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.
Figure 3.8a Real GDP in the UK and Japan, using linear scales (top) and ratio scales (bottom).
Ryland Thomas and Nicholas Dimsdale. 2017. ‘A Millennium of Macroeconomic Data’. Bank of England OBRA dataset; UK Office for National Statistics. 2024. Gross Domestic Product; Fukao, K., Makino, T., and Settsu, T. 2021. Human capital and economic growth in Japan: 1885–2015. Journal of Economic Surveys, 35(3), 710-740; OECD. 2023. Gross domestic product, Total economy.
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%.
The rule of 70 for growth rates
Calculations involving compound growth rates are difficult to do mentally, but there is a handy rule of thumb that we can use for one particular situation. If the economy is growing at a constant rate, the number of years it will take for real GDP to double is approximately 70 divided by the annual growth rate:
\[\text{number of years for real GDP to double} = \frac{70}{\text{annual growth rate %}}\]For this reason, we refer to this approximation as the ‘rule of 70’. The rule of 70 is useful if we are looking at growth rates over long periods of time, in which case the number in the denominator is the compound annual growth rate.
Example: If the compound annual growth rate of GDP is 2%, then it would take approximately 70/2 = 35 years for GDP to double.
If real GDP was growing more slowly at a rate of 1%, then it would take approximately 70/1 = 70 years for GDP to double.
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.
Exercise 3.3 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’). Read this article, and note Figures 5, 6, and 7 especially, to find out more.
- 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?
- Does knowing whether a country is in recession make a difference to policymakers whose job it is to manage the economy?
Exercise 3.4 How to use FRED
If you want real-time macroeconomic data on the German unemployment rate or China’s output growth, you do not need to learn German and Chinese, or struggle to get to grips with national archives, because FRED does it for you! Federal Reserve Economic Data (FRED) is a comprehensive, up-to-date data source maintained by the Federal Reserve Bank of St Louis in the US, which is part of the US central banking system. It contains the main macroeconomic statistics for almost all developed countries going back to the 1960s. FRED also allows you to create your own graphs and export data to a spreadsheet.
To learn how to use FRED to find macroeconomic data, follow these steps:
- Visit the FRED website.
- Use the search bar and type ‘Real Gross Domestic Product’ and the name of a major global economy. Select the annual series for real (constant prices) GDP for this country. This is clearly labelled as ‘Real Gross Domestic Product’ for your chosen country.
- Click the ‘Edit graph’ button, above the top-right corner of the graph.
- Click the ‘Add line’ button. Search for the annual series for nominal (current prices) GDP. This is labelled as simply ‘Gross Domestic Product’ for your chosen country. Add this series to your graph.
- You can use the ‘Edit graph’ button to modify the frequency of your data, if it is not annual.
You can also watch this short tutorial to understand how FRED works.
Use the graph you created to answer these questions:
- What is the level of nominal GDP in your chosen country this year?
- FRED tells you that the real GDP is chained in a specific year (this means that it is evaluated in terms of constant prices for that year). Note that the real GDP and the nominal GDP series cross at one point. Why does this happen?
From the FRED graph, keep only the real GDP series. You can remove a data series by using the graph editing tool. FRED shows recessions in shaded areas for the US economy using the NBER definition, but not for other economies. For other economies, assume that a recession is defined by two consecutive quarters of negative growth. In the graph editing tool, change the units of your series, and select ‘Percentage change from Year Ago’. The series now shows the percentage change in real GDP.
- How many recessions has your chosen economy undergone over the years plotted in the chart?
- What are the two biggest recessions in terms of length and magnitude?
Now add to the graph the quarterly unemployment rate for your chosen economy. (Click on ‘Add data series’ under the graph and search for ‘Unemployment’ and your chosen country name.)
- How does the unemployment rate react during the two main recessions you have identified?
- What was the level of the unemployment rate during the first and the last quarter of negative growth for those two recessions?
- What do you conclude about the link between recession and the variation in unemployment?
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 1948 for the US economy.
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.
GDP | Consumption | Investment | Government spending | Net exports | |
---|---|---|---|---|---|
Share of GDP in 2009 (%) | 100.00 | 68.00 | 17.32 | 17.02 | –2.34 |
Contribution to % change in real GDP | −2.80 | −1.06 | −3.52 | 0.64 | 1.14 |
Figure 3.9 Contributions to percentage change in real GDP in the US in 2009.
Federal Reserve Bank of St. Louis. 2015. FRED. Note that in this table, government investment is included in government spending and not in investment; United Nations. GDP and its breakdown at constant 2015 prices in US Dollars. Accessed 10 October 2023.
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.
Figure 3.10a Growth rates of consumption, investment, and GDP in the UK and US, per cent per annum (1956–2022).
Federal Reserve Bank of St. Louis. 2023. FRED.
Figure 3.10b Growth rates of consumption, investment, and GDP in Mexico and South Africa, per cent per annum (1961–2022).
OECD. 2023. OECD Statistics; The World Bank. 2023. World Development Indicators.
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.
Question 3.6 Choose the correct answer(s)
Read the following statements about economic growth and fluctuations, and choose the correct option(s).
- Even for countries where GDP has been trending upwards over the past two centuries, from year to year, economic growth fluctuates, so it does not follow a smooth process.
- According to the NBER definition, a recession is over once the economy begins to grow again. Under the alternative definition, output below normal level would be considered a recession even if the economy is growing.
- Figure 3.8b shows that during periods of high GDP growth, the unemployment rate tends to be low, and downturns in the business cycle are associated with rising unemployment.
- Figure 3.10a shows that for the UK and the US, investment is more volatile than consumption. Consumption tends to be relatively smooth in high-income countries.