The answer to a recession, according to Keynesian macroeconomics, is expansionary fiscal policy, such as tax cuts to boost consumption and investment or direct increases in government spending to shift the aggregate demand curve to the right.
Was Keynesian economics successful in ending the Great Depression?
The Great Depression provided stunning support of Keynes’ beliefs for Keynesian economists. The problem had begun with a dramatic drop in aggregate demand. For more than a decade, the recessionary gap generated by changes in aggregate demand has persisted. And, even though it had been forced on the country by a war that would prove to be one of the darkest events in world history, expansionary fiscal policy had put an end to the worst macroeconomic nightmare in US history.
What would Keynesians do in the event of a recessionary gap?
What could be the source of a recessionary gap? Anything that lowers the aggregate expenditure line, such as a reduction in consumption, an increase in savings, a drop in investment, a cut in government spending or a hike in taxes, or a drop in exports or a rise in imports, is a potential cause of recession. Furthermore, an economy in equilibrium with a recessionary gap may just stay there for a long period, resulting in high unemployment; remember, the definition of equilibrium is that no special adjustment of prices or quantities in the economy is required to chase the recession away.
In order for the aggregate expenditure function to shift from AE0 to AE1, the Keynesian answer to a recessionary gap is for the government to decrease taxes or boost spending. As a result of this change, the new equilibrium E1 is now at potential GDP, as indicated in Figure 1. (a).
What solution did John Maynard Keynes propose to the Great Depression’s problems?
You’ve probably heard an economist or historian suggest that World War II was responsible for our recovery from the Great Depression. This claim is based on a school of thought known as Keynesian economics. The General Theory of Employment, Interest, and Money was written by British economist John Maynard Keynes in 1936 to explain why the Great Depression had such a long period of time where labor markets did not appear to be in equilibrium, where the demand for labor and the supply of labor were equal. Many folks have been looking for work for years but have been unsuccessful. The problem, according to Keynes, was a lack of demand for products and services, which led to a lack of demand for labor. According to Keynes, the solution to this dilemma was to expand government spending.
The basic Keynesian model holds that government spending increases total demand, resulting in increased production and the hiring of additional workers. For example, near the conclusion of the Great Depression, the United States government spent a lot of money on tanks, planes, ships, and munitions in preparation for World War II. We then dispersed them over the globe, with many of them being blown up while battling our adversaries. But consider this: Would it make a difference if our adversaries blew up our weapons of war, or if we took them out to the Mojave Desert and blew them up ourselves? Clearly, our economy would thrive as long as the government continued to spend money on new weaponry.
With this example in mind, we might begin to wonder if Keynes’ theory is compatible with how the real world operates. Even for experienced economists, the method we measure our gross domestic product or aggregate economic activity is a source of consternation. These figures cover not just consumer spending, factory, machine, and producer spending, but also government spending, regardless of how that money is spent. So, if the government hired you and paid you $15 to dig a hole and fill it back up, the data would show $15 in government spending and $15 in economic output. The same economic rationale was demonstrated, for example, when a $15 million fighter jet was built and then destroyed. Neither of these options actually improves the economy or increases wealth.
If you know anyone who lived through WWII, ask them about their experiences. Inquire about the ration coupons they required to purchase even the most basic items. Inquire if they are able to purchase the items and services that they regularly do. Would anyone have remarked, “Oh my gosh, our economy is doing so much better,” if we had taken all the military men and women living in tents while serving in Europe and the Pacific and brought them to Central Park instead? Both, however, would suit the Keynesian notion of government economic growth.
A variety of variables helped us get out of the Great Depression, and they would help our economy today just as much. Increased international trade, fewer government regulations on the economy, and lower corporate and personal income tax rates enacted after the war are among them.
You can listen to Lecture 7 of Econ 101 if you want to learn more about Keynesian economics.
What was Keynes’ strategy for encouraging businesses to ramp up production during the Great Depression?
In the 1930s, the death of the business cycle as a regulatory mechanism was not immediately apparent. However, after the Great Financial Crash of 1929, when the economy was thrown into chaos, the cycle dropped down and did not rise again on its own. It remained on the ground. The financial catastrophe turned into a widespread economic slowdown, and the recession turned into a depression, with no signs of recovery.
This was true not only of the United States’ and other countries’ domestic economies, but also of the economic links between them. Internal growth mechanisms broke broken, and foreign economic adjustment mechanisms broke down as well. Rather than assisting in the resolution of difficulties, the gold standard became a tool for the quick transmission of crises from one country to the next. Trade deficits exacerbated the money supply contraction (since gold had to be exported to cover the excess of imports over exports) and put even more downward pressure on prices (including wages), leading to even more output and employment cuts. Unemployment has risen dramatically. It was abandoned during the Great Depression because no one wanted to conform to the gold standard’s discipline. The Great Depression saw a rapid spread of anti-freetrade sentiment demanding tariff and quota protection for local industry and jobs as a result of the need to safeguard each economy from others. Each country’s capitalists wanted to protect what was left of their markets from international competition by erecting barriers to imports, and its workers often believed that such safeguards would help them keep their employment. As governments responded to export obstacles by erecting greater hurdles to keep imports out, a variety of competitive protection measures emerged.
The upshot was a sharp drop in global commerce, a drying up of export markets, and a worsening of output and employment. This was terrible enough for the United States, which has a massive internal market. The situation was considerably more serious for many Western European countries whose capitalists had long relied on overseas markets. International trade breakdowns were a crucial element in making the Great Depression a global event, as well as causing it to be so deep and long-lasting. It resulted in the demise of the Gold Standard.
We can start by looking at the relationship between salaries and profits, consumption, and the availability of surplus for investment to understand why the slump was not followed by growth. When the cycle slowed and people lost their jobs, those who remained employed were more willing to accept lower pay, which capitalists translated into cheaper costs, bigger profits, more optimistic expectations, and new investment. There was widespread unemployment during the Great Depression, and salaries did decline, but this was not enough to spur new investment. Why? If you think about your own background, the “why” appears to be rather evident. This was the time when industrial employees eventually formed industrial unions in response to the mass-production organization of work. They battled for union recognition, higher salaries, and unemployment benefits, among other things.
Taylorism (the division of labor into relatively simple deskilled occupations) and the Fordist structure of mass production, particularly the assemblyline, ensured that each worker had just a small, often dull job that required little expertise and played only a little role in the overall assembly. (Charlie Chaplin’s film Modern Times, which you should not miss!) perfectly conveyed the monotony of this type of job and its consequences on workers.
The widespread imposition of this type of employment resulted in the de-skilling of an entire workforce, effectively outflanking the earlier skill-based trade unions. This meant that the American Federation of Labor’s (AFL) craft unions were no longer relevant to a new generation of manufacturing workers. As a result, the “mass workers,” as they are frequently referred to, formed the industry-wide union, an approach in which large numbers of workers with varying talents (as they were) were organized under the same organization.
Thus, significant industrial unions such as the United Automobile Workers (UAW), United Mine Workers (UMW), and others were formed in the 1930s, and these unions eventually merged to establish the Congress of Industrial Unions (CIO). (Eventually, the older AFL and the newer, larger CIO merged to become the AFL-CIO, which has controlled “organized labor” in the United States ever since.)
The campaigns that led to the founding of these unions had to deal with a lot of violent opposition from the corporate community. Workers fought back, meeting aggression with violence, and during the 1930s, this surge of confrontation limited pay cuts in the face of widespread unemployment. (The films Fist, starring Sylvester Stallone, and Hoffa, starring Jack Nickolson, about the founding of the Teamsters, are interesting partly because they show both the violence used by business and the way that violence forced workers to respond in kind, and, in some cases, to hire violence in the form of themob.) As a result, we get a glimpse of history as well as a deeper grasp of the much-discussed linkages between organized crime and various unions. Matewan, a recent John Sayles film, depicts the violence that employees faced during this time period, in this case in Appalachia’s coal mines.)
As a result of the tensions, salaries have become “sticky downwards.” In other words, wages could rise, but they couldn’t be brought down low enough to recover profits, even if unemployment remained high. As a result, conventional recessionary economic techniques could no longer be relied on to manage corporate difficulties with workers or the encroachment of consumption on surplus.
To say the least, this was a pivotal moment in history. It was a time when the system’s entire future was in jeopardy. The old solutions had failed, and new ones had to be discovered, or the economy and the society that surrounded it would deteriorate or revolutionize. This was the crisis in the United States, and similar crises occurred in other major parts of the globe.
This problem has been brewing for more than a decade. In 1917, there was a revolution in the Soviet Union, which was followed by a civil war and significant economic and social turmoil. There were other crises in Western Europe, the most spectacular of which were the events related with the German Revolution of 1918-19.
Different countries’ leaders responded to the challenge in various ways, depending on their historical, social, and political settings.
Through the Gulag, extensive police state persecution, and collectivization of the peasantry, Stalin attempted to tackle the problem of raising surplus (mainly to collect their produce). Hitler came to power during the Weimar Republic’s crisis and used Nazism, corporatism, and labor camps to solve the problem of workers’ revolt and capitalist accumulation. The solution that evolved slowly through Franklin Roosevelt’s New Deal policies in the United States and much of Western Europe was what we now call Keynesianism, named after John Maynard Keynes (1883-1946), an English economist who theorized and campaigned for a whole new style of analysis and policy. This was the option that would turn out to be the most progressive and effective. The Nazi option would be eliminated by 1945 as a result of the war. When Stalin died in 1953, the Soviets began a long and fruitless process of reforming their regime, which would culminate in Gorbachev’s failure.
Conclusion
Because of the recent resurrection of many classical ideas by economists around the Reagan and Bush administrations, understanding why classical economics no longer worked is crucial today. Will they work today if they didn’t work in the 1930s? Have the circumstances altered enough for them to work now?
Understanding the origins and key ideas of Keynesian economics is crucial not just because they were the economic principles used and taught for the past 30 years, but also because the collapse of growth over the previous two decades has coincided with a crisis in Keynesian economics.
The Keynesian era’s crisis still exists today, along with a slew of ongoing disagreements and discussions over potential solutions and theoretical approaches. There is a greater need now than ever in the last two decades for some background in policy and thought history.
Questions for Review
2. What happened during the Great Depression to make it difficult for the cycle’s conventional mechanisms to restore prosperity in the 1930s?
3. Define the terms “Fordism,” “mass production,” “mass worker,” and “de-skilling.”
Describe how they are connected.
4. What was the Keyensian answer to the Great Depression and the maintenance of growth, in terms of the variables we’ve discussed? In what sense did Roosevelt execute the solution?
5. Was Keynesianism a generalization of Fordism in any way? What exactly did it mean when it said it embodied the concepts of a non-zero-sum game?
6. What is a “productivity deal,” and what does it have to do with Keynesianism?
7. What actions could the government take to boost productivity growth?
8. What were the terms of the 1944 Bretton Woods agreements? What were they doing to avoid the gold standard’s problems? What did they mean when they said they were an international representation of Keynesianism?
9. Describe how a fixed exchange rate system works. What is the purpose of having foreign exchange reserves, and what is the role of the IMF?
10. What international liquidity issues arose in the post-World War II period? How did they get sorted out?
11. In the 1960s, why did the dollar and its role in the international economy come under fire?
12. What are “stand-by arrangements” with the IMF? How do they function? What exactly is “conditionality”? What are some examples of “conditions”?
Keynesian economics proposes a solution to economic difficulties.
- Demand drives supply, according to Keynesian economics, and strong economies spend or invest more than they save.
- During a recession, Keynes believed that governments should raise expenditure, even if it meant going into debt, to generate jobs and boost consumer purchasing power.
- Keynesian economics is criticized for encouraging deficit spending, limiting private investment, and producing inflation, according to critics.
What is the mechanism of Keynesian economics?
Because prices are mostly stable, Keynesians argue that changes in any component of spendingconsumption, investment, or government spendingcause production to change. If, for example, government spending rises while all other spending components stay constant, output rises.
What was FDR’s plan to end the Great Depression?
Between 1933 and 1939, President Franklin D. Roosevelt implemented a series of programs, public works projects, financial reforms, and laws known as the New Deal. The Civilian Conservation Corps (CCC), the Civil Works Administration (CWA), the Farm Security Administration (FSA), the National Industrial Recovery Act of 1933 (NIRA), and the Social Security Administration were all major federal programs and agencies (SSA). Farmers, the unemployed, youth, and the elderly were all helped. The New Deal imposed new restrictions and safeguards on the financial industry, as well as efforts to re-inflate the economy following a dramatic drop in prices. During Franklin D. Roosevelt’s first term in office, the New Deal programs included both congressional legislation and presidential executive orders.
The policies centered on what historians call to as the “3 R’s”: unemployment and poverty relief, economic recovery, and financial system reform to avoid a repeat depression. With its base in liberal ideas, the South, big city machines and newly empowered labor unions, and various ethnic groups, the New Deal produced a political realignment, making the Democratic Party the majority (as well as the party that held the White House for seven out of nine presidential terms from 1933 to 1969). The Republicans were divided, with conservatives rejecting the entire New Deal as anti-business and anti-growth, while liberals supported it. From 1937 to 1964, the realignment resulted in the formation of the New Deal coalition, which dominated presidential elections until the 1960s, while the conservative coalition primarily controlled Congress in domestic issues.
What is the Keynesian response to a recession? What is the justification for this solution?
Keynesian economists claim that the economy will be characterized by recessions and inflationary booms because the level of economic activity is dependent on aggregate demand, which can’t be relied on to stay at potential real GDP. The variations between positive and negative GDP gaps can be considered as part of this cycle.
Keynesians argue that the best way to get out of a slump is to use expansionary fiscal policy, such as tax cuts to boost consumption and investment or direct increases in government spending, which would both shift the aggregate demand curve to the right. For example, if aggregate demand was initially at ADr in Figure 2, indicating that the economy was in recession, the optimal policy would be for the government to shift aggregate demand to the right, from ADr to ADf, indicating that the economy was at full employment and potential GDP.
While it would be ideal if the government could spend more money on housing, roads, and other public goods, Keynes suggested that if the government couldn’t agree on how to spend money in practical ways, it would be forced to spend money in impractical ways. For example, Keynes advocated for the construction of structures similar to the Egyptian pyramids. He advocated that the government bury money underground and then allow mining corporations to recover the funds. While these ideas were made in jest, the point was to underline that a Great Depression is not the time to argue about the details of government spending programs and tax cuts when the goal should be to boost aggregate demand sufficiently to bring the economy up to potential GDP.
In a downturn, what would Keynes do?
During recessions, Keynes claimed, the public becomes fearful and cuts back on spending, resulting in more layoffs, which, in turn, results in less expenditure, creating a vicious cycle of economic collapse.