The Short Term

1
The Short Term
2
We have seen in the long run that the US economy
has had an upward trend of economic activity in
terms of producing goods and services. We now
want to switch our attention and study the short
term fluctuations around that long term
trend. Words and phrases you hear associated with
the short term are the business cycle, cyclical
fluctuations, expansions, recessions, booms and
busts. In this section we begin the study of the
economy in the short term and we will build a
model of the short term where we will consider
the actions of the 4 sectors of the economy
(households, businesses, governments and the rest
of the world). We will also add how monetary and
fiscal policy are tools that can be used to
influence the economic system.
3
This is an imaginary business cycle. But, note
the long term upward trend. IN the short term we
have ups and downs. Note that for a while on the
time line we could have a peak of economic
activity. This means that before and after this
time the level of activity is lower than at the
peak. Troughs are just the opposite in that they
are periods of lowest activity.
RGDP
peak
peak
trough
trough
Time in years
One business cycle is typically thought of as
occurring from peak to peak. The time period
where the economy is moving from peak to trough
is called a recession and the movement from the
trough to the next peak is called an expansion.
4
A rule of thumb about a recession is that RGDP
needs to fall for 2 consecutive quarters, or
more. But, more formally, a recession is a period
of time when RGDP growth is well below normal
(and may not even be negative). Note a
depression, like the one that occurred in the
1930s, is really just a sever recession. A boom
is just an extra big expansion. In the formal
definition of recession we say output growth is
below normal. This implies there is a natural
level of output at which the economy could
produce. Another name for this is the potential
output or potential GDP or the full-employment
level of output. Lets call Y the potential
output and recognize this is the maximum
sustainable amount of output capable of being
produced in an economy at a certain time given
the resource base and technology available in the
economy.
5
Analogy When jogging for exercise many folks do
not sprint the whole time. Sprinting is a
persons maximum speed, but not their maximum
sustainable speed. The potential GDP is analogous
to your jogging pace. Note that the better shape
you are in the faster is your jogging pace and
the same can be said about potential GDP. Lets
define Y - Y Actual GDP minus potential GDP
output or GDP gap. If Y Y gt 0 the output gap
is positive. If Y Y lt 0 the output gap is
negative. Let u the unemployment rate and we
saw before this includes folks unemployed for
frictional, structural and cyclical reasons. If
we could eliminate the business cycle we would
have the natural rate of unemployment u
frictional and structural unemployment.
6
u is the unemployment that would be consistent
with potential output, and so u u cyclical
unemployment. The point to think about here is
that part of the actual unemployment is the
natural unemployment that would occur, u, and
the cyclical component. Now, If Y Y lt 0 we
have a negative gap and u u gt0. This means we
have more than just the natural unemployment. We
also have cyclical unemployment. The idea is
that if output is less than potential then some
resources will also be idle, including labor. If
Y Y gt 0 we have a positive gap and u u lt 0.
This means we have less than the natural
unemployment, and certainly no cyclical
unemployment. The idea is that if output is more
than potential then some resources are being used
very intensively, including labor.
7
If Y - Y 0 we have no gap and u u 0.
This means we have just the natural unemployment.
We have no cyclical unemployment. The idea is
that if output is equal to potential then
resources are being used to their fullest,
including labor. Okuns Law (Y Y)/Y 2(u
u). Okuns law is base on observations made by
Authur Okun. The way to read this equation is
start on the left and say 1) For every extra
point in cyclical unemployment u u, 2) There
is a 2 point increase in the output gap as a
of the potential output.