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KEYNES AND THE BUSINESS CYCLE INTRODUCTION Economic fluctuations before the 19th century Origin in natural disasters Thought of as being outside human control A “business cycle” as a 19th century phenomenon: why? Increasing specialization, division of labor Increasing industrialization

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introduction
INTRODUCTION
  • Economic fluctuations before the 19th century
    • Origin in natural disasters
    • Thought of as being outside human control
  • A “business cycle” as a 19th century phenomenon: why?
    • Increasing specialization, division of labor
slide3
Increasing industrialization
  • Increasing interdependence, and collapse in one sector spreading to other sectors:
    • Decreasing sales
    • Layoffs
    • Lower income
    • Less spending
    • A downward cumulative process
slide4
A key role for firms:
    • Production plans, based on expected sales
    • Hiring plans, based on production plans
  • And for consumers:
    • Spending plans, based on expected income
    • Expected income, based on expected employment
slide5
Any role for government in 19th century thought?
    • Thought to be unnecessary: usually saw eventual recovery without intervention
    • Could expect small fluctuations in output, but no “general glut”
the great depression

THE GREAT DEPRESSION

The Classical Faith Shattered

slide7
Background: the Roaring Twenties
    • A time of rapid growth, prosperity
    • Relatively stable prices
    • Low unemployment-in most sectors
    • Growth industries: autos; construction; electricity; chemicals
    • Declining industries: agriculture; railroads; coal
slide8
Growing use of consumer credit
    • Unfamiliar to banks, consumers
    • Result: overextension
  • Growing inequality of income; and implications for consumer spending
slide9
1929 and after
    • Stock market crash, 1929
    • Massive wealth loss by 1933: about 80% of stock values gone
    • Recession beginning in 1929; ordinary through 1930; then the bottom falls out
      • 25% unemployment rate by 1933; never under 10% in the 30s
slide10
Real GDP fell by about 33% by 1933
    • 80% of investment disappears, 1929-1933
    • Over 40% of banks disappear-and no deposit insurance
  • Recovery? Not until World War II
slide11
What caused it? Why so deep, so long?
    • Ordinary recession, 1929
    • Expectations of normal recovery, 1930
    • Massive bank failures
      • Large decrease in money supply
      • Deflation
slide12
Effects on financial intermediation of deflation:
    • Decreases in borrower net worth (heavy debt burden)
    • Increased risk to lenders
    • Massive disruption of allocation of funds
    • Investment collapse
    • Effects long-lasting
slide13
Fed fails the test
    • Concern for maintaining the gold standard
    • Not serve as lender of last resort
    • Note 1935-36 contractionary policies
  • Macroeconomic consequences of financial system failure, especially
    • Large reductions in money supply
    • Interference with intermediation process
slide14
Decreased consumption, especially consumer durables
    • Heavy debt burden from 1920s
    • Uncertainty, due to stock market collapse
  • Restrictions on international trade: Smoot-Hawley tariff
slide15
Political response: the new Deal and its reforms
    • Monetary: already discussed
    • Agricultural: already discussed
    • Industry, and the National Industrial Recovery Act
      • Goal: Reduce “ruinous competition”
slide16
Raising prices to generate higher firm incomes, stimulating hiring-but is this backwards??
    • In the end:
      • Declared unconstitutional
      • Largely ineffective, in any case
  • SEC; and securities market regulation
  • Social Security: an income support mechanism
  • Public works programs: PWA; WPA; CCC
  • Goals: recovery; and reform
keynes s contribution
KEYNES’S CONTRIBUTION
  • The General Theory of Employment, Interest, and Money as revolutionizing macroeconomics
  • A response to the perceived failure of classical economics to explain the Depression
    • Classical Presupposition: Recessions self-correcting via operation of market forces
slide18
Key role for wage, price, interest rate flexibility
  • Say’s Law, and production occurring in order to obtain income for spending
  • And yet . . .unemployment stayed over 10% in the U. S. for a decade
slide19
Keynes’s diagnosis
    • A potential problem with saving
      • Primitive society: saving (not consuming) as simultaneously an act of investing (spending)
      • Industrial society: will my saving automatically find its way into capital accumulation elsewhere in the system?
        • Classical model: yes, via falling interest rates
slide20
Keynes: maybe not, as investment occurs in response to favorable profit prospects
  • Further: investment is volatile, uncertain; strongly affected by changeable expectations
  • Implication: some of income created by production process not necessarily find its way into new spending
slide21
Overall problem: may be thought of as a coordination failure
    • Some initial shock decreases spending
    • Firms constrained from hiring workers
    • Incomes fall
    • Households constrained from buying goods
    • Problem: who moves first to break the deadlock?
slide22
A new framework: aggregate demand/aggregate supply analysis
    • Aggregate demand
      • A way to talk about people’s spending plans in the aggregate
      • Components:
        • Consumption
        • Investment
slide23
Government spending on goods and services
      • Net exports (= exports - imports)
  • Aggregate supply: firms’ willingness to produce and sell output
  • Economy-wide equilibrium: occurs when AD = AS
slide24
The Great Depression? A collapse of aggregate demand
    • Causes of such collapse? Still unclear! But emphases on a variety of possibilities
    • Downward cumulative process worsened significantly by collapse of financial system, international trade
slide25
Policy implications of the General Theory: include a role for government in stabilizing the economy
    • Monetary policy, and the central bank
    • Fiscal policy
      • Changes in government budget: taxes; spending
      • May involve government deficits-which are not necessarily bad
slide26
If aggregate demand too low, could be raised by
      • Tax cuts
      • Increased government spending
      • Expansionary monetary policy (open-market purchases)
    • If aggregate demand too high, do the opposite
  • Was fiscal policy appropriate during the Depression?
    • No: scale too small
    • Depression ended during wartime: is war, then, good for the economy after all? No . . .
summary
SUMMARY
  • Keynes as changing the nature of the macroeconomic debate
  • What’s left of his analysis?
    • Focus on
      • Aggregate demand as driving short-run fluctuations in economic activity
      • Volatility of expectations, hence investment (and perhaps other) spending
slide28
In the long run, the economy may well adjust automatically to full employment-but it may take considerable time
  • Thus, there may be a role for stabilization policy on government’s part
  • Form of stabilization policy is still controversial, as is the speed of adjustment to full employment