Why the Great Depression?

Understanding why the Great Depression occurred is certainly progress. But policymakers also wanted to know if there was anything that could be done in the face of this economic catastrophe. One of Keynes’ most lasting contributions to economics is that he showed how different kinds of economic policy could be used to assist economies that were stuck in recessions. When markets are doing a good job of allocating resources, standard economic reasoning suggests that it is better for the government to stay out of the way. But when markets fail to allocate resources well, the government might be able to improve the overall functioning of the economy. The idea that markets left alone would coordinate aggregate economic activity is difficult to defend in the face of 25 percent unemployment of the labor force and a decline in economic activity of nearly 30 percent over a 4-year period. Thus the rationale for government intervention in the aggregate economy is that markets are failing to allocate resources properly, perhaps because prices and wages are sticky. Policy Remedies In the wake of the Great Depression, economists started advocating the use of government policy to improve the functioning of the macroeconomy. There are two kinds of government policy. Monetary policy refers to changes in interest rates and other tools that are under the control of the monetary authority of a country (the central bank).Fiscal policy refers to changes in taxation and the level of government purchases; such policies are typically under the control of a country’s lawmakers. Stabilization policy is the general term for the use of monetary and fiscal policies to prevent large fluctuations in real gross domestic product (real GDP). In the United States, the Federal Reserve Bank controls monetary policy, and fiscal policy is controlled by the president, the Congress, and state governments. In the countries of the European Union, monetary policy is controlled by the European Central Bank, and fiscal policies are controlled by the individual governments of the member countries. Keynes suggested that the cause of the Great Depression was an unusually low level of aggregate spending. This diagnosis suggests an immediate remedy: use government policies to increase aggregate spending. Because change in GDP = multiplier × change in autonomous spending, any government policy that increases autonomous spending will, through this equation, also increase GDP. There are many different policies at the disposal of the government, but they are similar at heart.