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Studying for a test? Prepare with these 5 lessons on Aggregate demand and aggregate supply.
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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.