Ways that illuminate economic fluctuations

→ Fluctuations in total output (GDP) affects unemployment
→ Size of the economy is measured using national accounts
→ Households respond to shocks by saving, borrowing and sharing
→ These strategies aren’t efficient to eliminate shocks because of the limit on
→ Investment spending by firms & households fluctuates more than consumption
Reverse Causality: A two-way causal relationship where A affects B and B also
affects A.
Linear Regression Line: The best-fitting line through a set of data.
Correlation: A statistical association in which knowing the value of one
variable provides info on the likely value of the other (e.g. both are high, etc.)
Correlation may not be causation because there may be a third factor that accounts
for correlation. To establish causal relationships, experiments are used or natural
experiments are exploited.
● Losing your job hurts – it causes stress (higher unemployment is related to
higher stress)
Correlated: knowing the value of one variable provides information on the
likely value of the other.
● It can be positive or negative
● It does not mean that there is a causal relationship between the variables
Linear regression line: the best-fitting line through a set of data.
● When a line of best fit is upward-sloping it says that higher values of the
variable on the horizontal axis are associated with higher values of the
variable on the vertical axis
● The compensation needed to restore wellbeing is an enormous amount, much
greater than the monetary loss associated with a spell of unemployment
13.1 Growth and fluctuations
Logarithmic Scale: A way of measuring a quantity based on the
logarithm function, f(x)=log(x).
Gross Domestic Product (GDP): A measure of the market value of the
output of the economy in a given period.
Recession: A period when output is declining or is below its potential
Business cycle: Alternating periods of positive and negative growth
● Economies in which the capitalist revolution has taken place have
grown over the long run. EJEMPLO GPD CORE DEL SUR Y NIGERIA
EN 1950
● Growth has not been smooth. POCO A POCO
● Downturns in the business cycle and rising unemployment are
● Economies can be going through a boom or a recession as growth
swings from positive to negative
● When reviewing GDP over a period and considering growth, using a log
variable/ ratio scale on the vertical axis can make the data much
○ The line of best fit represents the average annual growth rate.
● It is over once the economy begins to grow again, or when it goes back
to the normal output.
○ Hard to define what “normal output” is.
● Economic growth is not smooth and economies go through booms and
recessions as growth swings from positive to negative.
● Recession can be defined in two ways PRODUCCION DISMINUYE:
○ NBER definition: Output is declining. (The recession is over
once the economy begins to grow again).
○ Alternative definition: The level of output is below its normal
level, even if the economy is growing. (The recession is not over
until output has grown enough to get back to normal).
This definition is a matter of judgement (and thus controversy).
● The movement from the boom, to the recession, and back to boom is
known as the business cycle.
● There is a yearly change in GDP, in which recessions measured by
negative growth seem to happen about twice every 10 years.
● There are less frequent episodes of much larger fluctuations in output
● Unemployment varies over the business cycle.
● Downturns in the business cycle and rising unemployment are
Okun’s Law: Changes in the rate of GDP growth are negatively
correlated with the unemployment rate. (shows the relationship between
unemployment and GDP growth).
Okun’s Coefficient: Degree of correlation.
➔ Relationship between output, unemployment and well-being:
Output falls -> Unemployment rises -> Well-being falls.
13.2 Output growth and changes in unemployment
Unemployed are the people who:
● Were without work during the last four weeks, which means they
were not in paid employment or self-employment
● Were available for work
● Were seeking work, which means they had taken specific steps in
a specified recent period to seek paid employment or
The population of working age: all people aged between 15 and 64 years
● It is divided into two parts – the labour force, and those out of the labour
Labour force: the number of people who are or wish to be in paid
● People out of the labour force are not employed or actively looking for
● Okun’s law is used to show the relationship between output and
unemployment fluctuacion.
○ Okun noted that when a country’s output growth was high,
unemployment tended to decrease.
● Okun’s law has been a strong and stable empirical relationship in most
economies since WW2.
● Okun’s coefficient represents how a change in the output growth rate
will affect the unemployment rate:
○ Eg: The US has an Okun coefficient of -0.38 meaning that a
1% increase in the output growth rate decreases employment
by 0.38%.
● Okun’s law does not always hold perfectly:
○ In 2009, Spain, Japan and the US saw an increase in
unemployment that was higher than predicted.
○ Germany, however, saw a smaller change in unemployment (a
desirable result that economic policymakers would aim to
● Developing countries were hit less hard by the 2008 crisis than the
advanced economies.
● The relationship between output, unemployment and wellbeing can be
shown as follows:
13.3 Measuring the aggregate economy
● Economists use aggregated statistics to describe the economy as a
● The aggregate output (GDP) is the output of all producers in a country.
● The national accounts are statistics published by national statistical
offices that use information about individual behaviour to construct a
quantitative picture of the economy as a whole.
● There are 3 different ways to estimate GDP:
○ Spending
The total spent by households, firms, the government, and residents of other
countries on the home economy’s products.
○ Production
The total produced by the industries that operate in the home economy. This is
measured by value-added (value of output – costs of goods and services used
as inputs) by each industry to prevent double-counting.
○ Income
The sum of all incomes received, comprising wages, profits, the incomes of
the self-employed and taxes received by governments.
● The relationship between spending, production, and incomes in the
economy as a whole can be represented as a circular flow.
○ The national accounts measurement can be taken at the
spending stage, production stage or income stage.
● In theory, these should be the same and so the point at which
measurement is taken should not matter.
○ This is because any spending on a good or service, which must
have been produced, is income for whoever sold that output.
● Households and firms both receive income and spend it.
● The circular flow between households and firms (ignoring the
government and foreign interactions) is shown as follows:
● While one person’s expenditure is always another person’s income,
those people may be in two different countries:
○ This is the case with imports and exports.
● GDP is a domestic product and therefore exports are included in GDP;
imports are not.
● While public services that the government provides may not be explicitly
paid for, we can think of these as being paid for with tax, which
households paid to the government (although the services received and
tax paid will not necessarily correspond).
○ In this way, the government can be seen as a producer.
● We assume that government production is equal to the amount it costs
the government to produce (because public services are not sold in the
● Recessions are described as periods of negative output growth, but this
means that they must also be periods of negative expenditure
growth – people are buying less.
13.4 Measuring the aggregate economy: The components of GDP
● Consumption includes the goods and services purchased by
● Goods are normally tangible things.
● Durable goods last for longer than 3 years eg. a car or furniture.
● Non-durable goods last for shorter periods.
● Services are intangible things that households buy eg. gym membership
& medical care.
● Household spending on durable goods is counted as consumption in
the national accounts, although in economic terms these decisions are
more like investment decisions.
● This is the spending by firms on new equipment and new commercial
buildings, and spending on residential structures.
● Investment in the unsold output that firms produce recorded as the
change in inventories or stocks in the national accounts.
○ Including this is essential to ensuring that when we measure GDP
by the output method, it is equal to GDP measured by the
expenditure method.
● This represents the consumption and investment purchases by the
government (central and local government).
● Government consumption purchases are of goods and services.
○ Eg: Office equipment, cars, software, wages of civil servants and
○ Much of this is on health and education.
● Government investment spending is on the building of roads, schools
and defence equipment.
● Government transfers in the form of benefits and pensions are not
included here because households receive them as income.
○ When they are spent, they are recorded as CorI.
● Domestically produced goods and services that are purchased by
households, firms and governments in other countries.
● Goods and services purchased by households, firms and governments
in the home economy that is produced in other countries.
● This is the difference between the values of exports and imports.
● It is also called the trade balance.
● If this value is positive, it is called a trade surplus.
● If this value is negative, it is called a trade deficit.
➔ GDP (Y)
● In most countries, private consumption spending makes up the largest
share of GDP; investment spending accounts for a much smaller share.
● Percentage change in GDP:
○ (%Δ in consumption x share of consumption in GDP + (%Δ in
investment x share of investment in GDP) + (%Δ in govt.
spending x share of govt. spend. in GDP) + (%Δ in net exports x
share of net exports in GDP)
● Shortcomings of a GDP measure include:
○ It is a conventional measure of the size of an economy.
■ EJ: Environmental degradation is not taken into account.
○ Aggregate GDP does not always correlate to GDP per capita.
■ Migration may take place.
○ GDP per capita is a flawed measure of living standards.
13.5 How households cope with fluctuations BUENAS Y MALAS
● Economies fluctuate between good and bad times.
● GDP can also be divided into different components from the production
side (before we divided it into components on the expenditure side),
namely: Agriculture, Industry and Services.
○ The agricultural sector is by far the most volatile.
● In an agrarian economy, the weather, war and disease are all major
causes of good and bad years.
● The term shock is used in economics to refer to an unexpected event
eg. extreme weather.
● People think about the future, anticipate that unpredictable events may
occur, and usually act on these.
○ In a modern economy, this is the basis of the insurance industry.
● When considering how households in an agrarian economy cope with
fluctuations that cut their income in half from one season to the next, we
can distinguish between 2 situations:
○ Good or bad fortune strikes the household: Eg. A family
member becomes ill.
○ Good or bad fortune strikes the economy as a whole: Eg.
Drought, floods, disease.
People use 2 strategies to deal with shocks that are specific to their
○ Households that encounter unusually high income will save so
that when they need to, they can spend the savings.
○ Depending on credit-constraint, they may borrow in bad times.
○ Households that have been fortunate in a particular period can
help those hit by bad luck.
■ This is sometimes done among extended families, friends
or neighbours.
○ This has now taken the form of paying taxes, which pay
unemployment benefits.
● Informal co-insurance among family and friends is based on both
reciprocity and trust: you are willing to help those that have helped you
and trust others will do the same.
● Altruism towards those in need is usually involved, although
co-insurance can work without it.
● These strategies reflect 2 important aspects of household preferences:
○ People prefer a smooth pattern of consumption.
■ People dislike fluctuations in consumption as a result of
shocks and thus self-insure.
○ Households are not solely selfish.
■ They are willing to co-insure to provide support to each
other to help smooth the effect of good and bad luck,
trusting that others will do the same.
● Co-insurance is less effective if the bad shocks hit everyone at the
same time.
○ When a flood, drought or earthquake hits, it is more difficult for an
agrarian economy to protect the wellbeing of the people who are
● But when these shocks hit, co-insurance may be even more necessary,
because community survival requires that less badly hit households
help the worst-hit households:
○ In Farming economies of the past, people practised co-insurance
based on trust, reciprocity and altruism.
13.6 Why is consumption smooth?
● A basic source of stabilisation in any economy comes from the desire of
households to keep their level of consumption constant.
○ This requires households to plan and then borrow or save to
smooth the bumps in income (self-insurance).
● People prefer to smooth their consumption because there are
diminishing marginal returns to consumption at any given time.
● To visualise this behaviour, we can focus on predictable events.
● A person contemplating a future promotion and planning their spending
may be interested in moving consumption forward.
● The following shows the individual’s tendency to smooth consumption
Income over time
The blue line shows the path of
income over time: it starts low,
rises when the individual is
promoted and falls at retirement.
Consumption expenditure
This is the red line. It is smooth
(flat) from the point at which the
individual first gets a job.
The individual borrows while young
At this time income is low. The individual saves and repays the debt
when older and earning more, and finally runs down savings after
retirement when income falls again.
● Consumption changes before income do (assuming the individual
can borrow).
● The individual may be able to get a mortgage and live in a nice
house from earlier on (and then pay it off later).
This model of decision making highlights the desire of households for a
smooth consumption path.
● When considering what will happen is something unexpected occurs to
disturb the lifetime consumption plan, the model suggests the following:
○ The individual will make a judgement.
● This will be about whether the shock is temporary or permanent.
o If the shock is temporary: Little will change.
● A temporary fluctuation will not affect the lifetime consumption plan
○ If the shock is permanent:
■ The red line (lifetime consumption level) will be adjusted up
or down to reflect the new level of consumption.
● A household’s consumption smoothing may be limited by the following
○ Individuals/households not being able to implement long-term
consumption plans.
■ A lack of information may make this impossible.
■ Even with informtfation, it may be difficult to predict what
the future holds.
○ Credit constraints/ credit market exclusion.
■ Some families may not be able to borrow when their
income has fallen.
○ Weakness of will
■ A characteristic of human behaviour that leads people to be
unable to carry out the plans that they know is best.
○ Limited co-insurance
■ Those with a fall in income may not be able to expect
support from others that are more fortunate than them.
● Houses with little money either cannot borrow at all or do so with
extraordinarily high-interest rates.
○ The people that need credit to smoothen their consumption the
most are often unable to do so.
● The following shows the difference between households that are able to
borrow and those that are not:
Income over time Consumption smoothing
The blue lines on the figure show
that the path of income over time is
the same in both households.
The red line in the top panel shows
that, in a consumption-smoothing
household, consumption changes
immediately once the household
receives the news.
The effect of credit constraints
On the other hand, a credit-constrained household that cannot borrow has to
wait until the income arrives before adjusting its standard of living.
Figure 13.11 Consumption when credit constraints bind: An
anticipated rise in income.
Same income in both periods
Consider a household that receives
the same income, y, this period and
next period, indicated by the
endowment point A.
An unconstrained household
The interest rate is r so if the
household can borrow and save,
then it can choose any point on the
budget constraint, which has the
slope −(1 + r).
An unconstrained household
The interest rate is r so if the
household can borrow and save,
then it can choose any point on the
budget constraint, which has the
slope −(1 + r).
A negative shock
Now suppose that the household
experiences an unexpected negative
temporary shock to its income this
year, such as a bad harvest, which
lowers this year’s income to y′,
leaving expected income next year
unaffected at y.
The budget constraint
If it can borrow and save, then its
budget constraint has a slope of −(1
+ r) and passes through point A′.
The highest indifference curve
The highest curve that touches this
budget constraint does so at point
A″, showing that the household
prefers to smooth consumption,
consuming c′ in both periods. The
household borrows c′ − y′ now and
repays (1 + r)(c′ − y′) next period
following the shock.
Figure 13.12 Credit-constrained and unconstrained households: An
unanticipated temporary fall in income.
Weakness of will
● This is the inability to commit to a course of action that one will regret
● Suppose an individual learns that income is going to fall in the future,
perhaps because of retirement, job loss, an economic crisis etc.
● The following graph shows how a forward-looking household will
behave, compared to a household with weakness of will:
● The problem of not being able to save differs from the problem of not
being able to borrow: saving is a form of self-insurance and does not
involve anyone else.
● Most households lack a network of family and friends who can help out
in substantial ways over a long period when a negative income shock
○ Unemployment benefits provide this kind of co-insurance, but the
coverage of these policies can be very limited.
● The initial shock in income may be multiplied/ amplified by the fact that
families are limited in their ability to smooth consumption.
13.7 Why is investment volatile?
● Households tend to smooth consumption spending where possible, but firms
do not smooth investment spending.
○ They increase their PPE whenever they see an opportunity to make
● Unlike most consumption expenditure, investment expenditure can be
postponed and this is likely to produce clusters of investment projects at some
times and few at other times.
● When an innovation is introduced, firms using new technology can produce
output at a lower cost or higher quality.
○ They expand their share of the market.
● Firms that fail to follow may be forced out of business.
● As firms install new technologies (new equipment and machines), there will be
investment boom.
● This will be amplified if the firms producing the machinery and equipment
need to
expand their own production facilities to meet the extra demand.
● Investment by one firm pushes other firms to invest so they don’t lose their
market share
● Investment by one firm can also pull other firms to invest by helping to
increase their markets and potential profits.
● Over-investment can occur if there is irrational exuberance, leading to share
growing unsustainably and an eventual crash.
● Credit constraints also contribute to the clustering of investment projects and
the volatility of the aggregate investment.
● In a buoyant economy, profits are high and external finance from sources
outside the firm is easier.
○ Both of these can be used to finance investment projects.
● Consider a local economy comprising of 2 firms.
● Firm A’s machinery and equipment are not fully used – it could produce more
if it hires more employees.
● There is not enough demand to sell the products it would produce.
○ This is called low capacity utilization.
● The owner of Firm A has no incentive to higher more people or invest in new
● Firm B has the same problem.
● Together, the firms are part of a vicious circle:
● If A and B decide to invest and hire at the same time, there would be more
employees (who spend money), increasing the demand for the products of
both firms.
● Profits would rise in a virtuous cycle as follows
● These cycles highlight the role of expectations of future demand, which
depend on the behaviour of other actors.
● This can be considered with game theory as follows:
○ The actors–The 2 firms.
○ The actions they take – Invest or do not invest.
○ The information they have – They decide simultaneously i.e. they do
not know what the other has decided.
○ The payoff–The increased /decreased profits.
● There are 2 Nash equilibria – when the firms both make the same action.
○ Neither firm has a dominant strategy.
● This explains why investment tends to fluctuate a lot and why the virtuous and
vicious cycle is reinforcing – if owners think that other firms will invest they will
also invest and vice versa.
● The (10,10) Nash equilibrium is not Pareto efficient – both firms a=have low
capacity utilization and low hiring and investment.
○ Both firms could make higher profits at (100,100).
● This situation is a coordination game – a game in which there are 2 Nash
equilibria and one may be Pareto superior to the other.
● To move from the vicious cycle to the virtuous cycle, the firms need to
coordinate somehow or develop optimistic beliefs about what the other will do
i.e. business confidence.
● Government policy can be used to shift an economy from the
Pareto-inefficient outcome to the Pareto efficient outcome.
● Investment spending by firms will respond positively to the growth of demand
in the economy (in general).
● Business confidence indicators move closely with aggregate demand.
● Investment is much more volatile than consumption and consumption is less
volatile than GDP.
○ Consumption being less than GDP is less evident in middle-income
countries, perhaps due to credit-constraints making people less able to
smooth consumption.
● Government spending does not respond to innovation, so it’s less volatile than
● Demand for exports will fluctuate with the business cycle in other countries,
especially in response to booms and recessions in the countries that are large
export markets.
13.8 Measuring the economy: Inflation
● Inflation is an increase in the general price level in the economy, usually
measured over a year.
○ “Deflation” occurs if prices fall.
● Upward spikes in inflation have tended to occur in periods of economic crisis.
● Inflation rates have generally declined across the world since the 1970s.
● Inflation tends to be higher in poorer countries.
● An increase in the price of a product could be due to inflation, or it could be
that the specific product has become relatively more expensive (due to a
rightward shift in the demand curve or a leftward shift in the supply curve).
● The CPI measures the general level of prices that consumers have to pay for
goods and services, including consumption taxes.
○ The chosen goods and services reflect the spending of a typical
○ The goods and services are weighted according to the fraction of
household spending they account for.
● The GDP deflator is a price index that tracks the changes in prices of all
domestically produced final goods and services.
● The GDP deflator tracks the price changes of the components of domestic
GDP o Itincludesexportsandexcludesimports.
● The GDP deflator can also be expressed as the ratio of nominal (current
price) GDP to real (constant price) GDP.
○ This tool is therefore commonly used to transform a nominal GDP
series into a real GDP series.
13.9 Conclusion
In this unit, we have introduced two essential tools for understanding the economy:
the national accounts used to measure aggregate economic activity, and a set of
models that allow us to organize the data in ways that illuminate economic
fluctuations. Economists are often asked to provide forecasts about the future
development of the economy, and they use both data and models to do this. We
have learned in this unit that households and firms make forecasts when deciding on
their spending.
In the following two units, we focus on government policy. We shall see that in order
to make good forecasts and good policies, the government and central bank need to
take into account how households and firms think about the future and what may
disrupt their plans.

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