Short-Run Economic Fluctuations

Focus on Recession and Depression

Economic activity fluctuates from year to year. In most years, the production of goods and services rises.

Because of increases in the labor force, increases in the capital stock, and advances in technological knowledge, the economy can produce more and more over time.

This growth allows everyone to enjoy a higher standard of living. On average, over the past half century, the production of the U.S. economy as measured by real GDP has grown by about 3 percent per year.

In some years, however, instead of expanding, the economy contracts.
  • Firms find themselves unable to sell all the goods and services they have to offer, so they reduce production.
  • Workers are laid off, unemployment becomes widespread, and factories are left idle.
  • With the economy producing fewer goods and services, real GDP and other measures of income decline.

Such a period of falling incomes and rising unemployment is called a recession if it is relatively mild and a depression if it is more severe.

Recession is a period of declining real incomes and rising unemployment, of which for at least two consecutive three-month periods (quarters), the value of all the goods produced and sold in the economy falls. Depression is a severe form of recession.

An example of such a downturn occurred in 2008 and 2009. From the fourth quarter of 2007 to the second quarter of 2009, real GDP for the U.S. economy fell by 4.2 percent.

The rate of unemployment rose from 4.4 percent in May 2007 to 10.0 percent in October 2009—the highest level in more than a quarter century. Not surprisingly, students graduating during this time found that desirable jobs were hard to come by.

Don’t confuse short-run fluctuations with long-run trends with long-run trends
It is important to understand that, although economies often experience economic booms and recessions, these are short-run occurrences. If a recession continues for a year or more it may be tempting to assume that long-run growth Opens in new window will starts to decline.

However, even in the Great Depression of 1929 – 1933 Opens in new window, when economic growth rates in Australia and most other industrialized countries were negative for an extended period of time, history has demonstrated that the long-run growth path of potential real GDP continued to trend towards.

It is not the short-run fluctuations that determine long-run economic growth. Rather, it is technology Opens in new window, capital stock Opens in new window and the education Opens in new window and skill levels Opens in new window of human capital which, in most countries, have increased over time.
These are the questions we take up now.

The variables that we study are largely those we have discussed in greater detail in designated models. They include GDP Opens in new window, unemployment Opens in new window, interest rates Opens in new window, and the price level Opens in new window. Also familiar are the policy instruments of government spending, taxes, and the money supply.

The goal here is to explain the short-run deviations of these variables from long-run trends. In other words, rather than focusing on the forces that explain economic growth from generation to generation, we are now interested in the forces that explain economic fluctuations from year to year.

There is some debate among economists about how best to analyze short-run fluctuations, but most economists use the model of aggregate demand Opens in new window and aggregate supply Opens in new window.

Learning how to use this model for analyzing the short-run effects of various events and policies is the primary task ahead.

This post merely introduces the model’s two pieces: the aggregate-demand curve Opens in new window and the aggregate-supply curve Opens in new window. Before turning to the model, however, let’s look at some of the key facts that describe the ups and downs of the economy Opens in new window.

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