CASE STUDY

TWO BIG SHIFT IN AGGREGATE DEMAND: THE GREAT DEPRESSION AND WORLD WAR II

At the beginning of this chapter, we established three key facts about economic fluctuations by looking at data since 1965. Let’s now take a longer look at u.s. economic history. Figure 9 shows data since 1900 on  the percentage change in real GDP over the previous 3 years. In an enrage 3-year period, real GDP~rows about 10 percent-a bit more than 3 percent per year. The business cycle, however, causes fluctuations around this average. Two episodes jump out as being particularly significant: the large drop in real GDP in the early 1930s and the large increase in real GDP in the early 1940s. Both of these events are attributable to shifts in aggregate demand.

Figure 9 U.S. Real GDP Growth since 1900

The economic calamity of the early 1930s is called the Great Depression, and it is by far the largest economic downturn in u.s. history. Real GDP fell by 27 percent from 1929 to 1933, and unemployment rose from 3 percent to 25 percent. At the same time, the price level fell by 22 percent ‘over these 4 years. Many other countries experienced similar declines in output and prices during this period.

Economic historians continue to debate the causes of the Great Depression, but most explanations center on a large decline in aggregate demand. What caused aggregate demand to contract? Here is where the disagreement arises.

Many economists place primary blame on the decline in the money supply: From 1929 to 1933, the money supply fell by 28 percent. As you may recall from our discussion of the monetary system, this decline in the money supply was due to problems in the banking system. As households withdrew their money from financially shaky banks and bankers became more cautious and started holding greater reserves, the process of money creation under fractional-reserve banking went into reverse. The Fed, meanwhile, failed to offset this fall in the money multiplier with expansionary open-market operations. As a
result, the money supply declined. Many economists blame the Fed’s failure to act for the Great Depression’s severity.

Other economists have suggested alternative reasons for the collapse in aggregate demand. For example, stock prices fell about 90 percent during this period, depressing household wealth and thereby  consumer spending. In addition, the banking problems may have prevented some firms from obtaining the financing they wanted for investment projects, and this would have depressed investment spending. Of course, all of these forces may have acted together to contract aggregate demand during the Great Depression.