Chapter 11 Introduction to Macroeconomic Fluctuations

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Chapter 11Introduction to Macroeconomic
Fluctuations
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Introduction to Economic Fluctuations

• Modern economies are very dynamic new goods new
  jobs
• Many economic fluctuations are focused on
  specific sectors or industries.
• Decline in U.S. steel or automobile industries
• General, widespread economic fluctuations affect
  overall levels of employment, output and
  inflation.
• Change in oil prices
• Change in government spending
• Change in households saving and spending
  behavior
• Change in monetary policy by the Fed

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Introduction to Economic Fluctuations (continued)

• Key to understanding economic fluctuations
• In the short run wages and prices do not fully
  adjust to clear all markets.
• Eventually wages and prices adjust completely and
  the economy returns to full employment, or
  potential, output.

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Economic Fluctuations (a)

• In the United States real GDP fluctuates around a
  trend line which represents potential GDP or full
  employment output, Y f.
• An expansion is a period when output is rising.
• A recession or contraction is a period when
  output is falling.

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Economic Fluctuations (b)

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Economic Fluctuations (c)

• The output graph and unemployment move in
  opposite directions
• When the output gap is positive, GDP is above the
  trend line or potential output and unemployment
  is low

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Economic Fluctuations (d)
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Peaks and Troughs

• Peak the point where the economy moves from
  expansion to recession
• Trough the point where the economy moves from
  recession to expansion

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Peaks and Troughs Since 1980
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Business Cycles Are Not Regular

• The business cycle is neither regular nor
  periodic because the length of time between
  recessions varies.
• Since World War II, the average duration of
  expansions has been 57 months.
• The longest expansion in U.S. history began in
  1991 and ended in 2001.

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Peaks and Troughs (continued) Duration of
Economic Expansions
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Government is Seen as Being Responsible for the
Economy

• Full-Employment Act of 1946
• Humphrey-Hawkins Act (1978)
• Government should promote
• Full-employment
• Increases in real income
• Balanced growth
• Balanced federal budget
• Adequate productivity growth
• Reasonable price stability

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Unused Resources in Recessions

• During recessions, unemployment reflects unused
  resources, namely, unused labor and capital.
• There are unemployed workers, idle factories, and
  underutilized plants and equipment.

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Capacity Utilization

• Capacity utilization rates are as high as 90
  during an expansion.
• These rates can go as low as 70 during a
  recession.

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Measuring the Economic Costs of Recession Okun's
Law

• Okun's law Output gap (in ) -2(U U f).
• To use Okun's law we need an estimate for
  unemployment rate at full employment to estimate
  the output costs of a recession.
• At full employment there is seasonal, frictional,
  and structural unemployment.

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Recession of 1982

• Uf was about 6.
• Output gap was -8
• 8 of 1982 GDP is
• (0.08)(5.2 trillion) 420 billion in 2000
  dollars
• Okun's law -8 -2(U - 6) gives unemployment of
  U 10
• Actual unemployment was 9.7, roughly accurate

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Recession of 1992

• Unemployment was 7.5.
• Uf was about 6.
• So cyclical unemployment was 7.5 - 6 1.5.
• Okun's law Output gap -2(1.5) -3
• The economy lost 3 of GDP that year.
• Real GDP was 6.2 trillion in 1992.
• 3 of 6.2 trillion 186 billion, more than all
  nondefense spending that year

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Calculating the Costs of the Recession of 2001

• Step 1 find U and U f (the full-employment
  unemployment rate).
• U 6 most economists would put U f 5
• So there was 1 cyclical unemployment.
• Step 2 use Okuns law
• Output gap () -2(U U f) -2
• So the U.S. economy was performing 2 below
  potential in 2001.
• Step 3 (Output Gap)(GDP) (0.02)(10
  trillion) 200 billion.
• So the recession in 2001 cost the U.S. economy
  200 billion.
• About 600 per person or 2,400 for a family of
  four

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Failure of Labor Market Equilibrium

• The reason the U.S. macroeconomy suffers from
  fluctuations in production and employment is
  closely associated with the labor market.
• The rising unemployment in recessions is
  difficult to reconcile with the full-employment
  model where the labor market is in equilibrium
  since in that model, the real wage and employment
  fall during recessions

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The Real Wage during Recessions

• During recessions in the United States, the real
  wage is often constant and sometimes even rises.
• This happened in the Great Depression as well as
  in the deep recession of the early 1980s.

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Why Economies Experience Recessions

• Real wages do not adjust immediately to clear the
  labor market.
• When labor demand falls, the real wage, w/P,
  should fall.
• However the real wage often does not fall during
  a downturn.
• During the Great Depression the real wage rose
  initially due to deflation.
• This was also true in the recession of 2001.

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Real Wages and Unemployment

• In the United States there is no pattern relating
  unemployment and the real wage.

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Real Wages and Unemployment
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Real Wages and Unemployment

• The real wage is sticky and fails to fall quickly
  enough to maintain a constant equilibrium in the
  labor market.
• In recessions when labor demand falls, the real
  wage is relatively fixed so employment falls
  that is, in the labor market in the short run,
  employment adjusts, not the wage rate.

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Nominal versus Real Wages

• Real wage w/P nominal wage/price level
• Two reasons why the real wage fails to adjust
• The nominal wage fails to adjust quickly enough.
• The price level fails to adjust quickly enough.

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The Slow Adjustment of Nominal Wages

• Long term contracts fix wages for several years.
• Implicit contracts or understandings between
  employers and employees that during bad times,
  wages will not fall
• Efficiency wages higher wages may improve worker
  productivity

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Efficiency Wages

• Firms may pay efficiency wages and not cut wages
  during downturn because
• Cutting wages may mean the loss of a firm's best
  workers if other firms do not cut wages.
• If wages are cut, labor turnover increases and so
  do hiring and firing costs.
• Keeping wages fixed may reduce uncertainty.
• If a firm cuts wages to encourage workers to quit
  during a downturn, workers may not quit.
• It is easier and more certain to simply lay off
  workers and keep wages fixed.
• High wages keep morale and productivity high
• High wages make the cost of job loss high so
  workers work harder

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Slow Adjustment of Prices

• When demand changes in short run firms can change
  price or output
• Most firms have spare capacity so they change
  output not price
• Alternatively
• Since labor costs are the largest cost to firms
  and firms set prices as a mark-up over costs
• Then sticky wages leads to sticky prices

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Understanding Macroeconomic Fluctuations Key
Concepts

• Sticky real wages have the best chance to explain
  the behavior of the labor market in the United
  States during a recession.
• Sticky real wages may be due to the slow
  adjustment of nominal wages or the slow
  adjustment of prices.
• Evidence supporting sticky prices is strong over
  50 of firms change prices less frequently than
  once a year.

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Sticky Wages and Sticky Prices

• Sticky wages and prices do not adjust quickly
  enough.
• However wages and prices eventually adjust.
• For example
• A three-year wage contract with nominal wages
  increasing 3 each year
• If there is a recession in the second year, labor
  demand falls but wage inflation is constant at
  3, so the firm lays off workers.
• In the third year a new contract is unlikely to
  contain outright wage cuts but rather slower wage
  growth, or wage inflation at, say, 2 per year.

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Inflation Adjustment

• In the short run, there is a trade-off between
  inflation and unemployment.
• If unemployment is low ? tight labor market.
• Firms have to pay higher wages to keep workers.
• This wage inflation leads to price inflation.
• So low unemployment and higher inflation go
  together.

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Inflation, Monetary Policy, and Spending

• In response to inflation or recession, the Fed
  takes action that reinforces the trade-off
  between inflation and unemployment.

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How the Fed Acts and the Economy Responds

• Suppose inflation starts to rise.
• The Fed acts to reduce inflation this requires a
  rise in unemployment.
• The Fed will raise the real interest rate when
  inflation rises.
• Higher interest rates reduce investment and
  consumption of durables.
• This reduces spending and the demand for goods.
• As demand in the product market falls, labor
  demand falls.
• With sticky wages, employment falls and
  unemployment rises.
• A looser labor market eventually lowers wage
  inflation this lowers price inflation.
• To reduce inflation the Fed acts in such a way
  that unemployment increases

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Result of Fed Actions

• Higher unemployment results from the reaction of
  the Fed to high inflation.
• Overall, an increase in inflation leads to the
  Fed's reaction to raise interest rates, which
  lowers spending, which lowers demand.

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Aggregate Demand and Inflation

• These four fundamental relationships will help us
  understand short-run fluctuations.