Short-Run Fluctuations in Economics

These are my notes on short-run fluctuations in economics.

Recessions are periods in which real GDP falls.


Economic fluctuations have three key features; co-movement, limited predictability, and persistence.


Economic fluctuations occur because of technology shocks, changing sentiments, and monetary factors.


Economic shocks are amplified by downward wage rigidity and multipliers.


Economic booms are periods of expansions of GDP, associated with increasing employment and declining unemployment.


Three key factors contributed to the 2007-2009 recession: a collapsing housing bubble, fall in household wealth, and a financial crisis. The recession was accompanied by both a demand shock and a financial shock.


One key factor initiated the 2020 recession: a coronavirus pandemic. The pandemic led consumers to reduce their demand for goods and services because of both their concerns about their own household finances and their effort to avoid being infected by the coronavirus. The pandemic led firms to cut back their activities, both because consumers were reducing demand for goods and services and because firms found it costly or even impossible to operate safely during the pandemic.


Short run changes in the growth of GDP are referred to as economic fluctuations or business cycles.


Economic expansions are the periods between recessions. Accordingly, an economic expansion begins at the end of one recession and continues until the start of the next recession.


The Great Depression refers to the severe contraction that started in 1929, reaching a low point for real GDP in 1933. The period of below trend real GDP did not end until the buildup to World War II in the late 1930’s. 


Although there is no consensus on the definition, the term depression is typically used to describe a prolonged recession with an unemployment rate of 20 percent or more.


Real business cycle theory is the school of thought that emphasizes the role of changes in technology in causing economic fluctuations.


Animal spirits are psychological factors that lead to changes in the mood of consumers or businesses, thereby affecting consumption, investment and GDP.


Sentiments include changes in expectations about future economic activity, changes in uncertainty facing firms and households, and fluctuations in animal spirits. Changes in sentiments lead to changes in household consumption and firm investment.


Multipliers are economic mechanisms that amplify the initial impact of a shock.


A self-fulfilling prophecy is a situation in which the expectations of an event induce actions that lead to that event.


Aggregate demand is the economy’s overall demand for the goods and services that firms produce. Aggregate demand derives the hiring decisions of firms and consequently determines the labor demand curve.


Actual wages are also called nominal wages, which distinguishes them from wages adjusted for inflation, or real wages. To calculate real wages, economists divide nominal wages by a measure of overall prices.


The phillips curve describes the empirical relationship between employment growth and inflation, showing that employment growth tends to produce more inflation, especially when an economy is near full employment.


All economies experience economic fluctuations. The growth rate of GDP fluctuates from year to year. During recessions, real GDP contracts and unemployment increases. On rare occasions, a recession turns into a depression, like the great depression. From 1929 to 1933, real GDP declined by 26 percent, and the rate of unemployment rose from 3 percent to 25 percent. 


Economic fluctuations have three key properties. 


Co-movement is when consumption, investment, GDP, and employment generally fall and rise together. Unemployment moves in the opposite direction. 


Limited predictability of turning points: Economic fluctuations are not pendulum-like with regular up and down cycles. It is difficult to predict in advance when an economy will enter a recession and when a recession will end. 


Persistence: When the economy is growing, it will probably keep going the following quarter. Likewise, when the economy is contracting-when growth is negative-the economy will probably keep contracting the following quarter.


When the labor demand curve shifts to the left, employment and real GDP fall. When the labor demand curve shifts to the right, employment and real GDP rise.


Many factors explain fluctuations in economic activity.


Technology shocks: Changes’ in firms productivity translate into shifts in the demand curve for labor, causing fluctuations in employment and real GDP. The recession of 2020 was caused by the covid-19 pandemic, which is an example of a productivity shock.


Keynesian factors: Changes in sentiments, including changes in expectations, uncertainty, and animal spirits, influence firm and household behavior. If a firm becomes pessimistic, its demand curve for labor shifts to the left. If a firms’ customers become pessimistic, they reduce their purchases, decreasing demand for the firm’s products and shifting the firm's labor demand curve to the left. An initial shift in the labor demand curve creates a cascading chain of events, multiplying or amplifying the impact of the initial shock. For example, when firms lay off workers in response to a shock, the laid off workers cut their own consumption, reducing the demand for the products of other firms. Financial factors create additional multiplier effects. Defaults, bankruptcies, and declines in asset prices lead banks to scale back their lending to firms and households, generating another round of adverse shifts in the labor demand curve. 


Monetary and financial factors: A fall in the price level is contractionary because firms face downward wage rigidities-that is, they are unable or unwilling to cut wages. Employment declines by more than it would have with flexible wages. In addition, monetary contractions cause the real interest rate to rise, reducing investment. Finally, financial crises reduce the credit available to firms and households. All these channels will shift the labor demand curve to the left, reducing employment and real GDP.


Economic booms tend to increase employment and reduce unemployment as the labor demand curve of the economy shifts to the right and the multiplier effects increase employment further. Economic expansions may generate inflation if the economy is already near the level of full employment. Economic booms also have a dark side because if they reverse, the economy can overshoot and sink into a recession.


Multiplier effects help us understand the recession of 2007-2009. Between the late 1990’s and 2006, the US housing market experienced a bubble. This bubble burst in 2006, and real housing prices fell by approximately 40 percent. The construction industry, which had been booming until then, began a sharp contraction. Falling housing prices-and by implication falling wealth-led households to cut their consumption. Firms, seeing the demand for their products decline, reduced their labor demand, starting a spiral of layoffs and further reductions in household consumption. The collapse in housing prices also led to mortgage defaults and foreclosures. The defaults and foreclosures generated huge losses for many banks, which either failed or sharply cut lending, further worsening the recession.


The recession of 2020 was caused by the covid-19 pandemic, which reduced the productivity of economic exchange. Because of the risk of infection,households were less willing to demand goods and services, and many industries could not both profitably and safely supply goods and services. The first documented US infection occurred in January 2020. The US recession and stock market crash started in February, anticipating an initial large wave of infections and deaths from March to May. During this first wave of infections, large parts of the economy closed down, causing a leftward shift in the demand for labor and a spike in unemployment that was far sharper than any previously recorded in US history. The unemployment rate peaked at 14.8 percent in April, only two months after the recession started. Once the first wave of infections began to decline, many people returned to work, though the virus was still not under control. The US unemployment rate began to fall in May, just three months after the recession started.