Question

Before the Great Depression, the conventional wisdom among economists and policy makers was that the economy is largely self-regulating. a. Is this view consistent or inconsistent with Keynesian economics? Explain. b. What effect did the Great Depression have on conventional wisdom? c. Contrast the response of policy makers during the \(2007-2009\) recession to the actions of policy makers during the Great Depression. What would have been the likely outcome of the \(2007-2009\) recession if policy makers had responded in the same fashion as policy makers during the Great Depression?

Short answer

What was the effect of the Great Depression on this conventional wisdom, and how did the policy responses during the Great Depression compare with those during the 2007-2009 recession? What might have been the likely outcome of the 2007-2009 recession with Great Depression policy responses? Answer: Keynesian economics, which emphasizes the need for government intervention during economic downturns, is inconsistent with the conventional wisdom of economic self-regulation. The Great Depression challenged this conventional wisdom and led to the rise of Keynesian economics, which suggested the importance of government policies in stimulating aggregate demand and accelerating economic recovery. During the 2007-2009 recession, policymakers adopted more aggressive fiscal and monetary policies than in the Great Depression era, helping to stabilize financial markets and boost demand. If the policy responses during the 2007-2009 recession were similar to those of the Great Depression, the recession might have been more severe and prolonged due to the lack of government intervention.

Step-by-step solution

Part A: Consistency of Keynesian economics with self-regulation

To determine if the conventional wisdom (self-regulation) is consistent or inconsistent with Keynesian economics, we must first understand what Keynesian economics is. Keynesian economics is an economic theory developed by John Maynard Keynes that emphasizes the role of government actions and spending to stabilize the economy during recessions and depressions. According to Keynesian economics, governments should take proactive measures during economic downturns to increase aggregate demand, which includes adjustments in interest rates, tax, and government spending. Self-regulation refers to the idea that the economy will naturally correct itself over time, and government intervention is not necessary. In fact, some believe that government intervention could potentially prolong economic crises. Given this understanding, we can conclude that Keynesian economics is inconsistent with the conventional wisdom of economic self-regulation since it emphasizes the need for government intervention to stabilize the economy during economic downturns.

Part B: Effect of the Great Depression on conventional wisdom

The Great Depression was a severe economic depression that lasted from 1929 to 1939. During this time, the US faced high unemployment, low economic output, and widespread poverty. The Great Depression severely challenged the conventional wisdom of economic self-regulation. Many policymakers and economists began to realize that the economy might not correct itself naturally over time, and government intervention is necessary to swift recovery. The Great Depression led to the rise of Keynesian economics, which proposed that government policies, such as fiscal stimulus and monetary policy, could help to stimulate aggregate demand, create jobs, and accelerate economic recovery.

Part C: Comparison of policy responses during the Great Depression and the 2007-2009 recession

During the Great Depression, policymakers initially focused on a laissez-faire approach, believing that the economy would self-correct. However, as the situation worsened, government intervention increased, including the New Deal policies implemented by President Franklin D. Roosevelt, which aimed to increase demand and job creation. In contrast, policymakers during the 2007-2009 recession responded more quickly and aggressively with both fiscal and monetary policies, based on the lessons learned from the Great Depression. Large stimulus packages and quantitative easing by central banks played a significant role in stabilizing financial markets and boosting demand.

Part C: The likely outcome of the 2007-2009 recession with Great Depression policy responses

If policymakers had responded to the 2007-2009 recession in the same manner as they did during the Great Depression, the recession might have been deeper and prolonged due to the lack of government intervention. The absence of stimulus packages and quantitative easing measures could have led to higher unemployment, lower demand, and a slower recovery. The lessons learned from the Great Depression and the importance of government intervention in economic downturns, as highlighted by Keynesian economics, provided valuable knowledge for policymakers to make more informed decisions during the 2007-2009 recession.

Key concepts

Great Depression

The Great Depression was a catastrophic economic downturn that spanned from 1929 until approximately 1939. It began with the stock market crash in October 1929 and led to a vast economic decline characterized by massive unemployment, drastic falls in consumer spending, and a severe reduction in industrial output. This crisis wasn't limited to the United States; it had global repercussions.
During this time, the traditional belief in a self-regulating economy—that is, an economy capable of correcting itself without outside intervention—was significantly challenged. The magnitude and persistence of the Great Depression highlighted the limitations of relying solely on the market's natural corrective forces.
As a result, economists and policymakers started to recognize the need for new approaches to understanding and managing economies, eventually fostering the development of Keynesian economics, which emphasized proactive measures by governments to mitigate economic downturns.

self-regulation

Self-regulation refers to the belief that an economy will naturally adjust back to equilibrium without the need for external intervention. Proponents of this view hold that market forces, such as supply and demand, will balance themselves over time, correcting any short-term instabilities.
This hands-off or laissez-faire approach was predominant before the Great Depression. Economists and policymakers believed that issues like unemployment and inflation would resolve themselves as businesses and individuals adjusted to changing conditions.
However, the prolonged economic stagnation of the Great Depression made many question the effectiveness of a purely self-regulating market. It became evident that some economic disturbances could not revert to equilibrium in a timely and efficient manner without government assistance. This led to increased acceptance of government intervention as proposed by Keynesian theories.

government intervention

Government intervention became a cornerstone of economic policy following the insights gained during the Great Depression. Unlike the notion of self-regulation, where the market is left on its own, government intervention involves the active role of the state in mitigating economic downturns.
Various forms of intervention can include controlling interest rates, modifying tax policies, and direct government spending on public works. The goal is to adjust aggregate demand and smooth out economic cycles, thus preventing or curtailing recessions.

• Interest rate adjustments can help control inflation and encourage investment.
• Tax policies can stimulate consumer spending by altering disposable income.
• Public works can increase jobs and infrastructure development.

The New Deal, introduced by President Franklin D. Roosevelt during the Great Depression, exemplifies how government intervention can be utilized to foster economic recovery, providing jobs and reviving economic confidence.

fiscal policy

Fiscal policy involves the use of government spending and taxation to influence economic activity. It is a primary tool of Keynesian economics, recommended as a means to counteract economic fluctuations.
During economic downturns, such as the Great Depression or the 2007-2009 financial crisis, increasing government spending can help boost aggregate demand, leading to higher production and employment levels. Tax reductions during these periods can also increase consumer and business spending.
Conversely, in times of economic booms, fiscal policy can involve reducing spending and increasing taxes to prevent overheating and control inflation.
The swift application of fiscal policy in response to the 2007-2009 recession was notably informed by lessons from the Great Depression. This included a range of measures such as stimulus packages that aimed to invigorate the economy during that challenging period.