Why does output fluctuate

During the Great Depression, unemployment in the UK was higher than it had ever been, and it was particularly low during the World Wars.

Look at this article , especially Figures 5, 6, and 7, to find out more. 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. 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:. 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. Natural logs use base e, where e is a number approximately 2. 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 Using the chart functions in Microsoft Excel helps illustrate the relationship between plotting the data with a ratio scale on the vertical axis Figure Note that the tick marks double from 4, to 8, to 16, in Figure In each chart, a line appears alongside the data series.

Using Excel, we created Figure 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 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.

This time, we see an equation for a straight line with intercept 8. Now the slope of the line tells us the exponential, or equivalently, the compound annual growth rate of the series: 0. World Development Indicators. In each country chart, there is a downward-sloping line that best fits the points. The dot labeled in each graph in Figure We can see that in , all four of the advanced economies experienced their worst output contraction 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 However, like most developing economies, they were hit less hard by the crisis than the advanced economies.

Also, Malaysia had experienced a much worse contraction during the East Asian crisis in , when growth was —7. The following graph shows the relationship between real GDP growth and change in unemployment for the US between and The equation shown is the regression result for the best-fitting line. Based on this information, which of the following statements is correct? When we estimate a line of best fit, we also measure the R-squared R 2 , 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. The R 2 statistic is 0. 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. 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.

The national accounts are statistics published by national statistical offices that use information about individual behaviour to construct a quantitative picture of the economy as a whole. There are three different ways to estimate GDP:. In eighteenth century France, a group of economists, called the Physiocrats, studied the economy and compared the way it functioned to the circular flow of blood in the human body. This was a forerunner to how we think today about the circular flow in the economy that allows us to calculate GDP.

Money flows from the spender to the producer, from the producer to its employees or shareholders, and then is spent again on further output, continuing the cycle. The relationship between spending, production, and incomes in the economy as a whole can be represented as a circular flow: the national accounts measurement of GDP can be taken at the spending stage, the production stage, or the income stage.

If accurate measurement were possible, the total of expenditure, output, and incomes in a year would be the same so the point at which the measurement is taken would not matter. Households and firms both receive income and spend it. In the model of the economy in Figure 1. In Unit 20, we look at how the interaction of households and firms with the biosphere can be measured. The three methods for measuring GDP are best understood using a very simple economy comprising just three industries.

Incomes are received as wages and profits. Across all industries in the economy, wages plus profits will be equal to the value of final production which is equal to the total value added. Therefore, GDP can be defined according to any of these three perspectives.

This is the case with imports and exports : someone in China may buy rice from someone in Japan, implying that the expenditure is Chinese while the income is Japanese. How do we account for these transactions? For this reason, GDP is defined to include exports and exclude imports:.

The circular flow model in Figure 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:. 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.

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 OECD reports a statistical discrepancy for China equal to Consumption includes the goods and services purchased by households. Goods are normally tangible things.

Goods like cars, household appliances, and furniture that last for three years or more are called durable goods; those that last for shorter periods are non-durable goods. Services are things that households buy that are normally intangible, such as 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 This is the spending by firms on new equipment and new commercial buildings; and spending on residential structures the construction of new housing. Investment in the unsold output that firms produce is the other part of 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 what is produced , it is equal to GDP measured by the expenditure method what is spent, including investment by firms in unsold inventories. In contrast, investment accounts for almost half of GDP in China. Government consumption purchases are of goods such as office equipment, software, and cars and services such as wages of civil servants, armed services, police, teachers, and scientists.

Government investment spending is on the building of roads, schools, and defence equipment. Much of government spending on goods and services is for health and education. Government transfers in the form of benefits and pensions, such as Medicare in the US, or social security benefits in Europe, are not included in G because households receive them as income: when they are spent, they are recorded in C or I. It would be double-counting to record this spending in G too. The share of government spending on goods and services is slightly higher in Europe Remember, this excludes transfers such as benefits and pensions.

The greater difference in the role of the government between Europe and the US comes from those transfers. Domestically produced goods and services that are purchased by households, firms, and governments in other countries. Goods and services purchased by households, firms, and governments in the home economy that are produced in other countries. Also called the trade balance , this is the difference between the values of exports and imports X — M.

In , the US had a trade deficit of 3. The trade balance is a deficit if the value of exports minus the value of imports is negative; it is called a trade surplus if it is positive. 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.

Working with national accounts data is a way of learning about the economy, and an easy way to do this is to use the Federal Reserve Economic Data FRED. To learn more about the country where you live and how it compares to other countries, try Exercise In most countries, private consumption spending makes up the largest share of GDP see Figure We use the data in the national accounts to 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 The data is for , in the middle of the recession caused by the global financial crisis.

We can see that:. Federal Reserve Bank of St. Note that in the national accounts, government investment is counted as government spending and not investment. It contains the main macroeconomic statistics for almost all developed countries going back to the s.

FRED also allows you to create your own graphs and export data into a spreadsheet. You can also watch this short tutorial to understand how FRED works. You can remove a data series by using the graph editing tool. For other economies, assume that a recession is defined by two consecutive quarters of negative growth. The series now shows the percentage change in real GDP. Note: To make sure you understand how these FRED graphs are created, you may want to extract the data into a spreadsheet, and create a graph showing the growth rate of real GDP and the evolution of the unemployment rate since for the US economy.

Economies fluctuate between good and bad times. So far we have studied industrialized economies, but this is equally true in economies based on agriculture. Just as we divided GDP into different components from the expenditure side, we can also divide it into different sectors on the production side. Follow the analysis in Figure Stephen Broadberry, Bruce M. Campbell, and Alexander Klein.

British Economic Growth, — Cambridge: Cambridge University Press. The figure shows the growth rate of real GDP and its three main sectors at this time. In this period the average difference in the output of the agricultural sector from one year to the next is three times larger than that of the industrial sector ….

Partly due to modern farming methods, agriculture in modern India is not as volatile as it was in Britain before But it remains nearly twice as volatile as GDP as a whole. The World Bank. 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. 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?

People use two strategies to deal with shocks that are specific to their household: 3. 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.

Altruism towards those in need is also usually involved, although co-insurance can work without it. 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 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. The evidence for this is that people in the regions with high year-to-year variability in rainfall and temperature during the past years now display high levels of trust, and have more modern day co-insurance institutions such as unemployment benefit payments and government assistance for the disabled and poor.

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 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 The person contemplating a future promotion and planning their spending would be in a position similar to Julia in Unit 10 Figure It predicts that, although income fluctuates throughout our lives, our desired consumption is smoother.

We can use Figure The blue line shows the path of income over time: it starts low, rises when the individual is promoted and falls at retirement. This is the red line. It is smooth flat from the point at which the individual first gets a job. At this time income is low. More goods are produced because the output is increased and more goods are bought because of the lower prices. This AS-AD model shows how the aggregate supply and aggregate demand are graphed to show economic output. The AD curve shifts to the right which increases output and price.

In the long-run, the aggregate supply curve and aggregate demand curve are only affected by capital, labor, and technology.

Everything in the economy is assumed to be optimal. The aggregate supply curve is vertical which reflects economists' belief that changes in aggregate demand only temporarily change the economy's total output. In the long-run an increase in money will do nothing for output, but it will increase prices. Boundless Economics. Aggregate Demand and Supply. Introducing Aggregate Demand and Aggregate Supply. Concept Version 6.

Learning Objective Differentiate between short-run and long-run effects of nominal fluctuations. Key Points In the short run, output is determined by both the aggregate supply and aggregate demand within an economy. Anything that causes labor , capital , or efficiency to go up or down results in fluctuations in economic output. Although the beliefs of each school vary, all of the schools of economic thought have contributed to economic theory is some way.

The Keynesian School of economic thought emphasized the need for government intervention in order to stabilize and stimulate the economy during a recession or depression. In contrast, the Chicago School of economic thought focused price theory, rational expectations, and free market policies with little government intervention. The Austrian School of economic thought focused on the belief that all economic phenomena are caused by the subjective choices of individuals.

Unlike other schools, the Austrian school focused on individual actions instead of society as a whole. Privacy Policy. Skip to main content. Aggregate Demand and Supply. Search for:. Introducing Aggregate Demand and Aggregate Supply.

Explaining Fluctuations in Output In the short run, output fluctuates with shifts in either aggregate supply or aggregate demand; in the long run, only aggregate supply affects output. Learning Objectives Differentiate between short-run and long-run effects of nominal fluctuations. Key Takeaways Key Points In the short run, output is determined by both the aggregate supply and aggregate demand within an economy. The equilibrium is the point where supply and demand meet. According to Hume, in the short-run, and increase in the money supply will lead to an increase in production.

According to Hume, in the long-run, an increase in the money supply will do nothing. Key Terms nominal : Without adjustment to remove the effects of inflation in contrast to real. Classical Theory Classical theory, the first modern school of economic thought, reoriented economics from individual interests to national interests. Learning Objectives Identify the assumptions fundamental to classical economics.

Key Takeaways Key Points When classical theory emerged, society was undergoing many changes. Classical economics focuses on the growth in the wealth of nations and promotes policies that create national economic expansion. Classical theory assumptions include the beliefs that markets self-regulate, prices are flexible for goods and wages, supply creates its own demand, and there is equality between savings and investments.

Key Terms self-regulating : Describing something capable of controlling itself. Keynesian Theory Keynesian economics states that in the short-run, economic output is substantially influenced by aggregate demand. Shifts in aggregate demand impact production, employment, and inflation in the economy.