The Aggregate Demand Aggregate Supply framework helps describe macroeconomic problems and enables us to interpret recent economic history. This section provides an overview of U.S. business cycles in the twentieth century. Our discussion begins with the 1920s because the events of that decade and the next profoundly changed American perspectives on capitalism.

The Prosperous 1920s

The 1920s were prosperous by any yardstick. Following a minor dip in business activity after World War I, the United States enjoyed a boom lasting until 1929. Prosperity was sparked by (a) rapid growth of technology, labor productivity, and productive capacity; (b) the popularity of such new and important goods as telephones, radios, and autos; (c) the electrification of homes and industries; and (d) a wave of optimism lasting until 1929.

 

Rising auto production propelled such subsidiary industries as oil and rubber. Nationwide electrification also spurred demands for capital equipment and consumer goods. These were key ingredients for record growth. Rapid technological advances allowed growth without inflation because Aggregate Supply kept pace with growing Aggregate Demand.

The Great Depression of the 1930s

The year 1929 began with optimism that the boom would continue, but by October, a business slump was clearly under way. Then the economy collapsed, not to recover fully until the eve of World War II.15 Real disposable income fell more than 26% between 1929 and 1933, while unemployment rates mounted from 3.2% to nearly 25%. The 6% to 8% annual drop in average prices between 1929 and 1933 may sound great, but lower prices were almost meaningless to jobless workers. Family incomes and assets melted away. Despite sharp cuts in consumption spending, years of accumulated savings evaporated, and investment was insignificant.

 

Public welfare programs were meager, so the burden of relief fell primarily on private charities. But harsh times squelched donations. Average people in some countries suffered even more than most Americans; the Great Depression was worldwide. Many families became homeless when they could not afford rent. Other more fortunate families who were evicted from their homes lived with relatives for as long as possible. It was as if large parts of our population had been swept into the Dark Ages. Entire families spent their days prowling garbage dumps and foraging for scraps of clothing and food with which to stay warm and alive.

 

Hindsight provides explanations for the Great Depression that could not be derived from the supply-side emphasis of classical theory that dominated economic thinking into the 1930s. In Figure 11, if the Aggregate Demand curve falls from AD0 to AD1 (Panel B) the price level and real national income (Q) both decline. Employment is closely tied to national output, so employment also falls and unemployment rates tend to rise. Thus, recessions and depressions are almost uniformly periods when Aggregate Demand has plummeted.

 

War and Its Aftermath in the 1940s

The economy falteringly began to recover after the trough of 1933, but unemployment still hovered at 15% in 1940. Massive defense spending during World War II snapped the economy out of the depression in the early 1940s, apparently confirming John Maynard Keynes s ideas in his General Theory that recessionary trends could be overcome by boosting Aggregate Demand with massive doses of government spending.

 

The government imposed rationing to divert output to the war effort and price controls in attempts to defuse inflationary pressures. After World War II, most consumers had amassed huge savings because many goods had been tightly rationed or not produced at all. The price level jumped about 10% in 1946, after the war had ended and price controls were lifted. Aggregate Demand grew when families binged on new cars and appliances; manufacturing plants for these products had been restricted to war goods.

The Sluggish 1950s

The 1950s witnessed modest growth and nagging, but mild, doses of inflation. At the onset of the Korean War, many consumers, remembering the hassles from price controls and ration stamps during World War II, tried to stockpile goods they thought might be rationed. This panic buying precipitated a brief inflationary burst, but the price level was relatively stable over the rest of the decade, climbing at average annual rates of only 1% to 2%. A mild recession followed the Korean War (1950 1953), and another ended the decade.

The Booming 1960s

John F. Kennedy was the first major U.S. politician to propose tax cuts to stimulate Aggregate Demand when the economy was not in a deep depression. Lyndon Johnson s administration followed through with sharp cuts in tax rates. The experiment worked, and the nation heralded an era of prosperity under the guiding hands of Washington economists.

 

Panel B in Figure 11 helps characterize trends in the 1960s. Growth of Aggregate Demand from AD1 to AD0 increases employment, national income, and the price level. Many economists thought that macroeconomic fine-tuning could reduce an apparent trade-off between unemployment and inflation to a minor irritant. Then pressure from the Vietnam War began overheating our economic engine. Nevertheless, unemployment dropped to a low 3.2%, and the federal budget was last balanced in 1969.

Stagflation in the 1970s

Demand-side inflationary forces during the Vietnam War era induced President Nixon to introduce peacetime wage and price controls on August 15, 1971. The mid-1970s saw our first brush with serious supply-side inflation. Lagging productivity growth and rising prices for energy and other raw materials erupted in inflation and high unemployment that persisted through the decade. Real output grew slowly; on the average, unemployment rates rose, while the United States experienced its most persistent and severe inflation since the Civil War.

 

 

This stagflation is characterized in Figure 12. Although the economy as a whole grew in the 1970s, growth in Aggregate Supply remained below that of Aggregate Demand; the shift from AS0 to AS1 in Panel B of Figure 12 reflects this relative movement. Thus, declines (or slower growth) in Aggregate Supply relative to Aggregate Demand may account for economic stagnation.

 

 

The Erratic 1980s

From 1981 to 1983, attempts to quell inflation and reduce record interest rates fomented the deepest recession since the 1930s, illustrated as a decline in Aggregate Demand in panel B of Figure 10.  Supply-side tax cuts enacted in 1981 eventually stimulated both Aggregate Demand and economic growth. By the mid-1980s, inflation and unemployment were both relatively low, but federal deficits continued to mushroom. The U.S. national debt, which had tripled in the 1970s, tripled again between 1980 and 1990.

 

The international competitiveness of the U.S. economy became a paramount issue when goods from Pacific Rim countries (Japan, Taiwan, Hong Kong,...) and the European Community began flooding world markets, dislodging American products from markets they had once dominated. The dollar s status as the world s premier currency, which had begun to erode in the 1970s, continued to drift during the 1980s, and U.S. balances of payments and trade experienced huge deficits from 1982 into the 1990s. In the late 1980s, communist governments in Eastern Europe tumbled like rows of dominoes, heralding an end to a Cold War that had begun at the end of World War II. The decade closed with the United States in the midst of a prolonged but relatively minor recession.

Muddling Through in the 1990s

Huge deficits in the federal budget and in U.S. balances of trade and payments persisted into the mid-1990s, despite enactment of Deficit Reduction Acts in 1990 and 1993. Interest rates fell to the lowest rates in decades, but a recovery from a shallow worldwide recession proceeded only slowly after an upturn began in 1992. Trade barriers were lowered or largely eliminated worldwide through the General Agreement on Tariffs and Trade (GATT), between the United States, Canada and Mexico in the North American Free Trade Agreement (NAFTA), and through treaties in several other regions. People everywhere increasingly realized that adapting to the internationalization of almost all economies might be as formidable a task as curing the Great Depression seemed in 1933.

 

Macroeconomic analysts and government policymakers alike increasingly advocate cures for structural inefficiencies as ways to boost Aggregate Supply into the twenty-first century, with emphasis on increased efficiency in certain sectors of the economy. In the United States, movements were launched to reinvent (streamline) government and to reform the health-care system, which had grown from about 5% of national income in the 1950s to absorb roughly 14% of income by 1994.

 

Our Aggregate Demand Aggregate Supply framework helps illustrate economic events and the major goals of macroeconomic policy: full employment, price stability, and economic growth. But before we can discuss macroeconomic goals and policy options, we need to know more about the anatomy of unemployment, inflation, and growth.