[MUSIC] So now that we have this reference point defined, we can start looking at a business cycle and start to make some sense out of it, and look at it from the perspective of what does it need. Okay, so that's what we're going to do in the next few minutes. I'm going to be drawing for you a sort of generic business cycle. It, it's not any country in particular, alright? So we put, on the vertical axis, we're going to put GDP growth, alright. And on the horizontal axis, we're going to put time, okay. And if we do that, what is going to happen is as we draw the business cycle, it might look like this. It might be growing fast and then come down, come up again, dip down, go way down. It can do a lot of different things, right? And we look at these numbers and they don't make a lot of sense to us until we think of them in reference to the potential rate of GDP growth. Okay, so just assuming that this rate is constant, it's not, but for our purposes, it works. We can draw a line across this chart, this business cycle, a straight line which represents potential GDP growth. Okay? So for example, at the very beginning of this picture, maybe GDP is growing at the beginning here at 5%. And potential GDP growth is three. Okay? And so, we can identify then along this business cycle some different phases, okay, which correspond to those output gaps that we've just been talking about. Here at the beginning, the area I'm coloring in right now, this would be an area where GDP is growing too fast, okay, where we're above potential. Now there's another area over here where GDP is above potential, okay? In other words, the economy's growing too fast. And we would call these areas we would refer to them as inflationary gaps, okay? The common term we use is overheating, okay, and we've been talking about them as positive output gaps. Okay so, we would call these two zones that I've just colored in inflationary gaps, alright. Now, what tends to happen at these moments in the cycle, going back to the indicators that we talked about earlier, is when we're in a inflationary gap, usually we will find that inflation is going up. Inflation is accelerating, because remember, our definition of potential GDP, that's the highest rate of growth that we can sustain into the medium term without accelerating inflation. In these areas that I've colored, we've gone be-, we've gone beyond that rate of growth. So inflation is accelerating, and you can see that that's actually the problem we have at that phase of the business cycle. Now, on the good side, unemployment is going down in those moments. Okay? So we usually have some good news and some bad news. Sometimes, we'll see later on, we have all bad news, or all good news. But normally we've got some good news which is that unemployment is going down in these inflationary gaps. The bad news is that inflation is going up. Okay? So we kind of have to choose between these when we, decide what to do from a policy perspective. Okay, so those are the inflationary gaps where GDP growth is too high. Okay, but if we look at this picture, we also see some other zones. The ones that I'm striping here now where GDP growth is too low. In other words, GDP is growing lower than potential. Okay? That doesn't mean that GDP is shrinking, it doesn't mean it's a recession. But it's growing too slowly. You can see we've got a zone here, and then we've got another one over here where GDP growth is too low. And we call these two areas recessionary gaps, okay. It's a recessionary gap because GDP growth is lower than potential GDP growth. We're growing too slowly. We referred to these a few minutes ago as negative output gaps. When we're just talking about them in normal conversation, we call them a crisis. Okay? Because usually unemployment is pretty high, and this causes problems for the population, so we just refer to these as crisis. The technical term would be a recessionary gap. Now, the good news we have in a recessionary gap, as you can imagine, is that inflation is going down. Okay. So usually that's something we don't even notice because we're so worried about the other part, but this is the good news that we get in recessionary gaps. On the other hand, the bad news is that unemployment is going up. And this, the problem with unemployment going up, is that it makes life a lot worse for a few people, alright. Whereas inflation going up makes life worse for everybody but not a whole lot worse. So you know, you kind of have to think about which problem is most important. But here is if you look at the business cycle, we can see that in these inflationary gaps, we've got inflation accelerating, unemployment declining, because GDP is growing faster than potential. In the recessionary gaps, we've got inflation declining, unemployment rising, because GDP is growing slower than potential. And what's interesting to see is whether in the real world, this actually happens. Again, very much like the doctor looking at a human body. The doctor might expect the same body temperature from everybody, the same blood pressure from everybody, but of course we vary. You know, your blood, your body temperature may be normally quite low, and another person may be normally quite high. So when we look at economies in the same sense, we find that all these things don't work perfectly, alright? But at least they give us a reference point to see what's sort of normal. So in this picture that I've pulled up now, and this comes from the World Bank. They have a wonderful data bank, they call it the World DataBank, which has indicators on almost every country around the world. You can pull up the Excel with the data or you can actually look at charts, we'll draw the chart for you with these different indicators, and you can pick almost any country for this. So here, what I'm showing you is the United States, and I'm showing you three different indicators during this period which goes back to the early 90s. You can see that GDP growth is the the blue line. Okay. The inflation rate is the red line. And the unemployment rate is the green line. Okay. So, we would expect, again, I don't have output gaps here, I don't have potential GDP. We're just looking at what was observed in the economy. You can see GDP growth being quite high right at the end of the 90s. And you can see at that same time, can you see how unemployment is going down and inflation is going up, just as we've predicted in the business cycle that we've just drawn. Then you can look at the crisis again, looking at the blue line, you can see the crisis of starting in 2008, you can see how GDP growth goes down. Look at how inflation goes down at the same time, as we predicted, and unemployment goes up very high. So, you know, even though all of these things don't always work perfectly, you can actually observe these characteristics of the business cycle happening here. Let me see if I can get Germany for us as well, here. So, looking at the German data, you can see their unemployment rate is up there at the top. Okay. And then you can see their GDP growth is that blue line, and their inflation rate is the red line. And again, you can see that when they're growing relatively fast, look for example at about 1999-2000, they're growing relatively fast. You can see that unemployment comes down. And you can see inflation accelerating at that point. Probably they had an inflationary gap. Then you look at the crisis, you can see GDP growth going way down, actually becoming quite negative. And you can see that the inflation rate went down, okay, which is what we predicted. However, something funny happens here, which is that unemployment goes down, okay? And that has to do structural factor, structure reforming the economy, and we'll talk about that later on. But anyway, you can broadly see these relationships that we just talked about occurring. It's so typical that we actually have a concept, a, a name to refer to this relationship between inflation and unemployment, which is the Phillips curve. The Phillips curve shows inflation on the vertical axis, unemployment on the horizontal axis. And it actually draws, over time, in many countries, although it's not very stable, a downward sloping curve, which shows as unemployment goes down, inflation goes up. As unemployment goes up, inflation goes down. And we can move along that curve from left to right in a fairly reliable way in the short run, showing the relationship between these indicators. [MUSIC]
