Fiscal Policy and the Great Depression

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 depression: A depression is sharp and sustained decline in business activity that is considered more severe than a recession. crowding-out hypothesis: The crowding-out hypothesis is the idea that increases in federal spending inevitably cause reductions in private consumption or investment. For example, increases in government borrowing to cover a budget deficit may increase interest rates, reducing investment. The crowding-out hypothesis assumes that the economy is initially at a full employment level of output. absorption problem: The absorption problem is a generalization of the crowding out hypothesis, and summarizes how crowding out may cross international borders. The absorption problem is summarized by the equation: [G–T] = [S–I] + [M–X]. Thus, any federal government budget deficit (G-T) must be offset by an excess of private saving over private investment (S–I) or by an excess of imports over exports (M–X). This equation is a simplification and rearrangement of an accounting identity for Aggregate Expenditures: Y = C + I + G + (X–M) = C + S + T. If the economy is at its productive capacity, then unless a federal deficit is funded by foreigners (M–X), private investment may be “crowded out” because G–T will equal S–I. The Great Depression Output plummeted worldwide during “The Great Depression” of the 1930s. In the United States, the rate of unemployment rose from roughly 4-5% in 1929 to a high estimated at 25% in 1933. Output and employment did not completely recover until the onset of World War II.   In the figure (above - right), suppose the economy was initially in a severe depression, at point d. An increase in government spending to point f could trigger expansions of private investment and consumption (and saving) through a Keynesian multiplier process, resulting in a further adjustment to point b. The expansion of private consumption and investment shown as the move from point f to point b is sometimes called crowding-in. At point b, government spending and tax revenues and private consumption, saving, and investment could all exceed the levels at initial point d. The increase in economic activity in the U.S. economy during 1940-1943 as this country mobilized for war mirrored this movement from point d to point b.   Note: Military spending is not necessary to precipitate such a movement, which could as readily be prompted by public works projects (or even a mammoth federally sponsored Easter egg hunt). ________________________________________________________________________________________________________________________________________________ Author: Ralph Byrns Economics instructors and students are hereby granted provisional permission to use these materials for educational purposes only. Commercial use of any of these materials is forbidden. Withdrawal of this permission may be announced at this site without notice, and these materials may not be used thereafter without written permission.