Tutorial 7: Economic Fluctuations, Unemployment and Fiscal

Policy
The Economy
Prof. Jeanne Commault
Coordination: yuchen.huang@sciencespo.fr

Fall 2021, Collège universitaire - Sciences Po

Mandatory exercises are marked with an (*).

Key concepts to master:

• recession

• aggregate demand and its components; aggregate demand/supply shocks

• multiplier

• Okun’s law

• marginal propension to consume/import

• consumption and investment functions

• autonomous consumption/demand

• automatic stabilizers

• savinng paradox

• fiscal stimulus

• budget deficit/surplus

• public debt; sovereign debt crisis

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Exercise 1. Okun’s Law (*)

1. Look at the regression lines (the lines of best fit) in the figure. What prediction does the
regression line show for unemployment when the economy is not growing? Are the results
the same for all the countries?

2. Assume that the population in the economy is growing. Can you use this assumption to
provide an explanation for your in question 1? What else might explain the differences
between countries?

Exercise 2. Beveridge curves and the German labour market

Although according to the Beveridge curves, the German labour market does a better job at
matching workers with job openings, average unemployment in Germany over the period in the
figure below was higher than in the US.
Consider the possible role of aggregate demand (Section 8.2 from the Moodle site), on Okun’s
law, and Section 8.3 from the Moodle site, on aggregate demand and unemployment. What
kind of data could be used to find support for your hypothesis?

Exercise 3. 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

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archives, because FRED does it for you! FRED is a comprehensive up-to-date data source
maintained by the Federal Reserve Board 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 into Microsoft Excel. To learn how to use FRED to find macroeconomic data, use the
following steps:

• Click on this link to go to the FRED website

• Use the search bar and type ”Gross Domestic Product” (GDP) and the name of a
major global economy. Select the annual series for both nominal (current prices) and real
(constant prices) GDP for this country. Click the ”Add to Graph” button at the bottom
of the page. Use the graph that is created to carry out the following tasks:

1. What is the level of nominal GDP in your chosen country this year?

2. 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. 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.
At the bottom of the graph page, select ”Create your own data transformation” and click on
”Percent change from one year” (FRED gives you a hint about how to calculate a growth rate
at the bottom of the page: notes on growth rate calculation and recessions). The series now
shows the percent change in real GDP.

1. How many recessions has this economy undergone?

2. 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).

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 1. How does the unemployment rate react during the two main recessions you have identified?

2. What was the level of the unemployment rate during the first and the last quarter of
negative growth for those two recessions?

3. What do you conclude about the link between recession and the variation in unemploy-
ment?

Note: To make sure you understand how these FRED graphs are created, you may want to
extract the data in Microsoft Excel and reproduce the growth rate of real GDP, and the evolution
of the unemployment rate, on the same graph since 1948.

Exercise 4. The multiplier model (*)

Consider the multiplier model studied in class.

1. Write down the aggregate demand (AD) in an economy as the sum of household consump-
tion, government expenditure, investment and import/export.

2. If c0 is the ”fixed” part of consumption and c1 is the marginal propensity to consume with
respect to income, write down household consumption as a function of income (Y). Then
calculate the equilibrium level of output. Also illustrate your answer using a diagram.

3. Write down the expression of fiscal multiplier as a function of c1 . It is larger or smaller

when c1 is bigger? What does it mean to have a larger or smaller c1 ?

4. During the Great Depression, some economists estimated the marginal propensity to spend
at around 0.45. What is the size (in number) of the multiplier? If the government increases
spending by 1bn, what is the numerical value of increase in output?

5. Explain how the following characteristics of the US economy at the time could have
affected the value of the multiplier value: the size of government (see the figure below),
the fact that there were no unemployment benefits, and the fact that the share of imports
was small.

Exercise 5. Methods to estimate the multiplier

Consider the three methods discussed in session 8 from the Moodle site, that have been used to
estimate the size of the multiplier: the highways spending in the great recession in the US, the
Mafia-related dismissals in Italy, and wartime defence spending in the US. Why do you think
estimates of the size of the multiplier vary?
Use the material from session 8 (Moodle site) to support your explanation.

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Exercise 6. Stimulus without more debt
Read this article by Robert Shiller.
Assume the economy is in a recession. The government has a high level of debt and wants
to set a balanced budget i.e. G = T . How can the government achieve a fiscal stimulus effect
on GDP whilst keeping the budget balanced?
To answer the question, take the following steps.

1. Show how this is possible in a multiplier diagram, ensuring that you label the relevant
intercepts and angles. Make the diagram sufficiently accurate so that the exact size of the
multiplier is visible.

2. Explain in words how the government can achieve such a fiscal stimulus effect whilst
keeping the budget balanced.

3. Derive the balanced budget multiplier using algebra. (Hint: You will need to write down
expressions for the change in GDP associated with a change in both G and T and set
these equal to each other.)

4. Comment briefly on any disadvantages you see with the use of this balanced budget fiscal
stimulus.

To answer the question, make the following assumptions:

• Assume a lump sum tax. This means that the tax does not depend on the level of income,
T = T , rather than our usual assumption that T = tY .

• Also assume that the country does not have any imports or exports.