Lecture Principles of economics (Asia Global Edition) - Chapter 21

This chapter identify the four phases of the business cycle; explain the primary characteristics of recessions and expansions; define potential output, measure the output gap, and analyze an economy''s position in the business cycle; define the natural rate of unemployment and relate it to cyclical unemployment; apply okun''s law to analyze the relationship between the output gap and cyclical unemployment; discuss the differences between how the economy operates in the short run and the long run.

Short-Term Economic Fluctuations Chapter 21 McGraw­Hill/Irwin Copyright © 2015 by McGraw­Hill Education (Asia). All rights reserved.21­1 Learning Objectives Identify the four phases of the business cycle and explain the primary characteristics of recessions and expansions Use potential output and the output gap to analyze an economy's position in the business cycle Define the natural rate of unemployment and show how it is related to cyclical unemployment Apply Okun's law to analyze the relationship between the output gap and cyclical unemployment Discuss the differences between how the economy operates in the short run and the long run 21­2 Headlines from The New York Times – – – – – – – – “Home Sales and Prices Continue to Plummet” “As Jobs Vanish, Motel Rooms Become Home” “Global Stock Markets Plummet” “Energy Prices Surge, and Stocks Fall Again” “Steep Slide in Economy as Unsold Goods Pile Up” “Fed Plans to Inject Another $1 Trillion to Aid Economy” “World Bank Says Global Economy Will Shrink in ‘09” U.S economy has passed through its worst recession in 25 years 21­3 Recessions and Expansions • • Business Cycles are short-term fluctuations in GDP and other variables A recession (or contraction) is a period in which the economy is growing at a rate significantly below normal – – – • A period during which real GDP falls for two or more consecutive quarters A period during which real GDP growth is well below normal, even if not negative A variety of economic data are examined A depression is a particularly severe recession 21­4 Recessions and Expansions • A peak is the beginning of a recession – • A trough is the end of a recession – • • High point of the business cycle Low point of the business cycle An expansion is a period in which the economy is growing at a rate significantly above normal A boom is a strong and long lasting expansion 21­5 Fluctuations in US Real GDP, 1920-2010 21­6 Peak Trough Months U Rate (high) Change RGDP Next Expansion 8/29 3/33 43 24.9% –28.8% 50 months 5/37 5/38 12 19.0 –5.5 80 2/45 10/45 3.9 –8.5 37 11/48 10/49 11 5.9 –1.4 45 7/53 5/54 10 5.5 –1.2 39 8/57 4/58 6.8 –1.7 24 4/60 2/61 10 6.7 2.3 106 12/69 11/70 11 5.9 0.1 36 11/73 3/75 16 8.5 –1.1 58 1/80 7/80 7.6 –0.3 12 7/81 11/82 16 9.7 –2.1 92 7/90 3/91 7.5 –0.9 120 3/01 11/01 5.8 0.8 73 12/07 6/09 18 10.0 -4.1 21­7 Calling the 2007 Recession in the United States • NBER declared a recession December 2007 – – • Four important monthly indicators used to date recessions: – – – – • Previous recession ended November 2001 73 month expansion Industrial production Total sales in manufacturing, wholesale, and retail Non-farm employment Real after-tax household income Coincident indicators move with overall economy 21­8 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 U.S recessions of 1973 – 1975 and 1981 – 1982 U.S recession that began in 2007 21­9 Real GDP Growth, 2002–2012 China Newly Indust rialized Economies 2012 2011 2010 2009 2008 2007 2006 2005 -6 2004 Growt h Rat e of Real GDP (% ) 12 Year 21­10 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 percentage point increase in the output gap Suppose the economy begins with 1% cyclical unemployment and an recessionary gap of 2% of potential GDP – If cyclical unemployment increases to 2%, the recessionary gap increases to 4% of Y* 21­19 U.S Output Gap • According to Okun's Law Output gap = -2 x (u – u*) Year u 1995 5.6% 2000 4.0 2005 5.1 2010 9.6 • u* Y* ($B) 5.3% $9,216.4 5.0 10,880.7 5.0 12,576.3 5.2 14,017.1 Output Gap ($B) -$55.3 271.6 -25.2 - 1,233.5 In 1995, 2005, and 2010, the economy had a recessionary gap – In 2000, there was an expansionary gap 21­20 Importance of the Output Gap • • The 2010 output gap was -$1.2 trillion U.S population was 309 million – – • $1.2 trillion/309 million = $4,000 for a family of four In 2010 dollars it equals $16,000 for a family of four Policy makers pay attention to output gaps because of the impact it has on our standard of living – While average impact is $8,000 for a family of four, the distribution of costs are not even • Concentrated in households of workers laid off 21­21 Macroeconomic Policy 1999-2000 • Federal Reserve applied the brakes in 1999 and 2000 – – – • About 1997, cyclical unemployment rates became negative For 1997 and 1998, Fed saw the inflationary pressure as low due to • Gains in productivity • International competition Expansionary gap increased in 1999 and 2000 • Fed grew more concerned about inflation and began to slow the economy Recession in early 2001 caused Fed to reverse course 21­22 Short-Term Fluctuations • Output gaps arise for two main reasons – 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 21­23 Short-Term Fluctuations • Output gaps arise for several reasons – Changes in total spending at preset prices affects output levels • • • When spending is low, output will be below potential output Changes in economy-wide spending are the primary causes of output gaps Policy: adjust government spending to close the output gap 21­24 Causes of Short-Term Fluctuations • The economy has self-correcting mechanisms – Firms 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 21­25 Causes of Short-Term Fluctuations • The economy has self-correcting mechanisms – – Eventually, prices reach equilibrium and eliminate output gaps Production is at potential output levels • • Output is determined by productive capacity Spending influences only price levels and inflation 21­26 Al'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 21­27 Al'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 21­28 Al's Ice Cream – Setting Prices • Fully flexible prices are unrealistic – – Minute-by-minute pricing is confusing to customers Costs of an auction exceed Al's benefits • • Continuous purchases in low volumes by different customers Al sets prices – – – – Survey of competitors Product strengths and weaknesses Analyzes sales over time to see if adjustments are needed Al meets demand in the short run 21­29 Al's Ice Cream – Long Run • Al observes consistently strong demand for his products – – – • Al's first response is to raise prices – • Waiting lines Low inventory Fully utilized production capacity Implemented quickly Al evaluates expanding capacity – If expansion does not raises average costs, Al will expand and return to original prices 21­30 Al'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 opportunities In the long-run, prices reach equilibrium levels – Output is at its potential level 21­31 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 21­32 Short-Term Economic Fluctuations Causes Short-Term Economic Fluctuations Potential Output Symptoms Business Cycles Output Gaps Phases of Business Cycles Natural Rate of Unemployment 21­33 ... in economy-wide spending are the primary causes of output gaps Policy: adjust government spending to close the output gap 21 24 Causes of Short-Term Fluctuations • The economy has self-correcting... family of four Policy makers pay attention to output gaps because of the impact it has on our standard of living – While average impact is $8,000 for a family of four, the distribution of costs... four, the distribution of costs are not even • Concentrated in households of workers laid off 21 21 Macroeconomic Policy 199 9-2 000 • Federal Reserve applied the brakes in 1999 and 2000 – – – • About