The Keynesian explanation of the Great Depression

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 effect. 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. The Multiplier Toolkit: Section 16.19 “The Aggregate Expenditure Model” The solution for output in the aggregate expenditure model can be written in terms of changes as follows: change in GDP = multiplier × change in autonomous spending, where the multiplier is given by Saylor URL: http://www.saylor.org/books Saylor.org 251 multiplier = 1

1 – marginal propensity to spend .

Suppose that the marginal propensity to spend is 0.8. Then

multiplier = 1

1 – marginal propensity to spend =

1 1 – 0.8

= 1

0.2 = 5.

A given change in autonomous spending will lead to a fivefold change in real GDP. Economists refer to this as a multiplier process. Because (1 − marginal propensity to spend) is less than one, the multiplier is a number greater than one. This means that any change in autonomous spending is multiplied up to result in a larger change in GDP. Even relatively small decreases in spending can end up being damaging to an economy. The economics behind the multiplier comes from the circular flow of income. Begin with a decrease in autonomous spending. The reduction in spending means less demand for firms’ goods and services. Firms respond by cutting output. (As a reminder, the signal to firms that they should cut their output comes from the fact that they see a buildup of their inventory.) When firms cut their output, they require less labor and pay out less in wages, so household income decreases. This causes households to again cut back on consumption, so spending decreases further. Thus we go round and round the circular flow diagram: decreased spending leads to decreased output, which leads to decreased income, which leads to decreased spending, which leads to decreased output, and so on and so on. The process continues until the reductions in income, output, and consumption in each round are tiny enough to be ignored. We use the multiplier to carry out comparative static exercises in the aggregate expenditure model. In this case, the endogenous variable is real GDP, and the exogenous variable is autonomous spending. Given a change in autonomous spending, we simply multiply by the multiplier to get the change in real GDP when the price level is fixed. Let us do some back-of- the-envelope comparative static calculations, based on the assumption that the marginal propensity to spend is 0.8, so the multiplier is 5. Table 7.1 “Major Macroeconomic Variables, 1920–39*” tells us that real GDP decreased by approximately $75 billion between 1929 and 1930. With a multiplier of 5, we would need a drop in autonomous spending of $75 billion divided by 5, or $15 billion, to get this large a decrease in GDP. The population of the United States in 1930 was approximately 123 million, so a $15 billion decrease in spending corresponds to about $122 per person. Remember that the figures in Table 7.1 “Major Macroeconomic Variables, 1920–39*” are in terms of year 2000 dollars. It certainly seems plausible that households, who had been made significantly poorer by the collapse in the stock market, would have responded by cutting back spending by the equivalent today of a few hundred dollars per year. Our goal, you will remember, is to explain the events of the Great Depression. How are we doing so far? The good news is that we do have a story that explains how output could decrease as precipitously as it did in the Great Depression years: there was a major stock market crash, which made people feel less wealthy, so they decided to consume less and save more. If we look more closely, though, this story still falls short. When we examined the data for the Great Depression, we saw that—while output and consumption both decreased—consumption decreased much less than did output. For example, from 1929 to 1933, real GDP decreased by 26.5 percent, while consumption decreased by 18.2 percent. By contrast, investment (that is, purchases of capital by firms, new home construction, and changes in business inventories) decreased much more than output. In 1932, purchases of new capital were $11 billion (year 2000 dollars), compared to a level of $91 billion in 1929. This is a reduction in real investment of about 82 percent. We must look more closely at investment to see if our theory can also explain the different behavior of consumption and investment. 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.