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Reaganomics and Its Aftermath

Recovery was under way when President Ronald Reagan assumed office in January 1981, but high inflation seemed deeply ingrained. The new president promised to change things with a package of policies—mainly large tax cuts—that, he claimed, would both boost growth and reduce inflation.

However, the Federal Reserve under Paul Volcker was already deploying monetary policy to fight inflation—which meant using excruciatingly high interest rates to deter spending. So while inflation did fall, the economy also slumped—into its worst recession since the Great Depression. When the 1981–1982 recession hit bottom, the unemployment rate was approaching 11 percent, the financial markets were in disarray, and the word depression had reentered the American vocabulary. The U.S. government also acquired chronically large budget deficits, far larger than anyone had dreamed possible only a few years before. This problem remained with us for about 15 years.

The recovery that began in the winter of 1982–1983 proved to be vigorous and long lasting. Unemployment fell more or less steadily for about six years, eventually dropping below 5.5 percent. Meanwhile, inflation remained tame. These developments provided an ideal economic platform on which George H. W. Bush ran to succeed Reagan—and to continue his policies.

But, unfortunately for the first President Bush, the good times did not keep rolling. Shortly after he took office, inflation began to accelerate a bit, and Congress enacted a deficit-reduction package (including a tax increase) not entirely to the president’s liking. Then, in mid-1990, the U.S. economy slumped into another recession—precipitated by yet another spike in oil prices before the Persian Gulf War. When the recovery from the 1990–1991 recession proved to be sluggish, candidate Bill Clinton hammered away at the lackluster economic performance of the Bush years. His message apparently resonated with American voters.

Monetary policy refers to actions taken by the Federal Reserve to influence aggregate demand by changing interest rates.

Clintonomics: Deficit Reduction and the “New Economy”7

Although candidate Clinton ran on a platform that concentrated on spurring economic growth, the yawning budget deficit forced President Clinton to concentrate on deficit reduction instead. A politically contentious package of tax increases and spending cuts barely squeaked through Congress in August 1993, and a second deficit-reduction package passed in 1997. Transforming the huge federal budget deficit into a large surplus turned out to be the crowning achievement of Clinton’s economic policy.

Whether by cause or coincidence, the national economy boomed during President Clinton’s eight years in office. Business spending perked up, the stock market soared, unemployment fell rapidly, and even inflation drifted lower. Why did all these wonderful things happen at once? Some optimists heralded the arrival of an exciting “New Economy”—a product of globalization and computerization—that naturally performs better than the economy of the past.

The new economy was certainly an alluring vision. But was it real? Most mainstream economists would answer: yes and no. On the one hand, advances in computer and information technology did seem to lead to faster growth in the second half of the 1990s. In that respect, we did get a “New Economy.” But something more mundane also happened: A variety of transitory factors pushed the economy’s aggregate supply curve outward at an unusually rapid pace between 1996 and 1998. When this happens, the expected result is faster economic growth and lower inflation, as Figure 8 shows.

7 One of the authors of this book was a member of President Clinton’s original Council of Economic Advisers.

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FIGURE 8

The Effects of a

Favorable Supply Shift

	D1	S0
		S1
	D0
	C	S2
	E	B
PRICE LEVEL
	S0
		D1
	S1
	S2	D0

REAL GDP

Figure 8 takes the graphical analysis of economic growth from Figure 3 and adds a new aggregate supply curve, S2S2, which lies to the right of S1S1. With supply curve S2S2 instead of S1S1, the economy moves from point E not just to point C, as in the earlier figure, but all the way to point B. Comparing B to C, we see that the economy winds up both farther to the right (that is, it grows faster) and lower (that is, it experiences less inflation). That, in a nutshell, is how our simple aggregate demand–aggregate supply framework explains this episode of recent U.S. economic history.

Tax Cuts and the Bush Economy

The Clinton boom ended around the middle of 2000—just before the election of President George W. Bush. Real GDP grew very slowly in the second half of 2000 and then actually declined in two quarters of 2001, marking the first recession in the United States in 10 years.

The tax cut of 2001 turned out to be remarkably well timed, however, and the war on terrorism led to a burst of government spending. Both of these components of fiscal policy helped shift the aggregate demand curve outward, thereby mitigating the recession. (Refer back to Figure 1(b) on page 86.) The Federal Reserve also lowered interest rates to encourage more spending. The recession ended late in 2001. But the recovery was extremely weak until the spring of 2003, when growth finally picked up—remaining strong through 2006 before slowing a bit late in 2007 and into 2008. The tax cuts of 2001–2003, while giving the economy a boost, also brought back large budget deficits.

ISSUE REVISITED:

WHY DID THE ECONOMY SLOW DOWN?

At the start of this chapter, we asked why U.S. economic growth weakened after early 2006. The analysis in the chapter suggests that we should look for a slowdown in aggregate demand to find the answer. And, indeed, there was one—some (but not all) of it made in Washington. Why did policy makers do this? Worried about inflation, the Federal Reserve started raising in-

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terest rates in the middle of 2005. Tax cutting, which had helped propel the economy in the years 2002–2004 also petered out, partly because policy makers became worried about large budget deficits. In addition, the nation’s spending on housing began to sag as the so-called housing bubble burst. Each of these factors restrained the growth of aggregate demand, as compared to 2003–2005, and therefore the growth of real GDP.

THE PROBLEM OF MACROECONOMIC STABILIZATION: A SNEAK PREVIEW

This brief look at the historical record shows that our economy has not generally produced steady growth without inflation. Rather, it has been buffeted by periodic bouts of unemployment or inflation, and sometimes it has been plagued by both. We have also hinted that government policies may have had something to do with this performance. Let us now expand upon and systematize this hint.

To provide a preliminary analysis of stabilization policy, the name given to government programs designed to shorten recessions and to counteract inflation, we can once again use the basic tools of aggregate supply and demand analysis. To facilitate this discussion, we have reproduced as Figures 9 and 10 two diagrams found earlier in this chapter, but we now give them slightly different interpretations.

Stabilization policy is the name given to government programs designed to prevent or shorten recessions and to counteract inflation (that is, to stabilize prices).

Combating Unemployment

Figure 9 offers a simplified view of government policy to fight unemployment. Suppose that in the absence of government intervention, the economy would reach an equilibrium at point E, where the aggregate demand curve D0D0 crosses the aggregate supply curve SS. Now if the output corresponding to point E is too low, leaving many workers unemployed, the government can reduce unemployment by increasing aggregate demand. Subsequent chapters will consider in detail how this is done. But our brief historical review has already mentioned three methods: Congress can spend more or reduce taxes (“fiscal

	D1
	S
D0
	A
Price Level	E
	D1
S	D0
	Increase in
	output

Real GDP

FIGURE 9

Stabilization Policy to Fight Unemployment

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Real GDP

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policy”), as it recently did with the 2008 “stimulus” bill; or the Federal Reserve can lower interest rates (“monetary policy”), as it also did in late 2007 and early 2008. In the diagram, any of these actions would shift the demand curve outward to D1D1, causing equilibrium to move to point A. In general:

Recessions and unemployment are often caused by insufficient aggregate demand. When such situations occur, fiscal or monetary policies that successfully augment demand can be effective ways to increase output and reduce unemployment. But they also normally raise prices.

FIGURE 10

Stabilization Policy to Fight Inflation

		D0
		D2
	Level	Decrease
	Price
		in prices

S

Combating Inflation

The opposite type of demand management is called for when inflation is the main macroeconomic problem. Figure 10 illustrates this case. Here again, point E, the intersection of aggregate demand curve D0D0 and aggregate supply curve SS, is the equilibrium the economy would reach in the absence of government policy. But now suppose the price level corresponding to point E is considered “too high,” meaning that the price level would be rising too rapidly if the economy were to move to point E. Government policies that reduce demand from D0D0 to D2D2 can keep prices down and thereby reduce inflation. Some examples are reducing government spending or raising taxes, as

done by the Clinton administration in the 1990s, or raising interest rates, which the Federal Reserve did in 2005–2006. Thus:

S

Inflation is frequently caused by aggregate demand racing ahead too fast. When this is the case, fiscal or monetary policies that reduce aggregate demand can be effective anti-inflationary devices. But such policies also decrease real GDP and raise unemployment.

	E
		This, in brief, summarizes the intent of stabilization pol-
	B	icy. When aggregate demand fluctuations are the source of
		economic instability, the government can limit both reces-
		sions and inflations by pushing aggregate demand ahead
		when it would otherwise lag and restraining it when it
	D0	would otherwise grow too quickly.

D2	Does It Really Work?

Can the government actually stabilize the economy, as these simple diagrams suggest? That is a matter of some debate— a debate that is important enough to constitute one of our

Ideas for Beyond the Final Exam.

We will deal with the pros and cons in Part 3. But a look back at Figures 5 and 6 (page 93) may be instructive right now. First, cover the portions of the two figures that deal with the period after 1940, the portions from the shaded area rightward in each figure. The picture that emerges for the 1870–1940 period is that of an economy with frequent and sometimes quite pronounced fluctuations.

Now do the reverse. Cover the data before 1950 and look only at the postwar period. There is indeed a difference. Instances of negative real GDP growth are less common and business fluctuations look less severe. Although government policies have not achieved perfection, things do look much better.

When we turn to inflation, however, matters look rather worse. Gone are the periods of deflation and price stability that occurred before World War II. Prices now seem only to rise. This quick tour through the data suggests that something has changed. The U.S. economy behaved differently from 1950 to 2007 than it did from 1870 to 1940.

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An Introduction to Macroeconomics

Although controversy over this point continues, many economists attribute this shift in the economy’s behavior to lessons the government has learned about managing the economy—lessons you will be learning in the next Part of this book. When you look at the prewar data, you see the fluctuations of an unmanaged economy that went through booms and recessions for “natural” economic reasons. The government did little about either. When you examine the postwar data, on the other hand, you see an economy that has been increasingly managed by government policy— sometimes successfully and sometimes unsuccessfully. Although the recessions are less severe, this improvement has come at a cost: The economy appears to be more inflation-prone than it was in the more distant past. These two changes in our economy may be connected. But to understand why, we will have to provide some relevant economic theory.

We have, in a sense, spent much of this chapter running before we have learned to walk—that is, we have been using aggregate demand and aggregate supply curves extensively before developing the theory that underlies them. That is the task before us in the rest of Part 2.

101

IDEAS FOR

BEYOND THE

FINAL EXAM

| SUMMARY |

1.Microeconomics studies the decisions of individuals and firms, the ways in which these decisions interact, and their influence on the allocation of a nation’s resources and the distribution of income. Macroeconomics looks at how entire economies behave and studies the pressing social problems of economic growth, inflation, and unemployment.

2.Although they focus on different subjects, microeconomics and macroeconomics rely on virtually identical tools. Both use the supply-and-demand analysis introduced in Chapter 4.

3.Macroeconomic models use abstract concepts like “the price level” and “gross domestic product” that are derived by combining many different markets into one. This process is known as aggregation; it should not be taken literally but rather viewed as a useful approximation.

4.The best specific measure of the nation’s economic output is gross domestic product (GDP), which is obtained by adding up the money values of all final goods and services produced in a given year. These outputs can be evaluated at current market prices (to get nominal GDP) or at some fixed set of prices (to get real GDP). Neither intermediate goods nor transactions that take place outside organized markets are included in GDP.

5.GDP measures an economy’s production, not the increase in its well-being. For example, the GDP places no value on housework, other do-it-yourself activities, or leisure time. On the other hand, even commodities that might be considered as “bads” rather than “goods” are counted in the GDP (for example, activities that harm the environment).

6.America’s economic history shows steady growth punctuated by periodic recessions—that is, periods in which real GDP declined. Although the distant past included

some periods of falling prices (deflation), more recent history shows only rising prices (inflation).

7.The Great Depression of the 1930s was the worst in U.S. history. It profoundly affected both our nation and countries throughout the world. It also led to a revolution in economic thinking, thanks largely to the work of John Maynard Keynes.

8.From World War II to the early 1970s, the American economy exhibited steadier growth than in the past. Many observers attributed this more stable performance to the implementation of the monetary and fiscal policies (collectively called stabilization policy) that Keynes had suggested. At the same time, however, the price level seems only to rise—never to fall—in the modern economy. The economy seems to have become more “inflation-prone.”

9.Between 1973 and 1991, the U.S. economy suffered through several serious recessions. In the first part of that period, inflation was also unusually virulent. This unhappy combination of economic stagnation with rapid inflation was nicknamed “stagflation.” Since 1982, however, inflation has been low.

10.The United States enjoyed a boom in the 1990s, and unemployment fell to its lowest level in 30 years. Yet inflation also fell. One explanation for this happy combination of rapid growth and low inflation is that the aggregate supply curve shifted out unusually rapidly.

11.One major cause of inflation is that aggregate demand may grow more quickly than does aggregate supply. In such a case, a government policy that reduces aggregate demand may be able to stem the inflation.

12.Recessions often occur because aggregate demand grows too slowly. In this case, a government policy that stimulates demand may be an effective way to fight the recession.

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102 PART 2 The Macroeconomy: Aggregate Supply and Demand

| KEY TERMS |

Aggregation 84			Nominal GDP 88			Fiscal policy	95
Aggregate demand curve		86	Real GDP	88		Stagflation	96
Aggregate supply curve		86	Final goods and services 89			Monetary policy 97
Inflation	87		Intermediate good		89	Stabilization policy 99
Recession	87		Real GDP per capita		92
Gross domestic product (GDP) 88			Deflation	93

| TEST YOURSELF |

1.Which of the following problems are likely to be studied by a microeconomist and which by a macroeconomist?

a.The rapid growth of Google

b.Why unemployment in the United States fell from 2003 to 2006

c.Why Japan’s economy grew faster than the U.S. economy in the 1980s, but slower in the 2000s

d.Why college tuition costs have risen so rapidly in recent years

2.Use an aggregate supply-and-demand diagram to study what would happen to an economy in which the aggregate supply curve never moved while the aggregate demand curve shifted outward year after year.

3.Which of the following transactions are included in gross domestic product, and by how much does each raise GDP?

a.Smith pays a carpenter $50,000 to build a garage.

b.Smith purchases $10,000 worth of materials and builds himself a garage, which is worth $50,000.

c.Smith goes to the woods, cuts down a tree, and uses the wood to build himself a garage that is worth $50,000.

d.The Jones family sells its old house to the Reynolds family for $400,000. The Joneses then buy a newly constructed house from a builder for $500,000.

e.You purchase a used computer from a friend for $200.

f.Your university purchases a new mainframe computer from IBM, paying $25,000.

g.You win $100 in an Atlantic City casino.

h.You make $100 in the stock market.

i.You sell a used economics textbook to your college bookstore for $60.

j.You buy a new economics textbook from your college bookstore for $100.

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| DISCUSSION QUESTIONS |

1.You probably use “aggregates” frequently in everyday discussions. Try to think of some examples. (Here is one: Have you ever said, “The students at this college generally think . . .”? What, precisely, did you mean?)

2.Try asking a friend who has not studied economics in which year he or she thinks prices were higher: 1870 or 1900? 1920 or 1940? (In both cases, prices were higher in

the earlier year.) Most young people think that prices have always risen. Why do you think they have this opinion?

3.Give some reasons why gross domestic product is not a suitable measure of the well-being of the nation. (Have you noticed newspaper accounts in which journalists seem to use GDP for this purpose?)

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THE GOALS OF MACROECONOMIC POLICY

When men are employed, they are best contented.

BENJAMIN FRANKLIN

Inflation is repudiation.

CALVIN COOLIDGE

S omeone once quipped that you could turn a parrot into an economist by teaching him just two words: supply and demand. And now that you have been through Chapter 4 and Chapter 5, you see what he meant. Sure enough, economists think of the

process of economic growth as having two essential ingredients:

•The first ingredient is aggregate supply. Given the available supplies of inputs like labor and capital, and the technology at its disposal, an economy is able to produce a certain volume of outputs, measured by GDP. This capacity to produce normally increases from one year to the next as the supplies of inputs grow and the technology improves. The theory of aggregate supply will be our focus in Chapters 7 and 10.

•The second ingredient is aggregate demand. How much of the capacity to produce is actually utilized depends on how many of these goods and services people and businesses want to buy. We begin building a theory of aggregate demand in Chapters 8 and 9.

Inputs are the labor, machinery, buildings, and other resources used to produce outputs.

Outputs are the goods and services that the economy produces.

C O N T E N T S

PART 1: THE GOAL OF ECONOMIC GROWTH

PRODUCTIVITY GROWTH: FROM LITTLE ACORNS . . .

ISSUE: IS FASTER GROWTH ALWAYS

BETTER?

THE CAPACITY TO PRODUCE: POTENTIAL GDP AND THE PRODUCTION FUNCTION

THE GROWTH RATE OF POTENTIAL GDP

ISSUE REVISITED: IS FASTER GROWTH ALWAYS

BETTER?

PART 2: THE GOAL OF LOW UNEMPLOYMENT

THE HUMAN COSTS OF HIGH

UNEMPLOYMENT

COUNTING THE UNEMPLOYED:

THE OFFICIAL STATISTICS

TYPES OF UNEMPLOYMENT

HOW MUCH EMPLOYMENT IS “FULL EMPLOYMENT”?

UNEMPLOYMENT INSURANCE:

THE INVALUABLE CUSHION

PART 3: THE GOAL OF LOW INFLATION

INFLATION: THE MYTH AND THE REALITY

Inflation and Real Wages

The Importance of Relative Prices

INFLATION AS A REDISTRIBUTOR OF INCOME AND WEALTH

REAL VERSUS NOMINAL INTEREST RATES

INFLATION DISTORTS MEASUREMENTS

Confusing Real and Nominal Interest Rates

The Malfunctioning Tax System

OTHER COSTS OF INFLATION

THE COSTS OF LOW VERSUS HIGH INFLATION

LOW INFLATION DOES NOT NECESSARILY LEAD TO HIGH INFLATION

| APPENDIX | How Statisticians Measure Inflation

Index Numbers for Inflation The Consumer Price Index

Using a Price Index to “Deflate” Monetary Figures Using a Price Index to Measure Inflation

The GDP Deflator

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Growth policy refers to government policies intended to make the economy grow faster in the long run.

Corresponding to these two ingredients, economists visualize a dual task for those who make macroeconomic policy. First, policy should create an environment in which the economy can expand its productive capacity rapidly, because that is the ultimate source of higher living standards. This first task is the realm of growth policy, and it is taken up in the next chapter. Second, policy makers should manage aggregate demand so that it grows in line with the economy’s capacity to produce, avoiding as much as possible the cycles of boom and bust that we saw in the last chapter. This is the realm of stabilization policy. As we noted in the last chapter, inadequate growth of aggregate demand can lead to high unemployment, while excessive growth of aggregate demand can lead to high inflation. Both are to be avoided.

Thus, the goals of macroeconomic policy can be summarized succinctly as achieving rapid but relatively smooth economic growth with low unemployment and low inflation. Unfortunately, that turns out to be a tall order. In chapters to come, we will explain why these goals cannot be attained with machine-like precision and why improvement on one front often spells deterioration on another. Along the way, we will pay a great deal of attention to both the causes of and cures for sluggish growth, high unemployment, and high inflation.

But before getting involved in such weighty issues of theory and policy, we pause in this chapter to take a close look at the three goals themselves. How fast can—or should— the economy grow? Why does a rise in unemployment cause such social distress? Why is inflation so loudly deplored? The answers to some of these questions may seem obvious at first. But, as you will see, there is more to them than meets the eye.

The chapter is divided into three main parts, corresponding to the three goals. An appendix explains how inflation is measured.

PART 1: THE GOAL OF ECONOMIC GROWTH

To residents of a prosperous society like ours, economic growth—the notion that standards of living rise from one year to the next—seems like part of the natural order of things. But it is not. Historians tell us that living standards barely changed from the Roman Empire to the dawn of the Industrial Revolution—a period of some 16 centuries! Closer in time, per-capita incomes have tragically declined, on net, in most of the former Soviet Union and some of the poorest countries of Africa in recent decades. Economic growth is not automatic.

Growth is also a very slow, and therefore barely noticeable, process. The typical American probably will consume about 1 to 2 percent more goods and services in 2008 than he or she did in 2007. Can you perceive a difference that small? Perhaps not, but such tiny changes, when compounded for decades or even centuries, transform societies. During the twentieth century, for example, living standards in the United States increased by a factor of almost 7—which means that your ancestors in the year 1900 consumed roughly one-seventh as much food, clothing, shelter, and other amenities as you do today. Try to imagine how your family would fare on one-eighth of its current income.

PRODUCTIVITY GROWTH: FROM LITTLE ACORNS . . .

Small differences in growth rates make an enormous difference—eventually. To illustrate this point, think about the relative positions of three major nations—the United States, the United Kingdom, and Japan—at two points in history: 1870 and 1979. In 1870, the United States was a young, upstart nation. Although already among the most prosperous countries on earth, the United States was in no sense yet a major power. The United Kingdom, by contrast, was the preeminent economic and military power of the world. The Victorian era was at its height, and the sun never set on the British Empire. Meanwhile, somewhere across the Pacific was an inconsequential island nation called Japan. In 1870, Japan had only recently opened up to the West and was economically backward.

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