Demand-pull inflation under Johnson
A real-world example of the concepts behind the AD-AS model is the inflation that the United States experienced in the late 1960s. In this video, we break down some of the events going on at the time and use the AD-AS model to see if our predictions using this model match what really happened. Created by Sal Khan.
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- At9:06, real GDP returns to normal and prices are left inflated. Why doesn't the aggregate demand curve shift back and bring prices down along with it?(38 votes)
- This is an excellent question! Normally, one would expect that to happen in the AS/AD model. One major reason why AD doesn't return to its original equilibrium position has to do with wages in the modern era, which tend to be upwardly sticky -- that is, more likely to go up over time, but rarely down.
Assume for the moment that wages and salaries increase to keep pace with inflation. (These are called cost of living adjustments, remember.) Even if later the U.S. actually experienced a price level drop -- say, due to a decline in Aggregate Demand as government spending is cut -- the wages of American workers would probably not decrease in response. This is for various reasons, one being that the political cost of reducing the federal minimum wage would be too high for most lawmakers to seriously consider it. Consequently, American workers' real wages -- the buying power of their take-home dollars -- would begin to increase as price levels dropped. Their consumption would then increase in response, helping to offset the AD shift backward and maintain a higher price level than normal.
Couple this with the fact that wages are a major input price for all goods and services, and the end result is that price levels over the long term never seem to drop back to their former equilibrium point, but settle in at the new higher level produced by prior economic expansion. The AD curve shifts back only to the point where it intersects the LRAS curve at that higher price level; the SRAS curve would then adjust to intersect with the new LRAS/AD equilibrium.
A true deflationary effect in the macroeconomy would only occur due to a major recession with a huge decrease of Aggregate Demand; or by a significant increase in Short Run Aggregate Supply due to conditions that dramatically reduce production costs, allowing prices to drop while maintaining profitability and high employment.(65 votes)
- So, you can push the economy pretty hard and still have a low inflation as long as you don't overgo the economy's natural potential. If you do overheat, that's when you get a high inflation. Is that right? Is the only reason that a high inflation is bad that it signifies a unsustainable economy that might break down in the future? Or are there other ways to explain why high inflation is bad?(12 votes)
- Hi. You are right about the overheat.
A high rate of inflation usually disrupts investment scheduling: Noone wants to invest $1 dollar "today" with the risk being paid in (very) depreciated dollars "tomorrow".
If a high inflation rate is persistent, it gives rise to the risk of hyperniflation: An out of control spiral of wage and price rises, which is almost equivalent to default.(6 votes)
- In order to increase short term aggregate supply, the prices must go up. The prices would only go up if there is some sort of increase in aggregate demand. The example that Sal used to describe an increase in aggregate demand is a tax cut. The only problem is, it might increase a consumers demand for goods and services, but it will decrease the demand for the government goods and services. This means that there is actually no net change in aggregate demand. Will somebody please explain??!!(3 votes)
- That is if you are assuming that government spending will drop to match the tax cut. That is not the case in this example. Taxes drop, government spending stays the same, causing an increasing governent budget deficit.(5 votes)
- during the economic condition like now, what if we do the opposite to LBJ, we can allow deflation and wait the real GDP back to track(3 votes)
- Deflation can cripple an economy for decades and is not necessarily something you can just wait out.
Japan has been struggling with deflation for over 25 years and is taking some pretty drastic measures to try and stop it.(5 votes)
- At9:06shouldn't the SRAS move back to the left as workers demand for more wages so the equilibrium shifts back in line with the LRAS?(4 votes)
- Yes, as aggregate price (cost of production) goes up, the short run AS curve would shift towards intersecting the long run AS line at the current aggregate price. If the AD remained static as the AS adjusted, the inflation would continue until the aggregate price reached the intersection of the AD and LRAS. In reality, the AD curve will continue to shift as worker wages and government spending would also be adjusted in response to the inflation until the government spending (or taxation) policies are adjusted to stop overheating the economy. The overheating of the economy would not have occurred if LBJ had increased taxes to pay for the war and social programs because the government spending contribution to GDP would be offset by the decreased consumer spending due to the taxes. It is by taking on more debt that the government has the power to overheat the economy.(2 votes)
- Why wasn't the inflation under JFK? If his measures did the same as LBJ (shift the demand curve to the right) in order to bring the economy to its long run equilibrium, surely this would (acording to this model) cause some inflation aswell? As Sal said in a previous video, employment/inflation is a trade-off(2 votes)
- There was inflation during the Kennedy administration, but it wasn't as high as during the Johnson administration. Not to get too far into the weeds (and into more intermediate level macro), but some of it has to do with how much slack there is in the economy with regards to the price level and output.
Also, there is believed to be only a short-run tradeoff between inflation and unemployment.(3 votes)
- why is AD(gdp)and rgdp on the same graph but ones slopped and one is not?
Edit: o wait gdp curves because of inflation and rgdp is suppose to already include inflation making it a constant measurement.
how can you increase government spending and lower taxes at the same time?(2 votes)
- Borrowing! In a later lesson, we learn about the relationship between running a deficit (which is what happens when taxes are less than government spending) and interest rates.(2 votes)
- what is Keynesian policies Sal mentions at1:20?(1 vote)
- In this context, Keynesian policies generally refer to the use of government spending to stimulate an economy.(4 votes)
- Sal says the word inflation several times. What does that mean?(1 vote)
- Inflation is essentially when the prices of goods and services all increase, or value of money decreases. Think of it this way: last year, you were able to buy a gumball for 15 cents. This year, you bring 15 cents to the store to buy a gumball and the price went up to 35 cents, so the money you have can no longer be exchanged for the gum and instead you need more money. Now imagine that this is how it is for everything you try to buy this year (your fifteen cents isn't as valuable as it once was). Inflation is when the prices rise, but you don't get any richer (yet) to make up for the difference.(4 votes)
- what is the difference between inflation and expansionary gap?(1 vote)
- Inflation is a result of an expansionary gap (in some economic models). The expansionary gap is sometimes called an inflationary gap.(2 votes)
Male voice: What I want to do in this video is a little bit of 1960's U.S. economic history and then just see if our Aggregate Demand Aggregate Supply model fits the description of what actually happened. One could argue you don't need the ADAS model to describe what happened, but we should at least make sure that it does describe what happened. If we go to 1960, this is the very end of the Eisenhower administration. Eisenhower was a Republican in office. The only reason why I give his party affiliation is because if the economy is weak, and in 1960 the economy was weak and one can always debate whether it was due to the government or whether it was due to just the natural fluctuations in the economy, but in general, when the economy is weak, it tends to go against the party that is in power. In 1960, the Republicans were in power. There was a recession. One could argue that was a major reason why the Democratic candidate in the 1960 election was able to win, John F. Kennedy. In 1961, JFK is inaugurated. He becomes President of the United States. One of his top goals is to try to turn around this economy. He does it with what can best be described as Keynesian policies, and we'll talk more about that in future videos. In fact, I should probably devote many videos to Keynesian policies. It's the general idea that the government might be able to turn around a recession by sparking demand. The way that it would spark demand is try to put more money in people's pockets, or even in businesses' pockets. It would do that through some combination of increased government spending, maybe somehow giving money to the poor, some types of transfer programs, and tax cuts for people and for businesses so that they have more money to spend. These policies get implemented and over John F. Kennedy's term you do have GDP begins to turn back around, unemployment, I'll just write employment goes up, and inflation stays low. Inflation is low. These are all of the things that you want in an economy. Unfortunately, this is just kind of a sad human event, in 1963, John F. Kennedy, you probably know, is assassinated. Then his Vice President, Lyndon Baines Johnson, that is LBJ right over there, Lyndon Baines Johnson becomes President. LBJ becomes President. A little bit of trivia: He's tied for the tallest President in U.S. history, tied with Abraham Lincoln at 6'4". He inherits a very, very good economy; almost, one could argue, a perfect economy. If Keynesian policies were really to be practiced here to their full idea, in theory, once the economy started to get a little bit really overheated and really approaching its potential, in maybe 1964-1965, the government maybe should have started to pull back a little bit on its spending so that the economy doesn't get overheated. But Lyndon Baines Johnson did not do this. He kept things going, and in fact he added more fuel to the fire. One could argue that some of it was driven by geopolitics. A major factor was right over here, the Vietnam War, which was escalated in a major way under LBJ's administration. JFK was already dabbling in Vietnam, but it became a really major war for the United States under Lyndon Baines Johnson. So some combination of Vietnam, and he had a huge number of social programs, increased government spending, to try to ease inequality in the U.S. as well, so social programs. One could call it guns and butter. Social programs to try to ease inequality. The net effect of this is government spending even though the economy was already red hot, it was already at its potential, he wanted to increase government spending even more, so he kind of took it beyond its potential. He made it overheat a little bit and what happens in 1966 and onwards is that you have inflation starting to grow at a fairly uncomfortable rate. Inflation starts to grow dramatically. Just to get a sense of it, when I keep saying that the economy was at its potential and maybe he might have taken a little bit of his pedal off the gas, or his foot off of the pedal, I should say, is as we get into the beginning of his administration, 1964-1965, unemployment is in the 4-5% range. Inflation is in the 1-2% range. GDP is growing at a very healthy rate. Despite that, and maybe he could argue maybe his hand was forced by geopolitical events especially on military funding, the government continues to even spend more money, stimulates things even more because that money goes to soldiers' salaries, it goes to companies that provide, I guess that make napalm or make boats or make whatever else. All of these government programs inject even more dollars into the economy, and so you ended up with inflation. The economy was already operating at close to capacity and it made it go maybe even beyond its natural capacity. Let's see whether our ADAS model would make, would allow for this to happen, or would describe this, or would predict this given what was going on. Let's draw ... That right over there is my price axis. This right over here is my real GDP axis. Let me scroll down a little bit. This right over here is real GDP. If we go into the 1964-1965 timeframe, you could say that the U.S. is performing at its potential GDP. When I talk about its potential GDP, I'm saying that on the long run, assuming that people aren't overworked, assuming that factories are getting their proper maintenance, they're not being run so hard that they start cracking at the seams, this is how much that the U.S. can produce. If theory, if everyone worked even harder and didn't sleep and were doing things in an unsustainable way, they might even be able to produce more. One could view this as a theoretical maximum. When we talk about potential we're not talking about that short term theoretical maximum, we're talking about the maximum GDP that an economy can produce, I guess you could say, in a healthy way, or over the long run, assuming that people aren't overworked and that the factories aren't overworked in some way, shape or form. This could be our situation maybe in 1964-1965. Let's draw this right over here is the level of prices. We just want to see if, in general, we get this type of thing happening from our model. This is our aggregate supply in the long run. Our aggregate supply in the short run we know might look something like this. That's aggregate supply in the short run. Then from our model we will assume ... Let me draw that a little bit neater so it intersects a little bit better. This right over here is aggregate ... let me draw it a little bit better than that with the slope ... This is our aggregate supply in the short run. Aggregate supply in the short run. Let's draw our aggregate demand. I'll do that in this green color. Aggregate demand might look something like that. That is our aggregate demand. This is 1964-1965. Here we are, the economy's humming along at its potential. Now more gas is thrown on the flame. Government accelerates its spending; not just to turn on the economy; now because of Vietnam and all of these social programs. What's going to happen? That money's ending up in company and people's pockets, they're going to demand more. It's going to shift the demand curve to the right. At any given price, they're going to demand more. Aggregate demand is going to shift to the right. Maybe it goes, it shifts to the right, and maybe it goes someplace right over there. What is the new short term equilibrium? Aggregate demand is intersecting aggregate supply right over here. Right over there, and as we see, the equilibrium level of prices on this model now has gone up. Our productivity, we're now producing above potential. We're overheating a little bit. Actually, if you look at the data in 1966-1967, unemployment did become ridiculously low. It even got in kind of the three point something percent for a little while. Many people would argue that even now that is an unnaturally low level of unemployment; that people and factories are really operating at, maybe beyond full capacity, or beyond a sustainable full capacity. But, we see from this model what you think would happen actually does happen. Prices would go up. Right over there. Then on the long run, you really wouldn't be able to sustain this level of producing above your potential, and over the long run things would settle back right over here, and all you're left with, really, is the inflation.