Download Macroeconomics in Context: Aggregate Supply, Aggregate Demand, and Inflation and more Study notes Macroeconomics in PDF only on Docsity!
Macroeconomics in Context, Fourth Edition
Chapter 12 Aggregate Supply, Aggregate Demand, and Inflation
Putting It All Together
If you read the financial pages in any newspaper (or sometimes the front pages if economic issues are pressing), you will see discussion about government budgets and deficits, interest rate changes, and how these affect unemployment and inflation. You may also see news about changes in the availability of certain crucial resources— particularly energy resources—and about how the impact of such changes in resource supplies spread throughout the country’s economy. How does economic theory help to make sense of it all? In Chapter 8, we started to build a model of business cycles, focusing at first on the downturn side of the cycle and the problem of unemployment. In Chapters 9, 10, and 11 we explained economic theories concerning fiscal and monetary policy. So far, our models have focused on the “demand side,” illustrated by shifts of the aggregate expenditure (AE) curve. In this chapter, we complete the demand-side story, using the broader term “aggregate demand”, so that it includes explicit attention to the potential problem of inflation. Then we move on to the issue of the actual productive capacity of the economy, or “supply side” issues. Finally, we will arrive at a model that we can use to “put it all together.” We then use this model to analyze several real-world economic cases including recent trends in unemployment and inflation.
1 Aggregate Demand and Inflation
The AE curve in the Keynesian model used in the previous three chapters was graphed with income on the horizontal axis and output on the vertical axis. We mentioned that if output is above its full-employment level, there may be a threat of rising inflation, but nothing in the figures incorporated this idea. The graphs that we used all measured income, output, and aggregate expenditures without considering changes in price levels. It is time now to remedy that omission by introducing an explicit measure showing changes in prices.
1.1 The Aggregate Demand ( AD ) Curve
Recall from Chapter 8 that aggregate demand is the total level of spending in the economy. Since the level of spending is influenced by the changes in price levels, we use the aggregate demand (AD) curve to represent the relationship between the equilibrium level of output and inflation. To show this graphically, we put output ( Y ) on the horizontal axis and inflation on the vertical axis, (denoted by the symbol π).*^ This is shown in Figure 12.1. The AD curve shown here differs from the AE curve used in the preceding chapters since it takes into account changes in inflation and the reaction of the central bank to different levels of inflation, but the points on the AD curve all correspond to macroeconomic equilibrium points where the
- (^) Some versions of the AD curve use “price level” rather than inflation on the vertical axis. The authors of this text believe that using inflation better represents the reality of an economic system in which prices are rarely constant.
Keynesian AE curve crosses the 45° line. We are building on that previous equilibrium analysis by introducing an extra dimension—inflation—shown on the vertical axis.
Figure 12.1 The Aggregate Demand Curve
aggregate demand ( AD ) curve: graph showing the relationship between the rate of inflation and the total quantity of goods and services demanded by households, businesses, government, and the international sector
This view of aggregate demand assumes that higher inflation rates will tend to reduce total demand, for several reasons:
- When inflation rises, it reduces the value of money assets. Even if this does not reach the level of hyperinflation discussed in Chapter 10, it hurts savers and people who have money balances. This real wealth effect tends to reduce their consumption, lowering total demand.
real wealth effect: the tendency of consumers to increase or decrease their consumption based on their perceived level of wealth
- Inflation also lowers the real money supply , defined as M/P, where M is the nominal money supply and P is the general price level. This has an effect similar to contractionary monetary policy, raising interest rates and discouraging investment.
real money supply: the nominal money supply divided by the general price level (as measured by a price index), expressed as M/P
- Inflation hurts net exports by making domestically produced goods more expensive for foreigners and imports more attractive for domestic consumers. This decreases aggregate demand by decreasing net exports.†
† (^) As defined in Chapter 4, and discussed further in Chapter 13, net exports are exports minus imports, and represent a net addition to aggregate demand and GDP levels.
1.3 Shifts of the AD Curve: Monetary Policy
As we have noted, the Federal Reserve usually responds to higher inflation by increasing interest rates, and this is reflected in the slope of the AD curve. This kind of policy response, which aims to keep inflation near a target level, is a rather passive sort of monetary policy. Including it in the AD curve is based on the assumption that this kind of Fed response will be more or less automatic. A more active form of Fed intervention occurs when the Fed’s leaders decide to change policy more fundamentally—either by changing their inflation target or by shifting their focus to fighting unemployment. Such a change can shift the AD curve. For example, in a severe recession the Fed might decide that the economy requires additional stimulus. If the Fed instituted significant expansionary monetary policies, driving interest rates down (as it did, for example, in 2007 and again in 2020 to respond to recessions), this would, in theory, have the effect of boosting investment and shifting the AD curve to the right. Alternatively, if the Fed decided that its policies on inflation have been too lax, it could tighten monetary policy (this happened, for example, in 1982 and also in 2022 in response to inflation). This would have the effect of shifting the AD curve to the left. To summarize:
- The AD curve indicates levels of equilibrium GDP at different possible rates of inflation.
- The AD curve can be shifted by changes in levels of autonomous consumer spending, autonomous investment, fiscal policy, net exports, or by major changes in monetary policy.
Discussion Questions
1 “The negative slope of the AD curve means that higher levels of output will lead to lower levels of inflation.” Is this statement correct or not? Discuss. 2 Does the Fed always want the inflation rate to be as low as possible? Why or why not?
2 Capacity and the Aggregate Supply Curve
As we have noted in earlier chapters, increases in aggregate expenditure can push output up toward the full-employment level. In our current analysis, an increase in aggregate expenditure is shown by a rightward shift in the AD curve. But what happens when output reaches—or maybe even exceeds—the full-employment level? In a graph such as Figure 12.2, for example, there is nothing in the model that seems to prevent expansionary policies from just shifting the AD curve, and output, up and up and up. Obviously, this cannot be true in the real world. At any given time, there are only certain quantities of labor, capital, energy, and other material resources available for use. The U.S. labor force, for example, comprises just over 160 million people. The United States simply cannot, then, produce an output level that would require the work of 200 million people. This is a hard capacity constraint: What happens as an economy approaches maximum capacity can be modeled using the aggregate supply ( AS ) curve. The AS curve shows combinations of output and inflation that can, in fact, occur within an economy, given the reality of capacity constraints.
aggregate supply ( AS ) curve: graph representing the relationship between the rate of inflation and the total goods and services producers are willing to supply, given the reality of capacity constraints
2.1 The Aggregate Supply ( AS ) Curve
Figure 12.3 shows how aggregate supply is related to the rate of inflation. It will be easiest to explain the shape of the curve starting from the right, at high output levels. Moving from right to left, we can identify five important, distinct regions of the diagram. First (starting on the right in Figure 12.3), the vertical maximum capacity output line indicates the hard limit on a macroeconomy’s output. Even if every last resource in the economy were put into use, with everybody working flat out to produce the most they could, the economy could not produce to the right of the maximum capacity line.
maximum capacity output: the level of output an economy would produce if every resource in the economy were fully utilized
Just below the maximum capacity level of output, the AS curve has a very steep, positive slope. This indicates that, as an economy closely approaches its maximum capacity, it is likely to experience a substantial increase in inflation. If many employers are all trying to hire many workers and buy a lot of machinery, energy, and materials all at once, workers’ wages and resource prices will tend to be bid upward. But then, to cover their labor and other costs, producers will need to raise the prices that they charge for their own goods. Then, in turn, if workers find that the purchasing power of their wages is being eroded by rising inflation, they will demand higher wages, which leads to higher prices, and so on. The result is a phenomenon called a wage-price spiral , in which higher wages and higher prices lead to a steep rise in self-reinforcing inflation.
wage-price spiral: when upward pressure on wages creates upward pressure on prices and, as a result, further upward pressure on wages
In the real world, such steep increases in inflation are usually the result of dramatic pressures on producers, such as often occur during a national mobilization for war. During World War II, for example, the U.S. government pushed the economy very close to its maximum capacity—placing big orders for munitions and other supplies for the front, mobilizing the necessary resources by encouraging women to enter the paid labor force, encouraging the recycling of materials on an unprecedented scale, encouraging the planting of backyard gardens to increase food production, and in general pushing people’s productive efforts far beyond their usual peacetime levels. As a result, unemployment plummeted. The government, knowing that such pressures could lead to sharply rising inflation (as shown in the wage-price spiral region of Figure 12.3), kept inflation from getting out of hand by instituting wage and price controls — direct regulations telling firms what they could and could not do in the way of price or wage increases.
Moving further to the left, the AS curve shows a region in which the economy is below full employment, perhaps going into recession or recovering from a recession. The flat AS line shown in Figure 12.3 for this region indicates that, under these conditions, there is assumed to be no tendency for inflation to rise. Because a significant amount of labor and other resources are unemployed, there is no pressure for higher wages or prices. It is also likely that because wages and prices tend to be slow in adjusting downward, inflation will not fall either—at least not right away. When the economy is hit not by a regular recession, but by a really deep recession, such as one experienced in most industrialized countries in 2007-2009 and again in 2020, output is so far below the full employment level that inflation starts to drop, and may even become negative (deflation). In this situation, demand is so weak that a large number of companies may fail. Struggling to stay in business, firms are forced to cut prices in order to maintain at least some sales. Also, in such a situation, workers and their unions might agree to wage cuts which lowers firms’ costs and allows them to further reduce their prices. Here, the AS curve in Figure 12.3 slopes downwards again as a further fall in aggregate demand accelerates the process of disinflation (a decline in the rate of inflation) or even deflation (an absolute decrease in price levels).
disinflation: a decline in the rate of inflation
2.2 Shifts of the AS Curve: Inflationary Expectations
When people have experienced inflation, they come to expect it. They then tend to build the level of inflation that they expect into the various contracts into which they enter. If a business expects 4 percent inflation over the coming year, for example, it will add 4 percent to the selling price that it quotes for a product to be delivered a year into the future, just to stay even. If workers also expect 4 percent inflation, they will try to get at least a 4 percent cost of living allowance, just to stay even. A bondholder who expects 4 percent inflation and wants a 2 percent real rate of return will be satisfied only with an 6 percent nominal rate of return.§ In this way, an expected rate of inflation can start to become institutionally “built in” to an economy. As a first approximation, it is reasonable to assume that people expect something like the level of inflation that they have recently experienced (an assumption that economists call “adaptive expectations”). Thus, inflation can be, to some degree, self-fulfilling. Because different contracts come up for renegotiation at different times of the year, the process of building in inflationary expectations will take place only over time. Because of the time that it takes for prices and wages to adjust, we need to make a distinction between short-run and medium-run aggregate supply responses. The AS curve in Figure 12.3 was drawn for a particular level of expected inflation in the short run. Before people have caught on to the fact that the inflation rate might be changing, their expectations of inflation will continue to reflect their recent experience. In this model, an economy in recession, or on the horizontal part of the AS curve, will tend in the short run to roll along at pretty much the same inflation rate as it has experienced in the past. Tight labor and resource markets caused by a boom could tend to increase inflation, but this will initially come as a surprise to people and
§ (^) As noted in Chapter 11, Appendix A2, the real rate of return equals the nominal rate minus inflation, r = i – π.
will not immediately translate into a change in expectations. For the purposes of this model, you might think of the short run as a period of some weeks or months.
Figure 12.4 The Effect of an Increase in Inflationary Expectations on the Aggregate Supply Curve
Over a longer period of time—the medium run —however, a rise in inflation due to tight markets tends to increase people’s expectation of inflation.¶^ If they expected 2 percent inflation but over a period of time they experience 4 percent inflation, the next time that firms set prices or workers renegotiate contracts they may build in a 4 percent rate. Figure 12.4 shows how the AS curve shifts upward as people’s expectation of inflation rises. Note that the maximum capacity of the economy has not changed— nothing has happened that would affect the physical capacity of the economy to produce. All that has happened is that now, at any output level, people’s expectation of inflation is higher. Similarly, if people experience very loose markets for their labor or products (i.e. low demand), or lower inflation due to lack of aggregate demand and recessionary conditions, over the medium run the expected inflation rate may start to come down. Employers may find that they can still get workers if they offer lower wages. Unions might agree to lower wage increases as their members might be afraid of unemployment, but only need a small wage increase to guarantee stable purchasing power. Producers may raise their prices less this year than last year or cut prices, because they are having trouble selling in a slow market. When people start to observe wage and price inflation tapering off in some sectors of the economy, they may change their expectations about inflation. As people react to the sluggish aggregate demand that occurs during a recession, they will tend, over time, to lessen their expectations about wage and price increases. The graph for this would be similar to Figure 12.4, but would show the AS curve shifting downward instead of upward.
¶ (^) As distinguished from the long run , discussed in the Appendix.
1970s, and possible Russian limitations on natural gas supply have become a concern for many European economies.) Adverse supply shocks reduce the economy’s capacity to produce and, by concentrating demand on the limited supplies of resources that remain, tend to lead to higher inflation. Adverse supply shocks would be illustrated in a graph such as Figure 12.5, but with the direction of all the movements reversed.
Discussion Questions
1 Describe in words how the AS curve differs from the AD curve. What does each represent? What explains their slopes? 2 Do you get “cost of living” raises at your job or know people who do? Why does this practice have important macroeconomic consequences?
3 Putting the AS/AD Model to Work
Economists use the AS/AD model to illustrate three points about the macro-economy:
1 Fiscal and monetary policies affect output and inflation:
- Expansionary fiscal and monetary policies tend to push the economy toward higher output. If the economy is approaching its maximum capacity, they will also cause inflation to rise.
- Contractionary fiscal and monetary policies tend to push the economy toward lower output. Inflation may not fall quickly, but a persistently lower level of economic activity will tend to lower inflation over the long term.
2 Supply shocks may also have significant effects:
- Adverse supply shocks lower output and raise inflation.
- Beneficial supply shocks raise output and lower inflation.
3 Investor and consumer confidence and expectations also have important effects on output and inflation.
Bearing these principles in mind, we will see how this model helps to explain some major macroeconomic events.
3.1 An Economy in Recession
In Figure 12.6, we bring together the AS and AD curves for the first time. The (short run) equilibrium of the economy is shown as point E 0 , at the intersection of the two curves. Depending on how we place the curves in the figure, we could illustrate an economy that is in a recession, at full employment, or in a wage-price spiral. (We temporarily omit the maximum capacity line, but we reintroduce it when we discuss inflation.) In this specific case, the fact that E 0 is well to the left of the full-employment range of output indicates that the economy is in a recession. Private spending, as determined in part by investor and consumer confidence, along with government and foreign sector spending, are not enough to keep the economy at full employment. The fact
that the curves intersect on the flat part of the AS curve indicates that inflation (in the short run) is stable. So in this situation unemployment is the major problem. What can be done? Figure 12.6 models the real-world situation of the U.S. economy in the 2007–9 and 2020 recessions. Unemployment rose to 10 percent in 2009, and briefly to 14 percent in 2020, but inflation was very low in both periods. In this situation, the Federal government implemented major fiscal stimulus programs. The goal of the stimulus programs was to promote employment both through direct impact and through multiplier effects expanding private spending and employment. This effect is shown in Figure 12.7 as a rightward shift of the AD curve. As noted in Chapter 9 (Box 9.2), the 2009 stimulus plan was responsible for adding millions of jobs to the economy. While economists are not in agreement about how large the multiplier effects of the program were, many argue that without the program, the economy would have continued to plunge deeper into recession.^1 The effects, however, were not large enough to bring the economy back to full employment. The unemployment rate remained above 7 percent until 2013, and only gradually declined to 5 percent in late 2015. This is reflected in Figure 12.7 as an AD shift that moves output toward, but not into, the full-employment zone.
Figure 12.6 Aggregate Demand and Supply Equilibrium in Recession
(^1) Blinder and Zandi, 2010; CBO, 2012 ; Montgomery, 2012.
Box 12.1 Unemployment and Inflation: A Tale of Two Recoveries
By 2018, the U.S. economy had entered its ninth year of expansion following the crisis of 2008–09. As of early 2018, the unemployment rate was at 4.1 percent—the lowest since 2000—and hourly wages had increased by about 2.6 percent since the previous year. The strengthening conditions in the labor market raised concerns about the possibility of inflation, as the rising demand for workers could drive up salaries and prices. Amid fears of inflation, the Federal Reserve planned to raise interest rates at least three times in 2018. As of mid-2018, however, inflation rates remained below 2 percent. An Economic Policy Institute report argued that until wages are rising by at least 3.5 to 4 percent, there would be no threat that inflation would exceed the Fed’s 2 percent inflation target.^1 Some economists suggest that a moderate amount of inflation actually provides a good environment for economic activity: Economic research suggests that inflation is best in moderation. Price increases lead to wage increases, which make it easier to repay existing debts, like mortgages, and more attractive to incur new debts, like borrowing to start a company. Inflation also functions as a kind of economic WD-40, easing shifts in the allocation of resources. Perhaps most importantly, moderate inflation keeps the economy at a safe distance from deflation, or general price declines, which can freeze activity as would-be buyers wait for lower prices.^2 The trick for policymakers is to achieve just the right amount of inflation, without either allowing inflationary expectations to get out of hand, or pushing the economy back into recession. The experience of 2021/2022 was different. After a rapid recovery from the recession of 2020, inflation gained a definite foothold in the economy. At the end of 2021, prices had risen 5.8 percent over the year according to the Personal Consumption Expenditures index used by the Federal Reserve to gauge inflation. “Core prices”, which exclude volatile food and energy categories, rose 4.9 percent, the biggest increase since 1983.^3 At the same time, job growth was very strong, averaging over half a million jobs per month throughout 2021. So a clear policy success—rapid employment recovery—was accompanied by a problem of significant inflation. Economists differed in their interpretation of this combination. Former U.S. Treasury Secretary Lawrence Summers commented in early 2022, “We’ve got an overheated economy, and the Fed is going to have the very real challenge of cooling that economy off, and doing it in a controlled way.” Summers warned that there was “a surfeit of purchasing power and demand relative to the capacity of the economy to produce, and unless we bring those things into balance, we’re going to have not just higher inflation but possibly even accelerating inflation.”^4 Economist Paul Krugman, who admitted that he had not seen the inflation coming, nonetheless believed that it was significantly different from the inflation of the 1970s, which had required very drastic Fed action to control. He argued that “overall demand in the United States actually doesn’t look all that high” and that inflation had arisen primarily from “supply-chain issues.” This could be a time-limited phenomenon since “expected inflation has not (yet?) become entrenched the way it had by the end of the 1970s.”^5 But, according to Krugman, engineering a “soft landing” would still be tricky: “The Fed will adjust its policies based on incoming
economic data, but monetary policy acts with a substantial lag, so it can be many months before we know whether interest rates are too low, too high or just right.”^6
The recovery from the 2020 recession can be contrasted with the earlier experience of recovery from the 2007-2009 recession (see Box 12.1). In both cases, as the economy approached full employment there was concern about the possibility of rising inflation. But in the first case, inflation never became a serious problem, whereas in 2021-2022 it did. As with the earlier recession, considerable Federal stimulus was applied through expansionary fiscal policy, including the $2.2 trillion CARES Act of 2020 and the $1. trillion American Rescue Plan of 2021. The combined size of these programs was several times that of the 2009 stimulus. At the same time, the Fed implemented expansionary monetary policy, both keeping interest rates very low and expanding “quantitative easing”. The result of this combination of expansionary fiscal and monetary policies was a rapid recovery during late 2020 and 2021. But by the end of 2021, inflation had become a definite problem. This was the first time since the 1980s that the U.S. economy had suffered from significant inflation. To analyze this in terms of our AS/AD model, it will be useful to recall some lessons from the experience of inflation in the 1960s, 1970s, and 1980s.
Figure 12.8 A Greater Expansion of Aggregate Demand
3.2 An Overheated Economy
Problems with inflation were a major issue in the United States starting in the late 1960s. High government spending, in particular spending on the Vietnam war, meant that fiscal policy was excessively expansionary. Monetary policy during this period tended to accommodate the fiscal expansion. Although unemployment was very low as a result, by the late 1960s the economy started to “overheat,” causing inflation to rise.
Figure 12.10 The Phillips Curve in the 1960s
3.3 Responding to Inflation
Economic history shows that the Phillips curve is not always a reliable guide to policy. The developments of the 1970s came as a shock to Phillips-curve–minded economists and policymakers. During the 1970s unemployment and inflation both rose, and both stayed fairly high. Oil price increases by the OPEC cartel added considerably to already significant inflationary pressures. This combination of economic stagnation (recession) and high inflation came to be known as stagflation. In 1979, the price of oil was ten times higher than it had been in 1973. The overall inflation rate in the United States was more than 9 percent in 1979—and exceeded 10 percent (measured at an annual rate) during some months.
stagflation: a combination of rising inflation and economic stagnation
The high rates of inflation experienced in the late 1970s were very damaging to the economy. Once people experienced high inflation over a period of time, expectations of further inflation rose. At the same time, the economic problems associated with stagflation forced cutbacks in consumption, investment, and government spending, lowering aggregate demand. Figure 12.11 shows the combination of these effects, moving the economy from E 0 to E 1. The situation at equilibrium E 1 is shows stagflation—a combination of unemployment and high inflation. Even though the economy is no longer in the wage-price spiral range, inflation persists because inflation expectations have risen.
Figure 12.11 “Stagflation”—A Combination of Unemployment and Inflation
As we noted in Chapter 10, high rates of inflation can wipe out the value of people’s savings and make it very difficult for households and business to plan, save, and invest. Because unemployment was also high, as shown in Figure 12.11, it was difficult to see how consumers and businesses could ever recover confidence while inflation seemed out of control. Even though the economy was already in a recession, and the unemployment rate was above 7 percent, the Federal Reserve, under the chairmanship of Paul Volcker, took deliberate and drastic action to bring the long-term inflation rate down, by implementing very contractionary monetary policies. The effects of these “tight money” policies during the early 1980s can be seen in Figure 12.12.
Figure 12.12 The Effect of the Fed’s “Tight Money” Policies in the 1980s.
A complicating factor in 2021/2022 was that the inflation that began in 2021 had an unusual character. Economists differentiate between two major types of inflation: demand-pull inflation and cost-push inflation. Our discussion so far has focused on demand-pull inflation—the result of the Aggregate Demand curve moving too far to the right, exceeding supply capacity and thus forcing up wages and prices. Cost-push inflation, by contrast, results from supply-side restrictions and bottlenecks, and may occur even if overall demand is not high. This was the case, for example with the oil price increases of the 1970s. It was also evident in the recovery from the 2020 pandemic recession. The impact of COVID- 19 led to many supply-chain and transportation problems, as a shortage of workers in key areas made it difficult to meet consumer demands. The fact that many services, which required in-person contact, were impacted by COVID-19 also led consumers to shift their budgets in favor of goods purchases. The combination of greater demand and limited supply for many goods, for example in the automobile market, led to significant price increases.
demand-pull inflation: inflation primarily caused by excessive aggregate demand
cost-push inflation: inflation primarily caused by supply restrictions and bottlenecks
The appropriate policies for responding to the two types of inflation might differ. In the case of widespread supply-chain problems, it would be best to try to alleviate these problems directly rather than reducing aggregate demand. An overall reduction in demand could hurt the economy and employment without doing anything to remedy the supply problems. So which was type of inflation was the major problem in 20021/2022? There were probably elements of both. There is no question that the pandemic led to widespread supply problems. At the same time, as mentioned earlier, the CARES Act and American Rescue Plan between them had injected about $4 trillion of additional demand into the economy. Even in an approximately $20 trillion economy, that is a large amount of additional aggregate demand! This may well have been an appropriate response to high unemployment, but it did contribute to inflationary pressures. This logic was what drove the Fed in 2022 to implement a moderately contractionary monetary policy, to cool down excessive demand. But the situation was not as bad as the out-of-control inflation of the late 1970s, which led to much more drastic Fed policies to break the back of inflation even at the cost of plunging the economy into a deep recession. The hope was that inflation could be moderated this time without such drastic impacts on the economy. In addition to monetary policy, the perception of rising inflation had an impact on fiscal policy. The Biden administration had passed the $1.9 trillion Infrastructure Investment and Jobs Act in 2020. As noted in Chapter 9, this spending was spread over a ten-year period, so it would have little immediate impact on inflation. Nonetheless, the next major Biden initiative, the Build Back Better Act, also planned to cover a ten-year period and accompanied by revenue-raising provisions, ran into significant problems in Congress due to the perception that more spending at a time of inflation was unwise.
3.4 Technology and Globalization
We can use our AS/AD analysis to focus on one more historical period: the expansion of the 1990s. As with our analysis of the earlier 1960s-1980s period, past economic history may have some lessons for the present. From 1992 to 1998, unemployment rates and inflation rates steadily fell. In 1998, unemployment was 4.4 percent, the lowest it had been since 1971. Inflation was 1.6 percent, lower than it had been in more than 10 years. This was clearly the best macroeconomic performance in decades. Unemployment continued to fall for another two years, reaching 3.9 percent in 2000. What caused this sustained recovery? Significant advances in innovation—in particular enormous leaps in information technology, including the advent of widespread use of the Internet and information systems for business supplies, deliveries, and product design—provided a major impetus for this period of superior macroeconomic performance. This can be modeled as a period of beneficial supply shocks, as shown in Figure 12.14.
Figure 12.14 The Effects of Technological Innovation and Increased Efficiency
Many economists also point to increasing global competitiveness as a factor in the rising productivity of this period. Competition from foreign firms, they argue, made U.S. firms work harder to become efficient. Meanwhile, competition from foreign workers and anti-union government policies weakened the power of domestic unions. This helped keep wage and price inflation low, although it also had negative consequences for the U.S. distribution of income, as described in Chapters 1 and 14. The strong performance of the macroeconomy in the 1990s inspired economic optimism. A number of commentators wondered whether we were entering a “new economy” in which business cycles would become a thing of the past. Events after 2000 proved otherwise. In 2001–2 the stock market crashed, as the “dot-com” speculative bubble burst. About a year later, the economy slid into recession.
