Principles of Macroeconomics The Great Depression and the Birth of Macroeconomics

The Great Depression and the Birth of Macroeconomics Learning Objectives Understand the dynamics of the 1920s leading to the 1929 stock market crash. See the importance of the Great Depression for the birth of macroeconomics.

The Great Depression and the Birth of Macroeconomics The Roaring 1920s At the end of WWII in 1918, the US emerged victoriously. The beginning of the 20th century was characterized by the industrial revolution. Technological innovations, economic freedom, and consumer and producer confidence led to a stock market frenzy.

The Great Depression and the Birth of Macroeconomics The Roaring 1920s Source: NBER Macrohistory Database, NBER Series11009.

The Great Depression and the Birth of Macroeconomics What Caused the Stock Market Crash? The Bubble-Lifecycle: Technological revolution  everyone buys stocks  stock prices go up  companies make profits  stock prices go up more  people feel rich  people buy more stocks  stock prices go up even more  people now use their stocks as collateral to buy even more stocks  stock prices go up even more  Technological revolution fades out  companies cannot meet expectations anymore  investors cash in  stock market bubble bursts.

The Great Depression and the Birth of Macroeconomics The Gold Standard In addition to the bubble-lifecycle, the Gold Standard contributed to the slowing down of the economy towards the end of the 1920s. Gold Standard: Every Dollar is backed by an amount of real gold! The economy grew much faster than what gold could be discovered and therefore the money supply could not keep up with the real sector. Whenever there is less money to buy all the goods, the overall price level of the economy goes down. This is called deflation. Similarly, if the money supply grows much faster than the real output of goods and services, all that money drives up the economy's price level. This is called inflation.

The Great Depression and the Birth of Macroeconomics Why is deflation bad? Companies make less profit Companies’ real debt burden goes up. Deflation causes people to postpone spending because they expect prices to go down even more. This is becoming a self-fulfilling prophecy, because as companies sell less, they will have to lower prices. Companies make even less profit and stockholders start selling their stocks. Companies go bankrupt and with the companies many banks, which again causes a bank run.

The Great Depression and the Birth of Macroeconomics The Great Depression describes the economic downturn after the 1929 stock market crash. Source: NBER Macrohistory Database, NBER Series 08166.

The Great Depression and the Birth of Macroeconomics “In the Long Run We are All Dead” After the Great Depression, many people believed that the self-healing forces of the market would quickly lead again to the creation of new jobs and a return to economic growth. But how fast is “quickly”? A second? A couple of months? Some years? All we know from microeconomics is that “in the long run” markets clear. But nobody knows how long the “long run” is. All we know is that for macroeconomists, the “long run” is too long, on which they do not want to wait because they fear that in “the long run we are all dead.” (Keynes, 1923)

The Great Depression and the Birth of Macroeconomics Macroeconomics and the Short Run Macroeconomics is also called “short-run” economics, as opposed to classical “long-run economics.” Keynesian macroeconomics was supposed to save capitalism, not to replace it. The inventor of modern macroeconomics is John Maynard Keynes (1883-1946).

The Great Depression and the Birth of Macroeconomics A Brief Overview of Macroeconomics Macroeconomics thinks in terms of aggregates of all firms, all households, and the government. Macroeconomic ideas are behind such important concepts like Gross Domestic Product Aggregate Demand Aggregate Supply Monetary Policy and Fiscal Policy which are all concepts this course is concerned with.