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Chapter 13 (2) - Economic fluctuation and unemployment - Coggle Diagram
Chapter 13 (2) - Economic fluctuation and unemployment
Unit 5
In 1960 agriculture comprised 43% of the economy, which had declined to 17% in 2014.
To help us to think about the costs and causes of economic fluctuations, we begin with an agrarian economy. In an economy based on agricultural production, the weather—along with war and disease—is a major cause of good and bad years.
Figure 9 shows the growth rates of real GDP and agriculture in India since 1960.
We can distinguish between two situations:
Good or bad fortune strikes the household
Good or bad fortune strikes the economy as a whole
9
People use two strategies to deal with shocks that are specific to their household:
Self-insurance
Co-insurance
Figure 8 shows the growth rate of real GDP and of the three main sectors: agriculture, industry, and services.
Informal co-insurance among family and friends is based on both reciprocity and trust: you are willing to help those who have helped you in the past, and you trust the people who you helped to do the same in return.
Just as we divided GDP into different components from the expenditure side, we can also divide it into different sectors on the production side.
Altruism towards those in need is also usually involved, although co-insurance can work without it
Figure 8 illustrates fluctuations in production in the largely agrarian British economy between 1550 and 1700.
These strategies reflect two important aspects of household preferences:
People prefer a smooth pattern of consumption
Households are not solely selfish
8
Co-insurance is less effective if the bad shock hits everyone at the same time.
Unit 6
There are three other things that constrain the ways in which households can smooth their consumption when faced with income shocks. The first two concern limits on self-insurance, the third is a limit on co-insurance:
Credit constraints or credit market exclusion
Weakness of will
Limited co-insurance
11
What limits a household’s consumption smoothing? Many individuals and households are not able to make or implement long-term consumption plans. Making plans can be difficult because of a lack of information.
Figure 11 shows the reaction of two different types of households to an anticipated rise in income. Households that are able to borrow as much as they like are in the top panel.
The consumption-smoothing model suggests that:
The individual will make a judgement: This will be about whether the shock is temporary or permanent.
If the shock is permanent: We should adjust the red line in Figure 10 up or down to reflect the new long-run level of consumption that the individual adopts, consistent with the new pattern of forecast income.
If the shock is temporary: Little will change. A temporary fluctuation in income has almost no effect on the lifetime consumption plan, because it makes only a small change to lifetime income.
Credit-constrained households that are unable to get a loan or take out a credit card are in the bottom panel.
We next ask what happens when something unexpected occurs to disturb the lifetime consumption plan. What if the individual shown in the figure encounters an unexpected income shock?
12
Consumption changes before income does.
First consider a household that receives the same income, y, this period and next period, indicated by the endowment point A in Figure 12. 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 the slope −(1 + r).
In this simple example, before starting work, the individual’s income and consumption expenditure are the same—we assume, for example, that parents support their children until the children start work.
The budget constraint is another term for the frontier of the feasible set with the slope of −(1 + r)
We can use Figure 10 to visualize an individual’s tendency to smooth consumption expenditure.
We learn from this example that:
Without borrowing or lending, the endowment point and pattern of consumption coincide
Compared with the smoothing household, the credit-constrained household consumes less this period and more next period.
10
The household that can smooth consumption by borrowing is better off than the credit-constrained household.
The person contemplating a future promotion and planning their spending would be in a position similar to Julia in Unit 10 , who had limited funds in the present but knew she would have more later, and consequently was interested in moving some of her future buying power to the present by borrowing.
A temporary change in income affects the current consumption of credit-constrained households more than it does that of the unconstrained.
People prefer to smooth their consumption because there are diminishing marginal returns to consumption at any given time.
13
A basic source of stabilization in any economy comes from the desire of households to keep the level of their consumption of goods and services constant.
In Figure 13 an individual learns that income is going to fall in the future.
In the top panel of Figure 13 we again show a household behaving in a forward-looking manner to smooth consumption. The bottom panel shows a household with weakness of will that consumes all its income today even though it implies a large reduction in consumption in the future.
Saving is a form of self-insurance and doesn’t involve anyone else.
Unemployment benefits provide this kind of co-insurance—the citizens who turn out to be lucky in one year insure those who are unlucky.
When the demand for firms’ products fell, workers’ hours of work were cut, but as a result of both government policy and agreements between firms and their employees, very few Germans lost their jobs, and many of those at work were still paid as if they were working many more hours than they did.
Unit 7
In a buoyant economy, profits are high and firms can use these profits to finance investment projects.
Firm A’s machinery and equipment are not fully used, so the firm can produce more if it hires more employees. But there is not enough demand to sell the products it would produce. This situation is called low capacity utilization
Credit constraints are another reason for the clustering of investment projects and the volatility of aggregate investment.
15
Robert Shiller, the economist, argued that the Nasdaq index was driven high by what he called ‘irrational exuberance
16
Over-investment in machinery and equipment had occurred: investment did not begin growing again until 2003.
These two circles highlight the role of expectations of future demand, which depend on the behaviour of other actors.
Investment in new technology can lead to a stock market bubble and over-investment in machinery and equipment.
As in every game, we specify:
The actors: The two firms
The actions that they can take: Invest, or do not invest
The information they have: They decide simultaneously, so they do not know what the other has done.
The payoff: The profits resulting from each of the four pairs of actions that they could possibly take.
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They expand their share of the market. Firms that fail to follow may be forced out of business because they are unable to make a profit using the old technology. But new technology means that firms must install new machines. As firms do this, there is an investment boom.
The four possible outcomes of the interaction and the payoffs are given
When an innovation like the spinning jenny is introduced, firms using the new technology can produce output at lower cost or produce higher-quality output.
From this figure you can see what happens when the virtuous (both invest) and vicious (neither invest) circles occur.
If Firm A invests and B does not (the upper-right cell in the figure) then A pays to install new equipment and premises, but because the other firm did not invest there is no demand for the products that the new capacity could produce; so A makes a loss.
There are two Nash equilibria in this game (upper-left and lower-right). To find the Nash equilibria use the ‘dot’ and ‘circle’ method
If B invests, A’s best response is also to invest so a dot goes into the upper-left cell. If B does not invest, A chooses also not to invest so we place a dot in the bottom right-hand cell. Notice that A does not have a dominant strategy.
If A invests, B’s best response is to invest and if A does not invest, B chooses not to invest. The circles showing B’s best responses coincide with the dots: B also does not have a dominant strategy.
Where the dots and circles coincide, there are Nash equilibria.
We can generalize the argument about the role of coordination in investment to say that investment spending by firms will respond positively to the growth of demand in the economy.
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Figure 18 illustrates the relationship between the growth of aggregate demand (excluding investment), business confidence, and investment for the Eurozone.
19
20
As expected, Figures 19 and 20 show that investment is much more volatile than consumption in two rich countries (the UK and the US) and two middle-income countries (Mexico and South Africa).
Unlike investment, government spending (the G in the national accounts) does not respond to innovation or fluctuate with business confidence. We would predict it to be less volatile than investment
Firms increase their stock of machinery and equipment and build new premises whenever they see an opportunity to make profits.
Households tend to smooth their consumption spending when they can, but there is no similar motivation for a firm to smooth investment spending.
Unit 8
24
Figure 24 shows average rates of inflation in different regions of the world, and how they have changed over time.
Previously we saw that the downward spikes of economic crises were associated with upward spikes of unemployment; we now see that inflation was especially low in the 1930s and especially high in the 1970s. The peak in inflation followed the first of two oil price shocks (1973 and 1979) that were major disturbances to the global economy.
The Consumer Price Index (CPI) measures the general level of prices that consumers have to pay for goods and services, including consumption taxes.
In Figure 23, we show the rate of inflation over this period
The basket of goods and services is chosen to reflect the spending of a typical household in the economy.
23
The CPI excludes exports, which are consumed by foreign residents, but includes imports, which are consumed by households in the home economy.
These show the growth rate of GDP and the unemployment rate in the UK from 1875 to 2014.
The GDP deflator is a price index like the CPI, but it tracks the change in prices of all domestically produced final goods and services.
22
The GDP deflator tracks the price changes of the components of domestic GDP, that is, of C + I + G + X – M (the GDP deflator includes exports, which are produced by the home economy, but excludes imports, which are produced abroad).
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The GDP deflator can also be expressed as the ratio of nominal (or current price) GDP to real (or constant price) GDP
Unit 9
Households and firms make forecasts when deciding on their spending.
Two essential tools for understanding the economy:
the national accounts used to measure aggregate economic activity,
and a set of models that allow us to organize the data in ways that illuminate economic fluctuations.