Page 685 - The Principle of Economics

FACT 3: AS OUTPUT FALLS, UNEMPLOYMENT RISES
Changes in the economy’s output of goods and services are strongly correlated with changes in the economy’s utilization of its labor force. In other words, when real GDP declines, the rate of unemployment rises. This fact is hardly surprising: When firms choose to produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed.
Panel (c) of Figure 31-1 shows the unemployment rate in the U.S. economy since 1965. Once again, recessions are shown as the shaded areas in the figure. The figure shows clearly the impact of recessions on unemployment. In each of the re- cessions, the unemployment rate rises substantially. When the recession ends and real GDP starts to expand, the unemployment rate gradually declines. The unem- ployment rate never approaches zero; instead, it fluctuates around its natural rate of about 5 percent.
QUICK QUIZ: List and discuss three key facts about economic fluctuations.
EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS
Describing the regular patterns that economies experience as they fluctuate over time is easy. Explaining what causes these fluctuations is more difficult. Indeed, compared to the topics we have studied in previous chapters, the theory of eco- nomic fluctuations remains controversial. In this and the next two chapters, we de- velop the model that most economists use to explain short-run fluctuations in economic activity.
HOW THE SHORT RUN DIFFERS FROM THE LONG RUN
In previous chapters we developed theories to explain what determines most im- portant macroeconomic variables in the long run. Chapter 24 explained the level and growth of productivity and real GDP. Chapter 25 explained how the real in- terest rate adjusts to balance saving and investment. Chapter 26 explained why there is always some unemployment in the economy. Chapters 27 and 28 ex- plained the monetary system and how changes in the money supply affect the price level, the inflation rate, and the nominal interest rate. Chapters 29 and 30 ex- tended this analysis to open economies in order to explain the trade balance and the exchange rate.
All of this previous analysis was based on two related ideas—the classical di- chotomy and monetary neutrality. Recall that the classical dichotomy is the sepa- ration of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money). According to classical macroeconomic theory, changes in the money supply affect nominal vari- ables but not real variables. As a result of this monetary neutrality, Chapters 24, 25,
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 705