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17.1 The Great Depression and also Keynesian Economics

Learning Objectives

Exordinary the standard assumptions of the timeless college of assumed that dominated macroeconomic reasoning prior to the Great Depression, and also tell why the severity of the Depression struck a significant blow to this watch. Compare Keynesian and classic macroeconomic believed, mentioning the Keynesian explanation of extended recessionary and also inflationary gaps as well as the Keynesian approach to correcting these difficulties.

It is difficult to imagine that anyone that lived in the time of the Great Depression was not profoundly affected by it. From the start of the Depression in 1929 to the moment the economy hit bottom in 1933, actual GDP plunged almost 30%. Real per capita disposable revenue sank practically 40%. More than 12 million people were thrown out of work; the unemployment rate soared from 3% in 1929 to 25% in 1933. Some 85,000 businesses failed. Hundreds of countless families lost their houses. By 1933, about fifty percent of all mortgeras on all city, owner-populated dwellings were delinquent.David C. Wheelock, “The Federal Response to Home Mortgage Distress: Lessons from the Great Depression,” Federal Reserve Bank of St. Louis Review 90, no. 3 (Part 1) (May/June 2008): 133–48.

You are watching: Classicals saw the depression as a political problem, not an economic problem. why?

The economic situation started to recuperate after 1933, however a substantial recessionary gap persisted. Another downturn started in 1937, pushing the unemployment rate earlier up to 19% the complying with year.

The contraction in output that began in 1929 was not, of course, the first time the economy had actually slumped. But never before had actually the U.S. economic situation fallen so much and also for so long a duration. Economic historians estimate that in the 75 years prior to the Depression tright here had been 19 recessions. But those contractions had lasted an average of less than 2 years. The Great Depression lasted for even more than a decade. The severity and duration of the Great Depression differentiate it from various other contractions; it is for that reason that we give it a a lot stronger name than “recession.”

Figure 17.1 "The Depression and the Recessionary Gap" mirrors the course of genuine GDP compared to potential output throughout the Great Depression. The economic situation did not technique potential output until 1941, when the pressures of people battle compelled sharp increases in accumulation demand also.

Figure 17.1 The Depression and also the Recessionary Gap


The dark-shaded area shows actual GDP from 1929 to 1942, the upper line shows potential output, and the light-shaded location mirrors the difference between the two—the recessionary gap. The gap almost closed in 1941; an inflationary gap had actually opened up by 1942. The chart suggests that the recessionary gap continued to be extremely large throughout the 1930s.

The Classical School and also the Great Depression

The Great Depression came as a shock to what was then the conventional wisdom of economics. To view why, we have to go earlier to the timeless heritage of macroeconomics that dominated the economics profession when the Depression started.

Classical economicsThe body of macrofinancial assumed, linked primarily via nineteenth-century British economist David Ricarcarry out, that focused on the long run and on the forces that identify and also create growth in an economy’s potential output. is the body of macrofinancial believed associated primarily with 19th-century British economist David Ricarcarry out. His Principles of Political Economy and also Taxation, published in 1817, established a heritage that overcame macroeconomic believed for over a century. Ricarcarry out concentrated on the long run and also on the forces that recognize and also develop development in an economy’s potential output. He emphasized the ability of functional weras and prices to keep the economic climate at or close to its natural level of employment.

According to the classic college, achieving what we now call the organic level of employment and also potential output is not a problem; the economy deserve to carry out that on its very own. Classical financial experts well-known, yet, that the process would certainly take time. Ricarperform admitted that tbelow can be temporary durations in which employment would loss below the organic level. But his emphasis was on the lengthy run, and in the lengthy run all would be set appropriate by the smooth functioning of the price mechanism.

Economists of the classical institution witnessed the huge slump that emerged in a lot of the human being in the late 1920s and at an early stage 1930s as a short-run aberration. The economic climate would best itself in the long run, returning to its potential output and also to the organic level of employment.

Keynesian Economics

In Britain, which had been plunged into a depression of its very own, John Maynard Keynes had begun to build a new frame of macroeconomic analysis, one that suggested that what for Ricarperform were “momentary effects” could persist for a long time, and also at damaging expense. Keynes’s 1936 book, The General Theory of Employment, Interest and also Money, was to transdevelop the means many kind of financial experts believed around macroeconomic difficulties.

Keynes versus the Classical Tradition

In a nutshell, we deserve to say that Keynes’s book shifted the thrust of macroeconomic believed from the principle of accumulation supply to the idea of accumulation demand also. Ricardo’s emphasis on the tendency of an economic situation to reach potential output inevitably stressed the supply side—an economy tends to run at a level of output offered by the long-run aggregate supply curve. Keynes, in suggesting that what we now call recessionary or inflationary gaps can be produced by shifts in aggregate demand, moved the focus of macroeconomic evaluation to the demand also side. He argued that prices in the brief run are quite sticky and also said that this stickiness would certainly block adjustments to complete employment.

Keynes dismissed the idea that the economic situation would achieve full employment in the long run as irappropriate. “In the long run,” he created acidly, “we are all dead.”

Keynes’s job-related spawned a new college of macroeconomic thought, the Keynesian institution. Keynesian economicsThe body of macroeconomic assumed that asserts that alters in aggregate demand have the right to produce gaps in between the actual and potential levels of output, and that such gaps can be prolonged. It stresses the usage of fiscal and also financial policy to close such gaps. asserts that transforms in aggregate demand have the right to create gaps between the actual and potential levels of output, and also that such gaps have the right to be expanded. Keynesian economists anxiety the usage of fiscal and of financial policy to cshed such gaps.

Keynesian Economics and the Great Depression

The suffer of the Great Depression certainly appeared continuous with Keynes’s discussion. A reduction in accumulation demand also took the economy from above its potential output to listed below its potential output, and also, as we saw in Figure 17.1 "The Depression and also the Recessionary Gap", the resulting recessionary gap lasted for even more than a decade. While the Great Depression affected many countries, we shall focus on the U.S. experience.

The plunge in accumulation demand began with a collapse in investment. The investment boom of the 1920s had left firms through an expanded stock of capital. As the funding stock approached its preferred level, firms did not need as a lot new capital, and they reduced earlier investment. The stock industry crash of 1929 shook business confidence, further reducing investment. Real gross exclusive residential investment plunged practically 80% in between 1929 and 1932. We have actually learned of the volatility of the investment component of aggregate demand; it was exceptionally a lot in proof in the first years of the Great Depression.

Other determinants contributed to the sharp reduction in accumulation demand. The stock market crash diminished the wide range of a tiny fractivity of the population (just 5% of Americans owned stock at that time), but it certainly decreased the consumption of the basic populace. The stock sector crash also decreased consumer confidence throughout the economy. The reduction in wealth and also the reduction in confidence lessened intake spending and also shifted the accumulation demand also curve to the left.

Fiscal plan likewise acted to reduce aggregate demand also. As usage and revenue dropped, governments at all levels discovered their tax earnings falling. They responded by elevating taxes prices in an effort to balance their budgets. The federal government, for instance, doubled revenue tax rates in 1932. Total federal government tax earnings as a percentage of GDP shot up from 10.8% in 1929 to 16.6% in 1933. Higher taxes prices tended to mitigate consumption and accumulation demand also.

Other countries were experiencing declining incomes also. Their demand also for UNITED STATE products and solutions dropped, reducing the genuine level of exports by 46% in between 1929 and also 1933. The Smoot–Hawley Tariff Act of 1930 dramatically raised tariffs on assets imported right into the United States and also resulted in retaliatory trade-restricting law around the people. This act, which even more than 1,000 economists opposed in a formal petition, added to the collapse of world profession and also to the recession.

As if all this were not enough, the Fed, in impact, carried out a sharply contractionary financial plan in the beforehand years of the Depression. The Fed took no activity to prevent a wave of bank failures that swept the nation at the outcollection of the Depression. Between 1929 and 1933, one-3rd of all financial institutions in the United States failed. As a result, the money supply plunged 31% in the time of the duration.

The Fed might have prevented many kind of of the failures by engaging in open-industry operations to inject new reserves into the device and by lfinishing reserves to troubled banks through the discount window. But it mainly refoffered to carry out so; Fed officials periodically also applauded bank failures as a preferable way to weed out bad management!

Figure 17.2 Aggregate Demand also and also Short-Run Aggregate Supply: 1929–1933


Slumping accumulation demand lugged the economic climate well below the full-employment level of output by 1933. The short-run accumulation supply curve increased as nominal weras dropped. In this analysis, and also in succeeding applications in this chapter of the version of aggregate demand also and also accumulation supply to macrofinancial occasions, we are ignoring shifts in the long-run aggregate supply curve in order to simplify the diagram.

Figure 17.2 "Aggregate Demand and also Short-Run Aggregate Supply: 1929–1933" shows the transition in aggregate demand between 1929, as soon as the economic climate was operating just above its potential output, and also 1933. The plunge in aggregate demand also produced a recessionary gap. Our model tells us that such a gap need to develop falling wperiods, moving the short-run aggregate supply curve to the ideal. That happened; nominal wages plunged about 20% between 1929 and 1933. But we watch that the shift in short-run accumulation supply was inadequate to bring the economy back to its potential output.

The faiattract of shifts in short-run accumulation supply to bring the economy back to its potential output in the at an early stage 1930s was partly the outcome of the magnitude of the reductions in aggregate demand, which plunged the economy into the deepest recessionary gap ever tape-recorded in the United States. We recognize that the short-run accumulation supply curve started shifting to the best in 1930 as nominal wperiods fell, but these shifts, which would ordinarily rise genuine GDP, were overwhelmed by ongoing reductions in aggregate demand also.

A better factor blocking the economy’s return to its potential output was federal policy. President Franklin Roosevelt believed that falling weras and prices were in huge component to blame for the Depression; programs initiated by his administration in 1933 sought to block further reductions in wages and also prices. That stopped further reductions in nominal wages in 1933, thus protecting against even more shifts in accumulation supply. With recovery blocked from the supply side, and through no policy in area to rise accumulation demand, it is simple to watch currently why the economic situation stayed locked in a recessionary gap so lengthy.

Keynes said that expansionary fiscal policy stood for the surest tool for bringing the economic situation earlier to complete employment. The United States did not carry out such a policy until human being war prompted boosted federal spending for defense. New Deal plans did seek to stimulate employment with a variety of federal programs. But, via state and regional governments proceeding to cut purchases and raise taxes, the net impact of government at all levels on the economy did not rise accumulation demand during the Roosevelt management till the oncollection of people battle.For a discussion of fiscal plan in the time of the Great Depression, watch E. Cary Brvery own, “Fiscal Policy in the ’Thirties: A Reappraisal,” Amerihave the right to Economic Review 46, no. 5 (December 1956): 857–79. As Figure 17.3 "World War II Ends the Great Depression" shows, expansionary fiscal policies compelled by the war had actually carried output earlier to potential by 1941. The UNITED STATE enattempt right into World War II after Japan’s strike on American pressures in Pearl Harbor in December of 1941 brought about much sharper rises in federal government purchases, and also the economy pushed easily into an inflationary gap.

Figure 17.3 World War II Ends the Great Depression


Increased UNITED STATE federal government purchases, motivated by the beginning of World War II, finished the Great Depression. By 1942, raising accumulation demand had actually pumelted actual GDP past potential output.

For Keynesian financial experts, the Great Depression offered superior confirmation of Keynes’s principles. A sharp reduction in aggregate demand had acquired the trouble started. The recessionary gap created by the change in aggregate demand also had actually persisted for even more than a decade. And expansionary fiscal policy had put a swift finish to the worst macrofinancial nightmare in U.S. history—even if that plan had been compelled on the country by a battle that would prove to be among the worst episodes of people background.

Key Takeaways

Classical economic believed stressed the ability of the economic climate to achieve what we now call its potential output in the long run. It for this reason stressed the pressures that determine the place of the long-run accumulation supply curve as the components of income. Keynesian economics focuses on changes in accumulation demand and also their ability to create recessionary or inflationary gaps. Keynesian financial experts argue that sticky prices and also wperiods would certainly make it challenging for the economic climate to adjust to its potential output. Since Keynesian economists believe that recessionary and also inflationary gaps deserve to persist for lengthy periods, they urge the usage of fiscal and also monetary plan to change the aggregate demand also curve and to cshed these gaps. Aggregate demand also fell sharply in the first 4 years of the Great Depression. As the recessionary gap widened, nominal wages started to fall, and also the short-run aggregate supply curve began moving to the best. These shifts, yet, were not sufficient to close the recessionary gap. World War II forced the UNITED STATE government to shift to a sharply expansionary fiscal policy, and the Depression ended.

Try It!

Imagine that it is 1933. President Franklin Roosevelt has actually just been inaugurated and has named you as his senior economic adviser. Devise a program to carry the economic climate earlier to its potential output. Using the version of accumulation demand also and accumulation supply, show graphically exactly how your proposal could job-related.

Figure 17.4


Although David Ricardo’s focus on the long run emerged as the leading strategy to macroeconomic thought, not all of his contemporaries agreed with his perspective. Many eighteenth- and also nineteenth-century economic experts arisen theoretical disagreements suggesting that transforms in accumulation demand might impact the actual level of economic activity in the brief run. Like the brand-new Keynesians, they based their arguments on the idea of price stickiness.

Henry Thornton’s 1802 book, An Enquiry into the Nature and Effects of the Paper Crmodify of Great Britain, suggested that a reduction in the money supply can, bereason of wage stickiness, produce a short-run slump in output:

“The tendency, but, of an extremely great and also sudden reduction of the accustomed variety of financial institution notes, is to develop an inexplicable and also temporary ditension, and also a fall of price developing from that ditension. But a autumn developing from short-term distress and anxiety, will be attfinished most likely with no correspondent autumn in the price of wages; for the fall of price, and the distress and anxiety, will be understood to be short-term, and the price of wperiods, we recognize, is not so variable as the price of items. There is reason, therefore, to fear that the unorganic and extrasimple low price occurring from the type of dianxiety of which we now sheight, would occasion a lot discouragement of the fabrication of manufactures.”

A half-century previously, David Hume had noted that an increase in the quantity of money would boost output in the brief run, aget because of the stickiness of prices. In an essay titled “Of Money,” published in 1752, Hume defined the procedure via which an boosted money supply might boost output:

“At initially, no alteration is perceived; by levels the price rises, initially of one commodity, then of an additional, till the totality at leastern reaches a just propercent through the brand-new amount of (money) which is in the kingdom. In my opinion, it is just in this interval or intermediate case … that the encreasing amount of gold and silver is favourable to industry.”

Hume’s discussion suggests sticky prices; some prices are slower to respond to the boost in the money supply than others.

Eighteenth- and also nineteenth-century economists are mainly lumped together as adherents to the timeless school, yet their views were anything but uniform. Many kind of occurred an analytical framework that was rather similar to the important aspects of brand-new Keynesian economic experts this particular day. Economist Thomas Humphrey, at the Federal Reserve Bank of Richmond, marvels at the insights shown by beforehand economists: “When you read these old guys, you discover out initially that they didn’t soptimal with one voice. Tright here was no single body of thshould which everyone subscribed. And second, you discover out exactly how much they knew. You could take Henry Thornton’s 1802 book as a textbook in any type of money course today.”

Source: Thomas M. Humphrey, “Nonneutrality of Money in Classical Monetary Thought,” Federal Reserve Bank of Richmond Economic Review 77, no. 2 (March/April 1991): 3–15, and also personal intersee.

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Answer to Try It! Problem

An expansionary fiscal or monetary plan, or a combination of the two, would transition accumulation demand also to the appropriate as shown in Panel (a), ideally returning the economic climate to potential output. One item of proof arguing that fiscal plan would certainly work is the swiftness via which the economic climate reextended from the Great Depression as soon as World War II required the federal government to lug out such a plan. An alternative technique would certainly be to perform nopoint. Ultimately, that need to force nominal wages down better, developing increases in short-run aggregate supply, as in Panel (b). We perform not recognize if such a technique could have actually worked; federal policies enacted in 1933 prevented weras and prices from falling even more than they already had actually.