Principles of Macroeconomics Chapter 10 Economic Fluctuations Vocabulary Notes Introduction 1 Boom a period of time during which real GDP is above potential GDP 2 Slumps a period during which real GDP is below potential and or the employment rate is below normal Recessions decline in output and employment o Output potential output slump below normal Expansions rise in output and employment o Output potential output boom above normal Output vs Employment employment levels Prime age Ages 25 54 o This group s normal rate of employment is 95 5 Facts about economic fluctuations o Over the business cycle changes in output causes firms to change their o The shift from a strong expansion to a serious recession can occur rather suddenly within a few quarters o Recessions and the resulting slumps don t last forever The recession phase can be relatively brief o Slumps can be long and painful Can the Classical Model Explain Economic Fluctuations Shifts in Labor Supply If the labor supply shifted to the left the equilibrium would move up and to the left along the labor demand curve The level of employment would fall and output would fall with it Because sudden shifts of the labor supply curve are unlikely to occur and because they could not accurately describe the facts of the economic cycle the classical model cannot explain fluctuations through shifts in the supply of labor Shifts in Labor Demand A leftward shift in the labor demand curve would move us down and to the left along the labor supply curve Employment would fall and so would the real wage rate Does the Labor Market Clear o Answer Not always o Stick wages also referred to as downward wage rigidity wage rates that don t fall to the market clearing level right away Explanations Reluctance of firms to decrease wages because of the negative effects on worker morale or worker productivity Complexities of the way workers search for jobs and the way firms fill job openings Why would firms want to hire fewer workers at any given wage than they wanted to hire before leftward shift of demand curve A Change in Productivity o Workers have become less productive and therefore less valuable to firms o What leads to a change in productivity Decrease in capital Workers suddenly forgot how to do things o While changes in labor productivity can shift the labor demand curve they do not occur rapidly enough to explain real world economic fluctuations A Change in Total Spending o Total spending declines so firms are suddenly unable to sell all the output they produce Firms must cut back on production and hire fewer workers than before at any given wage o According to the classical model total spending is never deficient Remember Say s law assures us that total spending will equal whatever level of output firms decide to produce o In the classical model a change in spending cannot be the cause of a change in total output because spending cannot change unless output changes first This same logic applies to booms o While changes in spending play an important role in real world economic fluctuations the classical model rules them out as an initial case Verdict The classical Model Cannot Explain Economic Fluctuations Although the classical model works well in explaining the movements of the economy in the longer run it does a poor job of explaining the economy in the short run But why o In the classical model a change in output would have to come from a shift in either the labor supply curve or the labor demand curve We found that all possible explanations for these shifts were unrealistic and inconsistent with the facts of real world fluctuations What Triggers Economic Fluctuations Introduction During a boom because qualified workers are so scarce firms must compete fiercely with each other to hire them This drives up wage rates in the economy raises production costs for firms and ultimately causes firms to raise their prices o Competition Higher wage rates Higher production costs Rise in prices A Very Simple Economy Imagine an economy with just two people Yasmin and Pepe Yasmin is especially good at making yogurt but she eats only popcorn Pepe by contrast is very good at making popcorn but he eats only yogurt o By trading with one another this economy will operate at full employment because both individuals will be fully engaged in making products for each other trading equilibrium in the classical model o A breakdown in communication could lead to either a recession or an expansion The Real World Economy In making decisions each firm and each household considers only its own consequences What kind of problems can arise o A Change in Production o A Change in Spending Suppose Ford Motors believes that consumers will buy fewer of its cars next year Ford along with other automobile companies will start producing fewer automobiles and lay off some of its workers The laid off workers who will earn less income or none at all will cut back on their spending This will in turn cause other firms to cut back on their production to lay of their workers and son on A production decrease in one sector of the economy can work its way through other sectors causing a full blown recession Suppose that a large number of consumers begin to believe that a recession is likely in the near future They will start to save a larger proportion of their incomes Businesses will see their sales decline and in turn start to produce less and lay off some of their workers who will reduce their spending and so on A decrease in spending can trigger a downward spiral of further declines in production income and spending Spending changes can also trigger a boom Why Say s Law Doesn t Prevent Recessions Say s law total spending total income o If one sector changes its spending then other sectors should make up the difference so that total spending remains unchanged o Since households are spending less they are saving more This additional saving will go into the loanable funds market where it will be borrowed by business firms that will then spend it Ways that the loanable funds market could fail to turn one person s saving into someone else s spending o Saving versus Supply of Funds Saving Consumption Falls Planned Investment Unchanged Supply of Funds Consumption falls Planned investment rises Total Spending Falls Total Spending Unchanged When households spend less save more but do not supply all of their additional saving to the loanable funds market total spending will drop below total
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