Week 4 Short-run Economic Fluctuations Reference: Bernanke, Olekalns and Frank - Chapter 4 Key Issues What is a recession?

? Business cycle fluctuations Output gaps and cyclical unemployment Natural rate of unemployment Okuns law

Business Cycles Economies tend to experience periods of expansion and contraction in the level of economic activity. If we focus on GDP as a measure or economic activity then: A contraction is a period during which the level of GDP falls. An expansion is a period when GDP is rising.

Peaks and Troughs In moving between periods of expansion and contraction the economy will experience peaks and troughs. A peak is the beginning of a contraction, the high point of GDP prior to a downturn. A trough is the end of a contraction, the low point of economic activity prior to a recovery.

Stylised Representation of a Business Cycle

Level of GDP

expansion contraction

Peak

Trough

Peak

Time (quarters)

Quarterly Real GDP for Australia 1970-2011

Early 1980s Recession in Australia

122000 120000 Real GDP 118000 116000 114000 112000 110000 108000 Mar-81 Jun-81 Sep-81 Dec-81 Mar-82 Jun-82 Sep-82 Dec-82 Mar-83 Jun-83 Sep-83 Dec-83 Mar-84
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Melbourne Institute dates peak (Nov 1981) and trough (May 1983), see Table 4.1

Classical Business Cycle in Australia Classical cycle refers to peaks and troughs in the level of GDP Recession Dates Peak Trough No. of Months April 1951 September 1952 17 December 1955 December 1957 24 September 1960 September 1961 13 July 1974 October 1975 15 May 1976 November 1977 18 November 1981 May 1983 18 February 1990 October 1991 20
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Characteristics Recessions last 18 months on average Expansions last 60 months on average Rule of Thumb for a recession is at least two quarters of negative economic growth. This means the level of GDP has to fall for at least two quarters.

Australia GDP During the GFC

Negative growth rate Dec qtr. 2008 = -0.93 percent

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USGDP(Nominal, billionsof$)2006Q1 2010Q4

15000

14500

14000

13500

13000

12500

12000 2006I 2006II 2006III 2006 2007I 2007II 2007III 2007 2008I 2008II 2008III 2008 2009I 2009II 2009III 2009 2010I 2010II 2010III 2010 IV IV IV IV IV

Potential Output is the level of GDP an economy can Potential output produce when using its resources (labour and capital) at normal rates. Potential output is not the same as maximum output. Potential output grows over time with growth in labour and capital inputs and with growth in technology. e.g. An ageing workforce (-) Development and use of new technologies (+)
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* y ( )

Actual Output and Potential Output Actual output (y) can vary (expand or contract) due to: changes in potential output ( y * ), and changes in the utilisation rate of labour and capital For example in the short-run the utilisation rate of labour and capital can be above (or below) the normal rate.

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Output Gap Actual output does not always equal potential output. Difference is called output gap. Output gap = Actual GDP less Potential GDP * y y Output gap =
* y > y Positive output gap : called expansionary gap
* y < y Negative output gap : called contractionary gap

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Policymakers generally view both (persistent) contractionary and expansionary as problems. Contractionary gaps are associated with capital and labour not being fully utilised (cost in terms of forgone output). Expansionary gaps are associated with firms operating above normal capacity and can lead them to raise prices (inflationary)

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Natural Rate of Unemployment The unemployment rate ( u ) tends to co-move with the output gap in an economy. Contractionary gaps are associated with a high unemployment rate Expansionary gaps are associated with a low unemployment rate

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3 types of unemployment: frictional, structural & cyclical Definition Natural rate of unemployment ( u ) is the rate of unemployment that prevails when cyclical unemployment is zero. or Natural rate of unemployment = frictional + structural.
* u u Cyclical unemployment = *

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Relationships Contractionary Gap Output gap

y y* < 0

Cyclical unemployment
u u* > 0

negative Expansionary Gap Output gap

y y* > 0

positive

Cyclical unemployment
u u* < 0

positive

negative
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Okuns Law Quantitative Relationship

y y* * u u 100 ( ) = * y

An additional percentage point of cyclical unemployment is associated with a percentage point decline in the output gap. (NB. BOF (page 120) say increase not decline, but I think this is a typo from the US edition of the book, where they define the output gap as y*- y.)

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Magnitude of The size of can differ across different countries; For the US is estimated to be about 2.0 For Australia is estimated to be about 1.5

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Numerical Example (What is the change in output gap?) Suppose that over 2009 the actual rate of unemployment is forecast to rise from 5% to 7%. Assume: u * = 5% and =1.5
y y* * 100 ( u u ) = * y

percentage points We have a negative output gap, which is equal to 3.0 percent of potential output (or 0.03y*).

y y* 100 = 1.5(7 5) = 3.0 * y

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Output gap and cyclical unemployment in Australia (2000-10)

2.00 1.50

1.00

percent

0.50

0.00
ar-00 M Sep-00 ar-01 M Sep-01 ar-02 M Sep-02 ar-03 M Sep-03 ar-04 M Sep-04 ar-05 M Sep-05 ar-06 M Sep-06 ar-07 M Sep-07 ar-08 M Sep-08 ar-09 M Sep-09 ar-10 M

-0.50

-1.00

-1.50 u-u* (y-y*)/y*

u* and y* are based on linear time trends

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Estimate of Okuns Law for Australia (2000-2010)

2.0000

1.5000

y = -0.89x R2 = 0.38

1.0000

(y-y*)/y*

0.5000

-1.00

-0.50

0.0000 0.00 -0.5000

0.50

1.00

1.50

-1.0000

-1.5000 u-u*

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Spending and Output in the Short-Run Reference: Bernanke, Olekalns and Frank - Chapter 5 Key Issues A model of output determination Keynesian Model Planned verses actual expenditure A consumption function Equilibrium output in the short-run

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Background We have defined aggregate output or GDP and now we want a model of how it is determined. E.g. Why is GDP equal to 500 billion in a given period, rather than 550 billion? Model is based on the ideas of John Maynard Keynes. Classic book called The General Theory of Employment, Interest and Money (1936)

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Keynesian Model Key Assumption Prices of goods are fixed (common to say sticky) in the short-run Firms do not change prices in response to a change in demand for their product Instead they fix their price and then meet the demand by varying their level of production

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In the short-run firms will: accommodate a cut in demand by reducing output and employment, not by reducing prices. accommodate a rise in demand by increasing output and employment, not by increasing prices.

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Assumptions (Micro-economic Foundations) Firms have some ability to set prices (not perfectly competitive world) Firms face some cost to changing prices these are called menu costs In the long-run: sustained changes in demand will eventually lead firms to change their prices and cause production to return to normal capacity.
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Non-Keynesian View of the World (Classical point of view) There will never be excess production because firms will cut prices to sell it. (Perfect competition)

There will never be persistent unemployment because workers will cut their wages to keep and get jobs. (Market clear) Fluctuations in demand will be accommodated by flexible prices and wages without changes in output and employment (Price mechanism)

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Aggregate Expenditure Given the assumption that firms meet demand in the Keynesian model, aggregate output will be determined by the total level of desired spending. Define: Planned aggregate expenditure (PAE) as the total planned spending on final goods and services. 4 components of aggregate expenditure AE = C + I + G + NX

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Planned verses Actual Expenditure Suppose aggregate production (GDP) = 100 We know from Week 1 that actual expenditure must equal 100? However planned expenditure can differ from 100. Why is actual expenditure not always equal to planned expenditure? (Unplanned) Inventories
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Reconciliation Suppose PAE = 90, Y = 100 AE = PAE + Inventories = 100 100 = 90 + 10 = 100 Planned spending equals 90 but firms produced 100, the extra 10 units is assumed to be purchased by firms and becomes an inventory of unsold goods. The firms did not plan to buy the 10 units of goods and so it is called unplanned inventory investment.
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Define Actual Aggregate Expenditure (AE)

AE = C + I + G + NX

Planned Aggregate Expenditure (PAE)

PAE = C + I P + G + NX

I = actual investment (includes unplanned inventory investment I P = planned investment

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A Model of Consumption Expenditure So far we have defined PAE, but now we need an economic model of the determinants of PAE. To begin we will focus on what determines consumption expenditure. Hypothesize that an important influence on consumption spending by households is current disposable income. Disposable income = income less (net) taxes =YT
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Consumption Function
C = C + c(Y T )
C is exogenous (or autonomous) consumption.

Factors (other than disposable income) that could affect consumption, e.g. wealth, real interest rates The value of an exogenous variable is determined outside of the model under consideration
c(Y T ) captures the effect of disposable income on

consumption (sometimes called induced consumption) c = marginal propensity to consume (parameter).

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Marginal Propensity to Consume (MPC) MPC is the change in consumption when disposable income changes by a dollar.
C = C + c(Y T ) C MPC = =c (Y T )

Assume: 0 < c < 1 A dollar increase in disposable income raises consumption by less than one dollar

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Consumption Function

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Consumption Function C
C = C + c(Y T )

slope = c 0 (Y-T)

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PAE and Output Given our definition of PAE and model of consumption expenditure we can re-write PAE as follows
PAE = C + I P + G + NX

C = C + c(Y T )
PAE = C + c(Y T ) + I P + G + NX PAE = [C cT + I P + G + NX ] + cY

The first terms is independent of output and is called exogenous expenditure The second term is called induced expenditure since it depends on output
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Short-Run Equilibrium Output We define equilibrium as being when firms produce a level of output that equals planned aggregate expenditure
Y = PAE

Using the equation for PAE,

PAE = [C cT + I P + G + NX ] + cY

and the above definition of equilibrium it is straightforward to solve for equilibrium output.
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Equilibrium Output
Y = PAE

PAE = [C cT + I P + G + NX ] + cY

Substituting
Y = [C cT + I P + G + NX ] + cY

Collect terms in Y
Y (1 c) = [C cT + I P + G + NX ] 1 Ye = [C cT + I P + G + NX ] (1 c)

Y e is short-run equilibrium output

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