Unit 3 Aggregate demand and the multiplier model

3.5 Growth and fluctuations

In the last two decades, there were two unusually severe economic downturns, one associated with the global financial crisis and the other with the COVID-19 pandemic. However, fluctuations in economic activity are a typical occurrence in capitalist economies. Even for countries where GDP per capita has been rising over the last two centuries, shown in the hockey stick charts in The Economy 2.0: Microeconomics, Section 1.2, this process is generally not smooth.

To assess how GDP changes from period to period, we calculate its growth rate—that is, the percentage change. For example:

\[\begin{align*} \text{Real annual GDP growth in 2023 } &= \text{ % change in real GDP} \\ &= \frac{\text{GDP}_{2023} - \text{GDP}_{2022}}{\text{GDP}_{2022}} \times 100 \end{align*}\]

The top panel of Figure 3.8a shows real GDP between 1875 and 2023 for the UK and Japan. Since we want to focus on the size of the economy and how it changes from year to year, we examine total GDP rather than GDP per capita. In both countries, real GDP increased enormously over 140 years: on average, growth rates were positive. But there were also downturns, where annual growth rates were negative—particularly during the COVID-19 pandemic and after the Second World War.

The lower panel shows a different way of presenting the same data, which makes it easier to compare growth rates in different periods. We use a ratio scale on the vertical axis. On a ratio scale the gap between each pair of gridlines represents a constant ratio between the corresponding values—in this example, GDP doubles. In other words, a move from one gridline to the next represents a constant percentage increase (of 100% in this case). The effect of the ratio scale is that the slope of the graph at each point is equal to the growth rate. For example, in 1875 UK GDP was approximately £100,000m. Suppose that it had then grown at a constant rate, doubling every 35 years: £200,000m in 1910, £400,000m in 1945, etc. If you plotted these points they would appear as a straight line on the graph. By 2015 it would have reached £1,600,000m.

This is not far from what actually happened in the UK. Ignoring the short-term fluctuations, GDP appears as a roughly straight line on the ratio scale graph. The average annual growth rate over the whole period was 2.02%. If GDP had grown at a constant rate of 2.02%, it would have increased by 100% every 35 years. Looking more carefully, however, you can see that the line is steeper in the middle of this period; the average annual growth rate was higher in the mid-20th century than in the periods before the First World War, or since the millennium. These changes in growth rates are much more pronounced in Japan, where the ratio graph is far from a straight line. GDP grew very rapidly (the graph is steep) in the 25 years after the Second World War, with an average annual growth rate of 8.99%, but the average since 1990 has been just 0.51%.

Plotting GDP as in Figure 3.8a shows trends over long periods, but to focus on short-term fluctuations it is more helpful to plot annual GDP growth rates (the slopes of the ratio scale graph) on the vertical axis. Figure 3.8b shows that UK growth rates change a lot over the business cycle.

The business cycle

recession

The US National Bureau of Economic Research defines a recession as a period when output is declining. It is over once the economy begins to grow again. An alternative definition is a period when the level of output is below its normal level, even if the economy is growing. It is not over until output has grown enough to get back to normal. The latter definition has the problem that the ‘normal’ level is subjective.

The ups and downs of the series in Figure 3.8b show that economic growth is not a smooth process. We often hear about economies going through a boom or a recession as growth swings from positive to negative, but there is no standard definition of these words. The National Bureau of Economic Research (NBER), a US organization, defines it like this: ‘During a recession, a significant 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 definitions of recession:

• NBER definition: Output is declining. A recession is over once the economy 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. In the WS–PS model of Units 1 and 2, we used one definition of normal output: the equilibrium level of employment is where the WS and PS curves intersect. (We return to this issue in later units, where ‘normal output’ is often defined as that consistent with stable inflation, which, in the WS–PS model, is the level of output associated with the equilibrium level of employment.)

business cycle

Alternating periods of faster and slower (or even negative) growth rates. The economy goes from boom to recession and back to boom. See also: short-run equilibrium.

The movement from boom to recession and back to boom is known as the business cycle. Figure 3.8b shows that recessions measured by negative growth happen about twice every 10 years. And there are less frequent episodes of much larger fluctuations in output. In the twentieth century, the big downward spikes coincided with the end of the First and Second World Wars, and with the economic crisis of the Great Depression. In the twenty-first century, the global financial crisis (the ‘great recession’ described in Section 3.1) followed a period in which fluctuations were limited and which is referred to as the great moderation. More recently, the COVID-19 pandemic was associated with a large decline in output and then a relatively rapid recovery.

The lower part of Figure 3.8b shows 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.

The volatility of consumption and investment spending in the data

A big question in macroeconomics is: What drives the fluctuations in the economy? As a start to finding the answer, we can examine how each of the expenditure components of GDP contribute to its growth and decline.

The equation below shows how GDP growth can be broken down into the contributions made by each component of expenditure. The contribution of each component of GDP growth depends on both the share of GDP that the component makes up and its growth over the previous period.

\[\begin{equation} \text{percentage change in GDP =} \begin{split} & \text{(percentage change in consumption} \ \times\\ & \text{share of consumption in GDP)} \\ & \qquad\qquad\qquad\qquad + \\ & \text{(percentage change in investment} \ \times\\ & \text{share of investment in GDP)} \\ & \qquad\qquad\qquad\qquad + \\ & \text{(percentage change in government spending} \ \times\\ & \text{share of government spending in GDP)} \\ & \qquad\qquad\qquad\qquad + \\ & \text{(percentage change in net exports} \ \times\\ & \text{share of net exports in GDP)} \\ \end{split} \end{equation}\]

The table in Figure 3.9 shows the contributions of the components of expenditure to US GDP growth in one particular year. The data is for 2009, in the middle of the recession caused by the global financial crisis. The table shows the following:

• 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 while 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.

Figures 3.10a and 3.10b show that investment is much more volatile than consumption in two rich countries (the UK and the US) and two middle-income countries (Mexico and South Africa). The upward and downward spikes in the red series for investment are larger than those for the green series for consumption. This suggests that the behaviour of investment is important in explaining why economies experience booms and busts.

A close examination of the charts for the rich countries also shows that consumption is less volatile than GDP. The black peaks and troughs for GDP are larger than the green ones for consumption. This is less evident in the middle-income countries, perhaps because households there are less able to borrow in order to maintain their consumption in the face of shocks to their income.

Why is investment more volatile than consumption? The models in Sections 3.10 to 3.12 help explain. But first we develop a model to explain how a burst (or collapse) of investment is transmitted through the economy through the circular flow of income. This is the multiplier model.