Which fluctuates more

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. Nglish: Translation of fluctuate for Spanish Speakers. Britannica English: Translation of fluctuate for Arabic Speakers. Subscribe to America's largest dictionary and get thousands more definitions and advanced search—ad free! Log in Sign Up. Save Word. Definition of fluctuate. Temperatures fluctuated. Choose the Right Synonym for fluctuate swing , sway , oscillate , vibrate , fluctuate , waver , undulate mean to move from one direction to its opposite.

Examples of fluctuate in a Sentence His popularity has fluctuated during his term in office. In the desert, the temperature fluctuates dramatically. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Articles. Bitcoin What Determines the Price of 1 Bitcoin? Partner Links.

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Your Privacy Rights. To change or withdraw your consent choices for Investopedia. What are some other forms related to fluctuate? I'm sorry you're having a hard time finding the turkey variety right now. Inventory levels at the store are fluctuating, but our production teams are working hard to get them back on the shelves. Which of the following words is NOT a synonym for fluctuate? Writing in Ars Technica, John Timmer points out that aligning the coolant channels with all the components in a much more complex chip—whose activity could fluctuate based on the task—would be very tricky.

In addition, Enten found that favorable ratings can also fluctuate a lot after this point in the election cycle.

Cycle length can vary greatly from woman to woman, and even fluctuate from month to month. The numbers fluctuate , of course, but some trends can be discerned. Worst of all, they elide the obvious point that all revolts fluctuate between periods of progress and regression.

Margins fluctuate in every market, and there's no reason for farmers to be treated as a special case. Other ideas about crying fluctuate between the sociological and the biological.