TUTORIAL 4 (31 MARCH 4 APRIL) - ANSWER KEY

Business Cycles
Textbook Reference: Chapter 4
Main Concepts
Business Cycles: contractions and expansions
Potential output
Output gap
Natural rate of unemployment
Okuns law
Review Questions
Question 1
(i)

What is the difference between economic growth and economic fluctuations?

Economic growth can be defined as the growth in GDP over time, whereas economic
fluctuations can be defined by the differing growth rates of GDP in different periods.
(ii)

Define a contraction and an expansion using both growth and classical cycles.

BOF sect.4.1
There are differences in interpretation when we consider what are termed the classical
cycle and the growth cycle. Since for the Australian economy a movement from peak to
trough has rarely meant a decrease in real GDP, the growth cycle is a better explanation.
The classical cycle looks at what is happening to GDP in terms of the level of real GDP,
whereas the growth cycle looks at the growth rate of real GDP. A contraction is therefore
best described as a period of time (more than 1 or 2 quarters) for which the growth rate of
real GDP is significantly lower than normal, and an expansion is a period of time for which
the growth rate of real GDP is growing significantly faster than normal. Here normal refers
to the historically relevant long run average growth rate.

(iii)
What are the main characteristics of a recession? How are recessions identified
and do they differ from contractions?
A recession refers to a general or broad decline in economic activity. While there is a
standard rule-of-thumb definition of at last 2 consecutive quarters of decline in GDP, a
broader range of economic variables than just GDP are generally used to decide whether or
not an economy is in recession. For example, employment, income, industrial production,
unemployment, retail sales. These are often available on a more timely basis than is
quarterly GDP.
Claessens and Kose argue that some of the common characteristics of recessions are:
They typically last about a year and often result in a significant output cost. In particular, a
recession is usually associated with a decline of 2 percent in GDP. In the case of severe
recessions, the typical output cost is close to 5 percent.
The fall in consumption is often small, but both industrial production and investment
register much larger declines than that in GDP.
They typically overlap with drops in international trade as exports and, especially, imports
fall sharply during periods of slowdown.
The unemployment rate almost always jumps and inflation falls slightly because overall
demand for goods and services is curtailed. Along with the erosion of house and equity
values, recessions tend to be associated with turmoil in financial markets.
(iv)
What is meant by a depression and in what sense is it different to a recession.
See: http://www.imf.org/external/pubs/ft/fandd/2009/03/basics.htm
Claessens and Kose define a depression as a very severe recession where the decline in GDP
is greater than 10%. It could be argued that difference between a recession and depression
is more than the magnitude or length of a contraction. We could draw as distinction based
on:
- Causes (recessions are generally caused by monetary policy, while depressions involve a
contraction in asset prices and credit and a fall in the price level).
Characteristics of depression (importance of declines in asset prices; contraction of lending
and deflation).
- Different policy responses. Easier monetary policy is an appropriate response to a
recession and little need to use fiscal policy. Monetary policy is likely to be relatively
ineffective in a depression, so greater need for fiscal policy.
(v)
Give examples of firms that are likely to be adversely affected by a recession (i.e.
sales and profits decline). Are there any firms which are likely to see their sales and
profits rise during a recession?
Generally, producers of durable goods (eg. cars, new houses, clothing, capital goods) are
most severely affected by recessions. Industries that produce services (education) and nondurable goods (food) are affected least. Firms that deal in second hand goods or rent or
hire durable goods are likely to do well in a recession. Firms that produce or retail goods
that we could consider as inferior goods perform better in a recession in comparison to
goods that we consider as normal goods.

(vi)
Briefly explain how each of the following variables is likely to be influenced by a
recession: the natural rate of unemployment; the cyclical rate of unemployment and the
inflation rate.
The natural unemployment rate is defined as the sum of structural and frictional
unemployment. It excludes cyclical unemployment. Thus, the natural unemployment rate by
this definition should not be affected by a recession. Also by definition, it is the cyclical
unemployment rate that rises during a recession. Inflation tends to decline in the period
following a recession.
(vii) Define potential output. Is it possible for an economy to produce an amount
greater than potential output? Explain.
BOF 4.2.1
It is important to note that potential output is often referred to as the level of GDP that we
would have if we were always growing at the long-run economic growth rate, or when we
are on the economys long-run growth path.
(viii) Why do theories of economic fluctuations focus on aggregate demand rather than
potential GDP and why do theories of long-run economic growth focus on potential GDP
rather than spending?
It is generally thought that in macroeconomics, the long run is defined as a period of time
when prices and wages are fully flexible. Since price and wages are not fully flexible in the
short run, this time duration can refer to a period where [real] GDP is different from
potential GDP, resulting in periods of time away from full-employment.
So for instance, if aggregate spending is sufficiently lower than potential GDP (excess supply
in goods and labour markets), prices and wages may not adjust downwards (a failure of
markets to clear), creating unemployment, with long run equilibrium (potential GDP)
unchanged. Hence, aggregate spending is the driver of real GDP in the short run. Since
price and wages are fully flexible in the long run, spending will adjust to equal potential
GDP. Hence, potential GDP is the driver of long-run economic growth.

Question 2
(i)

Okuns law is given by the following equation;

Explain in words what the above equation implies.

(ii)

Using Okuns law complete the missing data in the following table.
Year
2008
2009
2010
2011

Real GDP
7840
8100

Potential GDP
8000

u
5
4.5
5

8200
8250

8415

u*
6
5
4

While the form of Okuns law is not specified in the question I will use the following version that BOF
indicate is appropriate for Australia.
(

It is just a matter of substituting into the above equation from the following table and solving for the
unknown variable.
2008
(

2009
(

2010
(

2011
(

Discussion Questions
Question 3
A common way to define a recession is that it corresponds to at least two consecutive
quarters of negative real growth. The Excel file GDP_Data.xls contains a quarterly index
(2000=100) of real GDP for the US and Australia from Dec. 1959 to Dec. 2010.
(i)
Use the data to calculate the quarterly real growth rate for each country (Dont
worry that it is an index, you can calculate growth rates in the usual manner). Using the
above definition of a recession identify the periods when each economy has been in a
recession. Report these dates in a table. By this definition did the Global Financial Crisis
produce a recession in Australia?
Date
Dec 1960
Mar 1961
Jun 1961
Sep 1961
Dec 1969
Mar 1970
Dec 1971
Mar 1972
Sep 1974
Dec 1974
Mar 1975
Sep 1975
Dec 1975
Sep 1977
Dec 1977
Jun 1980
Sep 1980
Dec 1981
Mar 1982
Sep 1982
Dec 1982
Mar 1983
Jun 1983
Dec 1990
Mar 1991
Jun 1991
Sep 2008
Dec 2008
Mar 2009
Jun 2009

US
-1.28
0.60
1.87
1.62
-0.47
-0.16
0.28
1.79
-0.99
-0.39
-1.22
1.68
1.31
1.79
-0.02
-2.05
-0.19
-1.25
-1.64
-0.39
0.08
1.24
2.25
-0.88
-0.48
0.67
-1.01
-1.74
-1.24
-0.18

AU
-0.54
-0.12
-1.24
-0.62
2.20
2.07
-0.32
-1.14
1.64
-0.17
0.41
-1.00
-1.67
-0.48
-0.29
0.26
0.71
-0.36
-0.81
-0.59
-1.58
-0.99
-0.22
0.48
-1.34
-0.26
0.53
-0.95
0.86
0.36

recession
AU

US
AU
US
AU
AU
US
US & AU

AU

US & AU

US

(ii)
Discuss the extent to which recessions in Australia occur at (approximately) similar
times to those in the US. To what extent is it true to say that Australia catches a cold
when the US sneezes?
There are 2 cases where US and Australian recessions overlap; around 1981-82 and 1990-91. There
are two other cases where a recession in US was followed by one in Australia; 69-70 and 74-75. In
these four cases the recession in Australia occurred simultaneously with the one in the US or closely
followed it. These cases would be consistent with the claim. But US had a short recession in 1980
and then one associated with the GFC which did not lead to recessions in Australia. In addition
Australia seems to have had 2 home-grown recessions in 1960-61 and 1977.