Book Reference: Jones – Chapter 9
Macroeconomic Theory
Introduction to Short Run
ECON2202
Spring 2024
9.1 Introduction
In this chapter, we learn
•how the gap between actual GDP and potential GDP
measures the economy’s performance in the short
run.
•how costly fluctuations in economic activity can be.
•that the rate of inflation tends to decline when the
economy is in a recession.
•a simple version of the short-run model that will
help us understand these patterns.
9.2 The Long Run, the Short Run, and Shocks
The long-run model is a guide to how the economy
behaves on average.
•Determines potential output and long-run inflation
Potential output
•Amount of production if all inputs were utilized at
their long-run sustainable levels
At any given time, the economy is unlikely to exactly
equal the long-run average.
The short-run model:
•Determines current output and current inflation
The Long Run, the Short Run, and Shocks
In the short-run model
•Assume the long run is given.
•Potential output and the long-run inflation rate
are exogenous.
•Current output deviates from potential output
because of economic shocks.
•The current level of output and inflation are
endogenous.
Trends and Fluctuations
Short-Run Fluctuation
“Detrended output” or short-run output:
•The difference in actual and potential output,
expressed as a percentage of potential output:
Economic Fluctuations and Short-Run Output
Short-Run Output in the United States
Fluctuations in U.S. GDP:
•Difficult to see graphically over a long period of time
•Have mostly been between + or –4% since 1950
The Great Depression:
•Negative gap during the 1930s
•Actual output was well below potential.
Short Run
A recession
•begins when actual output falls below potential.
•Short-run output becomes negative.
•ends when short-run output starts to rise.
•Short-run output becomes less negative.
Typically, during a recession,
•output is below potential for approximately 2 years.
•Loss of about $3,000 per person
•between 1.5 million and 3 million jobs are lost.
U.S. Real GDP, Actual and Potential
U.S. Economic Fluctuations
Changes in U.S. Employment
Case Study: The Great Depression
1930s worldwide calamity
•25 percent of Americans were unemployed.
•Industry production declined more than 60 percent.
The beginning of modern macroeconomics
Measuring Potential Output
There is no directly observable measure of potential
output in an economy.
Ways to measure potential output:
1. “Detrend” the actual GDP data to extract a smooth
trend
2. Use our long-run model (modifications of the Solow
model) to compute the potential output implied by
the theory
The Inflation Rate
What happens to inflation
around recession is not
obvious, but usually it
declines
Clicker Question 2
The short-run model determines
a. potential output and current inflation.
b. current output and long-run inflation.
c. current output and current inflation.
d. potential output and current output.
Clicker Question 2 – Answer
The short-run model determines
a. potential output and current inflation.
b. current output and long-run inflation.
c. current output and current inflation.
d. potential output and current output.
9.3 The Short-Run Model
The short-run model is based on three premises:
1. The economy is constantly being hit by shocks.
• Shocks: factors that cause fluctuations
2. Monetary and fiscal policies affect output.
• Policymakers can neutralize shocks to the
economy.
3. There is a dynamic trade-off between output and
inflation.
• Shown by the Phillips curve
The Philips Curve: tradeoff between inflation and output
The Phillips curve shows
• a positive relationship between the change in
inflation and short-run output.
Therefore
• a boom increases inflation.
• a recession decreases inflation.
Empirically, the slope is about 1⁄3.
• If output exceeds potential by 3 percent, the
inflation rate increases one percentage point.
The Phillips Curve
Measuring the Phillips Curve
Clicker Question 9
If the economy is in a period of deflation, the Phillips
curve implies that actual output is below potential
output.
a. true
b. false
Clicker Question 9 – Answer
If the economy is in a period of deflation, the Phillips
curve implies that actual output is below potential
output.
a. true
b. false
How the Short-Run Model Works
Assume policymakers can select short-run output
through monetary policy.
Example:
•1979: inflation was increasing due to oil prices.
•Monetary policy raises interest rates
(contractionary monetary policy).
•What happens?
•Recession!
9.4 Okun’s Law: Output and Unemployment
Why do we use both increase in GDP or decrease in
unemployment to talk about cycles?
Because they are inversely related in the short run!
Natural rate of unemployment:
•The rate of unemployment that exists in the long
run
Cyclical unemployment:
•Current unemployment minus the natural rate of
unemployment
Okun’s Law
Cyclical
unemployment
Current rate of
unemployment
Natural rate of
unemployment
Short-run
output
Okun’s Law for the U.S. Economy
9.5 Filling in the Details
The IS curve
•Shows how an economy’s output in the short run
depends negatively on the real interest rate
The MP curve
•Shows how monetary policy affects the real interest
rate