Economic Fluctuations Slides by John Pamela Hall ECONOMICS

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? 2

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

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

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 5

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 6

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

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 realworld 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 8

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

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 10

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? 11

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 12

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 13

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 14

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 15

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 16