Macroeconomics

Hint: You may find the following mathematical

trick helpful. If z

= wx, then the growth rate of

z is approximately the growth rate of w plus the

growth rate of x. That is,

D

z/z

≈ 

D

w/w

+

D

x/x.

3.

Suppose an economy described by the Solow

model is in a steady state with population

growth n of 1.8 percent per year and technolog-

ical progress g of 1.8 percent per year. Total out-

put and total capital grow at 3.6 percent per

year. Suppose further that the capital share of

output is 1/3. If you used the growth-account-

ing equation to divide output growth into three

sources—capital, labor, and total factor produc-

tivity—how much would you attribute to each

source? Compare your results to the figures we

found for the United States in Table 8-3.

D

(K/L)

⎯

K/L

D

A

⎯

A

D

(Y/L)

⎯

Y/L

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Business Cycle Theory: 

The Economy in 

the Short Run

P A R T   I V

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257

Introduction to 

Economic Fluctuations

The modern world regards business cycles much as the ancient Egyptians

regarded the overflowing of the Nile. The phenomenon recurs at intervals, it is

of great importance to everyone, and natural causes of it are not in sight.

—John Bates Clark, 1898

9

C H A P T E R

E

conomic fluctuations present a recurring problem for economists and pol-

icymakers. On average, the real GDP of the United States grows between

3 and 3.5 percent per year. But this long-run average hides the fact that the

economy’s output of goods and services does not grow smoothly. Growth is high-

er in some years than in others; sometimes the economy loses ground, and growth

turns negative. These fluctuations in the economy’s output are closely associated

with fluctuations in employment. When the economy experiences a period of

falling output and rising unemployment, the economy is said to be in recession.

A recent recession began in late 2007. From the third quarter of 2007 to the

third quarter of 2008, the economy’s production of goods and services expanded

by a paltry 0.7 percent—well below the normal rate of growth. Real GDP then

plunged sharply in the fourth quarter of 2008 and the first quarter of 2009. The

unemployment rate rose from 4.7 percent in November 2007 to 8.5 percent in

March 2009. In early 2009, as this book was going to press, the end of the reces-

sion was not yet in sight, and many feared that the downturn would get signifi-

cantly worse before things started to get better. Not surprisingly, the recession

dominated the economic news of the time, and addressing the problem was high

on the agenda of the newly elected president, Barack Obama.

Economists call these short-run fluctuations in output and employment the

business cycle. Although this term suggests that economic fluctuations are regular

and predictable, they are not. Recessions are actually as irregular as they are com-

mon. Sometimes they occur close together, while other times they are much far-

ther apart. For example, the United States fell into recession in 1982, only two

years after the previous downturn. By the end of that year, the unemployment

rate had reached 10.8 percent—the highest level since the Great Depression of

the 1930s. But after the 1982 recession, it was eight years before the economy

experienced another one.

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These historical events raise a variety of related questions: What causes short-

run fluctuations? What model should we use to explain them? Can policymak-

ers avoid recessions? If so, what policy levers should they use?

In Parts Two and Three of this book, we developed theories to explain how

the economy behaves in the long run. Here, in Part Four, we see how econo-

mists explain short-run fluctuations. We begin in this chapter with three tasks.

First, we examine the data that describe short-run economic fluctuations. Sec-

ond, we discuss the key differences between how the economy behaves in the

long run and how it behaves in the short run. Third, we introduce the model of

aggregate supply and aggregate demand, which most economists use to explain

short-run fluctuations. Developing this model in more detail will be our prima-

ry job in the chapters that follow.

Just as Egypt now controls the flooding of the Nile Valley with the Aswan

Dam, modern society tries to control the business cycle with appropriate eco-

nomic policies. The model we develop over the next several chapters shows how

monetary and fiscal policies influence the business cycle. We will see how these

policies can potentially stabilize the economy or, if poorly conducted, make the

problem of economic instability even worse.