The Great Recession, the Great Depression, and Great Macroeconomic Debates

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1 The Great Recession, the Great Depression, and Great Macroeconomic Debates

2 Previously The aggregate demand and aggregate supply model is a simplified view of the economy that helps us evaluate short-term fluctuations in real GDP and unemployment (business cycles). The AD-AS model helps us understand the macroeconomic impacts of real world changes and gives us an important tool to use in government policy analysis.

3 Big Questions 1. What exactly happened during the Great Recession and the Great Depression? 2. What are the major disagreements among macroeconomists?

4 The Recession of 2008 Officially from December 2007 to June 2009, making it the longest recession since WWII Named the Great Recession Longer in length than other recessions Deeper in effects than other recessions Significant problems in the financial markets, similar to what happened during the Great Depression

5 Depth and Duration of the Great Recession Figure 27.1.a here

6 Depth and Duration of the Great Recession Figure 27.1.b here

7 Analyzing the Great Recession with AD and AS Trouble in the financial markets in 2007 Declining real estate values in 2007 Defaults on mortgages Falling real estate values therefore led to a systematic problem in the U.S. financial markets These markets exhibit international interdependence, and the problem became a worldwide problem Breakdown in the loanable funds market This scenario represents an institutional breakdown, which shifts the LRAS left.

8 U.S. House Purchase Price Index Figure 27.2 here

9 Analyzing the Great Recession with AD and AS While institutional breakdowns affected aggregate supply, aggregate demand was also affected by two factors. Decrease in wealth Real estate is often the single largest portion of an individual s wealth. Stocks lost one-third of their value in Decrease in expected income People realized things were getting bad. Consumer spending decreases during times of uncertainty, decreasing AD further.

10 Consumer Sentiment Index Figure 27.3 here

11 Great Recession, AS and AD Analysis

12 Great Recession Numbers Second quarter of 2007 (pre-recession) Unemployment was below 5%. Real GDP was growing at a rate of 3.6%. Last quarter of 2008 Unemployment rate of 10% Real GDP had shrunk by 8.9%. 2012: Recession officially over, but effects linger Real GDP was growing at a rate of less than 2%. Unemployment remained at 8%. Government tried many tools to get growth back to normal.

13 Great Recession Numbers

14 Great Depression While Great Recession and Great Depression sound similar, the Great Depression was much, much worse

15 Great Depression Great Depression numbers: Economy contracted by 30% from 1929 to It took seven years for real GDP to return to its prerecession level. Unemployment was 2.2% in Unemployment was 25% in The unemployment rate was 15% for almost the entire decade of the 1930s.

16 Real U.S. GDP

17 Real GDP Comparison Figure 27.6.a here

18 Unemployment Comparison Figure 27.6.b here

19 Great Depression, AS and AD Analysis The Great Depression was characterized by some unique conditions: Effects were deep and long lasting It was actually two separate recessions (1929 to 1933 and 1937 to 1938). Most remarkable: prices across the economy fell throughout the decade. At the end of the 1930s, the price level was still 20% lower than The decline in prices indicates that the primary cause of the Great Depression was a decrease in AD.

20 Great Depression, AS and AD Analysis

21 Causes of the Depression Macroeconomic policy Encompasses government acts to influence the direction of the overall economy Much of the Depression was caused by faulty macroeconomic policy. Fiscal policy Comprises the use of government spending and taxes to influence the economy Monetary policy Involves adjusting the money supply to influence the economy

22 General Depression Events Stock market crash October 29, 1929, Black Thursday After this event, AD decreased due to people s lower expected future income : stock prices fell by almost 90%! The government s policy response? In 1928 and 1929, the government reduced the money supply in hopes of controlling stock prices, which policymakers thought were too high. The lower money supply brought on a panic among people.

23 Bank Problems This policy error involved banks all over the country as financial panic spread. 9,000 banks failed from Government had the ability to lend to these banks, but it didn t. Thus, the money supply decreased even further : money supply decreased by one-third. Economists views on the Depression today: The decline in the money supply and the resulting decrease in AD were the primary contributors to the beginning of the Great Depression.

24 Great Depression Other Factors Taxes Hoover and Roosevelt raised taxes in attempts to balance the budget. This further reduced AD. Smoot-Hawley Tariff Act Imposed tariffs on thousands of imported goods Set off a trade war, and other countries taxed U.S. exports, which decreased global demand for our products.

25 Big Disagreements in Macroeconomics Classical economists The economy s adjustment toward long-run equilibrium will happen naturally. General policy is to let the economy go and the market will correct itself. Keynesian economists Adjustment will be long and occur unpredictably with many delays. More inclined to call for government interventions in the market

26 Classical Economics Economy is self-correcting. Generally believe in the AD-AS framework shown Economy comes back to full employment in the long run, no matter what curves shifted. Adjustments generally occur quickly. Policies Pro-market, laissez-faire No significant role for government intervention in macroeconomic policy Focus on long-run growth (shifting LRAS) rather than AD shifts

27 The Strict Classical View

28 Say s Law Say s Law Supply creates its own demand Part of the old classical economic school If you build it, they will come. Implications Producing goods and services generates the means and the willingness to purchase other goods and services.

29 The Great Depression and Economic Theory The conditions of the Great Depression were bad by almost any measure and shook the view of Classical economics. Decade-long recession Contraction so severe that economy produced 30% less after four years 25% unemployment in % unemployment over the 1930s decade Fundamentally changed people s views of economy and role of government. Could the economy correct itself? Keynesian economics is created.

30 Keynesian Economics John Maynard Keynes, British economist The General Theory of Employment, Interest, and Money, in 1936 Offered a theory why cyclical unemployment may persist for longer time periods Believed that wages did not adjust downward quickly during recessions due to contracts and salary expectations. Wages are sticky downward. Therefore, high wages prevent labor markets reaching equilibrium and restoring full employment, creating a prolonged recession.

31 Keynesian Economics Major focus is on the demand side of the economy as the source of instability According to Keynes, government intervention (often in the form of a stimulus) would be needed in prolonged recessions to boost demand to restore the economy to long-run equilibrium. Most famous quote by Keynes: In the long run, we are all dead.

32 Keynesian Economics Cause of sticky downward wages? Wage agreements by unions (especially in 1930s) Money illusion; people didn t want to take a pay cut, especially in a recession. Keynesian policy Government can boost AD by increasing G since consumers are reluctant to increase C or I. Keynesian view on savings Savings is not helpful in the short run since it reduces AD. The short run is a crucial time frame.

33 Presidential Economics Is Obama a Keynesian? If you are Keynesian, it would of course mean that you are more likely to believe the economics idea presented by John Maynard Keynes rather than the Classical theory.

34 Classical versus Keynesian Economics Classical Keynesian Key Time Period Long run Short run Price Flexibility Prices flexible Prices sticky Savings Crucial to growth A drain on demand Key Side of Market Market Tendency Government Intervention Supply Stability, full employment Not necessary Demand Instability, cyclical unemployment Essential

35 Economics in Keynes vs. Hayek Keynes vs. Hayek Keynes: government intervention needed Hayek: leave the market alone.

36 Summary While short-term fluctuations (recessions and expansions) can be painful, the United States spends much less time in recession than in times past. In the recent Great Recession, we experienced lower output and high unemployment. However, the Great Depression in the 1930s was much worse and lasted much longer.

37 Summary Classical economists believe the market to be self-correcting and focus on long-run growth aimed at expanding the LRAS. Keynesian economists believe that market corrections can take a long time due to sticky wages, and focus on policy aimed at AD. Economist generally agree that the economy can be self-correcting in the long run, but disagree about the relative importance of the short run and long run.

38 Practice What You Know What was one of the main catalysts of the Great Recession, which began in December 2007? a. a large tax increase b. falling real estate prices c. bad monetary policy, which increased the money supply too much d. a lack of skilled labor

39 Practice What You Know What is true about the magnitude of the Great Depression? a. Output fell by 4% during the Depression. b. A large increase in the money supply almost caused hyperinflation. c. Prices rose higher than any time in the previous century. d. Unemployment reached a level of 25%.

40 Practice What You Know The Great Depression led to the creation of what school of thought in economics? a. Classical b. Keynesian c. Ricardian d. Smithian

41 Practice What You Know Classical economists will generally focus on policies that will a. cause short-run AD changes. b. emphasize increasing the LRAS. c. cause people to spend less money. d. prevent GDP from increasing too fast.

42 Practice What You Know What is the main reason Keynes believed that the economy won t return to equilibrium after a decrease in AD? a. the ineffectiveness of government intervention b. People wanted to remain in the depression because of lower prices. c. sticky wages d. imperfect information

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