The Origin of the Great Depression - Essay Example

Answer to Question 1
The Great Depression had its origin in the US stock market crash on October 29, 1929, which is known in economic history as Black Tuesday. Many investors who had poured their resources into the market lost them leading to a sudden economic collapse affecting not only the USA, where it was rooted, but taking with it the entire world. Though the tragedy occurred during the fourth quarter of 1929, the impact of same had been long-lasting till 1933 when the pitfall was the worst and every economic indicator had reached its worst. The adjoining diagram depicts the severity of the crash; it shows the growth rate of real GDP to have deteriorated by 8.61% in 1930 and by another 4.39% in 1932. Every other economic variable gave up simultaneously as is obvious from the next graph that depicts the trends taken by the rate of unemployment and that of inflation. While the rate of unemployment had reached a peak during 1933 when it equaled 25.2%, the rate of inflation as measured by the GDP deflator had been -11.46% in 1932. Hence, the economy at that point in time was suffering from a heavy recession. In fact, such was the vigor of the crisis that the monetarists could not inject liquidity into the nation even by lowering the rate of interest, supposed to discourage deposits and encourage loans. People around the economy had lost their trust in its fundamentals and wanted to hold back whatever they could so that aggregate demand was low. A low aggregate demand triggered a low aggregate supply and thus, equilibrium output production was low as well. The national government in their attempt to correct the scenario, restricted international trade and adopted a protectionist policy, which deteriorated the problem further.
It was when every school of economics had failed to correct the impact of the Great Depression that the Keynesian school of economics came to as the rescuer. John Maynard Keynes ruled out the prevailing classical concepts of economic growth. Instead, he stressed spending more money. He instructed the national government to open up to international trade and hence, stimulate aggregate demand and supply. Moreover, he also suggested the administration invest heftily into the economy even if that amounted to incurring deficits. Moreover, the rate of employment must be at its maximum achievable point so that people start earning and hence are instigated towards more spending (Barro, 2008, p. 405). This strategy introduced by Keynes came to be known in macroeconomics as the Keynesian school of thought, which still continues to be the intrinsic fundamental running economies around the world.
Answer to Question 2
The formulae being used to figure out the underlying information are,
Disposable Income (Yd) = Total Income (Y) – Net Taxes (T),
Investment (I) ≡ Savings (S),
Aggregate Expenditure (AE) = Consumption (C) + Investment (I) + Government Expenses (G)
The solved table has been presented underneath, with the expressions in italics being the ones that have been solved.
Y T Yd C S I G AE
1000 200 800 1,060 340 340 400 1800
2000 200 1,800 1,860 340 340 400 2,600
3000 200 2,800 2,660 340 340 400 3,400
4000 200 3800 3,460 340 340 400 4,200
5000 200 4,800 4,260 340 340 400 5,000
6000 200 5800 5,060 340 340 400 5,800
The formula to calculate the marginal propensity to consume (MPC) is,
MPC = Marginal Change in C/ Marginal Change in Yd = ΔC/ ΔYd (Baumol & Blinder, 2007, p. 544).
As consumption and disposable income grow at a constant rate, so here,
MPC = 800/ 1000 = 0.8.
The equilibrium level of income, YE is reached when Y = AE. Hence, in the present case,
YE = 5000 units.
The position of government budget is always at a deficit if tax is considered the only source of government revenue in this case. Since the government’s budget = T – G, the amount of government deficit in this case is, T – G = 200 – 400 = -200, implying a deficit.
Answer to Question 3
According to the diagram depicted, the rate of inflation and the rate of unemployment are inversely related to each other. At the initial point when the rate of inflation had been 13%, the level of unemployment is represented by the UN, which is but the natural rate. However, a fall in the supply of money leads to a fall in aggregate demand, and thus, producers lose any incentive to produce more. Such a mindset depreciates the aggregate production and manufacturers no longer need to employ as much labor as before. Hence, there are economy-wide retrenchments, thus pushing up the rate of unemployment to U2, which is well above the natural rate. The ultimate outcome of such a policy decision will be a recession, where the economy will suffer from a lack of liquidity. Such a situation arose in the USA recently giving it one of the worst financial crises that the economy ever faced. The central bank finally had to inject money to revive the economy from the plights of recession (Mankiw, 2003, p. 290).
The ultimate situation that the nation will face out of this naive policy could be illustrated with the help of the following graph.
It shows that with a fall in the supply of money, there is a rise in the corresponding rate of interest, given an unchanged demand for money schedule. When the rate of interest rises from R1 to R2, the equilibrium level of money in the economy falls from M1 to M2. With a fall in liquidity, purchasing power of the people fall as well, so the aggregate demand schedule moves down from D1 to D2. With the aggregate supply schedule remaining constant, equilibrium points move down from A to B, where the equilibrium quantity demanded (Q2) as well as the equilibrium price charged (P2) is much lower than the previous levels, viz., Q1 and P1 respectively. Read More