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We started this chapter by describing the experience of the economy of the United States and other countries in the 1930s. The catastrophic economic performance of that period was difficult to reconcile with the view of classical economists that markets always worked to coordinate aggregate economic activity. Although technological progress provides a plausible explanation of the roaring twenties, technological regress is much less convincing as a story of the Great Depression. Technological regress also cannot explain the behavior of the price level and real wages during the Great Depression.
The Keynesian view explains the Great Depression as being driven by a decrease in aggregate spending, caused primarily by two factors: household consumption decreased because the stock market crash reduced household wealth, and investment decreased because of disruption of the financial intermediation process and pessimism over the future of the economy. These reductions in spending, through the multiplier, led to large reductions in real output. This story is consistent with the observed reductions in consumption, investment, and real GDP. With sticky prices, these reductions in spending translate into lower real GDP. The simple Keynesian story also has two problems: it can explain increasing prices only by assuming an exogenous increase in autonomous inflation and it provides no explanation of why observed technology decreased in the Great Depression period.
Along with the Keynesian explanation of the Great Depression comes a solution: use government policies to manage aggregate spending. If the aggregate expenditure model were literally true, policymaking would become an exact science: the policymaker would start with a target level of output and then determine the level of, say, government purchases needed to reach that target. As you might imagine, life as an economic policymaker is more complicated. The economists and politicians designing fiscal and monetary policy do not have a perfect picture of the current state of the economy. Moreover, control over policy tools is often inexact, and policy decisions take time.
The Great Depression remains something of a puzzle to macroeconomists. This became very apparent again recently during the so-called Great Recession—the major economic downturn that began in 2008. There are some resemblances between the two episodes, and the experience of the Great Depression certainly influenced some of the monetary policy decisions that were made in recent years. In this chapter, we did not yet consider monetary policy in detail. Chapter 25 "Understanding the Fed", which discusses the conduct of monetary policy, also addresses monetary policy during the Great Depression.
The aggregate expenditure framework is not a very sophisticated theory of the economy. Much work in macroeconomics in the decades since the Great Depression has involved refining the various pieces of the aggregate expenditure model. Economists have developed more rigorous theories of consumption, investment, and price adjustment, for example, in which they emphasize how households and firms base their decisions on expectations about the future. But Keynes’ fundamental insight—that the level of output may sometimes be determined not by the productive capacity of the economy but by the overall level of spending—remains at the heart of macroeconomic research and policymaking today.
Photo exhibits about the Great Depression: