Back To CourseEconomics 102: Macroeconomics
16 chapters | 137 lessons | 14 flashcard sets
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Jon has taught Economics and Finance and has an MBA in Finance
Let's take a journey to a galaxy far, far away on the planet Econoworld. I want to welcome you to the nation of Macro, where everything is big.
Steaks are big - 72 ounces big. In the nation of Macro, movie theaters seat 10,000 people. Large iced coffees are big - 31 ounces. Wait a second - that's how big they already are. 31 gallons - now that's big. Nobody's falling asleep during economics lessons in Macro. Chocolate bars are twice as nice. Everything is big in Macro, and so is this lesson.
Let's imagine for a few minutes that you're riding around for four days on a big unicycle in the business district of the city of Growth, which is the capital of Macro. It can't be that difficult to ride a unicycle, you tell yourself with great anticipation of sitting on a seat way up high in the air. Here's where the unicycle takes you and what you observe along the way.
As you pass through the center plaza of the city, you enjoy a quick look at the downtown central park with its soft green grass and a peaceful river flowing through. A few moments later, you pass by a factory that makes chocolate. Now this is really starting to get interesting - either that or the dark chocolate I just ate is starting to kick in right about now. As you pass by, you turn and gaze into some large windows in the front of the factory that allow you a rare look at the activities taking place inside.
'What's going on in there?' you ask yourself. Inside the factory, several machines are going at a solid pace, all connected to each other, and an assembly line is at the end of those machines transporting chocolate bars towards an area where they will get wrapped and boxed up for distribution throughout the land of Macro.
Workers are spread out across the factory, and most of them seem busy, although you notice several of them standing in a corner goofing off and blowing bubbles. For a quick second you think to yourself 'Wow, what an easy job those people have!' You finally pass by the whole factory and continue on your way through the city, wishing that you could take some of that chocolate with you. As you continue to daydream about chocolate, you happen to pass by the mall, noticing that it's not empty and it's not full. So this is what happens on your first day of riding the unicycle through the city.
The second day, you get back on your unicycle again. As you pass through the city center, you travel the same path as before, and you're most interested in looking in on the factory to see what's going on inside. This time, as you pass by the front window and gaze into the factory, you can tell that every machine is going at full steam. It looks as though the machines are going faster this time. You look around the building, searching for the people who were standing in the corner goofing off before, but they aren't there. Every single person appears to be working very hard, and you even notice more people in there than you saw before. Chocolate bars are flying out of the machines onto the assembly line. All of a sudden, you see one of the machines break down because the workers are working it so hard.
You're quite happy on this day because you just got a raise at your job and you're on your way to the mall to spend it. When you get to the mall, you can barely find a parking spot for your unicycle because there are so many people there. So this is what happens to you during your second day of adventures.
Now it's the third day. You're riding on your unicycle through the city of Growth in the nation of Macro. As you pass by the factory, you gaze into the front window once more to see what's happening in there. This time, the machines are barely going. Almost no one is working in there. Very few chocolate bars are coming out! After you pass the factory, you pass the mall and you notice that almost nobody is there. 'Where did everybody go?' you wonder. On the third day, things aren't looking so good.
Finally, it's day four and you're starting to really get in great shape now because you've been riding this darn unicycle over and over again through the city, which is no joke. Your curiosity swells and you ride past the factory. As you do, you gaze into the window, but this time you can't see anything because the window is boarded up! Once you adjust your eyes, you can see that over the window is a sign that says 'For Sale,' and you realize that your beloved chocolate factory has closed down!
The phone rings and you take the call while you're riding. Although everything is big in the nation of Macro, your mood is definitely not, because this is a call from your boss, and she tells you that business is slow and then lets you go. As you pass by the factory and continue to ride through the city, all you can think of is how many chocolate bars you're going to need once you get home. As you pass by the mall, you notice that there is no mall. It's been demolished by a wrecking ball! What a rough day this has been.
Thankfully, you wake up the next day full of energy. You once again ride through the city and you discover that not only has the chocolate factory started up again but there's a new mall where the old one used to be. People are starting to drive in and park, and things are looking up once again. Today you stop for a big iced coffee and then your cell phone rings. As you take the call, a really big smile covers your face as a recruiter tells you that you have a new job waiting for you as a chocolate salesman!
So what we've been talking about is the business cycle. The economy doesn't grow smoothly - it goes through ups and downs, which economists call economic fluctuations. It grows in a fairly predictable pattern. Although we don't know when it will happen exactly, we know the pattern that will unfold when it does happen. That pattern is a cycle. Economists call this pattern of economic fluctuations the business cycle. The National Bureau of Economic Research (NBER) identifies and dates business cycles and turning points.
Just like the sun comes up in the morning, reaches a peak in the middle part of the day, sets in the evening, and starts all over again the next day, the economy experiences up and down cycles that have repeated throughout history as long as we've been keeping records. Just like the ocean brings in waves of water towards the beach one after another after another, the economy ebbs and flows.
The business cycle has two phases, expansion and recession (sometimes called contraction), and two turning points, which economists refer to as a peak and a trough.
When the chocolate factory was operating at a fairly good pace, when the mall was fairly busy, the economy of Macro was experiencing an expansion. Economists say that economic output is at its potential. In an expansion, real GDP is positive and inflation and unemployment tend to be low.
When the machines were operating at full capacity, when everyone was working, the mall was packed out, and you got a raise, that's when the economy reached a peak. Economists describe this by saying that actual output is above potential output. At the peak of a business cycle, real GDP is growing quickly, inflation is higher, and unemployment is very low.
On the other hand, when business was slow, hardly anyone was working, and the mall was empty, the economy was in recession, or what some people call a contraction. Economists say that actual output is below potential output when that happens. In a recession, real GDP shrinks for at least six months in a row, prices are falling, and unemployment is higher.
Finally, when the chocolate factory had shut down, when the mall was closed and demolished, and you lost your job, this was the worst part of the recession, what economists call the trough. At the trough of a business cycle, economists still say that actual output is way below potential because it takes time for things to get back to where they were before the recession. Real GDP has been shrinking but has now reached the bottom and is about to grow again. Inflation is very low and unemployment may still be high for a while.
So here we have two phases and two turning points, all happening in the same order: this is what we call the business cycle.
According to the NBER, the average length of an expansion is 35 months and the average length of a recession is 18 months, for a total of 53 months for a complete business cycle when you measure it from trough to trough.
Here's a table showing the economy over the course of an entire business cycle in the land of Macro, almost a thousand years from now.
As you can see, in the years 3010 and 3011, this economy was in an expansion. Prices were going up (this is inflation), but unemployment was going down. Then a year later the business cycle peaked at 7% real GDP. Inflation was higher and the unemployment rate dipped down to a low of 3%. By 3014, the economy began to experience recession and a trough. Real GDP was negative, prices went down instead of up, and the unemployment rate began rising substantially. Finally, in 3015 and 3016, a new expansion began. Notice that unemployment didn't start coming down until a year later. It takes companies longer to start hiring again after a recession, so the unemployment rate tends to lag behind everything else.
To summarize the key points: the economy doesn't grow smoothly. It goes through ups and downs, or economic fluctuations. However, it goes up and down in a predictable pattern. Economists call this pattern the business cycle. The National Bureau of Economic Research (NBER) identifies and dates business cycles and turning points.
The business cycle has two phases, expansion and recession (or sometimes called contraction), and two turning points, a peak and a trough. In an expansion, real GDP is positive and inflation and unemployment are low. At the peak of a business cycle, actual output is above potential output. Real GDP is growing fast, inflation is higher, and unemployment is very low. In a recession, real GDP shrinks for at least six months in a row, prices are falling, and unemployment is higher. Finally, at the trough of a business cycle, actual output is way below potential output. Real GDP has been shrinking but has reached the bottom and is about to grow again. Inflation is very low, and unemployment may stay high for a while.
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Back To CourseEconomics 102: Macroeconomics
16 chapters | 137 lessons | 14 flashcard sets