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

©2012 The McGraw-Hill Companies, All Rights Reserved

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Chapter 20: Short-term Economic Fluctuations


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Learning Objectives

1. Identify the four phases of the business cycle2. Explain the primary characteristics of

recessions and expansions3. 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


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The Economy in the Short Run


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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


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Fluctuations in Egyptian Real GDP, 1960-2009

1966-1967: Six-day war 1972-1973: Yom Kippur war 1991: Persian Gulf crisis


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Fluctuations in Moroccan Real GDP, 1960-2009

1960s: Post-independence political tensions including war with Algeria (Sand War – La guerre des sables)

1980s: Social unrest, drought, plummeting phosphate prices


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Fluctuations in Turkish Real GDP, 1960-2009

1978-1980: Oil shocks of the 1970s 2008-2009: Global financial crisis


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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


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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


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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


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Egyptian Recessions since 1960


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Moroccan Recessions since 1960


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Turkish Recessions since 1960


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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


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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.


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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, many—though not all—recessions have been preceded by increases in inflation. Inflation in Egypt reached 14.84 percent in 1965 before

declining to 9.04 percent during the 1966 recession.


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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


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The Natural Rate of Unemployment and Cyclical Unemployment

Recessionary gaps have high unemployment rates

Expansionary gaps have low unemployment ratesThe 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*


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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 16-

24 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


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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


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Okun’s 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*


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Output Gap in the US, Egypt, Morocco, and Turkey


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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.


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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.


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Why Do Short-Term Fluctuations Occur? A Preview and A Parable

Output gaps arise for two main reasons1. 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.


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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



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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



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The economy has self-correcting mechanismsFirms 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


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The economy has self-correcting mechanismsEventually, prices reach equilibrium

and eliminate output gapsProduction is at potential output levels

Output is determined by productive capacity Spending influences only rate of inflation


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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


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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


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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 customersAlaa 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


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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


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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

opportunitiesIn the long run, prices reach

equilibrium levels Output is at its potential level


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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

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

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