Intro to Short-Term economic Fluctuations

Recession/Contraction

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

Depression

a particularly severe recession

Peak

the beginning of a recession

high point of the business cycle

Trough

the end of a recession

low point of the business cycle

Expansion

a period in which the economy is growing at a rate significantly above normal

Boom

strong and long lasting expansion

Long Run vs Short Run

Monthly Indicators to Date Recessions

• Real personal consumption expenditures

• Non-farm employment

• Real after-tax household income

Symptoms of Business Cycle

• 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 labour 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

Inflation and the Business Cycle

Inflation generally decreases during a business cycle

• Decreases at other times as well

Potential Output (Y*)

• The maximum sustainable amount of output that an economy can produce – Also called full-employment output

  • Use capital and labour 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

  • Reflects growth rate of Y*

  • Variable rates of technical innovation, capital formation, weather conditions, etc.

  • Actual output does not always equal potential output

Output Gaps

• The difference between the economy’s actual output and its potential output, relative to potential output, at a point in time

  • Output gap (in percent) = Y – Y* Y*

Policy makers consider stabilization policies when there are output gaps

Recessionary Gap

•  a negative output gap; Y* > Y

  • Capital and labour resources are not fully utilized

  • Output and employment are below normal levels

mean output and employment are less than their sustainable level

Expansionary Gap

• a positive output gap; Y* < Y

  • Higher output and employment than normal

  • Demand for goods exceeds the capacity to produce them and prices rise

  • High inflation reduces economic efficiency

lead to inflation

Natural Rate of Unemployment

• Recessionary gaps have high unemployment rates

• At all times we have to deal with frictional and structural unemployment

• The natural rate of unemployment, u* , is the sum of frictional and structural unemployment

  • Unemployment rate when cyclical unemployment is 0

  • Occurs when Y is at Y*

Frictional Unemployment

Short-term unemployment related to matching of workers and jobs

Structural Unemployment

Long-term chronic unemployment in normal conditions – perhaps skills are outdated

Cyclical Unemployment

The difference between total unemployment, u, and u*

• Recessionary gaps have u > u*

• Expansionary gaps have u < u*

Okun’s Law

• Relates cyclical unemployment changes to changes in the output gap

  • One percentage point increase in cyclical unemployment means a 2 percent widening of a negative output gap, measured in relation to potential output

• 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 potential GDP 1

Output Gaps Reasons

• Changes in total spending at preset prices and wages affects output levels

  • When spending is low, output will be below potential output

  • The macroeconomy may adjust only slowly to shifts in aggregate demand because of sticky wages and prices—wages and prices that do not respond to decreases or increases in demand (contracts, coordination argument, menu costs, wage cuts depress morale and productivity of existing workers)

  • Changes in economy-wide spending are then the primary causes of output gaps in the short-run

  • Policy: adjust government spending to close the output gap by directly affecting the demand side of the economy

  • Markets require time to reach equilibrium price and quantity

  • Firms change prices infrequently (menu costs)

  • Use of costly company resources analysing competition and market demand before deciding on new prices

  • Frequent price changes are confusing

  • Quantity produced is not at equilibrium during the adjustment period

  • Firms produce to meet the demand at current prices

  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

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 pressures

Eventually in the long-run, prices reach equilibrium and eliminate output gaps

• Production is at potential output levels

  • Output is determined by productive capacity (capital and labour)

  • Spending influences only price levels and inflation (monetarism point of view)

Mortgage-Backed Security

Credit Default Swap

a security that is effectively an insurance policy against defaults related to MBS and CDOS

Subprime Mortgage Securitisation

Financial Panic

occurs when providers of short-term credit (depositors in a bank) suddenly lose confidence in the ability of the borrower (the bank) to repay; providers of short-term credit then quickly redraw their funds

Viscous Recessionary Spiral

Criticism of Financial Regulations

• bills create significant costs for financial firms, slowing down business and job creation

• legislation is too complex

• legislation has been “watered down” by lobbying efforts

How to Redirect Finance to the Goal of Increasing Overall Benefits to Society

• limit speculative activities of banks

• ban overly complex products or risky products

• ask investors to pay a modest tax on financial transactions (Tobin tax)