Tuesday, March 10, 2009

Notes on Chapter 9 - Economic Fluctuations


In the long run, the economy, measured by GDP, is constantly growing. You can see the long-term GDP growth trend in the graph of US GDP from 1947 through the end of 2008.

However, if you look at the graph carefully, you'll see that there are short-term periods in which the economy grows at a slower pace, stays level or even contracts. These periods of falling real national income are known as recessions. Eventually, the economy recovers and continues on its growth path.

Short-run fluctuations in output and employment are often correlated and known as the business cycle.

In our study of economic fluctuations, we seek to:

1. Obtain a more complete understanding of the data, primarily GDP and unemployment rate, that are used to measure the economy and describe the short-run fluctuations.

2. Understand differences between short-run and long-run economic behavior.

3. Develop a model which can be used to describe and predict economic behavior in the short-run. We will call this model the AD-AS model and base it on the concepts of aggregate demand and aggregate supply which will be developed in our analysis.

Our ultimate goal is to understand the economic variables well enough to control the cycle of economic fluctuations through effective fiscal and monetary policies. We're not trying to eliminate the cycle entirely. That would likely be impossible. Rather, we are attempting to minimize the severity of the peaks and troughs in the cycle.

GDP, Unemployment and Okun's Law

Some notes on GDP:
Average annual GDP growth in the US is 3.5%.
Officially, the NBER Business Cycle Dating Committee determines when recessions begin and end.
NBER's rule of thumb is that a recession is defined as two consecutive quarters of declining real GDP. This is a rule of thumb and not a strict definition. Other economic factors are taken into account in the final analysis.

Note: It's unclear to me whether the rule of thumb is defined by declining growth in GDP or by negative growth in GDP. I.e. is it enough for the growth to be slowing down, or does the growth rate have to actually be less then zero?
Another interesting question is whether we compare GDP growth from quarter to quarter or from one quarter to the same quarter 4 quarters ago. The later method would take into account seasonal changes to some degree.

GDP = Y = C + I + G + NX

So we might expect all the components of GDP to decline during a recession. That is the case for consumption (C) and investment (I). However, we find that recessions have a more dramatic impact on investment (I = equipment, structures, housing, inventories, etc) than on household consumption (C).

Some notes on unemployment:
During recessions, unemployment generally increases. Economic growth slows when more workers are unemployed. The unemployment rate is related to the decline in GDP by Okun's Law:

%ΔGDP = 3.5% - 2 x Δ%Unemployment
This formula essentially means that the economy, measured by GDP, will grow by 3.5% when the unemployment rate is stable. If unemployment increases, GDP will drop by 2% for every 1% that unemployment increases, and vice versa.

Edward S. Knotek, an economist at the Federal Reserve Bank of Kansas City, has written an interesting article entitled How Useful is Okun's Law?

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