Aggregate Supply and Demand at Work

    We can use the tools of aggregate supply and demand to understand some of the major events of post-World War II American history-the Vietnam war boom, the stagnation of the 19708, and the deep recession of the early 1980s.

   Vietnam War Boom The American economy experienced a period of unprecedented recovery and prosperity during the early 19603. GNP grew 4 percent annually, unemployment declined, and inflation was virtually absent.

   What forces lay behind this vigorous expansion? During this period, macroeconomic policymakers took fiscal measures to stimulate the economy by in~ creasing aggregate demand. In 1964 and 1965, personal and corporate taxes were cut sharply. By 1965, the economy was at its potential output.

   Unfortunately, the administration underestimated the size of the buildup for the Vietnam war; defense spending grew by 55 percent from 1965 to 1968. Even when it became clear that a major inflationary boom was underway, President Johnson refused to take painful fiscal steps to slow the economy-tax increases and civilian expenditure cuts came only in 1968, too late to prevent overheating. The Federal Reserve allowed rapid money growth and low interest rates to prevail. As a result, for much of the period 1966-1970, the economy operated far above its potential output.

   Figure 5-9 illustrates the events of this period. The tax cut and defense expenditures increased aggregate demand, shifting the AD curve to the right from AD to AD. The equilibrium moved from E to E. Output and employment rose sharply, but prices began to creep upward as output bumped capacity limits.

The lesson of this episode is that increasing aggregate demand produces a harvest of higher output and employment, but if expansion takes the economy well beyond potential output,an overheated economy and rice inflation will soon follow.
 
   Supply-Side Inflation Another important macroeconomic phenomenon, known as a supply shock, was seen during the 19705. A supply shock refers to a sudden change in conditions of cost or productivity that has a discontinuous impact upon aggregate 211. Supply shocks occurred with particular virulence in 1973, called the “year of the seven plagues,” which included crop failures, shifting ocean currents, massive speculation on world commodity markets, turmoil in foreign exchange markets, and a quadrupling of the price of OPEC crude oil. An “end-of the-world” mentality arose, with the cover of a popular magazine showing an empty cornucopia entitled “Running Out of Everything?”.

This jolt to crude material and fuel supplies showed up dramatically in their prices. The prices of crude materials and fuels rose more from 1972 to 1973 than they had in the entire period from the end of World War II to 1972.

   This sudden rise in the cost of raw materials constituted a supply shock. We can depict it as a sharp upward shift in the aggregate supply curve; to coax the same level of output from businesses would require them to charge substantially higher prices. This is illustrated in Figure 5-10, where the AS curve moves up from AS to AS’.

   A supply shock, seen as a sharp upward shift in the AS curve, results in higher prices along with a decline in output. Supply shocks thus lead to a deterioration of all the major goals of macroeconomic policy. 

   Tight Money, 1979-1982 By 1979 the economy had recovered from the 1973 supply shock. Output had returned to its potential. Just when inflation had slowed, however, another round of oil-price increases contributed to an accelerating two-digit inflation rate averaging 12 percent per year for 1979-1980. Such a rate was regarded as unacceptably high by political leaders of both the left and the right.

   Faced by an unacceptable inflation rate, policymakers took steps to slow economic growth and raise unemployment. The slowdown began when Paul Volcker, former chairman of the Federal Reserve Board, used monetary policy to raise interest rates in 1979 (these steps constitute “tight money”). After Ronald Reagan took office in 1981, his administration encouraged the tight-money policies.

   What was the impact? The higher interest rates led to a slowdown in spending on interest-sensitive components of aggregate demand. After 1979, we saw declines in housing construction, automobile purchases, business investment, and so forth.

   Figure 5-11 pictures the impact of monetary restraint on the economy. Tight money raised interest rates and reduced aggregate demand. This can be seen as a downward shift of the aggregate demand curve exactly the opposite of the impact of the defense buildup during the 1960s. The decrease in aggregate demand reduced output almost 10 percent below its potential by the end of 1982, and the unemployment rate rose from below 6 percent in 1979 to over 10 percent at the end of 1982. What was the reward for these austere measures? Inflation declined from an average of 12 percent per year in the 1979-1980 period to 4 percent during the period from 1983 to 1988. High unemployment succeeded in wringing inflation out of the economy.