[Economic Report of the President (2005)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 2

Expansions Past and Present

The U.S. economy began to expand rapidly in mid-2003, an expansion
that carried through to 2004. Real gross domestic product (GDP) rose
by 4.0 percent from the third quarter of 2003 to the third quarter of
2004. Employment grew steadily in 2004, with more than 2.6 million
jobs created on net since the job market turned around in August
2003. The unemployment rate has declined from a high of 6.3 percent
in June 2003 to 5.4 percent in December 2004--a rate below the average
unemployment rate of the 1970s, 1980s, and 1990s. Inflation picked
up modestly over the course of 2004 but remains low by historical
standards, with consumer prices having increased by 3.3 percent
during 2004. This state of affairs--strong growth, declining
unemployment, and moderate inflation--is remarkable in light of
the powerful contractionary forces at work since early 2000: the
bursting of the high-tech bubble of the 1990s, revelations of
corporate scandals, weak growth in the United States' major trading
partners, the war in Iraq, and the impact of the terrorist attacks.
The recent recession and expansion took place against the backdrop of
an economy undergoing fundamental changes. At the beginning of the
twentieth century, the agricultural sector was the biggest employer;
at the beginning of the twenty-first, the service-providing sector
employed the most people. Technical progress has spurred productivity
growth and raised living standards. The labor force increased
enormously, as the population grew and the labor force participation
rate of women rose over the course of the last century. The
development of new financial instruments helped people become
financially secure, and the expansion of the mortgage market has
helped a record number of people own homes.
Given these large changes in the structure of the U.S. economy, the
nature of economic expansions has probably also changed over time.
Enough time has now elapsed in the current expansion to allow
fruitful comparisons with previous expansions. The key findings are:
The last two expansions--the one starting in 1991 and the
current one--are similar to each other, but dissimilar to previous
expansions. Both have exhibited relatively moderate overall growth
in key economic variables.
The last two expansions followed especially shallow
recessions. Generally, shallow recessions are followed by shallow
ecoveries and deep recessions by robust recoveries.
Stabilization policy--fiscal and monetary policy--has been
particularly active during the last recession and expansion. The
boost to disposable income from fiscal policy has been especially
strong. Without these strong policies, the recession would have been
deeper and longer.

Overview of the Current Expansion
Chart 2-1 plots the level of real GDP in the current expansion, the
expansion of the 1990s, and the average of the five expansions from
1960 to 1990. The average provides a historical benchmark for the
behavior of expansions; the year 1960 is chosen as a starting point
to balance the need to smooth behavior over multiple expansions with
the need to recognize that changes in the nature of the economy over
time make earlier expansions less comparable to current ones. In
each expansion, real GDP is normalized to 100 at the trough of the
preceding recession (which is also the beginning of the expansion).
Dates of the troughs are determined by the National Bureau of
Economic Research. In the chart, each expansion begins at the
vertical line at 0; points to the left of that line occur during
the preceding recessions. The slope of each line is related to GDP
growth: steeper slopes imply bigger changes in the level of real GDP
per quarter, or faster growth.


The behavior of real GDP is similar in the 1990s and current
expansions, but both are different from the average prior expansion.
In particular, real GDP has risen less robustly during the last two
expansions than it did, on average, in the other expansions
since 1960.
In the average contraction prior to 1990, the level of real GDP
reached its peak approximately four quarters before the eventual
trough; in the 1990-1991 contraction, GDP reached its peak two
quarters before the trough. There were no consecutive quarters of
decline in the most recent contraction, with revised data showing
that real GDP dropped in the third quarter of 2000 and the first
and third quarters of 2001, but grew in the intervening quarters.

Consumption
The largest component of GDP, real personal consumption
expenditures, shows a similar pattern (Chart 2-2). Consumption
behavior during the last two expansions has been almost identical,
with the two recent expansions differing from prior expansions.
In the prior recessions, on average, consumption growth moderated
starting six quarters before the recession's eventual trough, did
not actually fall until two quarters before the trough, and began to
rise in the quarter before the trough. In the 1990-1991 recession,
consumption rose rapidly until two



quarters before the trough, dropped sharply until the trough, and
mostly grew thereafter. The most recent recession stands out as
different in that consumption continued to grow throughout. This
likely reflects the important role of fiscal and monetary stimulus
in supporting demand and the unusual extent to which the recession
resulted from a collapse in investment following the bubble of the
late 1990s.

Investment
In an average expansion prior to 1990, total nonresidential
investment started to rise at the business cycle trough, but
initially rose at a slower pace than consumption (Chart 2-3). In
the expansion of the 1990s, however, investment continued to fall
for four quarters after the trough, and in the most recent expansion,
investment fell for five quarters after the overall economy had
bottomed out.
Residential investment in the average of prior recessions began to
drop eight quarters before the business cycle trough and rose quite
sharply in the four quarters after the trough (Chart 2-4). The housing
market has been strong in the current expansion, though housing
investment has been increasing at a more moderate pace than in
expansions before 1990. This pattern is likely the result of the
unusual circumstance in which residential investment did not falter
along with the broader economy.  In turn, this lack of faltering may
be attributable to low mortgage rates and to the movement of
households' funds out of equities and into housing.
Real house prices have also behaved quite differently across the
two most recent expansions. Real prices dropped throughout the
expansion of the 1990s, reaching a low in 1995. They have risen by a
total of about 44 percent since then. More than half of this
increase, about 25 percent, has occurred since 2000. The recent
increases in house prices, which have been particularly large in some
urban markets, have raised concerns that the housing market may be
in a "bubble.'' It is worth noting in this context that home equity
as a share of net worth dropped during the 1990s, as real stock
prices rose rapidly while house prices fell for the first half of the
decade. This share has been rising since the late 1990s, but remains
below its high of about 22 percent reached in 1985. This rebalancing
of portfolios, pushing up the share of home equity in net worth closer
to its historical norm, raises the demand for housing. This increase
in housing demand may thus be partly responsible for the recent
run-up in house prices.

Exports
At the beginning of the current expansion, exports roughly matched
the behavior of expansions prior to 1990, in which exports picked up
relatively




slowly at the start of the expansion (Chart 2-5). An increase in the
rate of growth of exports during the last year has moved their
behavior closer to that of the 1990s expansion. The decline in
exports during the most recent recession was particularly large
relative to previous ones, as economic growth among major U.S.
trading partners slowed more than in most past business cycles; in
contrast, exports continued to rise during the 1990-1991 recession.
Thus both recent recessions and expansions show anomalous behavior,
though in different ways.




Labor Market
The behavior of the labor market was unusual in the most recent
recession and the last two expansions. Before 1990, on average,
payroll employment started to decline about three quarters before a
business cycle trough--that is, employment on average has continued to
rise in the early part of recessions (Chart 2-6). In an average
expansion, employment begins to grow at the start of the expansion
and reaches its previous peak three quarters after the trough. In the
expansion of the 1990s, however, employment continued to fall for
two quarters after the business cycle trough and did not reach its
previous peak value until another six quarters had passed. In the
most recent expansion, employment continued to fall for seven
quarters after the recession had ended and appears to be on track
to reach its prerecession level by early 2005.  Though both of the



most recent expansions have shown relatively weak employment growth,
they were also preceded by smaller declines in employment prior to
the trough.
The recent behavior of productivity can account for much of the
difference in employment growth (Chart 2-7). Productivity, defined as
output per hour worked, had been growing in line with the rates seen
in past expansions, but then accelerated four to six quarters after
the most recent trough. At 11 quarters after a business cycle
trough, productivity is usually about 8.5 percent above its value at
the trough; it is currently about 12 percent above its trough value.
During the most recent expansion, productivity growth has averaged
4.2 percent per year at an annual rate, up substantially from the
2.5 percent growth rate seen on average from 1995 to 2000. By
contrast, though the level of productivity growth was quite high
during the 1990s, at an annual growth rate of 2.1 percent, even three
years after the 1991 trough the level of productivity was not as
high relative to its trough value as had been the case in prior
expansions. Hence current productivity growth particularly stands
out.
In the short run, greater productivity growth sets the bar higher
for employment growth. With increased productivity, a given amount
of output can be produced with fewer hours worked, so real GDP must
grow more quickly for employment to grow. In the long run, however,
higher productivity growth leads to higher income per person, and
will thus be expected to




be positive for employment growth. This is because part of the
increase in output is distributed to workers in the form of higher
real wages and benefits and part to owners of capital in the form of
profits. The fraction of national income accorded to profits has
risen in recent years, with the share going to profits at 10.9
percent in the third quarter of 2004, up from an average of
9.3 percent during the 1980s and 1990s. The fraction accorded to
wage payments and benefits has been approximately constant over
longer periods of time. A return to the historical pattern would
result in rising real wages.
The behavior of unemployment during the recent expansion, though
atypical when compared with expansions from the 1960s through the
1980s, roughly matches the behavior of unemployment during the
1990s: a continued rise in unemployment after the beginning of the
expansion, followed by a gradual decline about a year later.

Summary
The beginnings of the last two expansions have been characterized by
moderate growth in key macroeconomic variables: real GDP,
consumption, investment, employment, and unemployment. The beginning
of the most recent expansion has seen slower growth in investment and
employment than the last one. The pace of economic expansion picked
up, however, in the middle of 2003. The more moderate rate of
employment growth is at least partly explained by unusually robust
growth in productivity--which further indicates higher future real
wage growth. Unemployment rose by less than in the last recession
and expansion. Both of the most recent expansions were preceded by
relatively mild recessions: the drop in real GDP was relatively
small, and consumption did not drop at all in the most recent
recession.
Symmetry in Recessions and Expansions
The last two expansions, though moderate, were preceded by shallow
recessions. Past recessions were deeper and subsequent expansions
more rapid. Together, the two sets of observations suggest that the
rate of expansion may be related to the rate of contraction. This
section evaluates that hypothesis.

Real GDP
Chart 2-8 plots the total percent contraction in real GDP during all
recessions since 1960 against the percent expansion in real GDP in
the four quarters following the trough. The latter time period is
chosen to allow a uniform standard of comparison across expansions.
Each point is labeled by




the year corresponding to the start of the recession as dated by
the National Bureau of Economic Research. A regression line is drawn
through the points; the position of the line is determined by a
statistical procedure known as linear regression, which tries to
determine the best possible line by minimizing the squares of the
sums of the vertical distances between each point and the line. The
line provides the best estimate for how much of an increase in real
GDP at the beginning of an expansion can be expected for a given
decline in real GDP during a recession.
The graph confirms the hypothesis. For example, the 1981 recession
and its aftermath saw a sharp drop in real GDP followed by a sharp
rise, while the 1990-1991 recession saw a shallow drop in real GDP
followed by a shallow rise. The regression line is upward-sloping,
providing statistical evidence that shallow recessions were followed
by initially shallow expansions and sharp recessions by initially
sharp expansions. An inset on the graph indicates a correlation of
about 0.5. A correlation measures how closely two variables are
related: a value of 1.0 indicates that the variables move together
perfectly, 0 indicates that the variables are unrelated, and
-1.0 indicates that the variables move in opposite directions. A
value of
0.5 indicates a fairly strong relationship.
The most recent recessions and expansions have been fairly moderate.
Indeed, real GDP actually rose over the course of the most recent
recession; this is true whether the last recession is dated to have
started in the fourth quarter of 2000 or the first quarter of 2001.

Components of Real GDP

Given the symmetry in contractions and expansions of real GDP, one
would expect some, if not all, of GDP's components--consumption,
investment, government spending (on consumption and investment),
and net exports--to show a similar pattern. The behavior of two major
parts of overall investment, real investment in equipment and
software and inventory investment, most strongly matches that of
real GDP.

The Labor Market

The relationship between the drops in employment during contractions
and the initial rises in employment during the subsequent expansions
is even stronger than the relationship between GDP declines during
recessions and GDP increases during expansions (Chart 2-9).
Drops in employment during contractions and rises during expansions
are smaller than many of the other variables we have seen--ranging
between a decline of 3 percent and an increase of 3.4 percent.
The most recent contractions saw especially small declines in
employment--between 0.8 percent




and 1.2 percent. Employment continued to decline into the beginning
of the expansions, though by less than 1 percent in each case. As noted above, given the rises in GDP of
over 2 percent during the first year of each expansion, the
difference reflects strong productivity growth.

A Possible Explanation: The Financial Accelerator

The charts above provide evidence that moderate recessions are
followed, at least initially, by moderate expansions, and sharp
recessions by initially rapid expansions. This is seen most strongly
in the behavior of real GDP and employment.
The largest component of GDP to follow the same pattern, investment,
suggests a possible explanation for this relationship. Investment
is positively correlated with GDP growth, rising when GDP growth is
rising and falling when GDP growth is falling. This relationship is
known as the "accelerator model" of investment: higher GDP growth
leads to more investment, which in turn leads to even faster GDP
growth. A shock that leads to a large decline in investment will
thus cause an even larger decline in GDP growth. When that shock
disappears, and investment rebounds to its previous level, GDP
growth will also show a similar rebound.
Research over the past two decades on the role of financial markets
in investment has provided an explanation for the relationship
between investment and GDP growth. To buy new capital goods, firms
rely on several sources of financing. These include internal funds,
such as retained earnings or capital infusions from firm owners, and
external funds, such as the proceeds from loans and the sales of
stocks and bonds. The amount of internal funds is related to the
firm's cash flow. In response to a slowdown in sales, cash flow will
likely decline, reducing the amount of internal funds and therefore
increasing the amount a firm needs to obtain from external finance.
But lenders will be less willing to loan funds to firms with smaller
cash flow, and the value of firms' collateral is also likely to have
decreased, further reducing their ability to obtain loans. Hence
firms might be forced to reduce their investment. This reduction in
turn will lead to lower output, lower cash flow, and yet again lower
investment--leading to a further deceleration in output. The effect
can work in reverse during economic expansions, with rising GDP
making it easier for firms to get financing for new investment
projects. This theory provides a possible explanation for why
changes in the amount of investment can have a multiplier impact
on the broader economy.
The "financial accelerator" effect is roughly proportional to the
size of the decline in GDP, since the change in cash flow and the
value of collateral would be expected to be roughly proportional to
the decline in output. There is no consensus, however, about the
magnitude of the accelerator effect. One study assessing the
response of investment by firms to a monetary policy tightening,
both with and without a financial accelerator, showed that the
presence of an accelerator can cause the decline in investment to
double compared to a situation in which there is no accelerator
effect. Another study noted that small firms, which are likely to be
more limited in their ability to borrow than large firms, show much
larger declines in inventory and sales growth during recessions than
do large firms. This finding further suggests an important role for
the financial accelerator.
The accelerator theory can also provide a link between asset price
bubbles and recessions and expansions. When the prices of equities
or real estate rise, the resulting increases in asset values raise
the value of collateral, making it easier for firms to obtain
financing for investment--thus further raising output growth.
Conversely, declines in asset values from the bursting of asset
price bubbles can discourage investment.
Although the financial accelerator theory helps explain why on
average the depth of the recession corresponds to the initial
strength of the expansion, the theory will not explain the behavior
of all recessions and expansions. Investment is affected by things
other than output growth, and, as will be discussed more fully later
in the chapter, economic shocks can affect other components of GDP.
In the most recent recession, for example, investment fell more
rapidly than in the average recession, but the fall in output was
not particularly large. The solid growth in consumption, boosted by
expansionary monetary and fiscal policy, helped reduce the fall in
output.

Summary
Moderate recessions are followed by moderate expansions and sharp
contractions by rapid recoveries. This may be a consequence of the
"financial accelerator" model of investment, in which firms' ability
to borrow is related to the growth rate of output.
Seen in this context, the unusually moderate growth experienced at
the beginning of the two most recent expansions seems less unusual,
since the preceding recessions were also relatively mild. This
observation begs the question of why the most recent recessions were
mild. One possibility is that stabilization policy may have been
more active and more effective during the last two recessions and
subsequent expansions. This hypothesis can be assessed by looking at
the two components of fiscal policy--taxes and spending--and at
monetary policy.

Stabilization Policy

Before discussing specific details of stabilization policy, it will
be useful to review what is known about the causes of business
cycles, the effects of policy on economic activity, and the
resulting challenges to the development and implementation of
effective policy.

Business Cycles: Causes

Standard economic models suggest that long-run growth of real GDP is
an outcome of technological progress, the accumulation of capital,
and growth in the labor force. The models also suggest that either a
larger labor force with a fixed capital stock or a larger capital
stock with a fixed labor force will produce smaller and smaller
additional amounts of output--a phenomenon known as diminishing
returns. Hence capital accumulation alone and increases in the
labor force alone will eventually result in higher levels of output
but slower rates of output growth.
In the very long run, output will grow only if technological progress
enables the production of more output for a given amount of capital
and labor. In the short run, various shocks--unexpected events that
cause large changes in the demand or supply of goods--can lead to
recessions and expansions. The recessions and expansions can be seen
as deviations from the long-run growth path.
Economic shocks can be divided into disturbances that affect
aggregate demand and those that affect aggregate supply. Aggregate
demand is the economy-wide demand for goods and services. It
consists of consumer spending, investment, government purchases, and
net exports (exports less imports). Aggregate supply is the
economy-wide supply of goods and services. Equilibrium in the
economy occurs when aggregate demand equals aggregate supply.
Shocks that depress aggregate demand tend to lower output, lower
employment (that is, raise unemployment), and put downward pressure
on prices. For example, a decline in stock prices could lead to lower
consumption spending. Shocks that raise aggregate demand have the
opposite effect; they raise output, raise employment (lowering
unemployment), and put upward pressure on prices. For example,
greater optimism by firms about the state of the economy could lead
to higher investment spending. Research has found that shocks to
aggregate demand tend to affect output first rather than prices, but
that these effects are temporary, lasting only a few years. However,
such disturbances have long-lasting effects on the levels of prices
and wages. That is, an increase in demand will lead to a temporary
boost for output but a permanent rise in the price level (though not
necessarily the inflation rate).
Shocks to aggregate supply, in contrast, tend to move output and
prices in opposite directions. A beneficial shock to aggregate
supply, such as a rise in productivity, raises output, lowers
unemployment, and puts downward pressure on prices. An adverse
shock to aggregate supply, such as an increase in the price of
energy, has the opposite effects. To the extent that aggregate
supply  disturbances influence the determinants of long-run
growth--the accumulation of capital, the supply of labor, and
technological progress--supply shocks can also have long-lasting,
even permanent, effects on the level and growth rate of output.

Economic Policy

The tools available to policymakers to affect the economy over a
short horizon (up to a few years) can be divided into fiscal policy
and monetary policy. Fiscal policy involves decisions about taxes,
transfers (such as unemployment insurance, Social Security, or
Medicare payments), and government purchases of goods and services.
Changes in all of these affect aggregate demand. In the short run,
lower taxes or higher transfer payments can lead to higher
disposable incomes and thereby boost consumption spending.
Government purchases directly affect spending and support aggregate
demand.
The effects of tax cuts may depend on the expected duration of the
cut. A prominent theory of consumption, the life-cycle/
permanent-income hypothesis, argues that people choose their
consumption to be in line with their expected lifetime resources. To
the extent they are able, people keep their consumption constant
over drops in income that are expected to be temporary by borrowing
or using their savings. Expected temporary increases in income
should be saved rather than consumed. Only sustained changes in
income would translate into equal-sized changes in consumption.
Under this theory, permanent cuts should permanently raise consumer
spending, as consumers would view disposable income as permanently
higher, while temporary tax cuts should only be saved. But even
temporary cuts could boost spending, however, if people cannot spend
as much as they would like or need to due to constraints on their
ability to borrow.
Tax changes can also increase the incentives for investment, boosting
the investment part of aggregate demand. Some tax changes can also
raise aggregate supply by, for example, boosting incentives for
labor supply or permanently increasing the incentives to accumulate
capital, or by removing distortions. These changes would be expected
to augment the long-run growth rate of the economy.
Monetary policy in the United States is conducted by the Federal
Reserve Board's Federal Open Market Committee (FOMC). The FOMC
targets a short-term interest rate, the Federal Funds rate, the rate
at which banks make overnight loans to one another. This interest rate
in turn influences other short-term and long-term nominal and real
(inflation-adjusted) interest rates in the economy.  In turn, these
interest rates affect interest-sensitive components of aggregate
demand, such as investment and consumption of durable goods (goods
used for long periods, such as refrigerators and cars). These
components of demand are especially affected by changes in interest
rates because firms often need to borrow to make investments and
consumers need to borrow to purchase durable goods. Low real
interest rates raise aggregate demand by boosting consumption and
investment; high real rates reduce aggregate demand. The effects of
monetary policy on output and other real variables will generally be
temporary. In the long run, the output effects of the changes in
aggregate demand caused by monetary policy largely disappear,
leaving effects only on the level of prices.
Research suggests that price stability--a low and stable rate of
inflation--may have important effects on aggregate supply and might
therefore be conducive to GDP growth. High and widely-varying rates
of inflation create substantial amounts of uncertainty about real
rates of return, making it difficult for people to make decisions
about investment.

Policy Design: Challenges
Policymakers use the elements of monetary and fiscal policy to try
to reduce the size of economic fluctuations. Making recessions more
moderate helps people by decreasing the amount of unemployment and
limiting the amount of real income loss. Restraining expansions to
sustainable levels reduces the risks of high inflation. Such policy
is often called countercyclical, since the aim of the policy is to
moderate the business cycle.
There is a broad consensus on the mechanisms by which fiscal and
monetary policy affect the macroeconomy, but less agreement about
the timing and magnitude of their effects. Fiscal policy changes,
especially tax policy changes, can work fairly rapidly. For example,
a temporary investment incentive can cause firms to move investment
forward and undertake projects now instead of in the future. But
enacting such a policy through the legislative and executive
branches of the government can take time. Monetary policy can be
changed more quickly, as the FOMC has eight scheduled meetings per
year and can meet more often if economic conditions warrant. In
contrast to fiscal policy, however, it takes time for interest-rate
changes to affect spending because investment plans take time to
adjust to changing financial conditions.
This uncertainty about the duration and magnitude of policy effects
means that policymakers considering changes in fiscal or monetary
policy must forecast future aggregate demand and supply disturbances
and their impact. For example, a policymaker considering a tax cut
must think about the state of the economy in six months and beyond,
when the tax cut will have its initial impact. The same is true for
monetary policy, in which it can take even more time for policy
changes to have an impact. Economic forecasting is inherently
difficult. It is not easy to determine the state of the economy even
six months out. Economic shocks are by definition unexpected.
New kinds of shocks can make predictions even more difficult. For
example, the oil-price shocks of the 1970s were likely hard to
forecast, since such sharp increases had not been observed in the past.
Successful execution of policy requires not only choices about the
type and extent of policy, but also about timing and duration. While
these are all difficult decisions to make, there is evidence that
there has been improvement over time. Technological improvements and
economic research have allowed economists and policymakers to get
more and better data more quickly on the state of the economy.
Economic models have improved as new ideas are developed and some
older ideas fail the test of time. Computers have allowed the
simulation of more alternative policy scenarios. Policymakers
learn from the past.
The following sections compare the behavior of fiscal and monetary
policy across recessions and expansions since 1960 to assess
differences in the application and effects of policy over time.

Fiscal Policy
The two components of short-run fiscal policy, taxes and government
spending (consumption and gross investment), show different behavior
across economic expansions. The following subsections consider each
in turn.

Taxes

The President signed three major tax bills into law between 2001 and
2003: the Economic Growth and Tax Relief Reconciliation Act (EGTRRA)
in June 2001, the Job Creation and Worker Assistance Act (JCWAA) in
March 2002, and the Jobs and Growth Tax Relief Reconciliation Act
(JGTRRA) in May 2003. A fourth bill, the Working Families Tax Relief
Act (WFTRA), signed in October 2004, extends some provisions of the
previous bills.
These bills--described in further detail in Chapter 3, Options for
Tax Reform, and in the 2004 Economic Report of the President--were
designed to boost both aggregate demand and aggregate supply. The
aggregate demand effects came in several parts. First, tax cuts to
individuals raised real disposable income (real income less taxes)
and thereby supported consumption. Second, the tax cuts provided
incentives for investment, both by lowering tax rates on personal
capital income and by increasing the amount of investment allowed
to be expensed by businesses. The investment incentives were also
designed to have long-term effects on aggregate supply, by
increasing the amount of capital accumulation.
The impact of the boost to aggregate demand can be assessed by
plotting the growth of real income and real disposable income across
expansions (Chart 2-10). During the first three years of an average
expansion, disposable income growth is only slightly larger than
personal income growth, suggesting that tax policy provides only a
small boost. In the 1990s expansion, there was essentially no
difference between real income growth and real disposable



income growth. Tax policy neither stimulated nor contracted demand.
In contrast, the difference has been quite large in the most recent
expansion. After-tax income has grown at a much faster rate than
before-tax income.
The timing of policy also likely helped stabilize the economy, which
was facing multiple contractionary forces in 2000 and 2001. The
first tax relief act was passed in the middle of the recession, so
households received tax-cut checks at an opportune time. Indeed, the
decline in the personal saving rate as a fraction of income indicates
that, on average, people were spending, boosting aggregate demand.
The incentives for investment also included in the tax relief act
were important in light of the particularly sharp drop in investment
during the last recession.

Government Spending (Consumption and Gross Investment)

Government spending (consumption and gross investment) (Chart 2-11)
on average tends to rise as the economy goes into recession and
continues to rise during the beginning of the subsequent expansion.
In the 1990s expansion, however, government spending flattened out
and began to decline. In the most recent expansion, government
spending rose at a faster rate than average, providing a bigger boost
to aggregate demand. A significant portion of this additional
spending is attributable to increased defense and homeland security
spending.



Federal government revenues had been affected by both the recession,
which had been under way for some time before the terrorist attacks
of 9/11, and the subsequent moderate growth of output during the
initial phase of the expansion. About half of the change in the
Federal government's fiscal position from a surplus in fiscal year
2001 to a deficit in fiscal year 2004 was attributable to the weaker
economy and related factors. Just under a quarter of the decline is
attributable to increased spending, principally related to defense
and homeland security, and a little more than a quarter of the
decline is attributable to the tax cuts.
While it is undesirable to have government deficits, they are
sometimes a prudent price to pay for stimulating economic growth.
Without aggressive fiscal policy during the most recent recession
and recovery, the large number of severe shocks facing the economy
might well have caused the recession to have been much longer and
deeper than it actually was, possibly further exacerbating the
deficit. In contrast, reducing the deficit by reversing the tax cuts
would have caused growth to slow even further.
Fiscal policy provided significant stimulus during the most recent
recession and recovery through both lower taxes and increased
spending. Real government spending increased during the 1990-1991
recession, and then remained at roughly its trough level for the
next year before beginning to decline. Hence spending provided only
modest stimulus at the beginning of the 1990s expansion.

Monetary Policy
Low real interest rates help stimulate real GDP growth by boosting
investment and purchases of consumer durables, thereby raising
aggregate demand; high real rates likewise reduce real GDP growth.
The Federal Reserve's principal policy tool, the Federal Funds rate,
influences other nominal and real interest rates. When the real
(inflation-adjusted) Federal Funds rate is low, monetary policy
will be stimulative (sometimes referred to as accommodative or
loose policy). When this rate is high, monetary policy will restrain
real GDP growth (sometimes referred to as tight monetary policy).
"Low" and "high" are both relative terms. In principle, it would
be best to compare the real Federal Funds rate with whatever
interest rate would make policy neither loose nor tight. This
rate can be thought of as the long-run equilibrium rate the
economy would tend to move toward as the effects of economic
shocks wear off. In practice, this equilibrium rate is not
observed. But over long periods of time, the economy tends to
drift back to its long-run equilibrium; hence the average level of
the real Federal Funds rate over a long period of time can provide
a useful, though necessarily imperfect, approximation for the
equilibrium rate.

In Chart 2-12, the solid line plots the nominal Federal Funds rate;
the dots plot the expected real Federal Funds rate, obtained by
subtracting a biannual survey measure of inflation expectations
(the Livingston survey) from the nominal rate. The chart suggests
that the real Federal Funds rate tends to fall during recessions
and rise during expansions--exactly what would be expected from
countercyclical monetary policy. But the timing of interest-rate
changes relative to the recessions and expansions has changed over
time. First, declines in the real Federal Funds rate have occurred
longer before the beginning of the last two recessions than before
the other recessions after 1960. In some prior recessions, real
rates began to decline only after the recession began. Since it can
take time for real interest rate changes to affect spending, earlier
actions by the Federal Reserve can reduce the depth of recessions.
Second, real rates have remained low during the last two expansions
for longer than during previous expansions. The real Federal Funds
rate has been well below its long-run average since the beginning
of 2001. This would be expected to have provided additional stimulus
at the beginning of the recovery and into the expansion. During the
course of 2004, the Federal Reserve raised its target for the nominal
Federal Funds rate from 1 percent to 2.25 percent. Although these
increases in the nominal rate also meant an increase in the real
rate, the real rate still remains well below its long-term average.



Fiscal policy played an especially important role in moderating
the last recession and in supporting the subsequent economic
expansion. During the most recent set of interest-rate cuts,
the nominal Federal Funds rate was reduced to 1 percent, possibly
leaving the Federal Reserve with reduced ability to provide
additional stimulus. The Federal Reserve could have used other means
of further easing policy. For example, it could have tried to target
a long-term interest rate by buying or selling long-term bonds.
Since long-term rates remained well above zero, such a policy would
have given the Federal Reserve additional room to carry out further
easing. The efficacy of this and other nontraditional policy methods
is unproven.
In sum, monetary and fiscal policy together likely explain a
significant part of the relative stability of the economy over the
last two recessions and expansions (see Box 2-1 for further
discussion).


______________________________________________________________________
Box 2-1: Is the Economy More Stable?

The relative moderation of the last two business cycles raises the possibility that the economy may be becoming more stable generally. In
the 60 years since World War II, a visible shift in the volatility of
the growth rate of real GDP occurred in the early 1980s (Chart 2-13).
Does this indicate a change in the nature of the business cycle, and if
so, what caused the change?



A variety of reasons have been offered to explain this shift. One possibility is that more active, and more effective, stabilization
policy had moderated economic fluctuations. Another is that the economy
has had a run of good luck; it has not experienced the same kinds of macroeconomic disturbances seen in earlier years, such as the oil-price
shocks seen in the 1970s and 1980s. Events of the past few years, such
as the terrorist attacks of 9/11 and the bursting of the high-tech
bubble of the 1990s, however, were significant shocks. The decline in volatility could also be largely attributable to better inventory
management. This could be the result of the adoption of ``just in time'' methods, in which goods are manufactured and supplied on demand. Yet
another possibility is that an increasing proportion of the economy is
now in the service sector, which has tended to be more stable than the
goods-producing sector.  It is likely that all of these effects have
worked together to reduce volatility.

______________________________________________________________________

Conclusion

Since the late 1980s, recessions and the initial stages of expansions
have become more moderate. Some of this change reflects the general
positive relationship between the size of recessions and size of
expansions, which is caused at least in part by the relationship
between firms' abilities to invest and the state of economic
activity (the ``financial accelerator''). The recent recessions and
expansions have been especially moderate, suggesting the economy has
become more stable in general. Part of this stability is likely
attributable to more active and timelier stabilization policy.