Chapter 20: Short-term Economic Fluctuations

1. Chapter 20: Short-term Economic Fluctuations

2. Learning Objectives • Identify the four phases of the business cycle • Explain the primary characteristics of recessions and expansions • Define potential output, measure the output gap, and analyze an economy's position in the business cycle • Define the natural rate of unemployment and relate it to cyclical unemployment • Use Okun's law to analyze the relationship between the output gap and cyclical unemployment • Discuss the differences between how the economy operates in the short run and the long run

3. The Economy in the Short Run

4. Recessions and Expansions • Recession (or contraction) is a period in which the economy is growing at a rate below normal • Depression a particularly severe recession • Commonly held to be 2 or more consecutive quarters of negative GDP growth • A variety of economic data are consulted

5. Fluctuations in Egyptian Real GDP, 1960-2009 • 1966-1967: Six-day war • 1972-1973: Yom Kippur war • 1991: Persian Gulf crisis

6. Fluctuations in Moroccan Real GDP, 1960-2009 • 1960s: Post-independence political tensions including war with Algeria (Sand War – La guerre des sables) • 1980s: Social unrest, drought, plummeting phosphate prices

7. Fluctuations in Turkish Real GDP, 1960-2009 • 1978-1980: Oil shocks of the 1970s • 2008-2009: Global financial crisis

8. Recessions and Expansions • A peak is the beginning of a recession • High point of the business cycle • A trough is the end of a recession • Low point of the business cycle

9. Recessions and Expansions

10. Some Facts About Short-Term Economic Fluctuations • Economists have studied business cycles for at least a century • Recessions and expansions are irregular in their length and severity • Contractions and expansions affect the entire economy • May have global impact • Great Depression of the 1930s was worldwide • US recessions of 1973 – 1975 and 1981 – 1982 • East Asian slowdown in the late 1990s

11. Symptoms of Business Cycles • 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 labor 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

12. Egyptian Recessions since 1960

13. Moroccan Recessions since 1960

14. Turkish Recessions since 1960

15. Output Gaps and Cyclical Unemployment: Potential Output and The Output Gap • Potential output, Y* , is the maximum sustainable amount of real GDP that an economy can produce • Also called full-employment GDP • Use capital and labor 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 • Reflect growth rate of Y* • Variable rates of technical innovation, capital formation, weather conditions, etc. • Actual output does not always equal potential output

16. Egyptian, Moroccan, and Turkish Recessions • Unemployment increases in Egypt from 1.5 to 1.6 percent during the 1972–1973 recession and to 9.6 percent during the 1991 recession. • As for Morocco, unemployment is high by international standards and peaks at 22.9 percent during the 1995 recession and at 22 percent during the 1999 recession. • As the Moroccan economy improves in 2000 by growing at 1.59 percent (versus 0.52 in 1999), unemployment also improves to 21.5 percent. • It is important to note that the high level of unemployment observed in countries like Egypt and Morocco is not only associated with economic activity but also with other demographic and political factors - factors deemed largely responsible for the Arab uprisings of 2011.

17. Egyptian, Moroccan, and Turkish Recessions • Like unemployment, inflation follows a typical pattern in recessions and expansions, though it is not so sharply defined. • Recessions tend to be followed soon after by a decline in the rate of inflation. • Inflation decreased from 9.04 percent to 0.70 percent during the Egyptian recession of 1966–1967. • Inflation decreased from 4.02 percent to 3.48 percent and to −1.01 percent during the Moroccan recession of 1964–1966. • Turkey faced unique circumstances (i.e. hyperinflation) that did not necessarily translate into lower inflation during recessions. • Furthermore, many—though not all—recessions have been preceded by increases in inflation. • Inflation in Egypt reached 14.84 percent in 1965 beforedeclining to 9.04 percent during the 1966 recession.

18. Output Gaps • Output gap is the difference between potential output and actual output at a point in time Output gap = Y* – Y • Recessionary gap is a negative output gap; Y* > Y • Expansionary gap is a positive output gap; Y* < Y • Policymakers consider stabilization policies when there are output gaps • Recessionary gaps mean output and employment are less than their sustainable level • Expansionary gaps lead to inflation to ration output

19. The Natural Rate of Unemployment and Cyclical Unemployment • Recessionary gaps have high unemployment rates • Expansionary gaps have low unemployment rates • The natural rate of unemployment, u*, is the sum of frictional and structural unemployment • Unemployment rate when cyclical unemployment is 0 • Occurs when Y = Y* • Cyclical unemployment is the difference between total unemployment, u, and u* • Recessionary gaps have u > u* • Expansionary gaps have u < u*

20. What Would Cause The Natural Rate of Unemployment to Decline? • Possible explanations • Frictional unemployment decreased • Structural unemployment decreased • Change in the age structure of the population • Decline in the share of working population ages 16-24 • This group has higher unemployment than older workers • Short-term jobs / Interrupt work for school • Frequent job changes increases frictional unemployment • Lower skills means more structural unemployment

21. What Would Cause The Natural Rate of Unemployment to Decline? • Labor markets may be more efficient at matching job openings and workers • Reduces frictional and structural unemployment • Temporary agencies • Temp work can lead to permanent position • Online job boards • Less time between jobs

22. Okun’s Law • Okun's law relates cyclic unemployment changes to changes in the output gap • One percentage point increase in cyclical unemployment means a 2 percentage point increase in the output gap • 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 Y*

23. Output Gap in the US, Egypt, Morocco, and Turkey

24. Output Gap in the US, Egypt, Morocco, and Turkey • All years listed for Egypt, Morocco, and Turkey were recession years, so the output gaps are expected to be recessionary gaps. • Contrary to expectations, recessionary gaps only took place in 1991 in Egypt, 1987, 1995, and 2000 in Morocco, and 1994 and 2008 in Turkey. • Despite the year 1992 being a recession year for Morocco, the natural rate of unemployment exceeds the actual unemployment rate.

25. Output Gap in the US, Egypt, Morocco, and Turkey • Such inconsistencies, also observed for Egypt and Turkey, cast doubt on the reliability of the data and impose serious limitations on the public and policymakers’ ability to deal effectively with recessions. • It is common knowledge, at least in the academic world, that one of the most daunting tasks in conducting research about countries in the developing world is the lack of reliable data. • This problem is likely due to various factors, including but not limited to data imperfections (i.e., missing observations), a lack of resources (i.e., human capital), the reluctance of various (primarily governmental) organizations to collect and disseminate data, or just a lack of interest.

26. Why Do Short-Term Fluctuations Occur? A Preview and A Parable • Output gaps arise for two main reasons • Growth in potential output itself may slow down or speed up, reflecting changes in the growth rates of available capital, labor, and technology. • Actual output may be higher or lower than potential output despite normal growth in potential output.

27. Why Do Short-Term Fluctuations Occur? A Preview and A Parable • Markets require time to reach equilibrium price and quantity • Firms change prices infrequently • Quantity produced is not at equilibrium during the adjustment period • Firms produce to meet the demand at current prices

28. Why Do Short-Term Fluctuations Occur? A Preview and A Parable • Changes in total spending at preset prices affects output levels • When spending is low, output will be below potential output • Changes in economywide spending are the primary causes of output gaps • Policy: adjust government spending to close the output gap

29. Why Do Short-Term Fluctuations Occur? A Preview and A Parable • The economy has 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 pressure

30. Why Do Short-Term Fluctuations Occur? A Preview and A Parable • 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 rate of inflation

31. Alaa's Ice Cream – Production Capacity • Daily output of the store is determined by • Production capacity • Amount of capital • Labor employed (includes hours worked) • Productivity of capital and labor • Capacity changes slowly, but periodic disruptions happen • Machine failure • Workers fail to report for work • Power outage • Supplies not delivered

32. Alaa's Ice Cream – Demand Fluctuations • Predictable changes hour by hour • Day of the week patterns • Annual cycles of demand • Unpredictable changes in demand • Weather • Community events • Increase sales or divert customers elsewhere • Demand for specific flavors

33. Alaa's Ice Cream – Setting Prices • Fully flexible prices are unrealistic • Minute-by-minute pricing is confusing to customers • Costs of an auction exceed Alaa's benefits • Continuous purchases in low volumes by different customers • Alaa sets prices • Survey of competitors • Product strengths and weaknesses • Analyzes sales over time to see if adjustments are needed • Alaa meets demand in the short run

34. Alaa's Ice Cream – Long Run • Alaa observes consistently strong demand for his products • Waiting lines • Low inventory • Fully utilized production capacity • Alaa's first response is to raise prices • Implemented quickly • Alaa evaluates expanding capacity • If expansion does not raises average costs, Alaa will expand and return to original prices

35. Alaa's Ice Cream – Macroeconomic Lessons • In the short run, producers meet demand at existing prices • Total spending drives output levels • Gather data and analyze business opportunities • In the long run, prices reach equilibrium levels • Output is at its potential level

36. Dynamic Pricing • Coca-Cola tested machines that could modify prices according to demand • Temperature sensors triggered higher prices on hot days • Machines could raise prices for periods of high demand • Justified as a response to consumer demand • Barriers to flexible pricing • Sophisticated vending machines increase costs • Consumers reacted negatively to change in pricing practices