Slides are prepared by Dr. Amy Peng, Ryerson University

Chapter FiveChapter FiveOutput, Business Cycles, Output, Business Cycles,

and Employmentand EmploymentMacroeconomics by Curtis, Irvine and BeggMacroeconomics by Curtis, Irvine and Begg

Canadian Edition, Canadian Edition, McGraw-Hill Ryerson, 2007McGraw-Hill Ryerson, 2007

©2007 McGraw-Hill Ryerson Ltd. Chapter 5 2

Learning Outcomes

This chapter explains:This chapter explains:• Short-run aggregate demand and supply• Equilibrium output and potential output• Changes in equilibrium output and income• Business cycles and output gaps• Okun’s Law: output gaps and unemployment

rates• Adjustments to output gaps• The role for macroeconomic policy

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.1 3

A Short-Run Aggregate Demand and Aggregate Supply Model

• Short run– Constant prices for factors of production– Fixed supply of labour, capital and

technology

• The short-run AD/AS model is closely related to the national accounts framework.

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.1 4

The Aggregate Demand and Supply Model

The intersection of the AD and AS shows real output measured by the expenditure approach (AD) equals to real income measured by the income approach (AS) at the price level given by the GDP Deflator 1152

117.0

AD2005

AS2005

Y = Real GDP (1997 $)

GD

P D

efla

tor

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.1 5

Aggregate Demand

• Aggregate Demand (AD) is planned planned aggregate expenditureaggregate expenditure on final good and service (C + I + G + NX) at different priceprice levels

• Negative relationship – Wealth Effect– Interest rate Effect– Substitution Effect

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.1 6

The Aggregate Demand Curve

• The AD curve shows planned aggregate expenditure at different prices

Y0

P0

AD

Real GDP and Income

GD

P D

efla

tor

Y1

P1

A

B

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.1 7

Aggregate Supply

• Aggregate Supply (AS) is output business would produce at different price levels, all other conditions constant.

• Positive Relationship

• Unit Production Cost

Y

T

Y

CCABI

Y

WP IN

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.1 8

The Aggregate Supply Curve

• The AS curve shows aggregate output as measured by real GDP at different prices

Y2

P2

AS

Real GDP and Income

GD

P D

efla

tor

Y3

P3

C

D

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.1 9

Equilibrium Real GDP and Price

The intersection of the AD and AS gives equilibrium real GDP and price at A

1152

117.0

AD2005

AS2005

Y = Real GDP (1997 $)

GD

P D

efla

tor

AP0

Y1 Y0

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.2 10

Equilibrium Output and Potential Output

• Short-run equilibrium is determined by AD and AS conditions.

• Potential output – Full employment output– Not the maximum output– Allow for “equilibrium unemployment”

• Actual Output

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.2 11

Potential GDP

Potential GDP is the economy’s output when the markets for factor inputs are in equilibrium

Yp

P1

P2GD

P D

efla

tor

Real GDP

Yp is not affected by changes in the price level

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.2 12

450000

550000

650000

750000

850000

950000

1050000

1150000

1250000

1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

Year

mill

ion

s 19

97$

Recession Recession

Recovery and Boom

Potential and Actual GDP in Canada 1975-2004

Figure 5.6

Potential GDP

Actual GDP

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.3 13

Business Cycles and Output Gaps

• Business cycles cause differences between actual and potential GDP

• Output Gaps measure the difference between actual and potential GDP

• Inflationary gaps and Recessionary gaps

%100Y

Y-Y gapOutput

p

p

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.3 14

The Output Gap in Canada, 1985-2005

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

1985-Q1 1988-Q1 1991-Q1 1994-Q1 1997-Q1 2000-Q1 2003-Q1

Year and Quarter

Pe

rce

nta

ge

of

Po

ten

tia

l GD

P

Figure 5.7

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.4 15

Output Gaps and Unemployment Rates

%100forcelabour

employed people ofnumber -forcelabour u

Unemployment Rate (u)

%100forcelabour

employment mequilibriu-forcelabour un

Natural Unemployment Rate (un)

)Y of rategrowth -Y of rategrowth (-u p21

Okun’s Law

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.4 16

Okun’s Law

A

C

B

gY1

gY2

gYp

0Δu<0 Δu>0

Gro

wth

in R

eal G

DP

Change in Unemployment Rate

At Point A

gY1 > gYp, the demand for labour inputs is growing faster than labour force, the unemployment rate falls

At Point B

gY = gYp, the demand for labour inputs is equal to labour force, the unemployment rate does not change

At Point C

gY1 < gYp, the demand for labour inputs is growing slower than labour force, the unemployment rate increases

Figure 5.9

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.4 17

Okun’s LawThe Effect of Growth in Real GDP on

Unemployment

-1.5-1

-0.50

0.51

1.52

2.53

3.54

-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4

% growth in Real GDP - % growth in Potential GDP

Ch

an

ge

in U

ne

mp

loy

me

nt

Ra

te

%

Application Box 5.2

Change in u rate = 0.11 – 0.4234 (growth in Y – growth in Yp)

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.2 18

Equilibrium Unemployment

• Frictional unemployment– entry and exit of workers– workers changing jobs

• Structural unemployment – mismatch between skills/experience of

supply of labour and skill/experience requirements of employers (labour demand)

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.2 19

Cyclical Unemployment

• NAIRU – nonaccelerating inflation rate of unemployment

• Recessionary output gap– reduced demand for labour– cyclical unemployment

• Inflationary output gap– increased demand for labour– cyclical “over” employment

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.5 20

Adjustments to Eliminate Output Gaps

A recessionary gap results in lower wage rates and other factor prices. AS shifts down, and equilibrium output increases to eliminate the gap.

Y0

P0

AD0

AS0

Real GDP

GD

P D

efla

tor

P1

AS1

Yp

Recessionary gap

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.5 21

Adjustments to Eliminate Output Gaps

A inflationary gap raises factor prices and costs. AS shifts up, and equilibrium output decreases to eliminate the gap.

Y0

P0

AD0

AS0

Real GDP

GD

P D

efla

tor P1

AS1

Yp

Inflationary gap

©2007 McGraw-Hill Ryerson Ltd. Chapter 5.6 22

The Role for Macroeconomic Policy

• Why are output gaps, especially recessionary gaps, persistent?– The flexibility or rigidity of wage and prices

• Can government policy work to eliminate output gap?– Fiscal Policy– Monetary Policy

©2007 McGraw-Hill Ryerson Ltd. Chapter 5 23

Chapter Summary

• The Aggregate and Supply model provides a framework for our study of operation of the economy– Aggregate Demand– Aggregate Supply– Short-run Equilibrium Real GDP and Price

• Potential outputPotential output is the economy’s output at full employment level

• Business CyclesBusiness Cycles are short-run fluctuations of actual real GDP around its potential

©2007 McGraw-Hill Ryerson Ltd. Chapter 5 24

Chapter Summary

• Output GapsOutput Gaps are the differences between actual real GDP and its potential

• Okun’s LawOkun’s Law makes a link between output gaps and unemployment rate

• Inflationary Gaps and Recessionary GapsInflationary Gaps and Recessionary Gaps • Actual output adjustsadjusts to potential output over

time if factor prices are flexible• Fiscal and Monetary policyFiscal and Monetary policy are tools

government and monetary authorities use