INTRODUCTION TO MACROECONOMICS (CONTINUED………..)

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Introduction to Economics ECO401

Lesson 8.2

INTRODUCTION TO MACROECONOMICS (CONTINUED...........)

The Great Depression and Say's Law:

The Great Depression was the longest and severest recession the world has ever seen. It

struck North America and Europe in the late 1920s after the Wall Street crash of 1929 (and

following the earlier hyperinflation in Germany, and the formation of the Soviet Union) and

lasted till the mid 1930s. It was characterized by persistent high unemployment, low

investment by firms and falling prices of goods, services and factors.

An important law the Classical subscribed to, which assumed particular importance in the

context of the Great Depression, was Say's law: "supply creates its own demand." The

implication of this was that involuntary unemployment (people being unemployed against their

wishes) was a temporary phenomenon as the excess supply of labour would cause wages to

fall thereby prompting firms to demand more labour. If there was persistent unemployment, it

was voluntary, i.e. workers themselves preferred to remain unemployed.

The Classicals' Views about Great Depression:

The Classicals' reading of the three problems of the Great Depression, i.e. low investment,

high unemployment and low output, was as follows:

a. Investment was low because the interest rate was too high in the loanable funds

market. Policy recommendation: savings be increased to lower the interest rate and

boost investment

b. Unemployment was high because of obstructions to the free market mechanism in the

labour market which were preventing wages from falling to the market clearing level.

Policy recommendation: these obstructions: benefit payments to unemployed, taxes on

income and trade unions be eliminated.

c. The AS curve was vertical therefore lack or excess of demand could not explain the

low level of activity in the aggregate market for goods and services. Policy

recommendation: focus on ways to move the AS curve to the right (i.e. supply side

measures).

The Keynesians' Views about Great Depression:

Keynes' view on the causes of the Great Depression and what needed to be done was very

different. He believed that there were overarching problems of low demand and static

pessimistic expectations that needed to be addressed rather than disequilibria in the loanable

funds, labour and goods markets. In particular, he maintained that:

a. Low investment was because of firms' bearish expectations about their ability to sell

the products they produced. Firms needed to see that the potential buyers of their

goods had the money and the willingness to buy goods before they could be convinced

to undertake more production thereof. Therefore, higher savings, which would lead to

low consumption expenditure on goods and services would not increase but decrease

investment by reinforcing firms' bearish expectations about their ability to sell their

products. Policy recommendation: households should be convinced to increase

consumption and reduce saving.

b. Unemployment was high and rising because the labour market equilibrium was moving

further and further away from the full employment level. This was not because wages

were being prevented from falling to the market clearing level, but because the market

clearing level fell further with each wage decrease. This happened because a reduction

in wages also lowered consumers' earning and spending power reinforcing firms'

pessimistic view of their ability to sell their products. Policy recommendation: higher

money payments to consumers should be given out (possibly by the state) in order to

increase their ability to buy the goods being produced by firms.

c. The AS curve was horizontal at the less than full employment level (i.e. when there

was excess capacity or slack in the economy), and upward sloping after that, so that an

Introduction to Economics ECO401

injection of aggregate demand in times of recession could materially increase output,

employment and national income.

In summary, Keynes believed that an economy could settle at equilibrium below the full

employment level, he advocated demand-side policies to lift the economy out of that

equilibrium towards full employment. He suggested the government spend itself and

encourage consumption spending. This would cause demand and prices of goods to rise,

generating firms' interest in producing more. This would in turn require hiring to go up, which

would cause labour incomes to go up which would lead to further higher demand for goods

and hence a reinforcement of the virtuous circle. Only such a circle could, according to

Keynes, change agents' pessimistic view of the future and take the economy out of

Depression.

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