Economic Report of the President

SummaryModerate recessions are followed by moderate expansions and sharpcontractions by rapid recoveries. This may be a consequence of the “financialaccelerator” model of investment, in which firms’ ability to borrow is relatedto the growth rate of output.Seen in this context, the unusually moderate growth experienced at thebeginning of the two most recent expansions seems less unusual, since thepreceding recessions were also relatively mild. This observation begs the questionof why the most recent recessions were mild. One possibility is thatstabilization policy may have been more active and more effective during thelast two recessions and subsequent expansions. This hypothesis can beassessed by looking at the two components of fiscal policy—taxes andspending—and at monetary policy.Stabilization PolicyBefore discussing specific details of stabilization policy, it will be useful toreview what is known about the causes of business cycles, the effects of policyon economic activity, and the resulting challenges to the development andimplementation of effective policy.Business Cycles: CausesStandard economic models suggest that long-run growth of real GDP is anoutcome of technological progress, the accumulation of capital, and growthin the labor force. The models also suggest that either a larger labor force witha fixed capital stock or a larger capital stock with a fixed labor force willproduce smaller and smaller additional amounts of output—a phenomenonknown as diminishing returns. Hence capital accumulation alone and increasesin the labor force alone will eventually result in higher levels of output butslower rates of output growth.In the very long run, output will grow only if technological progressenables the production of more output for a given amount of capital andlabor. In the short run, various shocks—unexpected events that cause largechanges in the demand or supply of goods—can lead to recessions andexpansions. The recessions and expansions can be seen as deviations from thelong-run growth path.Economic shocks can be divided into disturbances that affect aggregatedemand and those that affect aggregate supply. Aggregate demand is theeconomy-wide demand for goods and services. It consists of consumerspending, investment, government purchases, and net exports (exports lessChapter 2 | 61