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Chapter 6
I. Economic Fluctuations – analyzing the different patterns in GDP
1. Secular Trend – general tendency over long periods of time (several to many
decades). In the US this averages about 3% real growth per year, and trend
for periods of ten years or more have been positive.
2. Business Cycles – output and income experience a cycle of peak (boom),
contraction, trough (bust), and expansion. The boom-bust cycle usually
takes 6-8 years to complete, but can occur within only a few years or last
slightly over a decade. So, while the stages of the cyclical fluctuation are
unchanging, the duration of any specific boom-bust cycle is unpredictable.
3. Seasonal variations – Certain industries thrive mostly in particular seasons
4. Random variations – External, unexpected shock that affects the economy
II. A. Characteristics of the Recession
1. 6 months (2 consecutive quarters) of falling GDP is a recession
2. In a recession, all of the following will decrease (or remain stagnant):
output, employment, Investment and Consumption spending, Prices. In a recovery,
all of these will be increasing.
3. Unused Plant Capacity will be increasing in a recession and decreasing in
the expansion.
B. Goods Purchases:
1. Durables
Quantities will fall because people can postpone major purchases. Cars and
appliances that could be replaced will continue being used longer.
Prices very often remain flat or fall only slightly because the producers in
the durable goods industries have “concentrated” ownership, meaning varying
degrees of monopoly power exist.
2. Non-durables
Quantities are flat (unchanged) or only slightly declining because many nondurables are necessity goods, like food.
Prices may decrease as many producers of non-durables are in competitive
markets, so their prices fluctuate along with the business cycle.
III. Major Causes of GDP Fluctuation
1. Innovation: Technological Advancement
A. Often it occurs in “swarms” as one new invention or breakthrough leads
to several related advancements, or applications of the new technology such as all
the applications that grew out of the Internet.
B. The Internet example also shows how the new technology at first will see
a wide variety of business ideas putting it to use, but as the expansion slows down,
only the best (most profitable) ideas will survive.
C. Weaker firms die off and the expansion ends, signaling the beginning of
the contraction.
2. Political Events
A. Economic activity may be expansionary during (and leading up to) an
incumbent’s election season.
3. Random Events
A. Weather – unexpectedly harsh storms or natural disasters affect output
B. War – GDP and employment can increase if a country in recession
makes the expenditures associated with war
4. Aggregate Demand
Influenced by
C=Consumption Consumer Confidence, Interest Rate, Disposable Income,
Stock Market, Expectations
I=Investment
Interest Rate, GDP, Industry Conditions, Expectations
G=Gov’t
Requirements of political supporters and budgetary
Spending
constraints influence fiscal policy decisions on both G and
T (taxes)
5. AS – Aggregate Supply can shift in response to input prices changing, bad
weather or disasters.
IV. Leading Economic Indicators
“Leading” means predictive (as opposed to trailing)
By watching these indicators in the economy, GDP changes are predicted.
Some important indicators are:
1. Average work week
+
2. New unemployment claims
-
3. New consumer goods orders
+
4. Stock market prices
+
A. SM prices reflect profit expectations
B. SM prices reflect consumer wealth
C. Indicate the availability of opportunities for corporations to raise capital
through issuing new shares
5. Orders for new plants and equipment (Capital Goods) +
6. New Home building permits
+
7. Vendor Performance
-
A. Resource sellers (vendors sell inputs) lose efficiency as orders for their
services increase
8. Consumer Confidence
+
Dept. of Commerce puts the indicators into an ILI: index of leading indicators.
Like the CPI and other indexes, it begins at 100 in the base year so future periods
are easily comparable. The rule of thumb is if the ILI moves for three months in
the same direction, the economy (GDP) will move in that direction in the near
future.
Even though the ILI is not always correct, it usually is a good tool for fiscal and
monetary policy decisions to be made in advance of upcoming economic
fluctuations.
V. Unemployment
A. Types
From notes on Chapter 2: There are four types of labor unemployment. The
first three are considered “natural” in an economy where upward mobility is
allowed, and expected to be part of the labor force even in boom.
1. Structural unemployment – the unemployment created by the varying strength of
industries in a dynamic economy. Over time, an auto industry worker in Detroit
may find he needs to broaden his skill set and/or move geographically, and during
the transition period he is structurally unemployed. This is defined as a mismatch
between skills required (by firms) and skills possessed (by workers)
2. Frictional unemployment – job changes and time graduates take to land a job
that will come closer to maximizing their output and income. It increases
efficiency and reduces underemployment.
3. Seasonal unemployment – that portion of the labor force whose work depends
on weather (construction, ski resorts) predictably experience seasonal
unemployment in the off–season.
The fourth type of unemployment is not considered a permanent fact in the
economy, and is the type that Fiscal and Monetary policy seeks to eliminate.
4. Cyclical unemployment – job loss due to economic fluctuations. In a boom,
cyclical unemployment may be zero, but in a recession the number of cyclically
unemployed will grow. How serious the problem (resource underutilization =
inefficiency) becomes depends on the severity of the contraction in the economy.
B. Natural Rate
Combine the first three types (mainly, structural and frictional) and to get the
“natural rate of unemployment” of 4-6% nationally. The Phillips Curve (inflation
on vertical axis; unemployment on horizontal) shows the trade-off between these
two negatives in the economy.
1. In the long run, the Phillips curve is vertical at the natural rate. As an
example, in an expansion, you would move to the left along Short Run Phillips
Curve (1) from A to B; Demand is increasing, so unemployment is falling and
there is some rising inflation. The decline in real incomes causes contracts to be
renegotiated; higher wage rates signal to firms that input costs have risen, and
some layoffs result in unemployment returning to the original level with an overall
increase in prices (B to C) and a higher short run Phillips Curve (2) From A to C it
is all vertical movement along the long run Phillips Curve.
2. The reasons inflation has held steady at 1-3% through the 90’s despite
years of unemployment below the natural rate:
i. Low-priced imports cause domestic producers to restrain Price
increases in the goods market
ii. In industries where foreign labor is a viable alternative to deomstoc
jobs, wage containment will also occur and low wages keep inflation in check.
iii. Strong Productivity gains, which are due to technological
improvements such as the Internet and computer chips, as well as gains in human
capital through a more educated workforce and increasing numbers of trade
schools and skill-certification programs.
C. Discouraged Worker Effect
Those who have become structurally unemployed or who have low-skill levels
may stop looking for work. If so, they are no longer counted as unemployed
because the unemployment calculation takes a fraction equal to (numerator:) the
number actively looking for jobs/ (denominator:) the total labor force. Actively
looking is determined by the unemployment survey required to get unemployment
benefits. When those run out, the person is not counted in either the numerator or
the denominator, making the unemployment problem look not as bad as it is in
actuality. Because the numbers do not reveal how many Discouraged Workers
there are, it is a hidden cost of unemployment.
D. When GDP<GDP* (the economy is in a recession at less than full-capacity
GDP) there is inefficiency – underutilization of resources – and cyclical
unemployment.
E. Okun’s Law holds that for every 1% unemployment exceeds the natural rate,
GDP will fall 2% below GDP*
The difference between GDP* and actual GDP is called the “GDP gap.”
VI. Inflation
A. Demand-Pull Inflation
Anything that shifts to the right the overall demand in the economy is potentially
inflationary. This is less painful at recession GDP than GDP* because some extra
output will result. Demand-Pull inflation at GDP*, however, is purely inflationary.
B. Cost-Push Inflation
Aggregate Supply shifting to the left will cause this type of inflation. Usually the
external shock causing reduced supply is higher input costs (war and disasters
could also be the cause).
C. Assuming constant output, inflation affects those on fixed income the most.
1. Pensioners, welfare or Social Security recipients, non-union workers
2. On the other hand, some inflation can be beneficial to profits (input prices
are “stickier” than retail prices) and union workers (new contracts can be
negotiated at higher inflation expectations).
3. Since interest rates lag price changes, Real interest rate (Nominal interest
rate – inflation) will be lower due to inflation. Savers and lenders are hurt and
debtors benefit. If you are a debtor, the real value of the money to pay back when
it’s due is less than you thought it would be when it was borrowed.
4. Deflation will redistribute real wealth in the opposite direction described
in 1,2, and 3 above.