[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Thinking Like an Economist
INFORMATION AND MEASURING THE BUSINESS CYCLE
Designing macroeconomic policy requires accurate information
about the economy. Economists’ conclusions about
the severity of business cycles and whether the economy
has become more stable are affected by the quality of their
information.
Though some recessions are more severe than others, most
economists have accepted the view that recessions since World
War II have been, on average, milder than the recessions experienced
by the United States earlier in the century. Christina
Romer of the University of California, Berkeley, disagrees. She
notes that the macroeconomic data now available to economists
are vastly better than the data used in the early decades
of the twentieth century to gauge macroeconomic performance.
She has argued that in large part the apparent decline in
the severity of business cycles simply reflects improvements
in our ability to measure fluctuations in the economy. However,
most economists believe that better data do not explain the
whole story. Economists do assess the economy more accurately
today than was possible before World War II, but changes
in the economy and improvements in economic policymaking
also have helped make business cycles less severe.
Even though the quality of economic data has improved,
accurately judging the behavior of the economy remains difficult.
Policy must be based on some measures, such as potential
GDP, that must be estimated rather than observed directly.
During the 1970s, the growth of potential GDP slowed, but this
slowdown was not apparent to analysts at the time. By overestimating
potential GDP, the Federal Reserve, along with
most other analysts, made errors in evaluating the level of the
output gap and cyclical unemployment. These errors led to
policy decisions that, in hindsight and with better data, now
look to have been misguided.
firms normally have some spare capacity. In the short run, firms typically adjust production
rather than prices in response to changes in demand. Economists have identified
two key reasons for this tendency. 2
The Role of Costs The first explanation emphasizes the implications of sluggish
wage adjustment. Labor costs are, for most businesses, the major component of
their costs of production. In competitive markets, prices move in tandem with
marginal costs and changes in wages translate into changes in the marginal costs of
production. Some firms, at least in the short run, use a simple rule of thumb in pricing
their goods—they set price as a given markup over costs (e.g., 120 percent of
costs). In this case, prices adjust slowly to changes in demand because wages (and
therefore costs) adjust slowly.
Risk and Uncertainty Risk and imperfect information can significantly slow
price adjustments just as they did wage adjustments. In perfectly competitive markets,
firms simply take prices as given; with imperfect competition, firms have some
2 In some cases, these explanations seem to explain too much—they suggest that in some situations, prices and
wages will not adjust at all to, say, small changes in demand or costs. But the economy consists of many firms
in different circumstances. Some may not be able to respond at all, while others may respond fully. The average
for the economy demonstrates a slow response.
WHY ECONOMIES EXPERIENCE FLUCTUATIONS ∂ 647