Chapter 7 The Great Depression

The Puzzle of the Great Depression

Try to imagine yourself in the United States or Europe in the early 1930s. You are witnessing immense human misery amid a near meltdown of the economy. Friends and family are losing their jobs and have bleak prospects for new employment. Stores that you had shopped in all your life suddenly go out of business. The bank holding your money has disappeared, taking your savings with it. The government provides no insurance for unemployment, and there is no system of social security to provide support for your elderly relatives.

Economists and government officials at that time were bewildered. The experience in the United States and other countries was difficult to understand. According to the economic theories of the day, it simply was not possible. Policymakers had no idea how to bring about economic recovery. Yet, as you might imagine, there was considerable pressure for the government to do something about the problem. The questions that vexed the policymakers of the day—questions such as “What is happening?” and “What can the government do to help?”—are at the heart of this chapter.

Economists make sense of events like the Great Depression by first accumulating facts and then using frameworks to interpret those facts. We have a considerable advantage relative to economists and politicians at the time. We have the benefit of hindsight: the data we looked at in the previous subsection were not known to the economists of that era. And economic theory has evolved over the last seven decades, giving us better frameworks for analyzing these data.

Earlier, we said there are two possible reasons why output decreased.

1. There was a decrease in production due to a decrease in the available inputs into the aggregate production function. Since there was no massive decrease in the amount of physical capital or the size of the workforce, and people presumably did not suddenly lose all their human capital, this means that the culprit must have been a decrease in technology.
2. There was a decrease in aggregate spending. Households chose to reduce their consumption, firms chose to reduce their investment, and governments chose to reduce their spending. As a consequence, firms scaled back their production.

We look at each of these candidate explanations in turn.

A Decrease in Technology: The Multiple-Markets Perspective

Comparative statics is a technique that allows us to understand the effects of a decrease in technology in a particular market, such as the market for new homes. In a comparative statics exercise, we look at what happens to endogenous variables (in this case, production and prices of new homes) when we change an exogenous variable (in this case, technology). A decline in technology shifts the market supply curve leftward: at any given price, the decrease in technology means that the firm can produce less output with its available inputs. The result is shown in part (a) of Figure 7.4 "An Inward Shift in the Market Supply of Houses" for the housing market: output of new homes decreases and the price of new homes increases.

Figure 7.4 An Inward Shift in the Market Supply of Houses

(a) A decrease in technology leads to an inward shift of the market supply curve for houses. (b) The labor and other resources that are not being used to produce houses can now be used to produce other goods, such as cars.

If this decline in technology in the housing market were the only change in the economy, what would happen? Construction firms would fire workers because these firms were building fewer new homes. Over time, however, the fired construction workers would find new jobs in other sectors of the economy. The same logic applies to other inputs: capital and other inputs that were being used in the construction industry would be redeployed to other markets. For example, there would be additional labor and other inputs available for automobile production. Part (b) of Figure 7.4 "An Inward Shift in the Market Supply of Houses" shows the resulting outward shift in the supply curve for cars. It is difficult to explain the big decrease in output and the high rate of unemployment in the Great Depression through a change in technology in a single market.

Suppose, however, that this change in technology does not happen in just one market but occurs across the entire economy. Then a version of part (a) in Figure 7.4 "An Inward Shift in the Market Supply of Houses" would hold for each market in the economy. We would see declines in economic activity across a wide range of markets. Moreover, with declines in so many industries, we would expect to see lower real wages and less employment. The idea that workers could easily move from one industry to another is not as persuasive if the entire economy is hit by an adverse technology shock.

Using Growth Accounting to Understand the Great Depression

We use growth accounting to show how changes in output are driven by changes in the underlying inputs—capital, labor, and technology. Equivalently, we use the technique to give us a measure of the growth rate of technology, given data on the growth rates of output, capital, and labor:

We have omitted human capital from this growth accounting equation. We do so because, unfortunately, we do not have very good human capital measures for the period of the Great Depression. Human capital typically changes very slowly, so this is not too much of a problem: over a period of a decade, we do not expect big changes in human capital. Any changes in human capital that do occur are included in the catchall “technology” term.

The key ingredient needed for the growth accounting equation is the number a. It turns out that a good measure of a is the fraction of real GDP that is paid to owners of capital. Roughly speaking, it is the amount of GDP that goes to the profits of firms. Equivalently, (1 − a) is the fraction of GDP that is paid to labor. The circular flow of income reminds us that all income ultimately finds its way back to households in the economy, which is why these two numbers sum to one.

Can Technology Changes Explain the Roaring Twenties?

The economist John Kendrick applied such growth accounting to data from the Great Depression.See John W. Kendrick, Productivity Trends in the United States (Princeton, NJ: Princeton University Press, 1961), particularly Table A-XXII, p. 335, and the discussion of these calculations. Table 7.2 "Growth Rates of Real GDP, Labor, Capital, and Technology, 1920–39*" summarizes his findings. Each row in Table 7.2 "Growth Rates of Real GDP, Labor, Capital, and Technology, 1920–39*" decomposes output growth into three components. In 1923, for example, output grew at a very high rate of 14.2 percent. This growth in output came from labor growth of 9.9 percent and capital stock growth of 2.0 percent. The remainder, which we interpret as growth in technology, grew at 9.5 percent. By all accounts, 1923 was a good year. The other entries in the table can be read in the same way.

Real GDP and technology were both growing in most years in the 1920s. In the early 1930s both variables decreased, and both grew again as the economy recovered from the Great Depression. In other words, technology growth and output growth are positively correlated over this period. This suggests the possibility that changes in technology caused the changes in output—always remembering that, as we observed earlier, correlation need not imply a causal relationship. An improvement in technology causes firms to want to produce more. They demand more workers, so employment and real wages increase. The increased output, through the circular flow, means that there is increased income. Households increase both consumption and savings. Higher savings means higher investment, so, over time, the economy accumulates more capital. Exactly the opposite holds if there is a decrease in technology: in this case, employment, consumption, and investment all decrease.

Does this theory fit the facts? For the roaring twenties, we see growth in output, labor, and capital. In addition, there was a positive technology growth rate in almost all the years of the decade. These movements are indeed consistent with the behavior of an economy driven by improvements in technology. Jumping back for a moment to individual markets, improvements in technology shift supply curves rightward. Increased output is therefore accompanied by decreased prices. The aggregate price level is nothing more than a weighted average of individual prices, so price decreases in individual markets translate into a decrease in the overall price level. From Table 7.1 "Major Macroeconomic Variables, 1920–39*", the price level actually moved very little between 1922 and 1929, so this fits less well.

Overall, the view that technological progress fueled the growth from 1922 to 1929 seems broadly consistent with the facts. Given the simplicity of the framework that we are using, “broadly consistent” is probably the best it is reasonable to hope for.

Can Technology Changes Explain the Great Depression?

Now let us apply the same logic to the period of the Great Depression. Negative growth in output from 1930 to 1933 was matched by negative growth in labor and technology (except for 1931). The capital stock decreased from 1932 to 1935, reflecting meager investment during this period. When the economy turned around in 1934, technology growth turned up as well.

Imagine that the economy experienced negative technology growth from 1929 to 1933. The reduced productivity of firms leads to a decrease in demand for labor, so real wages and employment decrease. Lower productivity also means that firms did not think it was worthwhile to invest in building new factories and buying new machinery. Both labor and capital inputs into the production function declined. Once technology growth resumed in 1934, the story was reversed: labor and capital inputs increased, and the economy began to grow again. In this view, there was a substantial decline in the production capabilities of the economy, leading to negative growth in output, consumption, and investment. The Great Depression, in this account, was driven by technological regress.

Many economists are skeptical of such an explanation of the Great Depression. They have three criticisms. First, large-scale technological regress is difficult to believe on its face. Did people know an efficient way to manufacture something in 1929 but then forget it in 1930? Even remembering that technology includes social infrastructure, it is hard to imagine any event that would cause a decrease of 3 percent or more in technology—and if such an event did occur, surely we would be able to point to it and identify it.

Second, this explanation claims that labor input decreased because households saw lower real wages and voluntarily chose to consume leisure rather than work. By most measures, though, real wages increased. Moreover, it is difficult to equate a 25 percent unemployment rate, not to mention all the stories of how people could not find work, with a labor market in which households are simply moving along a labor supply curve.

Third, a prominent feature of the Great Depression is the decrease in the price level that occurred from 1929 to 1933. Table 7.1 "Major Macroeconomic Variables, 1920–39*" tells us that prices decreased by over 9 percent in both 1931 and 1932. However, a reduction in the level of potential GDP would cause an inward shift of market supply curves and thus an increase, rather than a decrease, in prices.

For most economists, the view of the Great Depression as a shift in technology is not convincing. Something else must have been going on. In particular, the very high unemployment rate strongly suggests that labor markets were malfunctioning. Thus, rather than viewing the large decreases in output in economies around the world as part of the normal functioning of supply and demand in an economy, we should perhaps consider it as evidence that sometimes things can go badly wrong with the economy’s self-correction mechanisms. If we want to explain the Great Depression, we are then obliged—as were the economists at the time—to find a new way of thinking about the economy. It was an economist named John Maynard Keynes who provided such a new approach; in so doing, he gave his name to an entire branch of macroeconomic theory.

The National Income Identity

The national income identityProduction equals the sum of consumption plus investment plus government purchases plus net exports. states that

ConsumptionThe total spending by households on final goods and services. refers to total consumption spending by households on final goods and services. Consumption is divided into three categories.

1. ServicesItems such as haircuts and legal services where the household purchases the time and skills of individuals.. These are items such as haircuts, restaurant meals, hotel nights, legal services, and movies. There is often no tangible product; the consumer purchases the time and skills of individuals (such as barbers, chefs, and lawyers). Production and consumption of services usually occur together.
2. Nondurable goodsGoods that do not last very long.. Examples include groceries, clothing, and DVDs—tangible products that (usually) have a fairly limited lifespan (typically less than three years).
3. Durable goodsGoods that last over many uses.. These are items such as automobiles, “white goods” (washing machines, refrigerators, and other appliances), and computers. They are tangible products that usually have a lifespan of several years.

The distinctions among these categories are not always as clear-cut as the definitions suggest. A good pair of blue jeans might outlast a shoddy dishwasher, even though the jeans are classified as a nondurable good and the dishwasher as a durable good.

InvestmentThe purchase of new goods that increase capital stock, allowing an economy to produce more output in the future. is the purchase of new goods that increase the capital stock, allowing us to produce more output in the future. Investment is divided into three categories.

1. Business fixed investmentA measurement of purchases of physical capital (plants, machines) for the production of goods and services.. Purchases of physical capital (plants, machines) for the production of goods and services
2. New residential constructionThe building of new homes.. The building of new homes
3. Inventory investmentThe change in inventories of final goods.. Change in inventories of final goods

The economist’s definition of investment is precise and differs from the way we often use the word in everyday speech. Specifically, economists do not use the term to mean the purchase of financial assets, such as stocks and bonds. Most of the time when we talk about investment in this book, we are referring to business fixed investment—the production of new physical capital goods. Inventory investment is a special category of investment that we explain in Section 7.3.2 "Inventory Investment".

As a rough rule of thumb, consumption spending is carried out by households, and investment spending is carried out by firms. But there is one important exception: new residential construction is included in investment. A new house purchased by a household is treated as investment, not consumption.

Government purchasesSpending by the government on goods and services. include all purchases of goods and services by the government. We include in our definition of “government” local as well as national government activity. In the United States, this means that we collapse together federal, state, and local governments for the purpose of our analysis.

This component of spending refers only to purchases of goods and services, not to transfersA cash payment from the government to individuals and firms.. So, if the federal government buys aircraft from Boeing or the local police department buys a fleet of Volvos, these are included in government purchases. However, a transfer you receive from the government—say, because you are unemployed and are being paid unemployment insurance—is not counted in GDP. (Of course, if you then use this income to purchase goods and services, that consumption is part of GDP.)

Net exportsExports minus imports. simply equal exports minus imports. They are included because we must correct for the expenditure flows associated with the rest of the world. Some spending in the economy goes to imported goods, which is not associated with domestic production. We must subtract these imports from total expenditures. Against that, some demand for domestically produced goods comes from other countries. We add these exports to total expenditure.

Inventory Investment

Inventory investment is a relatively minor component of GDP, but we need to understand it in some detail because it plays a key role in the Keynesian approach. When a firm produces output, it does one of two things with it: it either sells it or adds it to inventory. Thus an accounting relationship within a firm is that

If a firm produces more than it sells, its stocks of inventories increase. If a firm sells more than it produces, its stocks of inventories decrease. The inventories that a firm holds are counted as part of its capital stock, so any change in firms’ inventories is counted as a component of investment.

Suppose General Motors (GM) produces 10 million cars, anticipating that it will sell them all. Then imagine that demand is lower than expected, so it only sells 9.9 million. The result is that 100,000 cars pile up on GM’s lots, and the GM accountants record this as an addition to inventory. We want GDP to measure both production and spending, but we have 100,000 cars that have been produced but not purchased. The national income accounts get around this problem by effectively pretending that GM bought the cars from itself.

If the cars are then sold in the following year, they will not contribute to GDP in that year—quite properly, since they were not produced that year. The national accounts in the next year will show that 100,000 cars were sold to households, but they will also show that inventories decreased by 100,000 cars. Thus the accounts record expenditures on these cars as part of durable goods consumption, but the accounts also contain an offsetting reduction in inventory investment.

In some cases, firms change their stocks of inventory as a part of their business strategy. More often, changes in inventories occur because a firm did not correctly forecast its sales. Unplanned inventory investmentAn increase in inventories that comes about because firms have sold less than they anticipated. is an increase in inventories that comes about because a firm sells less than it anticipated. Because GM expected to sell all 10 million cars but sold only 9.9 million, GM had 100,000 cars of unplanned inventory investment.

Moreover, GM is likely to react swiftly to this imbalance between its production plans and its sales. When it sees its sales decrease and its inventory increase, it will respond by cutting its production back until it is in line with sales again. Thus, when an individual firm sees inventories increase and sales decrease, it typically scales down production to match the decrease in demand.

Now let us think about how this works at the level of an economy as a whole. Suppose we divide total spending in the economy into unplanned inventory investment and everything else, which we call planned spendingAll expenditures in an economy except for unplanned inventory investment..

Begin with the situation where there is no unplanned inventory investment—so GDP equals planned spending—and then suppose that planned spending decreases. Firms find that their production is in excess of their sales, so their inventory builds up. As we just argued, they respond by decreasing production so that GDP is again equal to planned spending, and unplanned inventory investment is once again zero. Thus, even though unplanned inventory investment can be nonzero for very short periods of time, we do not expect such a situation to persist. We expect instead that actual output will, in fact, almost always equal planned spending.

What Happened to the Components of GDP during the Great Depression?

Now let us look at how these components of GDP behaved during the 1930s. Table 7.3 "Growth Rates of Key Macroeconomic Variables, 1930–39*" presents these data in the form of growth rates. Remember that a positive growth rate means the variable in question increased from one year to the next, while a negative growth rate means it decreased.

We see again that real GDP decreased for four years in succession (the growth rates are negative from 1930 to 1933). The decrease in real GDP was accompanied by a decline in consumption and investment: consumption likewise decreased for four successive years, and investment decreased for three successive years. The decline in consumption was not as steep as the decline in real GDP, while the decline in investment was much larger. Were we to drill deeper and look at the components of consumption, we would discover that expenditures on durable goods decreased by 17.6 percent in 1930 and 25.1 percent in 1932, while expenditures on services decreased by only 2.5 percent in 1930 and 6.3 percent in 1932.

Whatever was happening during this period evidently had a much larger influence on firms’ purchases of investment goods, and on households’ spending on cars and other durable goods, than it did on purchases of nondurable goods (such as food) and services (such as haircuts). A similar pattern can be observed in modern economies: consumption is smoother than output, and spending on services is smoother than spending on durables. The reason for this is a phenomenon that economists call consumption smoothingThe idea that households like to keep their flow of consumption relatively steady over time, smoothing over income changes..

If your company has a good year and you get a big bonus, you will increase consumption spending not only this year but also in future years. To do so, you must save a portion of your bonus to pay for this higher consumption in the future. By the same logic, if your income decreases, your consumption will not decrease as much. People who became unemployed during the Great Depression did not reduce their consumption of services and nondurable goods to zero. Instead, as far as was possible, they drew on their existing savings, borrowed, and postponed purchases of durable goods.

Consumption of durable goods, in other words, resembles investment rather than consumption of nondurable goods and services. This makes sense because durable goods resemble investment goods that are purchased by households. Like investment goods, they yield benefits over some prolonged period of time. As an example, consider automobile purchases during the Great Depression. Although 5.4 million cars were produced in 1929, only 3.4 million were produced in 1930—a reduction of more than 37 percent in a single year. Instead of buying new cars, households simply held onto their existing cars longer. As a consequence of the boom of the 1920s, there were a lot of relatively new cars on the road in 1929: the number of cars less than 3 years old was about 9.5 million. Two years later, this number had fallen to 7.9 million.These figures are from Michael Bernstein, The Great Depression: Delayed Recovery and Economic Change in America, 1929–39 (Cambridge, MA: Cambridge University Press, 1987).

This reduction in activity in the automobile industry was matched by a reduction of inputs into the production process. By early 1933, there were only 4 workers for every 10 who had been employed 4 years previously. Equipment purchases for the transportation sector were so low that capital stock for this sector decreased between 1931 and 1935. In the turmoil of the Great Depression, many small car producers went out of business, leaving a few relatively large companies—such as Ford Motor Company and GM—still in business.

Similar patterns arose as the economy recovered. Investment, in particular, was astonishingly volatile. It decreased by about one-third in 1930 and again in 1931, and by over two-thirds in 1932, but rebounded at an astoundingly high rate after 1933. Consumption, meanwhile, grew at a slower rate than GDP as the economy recovered.

A Decrease in Aggregate Spending: The Multiple-Markets Perspective

Consider, as before, the market for new houses and suppose there is a reduction in spending on houses. Market demand shifts inward, causing a decrease in the price of houses, as shown in Figure 7.6 "An Inward Shift in Market Demand for Houses". The lower price means that construction firms choose to build fewer houses; there is a movement along the supply curve.

Figure 7.6 An Inward Shift in Market Demand for Houses

A decrease in demand for houses leads to a decrease in the price of houses and a lower quantity of houses being produced and sold.

As before, the effects are not confined to the housing market. Construction firms demand less labor, so the wages of these workers decrease. Employment in the construction industry declines, but these workers now seek jobs in other sectors of the economy. The increased supply of labor in these sectors reduces wages and thus makes it more attractive for firms to increase their hiring. Supply curves in other sectors shift rightward. Moreover, the income that was being spent on housing will instead be spent somewhere else in the economy, so we expect to see rightward shifts in demand curves in other sectors as well. In summary, if we are looking at the whole economy, a decrease in spending in one market is not that different from a decrease in technology in one market: we expect a reduction in one sector to lead to expansions in other sectors. The economy still appears to be self-stabilizing.

In this story, as is usual when we use supply and demand, we presumed that prices and wages adjust quickly to bring supply and demand into line. This is critical for the effective functioning of markets: for markets to do a good job of matching up demand and supply, wages and prices must respond rapidly to differences between supply and demand. Flexible pricesPrices that adjust immediately to shifts in supply and demand curves so that markets are always in equilibrium. adjust immediately to shifts in supply and demand curves so that price is always at the point where supply equals demand. If, for example, the quantity of labor supplied exceeds the quantity of labor demanded, flexible wages decrease quickly to bring the labor market back into equilibrium.

Suppose we instead entertain the possibility that wages and prices do not immediately adjust. Sticky pricesPrices that do not adjust immediately to shifts in supply and demand curves so that markets are not always in equilibrium. do not react immediately to shifts in supply and demand curves, and the adjustment to equilibrium can take some time. We defer for the moment the discussion of why prices might be sticky and concentrate instead on the implications of this new idea about how markets work. The easiest way to see the effects of price stickiness is to suppose that prices do not change at all. Figure 7.7 "A Shift in Demand for Houses When Prices Are Sticky" shows the impact of a decrease in demand for houses when the price of houses is completely sticky. If you compare Figure 7.7 "A Shift in Demand for Houses When Prices Are Sticky" to Figure 7.6 "An Inward Shift in Market Demand for Houses", you see that a given shift in demand leads to a larger change in the quantity produced.

Figure 7.7 A Shift in Demand for Houses When Prices Are Sticky

If the price in the market is “sticky,” it may not adjust immediately to the change in demand, resulting in a large decrease in the quantity of houses that are produced and sold.

What about the effects on other markets? As before, a decrease in demand for housing will cause construction workers to lose their jobs. If wages are sticky, these workers may become unemployed for a significant period of time. Their income decreases, and they consume fewer goods and services. So, for example, the demand for beef in the economy might decrease because unemployed construction workers buy cheaper meat. This means that the demand for beef shifts inward. The reduction in activity in the construction sector leads to a reduction in activity in the beef sector. And the process does not stop there—the reduced income of cattle farmers and slaughterhouse workers will, in turn, spill over to other sectors.

What has happened to the self-stabilizing economy described earlier? First, sticky wages and prices impede the incentives for workers to flow from one sector to another. If wages are sticky, then the reduction in labor demand in the construction sector does not translate into lower wages. Thus there is no incentive for other sectors to expand. Instead, these other sectors, such as food, see a decrease in demand for their product, which leads them to contract as well. Second, the decrease in income means that it is possible to see decreases in demand across the entire economy. It no longer need be the case that reductions in spending in one area lead to increased spending in other sectors.

The Circular Flow of Income during the Great Depression

So far, we have told this story in terms of individual markets. The circular flow helps us see how these markets come together in the aggregate economy. When we looked at the markets for housing and beef, we saw that a decrease in demand for housing led to a decrease in demand for labor and, hence, to lower labor income. We also saw that as income earned in the housing market decreased, spending decreased in the beef market. Such linkages are at the heart of the circular flow of income. Household spending on goods and services is made possible by a flow of income from firms. Firms’ hiring of labor is made possible by a flow of revenue from households. Keynes argued that this was a delicate process that might be prone to malfunction in a variety of ways.

Households are willing to buy goods and services if they have a reasonable expectation that they can earn income by selling labor. During the Great Depression, however, household expectations were surely quite pessimistic. Individuals without jobs believed that their chances of finding new employment were low. Those lucky enough to be employed knew that they might soon be out of work. Thus households believed it was possible, even likely, that they would receive low levels of income in the future. In response, they cut back their spending.

Meanwhile, the willingness of firms to hire labor depends on their expectation that they can sell the goods they manufacture. When firms anticipate a low level of demand for their products, they do not want to produce much, so they do not need many workers. Current employees are laid off, and there are few new hires.

Through the circular flow, the pessimism of households and the pessimism of firms interact. Firms do not hire workers, so household income is low, and households are right not to spend much. Households do not spend, so demand for goods and services is low, and firms are right not to hire many workers. The pessimistic beliefs of firms and workers become self-fulfilling prophecies.

The Aggregate Expenditure Model

In the remainder of this section, we build a framework around the ideas that we have just put forward. The framework focuses on the determinants of aggregate spending because, in this approach, the output of the economy is determined not by the level of potential output but by the level of total spending. This model is based around the idea of sticky prices—or, more precisely, it tells us what the output of the economy will be, at a given value of the overall price level. Once we understand this, we can add in the effects of changing prices.

Earlier, we introduced the national income identity:

This equation must be true by the way the national income accounts are constructed. That is, it is an accounting identity. We also explained that

It is possible for firms to accumulate or decumulate inventories unintentionally, but such a situation will not persist for long. Firms quickly respond to such imbalances by adjusting their production. The aggregate expenditure model takes the national income identity and adds to it the condition that unplanned inventory investment equals zero—equivalently, gross domestic product (GDP) equals planned spending:

Another way of saying this is that as long as we interpret investment to include only planned investment, the national income equation is no longer an identity but instead a condition for equilibrium.

The Relationship between Planned Spending and Output

We could now examine all four components of planned spending separately.Different chapters of this book delve deeper into these types of spending. For the moment, however, we group them all together. We focus on the fact that total planned spending depends positively on the level of income and output in an economy, for two main reasons:

1. If households have higher income, they are likely to increase their spending on many goods and services. The relationship between income and consumption is one of the cornerstones of macroeconomics.
2. Firms are likely to decide that higher levels of output—particularly if expected to persist—mean that they should build up their capital stock and thus increase their investment.

Figure 7.8 The Planned Spending Line

Planned spending is composed of autonomous spending (the amount of spending when real GDP equals zero) and induced spending (spending resulting from real GDP).

In summary, we conclude that when income increases, planned expenditure also increases. We illustrate this in Figure 7.8 "The Planned Spending Line", where we suppose for simplicity that the relationship between planned spending and GDP is a straight line:

planned spending = autonomous spending + marginal propensity to spend × GDP.

Autonomous spendingThe amount of spending that there would be in an economy if income were zero. is the intercept of the planned spending line. It is the amount of spending that there would be in an economy if income were zero. It is positive, for two reasons: (1) A household with no income still wants to consume something, so it will either draw on its existing savings or borrow against future income. (2) The government purchases goods and services even if income is zero.

The marginal propensity to spendThe slope of the planned spending line, measuring the change in planned spending if income increases by $1. is the slope of the planned spending line. It tells us how much planned spending increases if there is a $1 increase in income. The marginal propensity to spend is positive: Increases in income lead to increased spending by households and firms. The marginal propensity to spend is less than one, largely because of consumption smoothing by households. If household income increases by $1, households typically consume only a fraction of the increase, saving the remainder to finance future consumption. This equation, together with the condition that GDP equals planned spending, gives us the aggregate expenditure modelThe framework that links planned spending and output..

Toolkit: Section 16.19 "The Aggregate Expenditure Model"

The aggregate expenditure model takes as its starting point the fact that GDP measures both total spending and total production. The model focuses on the relationships between output and spending, which we write as follows:

planned spending = GDP and planned spending = autonomous spending + marginal propensity to spend × GDP.

The model finds the value of output for a given value of the price level. It is then combined with a model of price adjustment to give a complete picture of the economy.

Figure 7.9 Equilibrium in the Aggregate Expenditure Model

The aggregate expenditure framework tells us that the economy is in equilibrium when planned spending equals real GDP.

We can solve the two equations to find the values of GDP and planned spending that are consistent with both equations:

$$\text{equilibrium GDP}=\frac{\text{autonomous spending}}{1-\text{marginal propensity to spend}}\text{.}$$

We can also take a graphical approach, as shown in Figure 7.9 "Equilibrium in the Aggregate Expenditure Model". On the horizontal axis is the level of real GDP, while on the vertical axis is the overall level of (planned) spending in the economy. We graph the two relationships of the aggregate expenditure model. The first line is a 45° line—that is, it is a line with a slope equal to one and passing through the origin. The second is the planned spending line. The point that solves the two equations is the point where the two lines intersect. This diagram is the essence of the aggregate expenditure model of the macroeconomy.

The aggregate expenditure model makes no reference to potential output or the supply side of the economy. The model assumes that the total amount of output produced will always equal the quantity demanded at the given price. You might think that this neglect of the supply side is a weakness of the model, and you would be right. In Section 7.4.6 "Price Adjustment", when we introduce the adjustment of prices, the significance of potential output becomes clear.

Can a Decrease in Consumption Spending Explain the Great Depression?

We now apply this framework to the Great Depression. The aggregate expenditure approach suggests that output decreased in the Great Depression because aggregate spending decreased. Part (a) of Figure 7.10 "A Decrease in Aggregate Expenditures" shows how this process begins: a decrease in autonomous spending shifts the spending line down. The interpretation of such a shift is that, at every level of income, spending is lower. Such a decrease in spending is due to a decrease in (the autonomous component of) consumption, investment, government spending, or net exports (or some combination of these). Part (b) of Figure 7.10 "A Decrease in Aggregate Expenditures" shows what happens when the planned spending line shifts downward. The equilibrium level of real GDP decreases. So far, therefore, the aggregate expenditure model seems to work: a decrease in autonomous spending leads to a decrease in real GDP at the given price level. But we need to know why planned spending decreased.

Figure 7.10 A Decrease in Aggregate Expenditures

The Keynesian explanation of the Great Depression is that a decrease in autonomous spending caused the planned spending line to shift downward (a) leading to a decrease in the equilibrium level of real GDP (b).

Let us first consider the possibility that a reduction in consumption triggered the Great Depression. Recall that, between September and November 1929, the stock market in the United States crashed. This collapse meant that many households were suddenly less wealthy than they had been previously. A natural response to a decrease in wealth is to decrease consumption; this is known as a wealth effectThe effect on consumption of a change in wealth..

Wealth is distinct from income. Income is a flow: a household’s income is the amount that it receives over a period of time, such as a year. Wealth is a stock: it is the cumulated amount of the household’s savings. Is it plausible that wealth effects could explain a collapse of the magnitude of the Great Depression? To answer this, we need to determine how much real GDP decreases for a given change in autonomous spending.

Can a Decrease in Investment Spending Explain the Great Depression?

When GDP decreases, there can be an induced decrease in investment: declines in income lead firms to anticipate lower production in the future, meaning they see less of a need to build up their capital stock. But the changes in investment during the Great Depression were very large. Because it is implausible that such large variation was the result of changes in output alone, economists look for additional explanations of why investment decreased so much during the Great Depression.

During the Great Depression, the link between savings and investment was disrupted by bank failures. Between 1929 and 1933, a number of US banks went out of business, often taking the savings of households with them. People began to trust banks less, and many households stopped putting their savings into the financial sector. The financial sector is an intermediary between households and firms, matching up the supply of savings from households with the demand for savings by firms. Figure 7.11 "The Financial Sector in the Circular Flow of Income" shows the flows in and out of the financial sector. (Our focus here is on the role of this sector in matching savers and investors. As Figure 7.11 "The Financial Sector in the Circular Flow of Income" shows, however, funds also flow into (or from) the financial sector from the rest of the world and the government sector.)

Figure 7.11 The Financial Sector in the Circular Flow of Income

Financial institutions such as banks act as intermediaries in the circular flow of income. During the Great Depression, many banks failed, disrupting the matching of savings and investment.

To understand bank failures in the Great Depression, we need to take a moment to review what banks do. A bank is an institution that accepts money (“bank deposits”) from individuals. It then takes some of that money and puts it into longer-term projects—the construction of an apartment building, for example. The bank in this case issues a long-term loan to the company that plans to construct the new building.

At any time, a bank has a portfolio of assets. Some are liquidCapable of being easily and quickly exchanged for cash.; they are easily and quickly exchanged for cash. Some are illiquidNot capable of being easily and quickly exchanged for cash.; they cannot easily be converted into cash. Banks keep some assets in a highly liquid form, such as cash or very short-term loans, and also hold assets that are relatively illiquid, such as a two-year loan to a construction company.

At any time, depositors at a bank can choose to withdraw their money. Under normal circumstances, people are happy to leave most of their money in the bank, so only a small fraction of depositors want to withdraw money on any given day. The bank keeps some cash in its vaults to accommodate this demand. But suppose that times are not normal. Suppose that, as was the case during the Great Depression, depositors start to see that other banks are going out of business. Then they may worry that their own bank is also at risk of failing, in which case they will lose their savings. The natural response is to rush to the bank to withdraw money before the bank fails.

If a large number of depositors all try to withdraw money at once, the bank will run out of cash and other liquid assets. It will not be able to meet the needs of its depositors. The consequence is a bank runA significant fraction of a bank’s depositors all trying to withdraw funds at the same time.. And if the bank is unable to meet its depositors’ demands, it may be forced out of business altogether. This is known as a bank failureWhen a bank closes because it is unable to meet its depositors’ demands..

A striking feature of a bank failure caused by a bank run is that it is a self-fulfilling prophecy:

• If everybody believes that the bank is safe, then no one will withdraw money, and the bank will indeed be safe.
• If everybody believes that the bank is going to fail, then everyone will try to withdraw money, and the bank will indeed fail.

Notice that every individual’s decision about what to do is based on what that individual expects everyone else will do.

Figure 7.12 "Payoffs in a Bank-Run Game" presents the decisions underlying a bank run in a stylized way. Imagine that you deposit $100 in the bank. The table in the figure shows how much you obtain, depending on your own actions and those of other depositors. You and the other depositors must decide whether to leave your money in the bank (“don’t run”) or try to take your money out of the bank (“run”). If everyone else leaves money in the bank, then you can withdraw your money and get $100 or leave it in the bank and get the $100 plus $10 interest. If others do not run, then it is also best for you not to run. But if everyone else runs on the bank, then you get nothing if you leave your money in the bank, and you can (in this example) recover $20 if you run to the bank along with everyone else. Thus, if you expect others to run on the bank, you should do the same.

Figure 7.12 Payoffs in a Bank-Run Game

This table shows the payoffs in a bank-run game. That is, it shows you what you get back depending on your choice and everybody else’s choice about whether to run on the bank. If everyone else leaves money in the bank, then you should do the same, but if everyone else runs on the bank, you are better running as well.

Economists call this situation a coordination gameA strategic situation in which there are multiple equilibria.. In a coordination game, there are multiple equilibria. In this example, there is one equilibrium where there is no run on the bank, and there is another equilibrium where everyone runs to the bank to withdraw funds.

During the Great Depression, a story such as this played out not only at one bank but at many. Figure 7.13 shows what happened in terms of the aggregate expenditure framework. Prior to the Great Depression, the economy was in a “high confidence” equilibrium, in which the banking system was healthy and confidence was high. Then—for some reason—people became nervous about leaving money in banks, and it became much harder for firms to obtain loans. The cost of borrowing—the real interest rateThe rate of return specified in terms of goods, not money.—increased, and investment decreased substantially. The planned spending line shifted downward, and the economy moved to the bad “low confidence” equilibrium. The downward shift in planned spending leads to a decrease in real GDP, given the existing level of prices.

Figure 7.13 should look familiar; it is the same as part (b) of Figure 7.10 "A Decrease in Aggregate Expenditures". This is because a decrease in autonomous consumption and a decrease in autonomous investment both look the same in the aggregate expenditure model, even though the underlying story is different. Of course, it is also possible that both autonomous consumption and autonomous investment decreased.

Figure 7.13

Failures in the financial sector lead to a drop in investment spending. During the Great Depression, a decrease in confidence in the banking system meant that many banks failed, and it became more difficult and expensive for firms to borrow. The planned spending line shifted downward, and real GDP decreased.

To summarize, the banking crisis made households reluctant to put money in the banks, and banks were reluctant to make loans. Two banking measures help us see what was happening. The currency-deposit ratioThe total amount of currency (banknotes plus coins) divided by the total amount of deposits in banks. is the total amount of currency (that is, either banknotes or coins) divided by the total amount of deposits in banks. The loan-deposit ratioThe total amount of loans made by banks divided by the total amount of deposits in banks. is the total amount of loans made by banks divided by the total amount of deposits in banks.

If the currency-deposit ratio is low, households are not holding very much cash but are instead keeping wealth in the form of bank deposits and other assets. The currency-deposit ratio increased from 0.09 in October 1929 to 0.23 in March 1933.See Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), Table B3. This means that households in the economy started holding onto cash rather than depositing it in banks. You can think of the loan-deposit ratio as a measure of the productivity of banks: banks take deposits and convert them into loans for investment. During the Great Depression, the loan-deposit ratio decreased from 0.86 to 0.73.See Ben Bernanke, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” American Economic Review 73 (1983): 257–76, Table 1.

Price Adjustment

The story we have told explains why the economy departs from potential output but says nothing about how (if at all) the economy gets back to potential output. The answer is that prices have a tendency to adjust back toward their equilibrium levels, even if they do not always get there immediately. This is most easily understood by remembering that prices in the economy are, in the end, usually set by firms. When a firm sees a decrease in demand for its product, it does not necessarily decrease its prices immediately. Its decision about what price to choose depends on the prices of its inputs and the prices being set by its competitors. In addition, it depends on not only what those prices are right now but also what the firm expects to happen in the future. Deciding exactly what to do about prices can be a difficult decision for the managers of a firm.

Without analyzing this decision in detail, we can certainly observe that firms often keep prices fixed when demand decreases—at least to begin with. The result looks like that in Figure 7.6 "An Inward Shift in Market Demand for Houses". In the face of a prolonged decrease in demand, however, firms will lower prices. Some firms do this relatively quickly; others keep prices unchanged for longer periods. We conclude that prices are sticky; they do not decrease instantly, but they decrease eventually.Chapter 10 "Understanding the Fed" provides more detail about the price-adjustment decisions of firms. For the economy as a whole, this adjustment of prices is represented by a price-adjustment equationAn equation that describes how prices adjust in response to the output gap, given autonomous inflation..

This equation tells us that there are two reasons for increasing prices.

1. Prices increase because autonomous inflation is positive. Even when the economy is at potential output, firms may anticipate that their suppliers or their competitors are likely to increase prices in the future. A natural response is to increase prices, so autonomous inflation is positive.
2. Prices increase because the output gap is negative. The output gap matters because, as GDP increases relative to potential, labor and other inputs become scarcer. Firms see increasing costs and choose to set higher prices as a consequence. The “inflation sensitivity” tells us how responsive the inflation rate is to the output gap.

When real GDP is above potential output, there is upward pressure on prices in the economy. The inflation rate exceeds autonomous inflation. By contrast, when real GDP is below potential, there is downward pressure on prices. The inflation rate is below the autonomous inflation rate. The price-adjustment equation is shown in Figure 7.14 "Price Adjustment".

Figure 7.14 Price Adjustment

When an economy is in a recession, actual inflation is lower than autonomous inflation. In a boom, inflation is higher than its autonomous level.

We can apply this pricing equation to the Great Depression. Imagine first that autonomous inflation is zero. In this case, prices decrease when output is below potential. From 1929 to 1933, output was surely below potential and, as the equation suggests, this was a period of decreasing prices. After 1933, as the economy rebounded, the increase in the level of economic activity was matched with positive inflation—that is, increasing prices. This turnaround in inflation occurred even though the economy was still operating at a level below potential output. To match this movement in prices, we need to assume that—for some reason that we have not explained—autonomous inflation became positive in this period.

Policy Remedies

In the wake of the Great Depression, economists started advocating the use of government policy to improve the functioning of the macroeconomy. There are two kinds of government policy. Monetary policyChanges in interest rates and other tools that are under the control of the monetary authority of a country (the central bank). refers to changes in interest rates and other tools that are under the control of the monetary authority of a country (the central bank). Fiscal policyChanges in taxation and the level of government purchases, typically under the control of a country’s lawmakers. refers to changes in taxation and the level of government purchases; such policies are typically under the control of a country’s lawmakers. Stabilization policyThe use of monetary and fiscal policies to prevent large fluctuations in real GDP. is the general term for the use of monetary and fiscal policies to prevent large fluctuations in real gross domestic product (real GDP).

In the United States, the Federal Reserve Bank controls monetary policy, and fiscal policy is controlled by the president, the Congress, and state governments. In the countries of the European Union, monetary policy is controlled by the European Central Bank, and fiscal policies are controlled by the individual governments of the member countries.

Keynes suggested that the cause of the Great Depression was an unusually low level of aggregate spending. This diagnosis suggests an immediate remedy: use government policies to increase aggregate spending. Because

any government policy that increases autonomous spending will, through this equation, also increase GDP. There are many different policies at the disposal of the government, but they are similar at heart. The idea is to stimulate one of the components of aggregate spending—consumption, investment, government purchases, or net exports.

One fiscal policy measure is an increase in government purchases. Suppose the government increases its expenditure—perhaps by hiring more teachers, buying more tanks, or building more roads. This increases autonomous spending and works its way through the economy, just as in our earlier discussion of a decrease in autonomous consumption—except now we are talking about an increase rather than a decrease. If the government spends an extra dollar, this immediately expands income by that dollar. Extra income leads to extra spending, which leads to further increases in output and income. The process continues around and around the circular flow.

Imagine that, as before, the marginal propensity to spend is 0.8, so that the multiplier is 5. If the government increases expenditure on goods and services by $1 billion, overall GDP in the economy will increase by $5 billion. Thus to offset the decrease in real GDP of about $90 billion between 1929 and 1933, assuming a marginal propensity to spend of 0.8, the federal government should have increased government spending by $18 billion. The multiplier is a double-edged sword. It has the bad effect that it can turn small decreases in spending into big decreases in output. But it also means that relatively small changes in government spending can have a big effect on output.

Tax cuts are another way to stimulate the economy. If households have to pay fewer taxes to the government, they are likely to spend more on consumption goods. This form of policy intervention has been used over and over again by governments in the United States and elsewhere. Tax cuts, like government spending, must be paid for. If the government spends more and taxes less, then the government deficit increases. The government must borrow to finance such fiscal policy measures.Chapter 12 "Income Taxes" and Chapter 14 "Balancing the Budget" have more to say about fiscal policy.

The central bank can use monetary policy to affect aggregate spending. Monetary policy operates through changes in interest rates, which are—in the short run at least—under the influence of the central bank. Lower interest rates make it cheaper for firms to borrow, which encourages them to increase investment spending. Lower interest rates likewise mean lower mortgage rates, so households are more likely to buy new homes. Lower interest rates may encourage households to borrow and spend more on other goods. And lower interest rates can even encourage net exports.The link from interest rates to net exports is complicated because it involves changes in exchange rates. You do not need to worry here about how it works. We explain it, together with other details of monetary policy, in Chapter 10 "Understanding the Fed".

Monetary and Fiscal Policies during the Great Depression

We have argued that monetary and fiscal policies could have been used to help the economy out of the Great Depression. But what did policymakers actually do at the time? The answer comes in two parts: at the start of the Great Depression, they did not do much; after 1932, they did rather more.

Both presidential candidates campaigned in favor of conservative fiscal policy in 1932. Here are some excerpts from the party platforms.See John Woolley and Gerhard Peters, The American Presidency Project, accessed June 30, 2011, http://www.presidency.ucsb.edu.

From the Democratic Party platform:

From the Republican Party platform:

Both parties were arguing for cuts in government expenditures, not the increases that (with the benefit of hindsight and better theory) we have suggested were needed. Monetary policy was likewise not used to stimulate the economy at this time. It seems unlikely that the fiscal and monetary authorities knew what to do but did nothing. Instead, the tools of economic thought needed to guide policy were simply not sufficiently well developed at the time. In keeping with the prevailing view that the economy was self-correcting, the incumbent Republican president, Herbert Hoover, had insisted that “prosperity is just around the corner.”

The election of Franklin Roosevelt in 1932 was a turning point. After his election, President Roosevelt and his advisors created a series of measures—called the New Deal—that were intended to stabilize the economy. In terms of fiscal policy, the US government moved away from budget balance and adopted a much more aggressive spending policy. Government spending increased from 3.2 percent of real GDP in 1932 to 9.3 percent of GDP by 1936. These spending increases were financed by budget deficits.

Roosevelt also took action to stabilize the banking system, most notably by creating a system of deposit insurance. This policy remains with us today: if you have deposits in a US bank, the federal government insures them. According to the Federal Deposit Insurance Corporation (http://www.fdic.gov), not a single depositor has lost a cent since the introduction of deposit insurance.The FDIC site (http://www.fdic.gov) provides a discussion the history of this fund and current activities. The discussion of “Who is the FDIC?” (http://www.fdic.gov/about/learn/symbol/index.html) is a good place to start. Finally, the 1930s was also the time of the introduction of Social Security and other measures to protect workers. The Social Security Administration (http://www.ssa.gov) originated in 1935.General information on social security is available at http://www.ssa.gov. The history of the legislation, including various House and Senate Bills, is also available at http://www.ssa.gov/history/history.html. The original act included old-age benefits and the provision of unemployment insurance. The disability part of the program was created in 1956.

The New Deal brought about changes not only in policy but also in attitudes toward policymaking. Gardiner Means, who was an economic adviser to the Roosevelt administration in 1933, said of policymaking at the time: