CASE STUDY

THE RECESSION OF 2001

unemployment rate rose from 3.9 percent in December 2000 to 4.9 percent in August 2001 and to 6.3 percent in June 2003. The unemployment rate then began to decline. By January 2005, unemployment ha:d fallen back to 5.2 percent.What caused the recession, and what ended it? The answer to both questions is shifts in aggregate demand.

The recession began with the end of the dot-com bubble in the stock market. During the 1990s, many stock-market investors became optimistic about information technology, and they bid up stock prices, particularly of high-tech companies. With hindsight, it is fair to say that this optimism was excessive. Eventually, the optimism faded, and stock prices fell by about 25 percent from August 2000 to August 200 1. The fall in the stock market reduced household wealth, which in turn reduced consumer spending. In addition, when the new technologies started to appear less profitable than they had originally seemed, vestment spending fell. The aggregate-demand curve shifted to the left.

The third event that put downward pressure on aggregate demand was a series of corporate accounting scandals. During 2001 and 2002, several major corporations, including Enron and World Com, were found to have misled the public about their profitability. When the truth became known, the value of their stock plummeted. Even honest companies experienced stock declines, as stock-market investors became less
trustful of all accounting data. This fall in the stock market further depressed aggregate demand.

Policymakers were quick to respond to these events. As soon as the economic slowdown became apparent, the Federal Reserve pursued expansionary monetary policy. Money growth accelerated, and interest rates fell. The federal funds rate (the interest rate on loans between banks that the Fed uses as its short-term policy target) fell from 6.5 percent in December 2000 to 1.0 percent in June 2003. Lower interest rates stimulated spending by reducing the cost of borrowing. At the same time, with the president’s urging, Congress passed a tax cut in 2001, including an immediate tax rebate, and another tax cut in 2003 .. One goal of these tax cuts was to stimulate consumer and investment spending. Interest-rate cuts and tax cuts both shifted the aggregate-demand curve to the right, off setting the three contraction shocks the economy had experienced.

The recession of 2001 is a reminder of the many kinds of events that can influence aggregate demand and, thus, the direction of the economy.