Chapter 10 Economic Fluctuations Introduction Changes in output cause firms to change their employment levels o Ex In a recession many business firms lay off workers If asked why they would answer that they are reducing employment because they are producing less output Slumps a period during which real GDP is below potential and or the employment rate is below normal Can the Classical Model Explain Economic Fluctuations The classical model does a good job of explaining why the economy tends to operate near its potential output level on average over long periods of time Shifts in Labor Supply If the labor supply curve shifted to the left the equilibrium would move up and to the left along the labor demand curve o The level of employment would fall and output would fall with it o Leftward shift means that fewer people want to work at any given wage o In reality preferences tend to change very slowly and certainly not rapidly enough to explain recessions 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 o Employment would fall and so would the real wage rate o However this cannot explain recessions Does the Labor Market Clear The wage rate doesn t always adjust to the market clearing level right away called sticky wages or rage rigidity o Causes recession A Change in Productivity One possibility is that the labor demand curve shifts leftward because workers have become less productive and therefore less valuable to firms o Could happen if there were a sudden decrease in capital stock o A sudden change in productivity is an unlikely explanation for recessions Not likely that booms are explained by a sudden increase in productivity causing the labor demand curve to shift rightward 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 Another possibility is that the labor demand curve shifts leftward because total spending declines so firms are suddenly unable to sell all the output they produce o However total spending is never deficient While changes in spending play an important role in real world economic fluctuations the classical model rules them out as an initial cause Verdict The Classical Model Cannot Explain Economic Fluctuations 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 Spending and expectations about the future play a central role What Triggers Economic Fluctuations 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 Why do such deviations occur in the economy The Real World Economy A Change in Production Large numbers of people or firms each doing the best for themselves can create a macroeconomic change that makes everyone worse off What begins as a production decrease in one sector of the economy can work its way through other sectors causing a full blown recession With more production and more workers earning higher incomes spending increases in other sectors as well until output rises above the classical full employment level A Change in Spending A decrease in spending can trigger a downward spiral of further declines in production income and spending If business firms fearful of recession cut their spending on new capital equipment or govt cuts back on purchases for defense or highway construction or foreigners spend less on the economy s exports any of these scenarios can trigger the same downward spiral Spending changes can also trigger a boom o If households begin to think that good times are ahead they might spend more than normal As spending rises firms produce more and hire more workers creating still more spending and so on Why Say s Law Doesn t Prevent Recessions Say s law eliminates the potential impact of changes in consumption spending o If a critical assumption of the classical model holds that the interest rate adjusts until saving is equal to business and govt borrowing In the long run greater saving leads to greater investment and faster growth of the capital stock Three possible ways that the loanable funds market could fail to turn one person s saving into someone else s spending Saving versus Supply of Funds Not all saving is supplied to the loanable funds market Additional saving will flood into the market and drive down the interest rate until investment spending increases Decrease in spending by households has no effect on total spending 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 income violating Say s Law This is one reason why a decision by households to spend less save more can trigger a recession or contribute to a downward recessionary spiral Supply of Funds versus Lending Much of the saving and lending in the economy is done through financial intermediaries institutions that collect funds from savers and then lend them to borrowers ex bank When households save more spend less but financial intermediaries do not lend out all of the additional saving total spending will drop below total income violating Say s Law Other Influences on the Interest Rate Normally additional saving by households drives down the interest rate causing investment spending to rise But if households increase their saving and other forces prevent the interest rate from dropping then planned investment spending will not rise Once again if households spend less and save more total spending will decline When households save more spend less but other factors prevent the interest rate from falling to its market clearing level then some of the additional saving will not be borrowed and spent by others Total spending will drop below total income violating Say s Law The Interest Rate as a Cause of Booms and Recessions Interest rate changes by themselves can cause economic fluctuations If the interest rate rises people will be encouraged to save more and spend less o The higher interest
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