Introduction

In the first age of rapid economic growth after 1945, fluctuations in western European output and employment were so mild that the very notion of a “cycle” was transformed or even seemed obsolete. A second period of much slower average economic growth was marked by large and frequent oscillations, associated with the “oil shocks” and the Great Inflation of the 1970s and early 1980s. A third phase, characterized by smooth and modest swings in output and inflation which lasted until 2007, has been dubbed the “Great Moderation,” reflecting the gradual reduction of inflationary trends.

Different reasons have been proposed for these changing patterns, but a common factor is that the conduct of economic policy was critical. In this chapter we explain how governments contributed and responded to fluctuations in economic activity in Europe during the second half of the twentieth century. In the second section we sketch the basic ideas essential to understanding the relationship between economic policy and business cycles. They include the notion that monetary and fiscal policies influence fluctuations in output, employment, and inflation according to the financial openness of the economy (free capital flows versus capital controls), as well as the currency regime chosen by policy makers (pegged versus flexible exchange rates). We also document the timing of financial liberalization in Europe and the persistent preference of most European governments for pegged exchange rate regimes over the entire period.