Why does gdp fluctuate

Meanwhile, weak growth signals that the economy is doing poorly. If GDP falls from one quarter to the next then growth is negative.

This often brings with it falling incomes, lower consumption and job cuts. The economy is in recession when it has two consecutive quarters i. This marked the deepest recession for 80 years. We set interest rates in order to keep inflation low and stable.

Achieving this helps create the conditions needed for a healthy economy. Following the EU referendum, for example, we cut Bank Rate from 0. And in fact, whenever we consider different possible policy actions such as a change in interest rates , our remit requires us to pick whichever actions will boost economic growth the most while still meeting our primary objective for low and stable inflation.

We also have responsibilities to ward off the chances of a financial crisis from happening. This also helps create the conditions for economic growth. And here, too, our remit explicitly requires us to factor in the impact on growth when deciding on policy actions that help to keep the financial system safe. Growth in the economy matters for everyone — individuals, businesses, charities and the government.

It feeds in to other spheres of life, too: experts in many fields, from healthcare to climate change, need to make assumptions about future economic growth. Every three months we forecast economic growth up to three years ahead. Our forecasts are published in our Inflation Report and feed into our decisions about interest rates. View more You may also be interested in…. Would you like to give more detail?

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Analytics cookies We use analytics cookies so we can keep track of the number of visitors to various parts of the site and understand how our website is used. Skip to main content. Home KnowledgeBank Why does economic growth matter? For example, if GDP rose by 2 per cent one year, but the population grew by 4 per cent, then average GDP per person would have decreased. Similarly, GDP doesn't tell us anything about how evenly national income is split across the population. Income may have increased for everyone, or may have been concentrated in certain groups.

Finally, there are things that raise GDP but don't make the country better off. One example is the initial spending to replace buildings and infrastructure after a natural disaster, which boosts measures of economic growth. Consequently, when aggregate demand is measured it is the same as GDP E. Aggregate demand includes household spending also called consumption, C , investment by businesses and households I , spending by the government G and net spending from overseas X-M.

Household consumption C refers to spending by households on things like rent, groceries and utilities. It makes up the largest share of aggregate demand. The level of consumption by each household is largely dependent on their level of income Y. Household income that is not spent, is saved S. When household income increases, household spending usually increases as well. The amount of extra consumption for an extra dollar of income is called the marginal propensity to consume MPC. The simple expenditure multiplier refers to how much additional GDP results from an initial change in expenditure.

An initial increase in expenditure can lead to a larger increase in economic output because spending by one household, business or the government is income for another household, business or the government. If their MPC is 0. The total amount of additional GDP can be calculated using the simple multiplier k. A number of factors other than current income are also important for household spending. If households expect to have higher income in the future, household spending will generally increase.

Similarly, if household wealth increases, for example, due to rising housing prices, there will likely be an increase in household spending. In economic terms, investment refers to spending by businesses and households that increases the economy's capacity to produce goods and services.

This includes building new houses and offices, purchasing machinery, constructing roads and other physical infrastructure, as well as purchasing computer software and undertaking research and development. The level of investment in the economy is determined by a range of factors including interest rates, expected profits, government policy and changes in technology.

Governments spend money on hospitals, schools, defence, roads, transport and more. Government spending can be either structural or cyclical. Structural spending occurs regardless of the state of the economy; it includes, for example, spending on education, health services and defence. Other spending is more cyclical. For example, in an economic downturn when the unemployment rate has increased, there will be more government spending on programs to support the unemployed.

Net exports are made up of the spending on exports minus spending on imports. The spending of imports is subtracted from that on exports because GDP measures production within a country, and imports are produced overseas. Exports refer to goods and services that Australian businesses sell to other businesses, households and governments overseas.

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. The individual saves and repays the debt when older and earning more, and finally runs down savings after retirement, when income falls again. As we have seen in Unit 10, this assumes that the individual can borrow. Maybe it is possible to convince 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 earnings were to remain at the starting salary.

The labels on Figure 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:. To summarize, when individuals and households behave in the way shown in Figure They aim to avoid fluctuations in consumption even when income fluctuates. The Economist. Updated 14 May Some of the stories can be read online. Many individuals and households are not able to make or implement long-term consumption plans. Making plans can be difficult because of a lack of information.

Even if we have information, we may not be able to use it to predict the future with confidence. For example, it is often very hard to judge whether a change in circumstances is temporary or permanent. There are three other things that constrain the ways in which households can smooth their consumption when faced with income shocks.

The first two concern limits on self-insurance, the third is a limit on co-insurance:. 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 so. The credit constraints and credit market exclusion discussed in Units 10 and 12 help explain why borrowing is often not possible.

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. The blue lines on the figure show that the path of income over time is the same in both households. The red line in the top panel shows that, in a consumption-smoothing household, consumption changes immediately once the household receives the news. On the other hand, a credit-constrained household that cannot borrow has to wait until the income arrives before adjusting its standard of living.

We can think about these decisions using the two-period model of borrowing and lending from Unit 10, shown in Figure First consider a household that receives the same income, y , this period and next period, indicated by the endowment point A in Figure Consider a household that receives the same income, y , this period and next period, indicated by the endowment point A. Assume that the household prefers to consume the same amount each period, shown by the point A where the indifference curve is tangent to the budget constraint.

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. This could be because of retirement or job loss. It could also be because the individual is becoming pessimistic. Perhaps the newspapers predict an economic crisis. In the top panel of Figure The bottom panel shows a household with weakness of will that consumes all its income today even though it implies a large reduction in consumption in the future.

The blue lines in the figure show that income follows the same path in both sets of households. The red line in the top panel shows the consumption path for a consumption-smoothing household.

When it receives news of the imminent fall in income, it immediately starts saving to supplement consumption when income falls. In contrast, the weak-willed household does not react to the news, and keeps consumption high until income falls. For example, Daniel Read and Barbara van Leeuwen conducted an experiment with 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. Read: Daniel, and Barbara van Leeuwen. Organizational Behavior and Human Decision Processes 76 2 : pp. Most households lack a network of family and friends who can help out in substantial ways over a long period when a negative income shock occurs.

As 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 see Figure The result was that although aggregate income fell, consumption did not—and unemployment did not increase.

Empirical evidence shows that, even when income changes in predictable ways, consumption responds. Tullio Jappelli and Luigi Pistaferri. But most empirical evidence shows that credit constraints, weakness of will, and limited co-insurance mean that, for many households, a change in income results in an equal change in consumption.

In the case of a negative income shock such as the loss of a job, this means that the income shock will now be passed on to other families who would have produced and sold the consumption goods that are now not demanded. We will see in the next unit how the initial shock in income may be multiplied or amplified by the fact that families are limited in their ability to smooth their consumption.

This in turn helps us understand the business cycle and how policymakers may or may not help to manage it. His initial endowment is y , y , that is, an income y in both periods, which is depicted by point A. If possible, the consumer prefers to consume the same amount in both periods.

The interest rate is r. Assume that a credit-constrained consumer is not able to borrow at all. The following diagram shows the path of income for a household that receives news about an expected rise and fall in future income at the depicted times. Assume that the household prefers to smooth out its consumption if it can.

But, unlike eating and most other consumption expenditures, investment expenditures can be postponed. There are several reasons why this is likely to produce clusters of investment projects at some times, while few projects at other times.

In Unit 2, we saw how firms responded to profit opportunities in the Industrial Revolution by innovating. This helps explain why investment occurs in waves.

When an innovation like the spinning jenny is introduced, firms using the new technology can produce output at lower cost or produce higher-quality output. They expand their share of the market. Firms that fail to follow may be forced out of business because they are unable to make a profit using the old technology. But new technology means that firms must install new machines.

As firms do this, there is an investment boom. This will be amplified if the firms producing the machinery and equipment need to expand their own production facilities to meet the extra demand expected. But investment by one firm can also pull other firms to invest by helping to increase their market and potential profits.

An example of push investment is the hi-tech investment boom in the US. From the mids, new information and communications technology ICT was introduced into the US economy on a large scale. US Bureau of Economic Analysis. Fixed Assets Accounts Tables. Note: the series are in current US dollars. Nasdaq value is the yearly average of the close price value of the Nasdaq. Investment in new technologies is the investment in information processing equipment, computers and peripheral equipment, communication equipment, communication structure, and IPPR investments for software, semiconductors, and other electronic components and computers.

As we saw in Unit 11, investment in new technology can lead to a stock market bubble and over-investment in machinery and equipment. The chart shows in green the behaviour of the US stock market index on which hi-tech companies are listed. This is the Nasdaq index, introduced in Unit Robert Shiller has explained in a VoxEU podcast how animal spirits contribute to the volatility of investment. Investment in IT equipment the red line grew rapidly as a result of this confidence, but dropped sharply following the collapse in confidence that caused the fall of the stock market index.

This suggests that over-investment in machinery and equipment had occurred: investment did not begin growing again until Beliefs in the future of hi-tech led not only to share prices rising to levels that were unsustainable, but also to excessive investment in machinery and equipment in the hi-tech sector. Credit constraints are another reason for the clustering of investment projects and the volatility of aggregate investment.

In a buoyant economy, profits are high and firms can use these profits to finance investment projects. Access to external finance from sources outside the firm is also easier: in the US hi-tech boom, for example, the expansion of the Nasdaq exchange reflected the appetite of investors to provide finance by buying shares stocks in firms in the emerging ICT industries.

But there is not enough demand to sell the products it would produce. The owners of Firm A have no incentive to hire more workers or to install additional machinery that is, to invest. Firm B has the same problem. Because of low capacity utilization, profits are low for both. Thus when we think about both firms together we have a vicious circle:. If the owners of both A and B decide to invest and hire at the same time, they would employ more workers, who would spend more, increasing the demand for the products of both firms.

The profits of both would rise, and we have a virtuous circle:. These two circles highlight the role of expectations of future demand, which depend on the behaviour of other actors.

A game similar to those studied in Unit 4 can illustrate how to get out of the vicious circle and into the virtuous one. As in every game, we specify:. From this figure you can see what happens when the virtuous both invest and vicious neither invest circles occur. Note what happens if one of the firms invests but the other does not. If Firm A invests and B does not the upper-right cell in the figure then A pays to install new equipment and premises, but because the other firm did not invest there is no demand for the products that the new capacity could produce; so A makes a loss.

But had B known that A would invest, then B would have made higher profits by investing as well getting rather than only On the other hand, had B known that A was not going to invest, then it would have done better to also not invest. In this game, the two firms will do better if they do the same thing, and the best outcome is when both firms invest.

This is another reason that investment tends to fluctuate a lot. If owners of firms think that other firms will not invest, then they will not invest, confirming the pessimism of the other owners. This is why the vicious circle is self-reinforcing. The virtuous circle is self-reinforcing for the same reason.

Optimism about what other firms will do leads to investment, which sustains the optimism. There are two Nash equilibria in this game upper-left and lower-right. If B does not invest, A chooses also not to invest so we place a dot in the bottom right-hand cell. Notice that A does not have a dominant strategy. Where the dots and circles coincide, there are Nash equilibria.

The Nash equilibrium lower-right in which both firms have low capacity utilization and low hiring and investment is not Pareto efficient, because there is a change in which both make higher profits, namely if both firms decide to invest.