Interlocking gears representing the economy with houses, stock charts, and people

Decoding the Economy: How Finance, Labor, and Housing Shape Our Future

Samir D’Costa in Business & Economy August 2025 • 5 min read.

"Uncover the hidden connections between financial markets, employment, and housing investments that drive U.S. business cycles and affect your financial well-being."

The economy can feel like a vast, incomprehensible machine, its gears turning in mysterious ways that impact our jobs, investments, and overall financial stability. One key to understanding this machine is the "Goodwin pattern," which describes the cyclical relationship between economic activity and the labor share of income. Think of it as a dance: when the economy thrives, does the wealth get shared fairly with workers, or does it concentrate at the top? This dynamic has been a central focus for economists trying to make sense of boom and bust cycles.

But the Goodwin pattern, while insightful, doesn't tell the whole story. It often overlooks the crucial role of capital accumulation – how we invest in things like housing and infrastructure – and the complex interactions between the real economy and the financial sector. Housing, in particular, acts as a critical link. It's where many people invest their savings, and it's a major driver of economic growth during recoveries. Ignoring these connections leaves a big gap in our understanding.

Traditional economic models often fall short by assuming a static picture of the economy. They offer a single set of answers that are supposed to apply across different time periods, failing to capture the continuous shifts and changes that define the real world. This is especially problematic when analyzing the U.S. economy, which has undergone dramatic transformations, from the post-war "Golden Age" to the era of deregulation and the "Great Moderation." To truly understand what's happening, we need models that can adapt and evolve with the data.

The Goodwin Model: A Foundation for Understanding Economic Cycles

Interlocking gears representing the economy with houses, stock charts, and people

The Goodwin model is a theoretical framework that helps economists understand the cyclical interactions between economic activity and the labor share of income. It suggests that there is a constant struggle between capitalists and workers over the distribution of income. During times of economic expansion, unemployment decreases, and workers have more bargaining power, leading to an increase in wages and the labor share of income. This, in turn, reduces profits for capitalists, which eventually leads to a slowdown in investment and economic activity, causing a recession.

However, the Goodwin model has its limitations, particularly in capturing the complexities of modern economies. It tends to oversimplify the roles of capital accumulation, investment, and financial markets in driving economic cycles. One area where the Goodwin model falls short is in its lack of emphasis on the role of residential investment in setting off economic recovery. Additionally, the financial extensions of demand and distribution models have been somewhat limited.

Profit-Led vs. Wage-Led Demand: Some economists argue that the U.S. economy is 'profit-led,' meaning that increased profits drive investment and growth. Others argue for a 'wage-led' model, where higher wages fuel consumer spending and economic expansion.
Profit-Squeeze vs. Wage-Squeeze Distribution: Similar to demand, there are competing theories about how income gets distributed. The 'profit-squeeze' theory suggests that a tight labor market increases wages at the expense of profits, while the 'wage-squeeze' theory argues that economic growth benefits profits more than wages.

To address these limitations, a more nuanced approach is needed that integrates the real and financial sectors and accounts for time-varying relationships and volatilities. Recent research aims to capture these dynamics by using time-varying parameter models with stochastic volatility (TVP-VAR-SV), which allows economists to better understand continuous changes in the economy over time.

Putting It All Together: A More Complete Picture of the Economy

By combining insights from the Goodwin model with an understanding of financial and investment dynamics, we can develop a more complete picture of the forces that shape the U.S. economy. This more comprehensive framework will allow us to analyze the dynamic relationships between demand and distributive regimes, as well as their financial interactions over time. Although the model has its limitations due to it being a single country analysis, it finds valuable statistical evidence in favor of the Goodwin Pattern that has impacted the real and financial sector.

About this Article -

This article was crafted using a human-AI hybrid and collaborative approach. AI assisted our team with initial drafting, research insights, identifying key questions, and image generation. Our human editors guided topic selection, defined the angle, structured the content, ensured factual accuracy and relevance, refined the tone, and conducted thorough editing to deliver helpful, high-quality information.See our About page for more information.

This article is based on research published under:

DOI-LINK: https://doi.org/10.48550/arXiv.2310.05153,

Title: A Time-Varying Finance-Led Model For U.S. Business Cycles

Subject: econ.gn q-fin.ec

Authors: Marcio Santetti

Published: 08-10-2023

Everything You Need To Know

What is the 'Goodwin pattern,' and why is it important for understanding economic cycles?

The 'Goodwin pattern' describes the cyclical relationship between economic activity and the labor share of income. It focuses on the dynamic between economic success and wealth distribution between workers and capitalists. During economic expansion, decreased unemployment increases workers' bargaining power, leading to higher wages and a larger labor share of income. However, this reduces profits for capitalists, eventually slowing investment and causing a recession. While insightful, the 'Goodwin pattern' doesn't fully account for capital accumulation or the interactions between the real economy and the financial sector, especially the critical role of housing investments.

Why are traditional economic models sometimes inadequate for understanding the U.S. economy?

Traditional economic models often fall short because they present a static picture, offering a single set of answers that don't adapt to the continuous shifts in the real world. These models fail to capture the dramatic transformations in the U.S. economy, such as the shift from the post-war "Golden Age" to deregulation. A more dynamic approach, like time-varying parameter models with stochastic volatility (TVP-VAR-SV), is needed to understand the continuous changes over time.

How do 'profit-led' and 'wage-led' demand theories differ, and what do they suggest about economic growth?

The 'profit-led' theory suggests that increased profits drive investment and economic growth, implying that policies favoring corporate profitability would stimulate the economy. Conversely, the 'wage-led' model argues that higher wages fuel consumer spending and economic expansion, suggesting that policies supporting wage growth would be more effective. The U.S. economy's behavior likely involves a complex interaction between these two regimes, with their relative importance varying over time due to financial interactions and volatilities.

In what ways does the 'Goodwin model' oversimplify the complexities of modern economies, and what is missing?

The 'Goodwin model' simplifies modern economies by not fully capturing the roles of capital accumulation, investment, and financial markets in economic cycles. Specifically, it lacks emphasis on the role of residential investment in triggering economic recovery and has limited financial extensions. Furthermore, the model often assumes a constant relationship between labor share and economic activity, failing to account for time-varying dynamics and financial sector influences which a TVP-VAR-SV model addresses.

How can integrating the financial sector and investment dynamics with the 'Goodwin model' provide a more complete understanding of the U.S. economy?

By combining the 'Goodwin model' with financial and investment dynamics, a more comprehensive framework can be developed to analyze the relationships between demand and distributive regimes and their financial interactions over time. This approach considers the roles of housing investments, capital accumulation, and financial markets. Using tools like time-varying parameter models with stochastic volatility (TVP-VAR-SV) allows for a more nuanced understanding of continuous changes and volatilities in the economy, addressing the limitations of the 'Goodwin model' when applied in isolation. While the model has limitations due to it being a single country analysis, it finds valuable statistical evidence in favor of the 'Goodwin Pattern' that has impacted the real and financial sector.