Brief History of Macroeconomic Thought and Policy

Read this chapter to examine macroeconomic attitudes towards economic policies of the three main schools of economic thought: Classical, Keynesian, and Monetarist. Also, learn about modern day interpretations of the main ideas.

1. The Great Depression and Keynesian Economics

Keynesian Economics and the Great Depression

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

The plunge in aggregate demand began with a collapse in investment. The investment boom of the 1920s had left firms with an expanded stock of capital. As the capital stock approached its desired level, firms did not need as much new capital, and they cut back investment. The stock market crash of 1929 shook business confidence, further reducing investment. Real gross private domestic investment plunged nearly 80% between 1929 and 1932. We have learned of the volatility of the investment component of aggregate demand; it was very much in evidence in the first years of the Great Depression.

Other factors contributed to the sharp reduction in aggregate demand. The stock market crash reduced the wealth of a small fraction of the population (just 5% of Americans owned stock at that time), but it certainly reduced the consumption of the general population. The stock market crash also reduced consumer confidence throughout the economy. The reduction in wealth and the reduction in confidence reduced consumption spending and shifted the aggregate demand curve to the left.

Fiscal policy also acted to reduce aggregate demand. As consumption and income fell, governments at all levels found their tax revenues falling. They responded by raising tax rates in an effort to balance their budgets. The federal government, for example, doubled income tax rates in 1932. Total government tax revenues as a percentage of GDP shot up from 10.8% in 1929 to 16.6% in 1933. Higher tax rates tended to reduce consumption and aggregate demand.

Other countries were suffering declining incomes as well. Their demand for U.S. goods and services fell, reducing the real level of exports by 46% between 1929 and 1933. The Smoot–Hawley Tariff Act of 1930 dramatically raised tariffs on products imported into the United States and led to retaliatory trade-restricting legislation around the world. This act, which more than 1,000 economists opposed in a formal petition, contributed to the collapse of world trade and to the recession.

As if all this were not enough, the Fed, in effect, conducted a sharply contractionary monetary policy in the early years of the Depression. The Fed took no action to prevent a wave of bank failures that swept the country at the outset of the Depression. Between 1929 and 1933, one-third of all banks in the United States failed. As a result, the money supply plunged 31% during the period.

The Fed could have prevented many of the failures by engaging in open-market operations to inject new reserves into the system and by lending reserves to troubled banks through the discount window. But it generally refused to do so; Fed officials sometimes even applauded bank failures as a desirable way to weed out bad management!

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

Slumping aggregate demand brought the economy well below the full-employment level of output by 1933. The short-run aggregate supply curve increased as nominal wages fell. In this analysis, and in subsequent applications in this chapter of the model of aggregate demand and aggregate supply to macroeconomic events, we are ignoring shifts in the long-run aggregate supply curve in order to simplify the diagram.

Figure 17.2 "Aggregate Demand and Short-Run Aggregate Supply: 1929–1933" shows the shift in aggregate demand between 1929, when the economy was operating just above its potential output, and 1933. The plunge in aggregate demand produced a recessionary gap. Our model tells us that such a gap should produce falling wages, shifting the short-run aggregate supply curve to the right. That happened; nominal wages plunged roughly 20% between 1929 and 1933. But we see that the shift in short-run aggregate supply was insufficient to bring the economy back to its potential output.

The failure of shifts in short-run aggregate supply to bring the economy back to its potential output in the early 1930s was partly the result of the magnitude of the reductions in aggregate demand, which plunged the economy into the deepest recessionary gap ever recorded in the United States. We know that the short-run aggregate supply curve began shifting to the right in 1930 as nominal wages fell, but these shifts, which would ordinarily increase real GDP, were overwhelmed by continued reductions in aggregate demand.

A further factor blocking the economy's return to its potential output was federal policy. President Franklin Roosevelt thought that falling wages and prices were in large part to blame for the Depression; programs initiated by his administration in 1933 sought to block further reductions in wages and prices. That stopped further reductions in nominal wages in 1933, thus stopping further shifts in aggregate supply. With recovery blocked from the supply side, and with no policy in place to boost aggregate demand, it is easy to see now why the economy remained locked in a recessionary gap so long.

Keynes argued that expansionary fiscal policy represented the surest tool for bringing the economy back to full employment. The United States did not carry out such a policy until world war prompted increased federal spending for defense. New Deal policies did seek to stimulate employment through a variety of federal programs. But, with state and local governments continuing to cut purchases and raise taxes, the net effect of government at all levels on the economy did not increase aggregate demand during the Roosevelt administration until the onset of world war. For a discussion of fiscal policy during the Great Depression. As Figure 17.3 "World War II Ends the Great Depression" shows, expansionary fiscal policies forced by the war had brought output back to potential by 1941. The U.S. entry into World War II after Japan's attack on American forces in Pearl Harbor in December of 1941 led to much sharper increases in government purchases, and the economy pushed quickly into an inflationary gap.

Figure 17.3 World War II Ends the Great Depression

Increased U.S. government purchases, prompted by the beginning of World War II, ended the Great Depression. By 1942, increasing aggregate demand had pushed real GDP beyond potential output.

For Keynesian economists, the Great Depression provided impressive confirmation of Keynes's ideas. A sharp reduction in aggregate demand had gotten the trouble started. The recessionary gap created by the change in aggregate demand had persisted for more than a decade. And expansionary fiscal policy had put a swift end to the worst macroeconomic nightmare in U.S. history ­– even if that policy had been forced on the country by a war that would prove to be one of the worst episodes of world history.