Understanding the Great Depression

Now that we have covered the mechanics of the aggregate demand–aggregate supply model, let's use the model to help us to understand the worst recession in U.S. history: The Great Depression. The Great Depression was unlike any recession in recent times. Unemployment rose above 20%. 40% of all banks failed. GDP plummeted by 30%. And the stock market lost two-thirds of its value in just ten years. The Great Depression was largely caused by a series of negative aggregate demand shocks. But real shocks also contributed and slowed recovery.

Let's start in the 1920s -- The Roaring Twenties. ♪ [ragtime music] ♪ The economy was growing by almost 3% per year in per capita terms, and inflation was 0%. In 1929, however, the stock market crashed, partly caused by a reduction in the money supply. Investors lost a lot of wealth in the crash, and they reduced their consumption. Pessimism began to grow. And as pessimism grew, bank depositors began to worry about the banks, and some of them began to withdraw their money. This was a time before deposit insurance, so if you thought that your bank might go bankrupt, it made sense to run to the bank and withdraw your money before everyone else did.

During The Great Depression, thousands of banks failed, in four waves. And with each wave of bank failure, fear and uncertainty increased, leading to further reductions in consumption. Businesses began to look around, and they began to think -- "Maybe I should hold off on building a new factory. Let's just wait, and see what happens." This decline in investment spending was another shock to aggregate demand. Overall, investment dropped by an astounding 75% between 1929 and 1933. By 1940, the capital stock was actually lower than it had been in 1930. Aggregate demand had already been reduced drastically by 1931, and the U.S. economy was in bad shape.

But then, in the early 1930s, the Federal Reserve allowed the money supply to plunge by nearly 30% -- the largest negative shock in aggregate demand in U.S. history. By 1932, economists estimate that America's real growth rate was -13%, and inflation was -10%, a deflation. This extreme deflation made the situation even worse, because deflation increases the burden of debt. Suppose you owe $100. If prices fall by 10%, then your real debt has, in effect, been increased by 10%. You have to work harder and longer to pay the same debt. The deflation made debtors worse off -- bankrupting some, and causing others to cut back spending even more.

Now, in theory, the creditors were better off. But, in practice, the debtors cut back on their spending more than the creditors increased spending. So, deflation increased the burden of the debt and led to further falls in aggregate demand. The uncertainty, and the shrinking economy meant that even people who had money, they didn't want to spend -- not much on consumption, and certainly not on investment. The bottom line is that pretty much everyone wanted to spend less, but the only way that everyone can spend less is if the economy shrinks. And that's exactly what happened.

The Great Depression is, in many ways, the great fall in aggregate demand. But real shocks also contributed to, and slowed the economy's recovery. The bank failures mentioned earlier actually had two effects. When people lost their money, they couldn't spend, and so aggregate demand fell. But, in addition, the banks were financial intermediaries. And so, when the banks failed, the bridge between saving and investment collapsed, and the economy became less efficient. As is, often the case, real shocks are often intertwined with aggregate demand shocks.

As if all this wasn't bad enough, Mother Nature added to the problems of the U.S. economy. The Dust Bowl -- that was another real shock. In the early years of the Great Depression, farmland in Texas, Oklahoma, New Mexico, Colorado, and Kansas -- farmland dried up, and literally blew away. Farming became less productive as crops failed, and there wasn't enough water for all of the livestock. Between 1930 and 1940, some three and a half million people in the Plains States picked up and moved -- a mass migration, like the Gold Rush, but in reverse. This was a tremendous hit to the productive capacity of the U.S. agricultural sector.

Finally, several policy decisions also caused negative real shocks. The Smoot-Hawley Tariff, for example, enacted in 1930, taxed foreign goods. If nothing else had changed, this might have increased aggregate demand by encouraging spending on domestic goods. But in reality, other countries retaliated with similar tariffs, so our exports fell. Tariffs were also a real shock to the economy, because trade is a kind of technology. Trade lets us take one good, and transform it into another good. Tariffs make that technology less efficient, just like a productivity shock.

Finally, the National Industrial Recovery Act was a terrible piece of legislation. Under the Act, hundreds of industries adopted government-mandated codes that reduced competition, and prevented firms from lowering prices. In one famous case a tailor was fined and thrown in jail for charging 35 cents to press a suit instead of the legally required 40 cents. Moreover, at a time when investment was far too low, the Act put quotas on investment, and made competition in many industries illegal. Industries became monopolized and filled with cartels. Higher prices, lower output, less competition -- all of this delayed recovery.

Fortunately, some of the worst parts of the Act were declared unconstitutional in 1935. All of these real shocks, both natural and manmade -- they made an already bad situation even worse. It's impossible to cover the full complexity of the Great Depression in a short video. But that gives you a good overview of the essence of the crisis. But if you'd like to hear more about the Great Depression, vote here.