ECON6049 ECONOMIC ANALYSIS, S1 2021

Week 8: Unit 13 –
Economic Fluctuations
and Unemployment

1
OUTLINE
A. The business cycle
B. Measuring the aggregate economy
C. Economic fluctuations and consumption
D. Economic fluctuations and investment
E. Inflation
 A. THE BUSINESS CYCLE
• Business cycle = Alternating periods of positive (expansions) and negative
(contractions/recessions) growth rates. The high point of an expansion in economic
activity is called the peak of a business cycle and the low point of a recession, a trough.
• Recession
i. The US National Bureau of Economic Research defines it as a period when output is
declining. It is over once the economy begins to grow again.
ii. An alternative definition is a period when the level of output is below its normal level,
even if the economy is growing. It is not over until output has grown enough to get back
to normal. The latter definition has the problem that the ‘normal’ level is subjective.
iii. In the business press a common working definition of recession is when a country
records 2 or more consecutive quarters of negative economic growth it is said to be in
“recession”.
• The business cycle affects labour market outcomes and unemployment.
FLUCTUATIONS GDP & UNEMPLOYMENT IN THE UK
 OKUN’S LAW
• Okun’s Law = a strong and stable relationship between unemployment and GDP growth.

• Okun’s coefficient = The change in the unemployment rate in percentage points

predicted to be associated with a 1% change in the growth rate of GDP.
• Changes in the rate of GDP growth are negatively correlated with the unemployment
rate.
• Output falls → Unemployment rises → Well-being falls
OKUN’S LAW
 B. MEASURING THE AGGREGATE ECONOMY
National accounts = system used to measure overall output and expenditure in
a country.
 Three equivalent methods to measure GDP
1. Total spending on domestic products: The total spent by households, firms,
the government, and residents of other countries on the home economy’s
products.
2. Total domestic production (measured as value added). Value added for a
production process is the value of output minus the value of all inputs (called
intermediate goods). The capital goods and labour used in production are not
intermediate goods. The value added is equal to profits before taxes plus wages.
3. Total domestic income is the sum of all the incomes received, comprising
wages, profits, the incomes of the self-employed, and taxes received by the
government.
https://www.abs.gov.au/statistics/economy/national-accounts/australian-national-accounts-
national-income-expenditure-and-product/dec-2020#key-statistics
 COMPONENTS OF GDP
• Consumption (C) = Expenditure on consumer goods and services (Households)
• Investment (I) = Expenditure on newly produced capital goods (incl. equipment,
buildings, and inventories = unsold output) (Firms)
• Government spending (G) = Government expenditure on goods and services,
excluding government transfers to avoid double-counting.
https://www.aph.gov.au/About_Parliament/Parliamentary_Departments/Parliamentary_Library/p
ubs/rp/BudgetReview202021/AustralianGovernmentExpenditure
• Net exports (trade balance) = Exports (X) minus imports (M)
https://data.oecd.org/chart/6k8d
GDP = C + I + G + X – M
(Also known as Y, or aggregate demand)
COMPONENTS OF GDP IN SELECTED COUNTRIES IN 2013
US Eurozone (19 China
countries)

Consumption (C)
68.4% 55.9% 37.3%

Government
spending (G) 15.1% 21.1% 14.1%

Investment (I) 19.1% 19.5% 47.3%

Change in
inventories 0.4% 0.0% 2.0%

Exports (X) 13.6% 43.9% 26.2%

Imports (M) 16.6% 40.5% 23.8%
 MEASURING GOVERNMENT EXPENDITURE
• Government expenditure excludes transfers.
• Government transfers, such as unemployment benefits and pensions, are spending by
the government in the form of welfare payments to households or individuals.
• Transfers are NOT included in government spending (G) in the national accounts
because they simply transfer spending power and are not directly involved in the
production of output.
• There is a great difference in the role of the government between Europe and the US
also when it comes to transfers.
• In 2012, total government spending including transfers was 57% of GDP in France,
compared to 40% of GDP in the US.
 COMPONENTS OF GDP GROWTH

• Although consumption makes up about 70% of US GDP, the effect of

investment on GDP was more than three times larger.
 ECONOMIC FLUCTUATIONS
India England

• Economic fluctuations can be measured on the expenditure side (C, I, G, NX),

or on the production side (agriculture, industry services)
• Agriculture is highly volatile though less so than in the past.
• We look at fluctuations on the expenditure side.
 C. ECONOMIC FLUCTUATIONS AND
CONSUMPTION
• Shock = an unexpected event which causes GDP to fluctuate.
• There are two broad types of shocks:
i. Good or bad fortune strikes the household.
ii. Good or bad fortune strikes the entire economy.
 HOUSEHOLD SHOCKS
• People use two strategies to deal with shocks that are specific to their
household:
1. Self-insurance:
• save during good times (spend during bad) & borrow during bad.
• Income protection insurance.
2. Co-insurance – support from government and sometimes social
network.
• This reflects that households prefer to smooth their consumption, and
that they are (to a degree) altruistic.
 ECONOMY-WIDE SHOCKS
• Co-insurance is less effective if the bad shock hits everyone at the same
time.
• But when these shocks hit, co-insurance is even more necessary.
• In farming economies of the past or peasant societies based in volatile
climates, people practised co-insurance based on trust, reciprocity, and
altruism.
• Community co-insurance (at least in some countries) has been replaced
with government safety nets such as unemployment benefits, pensions
(aged, disability etc.).
 SMOOTHING CONSUMPTION
Households make lifetime consumption plans based on
expectations about the future, and react to shocks:

• Readjust long-run consumption

(red line) if shocks are
permanent.
• Long-run consumption will
change little if shocks are
temporary.
 CONSUMPTION SMOOTHING AND THE AGGREGATE
ECONOMY
• Consumption smoothing is a basic source of stabilisation in an economy.
• Limitations to consumption smoothing mean it cannot always stabilise
the economy;
 credit constraints – poor can’t borrow during bad times.
 weakness of will – people value the present over the future so don’t save
enough.
 limited co-insurance – unemployment benefits are limited & in most
countries they don’t exist.
• This helps us understand the business cycle and how to manage it.
D. ECONOMIC FLUCTUATIONS AND
INVESTMENT
 VOLATILE INVESTMENT
• Firms don’t have preferences for smoothing
like households. Investment by one firm
induces other firms to invest
1. High (low) demand → high (low) capacity
utilization → ↑(↓) investment → even higher
(lower) demand.
2. Higher demand → higher profits → easier to
borrow or outsiders to invest.
• New technology can also induce firms to invest at
the same time, if lowers cost &/or provides better
goods & services to customers.
 BUSINESS CONFIDENCE
Eurozone
• Investment decisions depend on
firms’ expectations about future
demand
• Business confidence coordinates
firms to invest at the same time.

https://data.oecd.org/leadind/business-confidence-index-bci.htm#indicator-chart
 INVESTMENT AND THE AGGREGATE ECONOMY
• The benefits of coordinating
investment makes cycles self-
reinforcing.
• Firms respond positively to the
growth of demand in the economy
and negatively to slowdowns.
• This is why investment is more
volatile than GDP.
 OTHER COMPONENTS OF GDP

• Government spending is less volatile than investment (does not

depend on business confidence).

• Exports depend on demand from other countries, so will fluctuate

according to the business cycles of major export markets.
E. INFLATION
 INFLATION, GDP, AND UNEMPLOYMENT

• Inflation = an increase in the general

price level in the economy
• Inflation tends to be lower during
recessions (high unemployment)
 TRENDS IN INFLATION

• A pick of inflation during economic crises

• General downward trend since 1970s
• Inflation tends to be higher in poor than in rich countries
 MEASURING INFLATION
The Consumer Price Index (CPI) measures the general level of prices that
consumers have to 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 = A measure of the level of prices for domestically produced

output (ratio of nominal to real GDP)
• Tracks prices of components of GDP (C, I, G, NX)