Try to imagine yourself in the United States or Europe in the early 1930s. You are witnessing immense human misery amid a near meltdown of the economy. Friends and family are losing their jobs and have bleak prospects for new employment. Stores that you had shopped in all your life suddenly go out of business. The bank holding your money has disappeared, taking your savings with it. The government provides no insurance for unemployment, and there is no system of social security to provide support for your elderly relatives.
Economists and government officials at that time were bewildered. The experience in the United States and other countries was difficult to understand. According to the economic theories of the day, it simply was not possible. Policymakers had no idea how to bring about economic recovery. Yet, as you might imagine, there was considerable pressure for the government to do something about the problem. The questions that vexed the policymakers of the day—questions such as “What is happening?” and “What can the government do to help?”—are at the heart of this chapter.
Economists make sense of events like the Great Depression by first accumulating facts and then using frameworks to interpret those facts. We have a considerable advantage relative to economists and politicians at the time. We have the benefit of hindsight: the data we looked at in the previous subsection were not known to the economists of that era. And economic theory has evolved over the last seven decades, giving us better frameworks for analyzing these data.
Earlier, we said there are two possible reasons why output decreased.
- There was a decrease in production due to a decrease in the available inputs into the aggregate production function. Since there was no massive decrease in the amount of physical capital or the size of the workforce, and people presumably did not suddenly lose all their human capital, this means that the culprit must have been a decrease in technology.
- There was a decrease in aggregate spending. Households chose to reduce their consumption, firms chose to reduce their investment, and governments chose to reduce their spending. As a consequence, firms scaled back their production.
We look at each of these candidate explanations in turn.
Toolkit: Section 16.15 "The Aggregate Production Function" You can review the aggregate production function and the inputs that go into it in the toolkit.
KEY TAKEAWAYS
During the Great Depression in the United States from 1929 to 1933, real GDP decreased by over 25 percent, the unemployment rate reached 25 percent, and prices decreased by over 9 percent in both 1931 and 1932 and by nearly 25 percent over the entire period.
The Great Depression remains a puzzle today. Both the source of this large economic downturn and why it lasted for so long remain active areas of research and debate within economics.
One explanation of the Great Depression rests on a reduction in the ability of the economy to produce goods and services. The second leading explanation focuses on a reduction in the overall demand for goods and services in the economy.
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Checking Your Understanding
The notes in ***Table 7.1 "Major Macroeconomic Variables, 1920–39*" state that the base year for the price level is 2000, so the price index has a value of 100 in that year. Approximately how much would you expect to have paid in the year 2000 for something that cost $2 in the late 1920s?
Using ***Table 7.1 "Major Macroeconomic Variables, 1920–39*", how can you see that the unemployment rate is countercyclical?
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