Download Chapter 28: Introduction to Macroeconomic Fluctu% ations

Chapter 28: Introduction to Macroeconomic Fluctuations
Key Questions:
1. Can the full-employment model explain unemployment ‡uctuations?
2. Why might unemployment result if wages fail to adjust in response to shifts in the
aggregate demand and supply curves for labor?
3. What are the key di¤erences between the full-employment model and a model that
can explain ‡uctuations?
4. What are the key concepts that economists use to analyze aggregate output and
employment in the short run when wages and prices are slow to adjust?
The theory of full-employment macroeconomics laid out in Part Two o¤ers important
insights. We used the model to explore
– the e¤ects of …scal de…cits on interest rates and exchange rates,
– the impact of changes in the supply of labor on the economy, and
– the role of monetary policy in a¤ecting in‡ation.
What was absent was an explanation for the ‡uctuations in real economic activity
and employment that also characterize market economies.
– Why did unemployment in the United States reach nearly 11 percent in November
and December of 1982 and fall to 3.9 percent in April 2000?
– Why did real GDP decline in 1990?
– Why was in‡ation over 10 percent in 1979 and under 3 percent in 1999?
Over the long run, as we have seen in Part Two, the economy has managed to create
jobs to keep pace with the increasing number of workers.
But we also learned in Chapter 24 that the unemployment rate is never zero in a
dynamic market economy.
– Some …rms and industries are shrinking— jobs are being lost— at the same time
that new jobs are being created.
– Workers voluntarily quit jobs to relocate or look for better positions.
– In the United States, it is estimated that 8 to 10 percent of workers— over ten
million workers— leave their jobs each quarter, either by quitting or by being laid
o¤.
– Unemployment also varies seasonally.
We call these normal patterns in unemployment
– structural unemployment,
– frictional unemployment, and
– seasonal unemployment.
But in addition to these normal levels of unemployment, there are times when the
unemployment rate becomes much higher than usual, with the economy experiencing
periods of slow job growth and rising unemployment.
– Labor markets seem not to clear— the demand for labor is less than the supply.
At other times, unemployment drops to unusually low levels, plant and equipment
operate at high rates of utilization, and the economy booms.
We call the ‡uctuations of the unemployment rate around its normal level cyclical
unemployment. Understanding these ‡uctuations in the economy is the primary focus
of Part Seven.
The key to understanding cyclical unemployment is the recognition of two important
"facts" about modern economies.
– First, prices and wages do not always adjust quickly. This means that the demand
for labor and the supply of labor will not always balance— the economy can depart
from full employment.
– Second, while wages and prices do not adjust quickly, they eventually do adjust
in response to demand and supply.
As they do, markets will be brought back into balance. This includes the labor
market.
Given enough time, wages will normally adjust to restore full employment.
In this and the next …ve chapters, we will study how the economy behaves when prices
and wages have not adjusted to balance demand and supply in the labor market.
This allows us to understand
– the causes of cyclical unemployment, why the economy experiences ‡uctuations,
and
– how monetary and …scal policy a¤ect in‡ation and cyclical unemployment.
We begin in this chapter by discussing why the full-employment model of Part Two
cannot explain the ‡uctuations in unemployment that modern economies experience.
To explain ‡uctuations we need to go beyond the full-employment model in several
important ways.
Four key concepts will guide our discussion of economic ‡uctuations and help us
understand both their causes and the role of government policies.
The most critical key concepts are that both wages and prices fail to respond quickly
to shifts in labor demand and supply.
– Because of its importance, the chapter concludes with an appendix that provides
a more complete discussion of some of the explanations for the failure of wages
and prices to adjust rapidly.
Economic Fluctuations
Panel A of Figure 28.1 shows the ‡uctuations in U.S. GDP over the past forty years.
– A smooth "trend line" has been drawn through the plotted line, tracing out a hypothetical path the economy would have taken had it grown smoothly throughout
this forty-year period.
This trend line provides an estimate of the path of potential output, the output
the economy would produce if full employment were always maintained.
– The economy is sometimes above the trend line and sometimes below.
The shaded bars in the …gure mark out economic recessions, periods during
which output declines signi…cantly.
During the almost forty-year period shown in the …gure, there were six recessions; the last recession was in the period 1990-1991.
Panel B shows the percentage by which the economy has been above or below the
trend line.
– The percentage deviation between actual GDP and potential GDP is called the
output gap.
– The …gure also shows the unemployment rate.
– When output grows relative to potential (so the output gap rises), the unemployment rate falls.
– When output falls relative to potential (so the output gap declines), the unemployment rate rises.
– Since 1960, the unemployment rate has averaged just a little above 6 percent of
the civilian labor force.
– But during recessions, it rises much higher.
In 1982 and 1983, for example, the unemployment rate exceeded 9 percent for
over eighteen months.
Perhaps the di¤erence between 6 percent unemployment and 9 percent sounds
small, but with a U.S. labor force of over 110 million at the time of the 1982
recession, that 3 percentage points translated into more than 3 million additional
workers unemployed.
Economic expansions are periods in which output grows.
To describe the point when the economy moves from an expansion to a recession or
from a recession to an expansion, economists use the terms
– peaks (high point in output) and
– troughs (low point in output).
These ‡uctuations in economic activity are called business cycles although the cycles
themselves di¤er in both
– their length and
– their severity.
Since World War II, the length of time between recessions has varied signi…cantly, as
Figure 28.2 shows.
– The average duration of expansions from World War II to the present was …fty-six
months,
– the shortest was twelve months, and
– the longest was the expansion that began in 1991.
Figure 28.3 provides a close-up of real GDP since 1980.
– The three recessions that occurred during this twenty-year period can be seen
clearly.
The troughs were in 1980, 1982, and 1991.
The peaks were in 1981 and 1990.
– The expansion that peaked in 1981 was unusually short and weak, making the
whole period from 1980 to 1982 one of weak economy growth.
This period in the early 1980s was associated with Federal Reserve Chairman
Paul Volcker’s actions to reduce in‡ation.
– Since 1982, however, the United States has experienced over two hundred months
of expansion broken only by one recession in 1990-1991 that lasted just eight
months.
– The 1990-1991 recession, and the slow recovery that followed it, played a major
role in the 1992 presidential election between George H. W. Bush and Bill Clinton.
One of Clinton’s election slogans, designed to call attention to the recession,
was “It’s the economy, stupid!”
Cyclical unemployment re‡ects unused labor resources.
– Idle factories and underutilized plant and equipment also accompany periods of
high unemployment.
– Figure 28.4 illustrates this by showing a measure of capacity utilization in the
manufacturing sector of the economy.
There is a cost to the economy if its labor and capital resources are not fully employed.
– The output that could have been produced with these productive resources is the
opportunity cost of cyclical unemployment.
– These costs can be very large.
Because of the costs, and the individual hardships, caused by high levels of cyclical
unemployment, most governments attempt to manage macroeconomic policies to
reduce its occurrence.
– In the United States, the Employment Act of 1946 and the Full Employment and
Balanced Growth Act of 1978 (often called the Humphrey-Hawkins Act) re‡ect
the commitment of the federal government to take responsibility for maintaining
full employment.
The Humphrey-Hawkins Act mandates the federal government to "... promote
full-employment and production, increased real income, balanced growth, a balanced Federal budget, adequate productivity growth, proper attention to national priorities, achievement of an improved trade balance . . . and reasonable
price stability."
How governments try to achieve these goals, and how successful they have been, are
among the topics we will discuss in the next few chapters.
Are “Cycles” Regular?
Calling ‡uctuations in economic activity "business cycles" may suggest a regular
pattern to these ‡uctuations. But
– business cycles follow irregular patterns, and
– predicting when an expansion will end and a recession will begin is often di¢ cult.
One reason is that there is little evidence that expansions die of old age— an economic
downturn is almost as likely to occur after three years of an expansion as after …ve
years.
In contrast, not only do economic downturns tend to be much shorter than expansions,
but also the longer they last, the more likely they are to end.
– The reason for this is partly that the longer the recession lasts, the stronger the
pressures are on the government to take action to stimulate the economy.
The Wage-Employment Puzzle
It is di¢ cult to reconcile economic ‡uctuations, and the associated changes in employment and wages, with the full-employment model.
We can start to understand why by considering an economy at full employment.
– The real wage is at the level that clears the labor market.
– Labor demand and supply are equal.
If the demand for labor curve and the supply of labor curve do not shift, the real wage
will remain constant at the value w0=P as shown in panel A of Figure 28.5.
Now consider what happens if the labor demand curve shifts to the left.
– If we apply the full-employment model to the labor market, we would predict that
when the demand for labor goes down, as in a recession, the real wage also falls,
as illustrated in panel B of Figure 28.5.
– A leftward shift in the demand for labor results in lower real wages.
– If the supply of labor is relatively unresponsive to real wage changes (that is, the
labor supply curve is inelastic), as depicted by the steepness of the line in panel
B,
the reduction in the real wage is large and
the fall in employment is small.
– In the real world, it does not seem to happen this way.
– In the Great Depression of the 1930s, for example, when the demand for labor fell
drastically, real wages in manufacturing actually rose.
One estimate shows that while unemployment increased from 5.5 percent in
1929 to 22 percent in 1934, real wages rose by more than 20 percent.
Nominal wages did fall during the depression, but prices fell more so that the
real wage actually rose.
Between 1929 and 1933, the average nominal wage fell by over 20 percent
before recovering in 1934.
– In the early 1980s, a much more recent example, real wages again rose as the
unemployment rate increased from below 6 percent to over 10 percent.
Figure 28.6 shows the real wage and unemployment rates during the 1980s and 1990s.
– Real wages have not been a¤ected very much by changes in unemployment.
There are three possible explanations.
The …rst is that the supply curve for labor is nearly horizontal and the demand curve
for labor has shifted, as shown in Figure 28.7, panel A.
– In this case, the labor market has moved along the labor supply curve to a new
point of equilibrium.
– Almost all economists reject this interpretation because of the extensive evidence
suggesting that the labor supply curve is relatively inelastic (steep), not ‡at.
The second possible interpretation is that there are shifts in the labor supply curve
that just o¤set the shifts in the labor demand curve, as depicted in panel B.
– The shifting demand and supply curves trace out a pattern of changing employment with little change in the real wage.
– Again, the labor market winds up at an equilibrium point with lower employment
and little change in the real wage.
– In this view, a recession is due to a decreased willingness to supply labor— in other
words, an increased demand for leisure.
But most economists do not see any persuasive evidence that the supply curve
for labor shifts much as the economy goes into or comes out of a recession, let
alone to the extent required in panel B.
And they see no reason why shifts in the demand curve for labor would normally
be o¤set by shifts in the supply curve.
The third interpretation is that there has been a shift in the demand curve for labor,
with no matching shift in the supply curve and no corresponding change in the real
wage, depicted in panel C of Figure 28.7.
– The labor market is stuck in disequilibrium; demand does not equal supply.
At the real wage w0=P , the amount of labor that workers would like to supply
remains at L0.
But as the demand for labor shifts, the number of workers hired at w0=P falls
from L0 to L1.
The di¤erence, L0
L1, is the level of cyclical unemployment.
People are willing to work at the going wage, but the work is not there.
– The same argument holds even if there is a slight shift in the labor supply curve
and a slight change in the real wage. The adjustment in the real wage is too small
to align demand with supply.
Nominal Versus Real Wages
When we discuss the labor market, it is important to keep in mind the distinction
between the real wage and the money, or nominal, wage.
– The nominal wage is the wage expressed in dollars.
In 1999, the average hourly wage in the private sector was $13.24.
– The real wage is a measure of the purchasing power of this $13.24.
What happens to the real wage as the nominal wage changes depends on how prices
are changing.
Even if the real wage is constant, the nominal wage may be changing.
– When the general level of prices is rising, the nominal wage will need to rise at
the same rate as prices to keep the real wage constant.
– If prices have been rising at 3 percent per year, the nominal wage also must rise
by 3 percent per year simply to maintain a constant real wage.
If nominal wages rise only 2 percent, then even though wages have gone up,
workers’real wages have fallen.
They will be unable to purchase as many goods and services as before.
– If the in‡ation rate rises from 3 percent to 5 percent, nominal wages must rise by
5 percent per year to keep the real wage constant.
When economies experience ongoing in‡ation, the wage- and price-setting decisions
of workers and …rms will re‡ect their expectations of in‡ation.
– Because individuals care about the purchasing power of their income, and …rms
care about the real costs of labor, nominal wages will rise to re‡ect expected
increases in prices.
– The higher the rate of in‡ation, the faster nominal wages will rise.
Both labor demand and labor supply depend on real wages, and it is the failure of
the real wage to adjust when the labor demand curve shifts to the left that leads to
increases in unemployment.
But why don’t real wages adjust quickly? Since the real wage is the nominal wage
relative to the prices of goods and services, the failure of the real wage to adjust can
be traced to slow adjustment of both nominal wages and many prices.
The Slow Adjustment of Nominal Wages
There are several reasons why nominal wages adjust slowly, and we will brie‡y mention
three.
– These are discussed more fully in the appendix to the chapter.
– The appendix also explains why prices, like wages, may adjust slowly to shifts in
demand and supply.
First, some wages may be set by union contracts that typically last for a …xed period—
three years is common.
– If the contract is signed just before an economic downturn, it may be more than
two years before any wage adjustment can occur, even if workers agree to one at
that time.
– Average union wages adjust slowly to changes in unemployment, since di¤erent
contracts expire in di¤erent months and di¤erent years.
– Similar rigidities may come about even in the absence of a union or an explicit
labor contract.
This is because the relations between employers and employees are governed by
a host of implicit understandings developed over time.
These implicit understandings are referred to as an implicit labor contract.
Although most workers are not covered by explicit contracts, it is common for
wages or salaries to be adjusted only once a year, again contributing to the
sluggish adjustment of nominal wages.
Second, even when labor demand falls short of labor supply, wages may not fall enough
to eliminate cyclical unemployment.
– Firms want to pay the wage that minimizes their total labor costs, called the
e¢ ciency wage.
– If paying higher wages leads to higher worker productivity, …rms may …nd they
make more pro…ts by paying a real wage higher than the one at which the labor
market would clear.
When Henry Ford opened his automobile plant in 1914, he paid his workers
more than double the going wage.
He wanted his workers to work hard.
He knew that his new technique of production— the assembly line— when
combined with motivated workers would increase his pro…ts.
– Productivity can depend on the wage for several reasons.
If a …rm cuts its wages, its best workers are the ones most likely to leave to …nd
another job.
Paying above average wages creates an incentive for workers to work hard
and remain with the …rm— losing a job at a high-paying …rm is costly to the
worker both because
a) the worker will be unemployed while searching for a new job and
b) any new job is likely to be at a …rm paying average wages.
– Finally, when a …rm cuts wages, workers are more likely to quit to look for another
job— the …rm’s labor turnover rate rises and the …rm faces the increased costs of
hiring and training new workers.
Third, cutting wages may be a risky strategy for a …rm that wants to reduce its labor
force.
– Whether the wage cut succeeds in getting workers to quit will depend on what
other …rms do— are other …rms also cutting wages?
– The …rm may face less uncertainty by simply laying o¤ the workers it does not
need.
To summarize, when sluggish nominal wages prevent the real wage from adjusting to
maintain labor market equilibrium, shifts in labor demand will result in ‡uctuations
in cyclical unemployment, as we illustrated in Figure 28.7, panel C.
– Such shifts can occur fairly rapidly, mainly because of changes in output.
– Wages fail to fall enough to restore equilibrium (where labor demand equals labor supply) when labor demand shifts downward, resulting in a rise in cyclical
unemployment.
– The slow adjustment of real wages can be traced to the slow adjustment of both
nominal wages and prices.
Understanding acroeconomic Fluctuations: Key Concepts
We have argued that the full-employment model of Part Two cannot explain cyclical
unemployment.
To understand economic ‡uctuations, and how government policies can a¤ect the
economy, economists have developed a basic model that di¤ers from the fullemployment model in several critical respects.
– Some of these di¤erences re‡ect behavior we observe around us, such as the slow
adjustment of wages.
– Other di¤erences re‡ect simplifying assumptions about how individuals, …rms, or
economic policymakers behave.
Fortunately, this model for understanding economic ‡uctuations shares many features
with the full-employment model of Part Two.
– And an important implication of the model of ‡uctuations is that once wages and
prices have had enough time to adjust, the economy returns to full employment,
where the model of Part Two holds sway.
We can identify four fundamental ideas that will help us understand economic ‡uctuations.
– Each will be discussed brie‡y in turn, giving an overview of the model of ‡uctuations.
– Each is developed in more detail in the chapters that follow.
Sticky Wages
Our …rst key concept is one we have already discussed: the fundamental explanation
for cyclical unemployment is that wages do not adjust quickly enough when either
the demand or the supply curve for labor shifts.
– At least for a while, and sometimes for extended periods of time, the demand for
labor at market wages can di¤er from the supply of labor.
– Because this is such a key assumption in macroeconomics, we will discuss some
of the reasons for the slow adjustment of wages later in this chapter.
When wages (and prices) have had enough time to adjust, supply and demand will
balance in all markets, including the labor market.
– Once this has happened, the level of employment, potential output, the real rate
of interest, and the price level are determined, as the full-employment model of
Part Two showed.
– Because it takes time for wages to fully adjust, we often refer to the fullemployment model as describing the economy in the long run.
The long run is a length of time su¢ cient to allow wages and prices to fully
adjust to equilibrate supply and demand.
When wages adjust sluggishly, the basic price mechanism that operates to balance
labor supply and demand cannot function e¤ectively.
In the short run, the period during which wages have failed to keep demand and
supply in balance,
– the level of employment can diverge from the full-employment level,
– and wages will not respond quickly enough to move the economy back to full
employment.
Sticky Prices
Like nominal wages, many prices are also sticky.
And just as shifts in labor demand lead to ‡uctuations in unemployment when wages
fail to adjust, shifts in product demand will lead to ‡uctuations in production.
When demand for a …rm’s product falls, the …rm might respond
– by lowering its price or
– by reducing production.
Our analysis of economic ‡uctuations is based on a fundamental insight: in the short
run, …rms adjust production and employment in response to demand.
– They adjust production, not prices, initially.
– This is the second key concept in understanding ‡uctuations.
This concept, like our …rst one, captures an important aspect of actual behavior.
– When demand at retail stores rises in December because of the holiday season,
for example, stores could respond by raising prices and keeping sales relatively
constant.
– Instead, they keep the prices constant and satisfy the greater demand with increased sales.
In some markets, prices do respond quickly to shifts in demand; competitive markets such as those for agricultural products usually are characterized by rapid price
adjustments.
In many markets, both price and production adjust.
– If an automobile company sees demand fall, it may o¤er rebates or other price
reductions to spur demand, but it will also scale back production, perhaps closing
an assembly line and laying o¤ workers.
Most markets, particularly those characterized by imperfect competition, experience
adjustments in production as demand shifts.
– In the appendix to this chapter we will discuss some of the reasons why …rms
respond to demand shifts by changing production levels rather than prices.
In‡ation Adjustment
In the short run, wages and prices are sticky. Changes in demand cause ‡uctuations
in output and employment.
But in macroeconomics, we also are interested in understanding the factors that
determine in‡ation, and our third key concept provides a link between unemployment
and in‡ation.
The adjustment of in‡ation turns out to be one of the keys to understanding how
economies return eventually to full employment.
But it is important to avoid two common confusions involving the distinctions between
levels versus rates of change on the one hand, and sticky versus constant on the other.
Levels Versus Rates of Change
In macroeconomics, it is very important to understand the di¤erence between the
price level and the in‡ation rate.
– The price level is an index number that measures overall prices relative to a base
year.
In 2000, when the base period was 1982-1984, the consumer price index (CPI)
was equal to 172.2.
Since the CPI is equal to 100 in the base period, this means that from 19821984 to 2000 the prices of the goods and services in the CPI had risen 72.2
percent.
– The in‡ation rate tells us how fast the price level is rising.
In 2000, the CPI in‡ation rate was 3.4 percent.
That means that the price level in 2000 was 3.4 percent higher than it had been
in the previous year.
– A higher in‡ation rate means the price level is rising faster.
– A lower in‡ation rate means the price level is rising more slowly.
– A negative in‡ation rate (de‡ation) would mean that prices are falling.
A higher price level does not mean in‡ation is higher.
– For example, the price level was much higher in 2000 than it was in 1982, but the
in‡ation rate was lower.
In‡ation in 1982 was 6.2 percent, compared to only 3.4 percent in 2000.
Prices were at a higher level in 2000 but they were rising more slowly than they
were in 1982.
Most discussions in macroeconomics focus on the rate of in‡ation, and many countries
have explicit policy objectives that call for keeping in‡ation low and stable.
– For that reason, we will also focus on in‡ation and the factors that determine it.
To understand what causes in‡ation to adjust, however, we draw upon the evidence
that wages and prices adjust slowly to shifts in demand and supply.
Sticky Versus Constant
If wages and prices are “sticky”, how can we be talking about in‡ation since that, by
de…nition, means wages and prices are changing?
When speaking about sticky wages and prices, economists mean that wages and prices
fail to adjust rapidly in the face of shifts in supply and demand.
Let’s use a simple example.
– A union and a …rm sign a labor contract that will last for three years.
– The contract calls for wages to rise, say, 3 percent each year.
– If something happens in year 2 of the contract that reduces the …rm’s demand
for labor, instead of falling to rebalance labor supply with the new, lower demand
for labor, wages will continue to rise at 3 percent per year, as called for in the
contract.
– The …rm will lay o¤ workers and employment falls.
– The wage did not adjust to keep demand and supply equal.
– Over time, wages (and prices) do adjust to balance demand and supply.
– In our example, when the labor contract comes up for renewal, if the …rm’s demand
for labor is still low, the new contract will probably call for only 2 percent wage
growth. The rate of wage in‡ation is lower.
What Causes In‡ation to Adjust?
The law of supply and demand tells us that whenever supply and demand are out of
balance in a market, there will be pressures for the price in that market to adjust.
The same applies for the aggregate economy.
The balance between labor demand and supply, as re‡ected in unemployment, will be
an important factor in‡uencing how wages change.
As cyclical unemployment falls— that is, labor markets become tight— …rms must
boost the wages they pay to attract new workers and retain their existing workforce.
In unionized sectors, a tight labor market increases the bargaining power of unions,
enabling them to negotiate larger wage increases.
So in tight labor markets, wages rise more rapidly. Conversely, increases in cyclical
unemployment will reduce wage and price in‡ation.
This connection between cyclical unemployment and in‡ation means that the economy
faces a trade-o¤.
– When the economy experiences a business cycle expansion and enjoys lower unemployment, in‡ation is likely to start to rise.
– To lower in‡ation typically requires a period of high cyclical unemployment.
This means that policymakers face a short-run trade-o¤: if in‡ation is too high,
the cost of lowering it will be temporarily high unemployment.
Of course, cyclical unemployment is not the only factor that a¤ects in‡ation. In
Chapter 31 we will discuss the additional factors.
In‡ation, Monetary Policy, and Spending
We have just set out three of the key concepts we will use as we explore the way the
economy behaves in the short run. These will help us start to understand economic
‡uctuations, but they also open up new questions.
For example, if …rms respond to shifts in demand by adjusting production and employment,
– what explains the level of demand?
– and what can cause it to shift?
– and is spending, like cyclical unemployment, also related to that other important
macro-economic variable, in‡ation?
The answer to the third question is yes. As in‡ation starts to rise, government policies,
and particularly monetary policy, act to reduce aggregate spending.
Governments try to keep in‡ation stable, and if it starts to rise, they need to slow the
economy down to moderate the increase in in‡ation.
– This is a consequence of our third key concept. Reducing in‡ation in the short
run requires a rise in cyclical unemployment.
– So when in‡ation rises, governments (actually their central banks responsible for
conducting monetary policy) take actions to reduce aggregate spending.
– Why?
Because our second key concept tells us that …rms react to a fall in demand by
reducing production.
When production falls, cyclical unemployment rises, acting to moderate the
initial rise in in‡ation.
Increases in in‡ation lead to reductions in aggregate spending and output.
Decreases in in‡ation reverse the process and lead to increases in spending
and output.
This relationship between in‡ation and aggregate spending depends in part on the
way monetary policy is conducted.
The behavior of the economy, as it experiences disturbances, will depend on what
policy responses occur, just as it depends on how …rms and households respond to
changing economic conditions.
If we want to understand how the economy operates, how it adjusts when world oil
prices jump or there is a …nancial crisis in Asia, we will need to incorporate the way
government acts.
In understanding short-run ‡uctuations in the economy, the role of the Federal Reserve
and its decisions regarding monetary policy are particularly important.
– In Chapter 25, we explained the basic tools of the Fed and discussed how the Fed
can in‡uence the nominal interest rate and the money supply.
– We also learned (see Chapter 24) that it is the real interest rate that a¤ects
households’saving decisions and …rms’investment decisions.
– The real interest rate is the nominal interest rate adjusted for in‡ation.
In the long run, at full employment, the real interest rate balances national
saving and investment.
In the short run, when the economy can ‡uctuate around full employment, the
Fed is able to a¤ect the real interest rate by in‡uencing the nominal interest
rate.
– Like many other central banks, the Fed reacts to changes in in‡ation.
If in‡ation rises, the Fed undertakes policies that result in a higher real interest
rate.
A decline in in‡ation results in a lower real interest rate.
– This type of monetary policy in reaction to in‡ation is most explicit in countries
where the central bank follows a policy of trying to keep in‡ation equal to a target
value— so-called in‡ation-targeting policy regimes.
– Fortunately, a wide range of monetary policy behaviors, and not just in‡ation
targeting, is consistent with a negative relationship between in‡ation and spending.
This link between in‡ation, monetary policy, and aggregate spending is our
fourth key concept.
We will focus on it in Chapter 30.
As with the other key concepts, we will need to understand
what changes lead to shifts in the relationship between in‡ation and spending,
as well as
what changes lead to movements along a given relationship.
Linking the Four Key Concepts
The four key concepts work together to explain how output and in‡ation are determined when the economy is not at full employment. Figure 28.8 shows how.
We can start at any one of the boxes and use the key concepts to travel around the
circle.
– For example, let’s suppose something causes demand to drop.
It might be a …nancial crisis in Asia or Latin America that reduces sales of U.S.
goods in those countries.
– The drop in demand causes U.S. …rms to scale back production— output falls.
– With production now at lower levels, …rms do not need as many workers, so layo¤s
occur and cyclical unemployment rises.
– Wages fail to adjust quickly enough to keep the economy at full employment.
– High cyclical unemployment leads to slower wage growth, and in‡ation declines.
– In the face of a decline in in‡ation, the Fed lowers interest rates.
– By helping to boost some types of spending, lower interest rates help o¤set some
of the initial drop in demand that started the process.
Over the next few chapters, we will examine each of these links in detail, learning
about how they operate and about the causes of economic ‡uctuations.
Summary
1. Economies experience recessions and booms in which output ‡uctuates around its
full-employment level. Recessions are periods in which real GDP declines, and booms
are when real GDP increases. The ‡uctuations in output are called business cycles.
2. If wages and prices do not adjust quickly enough to ensure markets are always in
equilibrium, where demand and supply are balanced, the economy may experience
‡uctuations in cyclical unemployment.
3. To explain cyclical unemployment, we need to explain why the aggregate labor market
does not clear. If real wages do not adjust to shifts in the aggregate supply or demand
for labor, and either the demand curve for labor shifts to the left or the supply curve
for labor shifts to the right, then the quantity of labor supplied will exceed the quantity
demanded at the prevailing wage and there will be cyclical unemployment.
4. Wages may be slow to adjust because of union contracts and implicit contracts that
lead to infrequent wage changes. Firms minimize total labor costs by paying the
e¢ ciency wage. Cutting wages may raise costs by lowering productivity, causing the
best workers to leave, or leading to higher labor turnover costs.
5. The labor market and the aggregate production function are key determinants of the
economy’s full-employment output, but in the short run, …rms adjust production in
response to ‡uctuations in demand. Thus, aggregate demand plays a critical role in
determining the short-run equilibrium level of output.
6. Our model of ‡uctuations will be built around four key components: (1) wages are
sticky; (2) prices are sticky; (3) there is a trade-o¤ between in‡ation and cyclical
unemployment in the short run; and (4) in‡ation and aggregate spending are linked
by monetary policy.