For most of this century, we've had one recession about every five years. On average a recession lasts for a little more than one year, during which real GDP falls from peak to trough by 6 percent. Expansions last almost four years on average, with real GDP rising from trough to peak by 22 percent. Hence, our current expansion (since 1991, or 5+ years) is already a relatively long one by historical standards; it remains to be seen if the 1990s will be characterized by lengthy expansions like those during the 1960s and the 1980s.
A recession can be triggered by many factors, and economists do not completely understand the business cycle mechanism. Hence, we have competing theories of the business cycle. One factor that does seem to be critical, however, is investment behavior. That is, the different theories agree that recessions begin when investment in new capital falters, and expansions emerge in the wake of revivals of investment activity.
Theories of the business cycle
There are three prominent contemporary theories of the business cycle, each of which has its adherents among macroeconomists. Two of these theories are grounded in rational expectations. That is, rational expectations theories of the business cycle begin with the premise that changes in money wages are determined by expected changes (rational expectations of changes) in the price level.
In fact, last week we actually looked at the new classical theory of the business cycle, without identifying it as such (our focus was on inflation, not the business cycle). The new classical theory views incorrect expectations about aggregate demand as the key source of economic fluctuations. In this approach, rational expectations of changes in aggregate demand and hence the price level determine changes in nominal wages, and hence the new SAS curve, so as to result in full employment if EAD is realized.
If you want to see how this process works, STEP BY STEP, click here.
If, however, the actual change in aggregate demand deviates from the expected change, then either recession or expansion may result.
If you want to see how this process works, STEP BY STEP, click here.
If you want to see how this process works, STEP BY STEP, click here.
The new Keynesian theory of the business cycle also is a rational expectations theory, but it adds a new wrinkle -- the notion that money wages are sticky (i.e., inflexible in the short term, due in part to long-term aspects of wage contracts).Even if this period we correctly anticipate aggregate demand for next period, it is possible in the new Keynesian view that next period's money wage level (and hence, the SAS curve) will already be determined based on last period's expectations. In the new Keynesian view, then, even correct expectations (this period) can result in fluctuations of real GDP from its potential level, because wages are based on earlier (incorrect) expectations.
These two theories have distinctly different policy implications. In the new classical view, a policy action that will change aggregate demand and that is anticipated will affect only the price level, and not real GDP or unemployment. The reason for this is that the anticipated change in aggregate demand will result in a corresponding change in wages and hence SAS, and this will offset the effects of the policy action on real GDP (see first diagram above).
In the new Keynesian view, by contrast, the fact that money wages change only slowly (as new contracts are negotiated) means that even a correctly anticipated policy action can change real GDP and unemployment, and thus be used in an attempt to stabilize the business cycle or increase real GDP.
If you want to see how this process works, STEP BY STEP, click here.
The third, and most controversial, theory of the business cycle is called real business cycle (RBC) theory. This theory views random fluctuations in productivity, resulting primarily from variations in the pace of technological change, as the key factor responsible for business cycles. These fluctuations in productivity are seen as causing changes in investment demand and in the demand for labor.An intellectually pleasing aspect of RBC theory is that a single factor -- technological change -- is seen as driving both business cycles and long-term growth. However, there are a number of other aspects of the theory that seem rather peculiar (to me and a lot of other economists) -- e.g., RBC theory assumes that there are large variations in labor supply due to an intertemporal substitution effect, and in RBC theory unemployment is always at the natural rate, with the natural rate fluctuating over the business cycle because the amount of job search fluctuates.
Hence, I mention RBC theory here for the sake of completeness, but now we'll move on to consider macroeconomic policy challenges.
Policy goals and indicators
Our focus now is on the following question: what can policy do to improve macroeconomic performance? Way back in chapter 5, Parkin identified five challenges for macroeconomic policy: boost long-term growth, stabilize the business cycle, lower unemployment, keep inflation under control, and lower the current account deficit. Here we will look at the first four of these challenges (those which represent domestic policy goals), through the lens of what we've learned during the semester.
The goal of boosting long-term growth is key, because over the long haul it has tremendous implications for our standard of living. With a population growth rate of 1 percent per year, real GDP growth of 2 percent per year (comparable to recent growth but below the average growth rate of per capita GDP of 1.7 percent experienced in the U.S. over the past century) means that per capita real GDP would roughly double over the course of your lifetimes. However, real GDP growth of 3 percent per year would result in a quadrupling, while growth of 4 percent per year would yield an eight-fold increase in real GDP per capita.
Increasing actual long-term growth can occur if policies are pursued that achieve high growth of potential GDP. As Parkin notes, the limits to sustainable growth are determined by environmental considerations, the availability of natural resources, and the extent to which people are willing to save and invest in new capital and new technologies.
Stabilizing the business cycle can not be done completely, since changes in potential GDP most likely occur at an uneven pace, reflecting fluctuations in the rate at which technological improvements occur. Hence, even if we were always at potential GDP, we would likely experience fluctuations in economic growth.
At the same time, deviations of real GDP from its potential level entail costs: a shortfall (recessionary gap) means that output is lost, while real GDP in excess of potential GDP (an inflationary gap) results in bottlenecks (labor and materials shortages) that typically put sharp upward pressure on wages and prices.
The goal of lowering unemployment is evident from the perspective of high rates of unemployment. That is, with high unemployment there is forgone output from the macroeconomic perspective (productive labor is idle, human capital accumulation is slowed), and there are real difficulties at the household level (social problems as well as economic difficulties). However, the goal should best be described not as lowering unemployment, but as maintaining low unemployment. That is, if unemployment is very low, it causes economic dislocations: wage and price increases emerge, expanding industries find it hard to obtain the labor they need, and bottlenecks develop.
From this perspective, then, the ideal situation is one where unemployment is kept close to its natural rate. Here, we need to recall that there is no universal consensus on what is the natural rate of unemployment -- Parkin suggests that most economists would put it at 6 percent, while a few believe it to be as low as 5 percent. To the extent that we can maintain our present rate of about 5.5 percent without inflation increasing, the "consensus" at 6 percent is likely to change. In any case, it should be clear that lowering the natural rate may be seen as an important policy goal (cf., active labor market policy).
The goal of keeping inflation under control reflects an effort to avoid the costs of inflation that were discussed in chapter 15 (transactions costs, reductions in potential GDP and in the long-term growth of real GDP). Parkin notes that price stability -- defined as a measured inflation rate of 0-3 percent -- is viewed as desirable by most economists.
Although we've identified four goals, three of them are linked. If we can keep the long-term growth of real GDP at its maximum sustainable rate, we will have also succeeded in avoiding cyclical fluctuations and keeping unemployment at its natural rate. In the short term, real GDP growth and inflation are likely to be positively related (cf., the short-run Phillips curve), but in the long run they are independent or negatively related. Hence, real GDP growth and inflation are the key indicators or targets of policy.
In thinking about macroeconomic policy challenges, it is useful to keep in mind recent U.S. economic performance. Looking at the experience of the US economy since 1960, we see that the 1960s were a decade of relatively high growth (4 percent per year; note rapid population growth) and quite low inflation. During the 1970s growth slowed (tied primarily to the oil recessions) while inflation soared to double digits.
The 1980s began with two recessions and negative growth, but then we experienced a long expansion with good growth; and at the same time inflation was slowing. The 1990s also began with a recession, and since then there's been moderate growth while inflation has continued to decline, almost reaching the level of the 1960s.
With this background, then, we turn next time to an examination of policy tools and performance, long-term growth policy, policy to combat unemployment and stabilize the business cycle, and policy to combat inflation.