cowentabarrokecon3e

Big Idea Eight: Economic Booms and Busts Cannot Be Avoided but Can Be Moderated

We have seen that growth matters and that the right institutions foster growth. But no economy grows at a constant pace. Economies advance and recede, rise and fall, boom and bust. In a recession, wages fall and many people are thrown into miserable unemployment. Unfortunately, we cannot avoid all recessions. Booms and busts are part of the normal response of an economy to changing economic conditions. When the weather is bad in India, for example, crops fail and the economy grows more slowly or perhaps it grows not at all. The weather doesn’t much affect the economy in the United States, but the U.S. economy is buffeted by other unavoidable shocks.

Although some booms and busts are part of the normal response of an economy to changing economic conditions, not all booms and busts are normal. The Great Depression (1929–1940) was not normal, but rather it was the most catastrophic economic event in the history of the United States. National output plummeted by 30 percent, unemployment rates exceeded 20 percent, and the stock market lost more than two-thirds of its value. Almost overnight the United States went from confidence to desperation. The Great Depression, however, didn’t have to happen. Most economists today believe that if the government, especially the U.S. Federal Reserve, had acted more quickly and more appropriately, the Great Depression would have been shorter and less deep. At the time, however, the tools at the government’s disposal—monetary and fiscal policy—were not well understood.

Today, the tools of monetary and fiscal policy are much better understood. When used appropriately, these tools can reduce swings in unemployment and GDP. Unemployment insurance can also reduce some of the misery that accompanies a recession. The tools of monetary and fiscal policy, however, are not all-powerful. At one time it was thought that these tools could end all recessions, but we know now that this is not the case. Furthermore, when used poorly, monetary and fiscal policy can make recessions worse and the economy more volatile.

A significant task of macroeconomic theory is to understand both the promise and the limits of monetary and fiscal policy in smoothing out the normal booms and busts of the macroeconomy.