Econ0002 - Unit 13 Notes PDF

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Econ0002 – Unit 13 NotesEconomic Fluctuations and Unemployment13 Growth and Fluctuations Business Cycles: o GDP per capita vs log The left shows the normal GDP per capita, the right shows the log of it  Transforming data into natural logs allows one to better observe growth  The two dotted stra...

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Econ0002 – Unit 13 Notes Economic Fluctuations and Unemployment 13.1 Growth and Fluctuations 

Business Cycles: o GDP per capita vs log

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The left shows the normal GDP per capita, the right shows the log of it Transforming data into natural logs allows one to better observe growth The two dotted straight lines show the annual growth rate in those periods clearly, reflecting on the steady growth at those times  The slope of the log graph, is the average annual growth rate of series  The flatter the line the lower the growth rate, the second period there was a 2% annual growth rate o GDP growth and unemployment are heavily linked:

  Downturns in the business cycle are associated with unemployment o Economic Growth:  From the previous two graphs one can notice that it is not smooth, as there are booms and recessions o Recession definitions:  NBER: Output is declining – a recession is over when the economy begins to regrow  Alternative: The level of output is below normal level, even if the economy is growing  Until output has grown enough to get back to normal it is not over  In this definition it is subjective as to what ‘normal output’ is  Or: When there are two consecutive quarters of negative economic growth  1

Einstein: Ratio Scales and Logarithms:

o Logarithmic scale:  f(x) = log(x), this function coverts a ratio to a difference log(a/b) = log(a) – log(b)  This is very useful, as if a national income doubles from 50 to 100, or from 1000 to 2000, the absolute difference would be 50 and 1000 respectively  However, log(100) – log(50) = 0.693, and log(2000) – log(1000) = 0.693  The ratio in each case is 2, and log(2) = 0.693  Hence it can compare % changes easily between two sets of countries o If data forms a straight line on a ratio (log) scale, then it means the growth rate is constant  One can do this by converting the data into natural logs and then plot it on a scale that is liner in logs – natural logs use base e which is very useful o Constant growth on those graphs is known as the exponential growth rate/compound annual growth rate/CAGR, which is the slope of the line when the natural log of the data is plotted

13.2 Output Growth and Changes in Unemployment 

Okun’s Law: o The empirical regularity that changes in the rate of growth of GDP are negatively correlated with the rate of unemployment  I.e. as growth and output is high, unemployment is low and vice versa o The slope of the line of best fit shows that a 1% increase in output would decrease e.g. unemployment rate by 0.38%, so Okun’s coefficient is -0.38  Okun’s coefficient: the change in unemployment rate in % points predicted to be associated with a 1% change in the growth rate of GDP o Overall the effect is:

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Einstein: Okun’s Law: o This is defined as: GDP growth ∆ ut =  t) α +β ¿ o Where:  Δut: change in unemployment rate at time t  (GDP growtht): is the real GDP growth at time t  α: intercept value  β: a coefficient determining how real GDP growth is predicted to be translated into a change in unemployment rate  this is Okun’s Coefficient, which is normally negative  R² statistic is between 0 and 1  Measures how well the data fits the line you draw through them  1: perfect fit  0: on observable relationship between observations + prediction  Here it measures how well Okun’s law approximates the data for real GDP growth + UE changes o Finding Okun’s Coefficient:  Plug in the value of real GDP growth in a certain year and solve the equation

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E.g. You get the coefficients from the regression line that you have plotted

13.3 Measuring the Aggregate Economy: 

Aggregate Statistics: o Aggregate Output (GDP): is the total output in an economy across all sectors and regions o 3 different ways to estimate GDP:  Spending: total spent by households, firms, the government, and residents of other countries on the home economy’s products  Production: total produced by industries that operate in the home economy  Measured by value added (value of outputs – value of inputs(i.e. cost of production is subtracted)) to prevent double counting as inputs are value added of another industry  Income: sum of all incomes received: wages, profit, income of self-employed, tax received by government

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Circular Flow between firms and households: o The national accounts measurement of GDP can be taken at the spending stage, the production stage, or the income stage  If accurate measurements were possible, the expenditure, output, and incomes in a year would be the same, so the point at which the measurement is taken would not matter  This is because any spending on a good or a service, which must have been produced, is income for whomever sold that output  Example:  Spend 20 on taco -> value added of the taco whose production was necessary for the sale is 20 -> income received is 20  Below shows circular flow between households and firms (ignoring the role of the government and purchases from and sales abroad for now)

 o Due to globalisation, someone’s expenditure can be someone else’s income in two different countries:  This is the case with imports and exports, how do we account for these transactions?  Exports are included in GDP, as part of domestic production  Imports are not as produced elsewhere  Hence GDP is defined to include exports and exclude imports:  As the value added of domestic production, or as expenditure on domestic production 3

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 As income due to domestic production Government inclusion in model:  Households to government: households pay taxes  Government to households: These taxes pay for the production of public services used by households The government can therefore be considered as another producer, except services are paid for by taxes Example:  Households pay £15,000 in taxes -> £15,000 in revenue to the government -> it uses to produce £15,00 in public goods and services  We assume that value added of government production = cost to government to produce as they are not sold on the market The fact that expenditure, output, and incomes are all equal means that we can use any one of these perspectives to help us understand the others

13.4 Measuring the Aggregate Economy: Components of GDP 

Consumption (C): o Goods and services purchased by households o Tangibility:  Tangible: Goods  Intangible: Services o Durability:  Durable: goods that last for 3 or more years e.g. cars, furniture  Durable goods are counted in consumption in national accounts  Non-durable: last for shorter periods

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Investment (I): o Spending by firms on new equipment and new commercial buildings, and on residential structures (construction of new housing) o Investment in the unsold output that firms produce is a part of investment but recorded as a separate item in national accounts (included though)  It is called the change in inventories or stocks  Including changes in stocks is essential to ensuring output (what is produced) is equal to expenditure (what is spent, including investment in unsold inventories) when calculating GDP

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Government Spending on Goods and Services (G): o Represents the consumption and investment purchases by the government (local & central)  These include goods and services, even wages of civil servants, police etc.  Lots of spending is on health, infrastructure and education o Government transfers in the form of benefits and pensions, are not recorded in G as they are seen as household income, so are recorded in I or C.

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Exports, Imports and Net Exports: o Exports (X):  Are domestically produced goods and services purchased by economic agents in other countries o Imports (M):

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Are goods and services purchased by economic agents in the home economy that are produced in other countries o Net Exports (X-M) or Trade Balance:  Is the difference between the value of exports and imports  Deficit: value of exports - imports is negative  Surplus: is value is positive GDP (Y): o GDP = Aggregate Demand = Output + exports – imports o Private consumption is usually the largest share of GDP o One can use the Federal Reserve Economic Data (FRED) to calculate how each component contributes to GDP fluctuations o The contribution of each component to GDP will depend on the component’s share of GDP and its growth over the previous period 

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The components can be used to see how effective policy is, what areas need working on, how different parts of the economy are working e.g. exports

Shortcomings (Evaluation) of GDP as a measure: o It is a conventional measure of the size of the economy: there are other factors that need to be considered e.g. environmental degradation o Distinguish aggregate GDP from GDP per capita: increases in population e.g. birth rate or immigration will change the impact of high GDP e.g. high GDP or large population vs high GDP and small population o GDP per capita is a flawed measure of living standards: e.g. it includes aspects that do not enhance wellbeing like cigarette advertising, air pollution, ambulances, jail and excludes, health, quality of education etc.

13.5 How Households Cope with Fluctuations 

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Agrarian British Economy: o An economy based on agriculture o During this period the 3 main sectors were: agriculture, industry and services  From the diagram below one can see how Agriculture drove the GDP growth, and it was very volatile  The services and industry sectors were much smaller and didn’t affect it too much

 o Shock: an exogenous change in some of the fundamental data used in a model  Weather largely determines good or bad years (+war/disease) in agriculture  In modern times people anticipate unpredictable events and try to cover themselves with insurance e.g. insurance industry o 2 different shocks:  Good or bad fortune for households: e.g. disease affecting an animal or family member who works  Good or bad fortune for economy as a whole: e.g. droughts, wide spread disease, war 

Household Shocks: o People use two main strategies to deal with these shocks:  Self-insurance: involves saving money so that one can spend their savings in periods of hardships e.g. temporary fall in income or need for extra expenditure to ensure smooth consumption  This tends to require having a high income  Or people may also borrow depending on their credit constraint  It is self-insurance as other households are not involved  Co-insurance: households pool money together to help another household out in difficult times  The modern form is paying tax which can provide support e.g. u/e benefits  It can be done between friends and family, but this is a based on reciprocity, altruism and trust (which can’t be enforced) o These strategies reflect two important aspects of household preferences:  People prefer smooth patterns of consumption: self-insure to avoid fluctuations  Households are not solely selfish:  They are willing to provide support to others to smooth the effect of a shock  Reciprocity and altruism is also important when they are through taxes as it is these motives that support public policies

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Economy-wide Shocks: o When shocks affect everyone it is difficult for co-insurance or self-insurance to work  E.g.it is not possible to store harvest for a bad time so co-insurance may be more important as community survival requires the less badly hit helping the worst hit  However, there are social norms which mean people help each other in these difficult situations

13.6 Why is Consumption Smooth? 

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Smooth Consumption: o Keeping a steady level of consumptions means households plan

They think about what happens to their income in future, if they borrow or save etc. There is also diminishing marginal returns to consumption at any given time, so one prefers to smooth consumption o Visualising an individual’s tendency to smooth consumption expenditure  In this example, before starting work, the individual’s income and consumption expenditure are the same – we assume that parents support children until they work  

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When one consumes more than income they borrow or use their savings When they have income higher than consumption they save or pay back debt A notable feature is that consumption changes before income does When one anticipates a promotion, they adjust consumption before they receive higher income The figure shows that there is more borrowing when young and income is low before one saves or repays debt when older and earning more before running down savings when retired

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Unexpected income shock: o If there is an unexpected income shock one will make a judgement if it is temporary or permanent  If it is permanent: then they would adjust the red line (consumption) up or down to reflect the new long run level of consumption that they choose to adopt based on the new pattern of forecast income  If it is temporary: little will change; there will be almost no effect on the lifetime consumption plan because it is only a small change to lifetime income o In summary:  If individuals and households behave in the way shown above, the economy will be dampened as spending decisions are considering the long term even when income fluctuates

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Limitations to household consumption smoothing: o Many individuals may not be able to implement long term consumption plans  This is mainly due to a lack of information  Even with information it is always hard to predict the future with confidence, it is hard to judge if a change is temporary or permanent o 3 constraints:  Limitations to self-insurance:  Credit constraints or credit market exclusion: restricts a family’s ability to borrow when income has fallen  Weakness of will: prevents some people carrying out plans they know would make them better off  Limitations to co-insurance:

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Limited Co-insurance: means those with less income can’t expect support from those with more income

Credit Constraints: o Consumption constrained and smoothing households:

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The income path is the same for both households However, in a consumption smoothing panel, it shows that they borrow to consume when they know their income will rise  But in one which can’t borrow they must wait till income increases before increasing consumption o We can look at this decision using the two period borrowing and lending model:  First, consider a household that receives the same income, y, this period and next period, indicated by the endowment point A  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 slope -(1+r)

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If households are unconstrained they can choose any point on the budget constraint If the household consumes the same in each period he is at A, the indifference curve is tangent to the budget constraint  If there was a negative shock to income this year, this will lower income to y’, leaving expected income next year unaffected at y  If the household can borrow and save, then the new endowment will be at A’  If it can borrow, the highest indifference curve will touch A’’, so the household prefers to smooth consumption and have equal amounts at c’ in both periods  It would borrow c’- y’ now and repay (1+r)(c’-y’) after the shock o We learn that:  Without borrowing/lending: the endowment and pattern of consumption coincide  The credit-constrained household will consume less this period & more next period 8

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The indifference curve at A’ is lower than A” so borrowing to smooth is better than the credit constrained household A temporary change in income affects the current consumption of credit-constrained houses more than unconstrained

Weakness of Will: o It means a household consumes all its income today even though it implies a large reduction in consumption in the future  The inability to commit to a course of action that one will regret later

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The top shows that consumption smoothing households will immediately start saving to supplement the fall in income when they hear news of the fall The weak willed will not react and keep consumption high until income falls  Tends to happen, that even if they know it is beneficial, when the time comes they often don’t do it

Limited Co-insurance: o People lack a network of people who can help in substantial ways when negative income shocks occur  Benefits provided by the government are a solution but provisions are still limited in some economies o Credit constraints, weakness of will and limited co-insurance:  Mean that when there is a change in income, there tends to be an equal change in consumption  In the case of negative income shock, e.g. loss of a job, it means the income shock will be passed on as this lack of consumption will affect producers, as there will now be unsold goods and services

13.7 Why is Investment Volatile? 

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Smooth consumption vs Investment: o Investment expenditures can be postponed meaning there isn’t as much need to smooth investment  Therefore they just invest when firms see an opportunity to make profits so there is often clusters of investment projects at some times o Investment leads to more investment:  When a firm invests it pushes others to invest or else they may lose market share or be unable to cover costs and eventually leave the industry  Investment by one firm can also pull other firms to invest by helping to increase their market and potential profits

Investment in new technology can lead to stock market bubbles and over investment in machinery and equipment  A fall in confidence leads to sharp falls in investment o Credit-Constraints:  These also cause clusters of investment projects and volatility of aggregate investment o Low capacity utilisation: is when a firm’s capital is not being fully utilised but there is not enough demand to sell the products it would produce if more staff were hired  There is no incentive to hire more workers or invest more  If there are 2 firms A and B, both firms would have this issue and profits are low for both 

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But, if both firms hire and invest at the same time they would employ more workers, who would spend more, increasing demand for the products of both firms, and leading to an increase in profit

 o These two circles highlight the role of expectations of demand, which depend on the behaviour of other actors o How to go from the vicious circle to the virtuous one:  The game:  The actors: 2 firms  The actions that they can take: invest or not invest  The information they have: they decide simultaneously so they do not know what the other did  The pay-off: profit from each pair of actions

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If only one firm invests then there is no demand for products the new capacity produces and so will make a loss  Here, firms will do better if they both invest  A reason why investment fluctuates is because if firms think others will not invest, they will not invest and vice versa  This is why the two cycles are self-reinforcing The 2 Nash equilibria in this game:  A nor B have no dominant strategy  One is the lower right box, where there is low capacity utilisation and low hiring and investment, this is not pareto efficient because there is a change where both can make higher profit (invest) These are called Coordination Games:  Is when there are two Nash Equilibria and one may be Pareto ...