Unit 13: Economic Fluctuations and Unemployment PDF

UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT HOW ECONOMIES FLUCTUATE BETWEEN BOOMS AND RECESSIONS AS THEY ARE CONTINUOUSLY THEMES AND CAPSTONE UNITS...

UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT HOW ECONOMIES FLUCTUATE BETWEEN BOOMS AND RECESSIONS AS THEY ARE CONTINUOUSLY THEMES AND CAPSTONE UNITS 17: History, instability, and growth HIT BY GOOD AND BAD SHOCKS Fluctuations in the total output of a nation (GDP) affect unemploy- ment, and unemployment is a serious hardship for people. 18: Global economy 21: Innovation 22: Politics and policy Economists measure the size of the economy using the national accounts: these measure economic fluctuations and growth. Households respond to shocks by saving, borrowing, and sharing to smooth their consumption of goods and services. Due to limits on people’s ability to borrow (credit constraints) and their weakness of will, these strategies are not sufficient to eliminate shocks to their consumption. Investment spending by firms (on capital goods) and households (on new housing) fluctuates more than consumption. Losing your job hurts. It causes stress. Following the global financial crisis in 2008, unemployment went up, as did the number of searches for antistress medication on Google. By plotting the increase in search intensity against the increase in the unemployment rate in the different states of the US (Figure 13.1), we see that states that had a larger increase in the unemployment rate between 2007 and 2010, also had a larger increase in searches for antistress medication. This suggests that higher unemploy- ment is related to higher stress. We say the two are correlated. The upward-sloping line summarizes the data by finding the line that best fits the scatter of points. This is called a line of best fit or a linear regression line. When a line of best fit is upward sloping, it means that higher values of the variable on the horizontal axis (in this case the rise in unemployment) are associated with higher values of the variable on the ver- tical axis (in this case, the increase in Google searches for antistress medication). 545  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT Many kinds of evidence show that being unemployed or fearing unemployment is a major source of unhappiness for people. It ranks alongside major disease and divorce as a stressful life event. Andrew E. Clark and Andrew J. Economists have estimated that becoming unemployed produces more Oswald. 2002. ‘A Simple Statistical unhappiness than is measured solely by the loss of earnings from being out Method for Measuring How Life of work. Economists Andrew Clark and Andrew Oswald have measured Events Affect Happiness’ the effect of important life events on how happy people claim to be when (https://tinyco.re/7872100). Inter- they are asked. In 2002, they calculated that the average British person national Journal of Epidemiology would need to be compensated by £15,000 ($22,500) per month after losing 31 (6): pp. 1139–1144. their job in order to be as happy as they were when they were employed. This is considerably larger than the loss of earnings (which at the time were £2,000 per month on average). The compensation needed to restore wellbeing is an enormous amount, much greater than the monetary loss associated with a spell of unemploy- ment. The reason is that unemployment dramatically reduces self-esteem and leads to a much greater reduction in happiness. As we saw in Unit 1, wellbeing depends on more than just income. Correlation may not be causation Can we draw the conclusion from the data in Figure 13.1 that higher reverse causality A two-way causal unemployment causes higher stress? Maybe we have it the wrong way relationship in which A affects B round, and actually Google searches cause unemployment. Economists call and B also affects A. this reverse causality. We can rule this out because it is unlikely that indi- linear regression line The best- vidual Google searches on the side effects of antidepressants could cause an fitting line through a set of data. increase in unemployment at the state level. Yet there are other possible explanations for this pattern. The Spurious Correlations website A natural disaster like Hurricane Katrina (https://tinyco.re/7393966) in shows how dangerous it is to draw the US state of Louisiana in 2005 could have triggered an increase in both a conclusion from correlation. stress and unemployment. This is an example where a third factor—in this James Fletcher. 2014. ‘Spurious case, the weather—might account for the positive correlation between Correlations: Margarine Linked to searches for antidepressants and unemployment. It warns us to be careful in Divorce?’ (https://tinyco.re/ concluding that an observed correlation implies a causal relationship 6825314). BBC News. between variables. View this data at OWiD https://tinyco.re/ 8246287 Yann Algan, Elizabeth Beasley, Florian Guyot, and Fabrice Murtin. 2014. ‘Big Data Measures of Human Well-Being: Evidence from a Google Stress Index on US States’. Sciences Po Working Paper. Figure 13.1 Changes in unemployment and wellbeing during the financial crisis: Evidence from the US states (2007–2010). 546  13.1 GROWTH AND FLUCTUATIONS To establish a causal relationship between variables, economists devise correlation A statistical association experiments (https://tinyco.re/8046664) (like those in Unit 4) or exploit in which knowing the value of one natural experiments (like the comparison of East and West Germany in variable provides information on Unit 1 or the estimate of the size of employment rents in Unit 6). the likely value of the other, for In Exercise 13.1, we show you a tool that you can use to examine your example high values of one ideas about how the overall wellbeing in a country can be compared with variable being commonly observed wellbeing in other countries. What is your recipe for a better life in your along with high values of the other country? How important do you think unemployment is? Do other things variable. It can be positive or neg- matter more or just as much—for example, good education, clean air, a high ative (it is negative when high level of trust among citizens, high income, or not too much inequality? values of one variable are observed In this unit, we learn about why economies go through upswings, during with low values of the other). It which unemployment falls, and downswings, during which it rises. We does not mean that there is a focus on the total spending (by households, firms, the government and causal relationship between the people outside the home economy) on the goods and services produced by variables. See also: causality, cor- people employed in the home economy. relation coefficient. EXERCISE 13.1 THE OECD BETTER LIFE INDEX The Better Life Index (https://tinyco.re/2887644), was created by the The OECD is an international Organization for Economic Cooperation and Development (OECD). It lets organization based in Paris, with 35 you design a measure of the quality of life in a country by deciding how member countries, most with high much weight to put on each component of the index. levels of GDP per capita. It was formed in 1948 to facilitate 1. Should a better life index include the following elements: income, postwar reconstruction in Western housing, jobs, community, education, environment, civic engagement, Europe. The OECD is an important health, life satisfaction, safety, and work-life balance? For each of these source of internationally elements, explain why or why not. comparable statistics on economic 2. Use the Better Life Index tool to create your own better life index for and social performance. the country where you are living. How does this country score on the topics that are important to you? 3. Rank the countries in the database using your own newly created better life index, and compare it with a ranking based exclusively on income. 4. For both of these indices, choose two countries with contrasting rankings and briefly suggest why this may be the case. 13.1 GROWTH AND FLUCTUATIONS Economies in which the capitalist revolution has taken place have grown over the long run, as illustrated in the hockey stick charts for GDP per capita in Unit 1. But growth has not been smooth. Figure 13.2 shows the case of the British economy, for which logarithmic scale A way of measuring a quantity based on the data over a long period is available. The first chart logarithm function, f(x) = log(x). The logarithm function shows GDP per person (per capita) of the popula- converts a ratio to a difference: log (a/b) = log a – log b. This is tion from 1875. This is part of the hockey stick very useful for working with growth rates. For instance, if graph from Unit 1. The chart next to it shows the national income doubles from 50 to 100 in a poor country and same data but plots the natural logarithm (‘log’) from 1,000 to 2,000 in a rich country, the absolute difference in of GDP per capita. This is a way of presenting the the first case is 50 and in the second 1,000, but log(100) – ratio scale that we used in Unit 1. log(50) = 0.693, and log(2,000) – log(1,000) = 0.693. The ratio in each case is 2 and log(2) = 0.693. 547  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT See the Einstein at the end of this section to explore the relationship between plotting the log of a variable and the use of a ratio scale on the ver- tical axis. By looking at the graph in levels of GDP per capita in the left-hand panel of Figure 13.2, it is hard to tell whether the economy was growing at a steady pace, accelerating, or decelerating over time. Transforming the data into natural logs in the right-hand panel allows us to answer the question about the pace of growth more easily. For example, for the period after the First World War, a straight line from 1921 to 2014 fits the data well. For a graph in which the vertical axis represents the log of GDP per capita, the slope of the line (the dashed black line) represents the average annual growth rate of the series. Immediately we notice that growth was steady from 1921 to 2014 (with a little uptick during the Second World War). You can see that a line drawn through the log series from 1875 to 1914 is flatter than the line from 1921, indicating that the growth rate was lower. We will explore long-run growth further in Units 16 and 17. In this unit we focus on fluctuations. These are the deviations from the dotted black line showing the long-run growth rate in Figure 13.2. The top panel of Figure 13.3 plots the annual growth rate of UK GDP gross domestic product (GDP) A between 1875 and 2014. Since we want to focus on the size of the economy measure of the market value of the and how it changes from year to year, we will examine total GDP rather output of the economy in a given than GDP per capita. period. Ryland Thomas and Nicholas Dimsdale. (2017). ‘A Millennium of UK Data’ (https://tinyco.re/0223548). Bank of England OBRA dataset. Figure 13.2 UK GDP per capita (1875–2014). 1. Annual growth rate after 1921 2. Annual growth rate 1875 to 1914 In the right-hand panel, the slope of the A line drawn through the log series line (the dashed black line) represents from 1875 to 1914 is flatter than the the average annual growth rate from line from 1921. The average growth 1921 to 2014. It was 2.0% per annum. rate in that period was only 0.9% per We can see that growth was steady. annum. 548  13.1 GROWTH AND FLUCTUATIONS Ryland Thomas and Nicholas Dimsdale. (2017). ‘A Millennium of UK Data’ (https://tinyco.re/0223548). Bank of England OBRA dataset. Figure 13.3 UK GDP growth and unemployment rate (1875–2014). 1. UK GDP growth and unemployment 3. The global financial crisis 4. Downturns and unemployment The panels show UK GDP growth and In the twenty-first century, the 2008 fin- We can see that downturns in the busi- the unemployment rate for the period ancial crisis followed a period in which ness cycle are associated with rising 1875–2014. fluctuations were limited. unemployment. In the business cycle of the early 1990s, unemployment 2. Peaks and troughs continued to rise for a time after the The arrows highlight the peak and growth rate began to rise. trough of a business cycle during the late 1980s and early 1990s. 549  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT It is clear from the ups and downs of the series recession The US National Bureau of Economic Research in Figure 13.3 that economic growth is not a defines it as a period when output is declining. It is over once smooth process. We often hear about economies the economy begins to grow again. An alternative definition is going through a boom or a recession as growth a period when the level of output is below its normal level, swings from positive to negative, but there is no even if the economy is growing. It is not over until output has standard definition of these words. The National grown enough to get back to normal. The latter definition has Bureau of Economic Research (NBER) the problem that the ‘normal’ level is subjective. (https://tinyco.re/3195217), a US organization, defines it like this: ‘During a recession, a signi- ficant decline in economic activity spreads across the economy and can last from a few months to more than a year.’ An alternative definition says that an economy is in recession during a period when the level of output is below its normal level. So we have two defini- tions of recession: NBER definition: output is declining. A recession is over once the eco- nomy begins to grow again. Alternative definition: the level of output is below its normal level, even if the economy is growing. A recession is not over until output has grown enough to get back to normal. There is a practical problem with the second definition: it is a matter of judgement, and sometimes controversy, over what an economy’s normal output would be (we return to this issue in later units, where we will see that ‘normal output’ is often defined as that consistent with stable inflation). The movement from boom, to recession, and back to boom is known as business cycle Alternating periods the business cycle. In Figure 13.3 you will notice that in addition to the of faster and slower (or even neg- yearly change in GDP, in which recessions measured by negative growth ative) growth rates. The economy seem to happen about twice every 10 years, there are less frequent episodes goes from boom to recession and of much larger fluctuations in output. In the twentieth century, the big back to boom. See also: short-run downward spikes coincided with the end of the First and Second World equilibrium. Wars, and with the economic crisis of the Great Depression. In the twenty- first century, the global financial crisis followed a period in which fluctuations were limited. In the lower part of Figure 13.3 you can see that the unemployment rate varies over the business cycle. During the Great Depression, unemployment in the UK was higher than it had ever been, and it was particularly low during the World Wars. EXERCISE 13.2 DEFINING RECESSIONS A recession can be defined as a period when output is declining, or as a period when the level of output is below normal (sometimes referred to as its ‘potential level’). Look at this article (https://tinyco.re/2305833), especially Figures 5, 6, and 7, to find out more. 1. Consider a country that has been producing a lot of oil and suppose that from one year to the next its oil wells run out. The country will be poorer than previously. According to the two definitions above, is it in a recession? 2. Does knowing whether a country is in recession make a difference to policymakers whose job it is to manage the economy? 550  13.1 GROWTH AND FLUCTUATIONS QUESTION 13.1 CHOOSE THE CORRECT ANSWER(S) The following is the graph of the natural log of UK real GDP per capita between 1875 and 2014: Based on this information, which of the following statements is correct? The graph shows that real GDP per capita in the UK in 1955 was about £8,000. The slope of the best-fit straight line is the average annual growth rate. The graph shows that the average growth rate was lower in the decades after 1921 than in the decades before 1918. The graph of real GDP per capita plotted using a ratio scale would look very different to the graph above. EINSTEIN Ratio scales and logarithms In Unit 1, we made frequent use of a ratio or log scale on the vertical axis to display long-run data. For example, we used ratio scales with the units doubling in Figure 1.1b and rising tenfold in Figure 1.2. The ratio scale is also called a logarithmic (or log) scale. We can write a scale where the tick marks on the vertical axis double like this: Or a scale where they rise tenfold, like this: The first is called a logarithmic scale in base 2; the second is in base 10. As we saw in the charts in Unit 1, if the data forms a straight line on a ratio (logarithmic) scale, then the growth rate is constant. A different method of using this property of logarithms is to first convert the data into natural logs and then plot it on a scale that is linear in logs. 551  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT Natural logs use base e, where e is a number (approximately 2.718) that has mathematically useful properties. We can use a calculator or a spreadsheet program to convert levels into natural logs. As you can see, when applied to this data, it converts the curved line in Figure 13.2 in the left-hand panel into one that is almost a straight line in the right-hand one. Using the chart functions in Microsoft Excel helps illustrate the rela- tionship between plotting the data with a ratio scale on the vertical axis (Figure 13.4a, which uses the doubling or base 2 scale) and transforming the data into natural logs and plotting on a linear scale (in logs) on the axis (Figure 13.4b). Note that the tick marks double from 4,096 to 8,192 to 16,384 in Figure 13.4a and rise from 8.5 to 9 to 9.5 in Figure 13.4b. Figure 13.4a The ratio scale and an exponential function. Figure 13.4b The linear scale in natural logs and a linear function. In each chart, a line appears alongside the data series. Using Excel, we created Figure 13.4a by selecting Analysis/Trendline, and then selecting ‘Exponential’. Excel finds the line or curve that best fits the data points: since the scale is a ratio scale, a straight line is displayed. The equation of 552  13.2 OUTPUT GROWTH AND CHANGES IN UNEMPLOYMENT the line is given. Other spreadsheet or graphing software offers similar features. We can see that the exponential function uses what is called base e in contrast to base 2 (doubling) or base 10 (increasing tenfold). The exponent on e tells us the compound annual growth rate of the series: it is 0.0214 × 100 = 2.14% per annum. In Figure 13.4b, if we use Excel to select the ‘Fit a linear function’ option, a straight line appears. This time, we see an equation for a straight line with intercept 8.7782 and slope 0.0214. Now the slope of the line tells us the exponential, or equivalently, the compound annual growth rate of the series: 0.0214 × 00 = 2.14% per annum. In summary: When a data series is plotted, either using a ratio scale or by transforming the data into natural logs, and the outcome is approximately linear, it means that the growth rate of the series is approximately constant. This constant growth rate is called an exponential growth rate. The exponential growth rate (known also as the compound annual growth rate or CAGR) is the slope of the line when the natural logarithm of the data series is plotted. Notice the persistent deviation of the British economy from the trend line following the 2008 financial crisis. 13.2 OUTPUT GROWTH AND CHANGES IN UNEMPLOYMENT We saw in Figure 13.3 that unemployment goes down in booms and up in recessions. Figure 13.5 shows the relationship between output and unemployment Okun’s law The empirical fluctuations, known as Okun’s law. Arthur Okun, an advisor to US regularity that changes in the rate President Kennedy, noticed that when a country’s output growth was high, of growth of GDP are negatively unemployment tended to decrease. Okun’s law has been a strong and stable correlated with the rate of empirical relationship in most economies since the Second World War. unemployment. See also: Okun’s Figure 13.5 plots the change in the unemployment rate (vertical axis) and coefficient. the growth rate of output (horizontal axis) for six countries: higher output growth is clearly associated with a decrease in unemployment. In each country chart, there is a downward-sloping line that best fits the points. In Okun’s coefficient The change in the US, for example, the slope of the line implies that, on average, a 1% the unemployment rate in increase in the output growth rate decreases the unemployment rate by percentage points predicted to be roughly 0.38 percentage points. We say that Okun’s coefficient is –0.38 in associated with a 1% change in the the US. Our Einstein at the end of this section shows how to derive the growth rate of GDP. See also: coefficient. Okun’s law. The dot labeled 2009 in each graph in Figure 13.5 shows the changes in real GDP and unemployment that occurred from 2008 to 2009, during the recession that followed the global financial crisis. We can see that in 2009, all four of the advanced economies experienced their worst output con- traction in 50 years. As predicted by Okun’s law, unemployment rose in Spain, Japan, and the US. In each of these three countries, however, the increase in unemployment was higher than Okun’s law predicted: the red dot is well above the black line of best fit. Germany looks very different: Okun’s law predicted a rise in 553  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT unemployment of 1.65 percentage points in Germany but, as the red dot shows, German unemployment hardly changed in 2009. An economic policymaker would surely want to know how Germany managed to protect jobs in the face of the largest decline in the economy’s output in 50 years. We will see why this occurred later in this unit. Brazil and Malaysia also experienced contractions in output and increases in unemployment in 2009. However, like most developing eco- nomies, they were hit less hard by the crisis than the advanced economies. Also, Malaysia had recently experienced a much worse contraction during the East Asian crisis in 1998, when growth was –7.4%—bad enough that it would not fit on our chart. We can summarize the relationship between output, unemployment, and wellbeing like this: OECD. 2015. OECD Statistics (https://tinyco.re/9377362); The World Bank. 2015. World Development Indicators (https://tinyco.re/9263826). Figure 13.5 Okun’s law for selected economies. 554  13.2 OUTPUT GROWTH AND CHANGES IN UNEMPLOYMENT EXERCISE 13.3 OKUN’S LAW 1. Look at the regression lines (the lines of best fit) in Figure 13.5 (page 554). What prediction does the regression line show for unemployment when the economy is not growing? Are the results the same for all the countries? 2. Assume that the population in the economy is growing. Can you use this assumption to provide an explanation for your results in question 1? What else might explain the differences between countries? QUESTION 13.2 CHOOSE THE CORRECT ANSWER(S) The following graph shows the relationship between real GDP growth and change in unemployment for the US between 1961 and 2013. The equation shown is the regression result for the best-fitting line. Based on this information, which of the following statements is correct? The unemployment rate remains stable when there is zero real GDP growth. Okun’s coefficient for the US is 1.2298. From the regression result, policy makers can be sure that a 1% increase in real GDP next year will definitely lead to a fall in the unemployment rate of 0.38%. With real GDP falling by 2.8% in 2009, the predicted rise in the unemployment rate would have been 2.3%. 555  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT EINSTEIN Okun’s law This is defined as: Δut is the change in unemployment rate at time t, (GDP growtht) is the real GDP growth at time t, α is the intercept value, and β is a coefficient determining how real GDP growth is predicted to be translated into a change in unemployment rate. Okun’s Law is an empirical linear rela- tionship that associates real GDP growth with changes in unemployment. The coefficient β, called Okun’s coefficient, is generally found to be negative, suggesting that a positive real GDP growth will be associated with a fall in the unemployment rate. The estimated Okun’s law relationship for Germany, for the period 1970–2013, has coefficients β = –0.20 and α = 0.53. When we estimate a line of best fit, we also measure the R-squared (R²), which is a statistic that lies between 0 and 1. It measures how closely the observed data fits the line that we draw through them, with 1 being a perfect fit, and 0 representing no observable relationship between the observations and the prediction. In our case, the R² statistic measures how well Okun’s law approximates the data for real GDP growth and unemployment changes. The R² statistic is 0.22 for Germany for the period 1970–2013, which is much lower than for the estimated Okun’s law equation for the US, which is 0.64. To work out the predicted percentage change in unemployment for Germany in 2009 using the Okun’s law equation, we simply plug in the value of real GDP growth for Germany in 2009 and solve the equation as follows: Okun’s law predicts that the fall in GDP of 5.1% in 2009 in Germany should have been associated with an increase in unemployment by 1.58 percentage points. 13.3 MEASURING THE AGGREGATE ECONOMY Economists use what are called aggregate statistics to describe the economy as a whole (known as the aggregate economy, meaning simply the sum of its parts brought together). In Figure 13.5, aggregate output (GDP) is the output of all producers in aggregate output The total output a country, not just those of some region, firm, or sector. Recall from Unit 1 in an economy, across all sectors that Diane Coyle, an economist who specializes in how we measure GDP, and regions. describes it as: Everything from nails to toothbrushes, tractors, shoes, haircuts, management consultancy, street cleaning, yoga teaching, plates, bandages, books, and the millions of other services and products in the economy. 556  13.3 MEASURING THE AGGREGATE ECONOMY The national accounts are statistics published by national statistical national accounts The system used offices that use information about individual behaviour to construct a for measuring overall output and quantitative picture of the economy as a whole. There are three different expenditure in a country. ways to estimate GDP: value added For a production process this is the value of output Spending: The total spent by households, firms, the government, and minus the value of all inputs (called residents of other countries on the home economy’s products. intermediate goods). The capital Production: The total produced by the industries that operate in the goods and labour used in produc- home economy. Production is measured by the value added by each tion are not intermediate goods. industry: this means that the cost of goods and services used as inputs to The value added is equal to profits production is subtracted from the value of output. These inputs will be before taxes plus wages. measured in the value added of other industries, which prevents double- counting when measuring production in the economy as a whole. Income: The sum of all the incomes received, comprising wages, profits, the incomes of the self-employed, and taxes received by the government. The relationship between spending, production, and incomes in the eco- In eighteenth century France, a nomy as a whole can be represented as a circular flow: the national group of economists, called the accounts measurement of GDP can be taken at the spending stage, the pro- Physiocrats, studied the economy duction stage, or the income stage. If accurate measurement were possible, and compared the way it func- the total of expenditure, output, and incomes in a year would be the same tioned to the circular flow of blood so the point at which the measurement is taken would not matter. in the human body. This was a This is because any spending on a good or a service, which must have forerunner to how we think today been produced, is income for whomever sold that output. If you buy a taco about the circular flow in the eco- from a street vendor for 20 pesos, then your expenditure is 20 pesos, the nomy that allows us to calculate value added of the taco whose production was necessary for this sale is 20 GDP. Money flows from the pesos, and the income received by the street vendor is also 20 pesos. The spender to the producer, from the same point applies if you purchase a car for $20,000, a massage for $50, or producer to its employees or insurance for $20 per month. shareholders, and then is spent Households and firms both receive income and spend it. Figure 13.6 again on further output, continuing shows the circular flow between households and firms (ignoring the role of the cycle. government and purchases from and sales abroad for now). In the model of the economy in Figure 1.12, we looked at the physical flows among households, firms, and the biosphere instead of the circular flow of income. In Unit 20, we look at how the interaction of households and firms with the biosphere can be measured. Figure 13.6 The circular flow model: Three ways to measure GDP. 557  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT GDP can be defined according to any of these three perspectives. But we imports (M) Goods and services have to be careful in the definition because, while it is always the case that produced in other countries and one person’s expenditure is another person’s income, globalization means purchased by domestic households, that often the two people are in different countries. This is the case with firms, and the government. imports and exports: someone in China may buy rice from someone in exports (X) Goods and services Japan, implying that the expenditure is Chinese while the income is produced in a particular country Japanese. and sold to households, firms and How do we account for these transactions? Since GDP is defined as governments in other countries. domestic product, it counts as Japanese GDP because the rice was produced (and sold) by Japan. So exports are included in GDP because they are part of domestic production, but imports are not because they are produced elsewhere. For this reason, GDP is defined to include exports and exclude imports: as the value added of domestic production, or as expenditure on domestic production as income due to domestic production The circular flow model in Figure 13.6 considered only households and firms, but the government, and the public services the government provides, can be incorporated in a similar way. Households receive some goods and services that are supplied by the government, for which they do not pay at the point of consumption. A good example is primary school education. The consumption and production of these services can be visualized using the circular flow model: Households to government: Households pay taxes. Government to households: These taxes pay for the production of public services used by households. In this way the government can be seen as another producer, like a firm— with the difference that the taxes paid by a particular household pay for public services in general, and do not necessarily correspond to the services received by that household. In Unit 19, we will look at how the payment of taxes and the receipt of public services or benefits varies across households. Since public services are not sold in the market, we also have to make a further assumption: that the value added of government production is equal to the amount it costs the government to produce. So we can say that if, for example, citizens on average pay $15,000 per year in taxes (the expenditure), that is $15,000 of revenues to the govern- ment (the income), which uses it to produce $15,000 worth of public goods and services (the value added). 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. We described recessions as periods of negative output growth. But this means they must also be periods of negative expenditure growth (output will only decline if people are buying less). Often, we can even say that output declines because people are buying less. This is very useful because we know a lot about what determines expenditure, which in turn helps us to understand recessions, as we will see in Unit 14. 558  13.4 MEASURING THE AGGREGATE ECONOMY: THE COMPONENTS OF GDP 13.4 MEASURING THE AGGREGATE ECONOMY: THE COMPONENTS OF GDP Figure 13.7 shows the different components of GDP from the expenditure side, as measured in the national accounts for economies on three different continents: the US, the Eurozone, and China. Consumption (C) Consumption includes the goods and services purchased by households. consumption (C) Expenditure on Goods are normally tangible things. Goods like cars, household appliances, consumer goods including both and furniture that last for three years or more are called durable goods; short-lived goods and services and those that last for shorter periods are non-durable goods. Services are long-lived goods, which are called things that households buy that are normally intangible, such as consumer durables. transportation, housing (payment of rent), gym membership, and medical treatment. Household spending on durable goods like cars and household equipment is counted in consumption in the national accounts, although as we will see, in economic terms the decision to buy these long-lasting items is more like an investment decision. From the table in Figure 13.7 we see that in the advanced countries, con- sumption is by far the largest component of GDP, close to 56% in the Eurozone and 68% in the US. This contrasts with China, where final con- sumption of households accounts for 37% of GDP. Investment (I) This is the spending by firms on new equipment and new commercial investment (I) Expenditure on buildings; and spending on residential structures (the construction of new newly produced capital goods housing). (machinery and equipment) and Investment in the unsold output that firms produce is the other part of buildings, including new housing. investment that is recorded as a separate item in the national accounts. It is called the change in inventories or stocks. Including changes in stocks is essential to ensuring that when we measure GDP by the output method inventory Goods held by a firm (what is produced), it is equal to GDP measured by the expenditure method prior to sale or use, including raw (what is spent, including investment by firms in unsold inventories). materials, and partially-finished or Investment represents a much lower share of GDP in OECD countries, finished goods intended for sale. roughly one-fifth of GDP in the US and the Eurozone. In contrast, invest- ment accounts for almost half of GDP in China. OECD. 2015. OECD Statistics US Eurozone (19 countries) China (https://tinyco.re/9377362); The World Consumption (C) 68.4% 55.9% 37.3% Bank. 2015. World Development Indicators (https://tinyco.re/9263826). Government spending (G) 15.1% 21.1% 14.1% OECD reports a statistical discrepancy Investment (I) 19.1% 19.5% 47.3% for China equal to -3.1% of GDP. Change in inventories 0.4% 0.0% 2.0% Exports (X) 13.6% 43.9% 26.2% Imports (M) 16.6% 40.5% 23.8% Figure 13.7 Decomposition of GDP in 2013 for the US, the Eurozone, and China. 559  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT Government spending on goods and services (G) This represents the consumption and investment purchases by the govern- government spending (G) Expend- ment (consisting of central and local government, often called ‘general iture by the government to government’). Government consumption purchases are of goods (such as purchase goods and services. When office equipment, software, and cars) and services (such as wages of civil used as a component of aggregate servants, armed services, police, teachers, and scientists). Government demand, this does not include investment spending is on the building of roads, schools, and defence spending on transfers such as equipment. Much of government spending on goods and services is for pensions and unemployment bene- health and education. fits. See also: government transfers Government transfers in the form of benefits and pensions, such as government transfers Spending by Medicare in the US, or social security benefits in Europe, are not included the government in the form of in G because households receive them as income: when they are spent, they payments to households or indi- are recorded in C or I. It would be double-counting to record this spending viduals. Unemployment benefits in G too. and pensions are examples. The share of government spending on goods and services is slightly Transfers are not included in gov- higher in Europe (21.1%) than in the US (15.1%). Remember, this excludes ernment spending (G) in the transfers (such as benefits and pensions). The greater difference in the role national accounts. See also: gov- of the government between Europe and the US comes from those transfers. ernment spending (G) In 2012, total government spending including transfers was 57% of GDP in trade balance Value of exports France, compared to 40% of GDP in the US. minus the value of imports. Also known as: net exports. See also: Exports (X) trade deficit, trade surplus. Domestically produced goods and services that are purchased by house- trade deficit A country’s negative holds, firms, and governments in other countries. trade balance (it imports more than it exports). See also: trade surplus, trade balance. Imports (M) Goods and services purchased by households, firms, and governments in trade surplus A country’s positive the home economy that are produced in other countries. trade balance (it exports more than it imports). See also: trade deficit, trade balance. Net exports (X − M) aggregate demand The total of the Also called the trade balance, this is the difference between the values of components of spending in the eco- exports and imports (X – M). nomy, added to get GDP: Y = C + I + In 2010, the US had a trade deficit of 3.4% of GDP and China had a trade G + X – M. It is the total amount of surplus of 3.6% of GDP. The trade balance is a deficit if the value of exports demand for (or expenditure on) minus the value of imports is negative; it is called a trade surplus if it is goods and services produced in the positive. economy. See also: consumption, investment, government spending, GDP (Y) exports, imports. To calculate GDP, which is the aggregate demand for what is produced in the country, we add the purchases by those in other countries (exports) and subtract the purchases by home residents of goods and services produced abroad (imports). Taking China as an example, its GDP is the aggregate demand for China’s output, which includes its exports less its imports. Working with national accounts data is a way of learning about the eco- nomy, and an easy way to do this is to use the Federal Reserve Economic Data (FRED) (https://tinyco.re/3965569). To learn more about the country where you live and how it compares to other countries, try Exercise 13.4 for yourself. In most countries, private consumption spending makes up the largest share of GDP (see Figure 13.7 to check). Investment spending accounts for a much smaller share (China’s very high level of investment, shown in Figure 13.7, is exceptional). We use the data in the national accounts to 560  13.4 MEASURING THE AGGREGATE ECONOMY: THE COMPONENTS OF GDP calculate how much each component of expenditure contributes towards GDP fluctuations. The equation below shows how GDP growth can be broken down into the contributions made by each component of expenditure. We can see that the contribution of each component to GDP growth depends on both the share of GDP that the component makes up and its growth over the previous period. The table in Figure 13.8 shows the contributions of the components of expenditure to US GDP growth. The data is for 2009, in the middle of the recession caused by the global financial crisis. We can see that: Although investment makes up less than one-fifth of US GDP, it was much more important in accounting for the contraction in the economy than the fall in consumption spending. Although consumption makes up about 70% of US GDP, the effect of investment on GDP was more than three times larger. In contrast to consumption and investment, government expenditure contributed positively to GDP growth. The US government used fiscal stimulus to prop up the economy whilst private sector demand was depressed. Net exports also contributed positively to GDP, which reflects both the stronger performance of emerging economies in the aftermath of the crisis and the collapse in import demand that accompanied the recession. Shortcomings of GDP as a measure Three things need to be kept in mind when using the concept of GDP: 1. It is a conventional measure of the size of an economy: We examined what GDP includes in Unit 1. In Unit 20, the concept of green growth accounting is introduced, which shows how to calculate the size of the economy and its growth taking into account environmental degradation. 2. Distinguish aggregate GDP from GDP per capita: This is especially import- ant when discussing growth. In this section, the focus has been on GDP Federal Reserve Bank of St. Louis. 2015. GDP Consumption Investment Government spending Net exports FRED (https://tinyco.re/3965569). Note 2009 −2.8 −1.06 −3.52 0.64 1.14 that in the national accounts, govern- ment investment is counted as government spending and not invest- Figure 13.8 Contributions to percentage change in real GDP in the US in 2009. ment. 561  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT and the contributions of the different components of demand to its growth. In other contexts, the relevant concept is a per capita measure. To see the difference, note that GDP in the UK grew by 7% between 2007 and 2015 but GDP per capita grew by only 0.8%. The explanation is that there was a large increase in immigration. 3. GDP per capita is a flawed measure of living standards: Recall from Unit 1 that Robert Kennedy’s 1968 speech at the University of Kansas (https://tinyco.re/9533853) highlighted these flaws (search for ‘Gross National Product’ in the text). EXERCISE 13.4 HOW TO USE FRED nomy using the NBER definition, but not for other eco- If you want real-time macroeconomic data on the nomies. For other economies, assume that a recession is German unemployment rate or China’s output growth, defined by two consecutive quarters of negative growth. you do not need to learn German and Chinese, or At the bottom of the graph page, select ‘Create your struggle to get to grips with national archives, because own data transformation’ and click on ‘Percent change FRED does it for you! FRED is a comprehensive up-to- from one year’ (FRED gives you a hint about how to date data source maintained by the Federal Reserve calculate a growth rate at the bottom of the page: notes Bank of St Louis in the US, which is part of the US on growth rate calculation and recessions). The series central banking system. It contains the main macroeco- now shows the percentage change in real GDP. nomic statistics for almost all developed countries going back to the 1960s. FRED also allows you to create 3. How many recessions has your chosen economy your own graphs and export data into a spreadsheet. undergone over the years plotted in the chart? To learn how to use FRED to find macroeconomic 4. What are the two biggest recessions in terms of data, follow these steps: length and magnitude? Visit the FRED website (https://tinyco.re/8136544). Now add to the graph the quarterly unemployment rate Use the search bar and type ‘Gross Domestic for your chosen economy (click on ‘Add data series’ Product’ (GDP) and the name of a major global eco- under the graph and search for ‘Unemployment’ and nomy. Select the annual series for both nominal your chosen country name). (current prices) and real (constant prices) GDP for this country. Click the ‘Add to Graph’ button at the 5. How does the unemployment rate react during the bottom of the page. two main recessions you have identified? 6. What was the level of the unemployment rate during Use the graph you created to answer these questions: the first and the last quarter of negative growth for those two recessions? 1. What is the level of nominal GDP in your chosen 7. What do you conclude about the link between country this year? recession and the variation in unemployment? 2. FRED tells you that the real GDP is chained in a specific year (this means that it is evaluated in terms Note: To make sure you understand how these FRED of constant prices for that year). Note that the real graphs are created, you may want to extract the data GDP and the nominal GDP series cross at one point. into a spreadsheet, and create a graph showing the Why does this happen? growth rate of real GDP and the evolution of the unemployment rate since 1948 for the US economy. From the FRED graph, keep only the real GDP series. FRED shows recessions in shaded areas for the US eco- 562  13.5 HOW HOUSEHOLDS COPE WITH FLUCTUATIONS QUESTION 13.3 CHOOSE THE CORRECT ANSWER(S) Which of the following statements is correct regarding measuring GDP? GDP can be measured either as the total spending on domestically produced goods and services, or the total value added in domestic production, or the sum of all incomes received from domestic pro- duction. Both exports and imports are included in the measurement of GDP. Government production is not included in the GDP. The value added of government production is computed using the price that public goods and services are sold at in the market. QUESTION 13.4 CHOOSE THE CORRECT ANSWER(S) Which of the following would increase GDP? A decline in imports, holding all other components of GDP constant. An increase in remittances paid to domestic residents by relatives living abroad. An increase in government spending. A decline in exports. 13.5 HOW HOUSEHOLDS COPE WITH FLUCTUATIONS Economies fluctuate between good and bad times. So far we have studied industrialized economies, but this is equally true in economies based on agriculture. Figure 13.9a illustrates fluctuations in production in the largely agrarian British economy between 1550 and 1700. Just as we divided GDP into different components from the expenditure side, we can also divide it into different sectors on the production side. Figure 13.9a shows the growth rate of real GDP and of the three main sectors: agriculture, industry, and services. Follow the analysis in Figure 13.9a to see how the agricultural sector drove fluctuations in GDP. Figure 13.9b shows the growth rates of real GDP and agriculture in India since 1960. In 1960 agriculture comprised 43% of the economy, which had declined to 17% in 2014. Partly due to modern farming methods, agriculture in modern India is not as volatile as it was in Britain before 1700. But it remains nearly twice as volatile as GDP as a whole. To help us to think about the costs and causes of economic fluctuations, shock An exogenous change in we begin with an agrarian economy. In an economy based on agricultural some of the fundamental data used production, the weather—along with war and disease—is a major cause of in a model. good and bad years. The term shock is used in economics to refer to an unexpected event, for example, extreme weather or a war. As we know, people think about the future and usually they anticipate that unpredictable events may occur. They also act on these beliefs. In a modern economy, this is the basis of the insurance industry. In an agrarian economy, households also anticipate that both bad luck and good harvests can occur. How do households cope with fluctuations that can cut their income in half from one season to the next? 563  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT View this data at OWiD https://tinyco.re/ 2907345 Stephen Broadberry, Bruce M. S. Campbell, and Alexander Klein. 2015. British Economic Growth, 1270–1870. Cambridge: Cambridge University Press. Figure 13.9a The role of agriculture in the fluctuations of the aggregate economy in Britain (1550–1700). 1. GDP growth between 1550 and 1700 3. Industry 5. Agriculture drove fluctuations in GDP The figure shows the growth rate of In this period the average difference in Between 1552 and 1553, the real GDP and its three main sectors at the output of the agricultural sector agricultural sector expanded by 41% this time. from one year to the next is three times and GDP rose by 17%. In the next year larger than that of the industrial the agricultural sector contracted by 2. Agriculture sector … 16% and the economy shrank by 8%. Clearly the agricultural sector is much more volatile than other sectors. 4. Services … and more than 10 times larger than that of the services sector. View the latest data at OWiD https://tinyco.re/0436267 The World Bank. 2015. World Development Indicators (https://tinyco.re/9263826). Figure 13.9b The role of agriculture in the fluctuations of the aggregate economy in India (1961–2014). 564  13.5 HOW HOUSEHOLDS COPE WITH FLUCTUATIONS We can distinguish between two situations: Good or bad fortune strikes the household: For example, when disease affects a family’s animals, or when a family member who plays an important role in farming is injured. Good or bad fortune strikes the economy as a whole: For example, when drought, disease, floods, a war, or an earthquake affects a whole area. Household shocks People use two strategies to deal with shocks that are specific to their self-insurance Saving by a house- household: hold in order to be able to maintain its consumption when there is a Self-insurance: Households that encounter an unusually high income in temporary fall in income or need some period will save, so that when their luck reverses, they can spend for greater expenditure. their savings. As we saw in Unit 10, they may also borrow in bad times if co-insurance A means of pooling they can, depending on how credit-constrained they are. It is called self- savings across households in order insurance because other households are not involved. for a household to be able to Co-insurance: Households that have been fortunate during a particular maintain consumption when it period can help a household hit by bad luck. Sometimes this is done experiences a temporary fall in among members of extended families or among friends and neighbours. income or the need for greater Since the mid-twentieth century, particularly in richer countries, co- expenditure. insurance has taken the form of citizens paying taxes, which are then used to support individuals who are temporarily out of work, called unemployment benefits. ‘New Cradles to Graves’ (https://tinyco.re/8856321). The Informal co-insurance among family and friends is based on both Economist. Updated 8 September reciprocity and trust: you are willing to help those who have helped you in 2012. the past, and you trust the people who you helped to do the same in return. Altruism towards those in need is also usually involved, although co-insur- altruism The willingness to bear a ance can work without it. cost in order to benefit somebody These strategies reflect two important aspects of household preferences: else. People prefer a smooth pattern of consumption: As we saw in Unit 10, they dislike consumption that fluctuates as a result of bad or good shocks Michael Naef and Jürgen Schupp such as injury or good harvests. So they will self-insure. report comparisons between Households are not solely selfish: They are willing to provide support to surveys and experiments using each other to help smooth the effect of good and bad luck. They often trust. Michael Naef and Jürgen trust others to do the same, even when they do not have a way of Schupp. 2009. ‘Measuring Trust: enforcing this. Altruistic and reciprocal preferences remain important Experiments and Surveys in even when co-insurance takes the form of a tax-supported unemploy- Contrast and Combination’ ment benefit, because these are among the motives for supporting the (https://tinyco.re/3956674). IZA public policies in question. Discussion Paper No. 4087. Economy-wide shocks Co-insurance is less effective if the bad shock hits everyone at the same time. When there is a drought, flood, or earthquake, it is more difficult for an agrarian economy to protect the wellbeing of the people who are affected. For example, it is not usually possible to store produce from a bumper harvest long enough to get through the next bad harvest, which may take several years to arrive. But when these shocks hit, co-insurance may be even more necessary, as community survival requires that less badly hit households help the worst- hit households. In farming economies of the past that were based in volatile 565  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT climates, people practised co-insurance based on trust, reciprocity, and altruism. These are norms, like the fairness norm we discussed in Unit 4, and they probably emerged and persisted because they helped people to survive in these regions that were often hit by bad weather shocks. Recent research suggests that they seem to have persisted even after climate had become largely unimportant for economic activity. Ruben Durante. 2010. ‘Risk, The evidence for this is that people in the regions with high year-to-year Cooperation and the Economic variability in rainfall and temperature during the past 500 years now Origins of Social Trust: An display high levels of trust, and have more modern day co-insurance insti- Empirical Investigation’ tutions such as unemployment benefit payments and government assistance (https://tinyco.re/7674543). for the disabled and poor. Sciences Po Working Paper. EXERCISE 13.5 HEALTH INSURANCE 1. Think about the health insurance system in your country. Is this an example of co-insurance or self-insurance? 2. Can you think of other examples of both co-insurance and self-insur- ance? In each case, consider what kinds of shocks are being insured against and how the scheme is financed. QUESTION 13.5 CHOOSE THE CORRECT ANSWER(S) Figure 13.9a (page 564) plots the growth rate of real GDP, as well as the growth rates of the agricultural, industrial, and service sectors between 1550 and 1700 in Britain. Which of the following statements can be deduced from the graph? The average growth rate of the agricultural sector was higher than that of the service sector for the period shown. The growth rate of the industrial sector was more volatile than that of the service sector. The agricultural sector largely drove fluctuations in GDP. The recession around 1560 was caused by contractions in all three sectors. 13.6 WHY IS CONSUMPTION SMOOTH? 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. Keeping a steady level of consumption means households have to plan. They think about what might happen to their income in the future, and they save and borrow to smooth the bumps in income. This is the self- insurance we discussed above. We have seen that this behaviour occurs in agrarian societies faced by weather and war shocks, but modern households also try to smooth their consumption. One way to visualize this behaviour is to focus on predictable events. A young person thinking about life can imagine getting a job, then enjoying a period of working life with income higher than the starting salary, followed by years in retirement when income is lower than during working life. As we saw in Unit 10, people prefer to smooth their consumption because there are diminishing marginal returns to consumption at any 566  13.6 WHY IS CONSUMPTION SMOOTH? given time. So having a lot of consumption later and little now, for example, is worse than having some intermediate amount of consumption in the two periods (Figure 10.3a). The person contemplating a future promotion and planning their spending would be in a position similar to Julia in Unit 10 (Figure 10.2), 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. The model of decision making for the individual that we introduced in Unit 3 and Unit 10 is the basis for thinking about consumption throughout a person’s life. It predicts that, although income fluctuates throughout our lives, our desired consumption is smoother. We can use Figure 13.10 to visualize an individual’s tendency to smooth consumption expenditure. 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. Follow the analysis in Figure 13.10 to see their income and con- sumption over time. A notable feature of Figure 13.10 is that consumption changes before income does. Like a family in an agrarian economy that begins saving for a daughter’s dowry before she is old enough to marry, the individual shown in Figure 13.10 anticipates receiving higher income after a promotion, and adjusts consumption upward ahead of time. As we have seen in Unit 10, this assumes that the individual can borrow. Maybe it is possible to convince Figure 13.10 Consumption smoothing through our lifetime. 1. Income over time 2. Consumption expenditure 3. The individual borrows while young The blue line shows the path of income This is the red line. It is smooth (flat) At this time income is low. The indi- over time: it starts low, rises when the from the point at which the individual vidual saves and repays the debt when individual is promoted and falls at first gets a job. older and earning more, and finally retirement. runs down savings after retirement, when income falls again. 567  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT the bank that the job is secure and prospects are good. If so, the individual can probably get a mortgage now, and live in a more comfortable house with a higher standard of living than would be the case if long-term earn- ings were to remain at the starting salary. The labels on Figure 13.10 show that the individual borrows while young and income is low, saves and repays the debt when older and earning more, and finally runs down savings after retirement, when income falls again. The model of decision making highlights the desire of households for a smooth path of consumption. 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? 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 13.10 up or down to reflect the new long-run level of consumption that the indi- vidual 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. To summarize, when individuals and households behave in the way shown in Figure 13.10, shocks to the economy will be dampened because spending decisions are based on long-term considerations. They aim to avoid fluctuations in consumption even when income fluctuates. In Portfolios of the Poor: How the What limits a household’s consumption smoothing? Many individuals World’s Poor Live on $2 a Day, and households are not able to make or implement long-term consumption Daryl Collins, Jonathan Morduch, plans. Making plans can be difficult because of a lack of information. Even Stuart Rutherford, and Orlanda if we have information, we may not be able to use it to predict the future Ruthven show how poor house- with confidence. For example, it is often very hard to judge whether a holds manage finances to avoid change in circumstances is temporary or permanent. literally living hand-to-mouth. There are three other things that constrain the ways in which house- ‘Smooth Operators’ holds can smooth their consumption when faced with income shocks. The (https://tinyco.re/7009658). The first two concern limits on self-insurance, the third is a limit on co-insur- Economist. Updated 14 May 2009. ance: Some of the stories can be read online (https://tinyco.re/8070650). Credit constraints or credit market exclusion: Introduced in Unit 10, this restricts a family’s ability to borrow in order to sustain consumption when income has fallen. Weakness of will: A characteristic of human behaviour that leads people to be unable to carry out the plans—for example, saving in anticipation of a negative income shock—that they know would make them better off. Limited co-insurance: So that those with a fall in income cannot expect much support in sustaining their incomes from others more fortunate than them. Credit constraints As we saw in Unit 10, the amount a family can borrow is limited, particularly if it is not wealthy. Households with little money cannot borrow at all, or only at extraordinarily high interest rates. Thus the people who most need credit to smooth their consumption are often unable to do 568  13.6 WHY IS CONSUMPTION SMOOTH? so. The credit constraints and credit market exclusion discussed in Units 10 and 12 help explain why borrowing is often not possible. Figure 13.11 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. Credit-constrained households that are unable to get a loan or take out a credit card are in the bottom panel. Follow the analysis in Figure 13.11 to see how the two households react to two key events: 1. News is received that income will rise at a predictable time in the future (for example, a promotion or a bequest). 2. The household’s income actually rises (the promotion happens, the inheritance comes through). We can think about these decisions using the two-period model of borrowing and lending from Unit 10, shown in Figure 13.12. First consider a household that receives the same income, y, this period and next period, indicated by the endowment point A in Figure 13.12. The interest rate is r Figure 13.11 Consumption when credit constraints bind: An anticipated rise in income. 1. Income over time 2. Consumption smoothing 3. The effect of credit constraints The blue lines on the figure show that The red line in the top panel shows On the other hand, a credit-constrained the path of income over time is the that, in a consumption-smoothing household that cannot borrow has to same in both households. household, consumption changes wait until the income arrives before immediately once the household adjusting its standard of living. receives the news. 569  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT so if the household can borrow and save, then it can choose any point on the budget constraint, which has the slope −(1 + r). The budget constraint is another term for the frontier of the feasible set with the slope of −(1 + r) which we used in Unit 10. Figure 13.12 Credit-constrained and unconstrained households: An unanticipated temporary fall in income. 1. Same income in both periods 3. Preference for smoothing 5. The budget constraint Consider a household that receives the Assume that the household prefers to If it can borrow and save, then its same income, y, this period and next consume the same amount each budget constraint has a slope of −(1 + r) period, indicated by the endowment period, shown by the point A where the and passes through point A′. point A. indifference curve is tangent to the budget constraint. 6. The highest indifference curve 2. An unconstrained household The highest curve that touches this The interest rate is r so if the household 4. A negative shock budget constraint does so at point A″, can borrow and save, then it can Now suppose that the household showing that the household prefers to choose any point on the budget con- experiences an unexpected negative smooth consumption, consuming c′ in straint, which has the slope −(1 + r). temporary shock to its income this both periods. The household borrows c′ year, such as a bad harvest, which − y′ now and repays (1 + r)(c′ − y′) next lowers this year’s income to y′, leaving period following the shock. expected income next year unaffected at y. 570  13.6 WHY IS CONSUMPTION SMOOTH? 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 house- hold consumes less this period and more next period. We can also see that the indifference curve that passes through A′ (not shown) is lower than the one that passes through A″. So the household that can smooth consumption by borrowing is better off than the credit- constrained household. A temporary change in income affects the current consumption of credit-constrained households more than it does that of the unconstrained. Weakness of will In Figure 13.13, an individual learns that income is going to fall in the weakness of will The inability to future. This could be because of retirement or job loss. It could also be commit to a course of action because the individual is becoming pessimistic. Perhaps the newspapers (dieting or foregoing some other predict an economic crisis. In the top panel of Figure 13.13 we again show a present pleasure, for example) that household behaving in a forward-looking manner to smooth consumption. one will regret later. It differs from The bottom panel shows a household with weakness of will that con- impatience, which may also lead a sumes all its income today even though it implies a large reduction in person to favour pleasures in the consumption in the future. present, but not necessarily act in a This feature of human behaviour is familiar to many of us. We often lack way that one regrets. willpower. The problem of not being able to save obviously differs from the problem of not being able to borrow: saving is a form of self-insurance and doesn’t involve anyone else. HOW ECONOMISTS LEARN FROM FACTS My diet starts tomorrow Economists have conducted experiments to test for behaviour that would help to explain why we don’t save even when we can. For example, Daniel Read and Barbara van Leeuwen conducted an experiment with 200 employees at firms in Amsterdam. They asked them to choose today what they thought they would eat next week. The choice was between fruit and chocolate. When asked, 50% of subjects replied that they would eat fruit next week. But, when next week came, only 17% actually chose to eat fruit. The experiment shows that, although people may plan to do something that they know will be beneficial (eat fruit, save money), when the time comes they often don’t do it. Read: Daniel, and Barbara van Leeuwen. 1998. ‘Predicting Hunger: The Effects of Appetite and Delay on Choice’. Organizational Behavior and Human Decision Processes 76 (2): pp. 189–205. 571  UNIT 13 ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT Limited co-insurance OECD. 2010. Employment Outlook Most households lack a network of family and friends who can help out in 2010: Moving Beyond the Jobs substantial ways over a long period when a negative income shock occurs. As Crisis (https://tinyco.re/5607435). we have seen, unemployment benefits provide this kind of co-insurance—the citizens who turn out to be lucky in one year insure those who are unlucky. But in many societies the coverage of these policies is very limited. A vivid demonstration of the value of smoothing through co-insurance is the experience of Germany during the drastic reduction in income experienced by that economy in 2009 (see Figure 13.5). 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 employ- ees, 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. The result was that although aggregate income fell, consumption did not—and unemployment did not increase. Figure 13.13 Consumption when households are weak-willed: An anticipated fall in income. 1. The path of income 2. Consumption smoothing 3. A weak-willed household The blue lines in the figure show that The red line in the top panel shows the In contrast, the weak-willed household income follows the same path in both consumption path for a consumption- does not react to the news, and keeps sets of households. smoothing household. When it receives consumption high until income falls. news of the imminent fall in income, it immediately starts saving to supplement consumption when income falls. 572  13.6 WHY IS CONSUMPTION SMOOTH? But most empirical evidence shows that credit constraints, weakness of Empirical evidence shows that, will, and limited co-insurance mean that, for many households, a change in even when income changes in income results in an equal change in consumption. In the case of a negative predictable ways, consumption income shock such as the loss of a job, this means that the income shock responds. Tullio Jappelli and Luigi will now be passed on to other families who would have produced and sold Pistaferri. 2010. ‘The Consumption the consumption goods that are now not demanded. Response to Income Changes’ We will see in the next unit how the initial shock in income may be (https:/