4.Short-Term Economic Fluctuations PDF

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Short-Term Economic Fluctuations

Output Gaps and Cyclical Unemployment Potential output •

The amount of output (real GDP) that an economy can produce when using its resources, such as capital and labour, at normal rates

•

Also called full-employment output or potential GDP

•

Indicated by Y*

Explaining variations in the economy’s growth rate Changes in the growth rate may reflect: o Variations in the growth of (Y*) o Deviations of actual output (Y) from potential output (Y*)

Output gap The difference between the economy’s potential output and its actual output at a point in time Y* - Y

Recessionary gap = +ve output gap Y* > Y 

Capital and labour resources are not fully utilized.



Output and employment are below normal levels.

Expansionary gap = -ve output gap Y > Y* 

Higher output and employment than normal



Demand for goods exceeds the capacity to produce them and prices rise.



High inflation reduces economic efficiency.

The natural rate of unemployment The part of the total unemployment rate that is attributable to frictional and structural unemployment Equivalently the unemployment rate that prevails when cyclical unemployment is zero, so that the economy has neither a recessionary nor an expansionary output gap

Natural rate of unemployment, u* •

Attributable to frictional and structural unemployment

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Cyclical unemployment equals zero

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No recessionary or expansionary gap

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Cyclical unemployment = u - u* o total unemployment - natural rate

During recessionary gaps: –

u > u* and cyclical unemployment is positive

During expansionary gaps: –

u < u* and cyclical unemployment is negative

Why Do Short-Term Fluctuations Occur? A Preview and a Parable •

In a world in which prices adjust immediately to balance the quantities supplied and demanded for all goods and services, output gaps would not exist.

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The assumption that prices adjust immediately is not realistic.

The Keynesian Model’s Crucial Assumption: Firms Meet Demand at Pre-Set Prices In the short run, firms meet the demand for their products at preset prices. •

Firms do not respond to every change in the demand for their products by changing their prices.

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Instead, they typically set a price for some period, then meet the demand at that price.

In the long run, firms will change prices

Planned Aggregate Expenditure Planned Aggregate Expenditure (PAE) •

Total planned spending on final goods and services

Components of planned aggregate expenditure •

Consumer expenditure or consumption (C) o Household spending on durables, nondurables, and services

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Investment (I) o New capital goods spending o New residential spending o Increases in inventories

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Government purchases (G) o Federal, state, and local spending on goods and services

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Net exports (NX) o Exports – imports

Planned aggregate expenditure with actual investment:

Consumer spending and the economy •

Consumption (C) accounts for approximately two thirds of total spending.

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The primary determinant of C is disposable income or income ( Y) minus net taxes (T).

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Disposable income = (Y – T).

Consumption function The relationship between consumption spending and its determinants, in particular, disposable (after-tax) income.

Relating consumption to income and other determinants 

The consumption function:

= a constant and represents the non-income determinants of C: o Consumer optimism No change in the salary but there has been a change in the government and consumers become more willing to spend.

o Wealth Salary has not changed but the new channels say that there is an increase in house worth. Matter in relation to stock prices. o Real interest rates Have a significant effect on consumer spending. Lower interest rate everything cheaper for example getting a loan.

c = marginal propensity to consume  

the amount by which consumption rises when disposable income rises 0...