Post on 14-Apr-2018
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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
• Okun’s law
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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.
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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.
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Stylised Representation of a Business Cycle
Level of GDP
expansion
contraction
Peak Trough Peak Time (quarters)
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Quarterly Real GDP for Australia 1970-2011
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Early 1980s Recession in Australia
108000
110000
112000
114000
116000
118000
120000
122000
M ar - 8 1
J un- 8 1
S e p- 8 1
D e c - 8 1
M ar - 8 2
J un- 8 2
S e p- 8 2
D e c - 8 2
M ar - 8 3
J un- 8 3
S e p- 8 3
D e c - 8 3
M ar - 8 4
R e a l G D P
Melbourne Institute dates peak (Nov 1981) and trough
(May 1983), see Table 4.1
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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 24September 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 quartersof negative economic growth.
This means the level of GDP has to fall for at least twoquarters.
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Australia GDP During the GFC
Negative growth rate Dec qtr. 2008 = -0.93 percent
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12000
12500
13000
13500
14000
14500
15000
2006‐I 2006‐II 2006‐III 2006‐
IV
2007‐I 2007‐II 2007‐III 2007‐
IV
2008‐I 2008‐II 2008‐III 2008‐
IV
2009‐I 2009‐II 2009‐III 2009‐
IV
2010‐I 2010‐II 2010‐III 2010‐
IV
US GDP (Nominal, billions of $) 2006 Q1 ‐ 2010 Q4
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Potential Output
Potential output (*
y ) is the level of GDP an economy can
produce when using its resources (labour and capital) atnormal 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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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
Output gap =* y y −
Positive output gap* y y > : called expansionary gap
Negative output gap* y y < : 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.
Cyclical unemployment =*uu −
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Relationships
Contractionary Gap
Output gap Cyclical unemployment
0*<− y y 0*
>− uu negative positive
Expansionary Gap
Output gap Cyclical unemployment0*
>− y y 0*<− uu
positive negative
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Okun’s Law
Quantitative Relationship
)(100 *
*
*
uu y
y y−−=
−
× β
An additional percentage point of cyclical unemploymentis associated with a β 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 β
The size of β can differ across different countries;
• For the US β is estimated to be about 2.0
• For Australia β 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: %5*=u and β=1.5
)(100 *
*
*
uu y
y y−−=
−
× β
0.3)57(5.1100*
*
−=−−=
−
×
y
y y
percentage points
We have a negative output gap, which is equal to
3.0 percent of potential output (or 0.03× y*).
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Output gap and cyclical unemployment in Australia(2000-10)
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
M a r - 0
0
S e p - 0 0
M a r - 0
1
S e p - 0 1
M a r - 0
2
S e p - 0 2
M a r - 0 3
S e p - 0
3
M a r - 0
4
S e p - 0 4
M a r - 0 5
S e p - 0
5
M a r - 0
6
S e p - 0 6
M a r - 0
7
S e p - 0 7
M a r - 0
8
S e p - 0 8
M a r - 0 9
S e p - 0
9
M a r - 1
0
p e r c e n t
u-u* (y-y*)/y*
u* and y* are based on linear time trends
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Estimate of Okun’s Law for Australia (2000-2010)
y = -0.89x
R2 = 0.38
-1.5000
-1.0000
-0.5000
0.0000
0.5000
1.0000
1.5000
2.0000
-1.00 -0.50 0.00 0.50 1.00 1.50
u-u*
( y -
y * ) / y *
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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 changein demand for their product
• Instead they fix their price and then meet thedemand 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 leadfirms 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 + ΔInventories = 100
100 = 90 + 10 = 100
Planned spending equals 90 but firms produced 100, theextra 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)
NX G I C AE +++=
Planned Aggregate Expenditure (PAE)
NX G I C PAE P
+++=
I = actual investment (includes unplanned inventoryinvestmentP
I = 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
= Y – T
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Consumption Function
)( T Y cC C −+=
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
)( T Y c − 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.
)( T Y cC C −+=
cT Y
C
MPC =
−Δ
Δ=
)( Assume: 0 < c < 1
A dollar increase in disposable income raisesconsumption by less than one dollar
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Consumption Function
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Consumption Function
C
)( T Y cC C −+=
C 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
NX G I C PAE P+++= )( T Y cC C −+=
NX G I T Y cC PAE P +++−+= )( cY NX G I cT C PAE
P++++−= ][
• 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
PAE Y =
Using the equation for PAE,
cY NX G I cT C PAE P++++−= ][
and the above definition of equilibrium it is
straightforward to solve for equilibrium output.
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Equilibrium OutputPAE Y =
cY NX G I cT C PAE P
++++−= ][ Substituting
cY NX G I cT C Y P
++++−= ][ Collect terms in Y
][)1( NX G I cT C cY P
+++−=− ][
)1(
1 NX G I cT C
cY
Pe+++−
−=
eY is short-run equilibrium output