ECO2004P

MACROECONOMICS II

Unit 13
Economic Fluctuations and Unemployment

Lecturer: Samuel Manu

Key Questions
oHow are GDP and inflation measured?

oWhat are the components of GDP?

oWhat is the relationship between GDP growth, unemployment and

inflation?

oHow do households cope with economic fluctuations?

oWhy is investment more volatile than consumption?

Outline
1. Growth and Fluctuations

2. Output Growth and Changes in Unemployment

3. Measuring the aggregate economy

4. How households cope with fluctuations

5. Why is consumption smooth

6. Why is investment volatile

7. Measuring Inflation
1. Growth and Fluctuations
 Gross Domestic Product
• Gross Domestic Product (GDP): measures the market value of the
output of final goods and services produced in the economy in a
given period.
• Nominal GDP: is GDP expressed in terms of the prices in that same
year (current prices)
• Increase in Nominal GDP could mean higher prices, increase in output
production or both

• Real GDP: is GDP expressed in terms of the prices in a base year

(constant prices)
• Increase in real GDP means an increase in output production
 GDP Growth
• Real GDP Growth: is the percentage change in real GDP.

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 − 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 𝑖𝑛 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = ∗ 100
𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 𝑖𝑛 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟

Real GDP growth between

2005 and 2013:

155 −145
= ∗ 100% =
145
6.897%
 Growth and Fluctuations
• Industrial revolution caused economies to grow over the long run.
• However, GDP growth has not been smooth.
• There are alternating periods of positive and negative growth. Thus,
economies go through booms and recessions
 Growth and Fluctuations
• Business cycle: Alternating periods of faster and slower (or even
negative) growth rates.

• What is a recession?
➢ NBER definition: a significant decline in economic activity spreads across the economy and can
last from a few months to more than a year
➢ Alternative definition: a period when the level of output is below its normal level.
• UK’s business cycle and unemployment between 1875 and 2014
2. Output Growth and
Changes in Unemployment
 Okun’s Law
• Okun’s Law: empirically observed
relationship between output and
unemployment fluctuations.

• Fall in output rise in unemployment

fall in wellbeing / living standards

• Okun’s coefficient : degree of correlation

• ∆𝑈𝑡 = 𝛼 + 𝛽(𝐺𝐷𝑃 𝐺𝑟𝑜𝑤𝑡ℎ𝑡 )

• What will happen to unemployment rate in

years where GDP growth is zero?
3. Measuring the aggregate economy
 Estimating GDP
• Aggregate output (GDP): Total output in the economy across all
sectors and regions.

• Three different ways to estimate GDP:

a. Spending (the expenditure approach): C + I + G + (X-M)

b. Production (value added approach): the sum of value added by each

industry

c. Income (income approach) : The sum of all the incomes received.

• If accurate measurement were possible, all three approaches would

give the same results.
 The Circular Flow Model
The circular flow model: 3 ways to measure GDP

NB: Diagram is simplified, it ignores the role of government, imports and exports.
 The Role of Government in the Circular Flow

• Purchases factors of production (mainly

labour) from households in the factor
market, and goods from firms in the goods
market.

• Provides public goods and services to

households and firms.

• Government spending is financed by taxes

paid by households and firms.
 The Role of the External Sector

The external sector (import and export)

• Domestic firms and households import goods

and services from the rest of the world.
• Payment for imports constitutes a leakage of
income from the domestic economy
• Goods and services are exported to other
countries.
• Payment for exports constitutes an injection
of income into the domestic economy.
 Financial Institutions in the Circular Flow

• Households and firms save a fraction of

their income with financial institutions
(leakage)

• Financial institutions act as intermediaries

and lend funds to firms to finance
investment spending (injection).
 Components of GDP
GDP from the expenditure side: Y = C + I + G + (X-M)
• Consumption (C): includes the goods and services purchased by households.

• Investment (I): Expenditure on newly produced capital goods (machinery and

equipment) and buildings, including new housing. (Include changes in inventories /
stocks)

• Government spending on goods and services (G): include consumption and

investment purchases by government. (Excludes government transfers)
• Exports (X): Domestically produced goods and services that are purchased by
households, firms, and governments in other countries.
• Imports (M): Goods and services purchased by households, firms, and
governments in the home economy that are produced in other countries.
• Net exports (X-M) / Trade Balance: Exports(X) − Imports (M)
 Components of GDP

In most countries, private consumption

makes up the largest share of GDP
 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.
 Class Exercise 2: Calculating GDP
Q. Calculate GDP using the expenditure approach
Solution

GDP = C + I + G + X – M

GDP= 4578 + 466 + 3987 + 30

= R 9,061 billion
 Class Exercise 3: Calculating GDP
• Assuming an economy produces only phones, oranges and laptops. Use
the information in the table below to calculate the value added GDP.
4. How Households Cope with
Fluctuations
 Household Shocks

The two situations:

a. Household Shocks: when good or bad times strikes a specific household
• Self insurance: households save in good times, and spend the savings in
bad times
• Co-insurance: assistance from another household or institution (family
members, social groups, unemployment benefits, etc.)

This reflects that: households prefer a smooth pattern of consumption, and

are not solely selfish
 Economy-wide Shocks
b. Economy-wide shocks: when good or bad fortune strikes the
economy as a whole

• 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-

community survival requires that less badly hit households help the
worst hit households
5. Why is Consumption Smooth?
 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

• Do not change long-run consumption

if shocks are temporary

They save and borrow to smooth the

bumps in income.
 Consumption Smoothing and the Aggregate Economy
Consumption smoothing is a basic source of stabilisation in an economy.

However, there are limitations to consumption smoothing:

• credit constraints
• weakness of will, and
• limited co-insurance

Limitations to consumption smoothing mean it cannot always stabilise

the economy; it may amplify the initial shock.

This helps us to understand the business cycle and how to manage it.
 Limitations to Smoothing: Credit Constraints

Credit constraints – limits on

amount borrowed/ability to
borrow.

The households unable to adjust

to a temporary income shock have
lower welfare.
 Limitations to smoothing: credit constraints

An unanticipated temporary fall

in income: two period analysis.
• Credit constrained: consumes
less in period 1 and more in the
next period.

• Smoothing household:
consumption is equal in both
periods.
 Limitations to Smoothing: Weakness of Will

Weakness of will – inability to commit

to beneficial future plans.

A household can smooth consumption

but doesn’t and may regret it later.

Inability to save Vs. Inability to borrow

6. Why is investment volatile?
 Volatile Investment
Firms don’t have preferences for smoothing like households.
They adjust investment plans to both temporary and permanent shocks, to
maximise their profits.
Investment decisions depend on firms’ expectations about future demand

Vicious Cycle arising from

demand expectations

Positive expectations of future demand Negative expectations of future demand

 Investment: A coordination game

Actors: the two firms

Actions: Invest, or Do not invest

Information: they decide

simultaneously

Payoff: profits from investment

Investment is the best response to other

firms’ investment (coordination game).
 Business confidence

Business confidence coordinates firms to invest at the same time.

 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.

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.
7. Measuring Inflation
 Inflation, GDP, and Unemployment
Inflation is an increase in the general price level in the economy (% change in CPI).
Deflation is a decrease in the general price level of goods and services, and disinflation
is a decrease in the rate of inflation.

The Consumer Price Index: an average of the prices for a fixed basket of consumer
goods and services, each weighted by its relative importance.
• CPI includes imports, excludes exports.
• CPI= 100 in the reference / base year

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),
• Includes exports, excludes imports
• Allows GDP to be compared across countries and over time
Inflation tends to be lower during recessions (high unemployment)
 Trends in inflation
• Upward spikes in inflation
during economic crises

• General downward trend

since 1970s

• Inflation tends to be higher in

poor than in rich countries
 CPI and Inflation
2019

Item
CPI basket
Quantity Price
Cost of CPI
• CPI 2019: 1119,5/1119,5=100
Oranges 89 8,5 756,5
Haircuts 66 5,5 363 CPI in 2019 as a base year
1119,5 100
• CPI 2020: 1223,4/1119,5=109,28
2020
CPI basket Cost of CPI
Item Quantity Price • Inflation 2020: (109,28-100/100)*100=9,28%
Oranges 89 9 801
CPI in Inflation
Haircuts 66 6,4 422,4 2020 in 2020
Cost of CPI basket at the current
period price. 1223,4 109,2809 9,280929
• Inflation 2021: (250,78 –109,28/109,28)*100=129,48%

Inflation
if CPI 2021 in 2021
250,78 129,4819
 Summary
1. Economic growth is not a smooth process – the economy goes through a
business cycle
• Households try to smooth their consumption over the business cycle (problem:
credit constraints)
• Investment is more volatile than GDP; the outcome of a self-reinforcing
coordination game
• Inflation moves with the business cycle

2. System of national accounts to measure the economy

• GDP = C + I + G + X – M
• Measuring GDP as income, spending, production

3. Measuring Inflation
• A negative relationship between output growth and unemployment.
 In the next unit

• The multiplier process: How limits on households’ ability

to save, borrow, and share risks affect GDP

• Fiscal policy: How government spending can help

stabilize the economy

• Aggregate demand and unemployment