Recessions and Expansions

• Business cycles: short-term fluctuations in GDP and other variables
• Recession: period where economy is growing at a rate significantly below normal
  • Real GDP falls for 2+ consecutive quarters
  • GDP growth well below normal
• Depression: particularly severe recession
• Peak: beginning of a recession, high point of business cycle
• Trough: end of a recession, low point of business cycle
• Expansion: period where economy growing faster than normal
• Boom: strong and lasting expansion

Recessions

• 1929-1933: 43 month economic collapse called Great Depression
• 2007-2009: 18 month Great Recession

Recession Determinants

Following coincident indicators are observed:

• Industrial production
• Total sales in manufacturing, wholesale and retail trade
• Non-farm employment
• Real after-tax income for households (excluding transfers like Social Security)

These indicators move with the overall economy

Short-term Fluctuations

• Unemployment is key indicator of short-term fluctuations
• Cyclical unemployment associated with recessions, rates rising sharply during these times
• Industries producing durable goods like cars, houses are more heavily affected than non-durable goods and service industries

Potential Output

• Potential output: denoted $Y^*$, also called potential real GDP of fill-employment output, is amount of output (real GDP) an economy can produce when using its resources like capital and labor at normal rates. It’s the max sustainable output
• Note this isn’t maximum output, as resources could in theory be used at greater than normal rates for short periods (just not sustainably)
• Grows over time, reflecting increases in labor productivity and capital

Reasons for Short-term Output Fluctuation

1. Rate of output growth may reflect changes in rate the country’s potential output is increasing
   • Changes in technology, capital investment, immigration, labor supply, worker productivity, can affect $Y^*$ and long term economic growth
2. Actual output doesn’t always equal potential output
   • May be inefficient, under or over utilizing resources, implying $Y < Y^*$ or $Y > Y^*$ respectively

Output Gaps

• Output gap: $Y-Y^*$, actual output minus potential output, $(Y-Y^*)/Y^*$
• Recessionary gap when negative output gap
  • Capital and labor not fully utilized
  • Output and employment below normal
• Expansionary gap is positive output gap
  • Higher output and employment than normal
  • Demand for goods exceeds production capacity, prices rise
  • High inflation reduces economic efficiency

Natural Rate of Unemployment

• Actual unemployment rate (u) is frictional + structural + cyclical
• Natural unemployment rate ($u^*$) is frictional + structural
  • Equal to $u$ when cyclical rate is zero, occurs when $Y^* = Y$

Reasons for Declining $u^*$

• Labor markets have become more efficient at matching workers with jobs, reducing frictional unemployment
• Aging population, young workers more prone to frictional and structural

Okun’s Law

• Okun’s Law: rule of thumb on relationship between output gap and cyclical unemployment
  • With a recessionary/expansionary gap , cyclical unemployment is positive/negative
  • 1% increase in cyclical unemployment has ~2% increase in output gap, measured as percentage of potential output
  • $\frac{Y-Y^*}{Y^*} = -2(u-u^*)$

Reasons for Short-term Output Fluctuation Revisited

• If prices adjusted immediately to balance quantity demanded with quantity supplied, there would be no output gaps. But in the short-run firms merely adjust output to meet demand and adjust prices later, known as meeting demand at preset prices
• When firms meet demands at preset prices, changes in economy-wide spending are primary cause of output gaps
  • If spending is low, firms just lower output (instead of changing prices), and thus actual output is lower than potential output, leading to recession
  • Firms eventually change prices to eliminate output gaps
• In the long run, price adjustments allow actual output to align with potential output. Economy is “self-correcting”, and in the long run output is determined by economy’s productive capacity, not by spending
• In the long run, spending merely influences the rate of inflation