inflation

. theory about how the econ- orny works. At one tirne, for examPle, a nation's eco- nomic vitalitY was thought to sPring from the stock of precious metals accumu- lated in the Public treasury' This theory spawned a

''' po1iry called mercantiiism' ' which held that, as a waY of

accumulating gold and sil-

ver, a nation should try to ir {" export more than it imPorts'

To achieve this, nations

duce a major tax increase

of the economy, just as we need not know every

i","ii of the uoay. rut we must understand essen- dal relationships among key variabies'

For example'

does the economy *otf *"U on its own' or does it ;;;;m poorly? If it performs poorly' are there i**"di"tl can we u" ttt" that a proposed remedy *""iJ "",

do more harm than good? When doctors

;idtt'; understand how the human body worked'

,h"1, ",,u*pted

"cures" were often worse than the

Ji*r"r. Much of the history of medicine describes misguided efforts to deal with maladies'

Even today'

medical care is based on less

mercanr*ism ffiiliTr:Ji1"[:""i?&t1: the inrortecttheorythat onJ study, only one in seven a nation's economic

urrt -!usJ t -'*t -,-. , li;u.*iu".t'ould be to medical interventions is sup- J""u*utut" precious ported by reliable scientific metals in the public lviaence.r For example, acet- treasqrY; this theorY prompted trade bar' aminophen (e'g', Tflenol) is riers io

"ut itnports, a popular pain reiiever, but

ffilljl'?#n t'oto^aY ruallY knows how it trade and the gains {rorn works' srecialization LikewiSe, policy makers economic maY adoPt the wrong Pre- {|::HlT;?i, .,, -"", scription

-b""""'" or a flawed

nomie activitY relative to the [ong'term growth t. As reported by Shenrvin Nuland, fi:i:il:i::?JJJ'' ;r,rr'iicjlua',dran,Midwivesand ;;;J'

-- -- Leech es:' NewYork llmes' 25 January

1 S95.

during the Great Depression' Economists have srnce

[-*,.'a that such a policy does-more harm than ;;.; "Jai

iott, debates about whether policies are

i"fnf"f or harmful were prevalent as poiicy makers t"tio"a*a to the zoo8-2oo9 economic downturn'

We turn now to the performance of the U'S'

economy.

Wz Hconomic Fluctuations and Growth The U.S. economy and other indush'ial

rnarket

u.orro*i"" historlcally have experienced alter-

;;;;; Fiods of expansion and contraction in u.loo*ic activity' Economic fluctuations are ti,"rir"andfaliofeconomicactivityrelativetothe torrg-,ur* growth trend of the economy'

These fluc-

arr"iionr, oibusiness cycles, vary in length and inten-

cirv- vet some featurua "ppu"t common to all' Th*

;;i il il*"t"*"*ilv invot"e the entire nation ani often many other eco-nomies around

the world' and

;;;;;;"early all dimensions of economic activ' ity, not just production and employment'

U.S, Economic Fluctuations Perhaps the easiest way to understand

the busine:s

.y.i" it ," *amine its components' During the r9z+*

70 PART z Fundamentals ol lrnacroeconcmtcs

Expansion

.::C r93os, WesleY C. Mitchell, :trector of the National Bureau :i Economic Research (NBER)' ;talyzed business cYcles, not- ,rg that the economY has two :hases: expansions and contrac- ::cns. During an exPansion, the economy's outPut increases. During a contraction, the econ- cmy's outPut decreases' Prior io World War Ii, a contraction might be so severe as to be calied a depression, which is a sirarp reduction in the nation's total production lasting more than a year and accomPanied bY high unemPloYment. A milder contraction is called a reces- sion, traditionallY defined as a decline in total outPut lasting at ieast two consecutive quar- ters, or at least six months' The U.S. economY exPerienced both recessions and dePressions before World War II. So far, there

P Yirllall' I

Hypothetical Business CYcles

(E 0)

c) o

o f o c) (E O) c) (', <tl (o

Jn

E o o O

LU

have been recessions but no depressions, so things

have improved. Despite these ups and downs, the U'S' economy

has grown dramatically over the longterm'The econ-

o*y-rro* produces about r3 times more outPut than it did in 1929. Output is measured by real GDq the value of final goods and services after stripping away

changes due to infiation, which is an increase in the

economy's average price level. Production increased

because of (r) increases in the amount and quality

of resources, especially labor and capital; (z) better technology; and (:) improvements in the rules of the game thit facilitate production and exchange, such -as

property rights, patent laws, the legal system, and

market practices. Exhibit r shows such a long-term growth trend

in reai GDP as an upward-sloping straight line' Economic fluctuations reflect movements around this growth trend. A contraction begins after the pre-

vious expansion has reached a peak, or high point,

and coniinues until the economy reaches a trough, or low point. The period between a peak and trough is a contraction, and the period between a trough and

subsequent peak is an expansion' Note that expan- sions last tonger than contractions, but the length of

the fuli cycle varies. Analysts at NBER have tracked the U'S' economy

backto igs+. Since then, the nation has experienced

3z peak-to-trough-to-peak cycles' No two have been

exactiy alike. During the 22 business cycles prior to

1945, expansions averaged z9 months and contrac-

tions zr-months' During the rr cycles since 1945' expansions stretched twice as longto 57 months' and

recessions fell by half to r r months' Thus since 1945

expansions are longer and recessions are shorter' goih developments have been hugely beneficial for

economic grtwttr and the U.S. standard of living' The

E

d I q

E

longest exPansion on record

lasted ro years, from March r99r to March zoor. The lon' gest contraction lasted five and a half Years, from 1873 to 1879.

Exhibit z shows annual percentage changes in real GDP since 1929. Years of declining real GDP are shown

as red bars and Years of increasing real GDP as biue bars. The big decline during the Great DePression of the early r93os and the sharP jump during World War II stand in stark contrast' Growth since r9z9 averaged

3.4 percent a Year- Although official data are not Yet avail- able, eventuallY the zoo8- 2oo9 recession will appear on charts like Exhibit z.

expanslon a period during whieh the economY's oulPut increases

contraction a period during whieh the economY's outPut tleclines

depressron a sharp reduction in an economy's total *utPut accompenied bY high unemployment lasting r$ore than a Year

recegsion a sustainad decline in the economY's tota! a$tp{rt lasting at least two consecutive quar- tevs, or six months; an ecsnomic contraciion

inflation an increase in the *conomy's average price level

CHAPTER 5 lniroduction to Macioecononiics 71

20

15

a E'o c) o. ;5 o, c

€o G c-5 C

-10

Exhibit z Annual Perceilage Ghange in U.S' Eeal GDP Since 1929

1930 1940 1950 1960 1970 lel

SoIJRCE: Bureau of Economic Analysis, U.S. Dept ol Commerce' For the latost data, go to

snowstorm or a Poor growing season. T\rrn- ing points-peaks and troughs-are thus iden- tified by the NBER onlY after the fact. Because a recession means outPut deciines for at least two consecutive quarters, a recession is not so des- ignated until at least six months after it begins.

As noted, fluctua- tions usually involve the entire nation. lndeed, major economies around the worid often move together. For examPle, the Great DePression

was a wofidwide calanrtry' Ttre -urrerrrpluyrrrttrrt'Ia'te

in Germany reached 34 percent, which helped bring

Hitler to power. The following section compares the year-to-year output changes in the United States with those in another major economyr the United Kingdom, during the last three decades.

The Global Economy Though business rycles are not perfectly synchronized

".tori countries, a tink is often apparent. Consider the

experience of two leading economies-the United Stites and the United Kingdom. Exhibit 3 shows for

each economy the year-to-year percentage change in real GDP since 1978. By examining the annual changes

in each economy, you can see some similarities' Both economies went into recession in the early r98os, in r99r, in zoot, and in zoo8. Notice also that over time,

the countries' gtowth rates have fluctuated less and

become more similar. \Mhen iinkage across economies occurs' a siump

in one major economy could worsen a recession in the other, and vice versa. For example, the terror- ist attacks on the United States in September 2oor affected economies around the world, reducing air-

line travel and lowering stock market prices' On the u, other hand, economic strength overseas can give $ the U.S. economy a lift, with overseas profits help- E ingcompanies offset aweakhome market'The same H p"it".., of worldwide decline occurred with the hous- ! ing and banking crisis of zoo8*zoo9. g

b

Leading Economic lndicators I Certain events foreshadow a turning point in "to-

3 nomic activity. Months before a recession is under 6

The intensity ol !.S' economic ttucruatrons vanes across regions. A recession hits hardest those regions

that produce capital goods, such as heavy machinery

and durable goods, such as appliances, furniture, and

automobiles. The demand for these goods falls more

during hard times than does the demand for other goodsand sennices, such as breakfast cereal, gasoline,

ind haircuts. In addition, housing, banks and finan- ciai institutions particularly suffered in zooS

Because of sea- sonal fluctuations and random distur-

bances, the econ- omy does not move smoothly through Phases of the business

cycle. Economists can't always dis- tinguish a tem- porary drop in

productionfrom the beginning of a downturn. A drop in Produc-

tion may result from a temPorary

slowdown, such as a

9/l1 attacks

72 PART 2 Fundamentals ol l/acroeconomics