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so dwellings, each the size of a dog house or chickencoop, often
constructed with much ingenuity out of wooden boxes, metal
cans, strips of cardboard or old tar paper. Here human beings
lived on the margin of civilization by foraging for garbage, junk,
and waste lumber. I found some . . . picking through heaps of
rubbish they had gathered before their doorways or cooking
over open fires or battered oilstoves. Still others spent their days
improving their rent-free homes . . . Most of them, according to
the police, lived by begging or trading in junk; when all else
failed they ate at the soup kitchens or public canteens. . . . They
lived in fear of being forcibly removed by the authorities, though
the neighborhood people in many cases helped them and the SOURCE: Mathew Josephson, Infidel in the Temple (New York: Knopf, 1967),
police tolerated them for the time being. pp. 82“83.




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Chapter 5 95
An Introduction to Macroeconomics



The Great Depression was a worldwide event; no country was spared its ravages. It lit-
erally changed the histories of many nations. In Germany, it facilitated the ascendancy of
Nazism. In the United States, it enabled Franklin Roosevelt to engineer one of the most
dramatic political realignments in our history and to push through a host of political and
economic reforms.

A Revolution in Economic Thought The worldwide depression also caused a
much-needed revolution in economic thinking. Until the 1930s, the prevailing economic
theory held that a capitalist economy occasionally misbehaved but had a natural tendency
to cure recessions or inflations by itself. The roller coaster bounced around but did not run
off the tracks. But the stubbornness of the Great Depression shook almost everyone™s faith
in the ability of the economy to correct itself. In England, this questioning attitude led
John Maynard Keynes, one of the world™s most renowned economists, to write The Gen-
eral Theory of Employment, Interest, and Money (1936). Probably the most important econom-
ics book of the twentieth century, it carried a message that was considered revolutionary
at the time. Keynes rejected the idea that the economy naturally gravitated toward smooth
growth and high levels of employment, asserting instead that if pessimism led businesses
and consumers to curtail their spending, the economy might be condemned to years of
stagnation.
In terms of our simple aggregate demand“aggregate supply framework,
Keynes was suggesting that there were times when the aggregate demand
curve shifted inward”as depicted in Figure 2 on page 87. As that figure
showed, the consequence would be declining output and deflation. This dole-
ful prognosis sounded all too realistic at the time. But Keynes closed his book
on a hopeful note by showing how certain government actions”the things we


SOURCE: © Pictorial Press Ltd/Alamy
now call monetary and fiscal policy”might prod the economy out of a de-
pressed state. The lessons he taught the world then are among the lessons we
will be learning in the rest of Part 2 and in Part 3”along with many qualifica-
tions that economists have learned since 1936. These lessons show how govern-
ments can manage their economies so that recessions will not turn into
depressions and depressions will not last as long as the Great Depression, but
they also show why this is not an easy task.
While Keynes was working on The General Theory, he wrote his friend John Maynard Keynes
George Bernard Shaw that “I believe myself to be writing a book on economic
theory which will largely revolutionize . . . the way the world thinks about eco-
nomic problems.” In many ways, he was right.



From World War II to 1973
The Great Depression finally ended when the United States mobilized for war in the early
1940s. As government spending rose to extraordinarily high levels, it gave aggregate de-
mand a big boost. Thus, fiscal policy was (accidentally) being used in a big way. The The government™s fiscal
policy is its plan for spend-
economy boomed, and the unemployment rate fell as low as 1.2 percent during the war.
ing and taxation. It can be
Figure 1(b) on page 86 suggested that spending spurts such as this one should lead to
used to steer aggregate
inflation. But much of the potential inflation during World War II was contained by price
demand in the desired
controls. With prices held below the levels at which quantity supplied equaled quantity direction.
demanded, shortages of consumer goods were common. Sugar, butter, gasoline, cloth, and
a host of other goods were strictly rationed. When controls were lifted after the war, prices
shot up.
A period of strong growth marred by several recessions after the war then gave way to
the fabulous 1960s, a period of unprecedented”and noninflationary”growth that was
credited to the success of the economic policies that Keynes had prescribed in the 1930s.
For a while, it looked as if we could avoid both unemployment and inflation, as aggregate
demand and aggregate supply expanded in approximate balance. But the optimistic
verdicts proved premature on both counts.



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Part 2
96 The Macroeconomy: Aggregate Supply and Demand



Inflation came first, beginning about 1966. Its major cause, as it had been so many times
in the past, was high levels of wartime spending. The Vietnam War pushed aggregate de-
mand up too fast. Later, unemployment also rose when the economy ground to a halt in
1969. Despite a short and mild recession, inflation continued at 5 to 6 percent per year.
Faced with persistent inflation, President Richard Nixon stunned the nation by instituting
wage and price controls in 1971, the first time this tactic had ever been employed in peace-
time. The controls program held inflation in check for a while. But inflation worsened dra-
matically in 1973, mainly because of an explosion in food prices caused by poor harvests
around the world.



The Great Stagflation, 1973“1980
In 1973 things began to get much worse, not only for the United States but for all oil-
importing nations. A war between Israel and the Arab nations precipitated a quadrupling of
oil prices by the Organization of Petroleum Exporting Countries (OPEC). At the same time,
continued poor harvests in many parts of the globe pushed world food prices higher. Prices
of other raw materials also skyrocketed. By unhappy coincidence, these events came just as
the Nixon administration was lifting wage and price controls. Just as had happened after
World War II, the elimination of controls led to a temporary acceleration of inflation as
prices that had been held artificially low were allowed to rise. For all these reasons, the in-
flation rate in the United States soared above 12 percent during 1974.
Meanwhile, the U.S. economy was slipping into what was, up to then, its longest and
most severe recession since the 1930s. Real GDP fell between late 1973 and early 1975, and
the unemployment rate rose to nearly 9 percent. With both inflation and unemployment
unusually virulent in 1974 and 1975, the press coined a new term”stagflation”to refer
Stagflation is inflation
that occurs while the to the simultaneous occurrence of economic stagnation and rapid inflation. Conceptually,
economy is growing slowly what was happening in this episode is that the economy™s aggregate supply curve, which
(“stagnating”) or in a
normally moves outward from one year to the next, shifted inward instead. When this
recession.
happens, the economy moves from a point like E to a point like A in Figure 7. Real GDP
declines as the price level rises.
Thanks to a combination of government actions and natural economic forces, the econ-
omy recovered. Unfortunately, stagflation came roaring back in 1979 when the price of oil
soared again. This time, inflation hit the astonishing rate of 16 percent in the first half of
1980, and the economy sagged.



F I GU R E 7
The Effects of an S1
Adverse Supply Shift D
S0



A
Price Level




E




S1 D

S0


Real GDP




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Licensed to:

Chapter 5 97
An Introduction to Macroeconomics



Reaganomics and Its Aftermath
Recovery was under way when President Ronald Reagan assumed office in January 1981,
but high inflation seemed deeply ingrained. The new president promised to change things
with a package of policies”mainly large tax cuts”that, he claimed, would both boost
growth and reduce inflation.
However, the Federal Reserve under Paul Volcker was already deploying monetary Monetary policy refers to
actions taken by the Fed-
policy to fight inflation”which meant using excruciatingly high interest rates to de-
eral Reserve to influence
ter spending. So while inflation did fall, the economy also slumped”into its worst
aggregate demand by
recession since the Great Depression. When the 1981“1982 recession hit bottom, the
changing interest rates.
unemployment rate was approaching 11 percent, the financial markets were in disar-
ray, and the word depression had reentered the American vocabulary. The U.S. govern-
ment also acquired chronically large budget deficits, far larger than anyone had
dreamed possible only a few years before. This problem remained with us for about
15 years.
The recovery that began in the winter of 1982“1983 proved to be vigorous and long last-
ing. Unemployment fell more or less steadily for about six years, eventually dropping
below 5.5 percent. Meanwhile, inflation remained tame. These developments provided an
ideal economic platform on which George H. W. Bush ran to succeed Reagan”and to
continue his policies.
But, unfortunately for the first President Bush, the good times did not keep rolling.
Shortly after he took office, inflation began to accelerate a bit, and Congress enacted a
deficit-reduction package (including a tax increase) not entirely to the president™s liking.
Then, in mid-1990, the U.S. economy slumped into another recession”precipitated by yet
another spike in oil prices before the Persian Gulf War. When the recovery from the
1990“1991 recession proved to be sluggish, candidate Bill Clinton hammered away at the
lackluster economic performance of the Bush years. His message apparently resonated
with American voters.



Clintonomics: Deficit Reduction and the “New Economy”7
Although candidate Clinton ran on a platform that concentrated on spurring eco-
nomic growth, the yawning budget deficit forced President Clinton to concentrate
on deficit reduction instead. A politically contentious package of tax increases and
spending cuts barely squeaked through Congress in August 1993, and a second
deficit-reduction package passed in 1997. Transforming the huge federal budget
deficit into a large surplus turned out to be the crowning achievement of Clinton™s
economic policy.
Whether by cause or coincidence, the national economy boomed during President
Clinton™s eight years in office. Business spending perked up, the stock market soared, un-
employment fell rapidly, and even inflation drifted lower. Why did all these wonderful
things happen at once? Some optimists heralded the arrival of an exciting “New
Economy””a product of globalization and computerization”that naturally performs
better than the economy of the past.
The new economy was certainly an alluring vision. But was it real? Most mainstream
economists would answer: yes and no. On the one hand, advances in computer and in-
formation technology did seem to lead to faster growth in the second half of the 1990s.
In that respect, we did get a “New Economy.” But something more mundane also hap-
pened: A variety of transitory factors pushed the economy™s aggregate supply curve
outward at an unusually rapid pace between 1996 and 1998. When this happens, the
expected result is faster economic growth and lower inflation, as Figure 8 shows.




One of the authors of this book was a member of President Clinton™s original Council of Economic Advisers.
7




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Licensed to:
Part 2
98 The Macroeconomy: Aggregate Supply and Demand



F I GU R E 8
S0
D1
The Effects of a
Favorable Supply Shift
S1
D0
S2
C

B
E




Price Level S0
D1
S1

D0
S2

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