Introduction to Economic Fluctuations

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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

Economic fluctuations present a recurring problem for economists and policymakers. On average, the real GDP of the United States grows about 3 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 higher 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 was approximately flat, in contrast to its normal 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 10.0 percent in October 2009. The recession officially ended in June 2009 when positive growth resumed, but the recovery was weak, and unemployment remained above 7.0 percent for the next four years. Not surprisingly, the recession dominated the economic news, and addressing the problem was high on the policy agenda during President Barack Obama’s early years in office.

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 common. Sometimes they occur close together, while at other times they are much farther apart. For example, the United States fell into a 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 policymakers 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 economists explain short-run fluctuations. We begin in this chapter with three tasks. First, we examine the data that describe short-run economic fluctuations. Second, 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 primary 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 economic 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.