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INTRODUCTION TO MACROECONOMICS (CONTINUED………..)

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Introduction to Economics ­ECO401
VU
Lesson 8.2
INTRODUCTION TO MACROECONOMICS (CONTINUED...........)
The Great Depression and Say's Law:
The Great Depression was the longest and severest recession the world has ever seen. It
struck North America and Europe in the late 1920s after the Wall Street crash of 1929 (and
following the earlier hyperinflation in Germany, and the formation of the Soviet Union) and
lasted till the mid 1930s. It was characterized by persistent high unemployment, low
investment by firms and falling prices of goods, services and factors.
An important law the Classical subscribed to, which assumed particular importance in the
context of the Great Depression, was Say's law: "supply creates its own demand." The
implication of this was that involuntary unemployment (people being unemployed against their
wishes) was a temporary phenomenon as the excess supply of labour would cause wages to
fall thereby prompting firms to demand more labour. If there was persistent unemployment, it
was voluntary, i.e. workers themselves preferred to remain unemployed.
The Classicals' Views about Great Depression:
The Classicals' reading of the three problems of the Great Depression, i.e. low investment,
high unemployment and low output, was as follows:
a. Investment was low because the interest rate was too high in the loanable funds
market. Policy recommendation: savings be increased to lower the interest rate and
boost investment
b. Unemployment was high because of obstructions to the free market mechanism in the
labour market which were preventing wages from falling to the market clearing level.
Policy recommendation: these obstructions: benefit payments to unemployed, taxes on
income and trade unions be eliminated.
c. The AS curve was vertical therefore lack or excess of demand could not explain the
low level of activity in the aggregate market for goods and services. Policy
recommendation: focus on ways to move the AS curve to the right (i.e. supply side
measures).
The Keynesians' Views about Great Depression:
Keynes' view on the causes of the Great Depression and what needed to be done was very
different. He believed that there were overarching problems of low demand and static
pessimistic expectations that needed to be addressed rather than disequilibria in the loanable
funds, labour and goods markets. In particular, he maintained that:
a. Low investment was because of firms' bearish expectations about their ability to sell
the products they produced. Firms needed to see that the potential buyers of their
goods had the money and the willingness to buy goods before they could be convinced
to undertake more production thereof. Therefore, higher savings, which would lead to
low consumption expenditure on goods and services would not increase but decrease
investment by reinforcing firms' bearish expectations about their ability to sell their
products. Policy recommendation: households should be convinced to increase
consumption and reduce saving.
b. Unemployment was high and rising because the labour market equilibrium was moving
further and further away from the full employment level. This was not because wages
were being prevented from falling to the market clearing level, but because the market
clearing level fell further with each wage decrease. This happened because a reduction
in wages also lowered consumers' earning and spending power reinforcing firms'
pessimistic view of their ability to sell their products. Policy recommendation: higher
money payments to consumers should be given out (possibly by the state) in order to
increase their ability to buy the goods being produced by firms.
c. The AS curve was horizontal at the less than full employment level (i.e. when there
was excess capacity or slack in the economy), and upward sloping after that, so that an
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Introduction to Economics ­ECO401
VU
injection of aggregate demand in times of recession could materially increase output,
employment and national income.
In summary, Keynes believed that an economy could settle at equilibrium below the full
employment level, he advocated demand-side policies to lift the economy out of that
equilibrium towards full employment. He suggested the government spend itself and
encourage consumption spending. This would cause demand and prices of goods to rise,
generating firms' interest in producing more. This would in turn require hiring to go up, which
would cause labour incomes to go up which would lead to further higher demand for goods
and hence a reinforcement of the virtuous circle. Only such a circle could, according to
Keynes, change agents' pessimistic view of the future and take the economy out of
Depression.
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Table of Contents:
  1. INTRODUCTION TO ECONOMICS:Economic Systems
  2. INTRODUCTION TO ECONOMICS (CONTINUED………):Opportunity Cost
  3. DEMAND, SUPPLY AND EQUILIBRIUM:Goods Market and Factors Market
  4. DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED……..)
  5. DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED……..):Equilibrium
  6. ELASTICITIES:Price Elasticity of Demand, Point Elasticity, Arc Elasticity
  7. ELASTICITIES (CONTINUED………….):Total revenue and Elasticity
  8. ELASTICITIES (CONTINUED………….):Short Run and Long Run, Incidence of Taxation
  9. BACKGROUND TO DEMAND/CONSUMPTION:CONSUMER BEHAVIOR
  10. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….)
  11. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….)The Indifference Curve Approach
  12. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….):Normal Goods and Giffen Good
  13. BACKGROUND TO SUPPLY/COSTS:PRODUCTIVE THEORY
  14. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):The Scale of Production
  15. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):Isoquant
  16. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):COSTS
  17. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):REVENUES
  18. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):PROFIT MAXIMISATION
  19. MARKET STRUCTURES:PERFECT COMPETITION, Allocative efficiency
  20. MARKET STRUCTURES (CONTINUED………..):MONOPOLY
  21. MARKET STRUCTURES (CONTINUED………..):PRICE DISCRIMINATION
  22. MARKET STRUCTURES (CONTINUED………..):OLIGOPOLY
  23. SELECTED ISSUES IN MICROECONOMICS:WELFARE ECONOMICS
  24. SELECTED ISSUES IN MICROECONOMICS (CONTINUED……………)
  25. INTRODUCTION TO MACROECONOMICS:Price Level and its Effects:
  26. INTRODUCTION TO MACROECONOMICS (CONTINUED………..)
  27. INTRODUCTION TO MACROECONOMICS (CONTINUED………..):The Monetarist School
  28. THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME
  29. THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME (CONTINUED……………..)
  30. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME
  31. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..)
  32. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..):The Accelerator
  33. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS
  34. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….)
  35. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Causes of Inflation
  36. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):BALANCE OF PAYMENTS
  37. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):GROWTH
  38. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Land
  39. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Growth-inflation
  40. FISCAL POLICY AND TAXATION:Budget Deficit, Budget Surplus and Balanced Budget
  41. MONEY, CENTRAL BANKING AND MONETARY POLICY
  42. MONEY, CENTRAL BANKING AND MONETARY POLICY (CONTINUED…….)
  43. JOINT EQUILIBRIUM IN THE MONEY AND GOODS MARKETS: THE IS-LM FRAMEWORK
  44. AN INTRODUCTION TO INTERNATIONAL TRADE AND FINANCE
  45. PROBLEMS OF LOWER INCOME COUNTRIES:Poverty trap theories: