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 investment. As seen in Figure 3 , fixed investment spending as a share of GDP fell below its post-war average in the early s, but rose above average in the late s, contributing to the high GDP growth rates of that period. Beginning in the recession, investment spending declined as a share of GDP.
It began rising again in , but has still not reached the levels of the late s. The case can be made, however, that when considering the effect of investment spending on GDP growth, 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 In other words, the recovery in investment spending since is being driven primarily by the housing boom, not business investment.
Note: Fixed investment is the sum of residential investment and non-residential investment spending. Fixed investment excludes changes in inventories. 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 This acceleration reversed the productivity slowdown that lasted from to , bringing it closer to the growth rate of to 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. That pattern did not hold in the periods from to or to , 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 s 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.
Note: Table is measured in terms 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. 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.
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. To reduce spending in the economy, the Fed raises interest rates, 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 recession through ; 13 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 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, 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 years. By contrast, the Fed is highly insulated from political pressures, 15 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 otherwise would have been.
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 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 deficit. 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 s. 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 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 potentially choose policies with the intent of cancelling out each other's actions.
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. Actively scan device characteristics for identification. Use precise geolocation data.
Select personalised content. Create a personalised content profile. Measure ad performance. Select basic ads. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. The term economic cycle refers to the fluctuations of the economy between periods of expansion growth and contraction recession. Factors such as gross domestic product GDP , interest rates, total employment, and consumer spending, can help to determine the current stage of the economic cycle.
Understanding the economic cycle can help investors and businesses understand when to make investments and when to pull their money out, as it has a direct impact on everything from stocks and bonds, as well as profits and corporate earnings. An economic cycle, which is also known as a business cycle , is the circular movement of an economy as it moves from expansion to contraction and back again.
Economic expansion is characterized by growth. A contraction, on the other hand, sees it go through a recession, which involves a decline in economic activity that spreads out over at least a few months.
The economic cycle is characterized by four stages, which are also referred to as the business cycle. These four stages are:. The recovery phase may sometimes be referred to by some as a fifth stage. You can use a number of key metrics to determine where the economy is and where it's headed. For instance, an economy is often in the expansion phase when unemployment begins to drop and more people are fully employed.
Similarly, people tend to prioritize and curb their spending when the economy contracts. That's because money and credit are harder to come by as lenders often tighten up their lending requirements. As noted above, it's important for investors and corporations to understand how these cycles work and the risks they carry because they can have a big impact on investment performance.
Investors may find it beneficial to reduce their exposure to certain sectors and vehicles when the economy starts to contract and vice versa. Business leaders may also take cues from the cycle to determine when and how they'll invest and whether they'll expand their companies.
Businesses and investors also need to manage their strategy over economic cycles, not so much to control them but to survive them and perhaps profit from them. Measured primarily by changes in the gross domestic product GDP , NBER measures the length of economic cycles from trough to trough or peak to peak. From the s to the present day, U. However, there is wide variation in the length of cycles, ranging from just 18 months during the peak-to-peak cycle in up to the current record-long expansion that began in This wide variation in cycle length dispels the myth that economic cycles can die of old age, or are a regular natural rhythm of activity akin to physical waves or swings of a pendulum.
But there is debate as to what factors contribute to the length of an economic cycle and what causes them to exist in the first place. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades. The NBER's researchers have selected turning points for over 30 business cycles, beginning in the mids.
How do NBER recessions differ from the common description of a recession as, "a period when real gross domestic product declines for two consecutive quarters? The NBER's seven-member Business Cycle Dating Committee examines monthly economic indicators that provide a good industry-wide economic perspective to date business cycles.
Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content. Create a personalised content profile. Measure ad performance. Select basic ads. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights.
Measure content performance. Develop and improve products. List of Partners vendors. Burns and Wesley C. Mitchell, Measuring Business Cycles, remains definitive today. In essence, business cycles are marked by the alternation of the phases of expansion and contraction in aggregate economic activity, and the comovement among economic variables in each phase of the cycle. Aggregate economic activity is represented by not only real i. A popular misconception is that a recession is defined simply as two consecutive quarters of decline in real GDP.
Notably, the —61 and recessions did not include two successive quarterly declines in real GDP. A recession is actually a specific sort of vicious cycle, with cascading declines in output, employment, income, and sales that feed back into a further drop in output, spreading rapidly from industry to industry and region to region. This domino effect is key to the diffusion of recessionary weakness across the economy, driving the comovement among these coincident economic indicators and the persistence of the recession.
On the flip side, a business cycle recovery begins when that recessionary vicious cycle reverses and becomes a virtuous cycle, with rising output triggering job gains, rising incomes, and increasing sales that feed back into a further rise in output. The recovery can persist and result in a sustained economic expansion only if it becomes self-feeding, which is ensured by this domino effect driving the diffusion of the revival across the economy.
Of course, the stock market is not the economy. Therefore, the business cycle should not be confused with market cycles , which are measured using broad stock price indices. The severity of a recession is measured by the three D's: depth, diffusion, and duration.
A recession's depth is determined by the magnitude of the peak-to-trough decline in the broad measures of output, employment, income, and sales. Its diffusion is measured by the extent of its spread across economic activities, industries, and geographical regions. Its duration is determined by the time interval between the peak and the trough. In analogous fashion, the strength of an expansion is determined by how pronounced, pervasive, and persistent it turns out to be.
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