HOW DO SHOCKS TO THE UNITED STATES ECONOMY EFFECT REAL GDP AND ECONOMIC GROWTH

INTERMEDIATE MACROECONOMIC THEORY LITERATURE REVIEW

BY Alexis M. Candace K.

Section II Margaret M. McConnell and Gabriel Perez-Quiros studied the apparent reduction in the volatility of U.S. output fluctuations over the period stating in the early 1980s,1 which supposedly gave rise to the death of the business cycle. They began their paper with a graph of U.S. real GDP growth from the second quarter and 1953 to the second quarter in 1999, which showed a very obvious decrease in the volatility of the growth rate. Using statistical analysis, McConnell and Perez-Quiros determined that the structural change in the GDP growth rate volatility occurred in the first quarter of 1984. In an attempt to find the source of this decline in volatility, the team separated output into expenditures on goods, services, and structures, and then statistically analyzed each expenditure to determine when the break in volatility occurred. They eventually found that the break in the goods expenditure volatility was aligned with the break in aggregate volatility, which occurred in 1984:1. Narrowing down even further, the team decomposed the goods expenditure down to durable and nondurable goods to determine the breaks for each of these; they discovered that the break in volatility for output of durable goods also occurred in 1984:1. They included a very explanatory graph showing production and sale of durable goods from 1953:2 to 1999:2, which almost mirrored the aggregate expenditure growth graph. Finally, McConnell and Perez-Quiros drew two final conclusions to the paper: first, they pointed out that a shift to services away from goods production did not explain the reduction in volatility because the break itself was identified from within the goods production expenditure. Secondly, they concluded that the break would signify the end of extreme movements in GDP growth rates.
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M. McConnell and Gabriel Perez-Quiros, Output Fluctuations in the United States: What Has Changed Since the Early 1980s? The American Economic Review (December 2000), 1464-1476.

1Margaret

3 In their study regarding inventory dynamics and the apparent moderation of the business cycle that occurred in the mid-1980s, Jonathan McCarthy and Egon Zakrajsek furthered the research conducted by Margaret M. McConnell and Gabriel Perez-Quiros. Like the aforementioned authors, McCarthy and Zakrajsek also admitted that fluctuations in economic activity over the past 20 years have been exceptionally milk compared with previous post-war business cycles.2 The team pointed out three hypotheses that exist in order to help explain the volatility decline. The first is the implementation of a more transparent monetary policy since the early 1980s. The second argues that perhaps economic shocks have been less frequent and less severe since the early 1980s. The third says that improved business practices have allowed firms to respond to economic shocks in a way that dampens aggregate fluctuations. To complete the study, the authors examined changes in inventory dynamics in the U.S. manufacturing sector in order to see if these changes played a part in what they refer to as the Great Moderation, then created a model based on some of the data they retrieved. During their research, the authors found that both inventory management and monetary policy both changed around the estimated time of the break in economic volatility determined by McConnell and Perez-Quiros. The authors then concluded that both factors most likely had a significant effect in the beginning of a more stable macroeconomic trend. J. Steven Landefeld, Eugene P. Seskin, and Barbara M. Fraumeni gave a detailed description on the measurement of GDP, starting with a history of how this measurement was created. Specifically regarding the expenditures approach, the authors outlined the various ways of measuring investment, imports, exports, and government expenditures, as well as wages and corporate profits. The team said that, conceptually, GDP as measured by the final expenditures

Jonathan McCarthy and Egon Zakrajsek. Invetory Dynamics and Business Cycles: What Has Changed? Journal of Money, Credit, and Banking (March-April 2007), 592-613.
2

4 approach should equal gross domestic income3 . GDP and the gross domestic income will, however, begin to differ over time due to imperfect source data and the use of varying estimation methods. For example, the team reported that over the last decade, the average difference in the quarterly levels between GDP and gross domestic income was -0.2 percentage point, and the average difference in the quarterly growth rates was also -0.2 percentage point. Despite these differences, measuring both GDP and gross domestic income is important to assess an economys current economic state. Moreover, the authors discussed the accuracy of the GDP measurement. They stressed the importance of comparing quarterly and annual estimates and the benchmark estimates based on the censuses in applicable years, as well as comparing earlier estimates to later estimates. Lastly, the team outlined the challenges that exist in gathering information that applies to measuring GDP. For instance, the accuracy of the information pertaining to the service sector is still subpar in comparison to that available for other sectors; also, many challenges lie in the fact that certain economic components, such as stock options and pensions are difficult to evaluate. Nonetheless, the team is confident that the Bureau of Economic Analysis will continue its work to find new sources of information. In their study, Rebeca Jimenez-Rodriguez and Marcelo Sanchez assess the effects of oil price shocks on the real economic activities of the main industrialized countries.4 To do this, they created a model with the following set of variables: real GDP, real wage, inflation, and short- and long-term interest rates. After their study, Jimenez-Rodriguez and Sanchez found evidence of a non-linear impact of oil prices on real GDP; specifically, oil price increases were found to be more noteworthy in regards to GDP growth than oil price decreases. In two

J. Steven Landfeld, Eugene P. Seskin, and Barbara M. Fraumeni. Taking the Pulse of the Economy: Measuring GDP. The Journal of Economic Perspectives (Spring 2008), 193-216. 4 Rebeca Jimenez-Rodriguez and Marcelo Sanchez. Oil price shocks and real GDP growth: Empirical Evidence for Some OECD Countries. Applied Economics (2005), 201-228.

5 interesting discoveries, increases in oil prices were found to have a significant negative impact in all oil importing countries but Japan, and the increases in oil prices were most detrimental for the United States. In their conclusion, the authors said that oil price shocks are, together with monetary shocks, the largest source of variation other than the variable itself for most of the nations they analyzed. Each source outlined above give a greater understanding in the measurement, accuracy, and volatility of GDP. The two studies conducted by McConnell and Perez-Quiros and McCarthy and Zakrajsek both discussed the volatility of the GDP growth rate from post-war time until 1984, when volatility suddenly decreased. The first team discovered when this break actually occurred, while the second team offered different explanation for why this may have happened. The third source was essentially a breakdown of how GDP is measured, which is helpful when trying to analyze which independent variables may cause significant changes in the overall measurement. The last team of researchers gave a specific example of how GDP is affected by an economic shock, specifically a change in oil prices. All will be very helpful in researching the effect of positive and negative shocks and unemployment on GDP. Section III A widely recognized economic theory by the name of Okuns law deals with unemployment and its effect on the GDP of a country. Okuns law emphasizes the linear relationship between decreases in unemployment and increases in GDP. It must be pointed out that Okun used data from the United States to determine this law and that the tradeoff in other economies, called Okun coefficients, usually differ. Arthur Okuns original law stated that GDP falls by 3 percent for every percentage point that unemployment rises. Okun determined this rule by looking at data between World War II and 1960 in the United

6 States and pointed out it was only accurate within the unemployment levels of that time period, 3 to 7.5 percent. By looking at more recent data the law has been changed to state that for every 1 percent rise in unemployment GDP falls by 2 percent. The algebraic expression of Okuns Law is: (Y Y)/ Y = 2(u u)

Where Y equals full- employment output, Y equals actual output, u equals the natural rate of unemployment and u equals the actual unemployment rate. The following graph shows the actual relationship between output growth and unemployment between 1960 and 1996.

The question this paper will answer is that of how shocks affect GDP of an economy. Because shocks can either positively or negatively affect unemployment they can also have a positive or negative affect on GDP. By analyzing shocks and their affect on employment levels one can determine the expected change in GDP, an increase or a decrease.

7 The functional model that is used for research is: Real GDP = f(Shocks, Unemployment) One can expect that the relationship between Real GDP and Unemployment to be a negative one because of Okuns Law which states that, in every economy, as unemployment rises GDP will fall by that particular economys Okun coefficient. In the United States the Okun coefficient is 2. The effects of shocks are a little more complicated to determine because there are positive and negative shocks to an economy. A positive shock can be expected to raise real GDP while a negative one will cause it to fall. By analyzing whether or not a shock was positive or negative and if unemployment fell or rose one can determine if real GDP will rise or fall. Both of the independent variables have a large effect on real GDP as seen by Okuns law for unemployment and past shocks to the economy, such as the oil price shock of 1973. The use of both independent variables will enable the proper estimation of whether or not real GDP will rise or fall. Section IV The methodology will begin with collecting data on GDP growth from 1960 to 1989. Next, positive and negative shocks to GDP that occurred during these years will be compiled on a timeline that will be aligned with the data on GDP growth to determine any connections. Finally, information on unemployment rates from this same period will be aligned with both data sets from above to see any relationships that will exist between unemployment and shocks. In order to calculate changes in GDP growth and unemployment from year to year, the differencing method will be utilized. Because shocks are not necessarily quantifiable, they will be identified in terms of severity on a scale that will be determined during the research process. The National Bureau of Economic Research (NBER), the Economic Report of the President during the given period, the Federal Reserve of Economic Data (FRED), and DataFerret will be used into order to

8 gather statistical information. Specifically, FRED will provide data on GDP and unemployment rates, while the Economic Report of the President for each year will aid in determining shocks.

9 Works Cited 1. David Altig, Terry Fitzgerald, and Peter Rupert, Okun's Law Revisited: Should We Worry about Low Unemployment?, 1997, [online], available from http://www.clevelandfed.org/research/commentary/1997/0515.htm, 14 March 2011.