The Great Depression and Keynesian Economics

1
Lesson 17-1 The
Great Depression and Keynesian Economics
2
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.
3
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.  
4
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.  
5
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.  
6
Government raised taxes to offset the decline in
spending and thereby reduced consumption.   Becaus
e 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.