Unit 13

ECONOMIC FLUCTUATIONS AND UNEMPLOYMENT

OUTLINE
A. Introduction
B. The business cycle
C. Measuring the aggregate economy
D. Economic fluctuations and consumption
E. Economic fluctuations and investment
F. Inflation
Skip discussion on coordination games in 13.7
A. Introduction
 The Context for This Unit
We previously looked at how individuals make decisions about
saving and consumption in Unit 9 of ESPP.

These decisions also depend on economic conditions (prices,

unemployment), and affect firms’ decisions (investment).
• How do households and firms respond to economic conditions?
• What indicators can we use to measure economic conditions?
 This Unit
• Measuring the size of an economy: GDP and its
components

• How households smooth fluctuations in their income

• The role of firms’ investment decisions in the business

cycle

• Introducing inflation
B. The business cycle
 The business cycle
Economic growth is not a smooth process.

Business cycle = Alternating periods

of positive and negative growth rates.

Recession = period when output is

declining or below its potential level

The business cycle affects labour

market outcomes.
 Okun’s Law Quiz!

Okun’s Law = a strong and stable

relationship between unemployment
and GDP growth.

Changes in the rate of GDP growth

are negatively correlated with the
unemployment rate.

Output falls → Unemployment rises

C. Measuring the aggregate
economy
 Measuring the aggregate economy
National accounts = system used to measure overall output
and expenditure in a country.

3 equivalent ways to measure GDP:

1. Total spending on domestic products
2. Total domestic production (measured as value added)
3. Total domestic income
Measuring the aggregate economy
 Components of GDP
• Consumption (C) = Expenditure on consumer goods and services
• Investment (I) = Expenditure on newly produced capital goods
(incl. equipment, buildings, and inventories = unsold output)
• Government spending (G) = Government expenditure on goods
and services (excluding transfers to avoid double-counting)
• Net exports (NX) = Exports (X) - imports (M)

GDP = C + I + G + NX Quiz
(Also known as Y, or aggregate demand)
EU27 GDP (2023) and Its Components
A brief excursus on the open
economy
 Expenditure and Production in an
Open Economy
CA = EX – IM = Y – (C + I + G )
• When:
• production > domestic expenditure Y > (C + I + G )
• exports > imports EX >IM
• current account > 0 and trade balance > 0 CA>0 TB>0
• when a country exports more than it imports, it earns more income from exports than it
spends on imports
• net foreign wealth is increasing
Expenditure and Production in an Open
Economy
CA = EX – IM = Y – (C + I + G )
• When:
• production < domestic expenditure Y < (C + I + G )
• exports < imports EX < IM
• current account < 0 and trade balance < 0 CA<0 TB<0
• when a country exports less than it imports, it earns less income from exports than it spends
on imports
• net foreign wealth is decreasing
Saving in a closed economy
• National saving (S) = national income (Y) that is not spent
on consumption (C) or government purchases (G).
S=Y–C–G
S = (Y – C – T) + (T – G)
S = Sp + Sg
Sp=private saving
Sg=government saving
S=I saving=investment
Saving in an open economy
CA = Y – (C + I + G )
= (Y – C – G ) – I
= S – I
current account = national saving – investment
current account = net foreign investment
How Is the Current Account Related to
National Saving?
CA = S – I
• CA > 0
• EX>IM
• S > I: net foreign investment and financial capital outflows for the domestic
economy are positive.

• A country that exports more than it imports has high national saving
relative to investment.
• It can finance investment by saving
How Is the Current Account Related to
National Saving?
CA = S – I
• CA < 0
• EX<IM
• S < I: net foreign investment and financial capital outflows for the domestic economy are
negative.

• A country that imports more than it exports has low national saving relative to
investment.
• To finance investment it acquires foreign funds equal to the current account
deficit
Current account balance (% GDP)

Germany

China

USA
Balance of Payments Accounts
• A country’s balance of payments accounts for its payments to and its receipts
from foreigners.
• An international transaction involves two parties, and each transaction enters the
accounts twice: once as a credit (+) and once as a debit (–).
Balance of Payments Accounts
• The balance of payments accounts are separated into 3 broad accounts:
• current account: accounts for flows of goods and services (imports
and exports).
• financial account: accounts for flows of financial assets (financial
capital).
• capital account: flows of special categories of assets (capital):
typically nonmarket, non-produced, or intangible assets like debt
forgiveness, copyrights and trademarks.
How Do the Balance of Payments
Accounts Balance?
• Due to the double entry of each transaction, the balance of payments accounts
will balance by the following equation:
current account +
financial account +
capital account = 0
CA+KA=0
Where KA=financial account+capital account
 Italy’s current account balance (%GDP)
Nel 2023 il conto corrente dell’Italia è tornato in
avanzo. Il recupero rispetto all’anno precedente, di
circa 2 punti percentuali di prodotto, è dovuto
principalmente al minore deficit energetico, che si
è quasi dimezzato rispetto al 2022 in seguito alla
flessione dei prezzi delle materie prime
energetiche, in particolare del gas naturale. Anche
il saldo dei beni non energetici è migliorato, di 0,7
punti in rapporto al PIL.
Il disavanzo dei servizi si è ridotto nel confronto
con il 2022, soprattutto a causa dell’ampliamento
del surplus della bilancia turistica (1,0 per cento
del prodotto, in linea con il valore del 2019). Tale
aumento è stato trainato dalla spesa dei
viaggiatori provenienti dai paesi esterni alla UE,
tornata ai livelli del 2019; quella dei turisti
provenienti dall’Unione li aveva già recuperati nel
2022. Sono cresciute in particolare le entrate
legate a viaggi culturali e visite alle città d’arte, che
Source: Annual Report 2022, Bank of Italy erano state più penalizzate durante la pandemia.
Italy’s
Balance of
Payments

Source: Annual Report

2023, Bank of Italy
 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.
D. Economic fluctuations
and consumption
 Economic fluctuations
India (1961–2020)

Economies fluctuate between good and bad times. This is true for
industrialised as well as agrarian societies. Interactive data
 Shocks

Shock = an unexpected event (such as extreme weather) which

causes GDP to fluctuate.

There are two broad types of shocks:

1. Good or bad fortune strikes the household (idiosyncratic risk)
2. Good or bad fortune strikes the entire economy (systemic
risk)
 Household shocks
People use two strategies to deal with shocks that are specific to
their household:
1. Self-insurance – saving and borrowing. Other households are
not involved.
2. Co-insurance – support from social network or government.

These strategies reflect households’ preferences:

• Consumption smoothing
• Altruism
 Consumption Smoothing
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

Modigliani’s Life-cycle theory of consumption / Friedman’s Permanent income hypothesis

 Consumption smoothing
and the aggregate economy
Consumption smoothing is a source of stabilisation in an
economy.

When there are limitations to consumption smoothing (e.g.,

credit constraints) this stabilisation effect is limited (it may
even amplify the initial shock)
 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.
E. Economic fluctuations
and investment
 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.

High demand → high capacity utilisation,

→ investment → even higher demand

Investment decisions depend on firms’

expectations about future demand
Business confidence
Business
confidence brings
firms to invest.

When business
confidence is high,
all firms invest: the
cycle is self-
reinforcing.
Source: ISTAT
 Investment and the aggregate economy
• Firms respond
positively to the
growth of demand in
the economy.
• This is why investment
is more volatile than
GDP.
How volatile are the 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.
F. Inflation
 Inflation, GDP, and Unemployment
Inflation = an increase in the general
price level in the economy
Inflation tends to be lower during
recessions (high unemployment)
 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
• 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
 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

• Limitations of fiscal policy: The consequences of

being part of the world economy