Three Key Facts about Economic Fluctuations

Updated Jun 26, 2020

Economic activity fluctuates over time. That means, while most economies experience growth in the long run, there may be years where this growth slows down or doesn’t happen at all. Although governments try their best to prevent economic downturns, these fluctuations cannot be entirely avoided. They occur in all countries and repeatedly throughout history. Thus, to understand how these fluctuations happen and what effects they have on other macroeconomic indicators, we can look at some of their most relevant properties. More specifically, there are three key facts about economic fluctuations that stand out: (1) economic fluctuations are irregular and unpredictable, (2) most macroeconomic measures fluctuate together, and (3) as the output falls, unemployment rises.

1. Economic Fluctuations are Irregular and Unpredictable

Economic fluctuations describe the economy’s ups and downs. When the economy grows, businesses can grow as well and make higher profits. By contrast, when the economy slows down, firms make less money, and profits decline. These fluctuations are often referred to as business cycles. However, that term is somewhat misleading because it suggests that they follow a regular and predictable pattern. In reality, however, nobody knows when and by how much the economy is going to shift.

For example, when we analyze the US GDP from 1960 to 2019, we can see that it has grown significantly over the years. However, if we look closely, we can also see that despite the overall growth, there have been several recessions in the short run. We speak of a recession when GDP falls for at least two consecutive quarters. As the graph below shows, the most severe recession (i.e., depression) in recent history was the financial crisis in 2008/2009.

Source: The World Bank

However, apart from the financial crisis, there have been several other recessions over the last 60 years. There was the oil crisis in 1973, the energy crisis in 1981, the oil price shock in 1990, and the collapse of the dot-com bubble in 2001, to name a few. As you can see, the time between those recessions as well as their magnitude varies quite a bit. Thus, it’s virtually impossible to predict when the next recession is going to happen.

2. Most Macroeconomic Measures Fluctuate Together

In most cases, economists use real GDP to measure economic changes. The reason for this is that it is the most comprehensive measure of economic activity. However, as it turns out, most macroeconomic indicators that measure either income, spending, or production correlate strongly with one another. That means, whenever the economy falls into a recession, indicators like per capita income or retail sales fall along with GDP. To see this, take a look at the graph below, which shows the US adjusted net national income per capita from 1970 to 2019.

Source: The World Bank

As you can see, the growth of per capita income is closely correlated to the development of the economy’s GDP. When the economy is in bad shape, firms eventually have to lay-off workers. As a result, more people are without a job, and the average income per person falls.

3. As the Output Falls, Unemployment Rises

Unemployment is closely related to economic output. The reason for this is that the level of output ultimately dictates the size of the labor force required within the economy. Simply put, a firm that produces only a few hundred units of output usually requires fewer workers than a firm that produces several thousand units of output. Thus, unlike most other macroeconomic measures, the unemployment rate is negatively correlated to GDP. That means when a country’s GDP falls, its unemployment rate rises, and vice versa.

Source: The World Bank

As you can see from the illustration above, the US unemployment rate significantly increased whenever a recession occurred. However, it is important to note that there is usually a time-lag between the changes in economic output and unemployment. That means, when the economy falls into a recession, it takes some time before firms have to lay-off workers. Similarly, when economic growth resumes, the unemployment rate will likely continue to rise for a few months before it recovers. Therefore, unemployment is considered a lagging indicator.

Summary

Economic activity fluctuates over time. They occur in all countries and repeatedly throughout history. Therefore it is critical to understand how these fluctuations happen and what effects they have on other macroeconomic indicators. There are three key facts about economic fluctuations that stand out: (1) economic fluctuations are irregular and unpredictable, (2) most macroeconomic measures fluctuate together, and (3) as the output falls, unemployment rises.