economic fluctuations Flashcards
In economics, what does the term “shock” refer to?
An unexpected event, such as a war, natural disaster, or sudden economic change.
What are the two types of fluctuations households must cope with?
Shocks to the individual household (e.g., illness, injury)
Shocks to the entire economy (e.g., drought, war, flood)
What is self-insurance?
When households save during good times to support themselves during bad times; may also involve borrowing.
What is co-insurance?
When fortunate households help less fortunate ones—informally through family/friends or formally through taxes and public benefits.
What makes informal co-insurance work?
Reciprocity, trust, and sometimes altruism—helping others who have helped you or who might return the favor.
What two preferences drive these coping strategies?
A desire for smooth consumption (avoid income-related consumption swings)
A willingness to help others and trust in social reciprocity
Why is co-insurance less effective during economy-wide shocks?
Because everyone is affected at the same time and no one is in a position to help.
Why do households try to keep consumption smooth?
To stabilize their standard of living despite fluctuating income—this is called self-insurance.
How do households achieve smooth consumption?
By planning, saving, and borrowing over time to even out income ups and downs.
What is the purpose of consumption smoothing in an individual’s lifetime?
To maintain a stable consumption level by borrowing when young, saving when earning more, and using savings during retirement.
How do people react to unexpected events (shocks) in the consumption smoothing model?
If permanent: They adjust long-term consumption plans.
If temporary: Consumption changes little; the shock has a minor effect on lifetime consumption.
Why do economy-wide shocks not always lead to large changes in spending?
Because households base spending on long-term income expectations, not short-term fluctuations.
What are three key constraints on a household’s ability to smooth consumption?
Credit constraints (can’t borrow when income is low)
Weakness of will (trouble sticking to plans like saving)
Limited co-insurance (lack of support from others)
What are credit constraints?
When households cannot borrow freely to maintain consumption during low-income periods.
How does “weakness of will” limit consumption smoothing?
People fail to act on plans they know would benefit them, like saving for future shocks.
How do credit-constrained households react to expected future income increases?
They must wait until the income actually arrives to increase spending, unlike others who can borrow in advance.
What happens to credit-constrained households when they receive news of future income?
They cannot adjust consumption until the income actually arrives, so their standard of living changes later.
What is the slope of the budget constraint in a two-period model with borrowing/saving?
The slope is −(1 + r), where r is the interest rate.
What happens when a household faces a temporary negative income shock but can borrow?
They borrow now to smooth consumption across both periods, repaying the loan with future income.
Why is a smoothing household better off than a credit-constrained household?
Because they maintain stable consumption across periods, while credit-constrained households face sharp fluctuations
How does a temporary income change affect credit-constrained vs. unconstrained households?
It affects credit-constrained households more, as they must adjust consumption immediately.
What is weakness of will in consumption smoothing?
The inability to save even when people know they will need those savings in the future.
How does weakness of will differ from credit constraints?
Weakness of will is a behavioral issue preventing saving, while credit constraints prevent borrowing.
Why is co-insurance limited for most households?
They often lack friends or family able to provide long-term support, and public benefits like unemployment aid are limited.
What happens when households can’t smooth consumption?
Income shocks translate directly into consumption shocks, reducing demand and impacting other households in the economy.
Why is investment more volatile than consumption?
Unlike eating, investment can be postponed, causing firms to cluster projects during certain periods and delay during others.
How can one firm’s investment influence other firms?
It can push others to invest to stay competitive or pull them in by expanding the market and profit opportunities.
What can cause over-investment in machinery and equipment?
Peer influence among firms and overly optimistic expectations about future demand.
How do credit constraints affect investment volatility?
In good times, high profits and easier access to finance make investment more likely. In downturns, low profits and tighter credit reduce investment.
What is low capacity utilization?
When a firm’s machinery and equipment are underused, meaning it could produce more if demand justified it.
How can low capacity utilization lead to a vicious circle?
Firms don’t invest due to low demand, which keeps employment and income low, further reducing demand and profits.
What creates a virtuous circle in investment?
Positive expectations: Firms invest and hire, workers spend more, demand and profits rise, encouraging more investment.
What creates a vicious circle in investment?
Negative expectations: Firms don’t invest or hire due to low demand, keeping demand and profits low, which discourages investment further.
Name six barriers to consumption smoothing.
Can’t implement long-term plans
Lack of information
Can’t predict the future
Limited co-insurance
Weakness of will
Credit constraints
