibrium • 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

16. Where Do We Go From Here? • 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