Economic Fluctuations and Unemployment Flashcards
How to measure GDP
National Accounts: system used to measure overall output and expenditure in a country
Total spending on domestic products by households
Total domestic production (value added), (value of output-value of inputs)
Total domestic income: wages, profits, self-employed income, taxes received by gov’t
How do we account for international transactions?
Exports (X), produced in country consumed abroad
Imports (M), produced overseas, consumed domestically
How do we incorporate government?
Treat as producer, pay for services using taxes
GDP Equation
C + I + G + (X-M)
Consumption, C, goods and services purchased by households, tangible vs intangible (largest share)
Investment, I, spending by firms on new machinery, spending on residential structures, inventory (raw mats, unsold items)
Why count inventory? Equates GDP by expenditure method to output method
Government Spending, G, spending on goods, services: roads, schools, hospitals, military defence
Excludes government transfers - pensions and unemployment benefits, avoids double counting
Trade Balance (X-M): X-M<0 (trade deficit), X-M>0 (trade surplus)
GDP doesn’t account for environmental impacts, inequality or the informal care work
Inflation
An increase in the general price level in the economy, measured over a year (usually)
Deflation: a decrease in the general price level
Inflation Trends
Upwards spikes in periods of economic crisis
Downward trend worldwide since 1970s
Higher inflation in poor countries than in richer countries
Consumer Price Index, CPI
General level of prices that consumers have to pay for goods and services, including consumption taxes
Based on representative bundle of consumer goods, cost of living
Excludes exports, include imports, exports aren’t consumed by residents
Measured as ((CPIt-CPTt-1)/(CPIt-1))*100, percentage change in CPI = Inflation
GDP Deflator (output method)
measure of the levels of prices for domestically produced output (ratio of nominal to real GDP)
Tracks prices of GDP components
Allows GDP to be compared across countries and over time
(GDPnominal/GDPreal)*100
Why do we measure inflation?
Want to know what has changed in the economy in real terms
Need inflation to compare aggregate variables at different points in time
Country comparison
Time period comparison
Short run fluctuations in GDP
Business cycles: Alternating periods of positive and negative growth rates
Recession: period when output is declining or below its potential level
Alternative definition: significant decline in economic activity spread across the economy that can last from a few months to more than a year
The decline has to be prolonged and widespread: visible in real GDP, real income, employment, industrial production and wholesale-retail sales
Why do we care about recessions?
Good indicator of the actions of each agent in the economy
Central bank cutting IR in order to encourage spending
Firms and households, would want to know about changes in IR in advance to plan spending and investment decisions
Governments also need to know in order to know where to target spending
Okun’s law
Change in unemployment = a + beta(real GDP growth)
R^2 measures how well the Okun’s law fits the data
Households and Fluctuations
Shock: unexpected event (such as extreme weather) which causes GDP to fluctuate
Household shock (only one entity is affected, not economy wide), ways households can try and build safety nets:
Self insurance: saving and borrowing. Other households are not involved in this process, such as using the stock market
Co-insurance: support from social network (extended family), help to recover or gov’t (unemployment benefit), such as private health insurance, they are gathering money from a network of customers
Informal co-insurance is based in reciprocity and trust, altruism is usually involved
Households prefer consumption smoothing and that they are altruistic
Economy-Wide shocks
Co-insurance is less effective if bad shocks hits everyone at the same time
But is more important as badly affected households need to help those hit even worse
Large role of trust, reciprocity and altruism:
Variable rainfall and weather
Consumption Smoothing
Diminishing marginal returns to consumption
MRS changes as you move along the curve
Pure Impatience
Characteristic of a person who values an additional unit of consumption now over an additional unit later, when the amount of consumption is the sae now and later
Myopia: present satisfaction of desires are stronger than the satisfaction at a future date
Prudence: uncertainty about being around in the future, hence present consumption may be a good idea
Smoothing and Economy
Consumption smoothing is a basic source of stabilisation in the economy
Limitations mean it is unable to always stabilise the economy, it may amplify the shock as:
Lack of information: difficult to change if shock is permanent or temporary
Credit constraints
Weakness of will
Limited co-insurance
Consumption smoothing households => consumption changes immediately after news
Credit constrained HH => no borrowing/wait until income changes
Weakness of will limitation
Inability to commit to beneficial future planes
Inability to save to smooth consumption
Using nudges to push people to do the right thing, behavioural econ
Pension, opt in vs opt out system
Opt in became the default setting for pension plans, had to deliberately choose to opt out
Limited Co-Insurance
Networks of family and friends helping and unemployment benefits provided by the government
Example of co-insurance, Germany 2009:
Had a large recession, but low unemployment
German gov’t paid a portion of workers’ incomes
Workers’ worked fewer hours but there was few layoffs
What happens when you have these limitations
A change in income will lead to an equal change in consumption
A negative income shock, such as the loss of a job, will be passed onto other families who produce and sell the goods which aren’t demanded
Investment volatility
Firms don’t have preferences for smoothing like households
They adjust investment plans to shocks to max profits, inv decisions depend on firm’s expectations about future demand
Therefore investment occurs in waves and is very volatile
Push Factors
Innovation at firm level => low cost or higher value production => market share => forces some other firms out the market
Too keep up other firms install the new machines => investment boom as they need to expand their own production
Investment by one firm pushes other firms to invest
Credit constraints:
Another reason for the clustering of investment projects and the volatility of aggregate investment:
In a buoyant economy, profits are high and firms can use these profits to advance production
Pull Factors
Firm A decide whether to fully utilise their physical capital
Leads to no incentive to hire more workers to add machinery
Means firm B will have the same problem
Low expectation of future demand -> low capacity util - > no incentive to incest or hire -> little spending by firms or worker —->
If they are in an expansionary period:
Firms invest and hire = higher spending by firms on workers = high demand for firm’s products = high cap util and profits ===
C and I fluctuations
Investment is much more volatile than consumption
Economic conditions of countries affect levels of fluctuations
I and C are procyclical, move same direction as GDP changes