Economic growth (increases in gross domestic product (GDP)) may appear to be unambiguously good because income can only rise over time if output rises. But quarterly GDP growth can be affected by four different factors, and each of these factors has different implications for policy and for general well-being. Figure 1 illustrates these factors graphically over the past two business cycles. The four factors, listed by length of duration from transient to long-term, are as follows: Random or One-time Events . Some of the changes in quarterly growth rates from quarter to quarter are not persistent and may have no particular cause that can be systematically identified or predicted. Other changes are caused by one-time events that have no lasting impact on the national economy, such as the natural disasters that struck the economy in the fourth quarter of 2005. These disasters are widely credited with having caused below average growth in the fourth quarter of 2005 and above average growth in the first quarter of 2006 (because of rebuilding). Random contributions to economic growth can be thought of as roughly the distance between the line labeled quarterly GDP growth in Figure 1 and the line labeled business cycle. As can be seen, the distance between these lines is usually modest, but at times can be large. Seasonal Fluctuations . Economic activity fluctuates in a predictable way over the course of the year. For example, agricultural output peaks at harvest time and consumption rises during the holidays. Since these seasonal fluctuations have no lasting effect on the economy and do not offer any predictive information about the economy's future path, they are routinely stripped out of the data before it is used by the general public. Therefore, seasonal effects are not shown in Figure 1 . Business Cycle Effects . Over the course of several years, the economy routinely experiences a predictable pattern of boom (expansion), followed by bust (recession), followed by recovery that begins the pattern anew. This can be seen in the line marked "business cycle" in Figure 1 . Recessions are represented by the valleys that occur in the early 1990s and 2000s, expansions are represented by the inclines after a recession and peaks that occur later in the decades. Since the 1980s, an entire cycle has taken about a decade. While the government cannot prevent cyclical fluctuations, it can attempt to soften the booms and busts of the business cycle through monetary and fiscal policy. Structural Growth . In the long run, economic progress is not driven by random, seasonal, or cyclical fluctuations. It depends on an increase in labor and capital (physical investment) inputs and productivity improvements. Structural growth can be represented by the trend line in Figure 1 , which undergoes a slight increase in the mid-1990s that will be discussed later in the report. Over time, the growth rates of these inputs and productivity vary, but important, lasting shifts occur infrequently. Microeconomic policy changes can foster faster growth in labor, capital, and productivity at the margin. In addition, government budget deficits can reduce the growth of the capital stock. This report focuses on the two most important sources of economic growth, cyclical and structural, and discusses how policy can influence them. In the long run, economic growth is determined solely by the growth rate of productivity and capital and labor inputs that determine the overall production of goods and services—what is sometimes referred to as the "supply side" of the economy. But in the short run, growth can be influenced by the rate of overall spending, also known as the "demand side" of the economy. Overall spending includes consumer spending, business spending on capital goods, government spending, and foreign spending on U.S. exports. Spending and production are equalized by prices. Because prices adjust gradually, spending can temporarily grow faster or slower than the potential growth rate of the supply side of the economy. Recessions are characterized by a situation where spending is not growing fast enough to employ all of the economy's labor and capital resources. Recessions can come to an end because government has used fiscal or monetary policy to boost spending or because spending recovers on its own when prices have gradually adjusted. Economic booms eventually give way to "overheating," which is characterized by a situation where spending is growing too fast, and labor, capital, and productivity cannot grow fast enough to keep up. In this scenario, faster economic growth can become "too much of a good thing" because it is unsustainable. Overheating is typified by a rise in inflation—because there is a greater demand for goods than supply of goods, prices begin to rise. Overheating typically gives way to recession when, in order to offset the rise in inflation, monetary policy is tightened to reduce overall spending to the point where it is growing at the same pace as overall supply again. In essence, policymakers trade off a lower rate of economic growth in the short run to achieve a more stable and higher average growth rate over time. Although there is no foolproof way to differentiate between changes in growth being caused by cyclical forces and structural forces, movements in the inflation rate offer a good indication. When inflation is rising, growth is probably above its sustainable rate because overall spending is growing too fast, and when inflation is falling, growth is probably below its sustainable rate because overall spending is too sluggish. Inflation is not a perfect indicator of cyclical activity, however, because sudden spikes in the price of specific goods sometimes cause overall inflation to temporarily change. Volatile energy prices are the prime example of when a change in inflation may not correspond with the business cycle. Just as rapid economic growth can be too much of a good thing, so too can rapid increases in employment and decreases in the unemployment rate. As explained above, the economy's potential growth rate is determined by the growth rate of inputs to the production process, such as labor. When employment rises faster (slower) than the labor force grows, the unemployment rate will fall (rise). With enough employment growth, at some point all available labor will be utilized in the production process, and this will happen before the unemployment rate reaches zero. Unemployment never reaches zero because some workers will always be in the process of leaving an old job and finding a new one, and some workers will always be in the wrong place at the wrong time for the skills they have compared to the skills needed for local employment opportunities. The rate of unemployment consistent with employment for all workers who do not fall into these two categories is known as the "natural rate of unemployment" or "full employment" or the "non-accelerating inflation rate of unemployment (NAIRU)." If overall spending is growing rapidly enough, unemployment can be temporarily pushed below the natural rate. When unemployment is pushed below the natural rate, too many jobs will be chasing too few workers, causing wages to rise faster than productivity. But wages cannot persistently rise faster than productivity because, again, overall spending cannot grow faster than production (assuming labor's share of income remains constant). Wages can temporarily rise faster than productivity, but the result would be rising inflation. In recessions, the process works in reverse. Because spending is insufficient to match potential production, businesses lay off workers. This causes the unemployment rate to rise above the natural rate. As unemployment rises, workers moderate their wage demands in order to find scarce jobs or keep existing jobs. As a result, inflation falls. As Table 1 suggests, to date, the boom and bust pattern is predictable, but has proven unavoidable. Since World War II, the median length of a recession has been 10 months and the median cumulative contraction in output has been 2% of GDP. Two recessions, those beginning in 1973 and 1981, were unusually long. The 1981 recession followed a brief recession that had ended a year earlier; these two recessions are sometimes referred to collectively as the "double dip" recession. From 1945 to 1981, there were eight recessions; since 1982, there have been only two. Of course, the complement of less frequent recessions is longer expansions. Since World War II, there have been three very long expansions, occurring in the 1960s (lasting 106 months), 1980s (92 months), and 1990s (120 months, the historical record). The current expansion, which began in November 2001, may eventually turn out to be a long one as well—through June 2007, it was already the fourth longest since World War II. The pattern of longer expansions and less frequent recessions that has prevailed since the 1980s expansion has been dubbed the "great moderation" by economists. Research has demonstrated statistically that there has been a fundamental change in the economy's behavior since the mid-1980s. Not only has the business cycle been smoother, random fluctuations in growth have also been smaller since then. Economists have three hypotheses for what has caused the great moderation: a change in the structure of the economy; better policy, notably monetary policy; or simply better luck. Expectations play an important role in the business cycle, and people's expectations are not always rational. John Maynard Keynes described the cause as "animal spirits," or people's tendency to let emotions, particularly swings from excessive optimism to excessive pessimism, influence their economic actions. For example, businesses make investment decisions based on their projections of future rates of return, which will depend on future sales and so on. These inherently uncertain projections change as current conditions change. If businesses believe economic conditions will be unfavorable in the future, they will not make investments today, reducing the growth rate of GDP from what it otherwise would have been. Likewise, households may postpone purchases of durable goods or housing if economic conditions look unfavorable. People's projections of the future may be overly influenced by the present or recent past. "Economic shocks" also play a dominant role in the business cycle. A shock refers to any sharp and sudden change in economic circumstances on the demand or supply side of the economy that disrupts the steady flow of economic activity.