After you have read this section, you should be able to answer the following questions:
- What is stabilization policy?
- What is monetary policy, and how was it used during the Great Depression?
- What is fiscal policy, and how was it used during the Great Depression?
Understanding why the Great Depression occurred is certainly progress. But policymakers also wanted to know if there was anything that could be done in the face of this economic catastrophe. One of Keynes’ most lasting contributions to economics is that he showed how different kinds of economic policy could be used to assist economies that were stuck in recessions.
When markets are doing a good job of allocating resources, standard economic reasoning suggests that it is better for the government to stay out of the way. But when markets fail to allocate resources well, the government might be able to improve the overall functioning of the economy. The idea that markets left alone would coordinate aggregate economic activity is difficult to defend in the face of 25 percent unemployment of the labor force and a decline in economic activity of nearly 30 percent over a 4-year period. Thus the rationale for government intervention in the aggregate economy is that markets are failing to allocate resources properly, perhaps because prices and wages are sticky.
In the wake of the Great Depression, economists started advocating the use of government policy to improve the functioning of the macroeconomy. There are two kinds of government policy. Monetary policy refers to changes in interest rates and other tools that are under the control of the monetary authority of a country (the central bank). Fiscal policy refers to changes in taxation and the level of government purchases; such policies are typically under the control of a country’s lawmakers. Stabilization policy is the general term for the use of monetary and fiscal policies to prevent large fluctuations in real gross domestic product (real GDP).
In the United States, the Federal Reserve Bank controls monetary policy, and fiscal policy is controlled by the president, the Congress, and state governments. In the countries of the European Union, monetary policy is controlled by the European Central Bank, and fiscal policies are controlled by the individual governments of the member countries.
Keynes suggested that the cause of the Great Depression was an unusually low level of aggregate spending. This diagnosis suggests an immediate remedy: use government policies to increase aggregate spending. Because
\[change\ in\ GDP\ =\ multiplier \times change\ in\ autonomous\ spending,\]
any government policy that increases autonomous spending will, through this equation, also increase GDP. There are many different policies at the disposal of the government, but they are similar at heart. The idea is to stimulate one of the components of aggregate spending—consumption, investment, government purchases, or net exports.
One fiscal policy measure is an increase in government purchases. Suppose the government increases its expenditure—perhaps by hiring more teachers, buying more tanks, or building more roads. This increases autonomous spending and works its way through the economy, just as in our earlier discussion of a decrease in autonomous consumption—except now we are talking about an increase rather than a decrease. If the government spends an extra dollar, this immediately expands income by that dollar. Extra income leads to extra spending, which leads to further increases in output and income. The process continues around and around the circular flow.
Imagine that, as before, the marginal propensity to spend is 0.8, so that the multiplier is 5. If the government increases expenditure on goods and services by $1 billion, overall GDP in the economy will increase by $5 billion. Thus to offset the decrease in real GDP of about $90 billion between 1929 and 1933, assuming a marginal propensity to spend of 0.8, the federal government should have increased government spending by $18 billion. The multiplier is a double-edged sword. It has the bad effect that it can turn small decreases in spending into big decreases in output. But it also means that relatively small changes in government spending can have a big effect on output.
Tax cuts are another way to stimulate the economy. If households have to pay fewer taxes to the government, they are likely to spend more on consumption goods. This form of policy intervention has been used over and over again by governments in the United States and elsewhere. Tax cuts, like government spending, must be paid for. If the government spends more and taxes less, then the government deficit increases. The government must borrow to finance such fiscal policy measures. Chapter 27 "Income Taxes" and Chapter 29 "Balancing the Budget" have more to say about fiscal policy.
The central bank can use monetary policy to affect aggregate spending. Monetary policy operates through changes in interest rates, which are—in the short run at least—under the influence of the central bank. Lower interest rates make it cheaper for firms to borrow, which encourages them to increase investment spending. Lower interest rates likewise mean lower mortgage rates, so households are more likely to buy new homes. Lower interest rates may encourage households to borrow and spend more on other goods. And lower interest rates can even encourage net exports.The link from interest rates to net exports is complicated because it involves changes in exchange rates. You do not need to worry here about how it works. We explain it, together with other details of monetary policy, in Chapter 25 "Understanding the Fed".
Monetary and Fiscal Policies during the Great Depression
We have argued that monetary and fiscal policies could have been used to help the economy out of the Great Depression. But what did policymakers actually do at the time? The answer comes in two parts: at the start of the Great Depression, they did not do much; after 1932, they did rather more.
Both presidential candidates campaigned in favor of conservative fiscal policy in 1932. Here are some excerpts from the party platforms.See John Woolley and Gerhard Peters, The American Presidency Project, accessed June 30, 2011, http://www.presidency.ucsb.edu.
From the Democratic Party platform:
We advocate an immediate and drastic reduction of governmental expenditures by abolishing useless commissions and offices, consolidating departments and bureaus, and eliminating extravagance to accomplish a saving of not less than twenty-five per cent in the cost of the Federal Government. And we call upon the Democratic Party in the states to make a zealous effort to achieve a proportionate result.
We favor maintenance of the national credit by a federal budget annually balanced on the basis of accurate executive estimates within revenues, raised by a system of taxation levied on the principle of ability to pay.“Democratic Party Platform of 1932,” The American Presidency Project, accessed June 30, 2011, http://www.presidency.ucsb.edu/ws/index.php?pid=29595#ax zz1N9yDnpSR.
From the Republican Party platform:
The President’s program contemplates an attack on a broad front, with far-reaching objectives, but entailing no danger to the budget. […]
Constructive plans for financial stabilization cannot be completely organized until our national, State and municipal governments not only balance their budgets but curtail their current expenses as well to a level which can be steadily and economically maintained for some years to come. “Republican Party Platform of 1932,” The American Presidency Project, accessed June 30, 2011, http://www.presidency.ucsb.edu/ws/index.php?pid=29638#axz z1N9yDnpSR.
Both parties were arguing for cuts in government expenditures, not the increases that (with the benefit of hindsight and better theory) we have suggested were needed. Monetary policy was likewise not used to stimulate the economy at this time. It seems unlikely that the fiscal and monetary authorities knew what to do but did nothing. Instead, the tools of economic thought needed to guide policy were simply not sufficiently well developed at the time. In keeping with the prevailing view that the economy was self-correcting, the incumbent Republican president, Herbert Hoover, had insisted that “prosperity is just around the corner.”
The election of Franklin Roosevelt in 1932 was a turning point. After his election, President Roosevelt and his advisors created a series of measures—called the New Deal—that were intended to stabilize the economy. In terms of fiscal policy, the US government moved away from budget balance and adopted a much more aggressive spending policy. Government spending increased from 3.2 percent of real GDP in 1932 to 9.3 percent of GDP by 1936. These spending increases were financed by budget deficits.
Roosevelt also took action to stabilize the banking system, most notably by creating a system of deposit insurance. This policy remains with us today: if you have deposits in a US bank, the federal government insures them. According to the Federal Deposit Insurance Corporation ( http://www.fdic.gov), not a single depositor has lost a cent since the introduction of deposit insurance.The FDIC site ( http://www.fdic.gov) provides a discussion the history of this fund and current activities. The discussion of “Who is the FDIC?” ( http://www.fdic.gov/about/learn/symbol/index.html) is a good place to start. Finally, the 1930s was also the time of the introduction of Social Security and other measures to protect workers. The Social Security Administration ( http://www.ssa.gov) originated in 1935.General information on social security is available at http://www.ssa.gov. The history of the legislation, including various House and Senate Bills, is also available at http://www.ssa.gov/history/history.html. The original act included old-age benefits and the provision of unemployment insurance. The disability part of the program was created in 1956.
The New Deal brought about changes not only in policy but also in attitudes toward policymaking. Gardiner Means, who was an economic adviser to the Roosevelt administration in 1933, said of policymaking at the time:
It was this which produced the yeastiness of experimentation that made the New Deal what it was. A hundred years from now, when historians look back on this, they will say a big corner was turned. People agreed old things didn’t work. What ran through the whole New Deal was finding a way to make things work.
Before that, Hoover would loan money to farmers to keep their mules alive, but wouldn’t loan money to keep their children alive. This was perfectly right within the framework of classical thinking. If an individual couldn’t get enough to eat, it was because he wasn’t on the ball. It was his responsibility. The New Deal said: “Anybody who is unemployed isn’t necessarily unemployed because he is shiftless.” See Studs Terkel, Hard Times: An Oral History of the Great Depression (New York: Pantheon Books, 1970), 247.
- Stabilization policy entails the use the monetary and fiscal policy to keep the level of output at potential output.
- Monetary policy is the use of interest rates and other tools, under the control of a country’s central bank, to stabilize the economy. During the Great Depression, monetary policy was not actively used to stabilize the economy. A major component of stabilization after 1932 was restoring confidence in the banking system.
- Fiscal policy is the use of taxes and government spending to stabilize the economy. During the first part of the 1930s, contractionary fiscal policy may have deepened the Great Depression. After 1932, fiscal policy became more expansionary and may have helped to end the Great Depression.
- Suppose the government wants to increase real GDP by $1,000. Explain why a smaller multiplier implies that the government must increase its spending by more to increase real GDP by this amount.
- Did the government miss a chance to carry out stabilization policy before 1932?