Week 4

Lectures 7 & 8
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

116.0

114.0

112.0
Real GDP Index (2000=100)

What is a recession? (Who is this?)

122.0

120.0

118.0

110.0

108.0

106.0

Mar 2012

Sep 2011

Mar 2011

Sep 2010

Mar 2010

Sep 2009

Mar 2009

Sep 2008

Mar 2008

Sep 2007

Mar 2007

Sep 2006

Mar 2006

Sep 2005

Mar 2005

116.0

114.0

112.0
Real GDP Index (2000=100)

What is a recession? (Who is this?) United States

122.0

120.0

118.0

110.0

108.0

106.0

Mar 2012

Sep 2011

Mar 2011

Sep 2010

Mar 2010

Sep 2009

Mar 2009

Sep 2008

Mar 2008

Sep 2007

Mar 2007

Sep 2006

Mar 2006

Sep 2005

Mar 2005

126.0

124.0

122.0

120.0

118.0
Real GDP Index (2000=100)

What is a recession? (Who is this?)

132.0

130.0

128.0

116.0

114.0

112.0

Mar 2012

Sep 2011

Mar 2011

Sep 2010

Mar 2010

Sep 2009

Mar 2009

Sep 2008

Mar 2008

Sep 2007

Mar 2007

Sep 2006

Mar 2006

Sep 2005

Mar 2005

126.0

124.0

122.0

120.0

118.0
Real GDP Index (2000=100)

What is a recession? (Who is this?) New Zealand

132.0

130.0

128.0

116.0

114.0

112.0

Mar 2012

Sep 2011

Mar 2011

Sep 2010

Mar 2010

Sep 2009

Mar 2009

Sep 2008

Mar 2008

Sep 2007

Mar 2007

Sep 2006

Mar 2006

Sep 2005

Mar 2005

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.

Mar-1975
Mar-1976
Mar-1977
Mar-1978
Mar-1979
Mar-1980
Mar-1981
Mar-1982
Mar-1983
Mar-1984
Mar-1985
Mar-1986
Mar-1987
Mar-1988
Mar-1989
Mar-1990
Mar-1991
Mar-1992
Mar-1993
Mar-1994
Mar-1995
Mar-1996
Mar-1997
Mar-1998
Mar-1999
Mar-2000
Mar-2001
Mar-2002
Mar-2003
Mar-2004
Mar-2005
Mar-2006
Mar-2007
Mar-2008
Mar-2009
Mar-2010
Mar-2011
Mar-2012
Mar-2013
Mar-2014
Mar-2015

$m, cvm

Quarterly Real GDP for Australia 1975-2015

450000

400000

350000

300000

250000

200000

150000

100000

50000

Early 1980s Recession in Australia (Real GDP)

138000
136000

$ mill, cvm

134000
132000
130000
128000
126000
124000
122000
Mar-1984

Dec-1983

Sep-1983

Jun-1983

Mar-1983

Dec-1982

Sep-1982

Jun-1982

Mar-1982

Dec-1981

Sep-1981

Jun-1981

Mar-1981

Melbourne Institute dates peak (Nov 1981) and trough (May

1983), see Table 4.1

Stylised Representation of a Business Cycle

Level of
GDP

expansion
contraction
Peak

Trough Peak

Time (quarters)

10

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

11

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.

12

Mar-2015

Dec-2014

Sep-2014

Jun-2014

Mar-2014

Dec-2013

Sep-2013

Jun-2013

Mar-2013

Dec-2012

Sep-2012

Jun-2012

Mar-2012

Dec-2011

Sep-2011

Jun-2011

Mar-2011

Dec-2010

Sep-2010

Jun-2010

Mar-2010

Dec-2009

Sep-2009

Jun-2009

Mar-2009

Dec-2008

Sep-2008

Jun-2008

Mar-2008

Dec-2007

Sep-2007

Jun-2007

Mar-2007

Dec-2006

Sep-2006

Jun-2006

Mar-2006

$m, cvm

Australia GDP During the GFC (Mar 2015 Data)

410000

390000

370000

350000

330000

310000

290000

270000

250000

Negative growth rate Dec qtr. 2008 = -0.80 percent

13

US
Euro Area
Mar 2012

Dec 2011

Sep 2011

Jun 2011

Mar 2011

Dec 2010

Sep 2010

Jun 2010

Mar 2010

Dec 2009

Sep 2009

Jun 2009

Mar 2009

Dec 2008

Sep 2008

Jun 2008

Mar 2008

Dec 2007

Sep 2007

Jun 2007

Mar 2007

Dec 2006

Sep 2006

Jun 2006

Mar 2006

Dec 2005

Sep 2005

Jun 2005

Mar 2005

Index 2000=100

US, UK and Euro Area real GDP during the GFC

130.0

125.0

120.0

115.0

110.0

105.0

100.0

UK

14

South Korea

Mar 2012

Dec 2011

Sep 2011

Jun 2011

Mar 2011

Dec 2010

Sep 2010

Jun 2010

Mar 2010

Dec 2009

Sep 2009

Jun 2009

Mar 2009

Dec 2008

Sep 2008

Jun 2008

Mar 2008

Dec 2007

Sep 2007

Jun 2007

Mar 2007

Dec 2006

Sep 2006

Jun 2006

Mar 2006

Dec 2005

Sep 2005

Jun 2005

Mar 2005

Index 2000=100

South Korea and Singapore real GDP during the GFC

190.0

180.0

170.0

160.0

150.0

140.0

130.0

120.0

110.0

100.0

Singapore

15

Potential Output
*
y
Potential output ( ) is the level of GDP an economy can

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
16

Actual GDP

Mar 2012

Nov 2011

Jul 2011

Mar 2011

Nov 2010

Jul 2010

Mar 2010

Nov 2009

Jul 2009

Mar 2009

Nov 2008

Jul 2008

Mar 2008

Nov 2007

Jul 2007

Mar 2007

Nov 2006

Jul 2006

Mar 2006

Nov 2005

Jul 2005

Mar 2005

Nov 2004

Jul 2004

Mar 2004

Nov 2003

Jul 2003

Mar 2003

Nov 2002

Jul 2002

Mar 2002

Nov 2001

Jul 2001

Mar 2001

Nov 2000

Jul 2000

Mar 2000

Real GDP Index (2000=100)

Actual Output and Potential Output (South Korea)

170.0

160.0

150.0

140.0

130.0

120.0

110.0

100.0

90.0

80.0

Potential GDP (estimate)

17

Actual Output and Potential Output

Actual output (y) can vary (expand or contract) due to:
*
y
changes in potential output ( ), 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.

18

Mar 2012
Sep 2011
Mar 2011
Sep 2010
Mar 2010
Sep 2009
Mar 2009
Sep 2008
Mar 2008
Sep 2007
Mar 2007
Sep 2006
Mar 2006
Sep 2005

Mar 2005
Sep 2004
Mar 2004
Sep 2003
Mar 2003
Sep 2002
Mar 2002
Sep 2001
Mar 2001
Sep 2000
Mar 2000
-1

-2
% of potential output

Output Gap (South Korea)

4

-3

-4

-5

-6

19

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

20

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)

21

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

22

3 types of unemployment: frictional, structural & cyclical

Definition
*
u
Natural rate of unemployment ( ) is the rate of
unemployment that prevails when cyclical unemployment is
zero.

or
Natural rate of unemployment = frictional + structural.
*
u

u
Cyclical unemployment =

23

Relationships
Contractionary Gap
Output gap
y y* 0
negative

Cyclical unemployment
u u* 0
positive

Expansionary Gap
Output gap
y y* 0
positive

Cyclical unemployment
u u* 0
negative
24

Okuns Law
Quantitative Relationship
y y*
*
100

(
u

u
)
*
y
An additional percentage point of cyclical unemployment is
associated with a percentage point decline in the output
gap.
(NB. BOF (page 128) 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.)

25

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 1.8

26

Numerical Example (What is the change in output gap?)

Suppose that over 2014 the actual rate of unemployment is
forecast to rise from 5% to 7%.
*
u
5% and =1.8
Assume:

y y*
*
100

(
u

u
)
*
y
y y*
100
1.8(7 5) 3.6
*
y

percentage points

We have a negative output gap, which is equal to

3.6 percent of potential output (or 0.036y*).

27

-0.5

[(Y-Y*)/Y*]100

Mar-2015

Oct-2014

May-2014

Dec-2013

Jul-2013

Feb-2013

Sep-2012

Apr-2012

Nov-2011

Jun-2011

Jan-2011

Aug-2010

Mar-2010

Oct-2009

May-2009

Dec-2008

Jul-2008

Feb-2008

Sep-2007

Apr-2007

Nov-2006

Jun-2006

Jan-2006

Aug-2005

Mar-2005

Oct-2004

May-2004

Dec-2003

Jul-2003

Feb-2003

Sep-2002

Apr-2002

Nov-2001

Jun-2001

Jan-2001

Aug-2000

Mar-2000

Output gap and cyclical unemployment in Australia (2000-15)

2

1.5

0.5

-1

-1.5

-2
u-u*

u* and y* are based on linear time trends

28

Estimate of Okuns Law for Australia (2000-2015)

2

1.5

Output Gap

0.5

-1.5

0
-1

-0.5

0.5

1.5

-0.5

-1

-1.5

y = -0.45x

-2
Cyclical Unemployment

29