CHAPTER 2

Refresher on Macroeconomic Measurements and the Business Cycle

Introduction

This chapter reviews the importance of some of the main macroeconomic indicators. Some of the main macroeconomic measurements include inflation, unemployment, interest rates, and gross domestic product (GDP) along with the GDP components. The business cycle is also a key characteristic of macroeconomic performance. Additionally, this chapter discusses Okun’s law, which expresses the inverse correlation between unemployment and GDP.

Inflation

The inflation rate is the average percentage rate of change in prices during a time period, such as one year. The Bureau of Labor Statistics (BLS) estimates various types of inflation. Three common measures of inflation relate to the average price of consumer products, the average price of producer goods, and the average price of all products in the economy. The inflation rate equals the percentage rate of change in the corresponding price index. The price index is an estimate of the average price level of goods. The Consumer Price Index (CPI) is a measure of the average price of consumer products. The Producer Price Index (PPI) is a measure of the average price of goods that producers purchase. The GDP deflator is a measure of the average price of all products in the economy. For example, the CPI was 244.028 in Jan 2017 and 249.245 in Jan 2018. Over that one-year time frame, the inflation rate for consumer products was 2.14 percent = 100 ×(249.245 − 244.028)/244.028

Consumer product inflation has been mild in the U.S. economy since the early 1980s, typically at a rate of less than 5 percent. Low inflation is called creeping inflation, walking inflation, or mild inflation. In contrast, hyperinflation is extreme inflation of 1,000 percent or more in a one-year period. Hyperinflation occurs from massive printing of money by the central bank. Hyperinflation arises from monetization (printing money) to pay off high government debt.

Generally, inflation occurs when the central bank expands money supply at a rate that is substantially greater than real economic growth. With hyperinflation, money supply growth occurs at a percentage rate of many hundreds or even thousands of times greater than real economic growth. Hyperinflation causes economic breakdown, often leading to recession or even a depression. Business production declines because of extremely high and unstable inflation. Business calculations become difficult and risky under conditions of hyperinflation. This leads to inefficiency and reduced economic activity.

Another category of high inflation that is not as severe as hyperinflation is called galloping inflation. An inflation rate of 100 percent per year is an example of galloping inflation. Both galloping inflation and hyperinflation occur from excessive printing of money by the central bank.

Disinflation is another type of inflationary effect. This refers to a declining inflation rate. Disinflation, for example, occurs if inflation falls from 5 percent to 3 percent. Deflation is an alternative term that is sometimes used to mean the same thing as disinflation. However, a more correct usage of the term “deflation” refers to an overall decline in the average price level or in other words negative inflation. For example, deflation takes place if inflation falls from 3 percent to −1 percent. Average prices become cheaper if deflation arises. Deflation does not normally occur in a growing economy with increasing demand for goods. Expanding demand for products pulls prices upward.

Nominal GDP versus Real GDP

A widely used indicator of overall national economic performance is GDP. This is the total production of new goods and services in the economy. GDP equals the sum of economic expenditures on new final goods and services across all industries and throughout all geographic regions in a country. GDP in the United States is estimated quarterly and annually by the Bureau of Economic Analysis (BEA).

GDP is estimated nominally and in real terms. Nominal GDP (NGDP) is the dollar value of all new production based on the prices of the new products that are bought and sold. NGDP equals the quantity of all new final products multiplied by the prices of the products.

Real GDP (RGDP), on the other hand, corrects for the distorting effect of changes in product prices. NGDP tends to rise over time. This occurs based on two factors. NGDP rises partly because of more production of goods and services, and partly because of increasing product prices, which is inflation.

RGDP adjusts for the distorting effect of inflation on the measurement for total production in the economy. RGDP is basically a quantity measure for the total amount of new final goods and services. Mathematically, RGDP equals NGDP divided by the average price level (price index) of new goods and services. The price index for the whole economy is called the GDP deflator. Expressed alternatively, NGDP equals the average price of new products (GDP deflator) multiplied by the quantity of new products (RGDP).

RGDP = NGDP ÷ GDP deflator

or

NGDP = GDP deflator × RGDP

If NGDP is $20 trillion and the price index is 150, then RGDP is $13.33 trillion (=$20/1.5). To calculate RGDP, the price index is converted into decimal format so that 150 becomes 1.5.

GDP growth is the percentage rate of change in the GDP level over time. Just as the GDP level is measured in nominal terms and real terms, GDP growth is also measured nominally and in real terms. RGDP growth provides a better measure of economic strength than NGDP growth. Analogous to the RGDP level, RGDP growth discounts for the distorting effect of inflation. RGDP growth equals NGDP growth minus inflation:

RGDP growth = NGDP growth − inflation

or

NGDP growth = RGDP growth + inflation

Suppose NGDP growth is 6 percent. This is the percentage growth in new expenditures as measured by the prices of products. Now assume product prices rise by 6 percent. RGDP growth is zero. The 6 percent increase in NGDP is fully attributable to the 6 percent rise in prices. In this case, the amount of new goods and services produced in the economy is unchanged. As a further example, suppose inflation is 2 percent and NGDP growth is 6 percent. RGDP growth is consequently equal to 4 percent. Production of new goods rises by 4 percent, while prices increase by 2 percent.

RGDP growth is the percentage change in the quantity of new goods and services in the economy. Positive RGDP growth indicates an expanding or growing economy. Negative RGDP growth indicates a contracting economy, usually associated with an economic recession.

Potential RGDP and the RGDP gap are two more indicators of economic performance. Potential RGDP is the level of output that occurs if the macroeconomy is operating at potential capacity and efficiency corresponding to full usage of all economic resources, including full employment of labor and capital. The RGDP gap, on the other hand, is the percentage difference between potential RGDP and the actual RGDP.

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If potential RGDP is $20 trillion and actual RGDP is $19 trillion, then the RGDP gap is 5 percent (= 100 × (20 − 19)/20). This signifies 5 percent inefficiency. Alternatively, suppose the economy is operating at potential RGDP so that labor utilization is at full employment. Actual RGDP is equal to potential RGDP in this case, and the RGDP gap is zero. The economy is efficient.

In a sluggish economy, the RGDP gap is a positive value. This occurs because actual RGDP is less than potential RGDP. If actual RGDP is temporarily greater than potential RGDP, then an overheated economy occurs. The RGDP gap is negative in this instance. An overheated economy tends to cause higher inflation because a strong macroeconomic demand drives up prices. A negative RGDP gap, however, is a temporary phenomenon and cannot be sustained. Potential RGDP is the maximum level of RGDP than can be maintained over an extended period of time. Actual RGDP can only occur above potential RGDP for a relatively short time span, perhaps one year or so, until market forces cause actual RGDP to adjust downward to the potential level.

Components of GDP

GDP equals the sum of four main components of macroeconomic activity. The four sectors are consumption expenditure (C), gross domestic private investment (I), government spending (G), and net exports (NX).

GDP = C + I + G + NX

Table 2.1 NGDP and its four components.

Table 2.1 Components of nominal GDP

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This table shows NGDP in billions of dollars. Each of the components and subcomponents of NGDP is shown in the table. For example, during the third quarter of 2014, NGDP was about $17.6 trillion ($17,599.8 billion). Of this total amount, consumer spending was about $12 trillion, investment was about $2.9 trillion, the level of net exports was about −$0.517 trillion, and government expenditure was about $3.21 trillion.

Consumer Spending and the Consumption Function

The largest component of NGDP is personal consumption expenditures. This is also referred to as consumption or consumer spending. This sector makes up nearly 70 percent of GDP in the U.S. economy (0.68 = $12 trillion/$17.6 trillion). Consumption is made up of three subsectors: durable goods, nondurable goods, and services. Durable goods are products that tend to last for a relatively long period of time. Some examples include automobiles, household appliances, furniture, and computers. Nondurable goods are perishable products. Examples of nondurable goods include food, clothing, and gasoline.

Services consist of consumer spending on activities or assistance received rather than spending on material products. Examples of consumer services include watching a movie in a theater, education in schools, and getting a haircut. Services are the largest subsector of consumer expenditures. The U.S. economy is sometimes referred to as a service economy.

The most important determinant of consumption spending is disposable income. Disposable income is the level of household income available for spending and saving after all taxes are subtracted and all government transfers (such as social security and unemployment benefits) are added. The part of disposable income that is not spent goes to saving. The greater the level of income, the higher the amount of consumer spending. The lower the level of income, the smaller the amount of consumer expenditures.

The relation between consumption and disposable income exhibits a stable linear pattern and is called the consumption function. This is illustrated in Figure 2.1.

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Figure 2.1 Consumption function

Source: Federal Reserve Economic Data (FRED)

Consumer spending is depicted along the vertical axis, and disposable income is displayed along the horizontal axis. The chart shows an upward-sloping effect for consumer spending relative to income. Higher disposable income leads to more consumer spending. In addition to income, some other determinants that affect consumer spending are wealth, household debt, and consumer confidence.

Economic Investment versus Financial Investment

Economic investment versus financial investment are two distinct ways of thinking about investment. These two classifications of investment are sometimes confused with each other. The two categories of investment are distinct but indirectly related. Economic investment is directly included in the GDP calculation and is referred to as gross private domestic investment. Financial investment, on the other hand, is not a part of GDP. However, financial investment functions as a major source of funds used by firms to purchase economic investment in tools, capital equipment, factories, etc.

Financial investment consists of financial assets that serve as a store of wealth from a saving perspective. Some examples of financial investment include stocks, bonds, government securities, and bank account deposits. The main purpose of financial investment from a saving point of view is to increase income and wealth through interest earnings, dividends, and capital gains.

From a business perspective, economic investment or real investment is the use of funds associated with financial investment for the purpose of buying new plant, equipment, and tools to increase production capacity. Businesses, for example, sell stocks and bonds to the public as a source of funds to buy plant and equipment. Economic investment is an economic resource, along with labor and natural resources. Financial investment is not a resource but a source of funding that is used to purchase the resource of economic investment.

Gross Private Domestic Investment and Investment Demand

Gross private domestic investment is an important component of GDP that affects future economic growth. Investment, however, is a smaller component of GDP than the larger sector of consumption expenditures. Additionally, economic investment fluctuates up and down to a greater degree than consumer spending. Economic investment is often considered the engine for economic growth. Investment directly affects production capacity. If economic investment is strong, the total amount of capital stock resource in the economy rises. This adds to the production potential of the economy. If economic investment is high, the capital stock increases substantially, and the economy grows rapidly. If investment is low, the capital stock rises slowly. The economy consequently grows slowly or may contract. The total capital stock equals the accumulation of economic investment over time, excluding the effects of depreciation (the wearing out) of capital. Similarly, economic investment equals the change in the total capital stock, excluding the effects of depreciation.

Figure 2.2 shows the up-and-down pattern of real economic investment in relation to RGDP in the U.S. economy.

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Figure 2.2 Relation between gross private domestic investment and GDP

Source: FRED

The dashed line is the economic investment growth rate, while the solid line is RGDP growth. The graph shows that a strong level of investment tends to pull economic growth upward. A low level of investment drags RGDP growth downward, sometimes into the recession range of negative RGDP growth. The vertical shaded regions in the graph are periods of economic recession.

Total private domestic investment consists of three main types of expenditures, as expressed in Table 2.1. They are nonresidential investment (or business investment), residential investment, and the change in business inventories. Business investment refers to new plant, equipment, factories, other construction, and tools that are used by firms in the production of goods and services. Residential investment is construction of housing, apartments, and other residential structures. The change in business inventories is also included in investment. Inventories refer to unsold goods that firms intend to sell. The change in inventories often rises if businesses sell less than expected. This is frequently a signal that the economy is growing less than anticipated. The change in inventories often decreases if sales are greater than predicted. This often suggests the economy is growing faster than anticipated.

A major determinant of economic investment is interest rates. Interest rates adversely affect business and residential investment. Higher interest rates mean higher borrowing costs. Economic investment consequently declines. Firms borrow less funds for purchases of new plant and equipment as borrowing costs rise. Lower interest rates mean lower borrowing costs. Economic investment and economic growth consequently tend to rise. Firms borrow more funds at lower borrowing costs to purchase more plant and equipment. The relation between economic investment and the interest rate is sometimes called the investment demand relation.

Figure 2.3 shows the inverse correlation between the AAA corporate bond interest rate and economic investment.

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Figure 2.3 Relation between investment and the interest rate

Source: FRED

The AAA corporate bond rate is measured along the vertical axis, and the real gross domestic investment is indicated along the horizontal axis. The downward pattern of the data, although not perfectly correlated, shows a general inverse correlation between the interest rate and investment. The downward-sloping line is a rough approximation of the investment demand curve. The reason that all the data points do not perfectly occur on the investment demand line is because other factors also affect investment. Some of the other factors are profitability, business expectations, technology, taxes, and government regulation of business.

Government Expenditures

Government expenditures make up almost one-fifth of GDP (0.18 = 3.21/17.6 from Table 2.1). The largest category of government spending at the federal level is military purchases. Some examples of government spending at the state and local levels are public education, law enforcement, and social welfare. Government spending also includes health care expenditures, including the Medicaid and Medicare programs.

One category of government activity that is not directly included in GDP is government transfer programs. This is because no direct government purchases are involved. Transfer payments consist of the flow or redistribution of funds from taxpayers to transfer recipients. Transfers do not appear in GDP until the transfer income is spent on consumer goods and services by the recipients.

Social security is an example of a transfer program because the activity involves a transfer of income from wage earners in the form of a tax. The funds are redistributed to retirees in the form of retirement income. If social security recipients spend their social security income on new goods, such as food and clothing, then this economic activity is included in GDP as consumption expenditure.

For many nations, government spending makes up a larger share of GDP than the United States. This occurs because many countries such as Canada and the countries of Western Europe have a more expansive system of government-provided health care than the United States. The issue of government spending and the corresponding issue of taxation and their impact on the economy is called fiscal policy, which will be discussed in Chapter 4.

Net Exports or the Trade Balance

Net exports is also referred to as the trade balance. Net exports are the fourth category of GDP. Net exports (NX) equal total exports (X) minus total imports (M). Since the mid-1970s, the level of net exports in the United States has been negative. This indicates a trade deficit. Table 2.1 shows that the trade deficit was −516.5 billion dollars in the third quarter of 2014. Of this amount, total exports of goods and services were 2.3665 trillion dollars, while total imports were 2.883 trillion dollars (NX = XM = −0.5165 trillion dollars = 2.3665 trillion dollars minus 2.883 trillion dollars).

Some other indicators of international economic activity besides the trade balance include exchange rates, international investments, and the balance of payments. These international economic considerations are not directly included in GDP.

Unemployment

The unemployment rate is an estimate for the percentage of the labor force who are jobless. Unemployed persons do not currently have jobs, but are actively seeking work through job applications, resumes, interviews, and so forth. The total labor force equals the sum of all persons who are working either full time or part-time plus the number of individuals who are unemployed.

The unemployment rate excludes people who are outside of the labor force. The out-of-the-labor-force category consists of individuals who are unable to work for various reasons plus people who are capable of work but who decide not to seek employment. Some examples of persons who are out-of-the labor force are retired individuals, stay-at-home parents, children, institutionalized or disabled persons who are unable to work, and individuals in prisons.

Approximately half of the population in the United States is in the labor force, while about half of the population is out of the labor force. The unemployment rate, as estimated by the BLS, probably underestimates the full extent of the unemployment problem. The BLS unemployment calculation, for example, does not consider the effects of underemployment and discouraged workers.

Underemployment refers to people who are working part time but who prefer to work full time if the opportunity occurs. Additionally, the unemployment rate does not consider whether employees are working in their preferred occupations or not. Discouraged workers, on the other hand, consist of people who are jobless but who gave up actively searching for work because of low prospects. Discouraged workers are excluded from the unemployment statistic until they begin actively searching for jobs.

Natural Unemployment Rate: Structural Unemployment plus Frictional Unemployment

The economy is at full efficiency and peak capacity at potential GDP if all economic resources including labor are employed and effectively utilized. Full employment of labor does not mean the unemployment rate is zero. Even in a best-case scenario, some unemployment is inevitable because of job firings and job quits. These are people who are temporarily out of work and between jobs.

Full employment of labor corresponds to what is called the natural unemployment rate. This is equal to approximately 5 percent in the United States. The natural unemployment rate is the efficient level of unemployment. The natural rate of unemployment is often referred to as NAIRU. This stands for the nonaccelerating inflation rate of unemployment.

The natural unemployment rate equals the sum of two subcategories of unemployment. They are structural unemployment plus frictional unemployment. Structural unemployment equals about 2½ percent. Frictional unemployment also equals about 2½ percent. This yields a natural unemployment rate of about 5 percent.

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Structural unemployment is the percentage of the labor force who are jobless because of insufficient job skills relative to the employment opportunities available. Lack of proficiency in reading, writing, math, and computer skills, and insufficient education or training are among the main causes of structural unemployment.

Because of intense competition in the global economy, many semiskilled workers in manufacturing industries have lost jobs as domestic factories have closed and relocated to developing countries with cheaper wages. Some laid-off factory workers fall under the category of structural unemployment if they lack work skills to be reemployed in other jobs. Structurally unemployed individuals sometimes experience long-term joblessness. Some structurally unemployed persons may face long periods of time without work, until they attain the necessary occupation skills to regain employment.

Besides structural unemployment, the other category of unemployment is frictional. This type of unemployment corresponds to people who are temporarily out of work because of firings or job quits. However, structurally unemployed persons possess sufficient job skills to be rehired in a relatively short period of time, usually within a few weeks or a few months. Frictional unemployment has one beneficial effect. Frictional unemployment can contribute to labor productivity. Frictional unemployment signifies flexibility in the labor market. Frictional unemployment helps facilitate a better match between employers and employees. This promotes greater labor productivity and more efficiency.

Frictional unemployment refers to individuals who either quit or are fired, but subsequently are rehired within a short time. Consequently, frictionally unemployed persons may obtain a better fit with the next employer in terms of job requirements and career interests. The greater the compatibility between the employee and the employer, the higher the labor productivity and economic efficiency in the workplace.

Cyclical Unemployment or the Unemployment Gap

If the actual unemployment rate ends up being higher than the natural unemployment rate, then the labor market and the economy are in a state of inefficiency. The gap between actual unemployment and natural unemployment is called cyclical unemployment or the unemployment gap.

Cyclical unemployment is a measure of the amount of slack or inefficiency in the labor market. Suppose the actual unemployment rate is 7 percent while the natural unemployment rate is 5 percent. In this case, cyclical unemployment is 2 percent. Alternatively, suppose the economy is operating efficiently at the natural unemployment rate of 5 percent. In this instance, the unemployment gap and cyclical unemployment are zero.

The actual unemployment rate equals the sum of structural unemployment, frictional unemployment, and cyclical unemployment.

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Business Cycle

The business cycle is the up-and-down pattern of macroeconomic performance over time. Business cycle fluctuations may be expressed in terms of various indicators, such as the level of RGDP, the RGDP growth rate, unemployment, or even inflation and interest rates.

Figure 2.4 shows the general business cycle pattern in terms of the RGDP level over time.

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Figure 2.4 Business cycle pattern

The wavelike pattern, as shown by the curved line, depicts business cycle fluctuations. The up-and-down movement of economic performance consists of three main parts. They are economic expansions, economic recessions, and the economic growth trend or the secular growth trend. Periods of upward movement in RGDP indicate economic expansions. Episodes of declining RGDP signify economic contractions or recessions. An economic expansion occurs if RGDP is rising. An economic recession occurs if RGDP is declining. In the U.S. economy, expansions often last for 5 to 6 years or sometimes longer. Economic recessions occur for shorter durations of time, frequently between 1 and 2 years.

The secular trend is the upward-sloping straight line. This indicates the average growth rate for the economy. In the U.S. economy, the average RGDP growth rate is about 2½ percent per year. This upward trend of economic growth occurs because of advancements in commercial technology as well as from increasing economic resources such as labor and capital. In subsequent chapters, we consider the issue of political influences on the business cycle.

Figure 2.5 shows the actual business cycle pattern for the United States in terms of RGDP growth and the unemployment rate. These two macroeconomic variables are measured along the vertical axis in the chart. The unemployment rate is shown as the dashed line, while RGDP growth is shown as the solid line. Time in years from 1965 to 2014 is measured along the horizontal axis. The shaded regions are periods of economic recession, while the other time periods are associated with economic expansion.

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Figure 2.5 Unemployment and RGDP growth

Source: FRED

The chart shows up-and-down variations in RGDP growth and unemployment. Periods of high RGDP growth are often associated with declining unemployment. When economic growth is strong, firms tend to hire more workers to produce more goods. The unemployment rate consequently declines. Periods of low RGDP growth often occur in the gray-shaded regions in the graph. This depicts economic recessions and rising unemployment. When economic growth is weak, firms employ fewer workers because of reduced production of goods and services. Therefore, unemployment tends to worsen.

Okun’s Law

A positive unemployment gap (positive cyclical unemployment) occurs if actual unemployment is greater than natural unemployment. Correspondingly, actual GDP is likely to be less than potential GDP. The correlation between unemployment and GDP is called Okun’s law. This is named after the late economist Arthur Okun. Okun’s law is the inverse correlation between RGDP growth and the change in the unemployment rate. When GDP growth rises, unemployment tends to fall and vice versa.

Figure 2.6 shows Okun’s law in terms of RGDP growth and the change in unemployment rate.

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Figure 2.6 Okun’s law

Source: FRED

RGDP growth is measured along the vertical axis, while the change in the unemployment rate is shown along the horizontal axis. The downward-sloping line depicts the inverse correlation between the change in unemployment and real RGDP growth. Although the empirical correlation is not exact, the chart shows a general pattern of declining RGDP growth alongside periods of rising unemployment. The unemployment rate and real economic growth tend to move in opposite directions.

Okun’s law may also be expressed in terms of the GDP gap and unemployment. The greater the GDP gap (the percentage difference between potential GDP and actual GDP), the higher the unemployment rate. Figure 2.7 illustrates this effect. The figure shows a line chart of potential GDP, actual GDP, and the unemployment rate from 2002 to 2014.

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Figure 2.7 GDP gap and unemployment

Source: FRED

The solid line is potential GDP, the dashed line is actual GDP, and the dotted line is unemployment. The gray-shaded region is the Great Recession from December 2007 to June 2009. Prior to the Great Recession, the dashed line was approximately even with the solid line, indicating an efficient economy. The GDP gap was approximately zero. Alongside this GDP effect, unemployment declined as shown by the decreasing dotted line. During this period, business firms hired more workers to produce more goods associated with a strong GDP.

Prior to the Great Recession, actual unemployment fell to about 4½ percent, which is below the natural unemployment rate of around 5 percent. This unemployment outcome indicates macroeconomic overheating. An unemployment rate that falls below the natural unemployment rate because of a strong macroeconomic demand cannot be sustained and will likely lead to rising inflation. Figure 2.8 shows the pattern of inflation in association with actual GDP and potential GDP.

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Figure 2.8 GDP gap and inflation

Source: FRED

The dashed and solid lines once again denote actual GDP and potential GDP. Additionally, the dotted line is the CPI inflation rate. Prior to the Great Recession, inflation rose from about 2 percent in 2002 to above 4 percent by 2008. This inflationary outcome occurred because of a strong macroeconomic demand, which drove prices upward.

During the Great Recession, the dashed line fell below the solid line. In other words, actual GDP dropped below potential GDP. This indicates a positive GDP gap or a recessionary gap. The inefficiency of the Great Recession was associated with a weak macroeconomic demand and therefore less production of goods and services.

As predicted by Okun’s law, unemployment worsened alongside the widening gap between potential GDP and actual GDP. Unemployment, in this period, rose from around 5 percent to nearly 10 percent, as shown in Figure 2.7. During the Great Recession, fewer workers were employed by firms because of the decline in goods and services produced.

In addition, inflation fell as actual GDP dropped below potential GDP during the Great Recession. This recessionary gap led to declining inflation because of lower macroeconomic demand. During the Great Recession, inflation fell from about 4 to −0.5 percent. In other words, deflation briefly occurred during the Great Recession. In the next chapter, we discuss the theoretical interrelation between inflation, unemployment, and RGDP.

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