Economic Fluctuations and Unemployment

Question 1

How to measure GDP

Answer 1

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

Question 2

How do we account for international transactions?

Answer 2

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

Question 3

GDP Equation

Answer 3

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

Question 4

Inflation

Answer 4

An increase in the general price level in the economy, measured over a year (usually)

Deflation: a decrease in the general price level

Question 5

Inflation Trends

Answer 5

Upwards spikes in periods of economic crisis

Downward trend worldwide since 1970s

Higher inflation in poor countries than in richer countries

Question 6

Consumer Price Index, CPI

Answer 6

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

Question 7

GDP Deflator (output method)

Answer 7

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

Question 8

Why do we measure inflation?

Answer 8

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

Question 9

Short run fluctuations in GDP

Answer 9

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

Question 10

Why do we care about recessions?

Answer 10

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

Question 11

Okun’s law

Answer 11

Change in unemployment = a + beta(real GDP growth)

R^2 measures how well the Okun’s law fits the data

Question 12

Households and Fluctuations

Answer 12

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

Question 13

Economy-Wide shocks

Answer 13

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

Question 14

Consumption Smoothing

Answer 14

Diminishing marginal returns to consumption

MRS changes as you move along the curve

Question 15

Pure Impatience

Answer 15

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

Question 16

Smoothing and Economy

Answer 16

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

Question 17

Weakness of will limitation

Answer 17

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

Question 18

Limited Co-Insurance

Answer 18

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

Question 19

What happens when you have these limitations

Answer 19

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

Question 20

Investment volatility

Answer 20

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

Question 21

Push Factors

Answer 21

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

Question 22

Pull Factors

Answer 22

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 ===

Question 23

C and I fluctuations

Answer 23

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