We now apply this framework to the Great Depression. The aggregate expenditure approach suggests that output decreased in the Great Depression because aggregate spending decreased. Part (a) of Figure 7.10 "A Decrease in Aggregate Expenditures"shows how this process begins: a decrease in autonomous spending shifts the spending line down. The interpretation of such a shift is that, at every level of income, spending is lower. Such a decrease in spending is due to a decrease in (the autonomous component of) consumption, investment, government spending, or net exports (or some combination of these). Part (b) of ***Figure 7.10 "A Decrease in Aggregate Expenditures" shows what happens when the planned spending line shifts downward. The equilibrium level of real GDP decreases. So far, therefore, the aggregate expenditure model seems to work: a decrease in autonomous spending leads to a decrease in real GDP at the given price level. But we need to know why planned spending decreased.
Let us first consider the possibility that a reduction in consumption triggered the Great Depression. Recall that, between September and November 1929, the stock market in the United States crashed. This collapse meant that many households were suddenly less wealthy than they had been previously. A natural response to a decrease in wealth is to decrease consumption; this is known as a wealth effect.
Wealth is distinct from income. Income is a flow: a household’s income is the amount that it receives over a period of time, such as a year. Wealth is a stock: it is the cumulated amount of the household’s savings. Is it plausible that wealth effects could explain a collapse of the magnitude of the Great Depression? To answer this, we need to determine how much real GDP decreases for a given change in autonomous spending.
- 1812 reads
