Ec102 Chapter 26

Chapter 26
Short-Run
Fluctuations
© 2015 Pearson Education, Ltd.

26 Short-Run Fluctuations
Chapter Outline
26.1 Economic Fluctuations and Business Cycles

26.2 Macroeconomic Equilibrium and Economic
Fluctuations
26.3 Modeling Expansions
EBE What caused the recession of 2007‒2009?

Key Ideas
1. Recessions are periods (lasting at least two

quarters) in which real GDP falls.
2. Economic fluctuations have three key features:
co-movement, limited predictability, and
persistence.

Key Ideas
3. Economic fluctuations occur because of

technology shocks, changing sentiments, and
monetary/financial factors.
4. Economic shocks are amplified by downward
wage rigidity and multipliers.

Key Ideas
5. Economic booms are periods of expansion of

GDP, associated with increasing employment
and declining unemployment.
6. Three key factors contributed to the
2007‒2009 recession: a collapsing housing
bubble, a fall in household wealth, and a
financial crisis.
Economic fluctuations or business cycles:

Short-run changes in the growth of GDP.
We can examine the business cycle by comparing

the path of real GDP to a trend line.

Exhibit 26.1 Real U.S. GDP and a Trend Line (1929‒2013;

billions of 2009 constant dollars)
We can also examine the business cycle by

plotting the percent deviation of real GDP from
the trend line.
Question: What historical episodes can you

identify in the data?

Exhibit 26.2 Percent Deviation Between U.S. Real GDP and

Its Trend Line (1929–2013)
Answer:
• Great Depression from 1929 to 1940
• World War II from 1941 to 1945
• Great Recession from 2007 to 2009

A recession is defined as episodes of negative

economic growth.
An expansion is defined as a period of positive

growth. Expansions are periods between
recessions.
Since 1929, a recession has occurred about once

every six years, and recessions have lasted on
average about one year.
Exhibit 26.3 U.S. Recessions from 1929 to 2013

Economic fluctuations have three key properties:
1. Co-movement of many macroeconomic

variables
2. Limited predictability of fluctuations
3. Persistence in the rate of economic growth

Many aggregate macroeconomic variables grow or
contract together during booms and busts, exhibiting
a pattern of positive or negative co-movement.
Variables such as real consumption, real investment,

and employment move positively (or together) with
real GDP.
Variables such as unemployment move negatively (or

opposite) real GDP.

Exhibit 26.4 Real Consumption Growth Versus Real Investment

Growth (1929–2013)
Recessions and expansion do not follow a

repetitive, easily predictable pattern.
As a result, it is impossible to forecast during an

expansion when the expansion will end.
Similarly, it is impossible to forecast during a

recession when the recession will end.

Even though the beginnings and ends of
recessions are somewhat unpredictable, economic
growth is not random but persistent.
When the economy is growing, it will probably

keep growing the following quarter.
Likewise, when the economy is contracting, the

economy will probably keep contracting the
following quarter.
The Great Depression of 1929‒1933 illustrates

the three key properties of economic fluctuations:
1. Co-movement in economic aggregates

2. Limited predictability
3. Persistence in the rate of growth

Exhibit 26.5, Panel (a) The Great Depression

Exhibit 26.5, Panel (b) The Great Depression

Exhibit 26.5, Panel (c) The Great Depression

26.2 Macroeconomic Equilibrium and Economic Fluctuations
Question: Why are there economic fluctuations?
Answer: It depends on who you ask.
Caveat: There is a significant body of shared

knowledge that unexpected shifts to labor
demand, called shocks, are important.

At the beginning of a recession, the labor demand

curve shifts to the left due to:
1. A fall in output prices

2. A decrease in output demand
3. A decrease in labor productivity
4. A rise in input prices

In the case of a recession, if wages are flexible,

the leftward shift in the labor demand curve will
lead to a fall in wages and a decrease in the
quantity of labor.
As a result, real GDP

will decrease.

Exhibit 26.6, Panel (a) Leftward Shift in

the Labor Demand Curve with Flexible
Wages
Exhibit 26.6, Panel (b) The Relationship

Between Employment and Real GDP

If wages are downward rigid, the leftward shift in

the labor demand curve will lead to no change in
the wage rate and a larger decrease in the
quantity of labor.
As a result, output will decrease more under

downward rigid wages than under flexible wages.

Exhibit 26.6, Panel (b) The relationship

between employment and real GDP
Exhibit 26.6, Panel (c) Leftward shift in

the labor demand curve with downward
rigid wages

There are three different schools of thought on the

sources of economic fluctuations:
1. Real business cycle theory emphasizes

changes in productivity and technology
2. Keynesian theory focuses on business and
consumer expectations of the future.
3. Financial and monetary theory looks at
changes in prices and interest rates.
Real business cycle theory emphasizes changes

in productivity and technology:
• Technological advances and other

productivity-enhancing innovation cause
expansions.
• An increase in input prices like oil causes

recessions.

Keynesian theory focuses on changes in

expectations of the future:
• Animal spirits are the psychological factors

that lead to changes in business and consumer
mood or sentiment. Animal spirits can lead to
decreases in spending (recessions) or
increases in spending (expansions).

Keynesian theory (cont’d):
• A negative shock can hit the economy and

generate pessimism. Willingness to spend
decreases and is not offset by increased
spending in other parts of the economy.

Keynesian theory (cont’d):
• The initial decrease in spending is amplified

by further decreases in other persons’ spending
due to multipliers.

Financial and monetary theory—whose main

proponent is Milton Friedman—looks at changes
in prices and interest rates:
• A decrease in the money supply (M2) will

cause the price level to fall.
• A fall in the price level will reduce

employment because of downward wage
rigidity.
Financial and monetary theory (cont’d):
• A decrease in the money supply (M2) will also

cause an increase in the real interest rate.
• Higher real interest rates will reduce

investment spending by firms.

Multipliers can amplify

the effects of any
economic shock,
regardless of its source.
Consider a negative
consumption shock.

Exhibit 26.8 Multipliers in a Contracting Economy

By lowering household income, multipliers will

shift the labor demand curve further to the left.
As a result, wages and employment will decrease

further, to the trough of the business cycle.

Exhibit 26.9 Multipliers in an Economy with Flexible Wages

In addition, multipliers can reduce labor demand

further by:
• A fall in asset prices
• A rise in mortgage
defaults
• A rise in household and

firm bankruptcies
Here is how a shock plays out in the short run:
1. An initial shock shifts the labor demand curve

to the left.
2. Downward wage rigidity leads to greater

reductions.
3. Multipliers cause the labor demand curve to

shift leftward even more.
Exhibit 26.11 Multipliers in an Economy with Rigid Wages

Economic recovery in the medium run:
1. Market forces from (a) inventory rebuilding,

(b) technological advances, and (c) financial
intermediation shift the labor demand curve to
the right for a partial recovery.

Exhibit 26.12 Partial Recovery Due to a Partial Rightward Shift in

the Labor Demand Curve

Economic recovery in the medium run:
2. Expansionary monetary policy will lower

interest rates and raise inflation.
Lower interest rates will raise spending, which

shifts the labor demand curve to the right.
Higher inflation will lower real wages, which

shifts the labor supply curve to the left.
Exhibit 26.13, Panel (a) The Effect of Inflation on the Labor

Market Equilibrium
Note that the leftward shift in labor supply has an

impact only if the new market-clearing wage is
above the original wage rate.

Exhibit 26.13, Panel (b) The Effect of Inflation on the Labor

Market Equilibrium
The following diagram puts all these effects

together:
1. Pre-recession starting at point 1 to…
2. Recessionary trough at point 2 to…
3. Partial recovery at point 3 to…
4. Full recovery at point 4

Exhibit 26.14 Full Recovery

The focus so far has centered on recessions. We

now shift to economic expansions.
Suppose that Apple and other technology firms

become optimistic about the future demand for
their products.
Question: What happens to its demand for labor?

Exhibit 26.15 Rightward Shift in the Labor Demand Curve, Shift from 1 to 2
Only
In response, firms that supply the technology get

higher sales, and consumers start to spend more.
Question: What happens in the labor market?

Exhibit 26.15 Rightward Shift in the Labor Demand Curve

Evidence-Based Economics Example:
Question: What caused the recession of 2007–

2009?
Data: Historical data on housing prices (Case-

Shiller home price index), residential
investment (NIPA), foreclosure rates (Mortgage
Bankers’ Association), and bank balance sheets
(FDIC and Lehman Brothers).
Answer: Three key factors appear to have played

central roles in the crisis:
1. A fall in housing prices, which caused a

collapse in new construction

Exhibit 26.16 Index of Real Home Prices in 10 Major U.S. Cities

(January 1987–December 2013)

Exhibit 26.17 Real Investment in Residential Construction

(1987:Q1–2013:Q4; Normalized to 100 in 2009)

2. A sharp drop in consumption


3. Spiraling mortgage defaults that caused many

bank failures, leading the entire financial
system to freeze up

Exhibit 26.18 Percentage of U.S. Home Mortgages That Began

Foreclosure Proceedings, 2000–2013

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Chapter 26

© 2015 Pearson Education, Ltd.

26.1 Economic Fluctuations and Business Cycles

© 2015 Pearson Education, Ltd.

1. Recessions are periods (lasting at least two

© 2015 Pearson Education, Ltd.

3. Economic fluctuations occur because of

© 2015 Pearson Education, Ltd.

5. Economic booms are periods of expansion of

Economic fluctuations or business cycles:

We can examine the business cycle by comparing

© 2015 Pearson Education, Ltd.

Exhibit 26.1 Real U.S. GDP and a Trend Line (1929‒2013;

We can also examine the business cycle by

Question: What historical episodes can you

© 2015 Pearson Education, Ltd.

Exhibit 26.2 Percent Deviation Between U.S. Real GDP and

© 2015 Pearson Education, Ltd.

A recession is defined as episodes of negative

An expansion is defined as a period of positive

Since 1929, a recession has occurred about once

Exhibit 26.3 U.S. Recessions from 1929 to 2013

© 2015 Pearson Education, Ltd.

Economic fluctuations have three key properties:

1. Co-movement of many macroeconomic

© 2015 Pearson Education, Ltd.

Variables such as real consumption, real investment,

Variables such as unemployment move negatively (or

© 2015 Pearson Education, Ltd.

Exhibit 26.4 Real Consumption Growth Versus Real Investment

Recessions and expansion do not follow a

As a result, it is impossible to forecast during an

Similarly, it is impossible to forecast during a

© 2015 Pearson Education, Ltd.

When the economy is growing, it will probably

Likewise, when the economy is contracting, the

The Great Depression of 1929‒1933 illustrates

1. Co-movement in economic aggregates

© 2015 Pearson Education, Ltd.

Exhibit 26.5, Panel (a) The Great Depression

© 2015 Pearson Education, Ltd.

Exhibit 26.5, Panel (b) The Great Depression

© 2015 Pearson Education, Ltd.

Exhibit 26.5, Panel (c) The Great Depression

© 2015 Pearson Education, Ltd.

Question: Why are there economic fluctuations?

Answer: It depends on who you ask.

Caveat: There is a significant body of shared

© 2015 Pearson Education, Ltd.

At the beginning of a recession, the labor demand

1. A fall in output prices

© 2015 Pearson Education, Ltd.

In the case of a recession, if wages are flexible,

As a result, real GDP

© 2015 Pearson Education, Ltd.

Exhibit 26.6, Panel (a) Leftward Shift in

Exhibit 26.6, Panel (b) The Relationship

© 2015 Pearson Education, Ltd.

If wages are downward rigid, the leftward shift in

As a result, output will decrease more under

© 2015 Pearson Education, Ltd.

Exhibit 26.6, Panel (b) The relationship

Exhibit 26.6, Panel (c) Leftward shift in

© 2015 Pearson Education, Ltd.