Economic Growth and the Business Cycle: Characteristics, Causes, and Policy Implications

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

Economic growth can be caused by random fluctuations, seasonal fluctuations, changes in the
business cycle, and long-term structural causes. Policy can influence the latter two.
Business cycles refer to the regular cyclical pattern of economic boom (expansions) and bust
(recessions). Recessions are characterized by falling output and employment; at the opposite end
of the spectrum is an “overheating” economy, characterized by unsustainably rapid economic
growth and rising inflation. Capital investment spending is the most cyclical component of
economic output, whereas consumption is one of the least cyclical. Government can temper
booms and busts through the use of monetary and fiscal policy. Monetary policy refers to changes
in overnight interest rates by the Federal Reserve. When the Fed wishes to stimulate economic
activity, it reduces interest rates; to curb economic activity, it raises rates. Fiscal policy refers to
changes in the federal budget deficit. An increasing deficit stimulates economic activity, whereas
a decreasing deficit curbs it. By their nature, policy changes to influence the business cycle affect
the economy only temporarily because booms and busts are transient. In recent decades,
expansions have become longer and recessions shallower, perhaps because of improved
stabilization policy, or perhaps because of good luck.
Long-term growth receives less attention from policymakers than cyclical growth. Yet in a
broader view of history, long-term growth is the more important of the two because it is the key
to raising living standards. Long-term growth is caused by increases in labor, capital, and
productivity. Policy changes in the areas of education, taxation, competition, basic research, and
infrastructure can influence the economy’s long-term growth rate, but only at the margins. Long-
term growth has altered very little over most of U.S. history despite a broad array of policy
changes. That fact is less surprising when one considers that the main contributor to long-term
growth is technological progress, over which the government has little direct influence. In recent
years, long-term growth has accelerated modestly because of higher productivity growth, driven
mainly by what is popularly referred to as the “information technology (IT) revolution.” Although
the government had little direct influence over the IT revolution, it provided an environment in
which those technological changes were allowed to thrive, which likely explains why many other
economies did not experience a similar productivity acceleration.
This report will be updated as events warrant.

Introduc tion ..................................................................................................................................... 1
The Business Cycle.........................................................................................................................2
Employment and the Business Cycle........................................................................................3
Historical Patterns.....................................................................................................................3
What Causes the Business Cycle?.............................................................................................4
Sectoral Effects of the Business Cycle......................................................................................5
Long-Term Structural Growth.........................................................................................................6
Labor Supply Growth................................................................................................................7
Growth in the Capital Stock and the Role of Saving................................................................7
Productivity Growth..................................................................................................................8
Policy Implications........................................................................................................................10
Business Cycle Stabilization Policy........................................................................................10
Monetary or Fiscal Policy?................................................................................................11
Are Recessions Unavoidable?...........................................................................................13
Where Should the Tradeoff Lie Between Economic and Price Stability?........................14
Should Stabilization Policy “Fine Tune”?........................................................................15
Policies to Promote Long-Term Growth.................................................................................17
Figure 1. Quarterly GDP Growth, 1990:1-2007:1...........................................................................2
Figure 2. Quarterly Growth of GDP, Consumption, and Investment, 1990:1-2007:1.....................5
Figure 3. Investment Spending as a Share of GDP, 1946-2006.......................................................8
Figure 4. Federal Funds Rate, 1960-2007.....................................................................................17
Table 1. Recessions since World War II..........................................................................................4
Table 2. Productivity Growth Rates, 1949-2006.............................................................................9
Table 3. Estimated Sources of Potential GDP Growth, 1950-2017...............................................10
Table 4. Average Per Capita GDP Growth, Major Advanced Economies.....................................19
Author Contact Information..........................................................................................................20

Economic growth (increases in gross domestic product (GDP)) may appear to be unambiguously
good because income can only rise over time if output rises. But quarterly GDP growth can be
affected by four different factors, and each of these factors has different implications for policy
and for general well-being. Figure 1 illustrates these factors graphically over the past two
business cycles. The four factors, listed by length of duration from transient to long-term, are as
follows:
Random or One-time Events. Some of the changes in quarterly growth rates from quarter to
quarter are not persistent and may have no particular cause that can be systematically identified or
predicted. Other changes are caused by one-time events that have no lasting impact on the
national economy, such as the natural disasters that struck the economy in the fourth quarter of
2005. These disasters are widely credited with having caused below average growth in the fourth
quarter of 2005 and above average growth in the first quarter of 2006 (because of rebuilding).
Random contributions to economic growth can be thought of as roughly the distance between the
line labeled quarterly GDP growth in Figure 1 and the line labeled business cycle. As can be
seen, the distance between these lines is usually modest, but at times can be large.
Seasonal Fluctuations. Economic activity fluctuates in a predictable way over the course of the
year. For example, agricultural output peaks at harvest time and consumption rises during the
holidays. Since these seasonal fluctuations have no lasting effect on the economy and do not offer
any predictive information about the economy’s future path, they are routinely stripped out of the
data before it is used by the general public. Therefore, seasonal effects are not shown in Figure 1.
Business Cycle Effects. Over the course of several years, the economy routinely experiences a
predictable pattern of boom (expansion), followed by bust (recession), followed by recovery that ¹
begins the pattern anew. This can be seen in the line marked “business cycle” in Figure 1.
Recessions are represented by the valleys that occur in the early 1990s and 2000s, expansions are
represented by the inclines after a recession and peaks that occur later in the decades. Since the
1980s, an entire cycle has taken about a decade. While the government cannot prevent cyclical
fluctuations, it can attempt to soften the booms and busts of the business cycle through monetary
and fiscal policy.
Structural Growth. In the long run, economic progress is not driven by random, seasonal, or
cyclical fluctuations. It depends on an increase in labor and capital (physical investment) inputs
and productivity improvements. Structural growth can be represented by the trend line in Figure

1, which undergoes a slight increase in the mid-1990s that will be discussed later in the report.

Over time, the growth rates of these inputs and productivity vary, but important, lasting shifts
occur infrequently. Microeconomic policy changes can foster faster growth in labor, capital, and
productivity at the margin. In addition, government budget deficits can reduce the growth of the
capital stock.

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^m^o^vⁱ^ng^av^e^r^ag^e^.

Figure 1. Quarterly GDP Growth, 1990:1-2007:1
10
8
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4ang
2 ch

-2
-4
1990-I 1992-I 1994-I 1996-I 1998-I 2000-I 2002-I 2004-I 2006-I
quarterly GDP growthbusiness cycletrend growth
^Source:^Burea^{u of}^{Economic An}^{alysis, CR}^{S calculations.}
^Note:^{Quarterly growth rate}^{s ar}^{e ann}^{ualized and seasonally adjusted. The busines}^{s cycle series is ca}^lculated
^{using an}^{eight q}^uarter^{moving ave}^{rage. The trend g}^{rowth is calcula}^{ted using an}^{average with}^{a br}^eak^{point at}
¹⁹⁹^5:3.
This report focuses on the two most important sources of economic growth, cyclical and
structural, and discusses how policy can influence them.

In the long run, economic growth is determined solely by the growth rate of productivity and
capital and labor inputs that determine the overall production of goods and services—what is
sometimes referred to as the “supply side” of the economy. But in the short run, growth can be
influenced by the rate of overall spending, also known as the “demand side” of the economy.
Overall spending includes consumer spending, business spending on capital goods, government
spending, and foreign spending on U.S. exports.
Spending and production are equalized by prices. Because prices adjust gradually, spending can
temporarily grow faster or slower than the potential growth rate of the supply side of the
economy. Recessions are characterized by a situation where spending is not growing fast enough
to employ all of the economy’s labor and capital resources. Recessions can come to an end
because government has used fiscal or monetary policy to boost spending or because spending
recovers on its own when prices have gradually adjusted. Economic booms eventually give way
to “overheating,” which is characterized by a situation where spending is growing too fast, and
labor, capital, and productivity cannot grow fast enough to keep up. In this scenario, faster
economic growth can become “too much of a good thing” because it is unsustainable.
Overheating is typified by a rise in inflation—because there is a greater demand for goods than

supply of goods, prices begin to rise. Overheating typically gives way to recession when, in order
to offset the rise in inflation, monetary policy is tightened to reduce overall spending to the point
where it is growing at the same pace as overall supply again. In essence, policymakers trade off a
lower rate of economic growth in the short run to achieve a more stable and higher average
growth rate over time.
Although there is no foolproof way to differentiate between changes in growth being caused by
cyclical forces and structural forces, movements in the inflation rate offer a good indication.
When inflation is rising, growth is probably above its sustainable rate because overall spending is
growing too fast, and when inflation is falling, growth is probably below its sustainable rate
because overall spending is too sluggish. Inflation is not a perfect indicator of cyclical activity,
however, because sudden spikes in the price of specific goods sometimes cause overall inflation
to temporarily change. Volatile energy prices are the prime example of when a change in inflation
may not correspond with the business cycle.
Just as rapid economic growth can be too much of a good thing, so too can rapid increases in
employment and decreases in the unemployment rate. As explained above, the economy’s
potential growth rate is determined by the growth rate of inputs to the production process, such as
labor. When employment rises faster (slower) than the labor force grows, the unemployment rate
will fall (rise). With enough employment growth, at some point all available labor will be utilized
in the production process, and this will happen before the unemployment rate reaches zero.
Unemployment never reaches zero because some workers will always be in the process of leaving
an old job and finding a new one, and some workers will always be in the wrong place at the
wrong time for the skills they have compared to the skills needed for local employment
opportunities. The rate of unemployment consistent with employment for all workers who do not
fall into these two categories is known as the “natural rate of unemployment” or “full ²
employment” or the “non-accelerating inflation rate of unemployment (NAIRU).”
If overall spending is growing rapidly enough, unemployment can be temporarily pushed below
the natural rate. When unemployment is pushed below the natural rate, too many jobs will be
chasing too few workers, causing wages to rise faster than productivity. But wages cannot
persistently rise faster than productivity because, again, overall spending cannot grow faster than
production (assuming labor’s share of income remains constant). Wages can temporarily rise
faster than productivity, but the result would be rising inflation. In recessions, the process works
in reverse. Because spending is insufficient to match potential production, businesses lay off
workers. This causes the unemployment rate to rise above the natural rate. As unemployment
rises, workers moderate their wage demands in order to find scarce jobs or keep existing jobs. As
a result, inflation falls.
As Table 1 suggests, to date, the boom and bust pattern is predictable, but has proven
unavoidable. Since World War II, the median length of a recession has been 10 months and the

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^W^.^Ca^she^ll.

median cumulative contraction in output has been 2% of GDP. Two recessions, those beginning in
1973 and 1981, were unusually long. The 1981 recession followed a brief recession that had
ended a year earlier; these two recessions are sometimes referred to collectively as the “double
dip” recession. From 1945 to 1981, there were eight recessions; since 1982, there have been only
two. Of course, the complement of less frequent recessions is longer expansions. Since World
War II, there have been three very long expansions, occurring in the 1960s (lasting 106 months),
1980s (92 months), and 1990s (120 months, the historical record). The current expansion, which
began in November 2001, may eventually turn out to be a long one as well—through June 2007,
it was already the fourth longest since World War II.
The pattern of longer expansions and less frequent recessions that has prevailed since the 1980s
expansion has been dubbed the “great moderation” by economists. Research has demonstrated
statistically that there has been a fundamental change in the economy’s behavior since the mid-
1980s. Not only has the business cycle been smoother, random fluctuations in growth have also
been smaller since then. Economists have three hypotheses for what has caused the great
moderation: a change in the structure of the economy; better policy, notably monetary policy; or ³
simply better luck.
Table 1. Recessions since World War II
^Maximum
^{Period of C}^ontra^ction^{Months of}^Contra^ction^Cumulative^Contra^{ction in GDP}^Unemployment
^Rate
^{November 19}^48-O^{ctober 19}⁴⁹¹¹^1.7%^7.9%
^{July 1}⁹⁵^3-May¹⁹⁵⁴¹⁰^2.7^6.1
^{August 19}^57-Ap^ril¹⁹⁵⁸⁸^3.7^7.5
^{April 19}^60-Febr^uary¹⁹⁶¹¹⁰^1.6^7.1
^{December 19}^69-Novem^{ber 19}⁷⁰¹¹^0.6^6.1
^{November 19}^73-^Marc^h¹⁹⁷⁵¹⁶^3.0^9.0
^Janua^{ry 1}⁹⁸^0-July¹⁹⁸⁰⁶^2.2^7.8
^{July 1}⁹⁸^1-Novembe^{r 1}⁹⁸²¹⁶^2.9^10.8
^{July 1}⁹⁹^0-Marc^{h 1}⁹⁹¹⁸^1.5^7.8
^March²⁰⁰^1-Novembe^{r 2}⁰⁰¹⁸^0.6^6.3
^Source:^{National Burea}^{u of E}^{conomic Research.}
Expectations play an important role in the business cycle, and people’s expectations are not
always rational. John Maynard Keynes described the cause as “animal spirits,” or people’s
tendency to let emotions, particularly swings from excessive optimism to excessive pessimism,
influence their economic actions. For example, businesses make investment decisions based on
their projections of future rates of return, which will depend on future sales and so on. These
inherently uncertain projections change as current conditions change. If businesses believe

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economic conditions will be unfavorable in the future, they will not make investments today,
reducing the growth rate of GDP from what it otherwise would have been. Likewise, households
may postpone purchases of durable goods or housing if economic conditions look unfavorable.
People’s projections of the future may be overly influenced by the present or recent past.
“Economic shocks” also play a dominant role in the business cycle. A shock refers to any sharp
and sudden change in economic circumstances on the demand or supply side of the economy that
disrupts the steady flow of economic activity. A well known example are energy shocks: when the
price of energy suddenly rises, it disrupts both production, because energy is an important input to
the production process, and consumer demand, because energy products account for a sizeable ⁴
portion of consumer purchases. Other prominent shocks include natural disasters, global events
that influence foreign trade, financial market unrest, and so on. A sudden change in expectations
that affects consumer or investment spending can also be thought of as a shock to aggregate
demand. Since these shocks are typically unpredictable, the business cycle remains unavoidable.
Recessions are often attributed to periods when consumers decide to spend less, and recoveries to
a revival in consumer spending. As seen in Figure 2, this view is not very accurate—
consumption is actually one of the most stable components of spending. While its growth rate
falls in recessions, its growth rate usually stays positive and always falls by less than overall GDP
growth, which suggests that causation typically runs from growth to consumption. Fixed
investment is actually the most volatile component of spending. As seen in the Figure, it
undergoes larger declines than GDP during recessions, and bigger booms than GDP during
expansions.
Figure 2. Quarterly Growth of GDP, Consumption, and Investment, 1990:1-2007:1
^Source:^Burea^{u of}^{Economic An}^alysis.

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^E^m^pⁱ^ri^ca^l^E^vⁱ^d^en^ce^{, by}^Ma^r^c^L^a^bonte^.

Business inventories are another component of GDP that play an important role in the business
cycles. A buildup in inventories may result from lower sales than businesses had expected. When
this occurs, businesses may have to “work off” the inventory buildup before they begin to
produce again, thereby prolonging a downturn. If businesses have become more adept at
managing inventories thanks to “just in time” inventory management, it may help to explain why
recent recessions have been briefer and shallower.
The trade balance is typically counter-cyclical (helps soften the business cycle), all else equal.
Representing the gap between saving and investment, the trade deficit would be expected to
decline in a recession since investment would be expected to fall as a share of output. (Thought of
differently, the trade deficit would also be expected to decline since the growth consumption of
imports would fall as overall consumption growth fell.) Less foreign capital would be attracted to
the United States, causing the dollar to fall and exports to rise. In the 1990-1991 recession, the
trade deficit fell, but in the most recent recession , it rose contrary to what theory predicted.
However, national saving did not rise in the 2001 recession, as theory predicted—it fell more
rapidly than investment. The largest cause of the fall in national saving at the time was the
increase in the federal budget deficit.

Policymakers, the media, and citizens focus much of their attention on business cycle issues—
questions such as, “Will the economy enter a recession?” or “How much longer will the boom
continue?”—and how different policy options will affect the business cycle. But the economy is
self-equilibrating over time—a recession will eventually give way to an expansion, regardless of
what policy option is selected (although some policy choices will help end a recession faster than
others). Long-term growth is often neglected by comparison, yet sustained, permanent,
widespread increases in living standards depend on long-term growth, not the business cycle.
When reflecting on the differences in the average standard of living today compared to 100 years
ago or 200 years ago, an argument can easily be made that long-term growth trumps short-term ⁵
fluctuations in importance.
In a recession, boosting short-term growth is mainly a question of finding ways to stimulate
overall spending so that the economy operates at its productive capacity. In the long run, concerns
about matching the level of spending to the productive capacity of the economy are irrelevant
because it will happen on its own. Instead, long-term growth depends on increasing the
economy’s productive capacity.
The economy’s productive capacity can be boosted in only two ways—by boosting the
economy’s inputs or by using existing inputs more productively. Inputs take the form of labor and
physical capital (investment in plant and equipment).

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^D^e^te^r^m^inants^,^an^d^P^o^lic^y^{, by}^Craⁱ^g^K^.^Elw^e^ll.

Labor inputs increase when employment or hours worked increase. In the long run, increases in
employment will depend primarily on population growth, although changes in employment
patterns such as the entrance of women into the workforce can also be important at times. Higher
long-term employment will lead to higher GDP, but not necessarily higher living standards
because living standards are determined by per capita GDP. If the worker-population ratio stays
constant as the population increases, then the increase in the numerator (GDP) will be canceled
out by the increase in the denominator (population). Increases in employment can increase living
standards only if the employment-population ratio increases, but this ratio is relatively stable in
the long run since working age individuals have high and stable employment rates. The coming
decades could see a decline in the employment-population ratio caused by the aging of the
population.
Increases in the capital stock increase GDP because, to take the simplest example, a worker who
has more equipment to use can produce more over a fixed time. Once an environment has been
created where investment is profitable, the primary factor determining how quickly the capital
stock can grow over time is the national saving rate—real resources are needed to finance capital
investment, and these resources are only available to invest if they are saved rather than ⁶
consumed. Saving is transformed into investment through financial intermediation. National
saving comes from three sources: households, businesses, and the government. When the
government runs a budget deficit, it has a negative saving rate that reduces the resources available ⁷
to finance investment spending. Interest rates equilibrate saving and investment—when saving
becomes scarcer, interest rates rise, which causes investment to fall as previously profitable
investment projects become unprofitable at higher borrowing costs.
In recent years, national investment has greatly outstripped national saving, and the United States
has had to borrow from foreigners to bridge the gap. The only way to borrow from foreigners is
by running a trade deficit. As the saving rate has fallen, the trade deficit has risen, alleviating
upward pressure on interest rates. Since trade deficits in recent years have been large enough to
increase foreign indebtedness faster than GDP is increasing, the current pattern, by definition,
cannot persist indefinitely. At some point in the future, although there is no consensus how soon,
the trade deficit will have to decline, either through a rise in national saving or a decline in ⁸
investment.
As seen in Figure 3, fixed investment spending as a share of GDP fell below its post-war average
in the early 1990s, but rose above average in the late 1990s, contributing to the high GDP growth
rates of that period. Beginning in the 2001 recession, investment spending declined as a share of
GDP. It began rising again in 2003, but has still not reached the levels of the late 1990s. The case
can be made, however, that when considering the effect of investment spending on GDP growth,

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^Ca^she^ll.
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residential investment (housing construction) should be omitted because it is not an input into the
production process, and therefore does not increase future output. If residential investment is
omitted, then (non-residential) investment spending as a share of GDP shows little improvement
since 2003. In other words, the recovery in investment spending since 2003 is being driven
primarily by the housing boom, not business investment.
Figure 3. Investment Spending as a Share of GDP, 1946-2006
^Source:^Burea^{u of}^{Economic Ac}^tivity.
^Note:^F^{ixed investment is t}^{he s}^u^m^{of residential investment a}^{nd n}^{on-residential investment s}^pendin^{g. Fixed}
^{investment e}^{xcludes c}^hange^{s in i}^nventories.
Both labor and capital are subject to diminishing marginal returns, which means that as more
capital or labor is added to production, GDP will increase less, all else equal. In addition, there
are natural limits to how much labor inputs (both hours worked and the labor force participation
rate) can be increased, and the United States may already be operating close to those limits. This
implies that a long-term strategy to boost growth cannot rely solely on increasing inputs. Herein
lies the importance of productivity growth.
Even with a fixed amount of labor and capital, output can increase if inputs are used more
productively. Productivity increases can be caused by efficiency gains, better business practices,
technological innovations, research and development, or increasing the training or education of
the workforce. Economists often refer to the latter as an increase in “human capital,” since
education can be thought of as an investment in skills. Its importance to productivity growth
should not be underestimated since the creation and implementation of many technological
innovations would not be possible without it.
In the long run, productivity growth can be thought of as the main force driving increasing living
standards. This statement becomes intuitive when thinking of the goods and services available to
the typical American household today that did not exist for earlier generations. Capital investment

causes the economy to grow faster than it would based on productivity growth alone, but capital
investment without productivity growth would not lead to sustained growth.
Empirically, the measure that corresponds to the definition of productivity described here is
referred to as total-factor productivity or multi-factor productivity. It cannot be measured directly
since adjustments must first be made for changes in labor and capital inputs. Perhaps for this
reason, labor productivity, which is measured by simply dividing output by hours worked, is a
more popular and well-known measure. But because labor productivity can increase due to
increases in the capital stock or efficiency gains, it does not correspond directly to the conceptual
notion of productivity growth.
As seen in Table 2, there was a significant acceleration in productivity growth in 1996. This
acceleration reversed the productivity slowdown that lasted from 1974 to 1995, bringing it closer
to the growth rate of 1949 to 1973. Most economists believe that the information technology (IT)
revolution has been responsible for the productivity growth rebound. There is more disagreement
on whether the rebound will be permanent. Some economists argue that after the initial burst of
innovation caused by greater processing power and the invention of the internet, further
innovation will be limited and the productivity boom will fizzle out. Other economists argue that
the fruits of these technological breakthroughs will be longer lasting. The fact that productivity
growth continued to be strong after the 2001 recession certainly bolsters the latter argument, but
labor productivity growth has fallen each year since 2002 and fell below 2% in 2006 for the first ⁹
time since 1995.
Table 2. Productivity Growth Rates, 1949-2006
^(Non-^{farm Business Sector)}
¹⁹⁴^9-19⁷³¹⁹⁷^4-19⁹⁵¹⁹⁹^6-20⁰⁶
^{Labor Productivity}^2.9%^1.4%^2.7%
^{Multi-factor Productivity}^1.9%^0.4%^1.4%
^Source:^Burea^{u of La}^{bor Statistics.}
Table 3 shows the relative importance of the three sources of long-term GDP growth, as ¹⁰
estimated by the Congressional Budget Office (CBO). Since 2002, multi-factor productivity
growth has been a larger contributor to GDP growth than growth in the labor supply and capital
combined. That pattern did not hold in the periods from 1974 to 1990 or 1991 to 2001, when
multi-factor productivity growth was a smaller source of GDP growth in absolute and relative
terms. CBO projects that multi-factor productivity will continue to be the most important source
of GDP growth over the next ten years, as the growth rate of the labor supply continues to
decline. The post-World War II baby boom explains why labor supply growth increased in the

1970s (as the baby-boomers entered the workforce), and has decreased since (as the baby-

boomers have begun to retire). Because the growth in the labor supply is projected to decline
further, CBO’s projection that GDP growth over the next 10 years will remain relatively constant
depends on the assumptions that strong multi-factor productivity growth will continue and growth
in capital spending will revive.

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^Bria^{n W}^.^Ca^she^ll.
¹⁰^T^h^e^ta^ble^{is e}^s^tim^a^t^e^d^{in te}^rm^{s o}^f^poteⁿ^tia^{l g}^r^ow^{th in}^or^de^{r to}^e^limⁱⁿ^a^t^e^busiⁿ^e^{ss c}^y^c^l^e^e^f^f^e^c^t^s.

Table 3. Estimated Sources of Potential GDP Growth, 1950-2017
^(Non-^{farm Business Sector)}
^{Annual G}^r^o^{wth in}¹⁹⁵^0-¹⁹⁷^4-¹⁹⁹^1-²⁰⁰^2-²⁰⁰^7-20¹⁷
^Potential^:¹⁹⁷³¹⁹⁹⁰²⁰⁰¹²⁰⁰⁶^(projected)
^GDP^{4.0 3.4}^{3.5 3.1}^3.0
^Labor^Sup^ply^{0.9 1.4}^{0.8 0.8}^0.5
^Physical^Capital^{1.1 1.2}^{1.4 0.7}^1.1
^Multi-factor^Productivity^{1.9 0.8}^{1.3 1.6}^1.4
^Source:^{Congressional Budget}^Office,^{Budget and Economic Outlook}^{, January}²⁰⁰^{7, Table 2.2.}
^Note:^{Table is measured in term}^{s of potential growth in order to}^{eliminate cyclical effects.}
Multi-factor productivity’s relative contribution to rising living standards is even more important
than the table indicates for two reasons. First, much of the increase in capital is replacing rather
than supplementing existing capital that has depreciated. Although replacement capital increases
GDP (which is not adjusted for depreciation), it does not raise living standards. Second, as
discussed above, living standards depend on the level of GDP per capita, not GDP. Only increases
in the labor supply that exceed increases in population raise overall living standards, and most
increases in the labor supply match population growth.

Policymakers’ influence over economic activity is limited. Avoiding recessions or demonstrably
raising the economy’s long-term growth rate are policy goals that have proven elusive.
Nevertheless, good or bad policies can make a difference at the margins, and even incrementally
better performance can cumulate over time, so many policy improvements can have a low cost
and high reward.
There is widespread consensus among economists that the prudent stabilization policymaking
regime that has evolved since World War II is an important reason why the economy has become
less cyclical and recessions have become shallower (although better luck may have also played a
role). The government has two tools at its disposal to moderate the short-term fluctuations of the
business cycle—fiscal policy or monetary policy. Fiscal policy refers to changes in the budget
deficit. Monetary policy refers to changes in short-term interest rates by the Federal Reserve.
The government can use expansionary fiscal policy to boost overall spending in the economy by
increasing the budget deficit (or reducing the budget surplus). If the increased deficit is the result
of increased government spending, aggregate spending is boosted directly since government
spending is a component of aggregate demand. Since the deficit is financed by borrowing from
the public, resources that were previously being saved are now being used to finance government
purchases or production of goods and services. If the increased deficit is the result of tax cuts,
aggregate spending is boosted by the tax cut’s recipient to the extent that the tax cut is spent (not

saved or invested in financial securities).¹¹ In this case, resources that were previously being
saved are now at the disposal of the tax cut’s recipient, and to the extent that the recipient decides
to increase his consumption, aggregate spending will rise. Likewise, if the government wished to
reduce the growth rate of overall spending in the economy, it could reduce the deficit (called
contractionary policy) by raising taxes or cutting spending, in which case the process would work
in reverse. As discussed above, any boost in spending as the result of fiscal policy is temporary
since spending cannot grow faster than the economy’s productive capacity in the long run.
The Federal Reserve can use expansionary monetary policy to boost spending in the economy by
lowering the overnight interest rate, called the federal funds rate. The Fed alters interest rates by
adding or withdrawing reserves from the banking system. Lower interest rates increase interest-
sensitive spending, which includes physical investment (i.e., plant and equipment) by firms,
residential investment (housing construction), and consumer durable spending (e.g., automobiles
and appliances) by households. To reduce spending in the economy, the Fed raises interest rates, ¹²
and the process works in reverse.
Expansionary monetary or fiscal policy will produce, at best, fleeting gains in output when the
economy is operating at full employment. Expansionary policy works by boosting spending in
order to bring idle labor and capital resources back into use. When the economy is already near
full employment, there are few idle resources available, so the boost in spending quickly bids up
prices in labor and capital markets, generating higher inflation and interest rates. In the brief lag
between the boost in spending and the higher inflation, output might be temporarily boosted, but
the economy cannot function for long above full capacity.
Monetary policy plays the primary role in economic stabilization today and has several practical
advantages over fiscal policy. First, economic conditions change rapidly, and monetary policy is
much more nimble than fiscal policy. The Fed meets every six weeks to consider changes in
interest rates, and can call an unscheduled meeting any time in between. Changes to fiscal policy
are likely to occur once a year at most. For example, there were three large tax cuts from the 2001 ¹³
recession through 2006; in the same period, interest rates were changed 29 times. Once a
decision to alter fiscal policy has been made, the proposal must travel through a long and arduous
legislative process lasting months before it can become law, while monetary policy changes are ¹⁴
made instantly.
Second, political constraints frequently lead to fiscal policy being employed in only one direction.
Over the course of the business cycle, aggregate spending can be expected to be too high as often
as it is too low. This means that stabilization policy must be tightened as often as it is loosened,

¹¹^A^t^a^{x cu}^t^t^h^at^w^a^s^fⁱⁿ^aⁿ^ced^b^y^l^o^w^e^r^go^vern^m^eⁿ^t^sp^en^dⁱⁿ^g^w^o^u^l^dⁿ^o^t^stⁱ^m^u^l^at^{e ag}^greg^at^{e sp}^en^dⁱⁿ^g^b^ecau^{se t}^h^e
ⁱⁿ^{crease i}ⁿ^p^rⁱ^v^at^{e sp}^en^diⁿ^g^am^oⁿ^g^t^h^{e t}^a^{x cu}^t^’^{s reci}^pⁱ^ent^s^w^o^u^l^d^b^e^o^f^f^s^et^b^y^t^h^{e d}^{ecrease i}ⁿ^go^verⁿ^m^eⁿ^t^sp^en^dⁱⁿ^g^.^Iⁿ
^the^Ke^yⁿ^e^s^iaⁿ^m^ode^{l, the}^k^e^y^{to a}^stim^{ulus is the}^la^rg^e^r^de^fⁱ^c^{it, no}^t^the^ta^x^c^u^t.
¹²^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^{t R}^L³⁰³⁵^4,^M^o^ne^tar^y^P^o^lic^y^and^the^Fe^de^r^a^{l Re}^s^e^r^v^e^:^C^u^r^r^e^{nt P}^o^lic^y^a^nd
^Cond^itio^ns^,^by^G^a^{il E. Ma}^kⁱ^ne^{n a}^nd^Ma^r^c^L^a^bonte^.
¹³^T^h^e^ta^x^c^u^{ts a}^r^e^the^Ec^on^om^ic^Grow^{th a}^{nd T}^a^x^Re^lie^f^Re^c^onc^ilia^{tion A}^c^{t (}^P^.L^{. 10}^7-1⁶^),^the^Jo^{b Cre}^a^{tion a}ⁿ^d
^W^o^rk^e^r^A^ssist^aⁿ^c^e^A^c^{t (P}^.L^{. 1}^07-¹⁴⁷^{), a}ⁿ^{d t}^h^e^{Jobs a}^{nd G}^r^ow^{th T}^a^x^Re^lie^f^Re^c^onc^ilia^tion^A^c^{t (P}^.L^.¹⁰⁸^-2^7).
¹⁴^T^o^s^o^m^e^ex^te^{nt, f}ⁱ^s^c^a^l^polic^y^a^u^t^o^m^a^tic^a^l^l^y^m^itig^a^t^e^s^c^h^aⁿ^g^e^s^{in t}^h^e^busⁱⁿ^e^s^s^c^y^c^l^e^w^ithout^aⁿ^y^pol^icy^c^h^aⁿ^g^e^s
^b^ecau^{se t}^a^{x rev}^eⁿ^u^e^f^a^l^l^s^rel^a^tⁱ^v^e^t^o^G^D^P^and^cert^aⁱⁿ^m^aⁿ^d^a^t^o^ry^sp^en^dⁱⁿ^g^(su^c^h^{as un}^em^p^l^o^y^men^tⁱⁿ^su^ran^{ce) ri}^ses
^w^h^eⁿ^e^c^onom^ic^g^r^o^w^{th s}^l^ow^s^.

yet increasing the budget deficit is much easier politically than implementing the spending cuts or
tax increases necessary to reduce it. As a result, the budget has been in deficit in 44 of the past 49 ¹⁵
years. By contrast, the Fed is highly insulated from political pressures, and experience shows
that it is as willing to raise interest rates as it is to lower them. Persistent budget deficits lead to
the third problem.
Third, the long run consequences of fiscal and monetary policy differ. Expansionary fiscal policy
creates federal debt that must be serviced by future generations. Some of this debt will be “owed
to ourselves,” but some (presently, about half) will be owed to foreigners. When expansionary
fiscal policy “crowds out” private investment, it leaves future generations poorer than they ¹⁶
otherwise would have been. Expansionary monetary policy has no effect on generational equity.
Furthermore, the government faces a budget constraint that limits the scope of expansionary fiscal
policy—it can only issue debt as long as investors believe that the debt will be honored—even if ¹⁷
economic conditions require larger deficits to restore equilibrium.
Fourth, an economy, such as the United States, that is open to highly mobile capital flows changes
the relative effectiveness of fiscal and monetary policy. If expansionary fiscal policy leads to
higher interest rates, it will attract foreign capital looking for a higher rate of return. Foreign
capital can only enter the United States on net through a trade deficit. Thus, higher foreign capital
inflows lead to higher imports, which reduce spending on domestically-produced substitutes, and
lower spending on exports. The increase in the trade deficit would cancel out the expansionary
effects of the increase in the budget deficit to some extent (in theory, entirely). This theory is
borne out by experience in the past few years—as the budget deficit increased, so did the trade ¹⁸
deficit. Expansionary monetary policy would have the opposite effect—lower interest rates
would cause capital to flow abroad in search of higher rates of return elsewhere. Foreign capital
outflows would reduce the trade deficit through an increase in spending on exports and
domestically produced import substitutes. Thus, foreign capital flows would magnify the
expansionary effects of monetary policy.
In cases where economic activity is extremely depressed, monetary policy may lose some of its
effectiveness. When interest rates become extremely low, interest-sensitive spending may no
longer be very responsive to further rate cuts. Furthermore, interest rates cannot be lowered below
zero. In this scenario, fiscal policy may be more effective. But the United States has not found
itself in this scenario since the Great Depression, although Japan did in the 1990s.
Of course, using monetary and fiscal policy to stabilize the economy are not mutually exclusive
policy options. But because of the Fed’s independence from Congress and the Administration,
there is no way to coordinate the two policy options. If compatible fiscal and monetary policies
are chosen by Congress and the Fed, respectively, then the economic effects would be more
powerful than if either policy were implemented in isolation. For example, if stimulative
monetary and fiscal policies were implemented, the resulting economic stimulus would be larger

¹⁵^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^{t R}^L³¹⁰⁵^6,^Ec^on^om^ic^s^{of F}^e^de^r^a^{l Re}^s^e^r^v^e^I^nde^pe^nde^nc^e^{, by}^Ma^r^c^L^a^bonte^.
¹⁶^Aⁿ^e^x^ce^ption^to^the^r^u^le^w^ould^b^e^a^s^itua^tio^{n w}^h^e^r^e^the^e^c^onom^yⁱ^s^s^o^de^pr^e^s^s^e^{d t}^h^a^t^vⁱ^r^t^ua^lly^{no c}^r^ow^ding^out^ta^k^e^s
^p^l^{ace b}^ecau^{se t}^h^{e st}ⁱ^m^u^l^u^s^t^o^s^p^en^dⁱⁿ^g^gen^e^rat^e^{s e}^noug^{h r}^e^s^our^c^e^s^{to f}ⁱ^na^nc^e^ne^w^c^a^p^ita^{l s}^p^eⁿ^dⁱ^ng^.
¹⁷^T^h^e^aⁿ^a^l^og^ous^c^o^ns^tr^aⁱ^nt^on^m^one^ta^r^y^polic^y^is^tha^t^a^f^te^r^a^ce^r^t^aⁱ^{n lim}^{it, e}^x^pa^ns^iona^r^y^m^one^ta^r^y^policy^w^ould
^be^c^o^m^e^hig^h^l^y^inf^l^a^tiona^ry^{. But from}^the^c^u^rre^{nt sta}^r^tin^g^poi^nt^of^p^r^ic^e^sta^b^ility^{, proble}^m^{s w}^{ith inf}^l^a^t^{ion w}^oul^d
^pr^e^s^um^a^b^l^y^only^oc^c^u^r^a^f^t^e^r^a^poi^{nt w}^h^e^r^e^the^e^c^onom^y^ha^{d r}^e^turⁿ^e^d^to^f^u^{ll e}^m^ploy^m^e^nt.
¹⁸^Se^e^C^R^S^R^e^por^{t R}^S²¹⁴⁰^9,^T^h^e^B^udge^t^D^e^fic^{it a}^nd^the^Tr^ade^D^e^fic^it:^W^hat^I^s^Theⁱ^r^Re^l^a^ti^ons^hⁱ^p^?^,^b^y^Ma^r^c^L^a^bonte
^a^{nd G}^a^{il E. Ma}^kⁱ^ne^n.

than if one policy were stimulative and the other were neutral. But if incompatible policies are
selected, they could partially negate each other. For example, a stimulative fiscal policy and
contractionary monetary policy may end up having little effect on the economy one way or the
other. Thus, when fiscal and monetary policymakers disagree in the current system, they can ¹⁹
potentially choose policies with the intent of cancelling out each other’s actions. Whether this
arrangement is better or worse for the economy depends on what policies are chosen. If one actor
chooses inappropriate policies, then the lack of coordination usefully allows the other actor to try
to negate its effects. But if both actors choose appropriate policies, the policies could be slightly
less effective than if they had been coordinated.
If recessions are usually caused by declines in aggregate spending, and the government can alter
aggregate spending through changes in monetary and fiscal policy, then why is it that the
government cannot use policy to prevent recessions from occurring in the first place? While
recessions should theoretically be avoidable, there are several real world problems that keep
stabilization from working with perfect efficiency in practice.
First, many of the economic shocks that cause recessions are unforeseeable. Policymakers can
only react to the shocks after they have already occurred; by then, it may be too late to avoid a
recession. As their name suggests, economic shocks tend to be sudden and unexpected. Few
energy analysts predicted that the price of oil would rise from less than $20 per barrel in 2001 to
almost $70 per barrel in 2006; if the rise in price could not be predicted, then neither could its
effects on the economy.
Second, there is a time lag between a change to monetary or fiscal policy and its effect on the
economy because individual behavior adjusts to interest rate or tax changes slowly. For example,
higher interest rates will reduce housing demand, but only gradually—the Fed has been raising
interest rates since 2004, but the housing market did not cool off until 2006. Because of lags, an
optimal policy would need to be able to respond to a change in economic conditions before it
occurred. For example, if the economy were going to fall below full employment next year,
policy would need to be eased this year to prevent it.
Third, for stabilization policy to be effective given lags, policymakers must have accurate
economic forecasts. Yet even short-term economic forecasting—particularly in the case of turning
points in the business cycle—is notoriously inaccurate. In January 2001, for example, the
Congressional Budget Office, the Office of Management and Budget, the Federal Reserve, and ²⁰
virtually all major private forecasts predicted growth between 2.0% and 3.1% for the year. In
reality, the economy entered a recession two months later, and grew by 0.8% for the year. Given
the important role of unpredictable shocks in the business cycle, perhaps this should not be a
surprise.

¹⁹^{It is im}^porta^nt^to^ta^k^e^{this p}^o^ssibi^lity^{into c}^onsi^d^e^r^a^tio^{n w}^h^eⁿ^e^v^a^l^ua^ting^the^p^o^te^nt^ia^{l e}^f^f^e^c^t^{s of}^fⁱ^sc^a^l^pol^ic^y^{on the}
^bus^ine^s^s^c^y^c^l^e^.^B^e^ca^us^e^the^Fe^d^p^r^e^s^um^a^b^ly^c^hoos^e^s⁽^a^{nd c}^ontⁱⁿ^ua^lly^upda^te^s⁾^a^m^one^ta^r^y^polic^y^tha^t^aⁱ^m^s^{to k}^e^e^p^the
^e^c^onom^y^a^t^f^u^{ll e}^m^ploy^m^e^{nt, the}^Fe^{d w}^ould^ne^e^d^t^o^a^lte^r^its^po^lic^y^{to of}^f^s^e^t^the^e^f^f^e^c^t^s^of^aⁿ^y^s^tⁱ^m^ula^tiv^e^fⁱ^s^c^a^l^polic^y
^c^h^aⁿ^g^e^s^tha^t^m^o^v^e^{d the}^e^c^onom^y^a^bov^e^f^u^{ll e}^m^plo^y^m^e^{nt. T}^hus^{, the}^a^c^t^ua^{l ne}^{t s}^tim^ula^tiv^e^e^f^f^e^c^t^of^a^fⁱ^s^c^a^l^polic^y
^ch^an^{ge (af}^t^{er t}^a^kiⁿ^gⁱⁿ^t^o^acco^un^t^m^oⁿ^e^t^a^r^y^p^o^lⁱ^c^y^ad^j^u^st^m^eⁿ^t^{s) co}^u^l^d^b^e^l^e^{ss t}^h^an^t^h^{e ef}^fect^{s i}ⁿⁱ^s^o^l^atⁱ^oⁿ^.
²⁰^Blu^e^Chⁱ^p^,^Ec^on^om^ic^Iⁿ^dic^a^t^o^r^s^,^J^a^nua^r^y^2001.

Fourth, because forecasts are not always accurate, understanding of the economy is limited, and
because the economy does not always respond to policy changes as expected, policymakers
sometimes make mistakes. For example, if the natural rate of unemployment (NAIRU) rises and
policymakers do not realize it, they may think that expansionary policy is needed to reduce
unemployment. Economists believe that this is one reason inflation rose in the 1970s.
Fifth, in the case of monetary policy, changes in short-term interest rates do not lead to one-for-
one changes in long-term interest rates. Long-term interest rates are determined by supply and
demand, and many factors enter that equation besides short-term interest rates. Yet many types of
spending may be more sensitive to long-term rates, reducing monetary policy’s effectiveness. One
reason the housing boom continued after 2004 was that mortgage rates increased far less than the
federal funds rate.
Sixth, because policy changes do not lead to large and rapid changes in economic activity for the
reasons listed above, it may take extremely large policy changes to forestall a recession. Yet
policy changes of that magnitude could be destabilizing in their own right. For example,
extremely large swings in interest rates could impede the smooth functioning of the financial
system and lead to large swings in the value of the dollar. Large increases in the budget deficit
could hamper the government’s future budgetary flexibility. More modest policy changes are
more prudent in light of uncertainty.
Finally, policy’s influence on the economy is blunted by the open nature of the U.S. economy in
an era of increasing globalization. As discussed above, the expansionary effects of increases in
the budget deficit have been largely offset by increases in the trade deficit in recent years.
Likewise, the contractionary effects of higher short-term interest rates have not led to
significantly higher long-term rates because of the ready supply of foreign capital. Nevertheless,
higher short-term interest rates have still had a contractionary effect on the economy through the
larger trade deficit that accompanies foreign capital inflows. But in a situation where some
observers feared that the economy might be suffering from a housing bubble, higher interest rates
might have been a more desirable way to curb economic activity than an increase in the already
record-high trade deficit. An open economy is also one that is more influenced by developments
abroad—as the economy’s openness has increased over time, foreign economic shocks (positive
or negative) have had a larger effect on the United States, and domestic events, including policy
changes, have had a smaller effect.
If policymakers were concerned with only economic growth, policy decisions would be
considerably easier. Above average growth would lead to contractionary policy, and below
average growth would lead to expansionary policy. Given uncertainty about the true state of the
economy, policymakers could err on the side of caution when tightening to avoid recessions.
Unfortunately, policymakers must weigh these considerations against the effects of a policy
change on price stability (inflation). Typically, the same policy is needed to achieve both price
stability and economic stability (the Fed’s mandated goals)—a tightening of policy when
economic growth is above its sustainable rate will also help to keep inflation from rising, and
inflationary pressures are typically low during recessions. Of course, underlying policy decisions
are uncertain estimates of the economy’s sustainable rates of growth and unemployment, so
policymakers must decide how optimistic their assumptions of both should be. More optimistic
assumptions increase the risk of rising inflation, while more pessimistic assumptions increase the
risk of sub-par growth.

Besides uncertainty, goals also become conflicted when inflation and economic activity do not
move in the same direction. There are several possible reasons why inflation sometimes rises
although economic activity is sluggish. First, prices of individual goods may rise for reasons
unrelated to the business cycle. If the price of a specific good rises relatively quickly and other
prices do not fall, then overall inflation will rise. Most goods account for too small a share of
overall spending to boost inflation by more than a trivial amount. But a few goods, such as food,
shelter, and especially energy, are very large as a share of overall spending. Energy increased the
growth rate of the consumer price index by 0.5 percentage points from 2000 to 2006. The Fed has
argued that temporary individual price shocks that cause overall inflation to rise can be ignored as ²¹
long as they do not feed through to other prices. Yet it is difficult to argue that energy’s recent
effects on inflation have been only temporary, and non-energy price inflation has risen steadily
since 2003. Second, inflation shows persistence over time—current inflation is influenced by past
inflation, even when economic conditions have changed. Thus, an economic slowdown may not
instantly lead to lower inflation. Third, expectations play an important role in determining
inflation. Expectations change slowly, which partially explains inflation persistence, but
economists generally believe that they eventually adjust to accurately reflect circumstances. In
other words, persistently expansionary monetary policy will eventually lose its effectiveness,
causing inflation to rise even if economic growth is sluggish, as occurred in the 1970s.
Because of the role of expectations, any short-term tradeoff between inflation and growth will not
persist in the long run. In the long run, the economy will adjust to any attempts to keep
unemployment below its natural rate, and that adjustment will come about through a rising
inflation rate. In other words, monetary policy’s effect on output is temporary, but its effect on
inflation is permanent. Therefore, some economists argue that growth stability should be de-
emphasized as a policy goal and price stability should be given primacy, perhaps through a formal ²²
change to the Fed’s statutory mandate. And indeed, a policy objective of maximizing economic
stability would not deliver price stability, since price shocks would need to be completely
ignored. But as long as policymakers are mindful of the limits of economic stabilization, there is
no reason that monetary policy cannot be prudently used to reduce cyclical fluctuations without
undermining price stability. After all, economic stability and price stability often go hand-in-hand.
Another major debate is how vigorously stabilization policy should be pursued. This may seem
surprising—why would policymakers not take every action they could to keep the economy at
full employment? But given our limited understanding of economic fluctuations, skeptics argue
that less policy intervention—what they refer to as “fine tuning”—can often achieve better long-
term results. As discussed in the introduction, the rate of economic growth changes because of
both changes in the business cycle and random fluctuations. It is not obvious how to differentiate
between the two until after the fact. If monetary or fiscal policy is tightened in response to a
random fluctuation that temporarily boosts GDP growth, then future growth would be
inappropriately lower. Taken to the extreme, if policymakers altered policy in response to every
change in GDP growth (random or cyclical), then the economy could become more unstable.

²¹^T^h^{e p}^rⁱ^{ce sh}^o^c^{ks co}^u^l^d^no^t^h^a^{ve cau}^sed^o^v^eral^lⁱⁿ^f^l^atⁱ^oⁿ^t^o^ri^se^uⁿ^l^{ess i}^t^h^a^d^b^een^acco^mm^o^d^a^t^e^d^b^y^t^h^{e F}^e^d.^Wⁱ^t^h^a
^c^ons^ta^{nt m}^one^y^s^upply^,^the^rⁱ^s^eⁱⁿ^eⁿ^e^r^g^y^pr^ic^e^s^w^{ould ha}^v^e^be^eⁿ^of^f^s^e^t^b^y^a^f^a^{ll in o}^t^he^r^pr^ic^e^s^{. I}ⁿ^t^h^a^t^s^e^ns^e^,^the
^recen^t^ri^{se i}ⁿⁱⁿ^f^l^atⁱ^oⁿ^w^a^{s n}^o^tⁱⁿ^evi^t^a^b^l^e.
²²^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^t^98-^16,^S^h^o^u^ld^the^Fe^de^r^a^l^Re^s^e^r^v^e^Adopt^{an I}ⁿ^fl^ati^on^Tar^g^e^t^?^{, by}^Ma^rc
^L^a^bonte^a^{nd G}^a^{il E.}^Ma^kⁱ^ne^n.

Skeptics also argue that the economy will eventually return to full employment on its own
through natural market adjustments, so there are no permanent effects to a more “hands off”
policy approach.
But if policy was too “hands off,” policymakers would under-react to major swings in the
business cycle, most notably the onset of recessions. This could prolong a recession’s length and
increase its depth, posing (temporary) hardship in the form of higher unemployment. A policy of
fine tuning may lead to policy errors at times; the relevant question is whether the cumulative
errors that result are more or less harmful to the economy than a policy of responding less
vigorously to economic fluctuations.
The importance of policy lags and forecasting accuracy (discussed in the previous section) color
the fine tuning debate. Lags mean that by the time a policy change affects the economy, the state
of the economy may have already changed. While a policy of “fine tuning” could be optimal if
policymakers had perfect forecasts, it will fall short of optimal in the real world.
In practice, opponents of “fine tuning” argue that the Fed should respond more vigorously to
changes in inflation and less vigorously to changes in output. While most economists would argue
that the Fed has already moved in this direction, some would like to see this change codified
through the adoption of an inflation target, and by changing the Fed’s mandate to a single goal of
price stability. This approach would reduce but not remove the Fed’s response to business cycle
fluctuations because changes in the business cycle have a major influence on the inflation rate in
the short run.
Although some economists attribute the decline in the economy’s volatility to a shift in monetary
policy away from fine tuning, the Fed has still responded vigorously to changes in economic
conditions, often responding in an anticipatory fashion. For example, the Fed reduced interest
rates from 6.5% to 1.75% between January and December 2001, even though the recession,
which began in March 2001, was not officially declared until November 2001. Clearly, the Fed is
still willing to change interest rates quickly and drastically. Thus, either the Fed is still pursuing a
policy of fine tuning although conventional wisdom says otherwise, or fine tuning cannot be
defined in terms of large swings in interest rates.
However, “fine tuning” could have two other meanings. It could refer to frequent shifts in policy
direction, with higher rates being quickly followed by lower rates and so on. As Figure 4
illustrates, since the 1990s, the Fed has tended to pursue a consistent policy for an extended
period of time before changing directions. For example, the Fed tightened monetary policy
continually from June 2004 to June 2006. By contrast, in 1980 the federal funds rate was up 3
percentage points in March, then down 6.5 percentage points in May, then up 3 percentage points
in November. It is less clear that policy shifts are less common today than in the 1960s, however.

Figure 4. Federal Funds Rate, 1960-2007
^Source:^{Federal Reserve.}
^Note:^{Data are monthly market}^rate.
Fine tuning could also refer to a tendency to undertake sudden shifts in policy. When economic
growth picked up speed in 2004, the earlier monetary stimulus was arguably no longer necessary
to prevent a return to recession. The Fed decided to remove the stimulus very cautiously, raising
rates one-quarter of a percent every six weeks in order to see how the economy would react. In
the 1970s and 1980s, policy changes were often more sudden. In hindsight, if the Fed had raised
rates more quickly since 2004, it would likely have posed little harm to the current expansion. But
because of the unreliability of forecasts, the Fed had no way of knowing at the time that more
rapid growth would persist. Thus, the 2004-2006 strategy minimized the risk that the monetary
tightening would be destabilizing. The strategy was not without its own risks, however—it may
help explain why inflation has been undesirably high since 2005, according to Chairman ²³
Bernanke’s own definition. This episode illustrates that fine tuning and price stability are not
always at odds, as critics would have it.
As stated above, increases to the economy’s productive capacity (or “supply side”) are the key to
long-term, sustained improvements in living standards. The economy’s productive capacity can
be increased only by increasing productivity and inputs of labor and capital. While government
has a great effect on long-term economic growth overall by fostering an environment conducive
to capital investment and innovation, policy changes are likely to have economic effects that are
indirect and incremental. For example, an economy cannot operate at an advanced level without a
monetary and financial system, justice system, markets, and property rights that are all efficient

²³^C^h^aⁱ^r^m^aⁿ^B^e^rⁿ^aⁿ^k^e^ha^s^s^t^a^t^e^d^th^a^t^he^is^uⁿ^c^o^m^f^or^ta^ble^w^{ith a}^c^o^r^e^inf^l^a^{tion r}^a^te⁽^a^r^a^te^of^inf^l^a^{tion t}^h^a^t^om^its^f^ood
^an^d^en^ergy^{) t}^h^at^exce^ed^{s 2}^%^.

and well-functioning. But once those systems are in place, further reforms may have positive
effects on growth, but the effects are likely to be too small to be discernable in the data.
Other policy areas where good policy can foster higher long-term growth include education, ²⁴
taxation, competition, basic research, openness to trade, and infrastructure. Each of these policy
areas involves public goods that the private sector would under-provide without government
involvement. Regarding national saving, economists disagree whether government’s proper role
should be limited to eliminating the budget deficit so that its influence on saving is neutral, or ²⁵
whether it should be extended to encouraging higher household saving. Advocates of the latter
often argue that individuals are often too short-sighted to save as much as they desire later in life,
and point to the negative household saving rate as supporting evidence. Advocates of a more
neutral role for government argue that saving should be based on private choice, and the negative
household saving rate is evidence that the myriad government incentives to save already available
are ineffective. The importance of the falling saving rate to long-term growth can be seen in
recent capital investment levels, which have been below the historical average in this decade.
Another major challenge for long-term growth will be how to sustain growth in the labor supply
in the face of the retirement of the baby boomers, either through higher immigration or policies
that encourage labor force participation among older workers.
Nevertheless, expectations over how much policy changes can raise economic growth should be
tempered. As discussed earlier, increasing inputs of capital and labor play an important supporting
role in long-term growth, but productivity growth plays the primary role. Productivity growth
relies on technological innovation, made possible by human capital accumulation, research and
development, and entrepreneurship. Tax cuts or other policy changes can arguably alter labor and
capital inputs—and a case can be made that even inputs cannot be altered much—but there is
little evidence that government can effectively influence productivity growth directly. Recent
history bears this out. The only notable change in long-term economic growth in the last four
decades has been the surge in productivity growth since 1995. Although that surge would not
have been possible without a generally favorable policy environment, the surge itself has been
attributed to technological innovation, notably in high-tech industries, for which economists have
not found any evidence that changes in government policy were primarily responsible.
The general policy lesson from this experience would be that a policy environment where
innovation and entrepreneurship can prosper, without heavy intervention in the marketplace, will
result in more rapid economic growth. This principle is best demonstrated by comparing the ²⁶
United States to its peers. Of the seven major advanced world economies, Canada is the only
country besides the United States that has enjoyed a boost in per-capita GDP growth since 1996
(in fact, many countries’ growth rates were lower in the latter period), and the United Kingdom

²⁴^A^t^pr^e^s^eⁿ^{t, g}^o^v^e^rⁿ^m^e^{nt po}^lic^ie^s^t^o^b^oos^t^na^tio^na^{l s}^a^vⁱ^ng^w^ould^be^unlik^e^l^y^{to le}^a^d^to^hig^h^e^r^g^r^ow^th^r^a^te^s^vⁱ^a^hig^h^e^r
ⁱⁿ^vest^m^eⁿ^t^rat^e^s,^b^ecau^{se f}^o^rei^gⁿ^l^eⁿ^dⁱⁿ^g^h^a^{s al}^l^o^w^e^d^t^h^{e Un}ⁱ^t^ed^S^t^at^{es t}^o^achⁱ^e^{ve h}ⁱ^ghⁱⁿ^vest^m^eⁿ^t^rat^e^{s al}^read^y^.
^Rat^h^er,ⁱ^t^w^o^u^l^dⁱⁿ^crease^Am^eri^c^an^{s’ i}ⁿ^co^m^e^,^siⁿ^{ce m}^o^{re o}^f^t^h^{e i}ⁿ^co^m^e^gen^e^rat^e^dⁱⁿ^t^h^{e Uni}^t^e^d^S^t^at^{es w}^o^u^l^d^accru^e^t^o
^A^m^e^r^ic^aⁿ^s^r^a^the^r^thaⁿ^f^o^r^e^ig^ne^r^s^{. A}^s^note^d^a^bov^e^,^bo^os^ting^na^tio^na^{l s}^a^vⁱ^ng^w^{ould b}^oos^{t i}ⁿ^v^e^s^t^m^e^{nt i}ⁿ^the^lo^ng^r^uⁿ
^sⁱ^nc^e^f^o^r^e^ig^{n le}^nding^a^t^c^u^r^r^e^{nt le}^v^e^ls^is^not^pe^r^m^aⁿ^eⁿ^tl^y^s^u^s^t^aⁱ^na^ble^.
²⁵^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^{t R}^L³²¹¹^9,^C^an^Pu^blic^P^o^lⁱ^c^y^Raise^the^Savⁱⁿ^{g R}^a^te^?^,^by^Bria^{n W}^.^Ca^she^ll.
²⁶^I^t^isⁿ^o^t^us^e^f^{ul to c}^o^m^p^a^r^e^g^r^ow^t^h^r^a^te^s^{in t}^h^e^Uⁿⁱ^t^e^d^Sta^t^e^s^t^o^de^v^e^lopi^ng^e^c^onom^ie^s^s^u^c^h^a^s^I^ndia^or^C^hⁱⁿ^a^b^ecau^se
^thos^e^c^o^untrⁱ^e^s^a^r^e^s^t^a^r^ting^f^r^om^{a c}^a^p^ita^{l s}^t^oc^k^a^nd^pr^o^duc^tⁱ^v^ity^le^ve^{l tha}^t^{is a}ⁿ^or^de^{r of}^m^a^gⁿ^itude^l^o^w^e^{r tha}ⁿ^e^x^{ists in}
^t^h^{e Un}ⁱ^t^e^{d S}^t^at^es.^T^h^eref^o^r^e,^d^e^vel^o^pⁱⁿ^g^co^uⁿ^t^rⁱ^e^{s can}^achⁱ^e^{ve ver}^y^hⁱ^gh^rat^e^{s o}^f^gro^w^t^h^t^h^rou^g^h^“cat^ch^u^p^”^gro^w^t^h^,^b^y
^a^dopt^ing^a^l^r^e^a^d^y^e^xⁱ^s^ting^te^c^hnol^og^ie^s^.^B^y^c^ontr^a^s^t^{, the}^Uⁿ^ite^d^Sta^t^e^s^m^u^s^t^g^e^ne^r^a^te^g^r^o^w^{th by}^c^r^e^a^t^ing^ne^w
^te^c^hnol^og^ie^s^.

and Canada are the only countries that have seen growth rates comparable to the United States
since 1996, as seen in Table 4. This difference in economic experience since 1996 is all the more
surprising since the technological innovations that are thought to have driven the increase in U.S.
growth could be adopted by the other countries.
Table 4. Average Per Capita GDP Growth, Major Advanced Economies
¹⁹⁸^5-19⁹⁵¹⁹⁹^6-20⁰⁶
^{United States}^1.9^2.2
^{Canada 1.3}^2.3
^{France 1.6}^1.5
^Germa^{ny 2.1}^1.4
^{Italy 2.2}^1.1
^{Japan 2.9}
^{United Kingdom}^2.3^2.4
^Source:^Int^{ernational Moneta}^ry^Fund.
Presumably, because education levels and capital per worker in all of these countries are roughly
the same and the United States has the lowest national saving rate of the group, the main
differences that can account for the disparate economic experience between the English-speaking ²⁷
economies and the rest are policy differences. Namely, the English-speaking economies all have
a reputation for pursuing more “laissez-faire” (non-interventionist) economic policies than the
other countries, although comparing differences in countries’ overall economic policy is ²⁸
admittedly subjective. Most economists agree that one important principle underlying the
success of “laissez-faire” economies is that government should not try to “pick winners” by
allocating economic resources to favored industries. Otherwise, it is difficult to isolate which
policies are most important and what policy changes would have the largest effect on growth
going forward. And it is useful to keep in mind that the surge in productivity growth since 1995
has raised the average growth rate of the economy by only 0.3 percentage points—even major
economic changes have a limited effect. Nevertheless, if that differential could be sustained, the
improvement in living standards would eventually accumulate into a substantial difference.

²⁷^Aⁿ^11-^y^e^a^r^pe^rⁱ^{od s}^h^o^u^l^d^be^l^oⁿ^g^e^noug^{h t}^o^r^u^le^o^u^{t t}^h^a^t^t^h^e^dif^f^e^r^e^nc^e^is^c^a^u^s^e^{d by}^the^busⁱⁿ^e^s^s^cy^c^l^e^,^a^ltho^u^g^h
^s^o^m^e^w^{ould a}^r^g^u^e^tha^t^J^a^pa^n’^s^pr^oloⁿ^g^e^{d e}^c^oⁿ^o^mⁱ^c^s^l^u^m^{p is}^c^y^c^lica^lⁱⁿ^na^tur^e^{. T}^h^e^ot^he^r^p^o^te^nt^ia^{l b}^r^oa^{d e}^x^plaⁿ^a^tⁱ^on
^f^o^{r t}^h^{e d}ⁱ^sp^arat^{e resu}^l^t^s^b^e^t^w^een^c^o^uⁿ^t^rⁱ^e^{s co}^u^l^d^b^e^cu^l^t^u^r^al^dⁱ^f^f^e^ren^ces.
²⁸^For^aⁿⁱⁿ^te^rⁿ^a^tio^na^{l s}^t^u^d^y^{on t}^h^e^e^f^f^e^c^t^s^of^g^ove^rⁿ^m^e^{nt s}^p^e^ndi^ng^oⁿ^g^r^ow^{th, s}^e^e^C^R^S^R^e^por^{t R}^L³³³^43,^T^h^{e E}^f^f^ect^s
^{of G}^o^v^e^r^nm^eⁿ^t^Ex^peⁿ^d^itur^e^s^aⁿ^d^Re^v^e^nue^s^{on t}^h^e^Ec^o^nom^y^an^{d Ec}^onom^ic^W^e^ll-^Beⁱ^ng:^{A C}^r^os^s^-^N^a^ti^ona^{l A}^naly^s^is^{, by}
^T^hom^as^L^.^H^ung^e^r^f^o^r^d^.

^{Marc L}^a^bon^t^e
^Specialis^{t i}ⁿ^Macroecon^o^mⁱ^c^P^o^licy
^m^l^abon^t^e^@^c^rs^.l^oc.g^o^v^{, 7-}⁰⁶⁴⁰