Macroeconomics: fundamental concepts and principles

Macroeconomics

The Great Depression was probably one of the most significant economic events of the 20th century. Through the implications it provoked and its global reverberations for almost a decade, as for the number of individuals that were affected and the economic policies and reforms that it brought about, the Great Depression stands alone as the largest economic downturn of last century. This essay will start with an analysis of the macroeconomic causes that justified it and will subsequently look into the applied policies in the 1930s and the relevancy and implications for modern policy makers.

It is difficult to pinpoint from the very beginning one singular cause of the great depression. Because the Depression's start was marked by the Wall Street crash in 1929, we can support the idea that the stock crash was at least an element that triggered the economic crisis. The stock crash can be explained either by a "burst of the bubble" psychology in which an investing mania finally reached its peak and could no longer be controlled or, in macroeconomic terms, by the measures adopted by the Federal Reserve (most notably), an increase in the interest rates that discouraged credit and encouraged saving.

The raise in interest rates practiced by the Federal Reserve created what is now referred to as the "paradox of thrift." The term was created by Keynes to explain the actual cause of the Depression in terms of consumption and saving. As such, after the stock crash and raise in interest rates, spending was discouraged. Unfortunately, less spending meant that less investment was made in businesses and a gradual decrease in income and price levels, due to price deflation. The price deflation created a dangerous cycle that correlated low consumption levels with lower income. Lower income, in turn, created a pressure on debtors.

The correlations formed between debt and deflation are pointed out by Irving Fisher and mentioned by Ben Bernanke in his essay on the Great Depression. According to these sources, "falling asset and commodity prices created pressure on nominal debtors." At the same time, the pressure on debtors was generally reflected during economic depressions (the Great Depression included) by a continuous and aggressive sale of assets, because, obviously, the debtors needed to ensure that their debts could be paid. With supply generously peaking demand, prices continued to decrease, continuing the dangerous deflationary spiral.

On the other hand, theoreticians argued that the debt-deflation correlation was not necessarily a cause for economic depression, but for acutely a case of wealth redistribution, with the financial wealth of the debtors being moved/redistributed to the creditors, without necessarily having a direct consequence on the general flow of the national economy.

Nevertheless, Fisher's theory has come to be supported by some modern arguments in terms of risk - related debt costs. Indeed, such arguments point out towards the fact that the decline of the borrower's net value (in the sense of a decline in the value of his portfolio of assets) is bound to increase the risk that the creditor is being exposed to and, in this sense, it is also bound to increase the cost of lending for the borrower (higher risk needs to bring higher returns for the lender, which means a higher cost of capital for the borrower). Higher prices for borrowing would decrease the incentive to invest, because of more expensive sources of finance. Fewer investments would lead to a drop at macroeconomic levels.

The fact that the banks committed themselves to important amounts of credit during the 1920s and that, under the monetary pressure, many of the debtors could not pay their credits, led to the collapse of several important financial and banking institutions immediately following 1929. The banking and financial sector became practically inoperable during the first months after the crash and this practically meant that at that certain point, almost all sources of finance (credit and stock) were unavailable in a moment when this was needed to relaunch the economy.

Some theoreticians have named this bank contraction as one of the main causes of business and economic cycles.

Because the correlation between price and income was mentioned in one of the previous paragraphs, we should point out that this is an inversely proportional relationship. Falling price levels general raise real wages and this obviously raises the overall production costs of an entrepreneur. The reaction is to lay off people and reduce the workforce, thus gradually levelling the pressure of costs imposed. This, in turn, will raise unemployment levels, which was obviously one of the effects of the Great Depression.

Returning to the causes and effects of the Great Depression as reflected by the aggregate supply and demand, production and consumption, the Keynesian Cross provides perhaps the best explanations in this sense. The Keynesian Cross (see below) includes on a Expenditure vs. Production graphs two main lines: the AE line (red) and the Y = AE line. The latter is often referred to as the 45-degree line, because the angle it makes with the production-axis is exactly 45 degrees.

The 45-degrees line shows "all points in the exhibit in which aggregate expenditures is equal to aggregate production." We could go further than this and make aggregate production equivalent, in this case, to aggregate output on the market and the demand for gross domestic product is equal to the supply for the national gross domestic product. In the case of the Great Depression, as we have seen, the aggregate demand decreased in absolute levels because of the financial causes of the stock fall and faults of the banking system. Naturally, because the demand dropped to such a degree, then the disequilibrium in aggregate product market occurred.

It is time to have a look and see the trade - related causes and implications of the Great Depression. The 1920s and previously were equivalent with a period of high protectionism for the United States. This meant that the U.S. government imposed high trade barriers to imports from other country and the explanation for this was the intention to protect the national producers to the detriment of foreign exporters. The goal was for the U.S. national producers to overproduce to such a degree so as to cover the entire national market (or as high a proportion of it as possible) and export the remainder to other countries, notably the European partners.

The problem with such a policy was related to the interconnectivity of the global economy (even at that point). The European countries relied on U.S. money and financial resources to buy U.S. - made products, but the dependency went the other way as well, because the U.S. economy depended to a significant degree on the exports of goods it could see into Europe. The issue was that the Europeans could not pay for the American exports and American loans unless they could, in turn, participate to the global international trade. If the United States, their main purchasing partner, practiced tariff barriers that went up to 50%, it is obvious that the European purchasing power decreased to a degree to which it affected the international trade mechanism, complete with triggering a significant 30% decrease in the value of American exports. The phenomenon is much similar nowadays in relationship with the interconnectivity at a global level, with the exception that the global economy has already chosen liberalism and free trade as the best supporting element for this.

The response of the U.S. government and the FDR administration to all these challenges was the New Deal, a massive program to address the main problem that the economy faced at that point: contraction. Many sources argue that the FRD New Deal is not necessarily an expansionary fiscal policy and that FDR is definitely not a Keynesian. The main thing that the New Deal brought about was a significant increase in governmental spending that stimulated the economy in several correlated senses.