Economic Fluctuations and Unemployment - unit 13

Economic Fluctuations and Unemployment

Overview

This unit explores economic fluctuations, unemployment, and how these relate to the business cycle. It covers GDP, its components, and how households and firms make decisions that influence economic stability.

Key Objectives

• Understand GDP and its components.
• Understand how households smooth consumption in response to income shocks.
• Understand the role of firms' investment decisions in the business cycle.

Core Concepts

• Fluctuations in GDP affect unemployment.
• Households use saving, borrowing, and social support to smooth consumption.
• Investment spending is more volatile than consumption.
• Unemployment is a major source of unhappiness, reducing self-esteem and overall well-being.

Economic Growth Trends

• Most economies grow over the long term, but the average growth rate varies.
• The natural logarithm of GDP per capita helps visualize the pace of growth, revealing whether the economy grows at a steady pace, accelerates, or decelerates.

The Business Cycle

• Economic growth is not a smooth process; economies experience booms and recessions.
• The business cycle involves movements from boom to recession and back to boom.

Business Cycles and Unemployment

• There is a causal relationship between the business cycle and unemployment.
• Unemployment rates vary over the business cycle, increasing during recessions and decreasing during booms.

Defining the Business Cycle

• Business cycle: Alternating periods of positive and negative growth rates.
• Recession: A period when output is declining or below its potential/normal level, typically associated with higher unemployment rates.

Okun's Law

• Okun's Law describes the relationship between output growth and changes in the unemployment rate. The law can be expressed as: $\Delta u<em>t = \alpha + \beta g</em>{Yt}$
  • $\Delta u_t$: change in unemployment rate at time t.
  • $g_{Yt}$: real GDP growth at time t.
  • $\alpha$: intercept value.
  • $\beta$: coefficient indicating the predicted effect of real GDP growth on changes in the unemployment rate.

Measuring the Aggregate Economy

• Aggregate statistics describe the economy as a whole.
• Aggregate output (GDP) represents the total output of all producers in a country.

GDP: Nominal vs. Real

• Nominal GDP: Sum of the quantities of final goods produced multiplied by their current price. Increases over time due to increased production and rising prices.
• Real GDP: Sum of the quantities of final goods multiplied by constant (not current) prices. Indicates whether the economy produced more goods and services.

Calculating GDP

There are three equivalent ways to measure GDP:

1. Total domestic production (measured as value added):
2. Total spending on domestic products:
3. Total domestic income:
   • Sum of all incomes received, including wages, profits, incomes of the self-employed, and taxes received by the government.

Expenditure Approach: Components of GDP

• Consumption (C): Expenditure on consumer goods and services.
• Investment (I): Expenditure on newly produced capital goods, including equipment and buildings.
• Government spending (G): Government expenditure on goods and services (excluding government transfers and interest payments on government debt).
• Net exports (X-M): Difference between exports and imports; also called the trade balance.
  • Imports (M): Purchases of foreign goods and services.
  • Exports (X): Purchases of domestic goods and services by foreigners.

Trade Balance

• Deficit: X - M < 0
• Surplus: X - M > 0

GDP Equation

• The total income/production (GDP) can be written as:
  $Y = C + I + G + (X - M)$

Components of GDP: Global Perspective

• In most countries, private consumption makes up the largest share of GDP.

Contributions to GDP Growth

• Example: Contributions to percentage change in real GDP in the US in 2009.
  • GDP: -2.8
  • C: -1.06
  • I: -3.52
  • G: 0.64
  • NX: 1.14
• Investment had a more significant effect on GDP than consumption.
• Government expenditure contributed positively due to fiscal stimulus programs.
• Net exports contributed positively due to a fall in import demand and stronger performance of emerging economies.

Considerations when using GDP

• GDP is a conventional measure of the size of an economy.
• Distinguish aggregate GDP from GDP per capita.
• GDP per capita is a flawed measure of living standards.

Shocks and Economic Fluctuations

• Shock: An unexpected event that causes GDP to fluctuate.
• Types of shocks:
  • Idiosyncratic: Impacts individual households.
  • Aggregate: Impacts the entire economy.

Examples of Aggregate Shocks

• Potato blight in Ireland (1845-1846).
• Failure of Lehman Brothers (2008).
• Failed rains in eastern and southern Africa.
• Coronavirus pandemic.

Household Responses to Shocks

• Self-insurance: Saving and borrowing without involving other households.
• Co-insurance: Support from social network or government.
• Households prefer to smooth consumption and are altruistic.

Smoothing Consumption: A Model

• Maximize utility $U(c<em>0, c</em>1)$ derived from consumption today ($c<em>0$) and consumption tomorrow ($c</em>1$).
• Budget constraint today: $c<em>0 = y</em>0 - s$
• Budget constraint tomorrow: $c<em>1 = y</em>1 + s(1 + r)$

Substituting for savings s:

$c<em>0 + \frac{c</em>1}{1+r} = y<em>0 + \frac{y</em>1}{1+r}$

Consumption Smoothing

• Households make lifetime consumption decisions based on lifetime income.
• Adjust long-run consumption if shocks are permanent.
• Do not change long-run consumption if shocks are temporary.

Limitations to Consumption Smoothing

• Consumption smoothing is a stabilization factor, but limitations can amplify shocks.
• Credit constraints: Limits on borrowing ability.
• Weakness of will: Inability to commit to beneficial future plans.
• Limited co-insurance:

Smoothing Consumption with Credit Constraints

Suppose there is an increase in $y_1$

Economic Fluctuations and Investment

• Investment decisions depend on firms' expectations about future demand.

Investment Cycle

1. High capacity utilization and high profits.
2. Firms invest and hire.
3. Higher spending by firms and workers.
4. High demand for the firm's products.

Investment as a Coordination Game

• Actors: Two firms.
• Actions: Invest, or Do not invest.
• Information: Decide simultaneously.
• Payoff: Profits from investment.
• Investment is the best response to other firms’ investment (coordination game).

Business Confidence

• Business confidence coordinates firms to invest at the same time.

Investment and the Aggregate Economy

• Coordination benefits make cycles self-reinforcing.
• Firms respond positively to the growth of demand in the economy.
• Investment is more volatile than GDP.

Other components of GDP

• Government spending is less volatile than investment because it does not depend on business confidence.
• Exports depend on demand from other countries and fluctuate according to the business cycles of major export markets.

Key Takeaways

• Economic growth is not smooth.
• GDP can be measured by income, spending, and production.
• Households smooth consumption, but there are limitations.
• Investment is more volatile than GDP due to coordination.