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Thursday, March 31, 2011

Investment and Unemployment over Longer Periods of Time


  • Like Paul Krugman, Justin Wolfers also wrote yesterday about my blog post of January 14 on the correlation between investment and unemployment. Wolfers argues that the relationship did not exist in earlier years. He is wrong.

  • His argument is based on the observation that the scatter of points for the 1990-2010 period, shown in one of my graphs, shifts up and to the right—higher unemployment for a given level of investment—if you include the 1970s and 1980s. The scatter of points shift back down and to the left if you go back further. This shift up in unemployment in the 1970s and 1980s was due in part to the well-documented longer term increase in the natural rate of unemployment in the 1970s and 1980s, which many macroeconomists have researched and written about, but which Wolfers does not mention. When you recognize that such longer-term historical trends exist, you can see that there is a strong correlation between investment and unemployment that goes back before 1990.

  • The time-series plot below goes back to 1960. You can see frequent ups and downs in the investment ratio and most of these are related to the downs and ups in the unemployment rate. The exceptions are mainly due to the secular, longer-term rise and fall in the unemployment rate.

  • If you go beyond the chart and use some statistics, you can confirm these observations and be more pricise. For example, a simple regression of the change in the unemployment rate on the change in the investment ratio has a large and statistically significant coefficient of -.7 with a t-value of -10 over the 50 period.

  • As always in economics there are many factors at work, especially when you consider longer periods. But a longer history confirms the strong correlation I wrote about.