Chapter 7
Short-Term Economic Fluctuations: An Introduction
Economic Naturalist Discussion Questions
1.
Why don’t economists know for certain what phase of the business cycle the economy is in at a
particular time, but they are very good at telling us where we were before? (It is difficult to identify a
peak or trough until after the economy starts down or up.)
2.
How could employment during the Second World War be above full employment? (People entered
the labour force who otherwise would not have worked, e.g., women and the retired.)
3.
What other kinds of “sensors” could Coca-Cola add to its vending machines to change prices with
demand? (Any sensor that detects something that would increase a person’s demand for a drink, e.g.,
income or dehydration.)
Review Questions
1. Define recession and expansion. What are the beginning and ending points of a recession called? In postwar
Canada, which have been longer on average, recessions or expansions? LO1, LO2
A recession is a period in which the economy is growing at a rate significantly below normal, whereas
an expansion is a period in which the economy is growing at a rate significantly above normal. The
beginning point of a recession is called the peak (the point at which economic activity reaches its
highest point and begins to decline), whereas the end point of a recession (and the beginning of the
expansion) is called a trough. In postwar Canada, expansions have been longer than recessions on
average.
2. Why is the traditional term business cycles a misnomer? How does your answer relate to the ease or difficulty of
forecasting peaks and troughs? LO2
The term “cycle” implies a predictably recurring event. In fact, recessions and expansions are of
irregular length and size. This irregularity makes forecasting peaks and troughs quite difficult.
3. Which firm is likely to see its profits reduced the most in a recession: an automobile producer, a manufacturer of
boots and shoes, or a barbershop? Which is likely to see its profits reduced by the least? Explain. LO2
Generally, producers of durable goods are affected most by recessions while producers of services and
nondurables (like food) are affected least. This suggests that the automobile producer would see its
profits reduced the most, the barbershop the least. Boots and shoes are semi-durable, since a pair of
shoes may last for several years (and people can put off purchases of these for a while if necessary). Thus
the boot manufacturer’s losses are likely to fall in between those of the other two firms.
4. List four broad types of unemployment and their causes. Which of these types is the least costly economically?
LO4
The four broad types of unemployment are frictional unemployment, due to the process of matching
workers and jobs; structural unemployment, which occurs when workers are unable to fill available
jobs; seasonal unemployment, associated with the seasons; and cyclical unemployment, brought about
by recession. Frictional unemployment is the least costly.
5. How is each of the following likely to be affected by a recession: the natural unemployment rate, the cyclical
unemployment rate, the inflation rate? LO2, LO4
The natural unemployment rate is the sum of structural and frictional, and seasonal unemployment and
excludes cyclical unemployment. Thus the natural unemployment rate by definition should not be
affected by a recession. Also by definition, the cyclical unemployment rate rises in recession. The
inflation rate tends to decline in the period following a recession.
6. Define potential output. Is it possible for an economy to produce an amount greater than potential output?
Explain. LO3
Potential output, or potential GDP, is the amount of output the economy can produce when it is using
its inputs, such as capital and labour, at normal rates. Because inputs can be used at greater than
normal rates for a time (for example, workers can work overtime and machines can be used at night or
on weekends), it is possible for the economy to produce an amount exceeding potential output.
7. True or false, and explain: When output equals potential output, the unemployment rate is zero. LO5
False. When output equals potential output, the unemployment rate equals the natural unemployment
rate. Cyclical unemployment is zero when output equals potential output, but frictional and structural
unemployment still exist.
8. If the natural rate of unemployment is 5 percent, what is the overall rate of unemployment if output is 2 percent
below potential output? What if output is 2 percent above potential output? LO5
By Okun’s law, output that is 2% below potential output is associated with cyclical unemployment of
1%, so in that case the overall rate of unemployment (natural plus cyclical) would be 6%. If output is
2% above potential, cyclical unemployment is –1%, so overall unemployment equals 5% – 1% = 4%.
9.True or false, and explain: The length of unemployment spells is particularly long for workers in the age group of
15-25 years old. LO5
False. According to the data in the textbook, unemployment spells are particularly long for Canadian
workers aged 55 to 64.
Problems
1.Given below are data on real GDP and estimates of psotential GDP for Canada prepared by the IMF. For each
year, calculate the output gap as a percentage of potential GDP, and state whether the gap is a recessionary gap
or an expansionary gap, according to the IMF. Also, calculate the year-to-year growth rates of real GDP. LO1
Year
2004
2005
2006
2007
2008
2009
2010
Year
Real GDP (2002 $, billions)
Potential GDP (2002 $, billions)
2004
1211
1198
2005
1248
1230
2006
1283
1261
2007
1311
1290
2008
1318
1317
2009
2010
1286
1325
1337
1358
Real GDP Potential
Output
(2002
$, GDP (2002
gap
billions)
$, billions)
1211
1198
1.1
1248
1230
1.5
1283
1261
1.7
1311
1290
1.6
1318
1317
0.1
1286
1337
-3.8
1325
1358
-2.4
Recessionary
Real GDP
or
growth %)
expansionary
Expansionary
3.1
Expansionary
2.8
Expansionary
2.2
Expansionary
0.5
Expansionary
Recessionary
-2.4
Recessionary
3.0
2. Back in 2000, the Canadian unemployment rate averaged 6.8 percent and current dollar GDP reached $1056
billion (or $1.056 trillion). Pierre Fortin, a leading Canadian macroeconomist affiliated with the Université du
Québec à Montréal, had estimated Canada’s natural rate of unemployment for 2000 as being 5.3 percent. By
contrast, one could infer an estimate of a natural rate of unemployment of about 7 percent from official Bank of
Canada statements, such as the Bank’s claim that the Canadian economy was operating with an expansionary
gap for most of 2000 (when the actual unemployment rate was around 6.8 percent in most months).
Using Okun’s law, what would be the potential GDP number for 2000 corresponding to a natural
unemployment rate of 5.3 percent? What would be the dollar value of the recessionary gap? Also, what would
be the potential GDP number corresponding to a natural rate of 7 percent? What would be the dollar value of
the expansionary gap? LO3
If actual unemployment in 2000 averaged 6.8% and the natural rate of unemployment was
5.3%, then unemployment was 1.5% above the natural rate, so GDP was 3% below potential.
Since GDP was $1056 billion, then potential GDP would have to have been $1056/0.97 = $1089
billion. The recessionary gap would thus have been $33 billion. If the natural rate was instead
7%, then unemployment was 0.2% below the natural rate, so GDP was 0.4% above potential.
Then potential GDP would have to have been $1056/1.004 = $1052 billion. The expansionary
gap would thus have been $4 billion.
3.Using Okun’s law, fill in the four pieces of missing data in the following table. That is, replace (1), (2), (3), and
(4) with correct data. LO3
Natural
Actual
Year
Real
GDP
Potential
GDP
Unemployment
Rate (%)
Unemployment
Rate (%)
2009
7840
8000
(1)
6
2010
8100
(2)
5
5
2011
(3)
8200
4.5
4
2012
8415
8250
5
(4)
Filling in the blanks requires the use of Okun’s law stating that each extra percentage point of
cyclical unemployment is associated with about a 2-percentage-point increase in the output gap,
measured in relation to potential output.
Natural
Actual
Year
Real
GDP
Potential
GPD
Unemployment
Rate(%)
Unemployment
(Rate %)
2009
7840
8000
5
6
2010
8100
8100
5
5
2011
8282
8200
4.5
4
2012
8415
8250
5
4