Lesson 17-1 The Great Depression and Keynesian Economics

The Classical School and the Great Depression Classical economics is the body of macroeconomic thought associated primarily with nineteenth-century British economist David Ricardo. Ricardo focused on the long run and emphasized the ability of flexible wages and prices to keep the economy at or near its natural level of employment. The classical economists expected the economy to be self-correcting to potential output although there would be temporary short-run divergence from that output.

Keynesian Economics John Maynard Keynes in his book The General Theory of Employment, Interest, and Money published in 1936 sought to explain the long-running depression in Britain. Keynes versus the Classical Tradition Keynes’ major change in macroeconomic theory was to focus on aggregate demand rather than aggregate supply. He showed how shifts in aggregate demand could cause inflationary and recessionary gaps.

He maintained that prices were quite sticky in the short run. He argued that self-correction could take a very long time and was therefore irrelevant to macro policy. The school of Keynesian economics holds that changes in aggregate demand can create gaps between the actual and potential levels of output, and that such gaps can be prolonged. Keynesian economists stress the use of fiscal and monetary policy to close gaps.

Keynesian Economics and the Great Depression The Depression seemed to confirm Keynesian analysis. Investment fell first after an investment boom of the early 1920s left capital stock at desired levels. The stock market crash of 1929 shook business and consumer confidence and reduced consumption and investment. The crash also reduced wealth for about 5 percent of the population that held stocks and also reduced consumption.

Government raised taxes to offset the decline in spending and thereby reduced consumption. Because the depression was international in scope, net exports fell. Because of bank failures, the money supply was sharply reduced and the Fed did nothing to offset this. All of these shifted the aggregate demand to the left and resulted in declining real output and falling wages that shifted short-run supply to the right. The shift was insufficient to offset continuing declines in aggregate demand. Expansionary fiscal policy did not occur in significant amounts until the expenditures required for World War II.