Short - Term Economic Fluctuations

Short - Term EconomicFluctuations

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Recessions and Expansions

• Definitions: 1- A recession (or contraction) is a period in

which the economy is growing at a rate significantlybelow normal (output is growing more slowly thannormal).

2- A depression is an extremely severe or protracted recession.

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3- Peak is the beginning of a recession. It represents

the high point of economic activity prior to adownturn.

4- Trough is the end of a recession which marks the

low point of economic activity prior to arecovery.

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5- Expansion is the opposite of a recession. It is a

period in which the economy is growing at arate that is significantly above normal.

6- Boom is a particularly strong and protracted

expansion.

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• It is difficult to predict short-term economicfluctuations (recessions & expansions) becausethey are irregular in length and severity.

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Some Facts about Short-Term Economic Fluctuations

• Unemployment is a key indicator of short-term economicfluctuations.

• The unemployment rate typically rises sharply duringrecessions and recovers.

• Industries that produce durable goods such as cars, houses, andcapital equipment are more affected than others by recessionsand booms.

• In contrast, industries that provide services and nondurablegoods like food are much less sensitive to short – termfluctuations.

• Recessions tend to be followed by a decline in inflation andpreceded by an increase in inflation.

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Output Gaps and Cyclical UnemploymentPotential output & the output gap:Definition: Potential output, also called potential

GDP or full-employment output, is themaximum sustainable amount of output (realGDP) that an economy can produce.

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Output Gaps and Cyclical Unemployment

• Potential output is not a fixed number butgrows over time, reflecting increases in bothamounts of available capital and labour andtheir productivity.

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• Why does a nation’s output sometimes growquickly and sometimes slowly?

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• The answer includes two possibilities:• 1- changes in the rate of output growth may reflect changes in the rate at

which the countries potential output is increasing. For example,• Unfavourable weather would reduce the rate of potential output in

agricultural economy. Also, a decline in the rate of technologicalinnovation might reduce the rate of potential output growth in an industrialeconomy.

• Under the assumption that the country is using its resources at normal rates,so that actual output equals potential output, a significant slowdown inpotential output growth would tend to result in recession.

• When a recession results from slowing growth in potential output, thegovernment’s best response is to try promote saving, investment, humancapital, and other supporters of growth.

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• 2- a second possible explanation for short-termeconomic fluctuations is that actual output does notalways equal potential output. For example, potentialoutput may be growing normally, but for some reasonthe economy’s capital and labour resources may notbe fully utilized, so that actual output is below thelevel of potential output. This low level of output,resulting from underutilization of economicresources, would be interpreted as a recession.

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• Output gap is the difference between potential output and actual

output. Output Gap =Y-Y*Where, Y is the actual output Y* is the potential outputWhen Y<Y* (negative output gap), it is called recessionary gap.In contrast when Y>Y* (positive output gap), it is called

expansionary gap.

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• When there is a recessionary gap, capital and labour resourcesare not being fully utilized, and output and employment arebelow maximum sustainable levels.

• A prolonged expansionary gap is problematic because, firmstend to raise prices, when faced with a demand for theirproducts that exceeds their sustainable capacity. Thus,expansionary gap results in increased inflation reducing theefficiency of the economy in the long run.

• In case of existing of output gap (recessionary orexpansionary), policymakers try to eliminate the gap byreturning actual output to potential.

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The natural unemployment rate & Cyclical Unemployment

• Natural rate of unemployment (u*) is the part of the total

unemployment rate which is attributable to frictionaland structural unemployment; equivalently, theunemployment rate that prevails when cyclicalunemployment is zero. So that the economy hasneither a recessionary nor an expansionary outputgap.

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The natural unemployment rate & Cyclical Unemployment

• Cyclical Unemployment=u – u*Where, u is the total unemployment rate u* is the natural rate of unemployment.

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The natural unemployment rate & Cyclical UnemploymentIn a recession the actual (total) unemployment rate u

exceeds the natural unemployment rate u*, socyclical unemployment is positive.

In an expansion the actual unemployment rate is lower

than the natural rate, so that the cyclicalunemployment is negative.

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Output Gap & Cyclical Unemployment

• Okun’s Law this law indicates the relationship between

the output gap and the amount of cyclicalunemployment in the economy. According to Okun’slaw, each extra percentage point of cyclicalunemployment is associated with about a 2percentage point increase in the output gap, measuredin relation to potential output.

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Output Gap & Cyclical Unemployment

• If cyclical unemployment increases from 1percent to 2 percent of the labour force, therecessionary gap will increase from 2 percentto 4 percent of potential GDP.

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In Brief

• As stated, two possible reasons cause periods ofrecession and expansion (slowdowns and speedups inreal GDP growth)

• First: growth in potential output itself may slow downor speed up, reflecting changes in the growth rates ofavailable capital and labour and in the pace oftechnological progress.

• Second: even if potential output is growing normally,actual output may be higher or lower than potentialoutput – that is, expansionary or recessionary outputgaps may develop.

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Short - Term Economic Fluctuations

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