Economic Fluctuations and Unemployment Notes

Introduction to Economics: Economic Fluctuations and Unemployment

A. Introduction

  • This unit discusses how individual decisions depend on economic conditions like prices and unemployment, and how these decisions affect firms' investment decisions.

  • It explores how households and firms respond to economic conditions and what indicators can be used to measure these conditions.

B. The Business Cycle

  • Business cycle: Alternating periods of positive and negative growth rates.

  • Recession: A period when output is declining or below its potential level.

  • The business cycle affects labor market outcomes, indicating that economic growth is not a smooth process.

  • Okun’s Law: A strong and stable relationship between unemployment and GDP growth.

    • Changes in GDP growth rate are negatively correlated with the unemployment rate.

    • Output falls →\rightarrow Unemployment rises →\rightarrow Well-being falls.

    • Okun’s coefficient: Degree of correlation between GDP growth and unemployment.

C. Measuring the Aggregate Economy

  • National accounts: A system used to measure overall output and expenditure in a country.

  • Three equivalent ways to measure GDP:

    1. Total spending on domestic products.

    2. Total domestic production (measured as value added).

    3. Total domestic income.

  • The circular flow model demonstrates this equivalence.

  • Accounting for international transactions:

    • Exports (X) are included and imports (M) are excluded from GDP so that GDP includes value added, income from, or consumption of, domestic production.

  • Incorporating government:

    • Government is treated as another producer; public services are "bought" via taxes.

    • Assume that the cost of production captures the value added.

  • Components of GDP:

    • Consumption (C): Expenditure on consumer goods and services.

    • Investment (I): Expenditure on newly produced capital goods, including equipment, buildings, and inventories (unsold output).

    • Government spending (G): Government expenditure on goods and services, excluding transfers to avoid double-counting.

    • Net exports (trade balance): Exports (X) minus imports (M).

    • GDP = C + I + G + X – M (Also known as Y, or aggregate demand).

  • Typical GDP component percentages:

    • Consumption (C) is the largest share of GDP in most countries.

    • Examples:

      • US: Consumption (C) = 68.4%, Government spending (G) = 15.1%, Investment (I) = 19.1%, Change in inventories = 0.4%, Exports (X) = 13.6%, Imports (M) = 16.6%

      • Eurozone: Consumption (C) = 55.9%, Government spending (G) = 21.1%, Investment (I) = 19.5%, Change in inventories = 0.0%, Exports (X) = 43.9%, Imports (M) = 40.5%

      • China: Consumption (C) = 37.3%, Government spending (G) = 14.1%, Investment (I) = 47.3%, Change in inventories = 2.0%, Exports (X) = 26.2%, Imports (M) = 23.8%

D. Economic Fluctuations and Consumption

  • Economies fluctuate between good and bad times, applicable to both industrialized and agrarian societies.

  • Shock: An unexpected event (e.g., extreme weather) that causes GDP to fluctuate.

    • Two types of shocks:

      1. Shocks that affect individual households.

      2. Shocks that affect the entire economy.

  • Strategies to deal with household-specific shocks:

    1. Self-insurance: Saving and borrowing without involving other households.

    2. Co-insurance: Support from social network or government; reflects household preference to smooth consumption and altruism.

  • Economy-wide shocks:

    • Co-insurance is less effective but more necessary when the shock hits everyone simultaneously.

    • Historically, farming economies practiced co-insurance based on trust, reciprocity, and altruism.

  • Consumption smoothing: Households make lifetime consumption plans based on future expectations and react to shocks.

    • Readjust long-run consumption if shocks are permanent.

    • Do not change long-run consumption if shocks are temporary.

  • Consumption smoothing is a basic source of stabilization in an economy, but its limitations can amplify initial shocks.

    • Limitations: credit constraints, weakness of will, limited co-insurance.

E. Economic Fluctuations and Investment

  • Firms adjust investment plans to both temporary and permanent shocks to maximize profits, unlike households' preference for smoothing.

    • High demand leads to high capacity utilization, which encourages investment, further increasing demand.

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

  • Investment as a coordination game:

    • Actors: Two firms.

    • Actions: Invest or Do not invest.

    • Information: Decisions are made simultaneously.

    • Payoff: Profits from investment.

    • Investment is the best response to other firms’ investment.

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

  • Coordination of investment makes cycles self-reinforcing.

  • Firms respond positively to the growth of demand in the economy, making investment more volatile than GDP.

  • Government spending is less volatile than investment as it does not depend on business confidence.

  • Exports depend on demand from other countries and fluctuate with the business cycles of major export markets.

F. Inflation

  • Inflation: An increase in the general price level in the economy.

  • Inflation tends to be lower during recessions (high unemployment).

  • Trends in inflation:

    • Upward spikes during economic crises.

    • General downward trend since the 1970s.

    • Inflation tends to be higher in poorer countries than in richer countries.

  • Measuring inflation:

    • Consumer Price Index (CPI): Measures the general level of prices consumers pay for goods and services, including consumption taxes, based on a representative bundle of consumer goods ("cost of living").

      • Common measure of inflation = change in CPI.

    • GDP deflator: Measures the level of prices for domestically produced output (ratio of nominal to real GDP).

      • Tracks prices of components of GDP (C, I, G, NX).

      • Allows GDP to be compared across countries and over time.

Summary

  1. Economic growth is not a smooth process; the economy goes through a business cycle.

    • Households try to smooth their consumption over the business cycle, but face problems like credit constraints.

    • Investment is more volatile than GDP and is the outcome of a self-reinforcing coordination game.

    • Inflation moves with the business cycle.

  2. System of national accounts is used to measure the economy.

    • GDP = C + I + G + X – M.

    • GDP is measured as income, spending, and production.