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Transcript of 22-1 Economics: Theory Through Applications. 22-2 This work is licensed under the Creative Commons...
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22-1
Economics: Theory Through Applications
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22-2
This work is licensed under theCreative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License.To view a copy of this license,visit http://creativecommons.org/licenses/by-nc-sa/3.0/or send a letter toCreative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105,
USA
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Chapter 22The Great Depression
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Learning Objectives
• What was the Great Depression?
• What caused it?
• Will we ever have another one?
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Figure 22.1- US Real GDP, 1890-1939
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Figure 22.2- The Circular Flow of Income
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Table 22.1 - Major Macroeconomic Variables, 1920-1939*
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Figure 22.3 - The Great Depression in Other Countries
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Figure 22.4 - An Inward Shift in the Market Supply of Houses
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Using Growth Accounting to Understand the Great Depression
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Technology growth rate Output growth rate Capital growth rate 1 a Labor growth ratea
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Table 22.2 - Growth Rates of Real GDP, Labor, Capital, and Technology, 1920–1939*
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Figure 22.5 - The Firm Sector in the Circular Flow
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The National Income Identity
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Production Consumption+Investment+Government Purchases+Net Exports
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Inventory Investment
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Production = Sales + Changes in inventory
GDP = Planned spending + Unplanned inventory investment
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Table 22.3 - Growth Rates of Key Macroeconomic Variables, 1930–40*
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Figure 22.6 - An Inward Shift in Market Demand for Houses
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Figure 22.7 - A Shift in Demand for Houses When Prices Are Sticky
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The Aggregate Expenditure Model
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GDP=Consumption+Investment+Government Purchases+Net Exports
GDP = Planned spending + Unplanned inventory investment
Planned spending Consumption Investment Government purchases Net exports
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Figure 22.8 - The Planned Spending Line
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The Aggregate Expenditure Model
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Planned spending = Autonomous spending Marginal propensity to spend GDP
GDP Planned spending
Planned spending Autonomous spending Marginal propensity to spend GDP
Autonomous spendingEquilibrium GDP
1 Marginal propensity to spend
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Figure 22.9 - Equilibrium in the Aggregate Expenditure Model
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Figure 22.10 - A Decrease in Aggregate Expenditures
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The Multiplier
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Change in GDP Multiplier Change in autonomous spending
1Multiplier
1 Marginal propensity to spend
1 1 1Multiplier 5
1 Marginal propensity to spend 1 0.8 0.2
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Figure 22.11 - The Financial Sector in the Circular Flow of Income
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Figure 22.12 - Payoffs in a Bank-run Game
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Figure 22.13
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Price Adjustment
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Output gap Potential real GDP Actual real GDP
Inflation rate Autonomous inflation Inflation sensitivity Output gap
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Figure 22.14 - Price Adjustment
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Policy Remedies
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Change in GDP Multiplier Change in autonomous spending
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Key Terms
• Real gross domestic product (real GDP): A measure of production that has been corrected for any changes in overall prices
• Unemployment rate: The percentage of people who are not currently employed but are actively seeking a job
• Price level: A measure of average prices in the economy
• Inflation rate: The growth rate of the price index from one year to the next
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Key Terms
• Procyclical: An economic variable that typically moves in the same direction as real GDP, increasing when GDP increases and decreasing when GDP decreases
• Countercyclical: An economic variable that typically moves in the opposite direction to real GDP, decreasing when GDP increases and increasing when GDP decreases
• Correlation: A statistical measure of how closely two variables are related
• Potential output: The amount of real GDP the economy produces when the labor market is in equilibrium and capital goods are not lying idle 22-31
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Key Terms
• Aggregate spending: The total amount of spending by households, firms, and the government on the goods and services that go into real GDP
• National income identity: Production equals the sum of consumption plus investment plus government purchases plus net exports
• Consumption: The total spending by households on final goods and services
• Services: Items such as haircuts and legal services where the household purchases the time and skills of individuals
• Nondurable goods: Goods that do not last very long
• Durable goods: Goods that last over many uses
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Key Terms
• Investment: The purchase of new goods that increase capital stock, allowing an economy to produce more output in the future
• business fixed investment: A measurement of purchases of physical capital (plants, machines) for the production of goods and services
• New residential construction: The building of new homes
• Inventory investment: The change in inventories of final goods
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Key Terms
• government purchases: Spending by the government on goods and services
• Transfer: A cash payment from the government to individuals and firms.
• Net exports: Exports minus imports
• Unplanned inventory investment: An increase in inventories that comes about because firms have sold less than they anticipated
• Planned spending: All expenditures in an economy except for unplanned inventory investment
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Key Terms
• Consumption smoothing: The idea that households like to keep their flow of consumption relatively steady over time, smoothing over income changes
• Flexible prices: Prices that adjust immediately to shifts in supply and demand curves so that markets are always in equilibrium
• Sticky prices: Prices that do not adjust immediately to shifts in supply and demand curves so that markets are not always in equilibrium
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Key Terms
• Autonomous spending: The amount of spending that there would be in an economy if income were zero
• Marginal propensity to spend: The slope of the planned spending line, measuring the change in planned spending if income increases by $1
• Aggregate expenditure model: The framework that links planned spending and output
• Wealth effect: The effect on consumption of a change in wealth
• Multiplier: The amount by which a change in autonomous spending must be multiplied to give the change in output, equal to 1 divided by (1 – the marginal propensity to spend)
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Key Terms
• Liquid: Capable of being easily and quickly exchanged for cash
• Illiquid: Not capable of being easily and quickly exchanged for cash
• Bank run: A significant fraction of a bank’s depositors all trying to withdraw funds at the same time
• Bank failure: When a bank closes because it is unable to meet its depositors’ demands
• Coordination game: A strategic situation in which there are multiple equilibria
• Real interest rate: The rate of return specified in terms of goods, not money
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Key Terms
• Currency-deposit ratio: The total amount of currency (banknotes plus coins) divided by the total amount of deposits in banks
• Loan-deposit ratio: The total amount of loans made by banks divided by the total amount of deposits in banks
• Price-adjustment equation: An equation that describes how prices adjust in response to the output gap, given autonomous inflation
• Output gap: The difference between potential output and actual output
• Autonomous inflation: The level of inflation when the output gap is zero
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Key Terms
• Monetary policy: Changes in interest rates and other tools that are under the control of the monetary authority of a country (the central bank)
• Fiscal policy: Changes in taxation and the level of government purchases, typically under the control of a country’s lawmakers
• Stabilization policy: The use of monetary and fiscal policies to prevent large fluctuations in real GDP
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Key Takeaways
• During the Great Depression in the United States from 1929 to 1933, real GDP decreased by over 25 percent, the unemployment rate reached 25 percent, and prices decreased by over 9 percent in both 1931 and 1932 and by nearly 25 percent over the entire period
• The Great Depression remains a puzzle today
– Both the source of this large economic downturn and why it lasted for so long remain active areas of research and debate within economics
• One explanation of the Great Depression rests on a reduction in the ability of the economy to produce goods and services
– The second leading explanation focuses on a reduction in the overall demand for goods and services in the economy
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Key Takeaways
• Potential output is the amount of real GDP an economy could produce if the labor market is in equilibrium and capital goods are fully utilized
• A large enough decrease in potential output, say through technological regress, could cause the large decrease in real GDP that occurred during the Great Depression
• A reduction in potential output would lead to a decrease in real wages and an increase in the price level
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Key Takeaways
• Those implications are inconsistent with the facts of the Great Depression years
– Further, it is hard to understand how potential output could decrease by the extent needed to match the decrease in real GDP during the Great Depression
• Finally, a 25 percent unemployment rate is not consistent with labor market equilibrium
• The components of aggregate spending are consumption, investment, government purchases of goods and services, and net exports
• The national income identity states that real GDP is equal to the sum of the components of aggregate spending
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Key Takeaways
• During the Great Depression, both consumption spending and investment spending experienced negative growth
• Households use savings to retain relatively smooth consumption despite fluctuations in their income
• The stock market crash in 1929 reduced the wealth of many households, and this could lead them to cut consumption
– This reduction in aggregate spending, through the multiplier process, could lead to a large reduction in real GDP
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Key Takeaways
• The reductions in investment in the early 1930s, perhaps coming from instability in the financial system, could lead to a reduction in aggregate spending and, through the multiplier process, a large reduction in real GDP
• Stabilization policy entails the use the monetary and fiscal policy to keep the level of output at potential output
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Key Takeaways
• Monetary policy is the use of interest rates and other tools, under the control of a country’s central bank, to stabilize the economy. During the Great Depression, monetary policy was not actively used to stabilize the economy
– A major component of stabilization after 1932 was restoring confidence in the banking system
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Key Takeaways
• Fiscal policy is the use of taxes and government spending to stabilize the economy
– During the first part of the 1930s, contractionary fiscal policy may have deepened the Great Depression
– After 1932, fiscal policy became more expansionary and may have helped to end the Great Depression
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