ESSAY (200-300 words): What is inflation, and how does it affect consumers? Is inflation always bad? Describe a situation where inflation is positive?

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. theory about how the econ-
orny works. At one tirne, for
examPle, a nation’s eco-
nomic vitalitY was thought
to sPring from the stock of
precious metals accumu-
lated in the Public treasury’
This theory spawned a

”’ po1iry called mercantiiism’
‘ which held that, as a waY of

accumulating gold and sil-

ver, a nation should try to
ir {” export more than it imPorts’

To achieve this, nations

duce a major tax increase

of the economy, just as we need not know

i”,”ii of the uoay. rut we must understand essen-
dal relationships among key variabies’

For example’

does the economy *otf *”U on its own’ or does it
;;;;m poorly? If it performs poorly’ are there
i**”di”tl can we u” ttt” that a proposed remedy
*””iJ “”,

do more harm than good? When doctors

;idtt’; understand how the human body


“cures” were often worse than the

Ji*r”r. Much of the history of medicine describes
misguided efforts to deal with maladies’

Even today’

medical care is based on less

mercanr*ism ffiiliTr:Ji1″[:””i?&t1:
the inrortecttheorythat onJ study, only one in seven
a nation’s economic

urrt -!usJ t -‘*t -,-. ,
li;u.*iu”.t’ould be to medical interventions is sup-
J””u*utut” precious ported by reliable scientific
metals in the public lviaence.r For example, acet-
treasqrY; this theorY
prompted trade bar’ aminophen (e’g’, Tflenol) is
riers io

itnports, a popular pain reiiever, but

ffilljl’?#n t’oto^aY ruallY knows how it
trade and the gains {rorn works’
srecialization LikewiSe, policy makers
economic maY adoPt the wrong Pre-
{|::HlT;?i, .,, -“”, scription

or a flawed

nomie activitY relative
to the [ong’term growth t. As reported by Shenrvin Nuland,
fi:i:il:i::?JJJ” ;r,rr’iicjlua’,dran,Midwivesand

— —
Leech es:’ NewYork llmes’ 25 January

1 S95.

during the Great Depression’ Economists
have srnce

[-*,.’a that such a policy does-more harm than
;;.; “Jai

iott, debates about whether policies

i”fnf”f or harmful were prevalent as poiicy makers
t”tio”a*a to the zoo8-2oo9 economic downturn’

We turn now to the performance of the U’S’


Wz Hconomic Fluctuations
and Growth
The U.S. economy and other indush’ial


u.orro*i”” historlcally have experienced alter-

;;;;; Fiods of expansion and contraction
in u.loo*ic activity’ Economic fluctuations are
torrg-,ur* growth trend of the economy’

These fluc-

arr”iionr, oibusiness cycles, vary in length
and inten-

cirv- vet some featurua “ppu”t
common to all’ Th*

;;i il il*”t”*”*ilv invot”e the entire nation ani
often many other eco-nomies around

the world’ and

;;;;;;”early all dimensions of economic activ’
ity, not just production and employment’

U.S, Economic Fluctuations
Perhaps the easiest way to understand

the busine:s

.y.i” it ,” *amine its components’ During
the r9z+*

70 PART z Fundamentals ol lrnacroeconcmtcs


.::C r93os, WesleY C. Mitchell,
:trector of the National Bureau
:i Economic Research (NBER)’
;talyzed business cYcles, not-
,rg that the economY has two
:hases: expansions and contrac-
::cns. During an exPansion, the
economy’s outPut increases.
During a contraction, the econ-
cmy’s outPut decreases’ Prior
io World War Ii, a contraction
might be so severe as to be
calied a depression, which is a
sirarp reduction in the nation’s
total production lasting more
than a year and accomPanied bY
high unemPloYment. A milder
contraction is called a reces-
sion, traditionallY defined as a
decline in total outPut lasting
at ieast two consecutive quar-
ters, or at least six months’ The
U.S. economY exPerienced both
recessions and dePressions
before World War II. So far, there

P Yirllall’ I

Hypothetical Business CYcles









have been recessions but no depressions, so things

have improved.
Despite these ups and downs, the U’S’ economy

has grown dramatically over the longterm’The econ-

o*y-rro* produces about r3 times more outPut than
it did in 1929. Output is measured by real GDq the
value of final goods and services after stripping away

changes due to infiation, which is an increase in the

economy’s average price level. Production increased

because of (r) increases in the amount and quality

of resources, especially labor and capital; (z) better
technology; and (:) improvements in the rules of the
game thit facilitate production and exchange, such

property rights, patent laws, the legal system, and

market practices.
Exhibit r shows such a long-term growth trend

in reai GDP as an upward-sloping straight line’
Economic fluctuations reflect movements around
this growth trend. A contraction begins after the pre-

vious expansion has reached a peak, or high point,

and coniinues until the economy reaches a trough,
or low point. The period between a peak and trough
is a contraction, and the period between a trough and

subsequent peak is an expansion’ Note that expan-
sions last tonger than contractions, but the length of

the fuli cycle varies.
Analysts at NBER have tracked the U’S’ economy

backto igs+. Since then, the nation has experienced

3z peak-to-trough-to-peak cycles’ No two have been

exactiy alike. During the 22 business cycles prior to

1945, expansions averaged z9 months and contrac-

tions zr-months’ During the rr cycles since 1945′
expansions stretched twice as longto 57 months’ and

recessions fell by half to r r months’ Thus since 1945

expansions are longer and recessions are shorter’
goih developments have been hugely beneficial for

economic grtwttr and the U.S. standard of living’ The




longest exPansion on record

lasted ro years, from March
r99r to March zoor. The lon’
gest contraction lasted five
and a half Years, from 1873
to 1879.

Exhibit z shows annual
percentage changes in real
GDP since 1929. Years of
declining real GDP are shown

as red bars and Years of
increasing real GDP as biue
bars. The big decline during
the Great DePression of the
early r93os and the sharP
jump during World War
II stand in stark contrast’
Growth since r9z9 averaged

3.4 percent a Year- Although
official data are not Yet avail-
able, eventuallY the zoo8-
2oo9 recession will appear
on charts like Exhibit z.

a period during whieh
the economY’s oulPut

a period during whieh
the economY’s outPut

a sharp reduction in an
economy’s total *utPut
accompenied bY high
unemployment lasting
r$ore than a Year

a sustainad decline in
the economY’s tota!
a$tp{rt lasting at least
two consecutive quar-
tevs, or six months; an
ecsnomic contraciion

an increase in the
*conomy’s average
price level

CHAPTER 5 lniroduction to Macioecononiics 71






Exhibit z
Annual Perceilage Ghange in U.S’ Eeal GDP Since 1929

1930 1940 1950 1960 1970 lel

SoIJRCE: Bureau of Economic Analysis, U.S. Dept ol Commerce’ For the latost data,
go to

snowstorm or a Poor
growing season. T\rrn-
ing points-peaks and
troughs-are thus iden-
tified by the NBER onlY
after the fact. Because a
recession means outPut
deciines for at least two
consecutive quarters, a
recession is not so des-
ignated until at least six
months after it begins.

As noted, fluctua-
tions usually involve the
entire nation. lndeed,
major economies around
the worid often move
together. For examPle,
the Great DePression

was a wofidwide calanrtry’ Ttre -urrerrrpluyrrrttrrt’Ia’te

in Germany reached 34 percent, which helped bring

Hitler to power. The following section compares the
year-to-year output changes in the United States
with those in another major economyr the United
Kingdom, during the last three decades.

The Global Economy
Though business rycles are not perfectly synchronized

countries, a tink is often apparent. Consider the

experience of two leading economies-the United
Stites and the United Kingdom. Exhibit 3 shows for

each economy the year-to-year percentage change in
real GDP since 1978. By examining the annual changes

in each economy, you can see some similarities’ Both
economies went into recession in the early r98os, in
r99r, in zoot, and in zoo8. Notice also that over time,

the countries’ gtowth rates have fluctuated less and

become more similar.
\Mhen iinkage across economies occurs’ a siump

in one major economy could worsen a recession in
the other, and vice versa. For example, the terror-
ist attacks on the United States in September 2oor
affected economies around the world, reducing air-

line travel and lowering stock market prices’ On the u,
other hand, economic strength overseas can give $
the U.S. economy a lift, with overseas profits help- E
ingcompanies offset aweakhome market’The same H
p”it”.., of worldwide decline occurred with the hous- !
ing and banking crisis of zoo8*zoo9. g


Leading Economic lndicators I
Certain events foreshadow a turning point in “to-

nomic activity. Months before a recession is under 6

The intensity ol !.S’ economic ttucruatrons vanes
across regions. A recession hits hardest those regions

that produce capital goods, such as heavy machinery

and durable goods, such as appliances, furniture, and

automobiles. The demand for these goods falls more

during hard times than does the demand for other
goodsand sennices, such as breakfast cereal, gasoline,

ind haircuts. In addition, housing, banks and finan-
ciai institutions particularly suffered in zooS

Because of sea-
sonal fluctuations
and random distur-

bances, the econ-
omy does not
move smoothly
through Phases
of the business

cycle. Economists
can’t always dis-
tinguish a tem-
porary drop in

the beginning of
a downturn. A
drop in Produc-

tion may result
from a temPorary

slowdown, such as a

9/l1 attacks

72 PART 2 Fundamentals ol l/acroeconomics

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