Managerial economics (sometimes referred to as business economics), is a branch of economics that applies microeconomic analysis to decision methods of businesses or other management units. As such, it bridges economic theory and economics in practice. It draws heavily from quantitative techniques such as regression analysis and correlation, Lagrangian calculus (linear). If there is a unifying theme that runs through most of managerial economics it is the attempt to optimize business decisions given the firm's objectives and given constraints imposed by scarcity, for example through the use of operations research and programming.Almost any business decision can be analyzed with managerial economics techniques, but it is most commonly applied to:

Risk analysis - various models are used to quantify risk and asymmetric information and to employ them in decision rules to manage risk.

Production analysis - microeconomic techniques are used to analyze production efficiency, optimum factor allocation, costs, economies of scale and to estimate the firm's cost function.

Pricing analysis - microeconomic techniques are used to analyze various pricing decisions including transfer pricing, joint product pricing, price discrimination, price elasticity estimations, and choosing the optimum pricing method.

Capital budgeting - Investment theory is used to examine a firm's capital purchasing decisions.

At universities, the subject is taught primarily to advanced undergraduates and graduate business schools. It is approached as an integration subject. That is, it integrates many concepts from a wide variety of prerequisite courses. In many countries it is possible to read for a degree in Business Economics which often covers managerial economics, financial economics, game theory, business forecasting and industrial economics.

The term liquidity trap is used in Keynesian economics to refer to a situation where the demand for money becomes infinitely elastic, i.e. where the demand curve is horizontal, so that further injections of money into the economy will not serve to further lower interest rates. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Therefore, if the economy enters a liquidity trap area -- and further increases in the money stock will fail to further lower interest rates -- monetary policy will be unable to stimulate the economy.In the wake of the "Keynesian revolution" in the 1930s and 1940s, various neoclassical economists sought to minimize the concept of a liquidity trap by specifying conditions in which expansive monetary policy would affect the economy even if interest rates failed to decline. Don Patinkin and Lloyd Metzler were the most prominent writers in this regard. They specified the existence of a "Pigou effect," named for English economist A.C. Pigou, in which the stock of real money balances is an element of the aggregate demand function for goods, so that the money stock would directly affect the "IS" curve in an ISLM analysis, and monetary policy would thus be able to stimulate the economy even under the existence of a liquidity trap.While much of the economics profession had serious problems with the existence of significance of this Pigou Effect, academic economists had come to give little credence to the concept of a liquidity trap by the 1960s.

However, the concept came back to prominence in misconception in the 1990s when the Japanese economy fell into a period of prolonged stagnation and deflation despite the presence of near-zero interest rates. While the liquidity trap as formulated by Keynes refers to the existence of a horizontal demand curve for money at some positive level of interest rates, the liquidity trap invoked in the 1990s referred merely to the presence of zero interest rates, the assertion being that since interest rates could not fall below zero, monetary policy would prove to be impotent in those conditions, just as it was asserted to be in a proper exposition of a liquidity trap.While this 1990s invocation of the term "liquidity trap" was not in conformity with that asserted by Keynes, both treatments have in common first the assertion that monetary policy affects the economy only via interest rates and second the subsequent conclusion that monetary policy is impotent with respect to being able to stimulate the economy under those conditions.Much the same furor has emerged in the United States and Europe in 2008-9, as short-term policy rates for the various central banks have moved close to zero.Note that the neoclassical economists' assertion was that even under an occurrence of a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of both the Bank of Japan in the 1990s, when it embarked upon quantitative easing and of the central banks of the United States and Europe in 2008-9, with their foray into quantitative easing. All these policy initiatives are attempts to stimulate the economy through methods other than the mere reduction of short-term interest rates.

What Does Liquidity Trap Mean?A situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.

Demand curve shiftsMain article: Demand curve

An out-ward or right-ward shift in demand increases both equilibrium price and quantity

When consumers increase the quantity demanded at a given price, it is referred to as an increase in demand. Increased demand can be represented on the graph as the curve being shifted outward. At each price point, a greater quantity is demanded, as from the initial curve D1 to the new curve D2. More people wanting coffee is an example. In the diagram, this raises the equilibrium price from P1 to the higher P2. This raises the equilibrium quantity from Q1 to the higher Q2. A movement along the curve is described as a "change in the quantity demanded" to distinguish it from a "change in demand," that is, a shift of the curve. In the example above, there has been an increase in demand which has caused an increase in (equilibrium) quantity. The increase in demand could also come from changing tastes and fads, incomes, complementary and substitute price changes, market expectations, and number of buyers. This would cause the entire demand curve to shift changing the equilibrium price and quantity.If the demand decreases, then the opposite happens: an inward shift of the curve. If the demand starts at D2, and decreases to D1, the price will decrease, and the quantity will decrease. This is an effect of demand changing. The quantity supplied at each price is the same as before the demand shift (at both Q1 and Q2). The equilibrium quantity, price and demand are different. At each point, a greater amount is demanded (when there is a shift from D1 to D2).

The demand curve "shifts" because a non-price determinant of demand has changed. Graphically the shift is due to a change in the x-intercept. A shift in the demand curve due to a change in a non-price determinant of demand will result in the market's being in a non-equilibrium state. If the demand curve shifts out the result will be a shortage — at the new market price quantity demanded will exceed quantity supplied. If the demand curve shifts in, there will be a surplus — at the new market price quantity supplied will exceed quantity demanded. The process by which a new equilibrium is established is not the province of comparative statics — the answers to issues concerning when, whether and how a new equilibrium will be established are issues that are addressed by stochastic models — economic dynamics.

[edit] Supply curve shiftsMain article: Supply (economics)

An out-ward or right-ward shift in supply reduces equilibrium price but increases quantityWhen the suppliers' costs change for a given output, the supply curve shifts in the same direction. For example, assume that someone invents a better way of growing wheat so that the cost of growing a given quantity of wheat decreases. Otherwise stated, producers will be willing to supply more wheat at every price and this shifts the supply curve S1 outward, to S2—an increase in supply. This increase in supply causes the equilibrium price to decrease

from P1 to P2. The equilibrium quantity increases from Q1 to Q2 as the quantity demanded extends at the new lower prices. In a supply curve shift, the price and the quantity move in opposite directions.If the quantity supplied decreases at a given price, the opposite happens. If the supply curve starts at S2, and shifts inward to S1, demand contracts, the equilibrium price will increase, and the equilibrium quantity will decrease. This is an effect of supply changing. The quantity demanded at each price is the same as before the supply shift (at both Q1 and Q2). The equilibrium quantity, price and supply changed.When there is a change in supply or demand, there are three possible movements. The demand curve can move inward or outward. The supply curve can also move inward or

outward.

The purpose of this topic is show two alternative views of thebusiness cycle and the major problems of unemployment andinflation. The classical theory is first presented. TheKeynesian view is offered as a critique of the classical theory.CLASSICAL THEORYThe classical theory is essentially the laissez faire belief ofpure capitalism. In this view, business cycles are naturalprocesses of adjustment which do not require any action on thepart of government.

In Adam Smith's explanation of the invisible hand, the processwhich leads firms to produce what people want, no governmentis necessary: the economy works out its problems.

SAY'S LAWSay's law proposes that supply creates its own demand. This meansthat the income derived from producing certain goods by some,allows them to purchase goods produced by others. Sinceall people have a need to purchase goods, they will seek toproduce some goods to derive income and buy whatever they want. Thusthe product markets will always necessarily be in equilibrium.

Workers who earn income, earn that income in order to be able tobuy a variety of products they want. Thus, by working and producing goods, these workers generate the income with whichthese goods can be purchased.

CLASSICAL MONEY MARKETIf some income happens not to be consumed immediately it willenter the money market as a saving. This saving will be put backinto the economy as investment (i.e increase in capital) when it isborrowed. The interest paid by borrowers to savers assures thatno saving will be idle. The money market equilibrates through anadjustment in the interest rate.

The interest paid to those who save is an inducement to lendmoney. When the interest rate is high, people will want to saveor lend more. On the other side of the market, the borrowers are

discouraged to borrow too much by a high interest rate. Thus, the marketdoes tend to reequilibrate under the influence of the interestrate.

PRICE AND WAGE FLEXIBILITYThe classical theory proposes that all markets reequilibratebecause of adjustments in prices and wages which are flexible.For instance, if an excess in the labor force or productsexist, the wage or price of these will adjust to absorb theexcess.

If prices and wages are flexible, markets reequilibrate. If, forinstance, many people are unemployed, firms can hire workersat lower wages; but, hiring more workers precisely reduces unemployment.

INVOLUNTARY UNEMPLOYMENTThe classical theory proposes that no involuntary unemploymentwill exist because an adjustment in the wage rate will assurethat the unemployed will be hired again. In addition, the needof workers to buy goods will encourage them to accept work ateven the lower wage rates.

If wages are flexible as the classical economists argue, thena decrease in wages does allow firms to hire more workers. Onlythose who are reluctant to work for lower wages would then remainunemployed.

CLASSICAL-KEYNESIAN CONTROVERSYKeynesian employment theory is build on a critique of theclassical theory. In this critique, Keynes argued that saversand investors have incompatible plans which may not assure thatan equilibrium exists in the money market, that prices andwages tend to be rigid and equilibrium may not exist in theproduct and labor markets, and that periods of severeunemployment have occurred (which the classical theory denied).

The Keynesian theory was developed in the wake of the greatdepression. It was very hard to argue then that onlyvoluntary unemployment can exist as millions of workerswere out of work.

KEYNESIAN SAVING-INVESTMENT PLANSKeynes showed that savers and investors are separate groupswhich do not necessarily interact: financial intermediaries(banks) are in between. When a recession is present, investmentmay not be equal to saving because, although the interest rateis very low, 1) borrowers have poor sales prospect, 2)banks are afraid of lending because of potential bankruptcy, and3) savers want to wait for higher returns. This causes aliquidity trap: some saving is idle.

Banks do tend to be very prudent when making loans to businesses

when economic conditions do not seem promising. But, theirreluctance to make loans is itself contributing to the economicslow down.

KEYNESIAN PRICE-WAGE RIGIDITYKeynes argued that prices and wages are not flexible as theclassical theory asserts. Wages tend to be rigid on the downside because workers will not accept wages which do not permitthem to live adequately; this is reinforced by the actions ofunions. If wages are too low, unemployment will exist. In thecase of prices, firms producing large tag items prefer to cutproduction and lay off workers than cut price. Their monopolypower often permits them to act that way.

Since the mid l980's, there have been several instances whereemployees have accepted wage give-backs: for instance, in theairline and steel industries. Aside from these exceptions, wage decreases are extremely rare. The general pattern is oneof continuous increases, at least, to match cost of livingincreases.

AGGREGATE DEMANDAggregate demand shown graphically representsthe sum total of what household are willing and able to buyat different level of the price level.

Aggregate demand can be thought of as a combination of all thedifferent products people may want to buy.

REAL BALANCE EFFECTAggregate demand curve is downsloping because of the real balanceeffect. If prices are high, then the purchasing power ofmonetary assets decreases and individuals tend to feel poorerand buy less. If prices are low, the purchasing power ofmonetary assets increases, individuals tend to feel wealthierand buy more.

There is an inverse mathematical relationship between interestrates and financial assets. Securities markets, such as theNew York Stock Exchange, are very sensitive to inflation whichis the major cause for increasing interest rates. This sensitivity was observed in October 19, 1987 stock market crash. It was also observed in securities markets reactions to to lowering of interest rates by the US federal reserve bank in 2001.

AGGREGATE SUPPLYAggregate supply is made of three sections: the classical rangeis vertical, the Keynesian range is horizontal and theintermediate range is upsloping.Graph G-MAC7.1

The aggregate supply can be thought of as the combination of allthe goods that firms produce: it is GNP if the government isignored.

CLASSICAL RANGEThe classical range of aggregate supply is vertical becauseof the proposition of the classical theory that prices willadjust so that output is always at full employment. In thisrange, expanding aggregate demand will cause inflation,while contracting aggregate demand will reduce inflation.

There are many sectors of the economy where all adjustments takeplace through price changes. One can think of all goods relatedto fashion: if a dress is in high demand, it will be priced veryhigh; but if the dress is out of fashion, the price will be verylow and, eventually, it will not be produced at all.

KEYNESIAN RANGEThe Keynesian range of aggregate supply corresponds to theproposition that when price are very low, firms will prefer tocut production rather than sell at a loss. In this range, any changein aggregate demand will produce a change in output. Thus, inthe case of a recession the correct government policy is toexpand aggregate demand.

Numerous sectors of the economy have very few changes in price butsizable changes in the volume of production and the number ofemployees. For example, car manufacturers offer rebates which do not amount to even 10% of the value of a car. Compared tochanges in price of 50% or more in clothing for instance, thecar rebates are very small. The reason is the large fixed costs.Closings of entire car manufacturing plants are not uncommon during recessions.

INTERMEDIATE RANGEThis intermediate range of aggregate supply represents thecase of preliminary inflation (or sectoral inflation): whendemand and output expand, some sectors of the economy mayexperience bottlenecks and require that prices increase becauseoutput cannot.

Some sectors of the economy tend to experience price and quantity changes at the same time. This would seem to be trueof all the consumer goods sectors such as radios and televisions,or sport equipment.

AGGREGATE DEMAND POLICIESWhen the intersection of aggregate demand and aggregate supplyoccurs in the Keynesian horizontal range a recession andexcessive unemployment are present: the recommended policywould be to stimulate aggregate demand. When the intersectionis in the classical vertical range, inflation is present: therecommended policy would be to contract aggregate demand.Graph G-MAC7.2

Throughout the 1960's and the 1970's, the emphasis of the Americanadministration has been to stimulate aggregate demand in orderto control unemployment. Control of inflation was accomplishedwith the help of tax changes or controls over prices and wages.

SUPPLY SIDE POLICIESSupply side policies can be shown by attributing periods ofstagflation (high prices and low level of output) to upwardshifts of aggregate supply. The recommended policy would thennot be an increased aggregate demand which adds to inflation,but instead a shift in aggregate supply downward by cuttingcosts of production.

During the 1980's, the American administration has attempted to control

theeconomy by paying more attention to the supply side of theeconomy. Specifically, costs of production are affected byregulations, restrictions and subsidies enacted by governmentbodies.

CLASSICS AND KEYNES

TWO VIEWS OF THE ECONOMY

Macroeconomics is the study of economics from an overall point of view. Instead of looking so much at individual people and businesses and their economic decisions, macroeconomics deals with the overall pattern of the economy. To star with, we will look at two main groups of economists: the Classical Economists and the Keynesian Economists. Classical economists generally think that the market, on its own, will be able to adjust while Keynesian economists believe that the government must step in to solve problems. The two camps have differing ideas on the causes and solutions of unemployment. The Classical economists believe that unemployment is caused by excess supply, which is caused by the high price level of labor. Based on supply and demand, when wages are held too high by social and political forces, demand would be low and supply would be high and that excess supply represents unemployed people. Classical economists believe that if the economy were left on its own, it would adjust to reach an equilibrium wage for workers and the economy would be at full employment.

CLASSICAL ECONOMISTS-economists who believe in no government regulation of the economy

KEYNESIAN ECONOMISTS-economists who believe in government regulation of the economy

CLASSICAL ECONOMICS

Classical economists believe in Say's Law, which states that people supply things to the economy so they have income to demand things of the value they've supplied. Classical economists also argue that all money is always in the economy, because even when people put their income away in the form of savings in banks, stocks, etc. that money still flows back into the economy in the form of investment. When savings money flows into banks, even though it does not directly go to the industries in the form of purchases, banks loan this money to industries to invest in further development. Investmen takes the form of money to acquire new machines, labor, facilities,

SAY'S LAW-Law stating that with supply naturally comes demand; there is never oversupply

INVESTMENT-Resources spent on the means of production, so as to supply products into an economy and make a profit

MONEY-Something used to value goods so that they may be bought and sold

VELOCITY OF MONEY-The number of times that a unit of

etc. so that businesses grow.

Fig 2.1.1-Transfer of money

Crucial to the understanding of classical economics is an understanding of how money works. Money is just something that can value goods, used to exchange those goods among individuals in an economy. The quantity theory of money is the theory dealing with money and prices. It states that the price level in an economy depends on how much money is in the economy. In classical economics, the quantity theory of money centers around the equation "(Quantity of money) x (velocity of money) = (price level) x (quantity of goods sold)." Velocity of money just means how often money is spent. The price level times the quantity of goods sold obviously equals the GDP, total production. Velocity, then, times the amount of money would equal that. A coin, for example, is passed around from person to person throughout time and each time it is spent, it generates income worth its value. The number of times that coin was passed on throughout the year is its velocity and that times its value gives how much production it represents that year. When you add all the income generated by all the money out there, you get the GDP also.The velocity of this money depends on what the structure of an economy is like. It depends on things like where people work, where they shop, how often they shop, etc. Since no drastic economic restructuring could be expected to occur in any short period of time, this velocity is assumed to remain constant from year to year. (It does change, but this change is so incredibly slow as to be irrelevant.) Classical economics also stresses that the amount of goods and services produced is not affected by the money supply. This doctrine is the veil of money assumption. This assumption separated the world of finance (of purely monetary studies) and the rest of the economy (the production of goods and services). The veil of money theory basically says that when the money supply changes, the real economy does not because when money supply changes by a certain amount, everything else does as

currency is spent each year

VEIL OF MONEY ASSUMPTION-Changes in money supply do not affect real production of goods and services

Fig 2.1.1-Money flows from business to individuals in the form of paying jobs; households then spend most of it to buy products from business; the part that is saved in banks of the financial sector is invested in business

Fig 2.1.2-If there is a disequilibrium between supply and demand, the supply can never change. The price level simply moves until the demand is equal to supply.

well. If it doubles, then prices double, and people's pay doubles too to compensate for this, so nothing really changes. Classical economics states that money supply is the force that changes the price level.Since money supply changes prices and money supply is not affected by production, the amount of supply is independent of the price level. The amount of output is chosen by people and, according to classical economics, as long as they're no outside pressures intefering with the markets like politics, the amount of supply will always be at full employment level. Demand in the long term is not a problem because in the long term, based on Say's Law, supply generates its own demand and so there will be long-term equilibrium. As stated earlier, classical economists see the problem of unemployment as a self-solving problem like all other things. Wages will fall and then demand for labor will increase and eventually everyone who wants a job will get one.The long-term classical model does not solve short term problems. In the short term, there are always various fluctuations that move demand and supply out of balance of each other. There must be a mechanism to equalize them again.

Fig 2.1.2-Classical adjustment model

Suppliers in the classical model never change how much they supply, they just change their prices so that people will buy them. No matter what, supply is an independent concept. Suppliers will always produce how much they want to produce at a given time. Demand, however, can move by changes to the price level so that all that is produced is actually bought.

KEYNESIAN ECONOMICS

A basic argument made by John Maynard Keynes, a famous economist during the depression era who invented the idea of Keynesian economics, was that Say's law was just plain false. In Keynes's analysis of the economy, he looked at the problems

APC-average propensity to consume, what percentage of income people tend to spend; varies with how much income is made

of supply and demand separately. The problem of supply is relatively simple: supply generates income. What people make are bought, and thus the value of supply is always equal to the value of income. This income is then passed on to the consumers in the form of paychecks. The consumers then spend this money to buy various products. Keynesian economics have several concepts to explain how consumers spend their income.The money that people get are always split between consumption and savings. People who have enough money usually save some of it and spend most of it. There are two ratios Keynesian economics considers when dealing with consumption: the APC and the MPC. The APC, average propensity to consume, is a ratio telling us how much of people's income they tend to spend. The APC varies with income level. The MPC tells us what part of a change in income people tend to spend. For example, if the MPC was .5 and somebody got an increase of income of $1000, then they will spend $500 dollars of that increased income. Conversely, people will cut their spending by that ratio when they lose some income.

Fig 2.1.3-Keynesian consumption function

In this graph, we can see a graphical representation of Keynes's ideas. The blue line represents production. The red line represents how much people spend. The slope of the line, or how much the line goes upward for every increment horizontally, is the MPC, which in this case is 0.75 (how much of every extra piece of income is spent). The slope of the production line is 1 since production = income. When income is way too low, as shown in this, spending must exceed income because no matter what, there are some things that people must buy, like food. They do this through borrowing and dipping into savings, etc. Beyond a certain point, people have enough to save some of that money. APC can be represented on this graph as the ratio of the amount represented by the red line to the amount represented by the blue line at any point. Notice

MPC-marginal propensity ot consume, what percentage of a change in income people tend to spend

APS-average propensity to save, what percentage of income people tend to save; varies with how much income is made

MPS-marginal propensity ot save, what percentage of a change in income people tend to save

FIG 2.1.3-Based on Keynes's ideas, production and spending can be represented by two different curves. The two different curves meet at a point of equilibrium. If they are different, then production is adjusted until equilibrium is reached.

that this ratio changes, which makes sense in the context of Keynesian economics. At the point where spending equals production/income, the APC is 1 and at that point, people spend all the money they make.Of course, the rest of the money, the money that is not spent, goes into savings. There is also APS and MPS, the average propensity to save and marginal propensity to save. APS is what part of income people save and MPS is what part of additional income people save. APS+APC=1 and MPS+MPC=1, as savings and spending together equal income. Savings is the part of the graph between the two lines. When spending is more than income, people save, savings represented by the difference between income and spending. When spending is more than income, people take money out of past savings, the amount represented by the difference between spending and income. Another component of Keynes's analysis was the independence of investment. Unlike classical economics, which states that all savings go into investment, Keynes said that how much people invests is simply how much they feel like investing. There are more complicated models, but to keep this simple now, investment is not changed by savings or income. To keep the model simple, we will assume that government spending and foreign trade is all independent. If you add all these factors into the spending, the red line representing total spending would be shifted upwards (the whole line, the slope is still the same).Whenever the economy is not in equilibrium, firms change their production until equilibrium is reached. When there is more production than expenditure, there is an excess of supply, as firms are not selling everything they produce. Thus, they have to decrease production until production equals consumption on the graph. On the other hand, if there is too little supply, the portion of the graph where production is less than consumption, firms increase their production to meet the demands of customers until the two lines of output and spending meet at equilibrium. The economy is continually adjusting in the Keynesian model as various factors influence the independent factors of investment, government spending, and net export, factors outside of income and production. Interest rate changes, future predictions, and technology can affect investment. Government spending may change depending on varying political situations. Net export, too, can change with a nation's changing international position. These changes can move the spending curve up or down (again, shift as opposed to changing the slope) and thus force further adjustment of production. With his model, he explained the Great Depression: after the crash of 1929, people became scared. Invetment was cut as was spending. When this happened, companies decreased their production even more as

spending decreased and this was followed by a drop of spending as income fell (income=production). This drop continued until equilibrium was reached at a point that is way below that of full employment.

INFLATION AND UNEMPLOYMENT

THE PHILLIPS CURVE

When economists look at inflation and unemployment in the short term, they see a rough inverse correlation between the two. When unemployment is high, inflation is low and when inflation is high, unemployment is low. This has presented a problem to regulators who want to limit both. This relationship between inflation and unemployment is the Phillips curve. The short term Phillips curve is a declining one.

Fig 2.4.1-Short term Phillips curve

This is a rough estimation of a short-term Phillips curve. As you can see, inflation is inversely related to unemployment. The long-term Phillips curve, however, is different. Economists have noted that in the long run, there seems to be no correlation between inflation and unemployment.

PHILLIPS CURVE-The relationship between inflation and unemployment.

Fig 2.4.1-The short term phillips curve: inflation is inversely related to unemployment. When unemployment rises, inflation drops; when unemployment drops, inflation rises.

CLASSICAL VIEW OF INFLATION

In the classical view of inflation, the only thing that causes inflation is, in reality, changes in the money supply. Remember the classical quantity theory of money: (money supply) x (velocity) = (price level) x (amount of output). And remember that the classics assume that velocity and output are independent and relatively constant. Thus, as money supply rises, that naturally ups the price level, too, and increase in

price level is inflation.The classical economists believe that there is a natural rate of unemployment, the equilibrium level of unemployment of the economy. That is the long-term Phillips curve. Remember that the long-term Phillips curve is vertical because there inflation is not related to unemployment in the long-term. Unemployment, therefore, will just be at a given level, no matter at what point inflation is at. In the classical view, the point where the short-term Phillips curve intersects the long-term Phillips curve is the expected inflation. To the left side of that point, actual inflation is higher than expected and to the right, actual inflation is lower than expected. Basically, unemployment below natural unemployment leads to inflation higher than expected and unemployment higher than natural unemployment leads to inflation lower than expected.

KEYNESIAN VIEW OF INFLATION

As opposed to the Classics, who view inflation as a problem of ever-increasing money supply, Keynesians concentrate on the institutional problems of people increasing their price levels. Keynesians argue that firms raise wages to keep their workers happy. Firms then have to pay for that and keep making a profit by subsequently raising the prices. This causes an increase in both wages and prices and demands an increase of money supply to keep the economy running. So, the government then issues more and more money to keep up with inflation. This differs from the classical model. Classics view changing money supply as affecting inflation while Keynesians view inflation as the cause of changing money supply.

Circular flow of income

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In this simplified image, the relationship between the decision-makers in the circular flow model is shown. Larger arrows show primary factors, whilst the red smaller arrows show subsequent or secondary factors.

In economics, the term circular flow of income or circular flow refers to a simple economic model which describes the reciprocal circulation of income between producers and consumers.[1][2] In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income[1]. Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households.The circle of money flowing through the economy is as follows: total income is spent (with the exception of "leakages" such as consumer saving), while that expenditure allows the sale of goods and services, which in turn allows the payment of income (such as wages and salaries). Expenditure based on borrowings and existing wealth – i.e., "injections" such as fixed investment – can add to total spending.In equilibrium (Preston), leakages equal injections and the circular flow stays the same size. If injections exceed leakages, the circular flow grows (i.e., there is economic prosperity), while if they are less than leakages, the circular flow shrinks (i.e., there is a recession).More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports.Labor and other "factors of production" are sold on resource markets. These resources, purchased by firms, are then used to produce goods and services. The latter are sold on product markets, ending up in the hands of the households, helping them to supply resources.

Contents[hide]

1 Assumptions 2 Two Sector Model 3 Five sector model 4 See also 5 References

6 Further reading

[edit] AssumptionsThe basic circular flow of income model consists of six assumptions:

1. The economy consists of two sectors: households and firms.2. Households spend all of their income (Y) on goods and services or consumption (C). There is

no saving (S).3. All output (O) produced by firms is purchased by households through their expenditure (E).4. There is no financial sector.5. There is no government sector.6. There is no overseas sector.

[edit] Two Sector ModelTemplate:Unreferenced sections In the simple two sector circular flow of income model the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is:Y = E = OThis means that the expenditure of buyers (households) becomes income for sellers (firms). The firms then spend this income on factors of production such as labour, capital and raw materials, "transferring" their income to the factor owners. The factor owners spend this income on goods which leads to a circular flow of income.

[edit] Five sector modelThis section does not cite any references or sources.Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. (September 2009)

This article may contain original research or unverified claims. Please improve the article by adding references. See the talk page for details. (September 2009)

Table 1 All leakages and injections in five sector modelLEAKAGES INJECTIONSaving (S) Investment (I)Taxes (T) Government Spending (G)Imports (M) Exports (X)

Circular flow of income diagram

The five sector model of the circular flow of income is a more realistic representation of the economy. Unlike the two sector model where there are six assumptions the five sector circular flow relaxes all six assumptions. Since the first assumption is relaxed there are three more sectors introduced. The first is the Financial Sector that consists of banks and non-bank intermediaries who engage in the borrowing (savings from households) and lending of money. In terms of the circular flow of income model the leakage that financial institutions provide in the economy is the option for households to save their money. This is a leakage because the saved money can not be spent in the economy and thus is an idle asset that means not all output will be purchased. The injection that the financial sector provides into the economy is investment (I) into the business/firms sector. An example of a group in the finance sector includes banks such as Westpac or financial institutions such as Suncorp.The next sector introduced into the circular flow of income is the Government Sector that consists of the economic activities of local, state and federal governments. The leakage that the Government sector provides is through the collection of revenue through Taxes (T) that is provided by households and firms to the government. For this reason they are a leakage because it is a leakage out of the current income thus reducing the expenditure on current goods and services. The injection provided by the government sector is Government spending (G) that provides collective services and welfare payments to the community. An example of a tax collected by the government as a leakage is income tax and an injection into the economy can be when the government redistributes this income in the form of welfare payments, that is a form of government spending back into the economy.The final sector in the circular flow of income model is the overseas sector which transforms the model from a closed economy to an open economy. The main leakage from this sector are imports (M), which represent spending by residents into the rest of the world. The main injection provided by this sector is the exports of goods and services which generate income for the exporters from overseas residents. An example of the use of the overseas sector is Australia exporting wool to China, China pays the exporter of the wool (the farmer) therefore

more money enters the economy thus making it an injection. Another example is China processing the wool into items such as coats and Australia importing the product by paying the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.In terms of the five sector circular flow of income model the state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy. This can be shown as:

Savings + Taxes + Imports = Investment + Government Spending + Exports

ORS + T + M = I + G + X.

This can be further illustrated through the fictitious economy of Noka where:S + T + M = I + G + X

$100 + $150 + $50 = $50 + $100 + $150$300 = $300

Therefore since the leakages are equal to the injections the economy is in a stable state of equilibrium. This state can be contrasted to the state of disequilibrium where unlike that of equilibrium the sum of total leakages does not equal the sum of total injections. By giving values to the leakages and injections the circular flow of income can be used to show the state of disequilibrium. Disequilibrium can be shown as:

S + T + M ≠ I + G + X

Therefore it can be shown as one of the below equations where:Total leakages > Total injections

$150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + 150 (X)Or

Total Leakages < Total injections$50 (S) + $200 (T) + $125 (M) < $75 (I) + $200 (G) + 150 (X)

The effects of disequilibrium vary according to which of the above equations they belong to.If S + T + M > I + G + X the levels of income, output, expenditure and employment will fall causing a recession or contraction in the overall economic activity. But if S + T + M < I + G + X the levels of income, output, expenditure and employment will rise causing a boom or expansion in economic activity.To manage this problem, if disequilibrium were to occur in the five sector circular flow of income model, changes in expenditure and output will lead to equilibrium being regained. An example of this is if:S + T + M > I + G + X the levels of income, expenditure and output will fall causing a contraction or recession in the overall economic activity. As the income falls (Figure 4) households will cut down on all leakages such as saving, they will also pay less in taxation and with a lower income they will spend less on imports. This will lead to a fall in the leakages until they equal the injections and a lower level of equilibrium will be the result.The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the levels of income, expenditure and output will greatly rise causing a boom in economic activity. As the households income increases there will be a higher opportunity to save therefore saving in the financial sector will increase, taxation for the higher threshold will increase and they will be able to spend more on imports. In this case when the leakages

increase they will continue to rise until they are equal to the level injections. The end result of this disequilibrium situation will be a higher level of equilibrium.

Depression of the 1930s The economic depression that beset the United States and other countries in the 1930s was unique in its magnitude and its consequences. At the depth of the depression, in 1933, one American worker in every four was out of a job. In other countries unemployment ranged between 15 percent and 25 percent of the labor force. The great industrial slump continued throughout the 1930s, shaking the foundations of Western capitalism and the society based upon it. Economic Aspects President Calvin COOLIDGE had said during the long prosperity of the 1920s that "The business of America is business." Despite the seeming business prosperity of the 1920s, however, there were serious economic weak spots, a chief one being a depression in the agricultural sector. Also depressed were such industries as coal mining, railroads, and textiles. Throughout the 1920s, U. S. banks had failed--an average of 600 per year--as had thousands of other business firms. By 1928 the construction boom was over. The spectacular rise in prices on the STOCK MARKET from 1924 to 1929 bore little relation to actual economic conditions. In fact, the boom in the stock market and in real estate, along with the expansion in credit (created, in part, by low-paid workers buying on credit) and high profits for a few industries, concealed basic problems. Thus the U. S. stock market crash that occurred in October 1929, with huge losses, was not the fundamental cause of the Great Depression, although the crash sparked, and certainly marked the beginning of, the most traumatic economic period of modern times. By 1930, the slump was apparent, but few people expected it to continue; previous financial PANICS and depressions had reversed in a year or two. The usual forces of economic expansion had vanished, however. Technology had eliminated more industrial jobs than it had created; the supply of goods continued to exceed demand; the world market system was basically unsound. The high tariffs of the Smoot-Hawley Act (1930) exacerbated the downturn. As business failures increased and unemployment soared--and as people with dwindling incomes nonetheless had to pay their creditors--it was apparent that the United States was in the grip of economic breakdown. Most European countries were hit even harder, because they had not yet fully recovered from the ravages of World War I.) The deepening depression essentially coincided with the term in office (1929-33) of President Herbert HOOVER. The stark statistics scarcely convey the distress of the millions of people who lost jobs, savings, and homes. From 1930 to 1933 industrial stocks lost 80% of their value. In the four years from 1929 to 1932 approximately 11,000 U. S. banks failed (44% of the 1929 total), and about $2 billion in deposits evaporated. The gross national product (GNP), which for years had grown at an average annual rate of 3.5%, declined at a rate of over 10% annually, on average, from 1929 to 1932. Agricultural distress was intense: farm prices fell by 53% from 1929 to 1932. President Hoover opposed government intervention to ease the mounting economic distress. His one major action, creation (1932) of the Reconstruction Finance Corporation to lend money to ailing corporations, was seen as inadequate. Hoover lost the 1932 election to Franklin D. ROOSEVELT.The depression brought a deflation not only of incomes but of hope. In his first inaugural address (March 1933), President Franklin D. ROOSEVELT declared that "the only thing we have to fear is fear itself." But though his NEW DEAL grappled with economic problems throughout his first two terms, it had no consistent policy. At first Roosevelt tried to stimulate

the economy through the NATIONAL RECOVERY ADMINISTRATION, charged with establishing minimum wages and codes of fair competition in every industry. It was based on the idea of spreading work and reducing unfair competitive practices by means of cooperation in industry, so as to stabilize production and prevent the price slashing that had begun after 1929. This approach was abandoned after the Supreme Court declared the NRA unconstitutional in SCHECTER POULTRY CORPORATION V. UNITED STATES (1935). Roosevelt's second administration gave more emphasis to public works and other government expenditures as a means of stimulating the economy, but it did not pursue this approach vigorously enough to achieve full economic recovery. At the end of the 1930s, unemployment was estimated at 17.2%. Other innovations of the Roosevelt administrations had long-lasting effects, both economically and politically. To aid people who could find no work, the New Deal extended federal relief on a vast scale. The CIVILIAN CONSERVATION CORPS took young men off the streets and sent them out to plant forests and drain swamps. The government refinanced about one-fifth of farm mortgages through the FARM CREDIT ADMINISTRATION and about one-sixth of home mortgages through the Home Owners Loan Corporation. The WORKS PROGRESS ADMINISTRATION employed an average of over 2 million people in occupations ranging from laborers to musicians and writers. The PUBLIC WORKS ADMINISTRATION spent about $4 billion on the construction of highways and public buildings in the years 1933-39. The depression years saw a burst of union organizing, aided by the NATIONAL LABOR RELATIONS ACT of 1935. New industrial unions came into existence through the efforts of organizers led by John L. LEWIS, Walter REUTHER, Philip MURRAY, and others; in 1937 they won contracts in the steel and auto industries. Total union membership rose from about 3 million in 1932 to over 10 million in 1941. Political and Cultural Effects The expanded role of the federal government came to be accepted by most Americans by the end of the 1930s. Even Republicans who had bitterly opposed the New Deal shifted their stance.Wendell WILLKIE, the Republican presidential nominee in 1940, declared that he could not oppose reforms such as the regulation of the securities markets and the utility holding companies, the legal recognition of unions, or Social Security and unemployment allowances. What bothered him and other opponents of the New Deal, however, was the extension of the federal bureaucracy. The depression caused much questioning of inherited economic and political ideas. Sen. Huey P. Long (see LONG family) of Louisiana found a national following for his "Share the Wealth" program. The socialist writer Upton SINCLAIR was nearly elected governor of California in 1934 with a similar program for redistributing the state's wealth. Many writers and other intellectuals swung even further left, concluding that capitalism was on its way out; they were drawn to the Communist party by what they supposed to be the accomplishments of the USSR.In other countries the depression had even more profound effects. As world trade fell off, countries turned to nationalist economic policies that only exacerbated their difficulties. In politics the depression strengthened the extremes of right and left, helping Adolf HITLER to power in Germany and swelling left-wing movements in other European countries. The depression was thus a time of massive insecurity among peoples and governments, contributing to the tensions that produced World War II. Ironically, however, the massive military expenditures for that war provided the economic stimulus that finally ended the depression in the United States and elsewhere.  

Great Depression

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This article is about 1930s' economic crisis. For other uses, see The Great Depression (disambiguation).

Dorothea Lange's Migrant Mother depicts destitute pea pickers in California, centering on Florence Owens Thompson, age 32, a mother of seven children, in Nipomo, California, March 1936.

The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s.[1] It was the longest, most widespread, and deepest depression of the 20th century, and is used in the 21st century as an example of how far the world's economy can decline.[2] The depression originated in the United States, starting with the stock market crash of October 29, 1929 (known as Black Tuesday), but quickly spread to almost every country in the world.[1]

The Great Depression had devastating effects in virtually every country, rich and poor. Personal income, tax revenue, profits and prices dropped, and international trade plunged by a half to two-thirds. Unemployment in the United States rose to 25%, and in some countries rose as high as 33%.[3] Cities all around the world were hit hard, especially those dependent on heavy industry. Construction was virtually halted in many countries. Farming and rural areas suffered as crop prices fell by approximately 60 percent.[4][5][6] Facing plummeting demand with few alternate sources of jobs, areas dependent on primary sector industries such as cash cropping, mining and logging suffered the most.[7]

Countries started to recover by the mid-1930s, but in many countries the negative effects of the Great Depression lasted until the start of World War II.[8]

USA annual real GDP from 1910–60, with the years of the Great Depression (1929–1939) highlighted.

Unemployment rate in the US 1910–1960, with the years of the Great Depression (1929–1939) highlighted.

Contents[hide]

1 Start of the Great Depression 2 Causes

o 2.1 Monetarist explanations o 2.2 Debt deflation o 2.3 Structural explanations

2.3.1 Keynesian 2.3.2 Breakdown of international trade

o 2.4 New classical approach o 2.5 Austrian School o 2.6 Inequality of wealth and income

3 Turning point and recovery o 3.1 Gold standard o 3.2 World War II and recovery

4 Effects o 4.1 Australia o 4.2 Canada o 4.3 Chile o 4.4 France o 4.5 Germany o 4.6 Japan o 4.7 Latin America o 4.8 Netherlands o 4.9 South Africa o 4.10 Soviet Union o 4.11 United Kingdom o 4.12 United States

4.12.1 Hoover administration 4.12.2 Roosevelt administration

5 Political consequences 6 Social movements 7 Literature 8 Other "great depressions" 9 See also 10 References 11 Further reading 12 External links

Start of the Great Depression

US industrial production (1928–39).

US Farm Prices, (1928–35).

See also: Timeline of the Great Depression

Historians most often attribute the start of the Great Depression to the sudden and total collapse of US stock market prices on October 29, 1929, known as Black Tuesday.[1]

However, some dispute this conclusion, and see the stock crash as a symptom, rather than a cause of the Great Depression.[3][9] Even after the Wall Street Crash of 1929, optimism persisted for some time; John D. Rockefeller said that "These are days when many are discouraged. In the 93 years of my life, depressions have come and gone. Prosperity has always returned and will again."[10] The stock market turned upward in early 1930, returning to early 1929 levels by April, though still almost 30% below the peak of September 1929.[11] Together, government and business actually spent more in the first half of 1930 than in the corresponding period of the previous year. But consumers, many of whom had suffered severe losses in the stock market the previous year, cut back their expenditures by ten percent, and a severe drought ravaged the agricultural heartland of the USA beginning in the summer of 1930.By mid-1930, interest rates had dropped to low levels, but expected deflation and the reluctance of people to add new debt by borrowing, meant that consumer spending and investment were depressed.[12] In May 1930, automobile sales had declined to below the levels of 1928. Prices in general began to decline, but wages held steady in 1930; but then a deflationary spiral started in 1931. Conditions were worse in farming areas, where commodity prices plunged, and in mining and logging areas, where unemployment was high and there were few other jobs. The decline in the US economy was the factor that pulled down most other countries at first, then internal weaknesses or strengths in each country made conditions worse or better. Frantic attempts to shore up the economies of individual nations through protectionist policies, such as the 1930 U.S. Smoot–Hawley Tariff Act and retaliatory tariffs in other countries, exacerbated the collapse in global trade. By late in 1930, a steady decline set in which reached bottom by March 1933.

Causes

Crowd gathering on Wall Street after the 1929 crash.

Main article: Causes of the Great Depression

There were multiple causes for the first downturn in 1929, including the structural weaknesses and specific events that turned it into a major depression and the way in which the downturn spread from country to country. In relation to the 1929 downturn, historians emphasize structural factors like massive bank failures and the stock market crash, while

economists (such as Peter Temin and Barry Eichengreen) point to Britain's decision to return to the Gold Standard at pre-World War I parities (US$4.86:£1).Recession cycles are thought to be a normal part of living in a world of inexact balances between supply and demand. What turns a usually mild and short recession or "ordinary" business cycle into an actual depression is a subject of debate and concern. Scholars have not agreed on the exact causes and their relative importance. The search for causes is closely connected to the question of how to avoid a future depression, and so the political and policy viewpoints of scholars are mixed into the analysis of historic events eight decades ago. The even larger question is whether it was largely a failure on the part of free markets or largely a failure on the part of government efforts to regulate interest rates, curtail widespread bank failures, and control the money supply. Those who believe in a large role for the state in the economy believe it was mostly a failure of the free markets and those who believe in free markets believe it was mostly a failure of government that compounded the problem.Current theories may be broadly classified into three main points of view. First there are the monetarists, who believe that the Great Depression started as an ordinary recession, but that significant policy mistakes by monetary authorities (especially the Federal Reserve), caused a shrinking of the money supply which greatly exacerbated the economic situation, causing a recession to descend into the Great Depression. Related to this explanation are those who point to debt deflation causing those who borrow to owe ever more in real terms.Second, there are structural theories, most importantly Keynesian, but also including those who point to the breakdown of international trade, and Institutional economists who point to underconsumption and overinvestment (economic bubble), malfeasance by bankers and industrialists, or incompetence by government officials. The consensus viewpoint is that there was a large-scale loss of confidence that led to a sudden reduction in consumption and investment spending. Once panic and deflation set in, many people believed they could make more money by keeping clear of the markets as prices dropped lower and a given amount of money bought ever more goods, exacerbating the drop in demand.Lastly, there are various heterodox theories that downplay or reject the explanations of the Keynesian and monetarists. For example, some new classical macroeconomists have argued that various labor market policies imposed at the start caused the length and severity of the Great Depression. The Austrian school of economics focuses on the macroeconomic effects of money supply, and how central banking decisions can lead to overinvestment (economic bubble). The Marxist critique of political economy emphasizes the tendency of capitalism to create unbalanced accumulations of wealth, leading to overaccumulations of capital and a repeating cycle of devaluations through economic crises. Marx saw recession and depression as unavoidable under free-market capitalism as there are no restrictions on accumulations of capital other than the market itself.

Monetarist explanationsMain article: Causes of the Great Depression#Monetarist explanations

Crowd at New York's American Union Bank during a bank run early in the Great Depression.

Monetarists, including Milton Friedman and current Federal Reserve System chairman Ben Bernanke, argue that the Great Depression was mainly caused by monetary contraction, the consequence of poor policymaking by the American Federal Reserve System and continued crisis in the banking system.[13][14] In this view, the Federal Reserve, by not acting, allowed the money supply as measured by the M2 to shrink by one-third from 1929 to 1933, thereby transforming a normal recession into the Great Depression. Friedman argued that the downward turn in the economy, starting with the stock market crash, would have been just another recession.[15] However, the Federal Reserve allowed some large public bank failures – particularly that of the New York Bank of the United States – which produced panic and widespread runs on local banks, and the Federal Reserve sat idly by while banks collapsed. He claimed that, if the Fed had provided emergency lending to these key banks, or simply bought government bonds on the open market to provide liquidity and increase the quantity of money after the key banks fell, all the rest of the banks would not have fallen after the large ones did, and the money supply would not have fallen as far and as fast as it did.[16] With significantly less money to go around, businessmen could not get new loans and could not even get their old loans renewed, forcing many to stop investing. This interpretation blames the Federal Reserve for inaction, especially the New York branch.[17]

One reason why the Federal Reserve did not act to limit the decline of the money supply was regulation. At that time the amount of credit the Federal Reserve could issue was limited by laws which required partial gold backing of that credit. By the late 1920s the Federal Reserve had almost hit the limit of allowable credit that could be backed by the gold in its possession. This credit was in the form of Federal Reserve demand notes. Since a "promise of gold" is not as good as "gold in the hand", during the bank panics a portion of those demand notes were redeemed for Federal Reserve gold. Since the Federal Reserve had hit its limit on allowable credit, any reduction in gold in its vaults had to be accompanied by a greater reduction in credit. On April 5, 1933 President Roosevelt signed Executive Order 6102 making the private ownership of gold certificates, coins and bullion illegal, reducing the pressure on Federal Reserve gold.[18]

Debt deflationMain article: Causes of the Great Depression#Debt deflation

Irving Fisher argued that the predominant factor leading to the Great Depression was over-indebtedness and deflation. Fisher tied loose credit to over-indebtedness, which fueled speculation and asset bubbles.[19] He then outlined 9 factors interacting with one another under conditions of debt and deflation to create the mechanics of boom to bust. The chain of events proceeded as follows:

1. Debt liquidation and distress selling2. Contraction of the money supply as bank loans are paid off3. A fall in the level of asset prices4. A still greater fall in the net worths of business, precipitating bankruptcies5. A fall in profits6. A reduction in output, in trade and in employment.7. Pessimism and loss of confidence8. Hoarding of money9. A fall in nominal interest rates and a rise in deflation adjusted interest rates.[19]

During the Crash of 1929 preceding the Great Depression, margin requirements were only 10%.[20] Brokerage firms, in other words, would lend $9 for every $1 an investor had deposited. When the market fell, brokers called in these loans, which could not be paid back.

Banks began to fail as debtors defaulted on debt and depositors attempted to withdraw their deposits en masse, triggering multiple bank runs. Government guarantees and Federal Reserve banking regulations to prevent such panics were ineffective or not used. Bank failures led to the loss of billions of dollars in assets.[21] Outstanding debts became heavier, because prices and incomes fell by 20–50% but the debts remained at the same dollar amount. After the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. (In all, 9,000 banks failed during the 1930s). By April 1933, around $7 billion in deposits had been frozen in failed banks or those left unlicensed after the March Bank Holiday.[22]

Bank failures snowballed as desperate bankers called in loans which the borrowers did not have time or money to repay. With future profits looking poor, capital investment and construction slowed or completely ceased. In the face of bad loans and worsening future prospects, the surviving banks became even more conservative in their lending.[21] Banks built up their capital reserves and made fewer loans, which intensified deflationary pressures. A vicious cycle developed and the downward spiral accelerated.The liquidation of debt could not keep up with the fall of prices which it caused. The mass effect of the stampede to liquidate increased the value of each dollar owed, relative to the value of declining asset holdings. The very effort of individuals to lessen their burden of debt effectively increased it. Paradoxically, the more the debtors paid, the more they owed.[19] This self-aggravating process turned a 1930 recession into a 1933 great depression.Macroeconomists including Ben Bernanke, the current chairman of the U.S. Federal Reserve Bank, have revived the debt-deflation view of the Great Depression originated by Fisher.[23][24]

Structural explanationsKeynesianMain article: Causes of the Great Depression#Keynesian explanation

British economist John Maynard Keynes argued in General Theory of Employment Interest and Money that lower aggregate expenditures in the economy contributed to a massive decline in income and to employment that was well below the average. In such a situation, the economy reached equilibrium at low levels of economic activity and high unemployment. Keynes basic idea was simple: to keep people fully employed, governments have to run deficits when the economy is slowing, as the private sector would not invest enough to keep production at the normal level and bring the economy out of recession. Keynesian economists called on governments during times of economic crisis to pick up the slack by increasing government spending and/or cutting taxes.As the Depression wore on, Roosevelt tried public works, farm subsidies, and other devices to restart the economy, but never completely gave up trying to balance the budget. According to the Keynesians, this improved the economy, but Roosevelt never spent enough to bring the economy out of recession until the start of World War II.[25]

Breakdown of international tradeMain article: Causes of the Great Depression

Many economists have argued that the sharp decline in international trade after 1930 helped to worsen the depression, especially for countries significantly dependent on foreign trade. Most historians and economists partly blame the American Smoot-Hawley Tariff Act (enacted June 17, 1930) for worsening the depression by seriously reducing international trade and causing retaliatory tariffs in other countries. While foreign trade was a small part of overall economic activity in the United States and was concentrated in a few businesses like farming, it was a much larger factor in many other countries.[26] The average ad valorem rate

of duties on dutiable imports for 1921–1925 was 25.9% but under the new tariff it jumped to 50% in 1931–1935.In dollar terms, American exports declined from about $5.2 billion in 1929 to $1.7 billion in 1933; but prices also fell, so the physical volume of exports only fell by half. Hardest hit were farm commodities such as wheat, cotton, tobacco, and lumber. According to this theory, the collapse of farm exports caused many American farmers to default on their loans, leading to the bank runs on small rural banks that characterized the early years of the Great Depression.

New classical approachMain article: Causes of the Great Depression#New classical approach

Recent work from a neoclassical perspective focuses on the decline in productivity that caused the initial decline in output and a prolonged recovery due to policies that affected the labor market. This work, collected by Kehoe and Prescott,[27] decomposes the economic decline into a decline in the labor force, capital stock, and the productivity with which these inputs are used. This study suggests that theories of the Great Depression have to explain an initial severe decline but rapid recovery in productivity, relatively little change in the capital stock, and a prolonged depression in the labor force. This analysis rejects theories that focus on the role of savings and posit a decline in the capital stock.

Austrian SchoolMain article: Causes of the Great Depression#Austrian School explanations

Another explanation comes from the Austrian School of economics. Theorists of the "Austrian School" who wrote about the Depression include Austrian economist Friedrich Hayek and American economist Murray Rothbard, who wrote America's Great Depression (1963). In their view and like the monetarists, the Federal Reserve, which was created in 1913, shoulders much of the blame; but in opposition to the monetarists, they argue that the key cause of the Depression was the expansion of the money supply in the 1920s that led to an unsustainable credit-driven boom.One reason for the monetary inflation was to help Great Britain, which, in the 1920s, was struggling with its plans to return to the gold standard at pre-war (World War I) parity. Returning to the gold standard at this rate meant that the British economy was facing deflationary pressure.[28] According to Rothbard, the lack of price flexibility in Britain meant that unemployment shot up, and the American government was asked to help. The United States was receiving a net inflow of gold, and inflated further in order to help Britain return to the gold standard. Montagu Norman, head of the Bank of England, had an especially good relationship with Benjamin Strong, the de facto head of the Federal Reserve. Norman pressured the heads of the central banks of France and Germany to inflate as well, but unlike Strong, they refused.[28] Rothbard says American inflation was meant to allow Britain to inflate as well, because under the gold standard, Britain could not inflate on its own.In the Austrian view it was this inflation of the money supply that led to an unsustainable boom in both asset prices (stocks and bonds) and capital goods. By the time the Fed belatedly tightened in 1928, it was far too late and, in the Austrian view, a depression was inevitable.According to the Austrians, the artificial interference in the economy was a disaster prior to the Depression, and government efforts to prop up the economy after the crash of 1929 only made things worse. According to Rothbard, government intervention delayed the market's adjustment and made the road to complete recovery more difficult.[29]

Furthermore, Rothbard criticizes Milton Friedman's assertion that the central bank failed to inflate the supply of money. Rothbard asserts that the Federal Reserve bought $1.1 billion of

government securities from February to July 1932, raising its total holding to $1.8 billion. Total bank reserves rose by only $212 million, but Rothbard argues that this was because the American populace lost faith in the banking system and began hoarding more cash, a factor quite beyond the control of the Central Bank. The potential for a run on the banks caused local bankers to be more conservative in lending out their reserves, and this, Rothbard argues, was the cause of the Federal Reserve's inability to inflate.[30]

Inequality of wealth and incomeMain article: Causes of the Great Depression#Inequality of wealth and income

Power farming displaces tenants from the land in the western dry cotton area. Childress County, Texas, 1938.

Two economists of the 1920s, Waddill Catchings and William Trufant Foster, popularized a theory that influenced many policy makers, including Herbert Hoover, Henry A. Wallace, Paul Douglas, and Marriner Eccles. It held the economy produced more than it consumed, because the consumers did not have enough income. Thus the unequal distribution of wealth throughout the 1920s caused the Great Depression.[31][32]

According to this view, wages increased at a rate lower than productivity increases. Most of the benefit of the increased productivity went into profits, which went into the stock market bubble rather than into consumer purchases. Say's law no longer operated in this model (an idea picked up by Keynes).As long as corporations had continued to expand their capital facilities (their factories, warehouses, heavy equipment, and other investments), the economy had flourished. Under pressure from the Coolidge administration and from business, the Federal Reserve Board kept the discount rate low, encouraging high (and excessive) investment. By the end of the 1920s, however, capital investments had created more plant space than could be profitably used, and factories were producing more than consumers could purchase.According to this view, the root cause of the Great Depression was a global overinvestment in heavy industry capacity compared to wages and earnings from independent businesses, such as farms. The solution was the government must pump money into consumers' pockets. That is, it must redistribute purchasing power, maintain the industrial base, but reinflate prices and wages to force as much of the inflationary increase in purchasing power into consumer spending. The economy was overbuilt, and new factories were not needed. Foster and Catchings recommended[33] federal and state governments start large construction projects, a program followed by Hoover and Roosevelt.Franklin D. Roosevelt, elected in 1932 and inaugurated March 4, 1933, blamed the excesses of big business for causing an unstable bubble-like economy. Democrats believed the problem was that business had too much money, and the New Deal was intended as a remedy, by empowering labor unions and farmers and by raising taxes on corporate profits.

In addition, excess price and entry competition, integrated banking, and the sheer size of corporations were viewed as contributing factors.[34] Regulation of the economy was a favorite remedy to this problem.

Turning point and recovery

The overall course of the Depression in the United States, as reflected in per-capita GDP (average income per person) shown in constant year 2000 dollars, plus some of the key events of the period.[35]

Various countries around the world started to recover from the Great Depression at different times. In most countries of the world recovery from the Great Depression began in 1933.[1] In the United States recovery began in the spring of 1933.[1] However, the U.S. did not return to 1929 GNP for over a decade and still had an unemployment rate of about 15% in 1940, albeit down from the high of 25% in 1933.There is no consensus among economists regarding the motive force for the U.S. economic expansion that continued through most of the Roosevelt years (and the sharp contraction of the 1937 recession that interrupted it). According to Christina Romer, the money supply growth caused by huge international gold inflows was a crucial source of the recovery of the United States economy, and that the economy showed little sign of self-correction. The gold inflows were partly due to devaluation of the U.S. dollar and partly due to deterioration of the political situation in Europe.[36] In their book, A Monetary History of the United States, Milton Friedman and Anna J. Schwartz also attributed the recovery to monetary factors, and contended that it was much slowed by poor management of money by the Federal Reserve System. Current Chairman of the Federal Reserve Ben Bernanke agrees that monetary factors played important roles both in the worldwide economic decline and eventual recovery.[37] Bernanke, also sees a strong role for institutional factors, particularly the rebuilding and restructuring of the financial system,[38] and points out that the Depression needs to be examined in international perspective.[39] Economists Harold L. Cole and Lee E. Ohanian, believe that the economy should have returned to normal after four years of depression except for continued depressing influences, and point the finger to the lack of downward flexibility in prices and wages, encouraged by Roosevelt Administration policies such as the National Industrial Recovery Act.[40] Some economists hava called attention to the expectations of reflation and rising nominal interest rates that Roosevelt's words and actions portended.[41][42]

Gold standardEconomic studies have indicated that just as the downturn was spread worldwide by the rigidities of the Gold Standard, it was suspending gold convertibility (or devaluing the currency in gold terms) that did most to make recovery possible.[43] What policies countries followed after casting off the gold standard, and what results followed varied widely.Every major currency left the gold standard during the Great Depression. Great Britain was the first to do so. Facing speculative attacks on the pound and depleting gold reserves, in

September 1931 the Bank of England ceased exchanging pound notes for gold and the pound was floated on foreign exchange markets.

The Depression in international perspective.[44]

Great Britain, Japan, and the Scandinavian countries left the gold standard in 1931. Other countries, such as Italy and the United States, remained on the gold standard into 1932 or 1933, while a few countries in the so-called "gold bloc", led by France and including Poland, Belgium and Switzerland, stayed on the standard until 1935–1936.According to later analysis, the earliness with which a country left the gold standard reliably predicted its economic recovery. For example, Great Britain and Scandinavia, which left the gold standard in 1931, recovered much earlier than France and Belgium, which remained on gold much longer. Countries such as China, which had a silver standard, almost avoided the depression entirely. The connection between leaving the gold standard as a strong predictor of that country's severity of its depression and the length of time of its recovery has been shown to be consistent for dozens of countries, including developing countries. This partly explains why the experience and length of the depression differed between national economies.[45]

World War II and recoveryThe examples and perspective in this article may not represent a worldwide view of the subject. Please improve this article and discuss the issue on the talk page. (September 2009)

The Great Depression ended as nations increased their production of war materials at the start of World War II. A factory worker in 1942. Fort Worth, Texas.

The common view among economic historians is that the Great Depression ended with the advent of World War II. Many economists believe that government spending on the war caused or at least accelerated recovery from the Great Depression. However, some consider that it did not play a great role in the recovery, although it did help in reducing unemployment.[1][46][47]

The massive rearmament policies leading up to World War II helped stimulate the economies of Europe in 1937–39. By 1937, unemployment in Britain had fallen to 1.5 million. The mobilization of manpower following the outbreak of war in 1939 finally ended unemployment.[8]

America's late entry into the war in 1941 finally eliminated the last effects from the Great Depression and brought the unemployment rate down below 10%.[48] In the United States, massive war spending doubled economic growth rates, either masking the effects of the Depression or essentially ending the Depression. Businessmen ignored the mounting national debt and heavy new taxes, redoubling their efforts for greater output to take advantage of generous government contracts.Productivity soared: most people worked overtime and gave up leisure activities to make money after so many hard years. People accepted rationing and price controls for the first time as a way of expressing their support for the war effort. Cost-plus pricing in munitions contracts guaranteed businesses a profit no matter how many mediocre workers they employed or how inefficient the techniques they used. The demand was for a vast quantity of war supplies as soon as possible, regardless of cost. Businesses hired every person in sight, even driving sound trucks up and down city streets begging people to apply for jobs. New workers were needed to replace the 11 million working-age men serving in the military.[48]

EffectsThe majority of countries set up relief programs, and most underwent some sort of political upheaval, pushing them to the left or right. In some states, the desperate citizens turned toward nationalist demagogues—the most infamous being Adolf Hitler—setting the stage for World War II in 1939.

AustraliaMain article: Great Depression in Australia

Australia's extreme dependence on agricultural and industrial exports meant it was one of the hardest-hit countries in the Western world, amongst the likes of Canada and Germany. Falling export demand and commodity prices placed massive downward pressures on wages. Further, unemployment reached a record high of 29% in 1932,[49] with incidents of civil unrest becoming common. After 1932, an increase in wool and meat prices led to a gradual recovery.

Canada

Unemployed men march in Toronto, Ontario, Canada.

Main article: Great Depression in Canada

Harshly impacted by both the global economic downturn and the Dust Bowl, Canadian industrial production had fallen to only 58% of the 1929 level by 1932, the second lowest level in the world after the United States, and well behind nations such as Britain, which saw it fall only to 83% of the 1929 level. Total national income fell to 56% of the 1929 level, again worse than any nation apart from the United States. Unemployment reached 27% at the depth of the Depression in 1933.[50] During the 1930s, Canada employed a highly restrictive immigration policy.[51]

ChileSee also: Economic history of Chile

Chile initially felt the impact of the Great Depression in 1930, when GDP dropped 14 percent, mining income declined 27 percent, and export earnings fell 28 percent. By 1932 GDP had shrunk to less than half of what it had been in 1929, exacting a terrible toll in unemployment and business failures. The League of Nations labeled Chile the country hardest hit by the Great Depression because 80 percent of government revenue came from exports of copper and nitrates, which were in low demand.Influenced profoundly by the Great Depression, many national leaders promoted the development of local industry in an effort to insulate the economy from future external shocks. After six years of government austerity measures, which succeeded in reestablishing Chile's creditworthiness, Chileans elected to office during the 1938–58 period a succession of center and left-of-center governments interested in promoting economic growth by means of government intervention.Prompted in part by the devastating earthquake of 1939, the Popular Front government of Pedro Aguirre Cerda created the Production Development Corporation (Corporación de Fomento de la Producción, CORFO) to encourage with subsidies and direct investments an ambitious program of import substitution industrialization. Consequently, as in other Latin American countries, protectionism became an entrenched aspect of the Chilean economy.

FranceMain article: Great Depression in France

The Depression began to affect France around 1931. France's relatively high degree of self-sufficiency meant the damage was considerably less than in nations like Germany. However, hardship and unemployment were high enough to lead to rioting and the rise of the socialist Popular Front.

Germany

"Diligent young man seeks work"

Main article: Great Depression in Central Europe

Germany's Weimar Republic was hit hard by the depression, as American loans to help rebuild the German economy now stopped.[52] Unemployment soared, especially in larger cities, and the political system veered toward extremism.[53] The unemployment rate reached nearly 30% in 1932.[54] Repayment of the war reparations due by Germany were suspended in 1932 following the Lausanne Conference of 1932. By that time Germany had repaid 1/8th of the reparations. Hitler's Nazi Party came to power in January 1933.

Bonnie and Clyde were notorious bank robbers during what is sometimes referred to as the "public enemy era" between 1931 and 1935. During the Depression bankers became so unpopular that bank robbers, such as John Dillinger, became folk heroes.[55]

JapanThe Great Depression did not strongly affect Japan. The Japanese economy shrank by 8% during 1929–31. However, Japan's Finance Minister Takahashi Korekiyo was the first to implement what have come to be identified as Keynesian economic policies: first, by large

fiscal stimulus involving deficit spending; and second, by devaluing the currency. Takahashi used the Bank of Japan to sterilize the deficit spending and minimize resulting inflationary pressures. Econometric studies have identified the fiscal stimulus as especially effective.[56]

The devaluation of the currency had an immediate effect. Japanese textiles began to displace British textiles in export markets. The deficit spending, however proved to be most profound. The deficit spending went into the purchase of munitions for the armed forces. By 1933, Japan was already out of the depression. By 1934 Takahashi realized that the economy was in danger of overheating, and to avoid inflation, moved to reduce the deficit spending that went towards armaments and munitions. This resulted in a strong and swift negative reaction from nationalists, especially those in the Army, culminating in his assassination in the course of the February 26 Incident. This had a chilling effect on all civilian bureaucrats in the Japanese government. From 1934, the military's dominance of the government continued to grow. Instead of reducing deficit spending, the government introduced price controls and rationing schemes that reduced, but did not eliminate inflation, which would remain a problem until the end of World War II.The deficit spending had a transformative effect on Japan. Japan's industrial production doubled during the 1930s. Further, in 1929 the list of the largest firms in Japan was dominated by light industries, especially textile companies (many of Japan's automakers, like Toyota, have their roots in the textile industry). By 1940 light industry had been displaced by heavy industry as the largest firms inside the Japanese economy.[57]

Latin AmericaMain article: Great Depression in Latin America

Because of high levels of United States investment in Latin American economies, they were severely damaged by the Depression. Within the region, Chile, Bolivia and Peru were particularly badly affected.

NetherlandsMain article: Great Depression in the Netherlands

From roughly 1931 until 1937, the Netherlands suffered a deep and exceptionally long depression. This depression was partly caused by the after-effects of the Stock Market Crash of 1929 in the United States, and partly by internal factors in the Netherlands. Government policy, especially the very late dropping of the Gold Standard, played a role in prolonging the depression. The Great Depression in the Netherlands led to some political instability and riots, and can be linked to the rise of the Dutch national-socialist party NSB. The depression in the Netherlands eased off somewhat at the end of 1936, when the government finally dropped the Gold Standard, but real economic stability did not return until after World War II.[58]

Buried machinery in a barn lot; South Dakota, May 1936. The Dust Bowl on the Great Plains coincided with the Great Depression.[59]

Entering Gulag (a leaf from Eufrosinia Kersnovskaya's notebook). During the Depression thousands of Americans emigrated to the Soviet Union. Many were arrested as potential “spies” during the Great Terror of 1937-38.[60]

South AfricaMain article: Great Depression in South Africa

As world trade slumped, demand for South African agricultural and mineral exports fell drastically. The Carnegie Commission on Poor Whites had concluded in 1931 that nearly one-third of Afrikaners lived as paupers. It is believed that the social discomfort caused by the depression was a contributing factor in the 1933 split between the "gesuiwerde" (purified) and "smelter" (fusionist) factions within the National Party and the National Party's subsequent fusion with the South African Party.[61]

Soviet UnionMain article: Economy of the Soviet Union#Economic development

Having removed itself from the capitalist world system both by choice and as a result of efforts of the capitalist powers to isolate it, the Great Depression had little effect on the Soviet Union. A Soviet trade agency in New York advertised 6,000 positions and received more than 100,000 applications.[62] Its apparent immunity to the Great Depression seemed to validate the theory of Marxism and contributed to Socialist and Communist agitation in affected nations. Many Western intellectuals, like New York Times reporter Walter Duranty, looked upon Soviet Union with sympathies, ignoring criticisms about Soviet famine that killed millions of people.[63] President Roosevelt also looked upon Soviet Union with sympathies, favoring closer diplomatic and economic ties between two countries.[64]

United KingdomMain article: Great Depression in the United Kingdom

The effects on the industrial areas of Britain were immediate and devastating, as demand for British products collapsed. By the end of 1930 unemployment had more than doubled from 1 million to 2.5 million (20% of the insured workforce), and exports had fallen in value by 50%. In 1933, 30% of Glaswegians were unemployed due to the severe decline in heavy industry. In some towns and cities in the north east, unemployment reached as high as 70% as ship production fell 90%.[65] The National Hunger March of September–October 1932 was the largest[66] of a series of hunger marches in Britain in the 1920s and 1930s. About 200,000 unemployed men were sent to the work camps, which continued in operation until 1939.[67]

Shacks, put up by the Bonus Army (World War I veterans) on the Anacostia flats, Washington, DC, burning after the battle with the 1,000 soldiers accompanied by tanks and machine guns, 1932.[68]

United StatesMain article: Great Depression in the United States

Hoover administration

Bennett buggies, or "Hoover wagons", cars pulled by horses, were used by farmers too impoverished to purchase gasoline.

President Herbert Hoover started numerous programs, all of which failed to reverse the downturn.[69] In June 1930 Congress approved the Smoot-Hawley Tariff Act which raised tariffs on thousands of imported items. The intent of the Act was to encourage the purchase of American-made products by increasing the cost of imported goods, while raising revenue for the federal government and protecting farmers. However, other nations increased tariffs on American-made goods in retaliation, reducing international trade, and worsening the Depression.[70] In 1931 Hoover urged the major banks in the country to form a consortium known as the National Credit Corporation (NCC).[71] By 1932 unemployment had reached 23.6%, and it peaked in early 1933 at 25%,[72] a drought persisted in the agricultural heartland, businesses and families defaulted on record numbers of loans,[73] and more than 5,000 banks had failed.[74] Hundreds of thousands of Americans found themselves homeless and they began congregating in the numerous Hoovervilles that had begun to appear across the country.[75] In response, President Hoover and Congress approved the Federal Home Loan Bank Act, to spur new home construction, and reduce foreclosures. The final attempt of the Hoover Administration to stimulate the economy was the passage of the Emergency Relief and Construction Act (ERA) which included funds for public works programs such as dams and the creation of the Reconstruction Finance Corporation (RFC) in 1932. The RFC's initial goal was to provide government-secured loans to financial institutions, railroads and farmers. Quarter by quarter the economy went downhill, as prices, profits and employment fell, leading to the political realignment in 1932 that brought to power Franklin Delano Roosevelt.Roosevelt administration

Great Depression: man lying down on pier, New York City docks, 1935.

See also: New Deal and Recession of 1937

Shortly after President Roosevelt was inaugurated in 1933, drought and erosion combined to cause the Dust Bowl, shifting hundreds of thousands of displaced persons off their farms in the Midwest. From his inauguration onward, Roosevelt argued that restructuring of the economy would be needed to prevent another depression or avoid prolonging the current one. New Deal programs sought to stimulate demand and provide work and relief for the impoverished through increased government spending and the institution of financial reforms. The Securities Act of 1933 comprehensively regulated the securities industry. This was followed by the Securities Exchange Act of 1934 which created the Securities and Exchange Commission. Though amended, key provisions of both Acts are still in force. Federal insurance of bank deposits was provided by the FDIC, and the Glass-Steagall Act. The institution of the National Recovery Administration (NRA) remains a controversial act to this day. The NRA made a number of sweeping changes to the American economy until it was deemed unconstitutional by the Supreme Court of the United States in 1935.

CCC workers constructing road, 1933. Over 3 million unemployed young men were taken out of the cities and placed into 2600+ work camps managed by the CCC.[76]

Early changes by the Roosevelt administration included: Instituting regulations to fight deflationary "cut-throat competition" through the NRA. Setting minimum prices and wages, labor standards, and competitive conditions in all

industries through the NRA. Encouraging unions that would raise wages, to increase the purchasing power of the working

class. Cutting farm production to raise prices through the Agricultural Adjustment Act and its

successors. Forcing businesses to work with government to set price codes through the NRA.

These reforms, together with several other relief and recovery measures, are called the First New Deal. Economic stimulus was attempted through a new alphabet soup of agencies set up in 1933 and 1934 and previously extant agencies such as the Reconstruction Finance Corporation. By 1935, the "Second New Deal" added Social Security (which did not start making large payouts until much later), a jobs program for the unemployed (the Works Progress Administration, WPA) and, through the National Labor Relations Board, a strong stimulus to the growth of labor unions. In 1929, federal expenditures constituted only 3% of the GDP. The national debt as a proportion of GNP rose under Hoover from 20% to 40%. Roosevelt kept it at 40% until the war began, when it soared to 128%.By 1936, the main economic indicators had regained the levels of the late 1920s, except for unemployment, which remained high at 11%, although this was considerably lower than the 25% unemployment rate seen in 1933.

WPA employed 2 to 3 million unemployed at unskilled labor.

In the spring of 1937, American industrial production exceeded that of 1929 and remained level until June 1937. In June 1937, the Roosevelt administration cut spending and increased taxation in an attempt to balance the federal budget.[77] The American economy then took a sharp downturn, lasting for 13 months through most of 1938. Industrial production fell almost 30 per cent within a few months and production of durable goods fell even faster. Unemployment jumped from 14.3% in 1937 to 19.0% in 1938, rising from 5 million to more than 12 million in early 1938.[78] Manufacturing output fell by 37% from the 1937 peak and was back to 1934 levels.[79] Producers reduced their expenditures on durable goods, and inventories declined, but personal income was only 15% lower than it had been at the peak in 1937. As unemployment rose, consumers' expenditures declined, leading to further cutbacks in production. By May 1938 retail sales began to increase, employment improved, and industrial production turned up after June 1938.[80] After the recovery from the Recession of 1937–1938, conservatives were able to form a bipartisan conservative coalition to stop further expansion of the New Deal and, when unemployment dropped to 2%, they abolished WPA, CCC and the PWA relief programs. Social Security, however, remained in place.There has always been debate among politicians and scholars as to whether New Deal policies lengthened and deepened the Depression. One small voluntary response survey from 85 PhD holding members of the Economic History Society, which the author stated may not be representative of all economic historians, showed that there were statistically different opinions between economic historians who taught or studied economic history and those that taught or studied economic theory. The former were in consensus that the New Deal did not lengthen and deepen the depression, while the latter were more evenly divided.[81]

Political consequencesThe crisis had many political consequences, among which was the abandonment of classic economic liberal approaches, which Roosevelt replaced in the United States with Keynesian

policies. These policies magnified the role of the federal government in the national economy. Between 1933 and 1939, federal expenditure tripled, and Roosevelt's critics charged that he was turning America into a socialist state.[82] The Great Depression was a main factor in the implementation of social democracy and planned economies in European countries after World War II. (see Marshall Plan). Although Austrian economists had challenged Keynesianism since the 1920s, it was not until the 1970s, with the influence of Milton Friedman that the Keynesian approach was politically questioned.[83]

Social movementsThe rise of the Technocracy movement occurred around the transition time of the Hoover administration into that of Franklin Roosevelts administration. The Technocrats advocated a Non-market economics system based on Energy accounting, which was also a non political approach (biophysical economics) to governance.[84] Technocracy held that all politics and all economic arrangements based on the Price system (i.e., based on traditional economic theory) were antiquated. Also that building a successful modern government could be based on engineering principles. "Production for use," a term they used, was meant as a contrast to production for profit in the capitalist system. Production for use became a slogan for many of the radical-left movements of the era also. Upton Sinclair, among others, affirmed his belief in "production for use" and the Technocrats briefly made common cause with Sinclair, and even Huey Long, in California. But the Technocrats were not of the political left, as they held every political and economic system, from the left to the right, to be unsound. As a mass movement its real center was California where it claimed half a million members in 1934. Technocracy counted among its admirers such men as the novelist H.G. Wells, the author Theodore Dreiser and the economist Thorstein Veblen. Among the collection of movements of the 1930s, the Technocracy movement survives into the present day.[85]

LiteratureThe U.S. Depression has been the subject of much writing, as the country has sought to re-evaluate an era that caused emotional as well as financial trauma to its people. Perhaps the most noteworthy and famous novel written on the subject is The Grapes of Wrath, published in 1939 and written by John Steinbeck, who was awarded both the Nobel Prize for literature and the Pulitzer Prize for the work. The novel focuses on a poor family of sharecroppers who are forced from their home as drought, economic hardship, and changes in the agricultural industry occur during the Great Depression. Steinbeck's Of Mice and Men is another important novel about a journey during the Great Depression. The Great Depression is a novella written by Alon Bersharder about a sad, disgruntled temporary worker, making the title both a homage to the historical event and a pun. Additionally, Harper Lee's To Kill a Mockingbird is set during the Great Depression. Margaret Atwood's Booker prize-winning The Blind Assassin is likewise set in the Great Depression, centering on a privileged socialite's love affair with a Marxist revolutionary. The era spurred the resurgence of social realism, practiced by many who started their writing careers on relief programs such as the Federal Writers' Project; that experience and its effects is described in the history Soul of a People: The WPA Writers' Project Uncovers Depression America, by David Taylor (2009).

Other "great depressions"There have been other downturns called a "Great Depression," but none has been as worldwide for so long. British economic historians used the term "Great depression" to describe British conditions in the late 19th century, especially in agriculture, 1873–1896, a period also referred to as the Long Depression.[86] Several Latin American countries had severe downturns in the 1980s. Finnish economists refer to the Finnish economic decline around the breakup of the Soviet Union (1989–1994) as a great depression. Kehoe and

Prescott define a great depression to be a period of diminished economic output with at least one year where output is 20% below the trend. By this definition Argentina, Brazil, Chile, and Mexico experienced great depressions in the 1980s, and Argentina experienced another in 1998–2002. This definition also includes the economic performance of New Zealand from 1974–1992 and Switzerland from 1973 to the present, although this designation for Switzerland has been controversial.[87][88]

The economic crisis in the 1990s that struck former members of the Soviet Union was almost twice as intense as the Great Depression in the countries of Western Europe and the United States in the 1930s.[89][90] Average standards of living registered a catastrophic fall in the early 1990s in many parts of the former Eastern Bloc - most notably, in post-Soviet states.[91] Even before Russia's financial crisis of 1998, Russia's GDP was half of what it had been in the early 1990s.[90] Some populations are still poorer today than they were in 1989 (e.g. Ukraine, Moldova, Serbia, Central Asia, Caucasus). The collapse of the Soviet planned economy and the transition to market economy resulted in catastrophic declines in GDP of about 45% during the 1990–1996 period[92] and poverty in the region had increased more than tenfold.[93]

Chapter 9: Classical and Keynesian Theories

I. Classical and Keynesian theories of Aggregate SpendingA. Classical Theory believes that full-employment is the employment level the economy will

return to, and tends to remain at in the long run. Graphically, the pure Classical theorists

would have a vertical AS curve that shows the same GDP (GDP*) associated with full-

employment, at each price-level in the economy.

B. Keynesian Theory holds that unemployment is the normal state of the economy and

significant government intervention is required if employment/output targets are to be

reached. In this view, AS is horizontal.

C. The Classical reasoning:

1. Say’s law: Supply creates its own Demand. This reflects the “simple circular-flow

model,” that had firms employing all the resources (which are owned by

households) and the costs of these inputs is the income people use to buy all of the

output firms produce.

2. Abstinence Theory of Interest: To a great extent, it is the interest rate that

influences people’s savings. Money they do not spend (savings) becomes part of the

supply in the market for loanable funds. The quantity (horizontal axis) is dollars lent

out; the price of loanable funds is the interest rate. Business investment spending

(I) is also dependent on the interest rate, which will cause S=I in the long run.

3. Classical theorists held that wages and prices would change proportionately. For

example, imagine the prevailing salary is $100,000 a year, and firms have hired so

many people at that cost because demand is very high, causing output to increase –

and more labor hired shrinks the pool of those unemployed. This becomes an

expansion that is not sustainable, above long-run potential AS, which is vertical. All

the spending in the economy and the input costs getting passed on to consumers

both cause prices to rise. High prices in the product market signal AD to shift left

and high wage rates (input costs) cause layoffs (firm decrease output).

In a recession Classical theorists believed a 20% reduction in wages (to $80,000) would

mean a 20% decrease in prices as well. Through wage-price flexibility, output could be

maintained at the long run level.

D. Keynesian critique of Classical Theories

(John Maynard Keynes 1883-1946)

1. Say’s Law – Does better describing the conditions in which it was written (18th

Century France) than industrialized economies. Modern economies have

decentralized production but often profit makers are remote and far from the

production. Many employees never buy their firm’s products, and wages have an

effect on costs, but not the firm’s revenue (total sales). There are many ways to

increase Demand more effectively than to push for more output to be produced.

2. Abstinence Theory of Interest – to the idea that I=S at the market clearing interest

rate, Keynes argued that Investors and savers have different motivations. Rather

than just the interest rate, their decision on how much to save or invest depends on

other factors:

i. Savings may be based on a regular amount being put aside for retirement. It

may be for a purchase in the near future (car, house, college fund)

ii. Investment depends on firms’ expectations about GDP, Prices, Industry

demand

3. Wage-Price Flexibility – monopoly power of suppliers restricts flexibility in prices.

Unions restricts flexibility in wages. In deflation, debt worsens (becomes more

costly to the debtor in real terms). Because people are more aware of nominal than

real savings, any decrease in the price-level would have to be dramatic to cause

consumption to increase. (The Classical notion of the Pigou Effect stated that falling

prices increase asset value and make people feel wealthier and consume more)

Central Keynesian Conclusions:

1. AD determines Real GDP

2. In the short run, AD can be adjusted to achieve target GDP and unemployment

levels with prices not changing (fixed, flat prices)

3. When operating at a level other than capacity GDP (Y*) there are no forces to

automatically restore Y*

Usually, either unemployment (low Demand) or inflation (high Demand) exist.

One of the major implications of Keynesian conclusion is that government

involvement (through active fiscal policy) is essential to achieve Y*. Therefore some economists

regard Keynes as a modern-day “mercantilist” referring to the theory that governments should be

responsible for economic welfare.

II. AS-AD Analysis

A. Aggregate Demand-Aggregate Supply (AD-AS) Analysis

1. AD is the measure of entire planned spending on final goods and services at each level of

prices and RGDP.

i. The AD-AS graph is similar to the Demand and Supply for a single good. However,

on the horizontal axis is RGDP (real output, instead of Quantity of the single good) and the vertical

axis is the price level (tracked by an index like the CPI).

ii. At the equilibrium price level (where AD and AS cross) real output that AD plans

to purchase equals the output AS plans to produce.

iii. AD is determined by the four spending sectors. In other words these are AD’s

SHIFT FACTORS:

1. Consumption is influenced by several factors. Some of the most

important are Disposable Income (which will change if taxes change), Availability of credit (indicated

by the interest rate, which is determined in the market for loanable funds-meaning credit), and

consumer expectations.

2. Investment spending depends largely on interest rates, government

policies regarding business, and expectations.

3. Government expenditures are often built in to the budget, although

Congress and the President can make substantial changes in the level and type of spending that goes

on. They may implement new spending programs that are to be automatically countercyclical, or

eliminate existing “automatic stabilizers.” The automatic stabilizer would be any policy that

a.) Is Countercyclical:

It would lead to expansionary fiscal policy (such as Government spending increases) in bad

economies and contractionary fiscal policies (like tax increases) in good economies.

b.) Is Automatic

It fluctuates (without any new legislation needed) in immediate response to a change in income.

Examples: Income-Security payments (G rises when Y falls), progressive income tax system (T rises

when Y rises).

4. Net Exports are influenced by:

i. Trade Policy. Existence of tariffs or quotas on imports will decrease the imports

flowing into a country. So if a U.S. trading partner restricts the quantity of a certain good they will

import from us, that “quota” will decrease our exports. The same is true if this trading partner

imposes a “tariff,” a tax on the imported goods.

ii. Exchange rates. If the dollar is cheaper relative to foreign currencies, our exports

will increase because US producers (who want to be paid in dollars) are now making goods that the

rest of the world finds cheaper.

Net Exports (X-M) will also increase because M (imports) decreases in this example since foreign

goods have become more expensive due to the fact that the dollar does not go as far in purchasing

the foreign currency.

iii. Politics. Sometimes laws abroad will limit the profitability and income US

producers can make there by requiring that part of the production be owned by companies in their

country.

A demand shock will shift the entire AD curve if there is a curve in C, I, G, or Xn.

Some positive shocks to aggregate demand would be: Tax cut for individuals (C increases), Interest

rate cute (C and I increase), or G increasing. Shocks that would shift AD to the left including

worsening consumer expectations (C decreases) or consumers buying more imports (Xn decreases).

B. Why does AD slope downward?

1. Downward Sloping Due to:

i.The wealth effect

If the nominal value of everyone in a country’s Assets=A, then Real Assets would be expressed as

A/P or nominal assets over the price level (P). Moving down (to a lower price level) in the AD

diagram is associated with more output demanded since the real value of people’s wealth (assets)

has increased. Some of that increase in purchasing power will stimulate increased goods and

services purchases, thus moving horizontally in response to the fall in Prices

ii. The Interest Rate Effect

Real Money balances M/P increase with a fall in P, meaning the real value of the money supply (to

be detailed in Chapter 11) increases and banks have more to lend out. The increase in loanable funds

decreases the price of those funds: the interest rate. This means more output demanded (horizontal

movement in the AD response to the falling Price level) as consumer loans and business debt

increase to finance more purchases. Remember the low (falling) inflation, or even deflation, enables

banks to charge lower nominal interest rates and still get a stable real interest rate on loans.

iii. International effect

Ceteris Paribus, if prices are falling in the U.S. for domestically produced goods, we’ll be buying

fewer imports (increasing Aggregate Quantity Demanded)

iv. Multiplier Effect

Detailed in Chapter 10, it amplifies the other effects because of the “rounds of spending” that occur

when an exogenous shock, positive or negative, to some spending sector plays out over the near

future. For example, if the government raises taxes, that will restrain consumer spending, and C is a

major portion of expenditures. But the story doesn’t end there, because the lost spending is lost

revenue for many businesses and individuals who will in turn cut back a bit on their own spending

and some saving. But these people who have responded to the revenue loss now set off the next

group of businesses and individuals who would have received the spending, and they respond just

the same. It may be more intuitive to think of a positive exogenous shock, like a stock market boom.

C. Aggregate Supply

As measures the entire desired output of final goods and services at each level of prices and RGDP.

The shocks that can shift AS are

1. Input costs, and the availability of resources.

2. Capacity of capital and other factors of production

3. Investment plans (inversely related to the interest rate)

Directly relates to the level of capacity utilization

4. Technology.

5. Productivity

6. Expectations – about a variety of indications including the price level, consumer spending,

and industry conditions.

7. Gov’t policies. An increase in regulations and laws hindering and putting conditions on

private sector output will be a negative shock to AS while deregulation would be a positive shock.

The book adds to these: Excise and Sales taxes and import prices as shifters, which, along with those

listed above, comprise shift factors for SAS or Short-run AS.

LAS or Long-run AS can only be shifted by a real change in # of available inputs ((2) above, or (4) and

(5) above which make existing inputs produce at a higher level of potential output.

Therefore 2, 4 and 5 shift both SAS and LAS, which is easiest to draw with a kinked AS where both

the diagonal and vertical portions shift right.

D. The Upward slope of the AS curve is due to diminishing productivity of resources. As prices

rise and firms strive to take in more profits by producing more output, they have to hire more

factors of production. The additional labor is not as productive as the original workers who have

been working there longer and were the first people the company decided to hire due to their skills.

The additional workers decrease the average productivity per worker, making costs rise as output

rises.

In the opposite direction, moving down along an AS curve, less demand putting downward

pressure on prices signals to suppliers they should produce less. They layoff workers who are

generally the less productive, less senior, lower skilled of their workers. The increase in average

productivity lowers costs to the firm and makes them willing to offer the decreased level of output

at lower prices.

E. The AS curve is best understood as having three distinct “ranges” the first being horizontal,

the second diagonal, and the third vertical. The vertical portion is the full-employment range, and it

follows a vertical line straight up from the potential output level (the RGDP* if the economy is at the

natural rate of unemployment).

AD can increase through the full-employment range, but it will only raise prices, not RGDP.

Bottlenecks are associated with the diagonal portion; the economy can produce more, but producers

experience productivity loss and thus higher costs that are getting passed on to consumers. RGDP

and the price level both increase as AD moves to the right through this region.

The horizontal portion is “Unemployment” where output can be increased by whatever amount AD

requires with no increase in prices.

What Does Law Of Demand Mean?A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease and vice versa.

the law of demand is an economic law that states that consumers buy more of a good when its price decreases and less when its price increases (ceteris paribus).The greater the amount to be sold, the smaller the price at which it is offered must be in order for it to find purchasers.Law of demand states that the amount demanded of a commodity and its price are inversely related, other things remaining constant. That is, if the income of the consumer, prices of the related goods, and tastes and preferences of the consumer remain unchanged, the consumer’s demand for the good will move opposite to the movement in the price of the good."If the price of the good increases, the quantity demanded decreases, while if price of the good decreases, its quantity demanded increases."

Multiplier (economics)

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In economics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable.That is, suppose a one-unit change in some variable x causes another variable y to change by M units. Then the multiplier is M.

Contents[hide]

1 Common uses o 1.1 Money multiplier o 1.2 Fiscal multipliers o 1.3 Keynesian multiplier

2 General method 3 History 4 References

[edit] Common usesTwo multipliers are commonly discussed in introductory macroeconomics.

[edit] Money multiplierMain article: Money multiplier

See also: Fractional-reserve banking

In monetary macroeconomics and banking, the money multiplier measures how much the money supply increases in response to a change in the monetary base.The multiplier may vary across countries, and will also vary depending on what measures of money are considered. For example, consider M2 as a measure of the U.S. money supply, and M0 as a measure of the U.S. monetary base. If a $1 increase in M0 by the Federal Reserve causes M2 to increase by $10, then the money multiplier is 10.

[edit] Fiscal multipliersMain article: Fiscal multiplier

Multipliers can be calculated to analyze the effects of fiscal policy, or other exogenous changes in income and spending, on aggregate output.For example, if an increase in German government spending by €100, with no change in taxes, causes German GDP to increase by €150, then the spending multiplier is 1.5. Other types of fiscal multipliers can also be calculated, like multipliers that describe the effects of changing taxes (such as lump-sum taxes or proportional taxes).

[edit] Keynesian multiplierKeynesian economists often calculate multipliers that measure the effect on aggregate demand only. (To be precise, the usual Keynesian multiplier formulas measure how much the IS curve shifts left or right in response to an exogenous change in income or spending.) Opponents of Keynesianism have sometimes argued that Keynesian multiplier calculations are misleading; for example, according to the theory of rational expectations, it is impossible to calculate the effect of deficit-financed government spending on demand without specifying how people expect the deficit to be paid off in the future.

Consumer price indexA consumer price index (CPI) is a measure estimating the average price of consumer goods and services purchased by households. A consumer price index measures a price change for a constant market basket of goods and services from one period to the next within the same area (city, region, or nation).[1] It is a price index determined by measuring the price of a standard group of goods meant to represent the typical market basket of a typical urban consumer.[2] Related, but different, terms are the United Kingdom's CPI, RPI, and RPIX. It is one of several price indices calculated by most national statistical agencies. The percent change in the CPI is a measure estimating inflation. The CPI can be used to index (i.e., adjust for the effect of inflation on the real value of money: the medium of exchange) wages, salaries, pensions, and regulated or contracted prices. The CPI is, along with the population census and the National Income and Product Accounts, one of the most closely watched national economic statistics.

IntroductionTwo basic types of data are needed to construct the CPI: price data and weighting data. The price data are collected for a sample of goods and services from a sample of sales outlets in a sample of locations for a sample of times. The weighting data are estimates of the shares of the different types of expenditure as fractions of the total expenditure covered by the index. These weights are usually based upon expenditure data obtained for sampled decades from a sample of households. Although some of the sampling is done using a sampling frame and probabilistic sampling methods, much is done in a commonsense way (purposive sampling) that does not permit estimation of confidence intervals. Therefore, the sampling variance is normally ignored, since a single estimate is required in most of the purposes for which the index is used. Stocks greatly affect this cause.The index is usually computed yearly, or quarterly in some countries, as a weighted average of sub-indices for different components of consumer expenditure, such as food, housing, clothing, each of which is in turn a weighted average of sub-sub-indices. At the most detailed level, the elementary aggregate level, (for example, men's shirts sold in department stores in San Francisco), detailed weighting information is unavailable, so elementary aggregate indices are computed using an unweighted arithmetic or geometric mean of the prices of the sampled product offers. (However, the growing use of scanner data is gradually making weighting information available even at the most detailed level.) These indices compare prices each month with prices in the price-reference month. The weights used to combine them into the higher-level aggregates, and then into the overall index, relate to the estimated expenditures during a preceding whole year of the consumers covered by the index on the products within its scope in the area covered. Thus the index is a fixed-weight index, but rarely a true Laspeyres index, since the weight-reference period of a year and the price-reference period, usually a more recent single month, do not coincide. It takes time to assemble and process the information used for weighting which, in addition to household expenditure surveys, may include trade and tax data.Ideally, the weights would relate to the composition of expenditure during the time between the price-reference month and the current month. There is a large technical economics literature on index formulae which would approximate this and which can be shown to approximate what economic theorists call a true cost of living index. Such an index would show how consumer expenditure would have to move to compensate for price changes so as to allow consumers to maintain a constant standard of living. Approximations can only be computed retrospectively, whereas the index has to appear monthly and, preferably, quite soon. Nevertheless, in some countries, notably in the United States and Sweden, the philosophy of the index is that it is inspired by and approximates the notion of a true cost of living (constant utility) index, whereas in most of Europe it is regarded more pragmatically.The coverage of the index may be limited. Consumers' expenditure abroad is usually excluded; visitors' expenditure within the country may be excluded in principle if not in practice; the rural population may or may not be included; certain groups such as the very rich or the very poor may be excluded. Saving and investment are always excluded, though the prices paid for financial services provided by financial intermediaries may be included along with insurance.The index reference period, usually called the base year, often differs both from the weight-reference period and the price reference period. This is just a matter of rescaling the whole time-series to make the value for the index reference-period equal to 100. Annually revised weights are a desirable but expensive feature of an index, for the older the weights the greater is the divergence between the current expenditure pattern and that of the weight reference-period.

Transfer payment

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In economics, a transfer payment (or government transfer or simply transfer) is a redistribution of income in the market system. These payments are considered to be nonexhaustive because they do not directly absorb resources or create output. Examples of certain transfer payments include welfare (financial aid), social security, and government subsidies for certain businesses (firms).

What Does Government Purchases Mean?Expenditures made in the private sector by all levels of government, such as when a government entity contracts a construction company to build office space or pave highways.

Real Business Cycle Theory

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Real Business Cycle Theory (or RBC Theory) is a class of macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by real (in contrast to nominal) shocks. (The four primary economic fluctuations are secular (trend), business cycle, seasonal, and random.) Unlike other leading theories of the business cycle, it sees recessions and periods of economic growth as the efficient response to exogenous changes in the real economic environment. That is, the level of national output necessarily maximizes expected utility, and government should therefore concentrate on the long-run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to actively smooth economic short-term fluctuations.According to RBC theory, business cycles are therefore "real" in that they do not represent a failure of markets to clear, but rather reflect the most efficient possible operation of the economy, given the structure of the economy. It differs in this way from other theories of the business cycle, like Keynesian economics and Monetarism, which see recessions as the failure of some market to clear.RBC theory is associated with freshwater economics (the Chicago school of economics, in the neoclassical tradition), and is rejected and harshly criticized by other schools within mainstream economics, notably Keynesians.

Contents

[hide]

1 Business Cycles 2 Stylized Facts 3 Real Business Cycle Theory

o 3.1 Calibration o 3.2 Structural Variables

4 Criticism 5 See also 6 References

[edit] Business CyclesIf we were to take snapshots of an economy at different points in time, no two photos would look alike. This occurs for two reasons:

1. Many advanced economies exhibit sustained growth over time. That is, snapshots taken many years apart will most likely depict higher levels of economy activity in the later period

2. There exist seemingly random fluctuations around this growth trend. Thus given two snapshots in time, predicting the later with the earlier is nearly impossible.

FIGURE 1

A common way to observe such behavior is by looking at a time series of an economy’s output, more specifically gross national product (GNP). This is just the value of the goods and services produced by a country’s businesses and workers.Figure 1 shows the time series of real GNP for the United States from 1954-2005. While we see continuous growth of output, it is not a steady increase. There are times of faster growth and times of slower growth. Figure 2 transforms these levels into growth rates of real GNP and extracts a smoother growth trend. A common method to obtain this trend is the Hodrick-Prescott filter. The basic idea is to find a balance between the extent to which general growth trend follows the cyclical movement (since long term growth rate is not likely to be perfectly constant) and how smooth it is. The HP filter identifies the longer term fluctuations as part of the growth trend while classifying the more jumpy fluctuations as part of the cyclical component.

FIGURE 2

Observe the difference between this growth component and the jerkier data. Economists refer to these cyclical movements about the trend as business cycles. Figure 3 explicitly captures such deviations. Note the horizontal axis at 0. A point on this line indicates at that year, there is no deviation from the trend. All other points above and below the line imply deviations. By using log real GNP the distance between any point and the 0 line roughly equals the percentage deviation from the long run growth trend.

FIGURE 3

We call relatively large positive deviations (those above the 0 axis) peaks. We call relatively large negative deviations (those below the 0 axis) troughs. A series of positive deviations leading to peaks are booms and a series of negative deviations leading to troughs are recessions.At a glance, the deviations just look like a string of waves bunched together—nothing about it appears consistent. To explain causes of such fluctuations may appear rather difficult given these irregularities. However, if we consider other macroeconomic variables, we will observe patterns in these irregularities. For example, consider Figure 4 which depicts fluctuations in

output and consumption spending, i.e. what people buy and use at any given period. Observe how the peaks and troughs align at almost the same places and how the upturns and downturns coincide.

FIGURE 4

We might predict that other similar data may exhibit similar qualities. For example, (a) labor, hours worked (b) productivity, how effective firms use such capital or labor, (c) investment, amount of capital saved to help future endeavors, and (d) capital stock, value of machines, buildings and other equipment that help firms produce their goods. While Figure 5 shows a similar story for investment, the relationship with capital in Figure 6 departs from the story. We need a way to pin down a better story; one way is to look at some statistics.

FIGURE 5

FIGURE 6

[edit] Stylized FactsBy eyeballing the data, we can infer several regularities, sometimes called stylized facts. One is persistence. For example, if we take any point in the series above the trend (the x-axis in figure 3), the probability the next period is still above the trend is very high. However, this persistence wears out over time. That is, economic activity in the short run is quite predictable but due to the irregular long-term nature of fluctuations, forecasting in the long run is much more difficult if not impossible.Another regularity is cyclical variability. Column A of Table 1 lists a measure of this with standard deviations. The magnitude of fluctuations in output and hours worked are nearly equal. Consumption and productivity are similarly much smoother than output while investment fluctuates much more than output. Capital stock is the least volatile of the indicators.

TABLE 1

Yet another regularity is the co-movement between output and the other macroeconomic variables. Figures 4 - 6 illustrated such relationship. We can measure this in more detail using

correlations as listed in column B of Table 1. Procyclical variables have positive correlations since it usually increases during booms and decreases during recessions. Vice versa, a countercyclical variable associates with negative correlations. Acyclical, correlations close to zero, implies no systematic relationship to the business cycle. We find that productivity is slightly procyclical. This implies workers and capital are more productive when the economy is experiencing a boom. They aren’t quite as productive when the economy is experiencing a slowdown. Similar explanations follow for consumption and investment, which are strongly procyclical. Labor is also procyclical while capital stock appears acyclical.Observing these similarities yet seemingly non-deterministic fluctuations about trend, we come to the burning question of why any of this occurs. It’s common sense that people prefer economic booms over recessions. It follows that if all people in the economy make optimal decisions, these fluctuations are caused by something outside the decision-making process. So the key question really is: what main factor influences and subsequently changes the decisions of all actors in an economy?

[edit] Real Business Cycle TheoryEconomists have come up with many ideas to answer the above question. The one which currently dominates the academic Real Business Cycle Theory literature was introduced by Finn E. Kydland and Edward C. Prescott in their seminal 1982 work Time to Build And Aggregate Fluctuations. They envisioned this factor to be technological shocks i.e., random fluctuations in the productivity level that shifted the constant growth trend up or down. Examples of such shocks include innovations, bad weather, imported oil price increase, stricter environmental and safety regulations, etc. The general gist is that something occurs that directly changes the effectiveness of capital and/or labour. This in turn affects the decisions of workers and firms, who in turn change what they buy and produce and thus eventually affect output. RBC models predict time sequences of allocation for consumption, investment, etc. given these shocks.But exactly how do these productivity shocks cause ups and downs in economic activity? Let’s consider a good but temporary shock to productivity. This momentarily increases the effectiveness of workers and capital. Also consider a world where individuals produce goods they consume. The problem with this reasoning is that on aggregate level, this shock would average out.Individuals face two types of trade offs. One is the consumption-investment decision. Since productivity is higher, people have more output to consume. An individual might choose to consume all of it today. But if he values future consumption, all that extra output might not be worth consuming in its entirety today. Instead, he may consume some but invest the rest in capital to enhance production in subsequent periods and thus increase future consumption. This explains why investment spending is more volatile than consumption. The life cycle hypothesis argues that households base their consumption decisions on expected lifetime income and so they prefer to “smooth” consumption over time. They will thus save (and invest) in periods of high income and defer consumption of this to periods of low income.The other decision is the labor-leisure trade off. Higher productivity encourages substitution of current work for future work since workers will earn relatively more per hour today compared to tomorrow. More labor and less leisure results in higher output today. greater consumption and investment today. On the other hand, there is an opposing effect: since workers are earning more, they may not want to work as much today and in future periods. However, given the pro-cyclical nature of labor, it seems that the above “substitution effect” dominates this “income effect”.

Overall, the basic RBC model predicts that given a temporary shock, output, consumption, investment and labor all rise above their long-term trends and hence formulate into a positive deviation. Furthermore, since more investment means more capital is available for the future, a short-lived shock may have an impact in the future. That is, above-trend behavior may persist for some time even after the shock disappears. This capital accumulation is often referred to as an internal “propagation mechanism” since it converts shocks without persistence into highly persistent shocks to output.It is easy to see that a string of such productivity shocks will likely result in a boom. Similarly, recessions follow a string of bad shocks to the economy. If there were no shocks, the economy would just continue following the growth trend with no business cycles.Essentially this is how the basic RBC model qualitatively explains key business cycle regularities. Yet any good model should also generate business cycles that quantitatively match the stylized facts in Table 1, our empirical benchmark. Kydland and Prescott introduced calibration techniques to do just this. The reason why this theory is so celebrated today is that using this methodology, the model closely mimics many business cycle properties. Yet current RBC models have not fully explained all behavior and neoclassical economists are still searching for better variations.It is important to note the main assumption in RBC theory is that individuals and firms respond optimally all the time. In other words, if the government came along and forced people to work more or less than they would have otherwise, it would most likely make people unhappy. It follows that business cycles exhibited in an economy are chosen in preference to no business cycles at all. This is not to say that people like to be in a recession. Slumps are preceded by an undesirable productivity shock which constrains the situation. But given these new constraints, people will still achieve the best outcomes possible and markets will react efficiently. So when there is a slump, people are choosing to be in that slump because given the situation, it is the best solution. This suggests laissez-faire (non-intervention) is the best policy of government towards the economy but given the abstract nature of the model, this has been debated.A pre-cursor to RBC theory was developed by monetary economists Milton Friedman and Robert Lucas in the early 1970s. They envisioned the factor that influenced people’s decisions to be misperception of wages—that booms/recessions occurred when workers perceived wages higher/lower than they really were. This meant they worked and consumed more/less than otherwise. In a world of perfect information, there would be no booms or recessions.

[edit] CalibrationUnlike estimation, which is usually used for the construction of economic models, calibration only returns to the drawing board to change the model in the face of overwhelming evidence against the model being correct; this inverts the burden of proof away from the builder of the model. Since RBC models explain data ex post, it is very difficult to falsify any one model that could be hypothesised to explain the data. RBC models are highly sample specific, leading some to believe that they have little or no predictive power.

[edit] Structural VariablesCrucial to RBC models, "plausible values" for structural variables such as the discount rate, and the rate of capital depreciation are used in the creation of simulated variable paths. These tend to be estimated from econometric studies, with 95% confidence intervals. If the full range of possible values for these variables is used, correlation coefficients between actual and simulated paths of economic variables can shift wildly, leading some to question how successful a model which only achieves a coefficient of 80% really is.

[edit] CriticismReal Business Cycle Theory is a major point of contention within macroeconomics (Summers 1986): RBC theory categorically rejects Keynesian economics and real effectiveness of monetarism, which are the pillars of mainstream macroeconomic policy, while such noted mainstream economists as Larry Summers and Paul Krugman categorically reject RBC theory in turn:

"(My view is that) real business cycle models of the type urged on us by [Ed] Prescott have nothing to do with the business cycle phenomena observed in the United States or other capitalist economies." –(Summers 1986)

Instead, economists in the Keynesian tradition believe that the business cycles observed in the United States and other capitalist economies in the 20th century are often due to demand side issues, as in the theory of effective demand, rather than the supply-side only of RBC theory.By way of specific criticism of RBC theory as avanced by Prescott, (Summers 1986) lists four:

Prescott uses incorrect parameters (one third of household time devoted to market activity rather than one sixth; historical real interest rates of 4% rather than 1%);

absence of independent evidence for the technology shocks that supposedly cause the business cycle, and notably being unable to point to technological causes of observed recessions;

Prescott's models ignore prices, and its predictions on asset prices are rejected by 100 years of data by Prescott's own work;

Prescott ignores exchange failures (e.g., failures of factories to trade their goods for workers' labor), which are central to Keynesian accounts of the causes of the Great Depression, among other crises.

Instead, credit crunches, a nominal and financial cause, rather than the real causes proposed by RBC theory, are proposed as better explanations of the business cycle, notably according with observed recessions, as in the work of (Eckstein and Sinai, 1986).