Short-Term Economic Fluctuations: An Introduction Short-Term Economic Fluctuations: An Introduction Principles of Macroeconomics Dr. Gabriel X. Martinez

Short-TermEconomic Fluctuations:

An Introduction

Short-TermEconomic Fluctuations:

An Introduction

Principles of Macroeconomics

Dr. Gabriel X. Martinez

Ave Maria University

Chapter 25: Short-Term Economic FluctChapter 25: Short-Term Economic Fluctuations: An Introductionuations: An Introduction

22Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

Posted: 02/01/2001 12:24 amPosted: 02/01/2001 12:24 amLast Updated: 2001-02-01 10:49:54-Last Updated: 2001-02-01 10:49:54-0505The Federal Reserve has cut interest The Federal Reserve has cut interest rates for the second time this month. rates for the second time this month. With so many area businesses With so many area businesses closing, Michiana residents worry it closing, Michiana residents worry it may be too late to save the economy may be too late to save the economy from slipping into recession. from slipping into recession.

Mark Eagen, the president and CEO Mark Eagen, the president and CEO of St. Joseph County's chamber of of St. Joseph County's chamber of commerce, is watching Michiana's commerce, is watching Michiana's economy closely and says it is slowing economy closely and says it is slowing down. While consumer spending has down. While consumer spending has obviously decreased, companies are obviously decreased, companies are feeling the effect. feeling the effect.

Closed in South Bend,

February 2001



Local effectsLocal effects Plant closings like Bayer in Plant closings like Bayer in Elkhart, bankruptcies like OMC Elkhart, bankruptcies like OMC Boats in Syracuse, along with Boats in Syracuse, along with the shutdown of Montgomery the shutdown of Montgomery Ward, L.S. Ayers and Ward, L.S. Ayers and Thermoplastics, as well as the Thermoplastics, as well as the downsizing of Whirlpool have all downsizing of Whirlpool have all taken a major toll on the area.taken a major toll on the area.


February 2001



According to Tyler Glynn of Edwards Jones According to Tyler Glynn of Edwards Jones Investments, “We feel a recession, or the Investments, “We feel a recession, or the effects of a possible oncoming of a recession, effects of a possible oncoming of a recession, more than other parts of the country because more than other parts of the country because we have so much of a base in manufacturing.” we have so much of a base in manufacturing.”

Ray of hopeRay of hopeWhile all the closings have left many people While all the closings have left many people jobless, a ray of hope is on the horizon. AM-jobless, a ray of hope is on the horizon. AM-General, an auto plant opening in Mishawaka, General, an auto plant opening in Mishawaka, will manufacture a new generation of the will manufacture a new generation of the Hummer 4-wheel drive sport utility. The Hummer 4-wheel drive sport utility. The additional 1500 jobs should make up for the additional 1500 jobs should make up for the recent loss in Michiana, but experts continue recent loss in Michiana, but experts continue to watch the economy closely. to watch the economy closely.


February 2001



Recessions and ExpansionsRecessions and Expansions

Recession (or contraction)Recession (or contraction) A period in which the economy is growing at a rate A period in which the economy is growing at a rate

significantly below normalsignificantly below normalThe NBER does not define a recession in terms of two The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread recession is a significant decline in economic activity spread across the economy, lasting more than a few months, across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.industrial production, and wholesale-retail sales.

• For more information, see the latest announcement on how the For more information, see the latest announcement on how the NBER's Business Cycle Dating Committee chooses turning NBER's Business Cycle Dating Committee chooses turning points in the Economy and its latest memo, dated 07/17/03. points in the Economy and its latest memo, dated 07/17/03.

DepressionDepression A particularly severe or protracted recessionA particularly severe or protracted recession



Fluctuations in U.S.Fluctuations in U.S.Real GDP, 1920-2001Real GDP, 1920-2001



Figure 2. Real Personal Income Less TransfersThe dark line shows the movement of income from May 2000 to the present and the shaded line the average over

the previous 6 recessions. Source: Bureau of Economic Analysis, U.S. Department of Commerce Source: The Conference Board (http://www.globalindicators.org)



Figure 3. Payroll EmploymentThe dark line shows the movement of employment from May 2000 to the present and the shaded

line the average over the previous 6 recessions. Source: Bureau of Labor Statistics, U.S. Department of Labor



Peak date (beginning)

Trough date (end)

Duration (months)

Highest unemployment

rate (%)

Change in real GDP (%)

Duration of subsequent expansion

(months)

Aug. 1929 Mar. 1933 43 24.9 -28.8 50

May 1937 June 1938 13 19.0 -5.5 80

Feb. 1945 Oct. 1945 8 3.9 -8.5 37

Nov. 1948 Oct. 1949 11 5.9 -1.4 45

July 1953 May 1954 10 5.5 -1.2 39

Aug. 1957 Apr. 1958 8 6.8 -1.7 24

Apr. 1960 Feb. 1961 10 6.7 2.3 106

Dec. 1969 Nov. 1970 11 5.9 0.1 36

Nov. 1973 Mar. 1975 16 8.5 -1.1 58

Jan. 1980 July 1980 6 7.6 -0.3 12

July 1981 Nov. 1982 16 9.7 -2.1 92

July 1990 Mar. 1991 8 7.5 -0.9 120

Mar. 2001 Dec. 2001* 9* 6.0* 0.2**Unofficial

U.S. Recessions Since 1929U.S. Recessions Since 1929




PeakPeak The beginning of a recession, the high point The beginning of a recession, the high point

of economic activity prior to a downturnof economic activity prior to a downturn

TroughTrough The end of a recession, the low point of The end of a recession, the low point of

economic activity prior to a recoveryeconomic activity prior to a recovery




ExpansionExpansion A period in which the economy is growing at a A period in which the economy is growing at a

rate significantly above normalrate significantly above normal

BoomBoom A particularly strong and protracted expansionA particularly strong and protracted expansion



Expansion ExpansionRecession

The Phases of the Business The Phases of the Business CycleCycle

Boom

Secular growth trend

DownturnUptu

rn

Trough

Peak

0Jan.-Mar

Tot

al O

utpu

t

Apr.-June

July-Sept.

Oct.-Dec.

Jan.-Mar

Apr.-June

July-Sept.

Oct.-Dec.

Jan.-Mar

Apr.-June

Why does this matter?



Business CyclesBusiness Cycles

Although we call them “cycles”, they are Although we call them “cycles”, they are not perfectly regular.not perfectly regular.

Business fluctuations are irregular and Business fluctuations are irregular and difficult to predict.difficult to predict.



U. S. Business CyclesU. S. Business Cycles

20

10

0

–10

–20

‘90‘801860 ‘70 1900 ‘10 ‘20 ‘30 ‘40 ‘50 ‘60 ‘70 ‘80 ‘90 ‘102000

Civil War

Recoveryof 1895

World War I

Panicof 1893 Panic

of 1907Great

Depression

Korean War Vietnam War

World War II




Economic NaturalistEconomic Naturalist Calling the 2001 recessionCalling the 2001 recession

Business cycle dating committee of the National Business cycle dating committee of the National Bureau of Economic Research Bureau of Economic Research

March 2001March 2001




Economic NaturalistEconomic Naturalist Calling the 2001 recessionCalling the 2001 recession

Indicators of the business cycleIndicators of the business cycle• Industrial productionIndustrial production• Total sales in manufacturing, wholesale trade, and retail Total sales in manufacturing, wholesale trade, and retail

tradetrade• Nonfarm employmentNonfarm employment• Real after-tax income of households excluding transfersReal after-tax income of households excluding transfers

Recessions are felt throughout the economyRecessions are felt throughout the economy



Economic fluctuations are irregular in Economic fluctuations are irregular in length and severitylength and severity

Economic fluctuations are felt throughout Economic fluctuations are felt throughout the economy and may have a global effectthe economy and may have a global effect

Some Facts About Short-term Some Facts About Short-term Economic FluctuationsEconomic Fluctuations



Real GDP Growth in Five Major Real GDP Growth in Five Major Countries, 1999-2002Countries, 1999-2002



Unemployment is a key indicator of short-Unemployment is a key indicator of short-term economic fluctuations.term economic fluctuations.

Industries that produce Industries that produce durabledurable goods are goods are more affected than more affected than nondurable & servicenondurable & service industries.industries. People give up buying refrigerators before People give up buying refrigerators before

they cut food expenditures.they cut food expenditures. Businesses stop making capital investments Businesses stop making capital investments

when their sales fall.when their sales fall.

Some Facts About Short-term Some Facts About Short-term Economic FluctuationsEconomic Fluctuations



U.S. Inflation, 1960-2001U.S. Inflation, 1960-2001

Recessions are usually followed by a decline in inflationRecessions are usually followed by a decline in inflationMany have been preceded by an increase in inflation.Many have been preceded by an increase in inflation.



U.S. Unemployment RateU.S. Unemployment Rate

Recessions are usually accompanied by high unemployment.Recessions are usually accompanied by high unemployment.Unemployment tends to remain high for a long time after the recession is Unemployment tends to remain high for a long time after the recession is over.over.

Output Gaps andOutput Gaps andCyclical UnemploymentCyclical Unemployment



Potential Output, Potential Output, Y* Y* (or potential real GDP (or potential real GDP or full-employment output)or full-employment output) The amount of output (real GDP) that an The amount of output (real GDP) that an

economy can produce when using its economy can produce when using its resources, such as capital and labor, at resources, such as capital and labor, at normalnormal rates. rates.




For example,For example, You may be able to study for 8 hours a day, You may be able to study for 8 hours a day,

normally.normally.8 hours of study is your “normal” rate.8 hours of study is your “normal” rate.

Right before finals, maybe you are putting in Right before finals, maybe you are putting in 12 hours a day.12 hours a day.

You are studying above your normal rate.You are studying above your normal rate.

But you may not be able to study 12 hours a But you may not be able to study 12 hours a day day all the timeall the time..




Notice that Notice that potential output potential output is is notnot the same the same as “maximum output”.as “maximum output”.

Because capital and labor can be utilized Because capital and labor can be utilized at greater-than-normal rates, at least for a at greater-than-normal rates, at least for a time, a country’s actual output time, a country’s actual output YY can can exceed potential output exceed potential output Y*Y*..




Potential Output

(water at normal capacity)

Maximum output

(water above normal capacity)

Potential OutputPotential Output



Potential outputPotential output is often designated with is often designated with Y*Y* (pronounced as “Y-star”).(pronounced as “Y-star”).

Actual outputActual output designated as designated as Y,Y, is the is the level of GDP that is actually counted using level of GDP that is actually counted using methods specified in chapters 18.methods specified in chapters 18.




Potential output is the GDP that can be Potential output is the GDP that can be produced if the factors of production are produced if the factors of production are used at their “normal” rates.used at their “normal” rates. The normal rate is generally not 100 percent The normal rate is generally not 100 percent

or maximum utilization.or maximum utilization. Workers must rest and machines must be Workers must rest and machines must be

maintained. Factories must be remodeled maintained. Factories must be remodeled and new computers must be installed, which and new computers must be installed, which takes time. Y* takes this takes time. Y* takes this plannedplanned downtime downtime into account.into account.






Below Potential Output

(water below normal capacity)

At Potential Output

(water at normal capacity)

Above Potential Output

(water above capacity)

Actual OutputActual Output



Potential output is defined as “full Potential output is defined as “full employment” even though some factors employment” even though some factors are idle.are idle.

Potential output = normal output = full-Potential output = normal output = full-employment outputemployment output




Why the output growth rate varies:Why the output growth rate varies: There may be changes in the rate at which There may be changes in the rate at which

the country’s potential output, the country’s potential output, Y*Y*, is , is increasing.increasing.

We often study this as part of “long-run” or We often study this as part of “long-run” or “growth” economics.“growth” economics.

Actual output, Actual output, YY, does not always equal , does not always equal potential output, potential output, Y*Y*..

We study this as part of “short-run” or We study this as part of “short-run” or “business-cycle” economics.“business-cycle” economics.




Y* reflects the number and the productivity of Y* reflects the number and the productivity of factors of production that are available in an factors of production that are available in an economy.economy.Increasing the number or quality (productivity) of Increasing the number or quality (productivity) of these factors will increase potential output. these factors will increase potential output. Potential output in the U.S. economy has grown Potential output in the U.S. economy has grown

demonstrably in response to increases in the labor demonstrably in response to increases in the labor supply, increased endowments of human capital, supply, increased endowments of human capital, advances in technology, expansions in the advances in technology, expansions in the infrastructure, improved institutions, protection of infrastructure, improved institutions, protection of several categories of natural resources, and other several categories of natural resources, and other changes. changes.




Output GapOutput Gap Y* Y* – – YY potential output – actual outputpotential output – actual output

Recessionary GapRecessionary Gap Y* > YY* > Y Y* Y* – – Y > 0Y > 0

Expansionary GapExpansionary Gap Y* < YY* < Y Y* Y* – – Y < 0Y < 0





How Y* grows over time

How Y moves

over time

time

$ Recessionary Gap

Y* - Y > 0Y* - Y > 0

Expansionary Gap

Y* - Y < 0Y* - Y < 0



When When Y* = Y,Y* = Y,

factors are working at the normal level and factors are working at the normal level and expectations are realized. The expectations are realized. The macroeconomy is producing according to macroeconomy is producing according to plan. Just the right quantity of goods and plan. Just the right quantity of goods and services are being produced. services are being produced.




Recessionary Gap: Recessionary Gap: Y* - Y > 0Y* - Y > 0 Capital and labor resources are not fully Capital and labor resources are not fully

utilizedutilized Output and employment are below normal Output and employment are below normal

levelslevelsFactors of production are idle or working at less Factors of production are idle or working at less than normal rates. Goods pile up and factors are than normal rates. Goods pile up and factors are laid off. The economy falls into a recession. laid off. The economy falls into a recession.




Recessionary Gap:Recessionary Gap:Y* - Y > 0Y* - Y > 0 Capital and laborCapital and labor

resources are not fullyresources are not fullyutilizedutilized




Expansionary Gap: Expansionary Gap: Y* - Y < 0Y* - Y < 0 Higher output and employment than normal, more Higher output and employment than normal, more

than it usually wants to produce.than it usually wants to produce.This above-normal level of output cannot be sustained This above-normal level of output cannot be sustained forever. Machines are running too fast andforever. Machines are running too fast andworkers are working too many hours. In thisworkers are working too many hours. In thiscase, the economy is struggling to expand,case, the economy is struggling to expand,but since output generally cannot expand fastbut since output generally cannot expand fastenough, prices must rise.enough, prices must rise.

Demand for goods exceed the capacityDemand for goods exceed the capacityto produce them and prices rise.to produce them and prices rise.

High inflation reduces economicHigh inflation reduces economicefficiency.efficiency.




““Recessionary output gaps are particularly Recessionary output gaps are particularly frustrating for policymakers…because they frustrating for policymakers…because they imply that the economy has the imply that the economy has the capacitycapacity to to produce more, but for some reason produce more, but for some reason available resources are not being fully available resources are not being fully utilized.”utilized.”

Frank and Bernanke.Frank and Bernanke.

The Rate of UnemploymentThe Rate of Unemployment



The Natural Rate of UnemploymentThe Natural Rate of Unemployment Recessionary gaps are characterized by high Recessionary gaps are characterized by high

unemployment.unemployment. Expansionary gaps are characterized by Expansionary gaps are characterized by

unusually low unemployment.unusually low unemployment. When Y=Y*, there is some unemployment, When Y=Y*, there is some unemployment,

called the called the natural rate of unemployment.natural rate of unemployment.




The Natural Rate of Unemployment and The Natural Rate of Unemployment and Cyclical UnemploymentCyclical Unemployment Types of unemployment (revisited)Types of unemployment (revisited)

FrictionalFrictional

StructuralStructural

CyclicalCyclical

The Natural Rate of UnemploymentThe Natural Rate of Unemployment



The Natural Rate of Unemployment and The Natural Rate of Unemployment and Cyclical UnemploymentCyclical Unemployment Natural rate of unemployment, Natural rate of unemployment, u*u*

Attributable to frictional and structural Attributable to frictional and structural unemploymentunemployment

Cyclical unemployment equals zeroCyclical unemployment equals zero

No recessionary or expansionary gapNo recessionary or expansionary gap


Natural Rate of Unemployment=

Frictional Unemployment + Structural Unemployment



Cyclical UnemploymentCyclical Unemployment During recessionary gaps (During recessionary gaps (Y* - Y > 0Y* - Y > 0):):

u > u* u > u*

cyclical unemployment is positive = cyclical unemployment is positive = u - u* > 0u - u* > 0

During expansionary gaps (During expansionary gaps (Y* - Y < 0Y* - Y < 0):):u < u* u < u*

cyclical unemployment is negative = cyclical unemployment is negative = u - u* < 0u - u* < 0




Economists almost always talk about an Economists almost always talk about an ununemployment rate.employment rate. Unemployment refers to something that is not Unemployment refers to something that is not

happening: workers are not going to work.happening: workers are not going to work.

An increase in the unemployment rate is looked An increase in the unemployment rate is looked upon with dismay.upon with dismay. An increase in GDP is good. An increase in the rate An increase in GDP is good. An increase in the rate

of growth of GDP is good. However, an increase in of growth of GDP is good. However, an increase in the rate of unemployment is at best unfortunate and the rate of unemployment is at best unfortunate and at worst, it is devastating for the economy.at worst, it is devastating for the economy.




Economic NaturalistEconomic Naturalist It seems that the natural rate of It seems that the natural rate of

unemployment in the United States has unemployment in the United States has declined. Why?declined. Why?

Aging labor forceAging labor force

More efficient labor marketMore efficient labor market




Economic NaturalistEconomic Naturalist Since there is no easy way to tell for sure how many Since there is no easy way to tell for sure how many

people are frictionally or structurally unemployed, we people are frictionally or structurally unemployed, we must depend on careful and educated hypotheses must depend on careful and educated hypotheses and plausible explanations about the changes in the and plausible explanations about the changes in the workforce. workforce.

The average age of the workforce has increased, and The average age of the workforce has increased, and older workers are more likely to remain in the jobs older workers are more likely to remain in the jobs that they have. Therefore, frictional unemployment is that they have. Therefore, frictional unemployment is reduced. If this is the case, then cyclical forces must reduced. If this is the case, then cyclical forces must explain a greater proportion of total unemployment. explain a greater proportion of total unemployment.




Arthur Okun was a famous economist Arthur Okun was a famous economist and a policy adviser to Kennedy.and a policy adviser to Kennedy.Being an economist, he combed the Being an economist, he combed the economic data for regularities and economic data for regularities and patterns between different variables.patterns between different variables.He found one such regularity betweenHe found one such regularity between

Y* – YY* – Yand and

u – u*u – u*

Okun’s LawOkun’s Law



Okun’s LawOkun’s Law Each extra percentage point of cyclical Each extra percentage point of cyclical

unemployment (u-u*) is associated with unemployment (u-u*) is associated with about a 2 percentage point increase in the about a 2 percentage point increase in the output gap (Y* – Y), measured in relation to output gap (Y* – Y), measured in relation to potential output.potential output.

Okun’s LawOkun’s Law

*2*

*uu

Y

YY



Example 12.1Example 12.1

Year u u* Y*

1982 9.7% 6.1% 3,433

1991 6.8 5.8 6,093

1998 4.5 5.2 8,563

1982•u - u* = cyclical unemployment•9.7 - 6.1 = 3.6%•Output gap = 2 x 3.6 = 7.2%•Output gap = 3,433 x .072

= $247 billion

1991•6.8 - 5.8 = 1%•Output gap = 6,093 x .02 = $122 billion

1998•4.5 - 5.2 = -0.7•Output gap = 8,563 x -0.14 = -$120 billion



Okun’s LawOkun’s Law The 1982 output gap per capitaThe 1982 output gap per capita

$247 billion/230 million = $1,074 $247 billion/230 million = $1,074 • Or $4,300 for a family of fourOr $4,300 for a family of four

In 2001 dollars it equals $7,100 for a family of fourIn 2001 dollars it equals $7,100 for a family of four




Plain English EconomicsPlain English Economics

The relationships mentioned in this section The relationships mentioned in this section will become very important in the following will become very important in the following chapters, so you may want to have a chapters, so you may want to have a “plain English” version of the material.“plain English” version of the material.




When economic activity speeds, actual output When economic activity speeds, actual output (Y) exceeds the potential or normal level of (Y) exceeds the potential or normal level of economic activity and a negative output gap economic activity and a negative output gap appears (Y* – Y is negative).appears (Y* – Y is negative).

In this case, the economy is operating at In this case, the economy is operating at greater-than-normal levels, so unemployment greater-than-normal levels, so unemployment levels will be very low. Everyone who can work levels will be very low. Everyone who can work will be working and actual unemployment (u) will will be working and actual unemployment (u) will be less than the normal rate of unemployment be less than the normal rate of unemployment (u*). The indicator (u – u*) will be negative.(u*). The indicator (u – u*) will be negative.




In symbols:In symbols:When Y* – Y < 0, u – u* < 0, an output gap When Y* – Y < 0, u – u* < 0, an output gap indicates an expansionary economy.indicates an expansionary economy.When Y* – Y > 0, u – u* > 0, indicating When Y* – Y > 0, u – u* > 0, indicating that unemployment is above normal.that unemployment is above normal.

The recap on page 656 is very good. You may The recap on page 656 is very good. You may want to write it out without symbols, read the want to write it out without symbols, read the section, and after reading it, put the symbols back section, and after reading it, put the symbols back in and work through the recap one more time. in and work through the recap one more time.



Economic NaturalistEconomic Naturalist Why did the Federal Reserve take measures Why did the Federal Reserve take measures

to slow down the economy in 1999 and 2000?to slow down the economy in 1999 and 2000?


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

and a Parableand a Parable



GDP fluctuates becauseGDP fluctuates because Y* grows, due to changes in the availability Y* grows, due to changes in the availability

of capital and labor and changes in of capital and labor and changes in technology.technology.

Y fluctuates, generating expansionary and Y fluctuates, generating expansionary and recessionary gaps.recessionary gaps.

Why Do Short-Term Fluctuations Why Do Short-Term Fluctuations Occur? A PreviewOccur? A Preview



If prices were absolutely flexible, demand If prices were absolutely flexible, demand would meet supply.would meet supply.

Markets would clear and no gaps would Markets would clear and no gaps would occur.occur.

If prices take time to adjust, firms will If prices take time to adjust, firms will “meet the demand” by changing “meet the demand” by changing quantityquantity at constant prices.at constant prices.




Because firms Because firms meet consumers’ meet consumers’ demanddemand, changes in the amount , changes in the amount consumers decide to spend affect output.consumers decide to spend affect output.Changes in economywide spending are Changes in economywide spending are the primary cause of output gaps.the primary cause of output gaps.Government can eliminate output gaps Government can eliminate output gaps by changing its own spending by changing its own spending

……or influencing the private sector’s or influencing the private sector’s spending.spending.




But eventually prices do adjust.But eventually prices do adjust.

Expansionary gaps lead to higher Expansionary gaps lead to higher inflation, recessionary gaps lead to lower inflation, recessionary gaps lead to lower inflation.inflation.

If consumer demand is higher than potential If consumer demand is higher than potential output, eventually firms will react by raising output, eventually firms will react by raising prices aggressively.prices aggressively.




Over a long period of time, firms will Over a long period of time, firms will change prices so that output gaps will change prices so that output gaps will disappear.disappear.

The economy “self-corrects” in the long The economy “self-corrects” in the long run, so that Y = Y*.run, so that Y = Y*.

In the long run, changes in spending only In the long run, changes in spending only affect inflation.affect inflation.




Al’s Ice Cream shopAl’s Ice Cream shop Potential output varies little, but there are Potential output varies little, but there are

many fluctuations in sales.many fluctuations in sales. Some fluctuations are regular and Some fluctuations are regular and

predictable, some are not.predictable, some are not. Al could not possibly change his prices in Al could not possibly change his prices in

response to every single event (higher response to every single event (higher prices on Saturday afternoons than prices on Saturday afternoons than mornings?)mornings?)

Why Do Short-Term Fluctuations Why Do Short-Term Fluctuations Occur? A ParableOccur? A Parable



Al’s Ice Cream shopAl’s Ice Cream shop Al posts fixed prices and “meets the Al posts fixed prices and “meets the

demand” at those prices.demand” at those prices. He adjusts them if, after a while, it’s clear He adjusts them if, after a while, it’s clear

that he’s made a mistake in forecasting the that he’s made a mistake in forecasting the demand.demand.

If, for example, he keeps running out of ice If, for example, he keeps running out of ice cream, he’ll cream, he’ll eventuallyeventually raise prices. raise prices.

Why Do Short-Term Fluctuations Why Do Short-Term Fluctuations Occur? A ParableOccur? A Parable



Economic NaturalistEconomic Naturalist Why did the Coca-Cola Company test a Why did the Coca-Cola Company test a

vending machine that “knows” when the vending machine that “knows” when the weather is hot?weather is hot?

Hot weather increases demand for Coke, so it Hot weather increases demand for Coke, so it would be profitable to raise prices.would be profitable to raise prices.

It provoked consumer complaints about fairness.It provoked consumer complaints about fairness.

And the weather-sensitive chip might be And the weather-sensitive chip might be expensive.expensive.

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

The Historical Development The Historical Development of Modern Macroeconomicsof Modern Macroeconomics



The Historical Development of The Historical Development of Modern Macroeconomics Modern Macroeconomics

The Great Depression of the 1930s led to The Great Depression of the 1930s led to the development of macroeconomics and the development of macroeconomics and aggregate demand tools to deal with aggregate demand tools to deal with recessions.recessions. During the Depression, output fell by 30 During the Depression, output fell by 30

percent and unemployment rose to 25 percent and unemployment rose to 25 percent.percent.

It seemed clear that the market was not It seemed clear that the market was not functioning.functioning.



From Classical to Keynesian From Classical to Keynesian EconomicsEconomics

ClassicalClassical economists had focused on long- economists had focused on long-run issues such as growth.run issues such as growth. Followers of Adam Smith, David Ricardo, Followers of Adam Smith, David Ricardo,

John Stuart Mill, etc.John Stuart Mill, etc.

Keynesians are called so after economist Keynesians are called so after economist John Maynard Keynes.John Maynard Keynes. Focus on short-run economic issues.Focus on short-run economic issues.



Classical EconomicsClassical Economics

The Classical approach was The Classical approach was laissez-fairelaissez-faire Markets are perfect if they are just left alone.Markets are perfect if they are just left alone. The market is self-adjusting (The market is self-adjusting (Say’s LawSay’s Law), so ), so

we should concentrate on the long-run and we should concentrate on the long-run and largely ignore the short-run.largely ignore the short-run.

Their solution to the high unemployment was Their solution to the high unemployment was to eliminate labor unions and government to eliminate labor unions and government policies that kept wages too high.policies that kept wages too high.



Classical EconomicsClassical Economics

Classical economists opposed deficit Classical economists opposed deficit spending by the governmentspending by the government Deficits are financed by borrowingDeficits are financed by borrowing These funds would have financed private These funds would have financed private

economic activity and jobs, so everything economic activity and jobs, so everything would cancel out.would cancel out.

And economic freedom would be limited by And economic freedom would be limited by government’s decisions.government’s decisions.



Say’s Law and Potential OutputSay’s Law and Potential Output

Say’s Law: supply creates its own demandSay’s Law: supply creates its own demand Y = Spending, therefore, Y= C + S = C + IY = Spending, therefore, Y= C + S = C + ITherefore, S = ITherefore, S = I

Therefore, the economy is always at Therefore, the economy is always at Potential OutputPotential Output Households and firms always buy up all the Households and firms always buy up all the

production.production.

Potential Output changes only with Potential Output changes only with Economic Growth.Economic Growth.



Say’s Law and Potential OutputSay’s Law and Potential Output

Classical economists argued that the Classical economists argued that the economy adjusts so quickly the long run economy adjusts so quickly the long run happens very quickly.happens very quickly. If the economy adjusts quickly to any If the economy adjusts quickly to any

disturbance, returning to Y = Y*, government disturbance, returning to Y = Y*, government policy is unnecessary / destabilizing.policy is unnecessary / destabilizing.

The quantity theory of money, which assumed Y The quantity theory of money, which assumed Y was constant, is a classical theory.was constant, is a classical theory.



The Possibility of The Possibility of UnemploymentUnemployment

However:However:

Suppose a large number of people in the Suppose a large number of people in the economy decide to spend less.economy decide to spend less.

And suppose that saving does not become And suppose that saving does not become investmentinvestment

Total spending would fall and unemployment Total spending would fall and unemployment would rise.would rise.

Incomes, consumption, and saving Incomes, consumption, and saving The economy reaches a new equilibrium which The economy reaches a new equilibrium which could be at an almost permanent recession.could be at an almost permanent recession.



The Paradox of ThriftThe Paradox of Thrift

A decrease in expenditures may cause A decrease in expenditures may cause decreasing output and a recession. decreasing output and a recession. So the government may need to intervene.So the government may need to intervene.

Notice that the key is that saving does not become Notice that the key is that saving does not become investment (which was assumed by Say’s Law).investment (which was assumed by Say’s Law).



The Essence of Keynesian The Essence of Keynesian EconomicsEconomics

Keynes concentrated on the short run Keynes concentrated on the short run rather than the long run.rather than the long run. This created the macroeconomic framework This created the macroeconomic framework

focused on stabilization policy.focused on stabilization policy.

Keynes thought that the economy Keynes thought that the economy could could get stuck in a rut.get stuck in a rut. Then “laissez-faire” would be Then “laissez-faire” would be

counterproductive.counterproductive.




He believed that the economy adjusted He believed that the economy adjusted very, very slowly.very, very slowly.

Particularly, he argued that prices are Particularly, he argued that prices are pretty much fixed for long periods of time pretty much fixed for long periods of time and change very slowly.and change very slowly. Sure, the actual output may go back to Sure, the actual output may go back to

potential output in the long run.potential output in the long run. But he thought the long run is so long that “But he thought the long run is so long that “ in in

the long run we are all deadthe long run we are all dead.”.”




According to Keynes:According to Keynes:

If investment demand If investment demand

job layoffs job layoffs consumer demand consumer demand

production and investment production and investment more job layoffs more job layoffs

consumer demand consumer demand , and so forth, and so forth



Equilibrium Income FluctuatesEquilibrium Income Fluctuates

Keynes:Keynes: Market forces do not work fast enoughMarket forces do not work fast enough

Prices and wages are inflexible (or “sticky”) for a Prices and wages are inflexible (or “sticky”) for a large number of reasonslarge number of reasons

Supply and Demand may not be strong Supply and Demand may not be strong enough to get the economy out of a recessionenough to get the economy out of a recession

Therefore, at certain times Therefore, at certain times thethe economy economy needs helpneeds help to reach its potential income. to reach its potential income.

Government expenditures or interest-rate changes Government expenditures or interest-rate changes may be necessary and usefulmay be necessary and useful



KeynesKeynes

John Maynard KeynesJohn Maynard Keynes Economist, diplomat, financier,Economist, diplomat, financier,

journalist, and patron of the arts.journalist, and patron of the arts. Publications include:Publications include:

The Economic Consequences of the PeaceThe Economic Consequences of the Peace

A Treatise on MoneyA Treatise on Money

The General Theory of Employment, Interest, and The General Theory of Employment, Interest, and MoneyMoney

Keynes

Pronounced “canes”



KeynesKeynes

John Maynard KeynesJohn Maynard Keynes The The General Theory of Employment, Interest, General Theory of Employment, Interest,

and Moneyand Money (1936): (1936):Revolutionized economic policyRevolutionized economic policy

Predicted that a decrease inPredicted that a decrease inaggregate spending could create aaggregate spending could create arecessionary gaprecessionary gap

Suggested that government policySuggested that government policycould be used to restore fullcould be used to restore fullemploymentemployment



KeynesKeynes

John Maynard KeynesJohn Maynard Keynes The The General Theory of Employment, Interest, General Theory of Employment, Interest,

and Money and Money (1936):(1936):Published in the trough of thePublished in the trough of theGreat Depression, and as aGreat Depression, and as aresponse to it.response to it.

Was (and is) tremendouslyWas (and is) tremendouslycontroversial and influential.controversial and influential.

Is the basis for much of what weIs the basis for much of what westudy today as short-run economics.study today as short-run economics.

Documents

Short-Term Economic Fluctuations: An Introduction Short-Term Economic Fluctuations: An Introduction Principles of Macroeconomics Dr. Gabriel X. Martinez