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Economics "Ask the Instructor" Clip 41 Transcript Is a recession inevitable after a major war is over? A major war definitely qualifies as an external shock to the economy. Government spending soars at the outset of a war. This causes aggregate expenditures to increase. Assuming that crowding out is not complete, the economy’s aggregate demand curve shifts to the right. However, once the war is over, military spending typically declines. The question is whether the decline in military spending that usually follows a war is certain to cause a recession. The short answer is no. Recessions did occur after both the Korean and Vietnam conflicts. But any shock to the economy can cause shifts in either aggregate demand or aggregate supply and, therefore, fluctuations in economic activity. In fact, three of the six recessions that have occurred since World War II have been associated with rising oil prices. But exactly what happened to the economy during the years immediately following World War II, our nation’s most expensive war. The decrease in military spending that occurred after WWII dwarfs the decreases that followed either the Korean or Vietnam conflicts. For example, between 1953 and 1956 military spending fell by about 27 percent. Following the Vietnam conflict, military spending fell by only 10 percent. In contrast, military spending fell by a whopping 90 percent following WWII. Because the decline in military spending was not entirely offset by increases in other types of government spending, federal spending overall declined by about 58 percent between 1945 and 1948. The U.S. economy did experience a recession after WWII. But it was not as severe as many had predicted. Constant dollar GDP in 1946 was about 12 percent below the 1945 level. Why was the economic downturn not more severe? Apparently, some crowding-in, the opposite of crowding out occurred! In other words, the reduction in government spending was partly (but not completely) offset by increases in private sector spending by household and businesses. For example, private investment increased by over 200 percent between 1945 and 1948. And consumer spending increased by over 15 percent. Pent-up demand is the reason usually given for the large increases in consumer spending that occurred after WWII. This refers to the fact that consumers had been forced to defer buying consumer goods because much of the economy’s plant and equipment had been converted from producing consumer goods to producing military output. In fact, no cars were produced during the war years. Auto plants had been converted to the production of military hardware such as army trucks and jeeps. In summary, there was a lot of concern immediately after WWII, particularly on the part of economists who had studied the new Keynesian theory, that there would be a huge deficiency of demand, which would cause the economy, to sink into a deep depression. The concern is understandable given that most of the decade prior to WWII had been characterized by depression. Some would interpret the fact that the economy avoided a major recession as supporting the classical model. Others would cite the 12 percent drop in output as evidence in support of the Keynesian model. Those who support the classical model believe that the economy adjusts relatively quickly; those who accept the Keynesian model think that the adjustments require many months or even years.