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 (sometimes referred to as business economics), is a branch of
economics that applies microeconomic analysis to decision methods of businesses or other
management units. As such, it bridges economic theory and economics in practice. It draws
heavily from quantitative techniques such as regression analysis and correlation, Lagrangian
calculus (linear). If there is a unifying theme that runs through most of managerial economics
it is the attempt to optimize business decisions given the firm's objectives and given
constraints imposed by scarcity, for example through the use of operations research and

Almost any business decision can be analyzed with managerial economics techniques, but it
is most commonly applied to:

á? x     - various models are used to quantify risk and asymmetric information

and to employ them in decision rules to manage risk.
á? ½      - microeconomic techniques are used to analyze production
efficiency, optimum factor allocation, costs, economies of scale and to estimate the
firm's cost function.
á? ½    - microeconomic techniques are used to analyze various pricing
decisions including transfer pricing, joint product pricing, price discrimination, price
elasticity estimations, and choosing the optimum pricing method.
á? Ô   - Investment theory is used to examine a firm's capital purchasing

At universities, the subject is taught primarily to advanced undergraduates and graduate

business schools. It is approached as an integration subject. That is, it integrates many
concepts from a wide variety of prerequisite courses. In many countries it is possible to read
for a degree in Business Economics which often covers managerial economics, financial
economics, game theory, business forecasting and industrial economics.

The term    is used in Keynesian economics to refer to a situation where the
demand for money becomes infinitely elastic, i.e. where the demand curve is horizontal, so
that further injections of money into the economy will not serve to further lower interest
rates. Under the narrow version of Keynesian theory in which this arises, it is specified that
monetary policy affects the economy only through its effect on interest rates. Therefore, if the
economy enters a liquidity trap area -- and further increases in the money stock will fail to
further lower interest rates -- monetary policy will be unable to stimulate the economy.

In the wake of the "Keynesian revolution" in the 1930s and 1940s, various neoclassical
economists sought to minimize the concept of a liquidity trap by specifying conditions in
which expansive monetary policy would affect the economy even if interest rates failed to
decline. Don Patinkin and Lloyd Metzler were the most prominent writers in this regard.
They specified the existence of a "Pigou effect," named for English economist A.C. Pigou, in
which the stock of real money balances is an element of the aggregate demand function for
goods, so that the money stock would directly affect the "IS" curve in an ISLM analysis, and
monetary policy would thus be able to stimulate the economy even under the existence of a
liquidity trap.
While much of the economics profession had serious problems with the existence of
significance of this Pigou Effect, academic economists had come to give little credence to the
concept of a liquidity trap by the 1960s.

However, the concept came back to prominence in misconception in the 1990s when the
Japanese economy fell into a period of prolonged stagnation and deflation despite the
presence of near-zero interest rates. While the liquidity trap as formulated by Keynes refers to
the existence of a horizontal demand curve for money at some positive level of interest rates,
the liquidity trap invoked in the 1990s referred merely to the presence of zero interest rates,
the assertion being that since interest rates could not fall below zero, monetary policy would
prove to be impotent in those conditions, just as it was asserted to be in a proper exposition of
a liquidity trap.

While this 1990s invocation of the term "liquidity trap" was not in conformity with that
asserted by Keynes, both treatments have in common first the assertion that monetary policy
affects the economy only via interest rates and second the subsequent conclusion that
monetary policy is impotent with respect to being able to stimulate the economy under those

Much the same furor has emerged in the United States and Europe in 2008-9, as short-term
policy rates for the various central banks have moved close to zero.

Note that the neoclassical economists' assertion was that even under an occurrence of a
liquidity trap, expansive monetary policy could still stimulate the economy via the direct
effects of increased money stocks on aggregate demand. This was essentially the hope of
both the Bank of Japan in the 1990s, when it embarked upon quantitative easing and of the
central banks of the United States and Europe in 2008-9, with their foray into quantitative
easing. All these policy initiatives are attempts to stimulate the economy through methods
other than the mere reduction of short-term interest rates.

- j   

A situation in which prevailing interest rates are low and savings rates are high, making monetary
policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in
savings because of the prevailing belief that interest rates will soon rise. Because bonds have an
inverse relationship to interest rates, many consumers do not want to hold an asset with a price
that is expected to decline.


Main article: Demand curve

An out or ri t rd shi t in demand increases both equilibrium price and quantit

hen consumers increase the quantit demanded ‘ ‘ , it is referred to as an

  ‘ . Increased demand can be represented on the graph as the curve being
shifted out ard. At each price point, a greater quantit is demanded, as from the initial curve
ÿ to the new curve ÿ. More people wanting coffee is an example. In the diagram, this raises
the equilibrium price from  to the higher . This raises the equilibrium quantit from  to
the higher . A movement along the curve is described as a "change in the quantit
demanded" to distinguish it from a "change in demand," that is, a shift of the curve. In the
example above, there has been an  ‘
 in demand which has caused an increase in
(equilibrium) quantit . The increase in demand could also come from changing tastes and
fads, incomes, complementary and substitute price changes, market expectations, and number
of buyers. This would cause the entire demand curve to shift changing the equilibrium price
and quantity.

If the  ‘   ‘

, then the opposite happens: an inward shift of the curve. If the
demand starts at ÿ, and  ‘

to ÿ , the price will decrease, and the quantity will
decrease. This is an effect of demand changing. The quantity supplied at each price is the
same as before the demand shift (at both Q1 and Q2). The equilibrium quantity, price and
demand are different. At each point, a greater amount is demanded (when there is a shift from
D1 to D2).

The demand curve "shifts" because a non-price determinant of demand has changed.
Graphically the shift is due to a change in the x-intercept. A shift in the demand curve due to
a change in a non-price determinant of demand will result in the market s being in a non-
equilibrium state. If the demand curve shifts out the result will be a shortage ² at the new
market price quantity demanded will exceed quantity supplied.If the demand curve shifts in,
there will be a surplus ² at the new market price quantity supplied will exceed quantity
demanded. The process by which a new equilibrium is established is not the province of
comparative statics ² the answers to issues concerning when, whether and how a new
equilibrium will be established are issues that are addressed by stochastic models²
economic dynamics.


Main article: Supply (economics)

An out-ward or right-ward shift in supply reduces equilibrium price but increases quantity

hen the suppliers' costs change for a given output, the supply curve shifts in the same
direction. For example, assume that someone invents a better way of growing wheat so that
the cost of growing a given quantity of wheat decreases. Otherwise stated, producers will be
willing to supply more wheat at every price and this shifts the supply curve  outward, to
²an  ‘

. This increase in supply causes the equilibrium price to decrease
from  to . The equilibrium quantity increases from  to  as the quantity demanded
at the new lower prices. In a supply curve shift, the price and the quantity move in
opposite directions.

If the quantity supplied  ‘

at a given price, the opposite happens. If the supply curve
starts at , and shifts inward to  , demand  ‘
, the equilibrium price will increase,
and the equilibrium quantity will decrease. This is an effect of supply changing. The quantity
demanded at each price is the same as before the supply shift (at both and ). The
equilibrium quantity, price and

hen there is a change in supply or demand, there are three possible movements. The
demand curve can move inward or outward. The supply curve can also move inward or

The purpose of this topic is show two alternative views of the
business cycle and the major problems of unemployment and
inflation. The classical theory is first presented. The
Keynesian view is offered as a critique of the classical theory.

The classical theory is essentially the laissez faire belief of
pure capitalism. In this view, business cycles are natural
processes of adjustment which do not require any action on the
part of government.

In Adam Smith's explanation of the invisible hand, the process

which leads firms to produce what people want, no government
is necessary: the economy works out its problems.

Say's law proposes that supply creates its own demand. This means
that the income derived from producing certain goods by some,
allows them to purchase goods produced by others. Since
all people have a need to purchase goods, they will seek to
produce some goods to derive income and buy whatever they want. Thus
the product markets will always necessarily be in equilibrium.

Workers who earn income, earn that income in order to be able to

buy a variety of products they want. Thus, by working and
producing goods, these workers generate the income with which
these goods can be purchased.


If some income happens not to be consumed immediately it will
enter the money market as a saving. This saving will be put back
into the economy as investment (i.e increase in capital) when it is
borrowed. The interest paid by borrowers to savers assures that
no saving will be idle. The money market equilibrates through an
adjustment in the interest rate.

The interest paid to those who save is an inducement to lend

money. When the interest rate is high, people will want to save
or lend more. On the other side of the market, the borrowers are
discouraged to borrow too much by a high interest rate. Thus, the market
does tend to reequilibrate under the influence of the interest


The classical theory proposes that all markets reequilibrate
because of adjustments in prices and wages which are flexible.
For instance, if an excess in the labor force or products
exist, the wage or price of these will adjust to absorb the

If prices and wages are flexible, markets reequilibrate. If, for

instance, many people are unemployed, firms can hire workers
at lower wages; but, hiring more workers precisely reduces

The classical theory proposes that no involuntary unemployment
will exist because an adjustment in the wage rate will assure
that the unemployed will be hired again. In addition, the need
of workers to buy goods will encourage them to accept work at
even the lower wage rates.

If wages are flexible as the classical economists argue, then

a decrease in wages does allow firms to hire more workers. Only
those who are reluctant to work for lower wages would then remain

Keynesian employment theory is build on a critique of the
classical theory. In this critique, Keynes argued that savers
and investors have incompatible plans which may not assure that
an equilibrium exists in the money market, that prices and
wages tend to be rigid and equilibrium may not exist in the
product and labor markets, and that periods of severe
unemployment have occurred (which the classical theory denied).

The Keynesian theory was developed in the wake of the great

depression. It was very hard to argue then that only
voluntary unemployment can exist as millions of workers
were out of work.


Keynes showed that savers and investors are separate groups
which do not necessarily interact: financial intermediaries
(banks) are in between. When a recession is present, investment
may not be equal to saving because, although the interest rate
is very low, 1) borrowers have poor sales prospect, 2)
banks are afraid of lending because of potential bankruptcy, and
3) savers want to wait for higher returns. This causes a
liquidity trap: some saving is idle.

Banks do tend to be very prudent when making loans to businesses

when economic conditions do not seem promising. But, their
reluctance to make loans is itself contributing to the economic
slow down.


Keynes argued that prices and wages are not flexible as the
classical theory asserts. Wages tend to be rigid on the down
side because workers will not accept wages which do not permit
them to live adequately; this is reinforced by the actions of
unions. If wages are too low, unemployment will exist. In the
case of prices, firms producing large tag items prefer to cut
production and lay off workers than cut price. Their monopoly
power often permits them to act that way.
Since the mid l980's, there have been several instances where
employees have accepted wage give-backs: for instance, in the
airline and steel industries. Aside from these exceptions,
wage decreases are extremely rare. The general pattern is one
of continuous increases, at least, to match cost of living

Aggregate demand shown graphically represents
the sum total of what household are willing and able to buy
at different level of the price level.

Aggregate demand can be thought of as a combination of all the

different products people may want to buy.


Aggregate demand curve is downsloping because of the real balance
effect. If prices are high, then the purchasing power of
monetary assets decreases and individuals tend to feel poorer
and buy less. If prices are low, the purchasing power of
monetary assets increases, individuals tend to feel wealthier
and buy more.

There is an inverse mathematical relationship between interest

rates and financial assets. Securities markets, such as the
New York Stock Exchange, are very sensitive to inflation which
is the major cause for increasing interest rates. This
sensitivity was observed in October 19, 1987 stock
market crash. It was also observed in securities markets reactions to
to lowering of interest rates by the US federal reserve bank in 2001.

Aggregate supply is made of three sections: the classical range
is vertical, the Keynesian range is horizontal and the
intermediate range is upsloping.

Graph G-MAC7.1
The aggregate supply can be thought of as the combination of all
the goods that firms produce: it is GNP if the government is

The classical range of aggregate supply is vertical because
of the proposition of the classical theory that prices will
adjust so that output is always at full employment. In this
range, expanding aggregate demand will cause inflation,
while contracting aggregate demand will reduce inflation.

There are many sectors of the economy where all adjustments take
place through price changes. One can think of all goods related
to fashion: if a dress is in high demand, it will be priced very
high; but if the dress is out of fashion, the price will be very
low and, eventually, it will not be produced at all.

The Keynesian range of aggregate supply corresponds to the
proposition that when price are very low, firms will prefer to
cut production rather than sell at a loss. In this range, any change
in aggregate demand will produce a change in output. Thus, in
the case of a recession the correct government policy is to
expand aggregate demand.

Numerous sectors of the economy have very few changes in price but
sizable changes in the volume of production and the number of
employees. For example, car manufacturers offer rebates which
do not amount to even 10% of the value of a car. Compared to
changes in price of 50% or more in clothing for instance, the
car rebates are very small. The reason is the large fixed costs.
Closings of entire car manufacturing plants are not uncommon during

This intermediate range of aggregate supply represents the
case of preliminary inflation (or sectoral inflation): when
demand and output expand, some sectors of the economy may
experience bottlenecks and require that prices increase because
output cannot.

Some sectors of the economy tend to experience price and

quantity changes at the same time. This would seem to be true
of all the consumer goods sectors such as radios and televisions,
or sport equipment.


When the intersection of aggregate demand and aggregate supply
occurs in the Keynesian horizontal range a recession and
excessive unemployment are present: the recommended policy
would be to stimulate aggregate demand. When the intersection
is in the classical vertical range, inflation is present: the
recommended policy would be to contract aggregate demand.

Graph G-MAC7.2

Throughout the 1960's and the 1970's, the emphasis of the American
administration has been to stimulate aggregate demand in order
to control unemployment. Control of inflation was accomplished
with the help of tax changes or controls over prices and wages.
Supply side policies can be shown by attributing periods of
stagflation (high prices and low level of output) to upward
shifts of aggregate supply. The recommended policy would then
not be an increased aggregate demand which adds to inflation,
but instead a shift in aggregate supply downward by cutting
costs of production.

During the 1980's, the American administration has attempted to control

economy by paying more attention to the supply side of the
economy. Specifically, costs of production are affected by
regulations, restrictions and subsidies enacted by government

Ô Ô ?


Macroeconomics is the study of economics from an overall CLASSICAL ECONOMISTS-
point of view. Instead of looking so much at individual people economists who believe in no
and businesses and their economic decisions, macroeconomics government regulation of the
deals with the overall pattern of the economy. To star with, we economy
will look at two main groups of economists: the Ô  
  and the     
  . Classical economists who believe in
economists generally think that the market, on its own, will be government regulation of the
able to adjust while Keynesian economists believe that the economy
government must step in to solve problems. The two camps
have differing ideas on the causes and solutions of
unemployment. The Classical economists believe that
unemployment is caused by excess supply, which is caused by
the high price level of labor. Based on supply and demand,
when wages are held too high by social and political forces,
demand would be low and supply would be high and that
excess supply represents unemployed people. Classical
economists believe that if the economy were left on its own, it
would adjust to reach an equilibrium wage for workers and the
economy would be at full employment.
Classical economists believe in    , which states that SAY'S LAW-Law stating that
people supply things to the economy so they have income to with supply naturally comes
demand things of the value they've supplied. Classical demand; there is never
economists also argue that all money is always in the oversupply
economy, because even when people put their income away in
INVESTMENT-Resources spent
the form of savings in banks, stocks, etc. that money still flows on the means of production, so as
back into the economy in the form of  
. When to supply products into an
savings money flows into banks, even though it does not economy and make a profit
directly go to the industries in the form of purchases, banks
loan this money to industries to invest in further development. MONEY-Something used to
Investmen takes the form of money to acquire new machines, value goods so that they may be
bought and sold
labor, facilities, etc. so that businesses grow.
number of times that a unit of
currency is spent each year

money supply do not affect real
production of goods and services

Fig 2.1.1-Money flows from

business to individuals in the
form of paying jobs; households
then spend most of it to buy
products from business; the part
that is saved in banks of the
Fig 2.1.1-Transfer of money financial sector is invested in

Fig 2.1.2-If there is a

disequilibrium between supply
Crucial to the understanding of classical economics is an
and demand, the supply can never
understanding of how
 works. Money is just something change. The price level simply
that can value goods, used to exchange those goods among moves until the demand is equal
individuals in an economy. The      
 is to supply.
the theory dealing with money and prices. It states that the
price level in an economy depends on how much money is in
the economy. In classical economics, the quantity theory of
money centers around the equation "(Quantity of money) x
(velocity of money) = (price level) x (quantity of goods sold)."
 just means how often money is spent. The
price level times the quantity of goods sold obviously equals
the GDP, total production. Velocity, then, times the amount of
money would equal that. A coin, for example, is passed around
from person to person throughout time and each time it is
spent, it generates income worth its value. The number of
times that coin was passed on throughout the year is its
velocity and that times its value gives how much production it
represents that year. When you add all the income generated
by all the money out there, you get the GDP also.

The velocity of this money depends on what the structure of an

economy is like. It depends on things like where people work,
where they shop, how often they shop, etc. Since no drastic
economic restructuring could be expected to occur in any short
period of time, this velocity is assumed to remain constant
from year to year. (It does change, but this change is so
incredibly slow as to be irrelevant.) Classical economics also
stresses that the amount of goods and services produced is not
affected by the money supply. This doctrine is the  

 . This assumption separated the world of
finance (of purely monetary studies) and the rest of the
economy (the production of goods and services). The veil of
money theory basically says that when the money supply
changes, the real economy does not because when money
supply changes by a certain amount, everything else does as
well. If it doubles, then prices double, and people's pay
doubles too to compensate for this, so nothing really changes.
Classical economics states that money supply is the force that
changes the price level.

Since money supply changes prices and money supply is not

affected by production, the amount of supply is independent of
the price level. The amount of output is chosen by people and,
according to classical economics, as long as they're no outside
pressures intefering with the markets like politics, the amount
of supply will always be at full employment level. Demand in
the long term is not a problem because in the long term, based
on Say's Law, supply generates its own demand and so there
will be long-term equilibrium. As stated earlier, classical
economists see the problem of unemployment as a self-solving
problem like all other things. Wages will fall and then demand
for labor will increase and eventually everyone who wants a
job will get one.

The long-term classical model does not solve short term

problems. In the short term, there are always various
fluctuations that move demand and supply out of balance of
each other. There must be a mechanism to equalize them
Fig 2.1.2-Classical adjustment model

Suppliers in the classical model never change how much they

supply, they just change their prices so that people will buy
them. No matter what, supply is an independent concept.
Suppliers will always produce how much they want to produce
at a given time. Demand, however, can move by changes to
the price level so that all that is produced is actually bought.

A basic argument made by John Maynard Keynes, a famous APC-average propensity to
economist during the depression era who invented the idea of consume, what percentage of
Keynesian economics, was that Say's law was just plain false. income people tend to spend;
In Keynes's analysis of the economy, he looked at the varies with how much income is
problems of supply and demand separately. The problem of
supply is relatively simple: supply generates income. What MPC-marginal propensity ot
people make are bought, and thus the value of supply is consume, what percentage of a
always equal to the value of income. This income is then change in income people tend to
passed on to the consumers in the form of paychecks. The spend
consumers then spend this money to buy various products.
Keynesian economics have several concepts to explain how APS-average propensity to save,
what percentage of income
consumers spend their income. people tend to save; varies with
how much income is made
The money that people get are always split between
consumption and savings. People who have enough money MPS-marginal propensity ot
usually save some of it and spend most of it. There are two save, what percentage of a
ratios Keynesian economics considers when dealing with change in income people tend to
consumption: the i½Ô and the c½Ô. The APC, average
propensity to consume, is a ratio telling us how much of
FIG 2.1.3-Based on Keynes's
people's income they tend to spend. The APC varies with ideas, production and spending
income level. The MPC tells us what part of a change in can be represented by two
income people tend to spend. For example, if the MPC was .5 different curves. The two
and somebody got an increase of income of $1000, then they different curves meet at a point of
equilibrium. If they are different,
will spend $500 dollars of that increased income. Conversely,
then production is adjusted until
equilibrium is reached.
people will cut their spending by that ratio when they lose
some income.

Fig 2.1.3-Keynesian consumption function

In this graph, we can see a graphical representation of

Keynes's ideas. The blue line represents production. The red
line represents how much people spend. The slope of the line,
or how much the line goes upward for every increment
horizontally, is the MPC, which in this case is 0.75 (how much
of every extra piece of income is spent). The slope of the
production line is 1 since production = income. When income
is way too low, as shown in this, spending must exceed
income because no matter what, there are some things that
people must buy, like food. They do this through borrowing
and dipping into savings, etc. Beyond a certain point, people
have enough to save some of that money. APC can be
represented on this graph as the ratio of the amount
represented by the red line to the amount represented by the
blue line at any point. Notice that this ratio changes, which
makes sense in the context of Keynesian economics. At the
point where spending equals production/income, the APC is 1
and at that point, people spend all the money they make.

Of course, the rest of the money, the money that is not spent,
goes into savings. There is also i½ and c½, the average
propensity to save and marginal propensity to save. APS is
what part of income people save and MPS is what part of
additional income people save. APS+APC=1 and
MPS+MPC=1, as savings and spending together equal
income. Savings is the part of the graph between the two lines.
When spending is more than income, people save, savings
represented by the difference between income and spending.
When spending is more than income, people take money out
of past savings, the amount represented by the difference
between spending and income. Another component of
Keynes's analysis was the independence of investment. Unlike
classical economics, which states that all savings go into
investment, Keynes said that how much people invests is
simply how much they feel like investing. There are more
complicated models, but to keep this simple now, investment
is not changed by savings or income. To keep the model
simple, we will assume that government spending and foreign
trade is all independent. If you add all these factors into the
spending, the red line representing total spending would be
shifted upwards (the whole line, the slope is still the same).

Whenever the economy is not in equilibrium, firms change

their production until equilibrium is reached. When there is
more production than expenditure, there is an excess of
supply, as firms are not selling everything they produce. Thus,
they have to decrease production until production equals
consumption on the graph. On the other hand, if there is too
little supply, the portion of the graph where production is less
than consumption, firms increase their production to meet the
demands of customers until the two lines of output and
spending meet at equilibrium. The economy is continually
adjusting in the Keynesian model as various factors influence
the independent factors of investment, government spending,
and net export, factors outside of income and production.
Interest rate changes, future predictions, and technology can
affect investment. Government spending may change
depending on varying political situations. Net export, too, can
change with a nation's changing international position. These
changes can move the spending curve up or down (again, shift
as opposed to changing the slope) and thus force further
adjustment of production. With his model, he explained the
Great Depression: after the crash of 1929, people became
scared. Invetment was cut as was spending. When this
happened, companies decreased their production even more as
spending decreased and this was followed by a drop of
spending as income fell (income=production). This drop
continued until equilibrium was reached at a point that is way
below that of full employment.



When economists look at inflation and unemployment in the PHILLIPS CURVE-The
short term, they see a rough inverse correlation between the relationship between inflation and
two. When unemployment is high, inflation is low and when
inflation is high, unemployment is low. This has presented a Fig 2.4.1-The short term phillips
problem to regulators who want to limit both. This relationship curve: inflation is inversely
between inflation and unemployment is the ½ . related to unemployment. When
The short term Phillips curve is a declining one. unemployment rises, inflation
drops; when unemployment
drops, inflation rises.

Fig 2.4.1-Short term Phillips curve

This is a rough estimation of a short-term Phillips curve. As

you can see, inflation is inversely related to unemployment.
The long-term Phillips curve, however, is different.
Economists have noted that in the long run, there seems to be
no correlation between inflation and unemployment.


In the classical view of inflation, the only thing that causes
inflation is, in reality, changes in the money supply.
Remember the classical quantity theory of money: (money
supply) x (velocity) = (price level) x (amount of output). And
remember that the classics assume that velocity and output are
independent and relatively constant. Thus, as money supply
rises, that naturally ups the price level, too, and increase in
price level is inflation.

The classical economists believe that there is a natural rate of

unemployment, the equilibrium level of unemployment of the
economy. That is the long-term Phillips curve. Remember that
the long-term Phillips curve is vertical because there inflation
is not related to unemployment in the long-term.
Unemployment, therefore, will just be at a given level, no
matter at what point inflation is at. In the classical view, the
point where the short-term Phillips curve intersects the long-
term Phillips curve is the expected inflation. To the left side of
that point, actual inflation is higher than expected and to the
right, actual inflation is lower than expected. Basically,
unemployment below natural unemployment leads to inflation
higher than expected and unemployment higher than natural
unemployment leads to inflation lower than expected.

? ??
As opposed to the Classics, who view inflation as a problem of
ever-increasing money supply, Keynesians concentrate on the
institutional problems of people increasing their price levels.
Keynesians argue that firms raise wages to keep their workers
happy. Firms then have to pay for that and keep making a
profit by subsequently raising the prices. This causes an
increase in both wages and prices and demands an increase of ??
money supply to keep the economy running. So, the
government then issues more and more money to keep up with
inflation. This differs from the classical model. Classics view
changing money supply as affecting inflation while
Keynesians view inflation as the cause of changing money



r ??v  ?se

c ?

In this simplified image, the relationship between the decision-makers in the circular flow model is
shown. Larger arrows show primary factors, whilst the red smaller arrows show subsequent or
secondary factors.

In economics, the term    

 or    refers to a simple economic
model which describes the reciprocal circulation of income between producers and
consumers.[1][2] In the circular flow model, the inter-dependent entities of producer and
consumer are referred to as "firms" and "households" respectively and provide each other
with factors in order to facilitate the flow of income[1]. Firms provide consumers with goods
and services in exchange for consumer expenditure and "factors of production" from

The circle of money flowing through the economy is as follows: total income is spent (with
the exception of "leakages" such as consumer saving), while that expenditure allows the sale
of goods and services, which in turn allows the payment of income (such as wages and
salaries). Expenditure based on borrowings and existing wealth ± i.e., "injections" such as
fixed investment ± can add to total spending.

In equilibrium (Preston), leakages equal injections and the circular flow stays the same size.
If injections exceed leakages, the circular flow grows (i.e., there is economic prosperity),
while if they are less than leakages, the circular flow shrinks (i.e., there is a recession).

More complete and realistic circular flow models are more complex. They would explicitly
include the roles of government and financial markets, along with imports and exports.

Labor and other "factors of production" are sold on resource markets. These resources,
purchased by firms, are then used to produce goods and services. The latter are sold on
product markets, ending up in the hands of the households, helping them to supply resources.


á? Œ Assumptions
á? ‰ Two Sector Model
á? º Five sector model
á? è See also
á? § References
á? D Further reading

† i 
The basic circular flow of income model consists of six assumptions:

Œ.? The economy consists of two sectors: households and firms.

‰.? Households spend all of their income (Y) on goods and services or consumption (C). There is
no saving (S).
º? ?  ? ?
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e?  ?
è? e
§? e
D? e

Template: nreferenced sections In the simple            the
state of equilibrium is defined as a situation in which there is no tendency for the levels of
income (Y), expenditure (E) and output (O) to change, that is:


This means that the expenditure of buyers (households) becomes income for sellers (firms).
The firms then spend this income on factors of production such as labour, capital and raw
materials, "transferring" their income to the factor owners. The factor owners spend this
income on goods which leads to a circular flow of income.

† ]    
s?sec?Ô             ?
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eve ?÷ 

ce?„           Ô  „ ?ese?
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Table 1 All leakages and injections in five sector model




The five sector model of the circular flow of income is a more realistic representation of the
economy. Unlike the two sector model where there are six assumptions the five sector
circular flow relaxes all six assumptions. Since the first assumption is relaxed there are three
more sectors introduced. The first is the Financial Sector that consists of banks and non-bank
intermediaries who engage in the borrowing (savings from households) and lending of
money. In terms of the circular flow of income model the leakage that financial institutions
provide in the economy is the option for households to save their money. This is a leakage
because the saved money can not be spent in the economy and thus is an idle asset that means
not all output will be purchased. The injection that the financial sector provides into the
economy is investment (I) into the business/firms sector. An example of a group in the
finance sector includes banks such as estpac or financial institutions such as Suncorp.

The next sector introduced into the circular flow of income is the Government Sector that
consists of the economic activities of local, state and federal governments. The leakage that
the Government sector provides is through the collection of revenue through Taxes (T) that is
provided by households and firms to the government. For this reason they are a leakage
because it is a leakage out of the current income thus reducing the expenditure on current
goods and services. The injection provided by the government sector is Government spending
(G) that provides collective services and welfare payments to the community. An example of
a tax collected by the government as a leakage is income tax and an injectioninto the
economy can be when the government redistributes this income in the form of welfare
payments, that is a form of government spending back into the economy.

The final sector in the circular flow of income model is the overseas sector which transforms
the model from a closed economy to an open economy. The main leakage from this sector are
imports (M), which represent spending by residents into the rest of the world. The main
injection provided by this sector is the exports of goods and services which generate income
for the exporters from overseas residents. An example of the use of the overseas sector is
Australia exporting wool to China, China pays the exporter of the wool (the farmer) therefore
more money enters the economy thus making it an injection. Another example is China
processing the wool into items such as coats and Australia importing the product by paying
the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.

In terms of the      

 the state of equilibrium occurs
when the total leakages are equal to the total injections that occur in the economy. This can
be shown as:

Savings + Taxes + Imports = Investment + Government Spending + Exports


S + T + M = I + G + X.

This can be further illustrated through the fictitious economy of Noka where:

$100 + $150 + $50 = $50 + $100 + $150
$300 = $300

Therefore since the leakages are equal to the injections the economy is in a stable state of
equilibrium. This state can be contrasted to the state of disequilibrium where unlike that of
equilibrium the sum of total leakages does not equal the sum of total injections. By giving
values to the leakages and injections the circular flow of income can be used to show the state
of disequilibrium. Disequilibrium can be shown as:


Therefore it can be shown as one of the below equations where:

Total leakages > Total injections

$150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + 150 (X)


Total Leakages < Total injections

$§ (S) + $‰ (T) + $Œ‰§ (M) < $7§ (I) + $‰ (G) + Œ§ (X)

The effects of disequilibrium vary according to which of the above equations they belong to.

If S + T + M > I + G + X the levels of income, output, expenditure and empl oyment will fall
causing a recession or contraction in the overall economic activity. But if S + T + M < I + G
+ X the levels of income, output, expenditure and employment will rise causing a boom or
expansion in economic activity.
To manage this problem, if disequilibrium were to occur in the five sector circular flow of
income model, changes in expenditure and output will lead to equilibrium being regained. An
example of this is if:

S + T + M > I + G + X the levels of income, expenditure and output will f all causing a
contraction or recession in the overall economic activity. As the income falls ÷  !
households will cut down on all leakages such as saving, they will also pay less in taxation
and with a lower income they will spend less on imports. This will lead to a fall in the
leakages until they equal the injections and a lower level of equilibrium will be the result.

The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the
levels of income, expenditure and output will greatly rise causing a boom in economic
activity. As the households income increases there will be a higher opportunity to save
therefore saving in the financial sector will increase, taxation for the higher threshold will
increase and they will be able to spend more on imports. In this case when the leakages
increase they will continue to rise until they are equal to the level injections. The end result of
this disequilibrium situation will be a higher level of equilibrium.

ÿ   "#$% 

The economic depression that beset the United States and other countries in the 1930s was
unique in its magnitude and its consequences. At the depth of the depression, in 1933, one
American worker in every four was out of a job. In other countries unemployment ranged
between 15 percent and 25 percent of the labor force. The great industrial slump continued
throughout the 1930s, shaking the foundations of Western capitalism and the society based
upon it. Economic Aspects President Calvin COOLIDGE had said during the long prosperity
of the 1920s that "The business of America is business." Despite the seeming business
prosperity of the 1920s, however, there were serious economic weak spots, a chief one being
a depression in the agricultural sector. Also depressed were such industries as coal mining,
railroads, and textiles.

Throughout the 1920s, U. S. banks had failed--an average of 600 per year--as had thousands
of other business firms. By 1928 the construction boom was over. The spectacular rise in
prices on the STOCK MARKET from 1924 to 1929 bore little relation to actual economic
conditions. In fact, the boom in the stock market and in real estate, along with the expansion
in credit (created, in part, by low-paid workers buying on credit) and high profits for a few
industries, concealed basic problems. Thus the U. S. stock market crash that occurred in
October 1929, with huge losses, was not the fundamental cause of the Great Depression,
although the crash sparked, and certainly marked the beginning of, the most traumatic
economic period of modern times. By 1930, the slump was apparent, but few people expected
it to continue; previous financial PANICS and depressions had reversed in a year or two. The
usual forces of economic expansion had vanished, however.
Technology had eliminated more industrial jobs than it had created; the supply of goods
continued to exceed demand; the world market system was basically unsound. The high
tariffs of the Smoot-Hawley Act (1930) exacerbated the downturn. As business failures
increased and unemployment soared--and as people with dwindling incomes nonetheless had
to pay their creditors--it was apparent that the United States was in the grip of economic
breakdown. Most European countries were hit even harder, because they had not yet fully
recovered from the ravages of World War I.) The deepening depression essentially coincided
with the term in office (1929-33) of President Herbert HOOVER. The stark statistics scarcely
convey the distress of the millions of people who lost jobs, savings, and homes. From 1930 to
1933 industrial stocks lost 80% of their value. In the four years from 1929 to 1932
approximately 11,000 U. S. banks failed (44% of the 1929 total), and about $2 billion in
deposits evaporated. The gross national product (GNP), which for years had grown at an
average annual rate of 3.5%, declined at a rate of over 10% annually, on average, from 1929
to 1932. Agricultural distress was intense: farm prices fell by 53% from 1929 to 1932.
President Hoover opposed government intervention to ease the mounting economic distress.
His one major action, creation (1932) of the Reconstruction Finance Corporation to lend
money to ailing corporations, was seen as inadequate. Hoover lost the 1932 election to
Franklin D. ROOSEVELT.

The depression brought a deflation not only of incomes but of hope. In his first inaugural
address (March 1933), President Franklin D. ROOSEVELT declared that "the only thing we
have to fear is fear itself." But though his NEW DEAL grappled with economic problems
throughout his first two terms, it had no consistent policy. At first Roosevelt tried to stimulate
the economy through the NATIONAL RECOVERY ADMINISTRATION, charged with
establishing minimum wages and codes of fair competition in every industry. It was based on
the idea of spreading work and reducing unfair competitive practices by means of
cooperation in industry, so as to stabilize production and prevent the price slashing that had
begun after 1929. This approach was abandoned after the Supreme Court declared the NRA
Roosevelt's second administration gave more emphasis to public works and other government
expenditures as a means of stimulating the economy, but it did not pursue this approach
vigorously enough to achieve full economic recovery. At the end of the 1930s,
unemployment was estimated at 17.2%. Other innovations of the Roosevelt administrations
had long-lasting effects, both economically and politically. To aid people who could find no
work, the New Deal extended federal relief on a vast scale. The CIVILIAN
CONSERVATION CORPS took young men off the streets and sent them out to plant forests
and drain swamps. The government refinanced about one-fifth of farm mortgages through the
FARM CREDIT ADMINISTRATION and about one-sixth of home mortgages through the
Home Owners Loan Corporation. The WORKS PROGRESS ADMINISTRATION employed
an average of over 2 million people in occupations ranging from laborers to musicians and
writers. The PUBLIC WORKS ADMINISTRATION spent about $4 billion on the
construction of highways and public buildings in the years 1933-39. The depression years
saw a burst of union organizing, aided by the NATIONAL LABOR RELATIONS ACT of
1935. New industrial unions came into existence through the efforts of organizers led by John
L. LEWIS, Walter REUTHER, Philip MURRAY, and others; in 1937 they won contracts in
the steel and auto industries. Total union membership rose from about 3 million in 1932 to
over 10 million in 1941. Political and Cultural Effects The expanded role of the federal
government came to be accepted by most Americans by the end of the 1930s. Even
Republicans who had bitterly opposed the New Deal shifted their stance.
-endell -ILLKIE, the Republican presidential nominee in 1940, declared that he could not
oppose reforms such as the regulation of the securities markets and the utility holding
companies, the legal recognition of unions, or Social Security and unemployment allowances.
-hat bothered him and other opponents of the New Deal, however, was the extension of the
federal bureaucracy. The depression caused much questioning of inherited economic and
political ideas. Sen. Huey P. Long (see LONG family) of Louisiana found a national
following for his "Share the -ealth" program. The socialist writer Upton SINCLAIR was
nearly elected governor of California in 1934 with a similar program for redistributing the
state's wealth. Many writers and other intellectuals swung even further left, concluding that
capitalism was on its way out; they were drawn to the Communist party by what they
supposed to be the accomplishments of the USSR.

In other countries the depression had even more profound effects. As world trade fell off,
countries turned to nationalist economic policies that only exacerbated their difficulties. In
politics the depression strengthened the extremes of right and left, helping Adolf HITLER to
power in Germany and swelling left-wing movements in other European countries. The
depression was thus a time of massive insecurity among peoples and governments,
contributing to the tensions that produced -orld -ar II. Ironically, however, the massive
military expenditures for that war provided the economic stimulus that finally ended the
depression in the United States and elsewhere.



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The X    was a severe worldwide economic depression in the decade preceding
-orld -ar II. The timing of the Great Depression varied across nations, but in most
countries it started in about 1929 and lasted until the late 1930s or early 1940s.[1] It was the
longest, most widespread, and deepest depression of the 20th century, and is used in the 21st
century as an example of how far the world's economy can decline.[2] The depression
originated in the United States, starting with the stock market crash of October 29, 1929
(known as Black Tuesday), but quickly spread to almost every country in the world.[1]

The Great Depression had devastating effects in virtually every country, rich and poor.
Personal income, tax revenue, profits and prices dropped, and international trade plunged by
a half to two-thirds. Unemployment in the United States rose to 25%, and in some countries
rose as high as 33%.[3] Cities all around the world were hit hard, especially those dependent
on heavy industry. Construction was virtually halted in many countries. Farming and rural
areas suffered as crop prices fell by approximately 60 percent.[4][5][6] Facing plummeting
demand with few alternate sources of jobs, areas dependent onprimary sector industries such
as cash cropping, mining and logging suffered the most.[7]

Countries started to recover by the mid-1930s, but in many countries the negative effects of
the Great Depression lasted until the start of -orld -ar II.[8]

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Historians most often attribute the start of the Great Depression to the sudden and total
collapse of US stock market prices on October 29, 1929, known as Black Tuesday.[1]
However, some dispute this conclusion, and see the stock crash as a symptom, rather than a
cause of the Great Depression.[3][9] Even after the -all Street Crash of 1929, optimism
persisted for some time; John D. Rockefeller said that "These are days when many are
discouraged. In the 93 years of my life, depressions have come and gone. Prosperity has
always returned and will again."[10] The stock market turned upward in early 1930, returning
to early 1929 levels by April, though still almost 30% below the peak of September 1929.[11]
Together, government and business actually spent more in the first half of 1930 than in the
corresponding period of the previous year. But consumers, many of whom had suffered
severe losses in the stock market the previous year, cut back their expenditures by ten
percent, and a severe drought ravaged the agricultural heartland of the USA beginning in the
summer of 1930.
By mid-1930, interest rates had dropped to low levels, but expected deflation and the
reluctance of people to add new debt by borrowing, meant that consumer spending and
investment were depressed.[12] In May 1930, automobile sales had declined to below the
levels of 1928. Prices in general began to decline, but wages held steady in 1930; but then a
deflationary spiral started in 1931. Conditions were worse in farming areas, where
commodity prices plunged, and in mining and logging areas, where unemployment was high
and there were few other jobs. The decline in the US economy was the factor that pulled
down most other countries at first, then internal weaknesses or strengths in each country
made conditions worse or better. Frantic attempts to shore up the economies of individual
nations through protectionist policies, such as the 1930 U.S. Smoot Hawley Tariff Act and
retaliatory tariffs in other countries, exacerbated the collapse in global trade. By late in 1930,
a steady decline set in which reached bottom by March 1933.


s ?

ce? ses??e?

There were multiple causes for the first downturn in 1929, including the structural
weaknesses and specific events that turned it into a major depressionand the way in which
the downturn spread from country to country. In relation to the 1929 downturn, historians
emphasize structural factors like massive bank failures and the stock market crash, while
economists (such as Peter Temin and Barry Eichengreen) point to Britain's decision to return
to the Gold Standard at pre--orld -ar I parities (US$4.86:£1).

Recession cycles are thought to be a normal part of living in a world of inexact balances
between supply and demand. -hat turns a usually mild and short recession or "ordinary"
business cycle into an actual depression is a subject of debate and concern. Scholars have not
agreed on the exact causes and their relative importance. The search for causes is closely
connected to the question of how to avoid a future depression, and so the political and policy
viewpoints of scholars are mixed into the analysis of historic events eight decades ago. The
even larger question is whether it was largely a failure on the part of free markets or largely a
failure on the part of government efforts to regulate interest rates, curtail widespread bank
failures, and control the money supply. Those who believe in a large role for the state in the
economy believe it was mostly a failure of the free markets and those who believe in free
markets believe it was mostly a failure of government that compounded the problem.

Current theories may be broadly classified into three main points of view. First there are the
monetarists, who believe that the Great Depression started as an ordinary recession, but that
significant policy mistakes by monetary authorities (especially the Federal Reserve), caused a
shrinking of the money supply which greatly exacerbated the economic situation, causing a
recession to descend into the Great Depression. Related to this explanation are those who
point to debt deflation causing those who borrow to owe ever more in real terms.

Second, there are structural theories, most importantly Keynesian, but also including those
who point to the breakdown of international trade, and Institutional economists who point to
underconsumption and overinvestment (economic bubble), malfeasance by bankers and
industrialists, or incompetence by government officials. The consensus viewpoint is that there
was a large-scale loss of confidence that led to a sudden reduction in consumption and
investment spending. Once panic and deflation set in, many people believed they could make
more money by keeping clear of the markets as prices dropped lower and a given amount of
money bought ever more goods, exacerbating the drop in demand.

Lastly, there are various heterodox theories that downplay or reject the explanations of the
Keynesian and monetarists. For example, some new classical macroeconomists have argued
that various labor market policies imposed at the start caused the length and severity of the
Great Depression. The Austrian school of economics focuses on the macroeconomic effects
of money supply, and how central banking decisions can lead to overinvestment (economic
bubble). The Marxist critique of political economy emphasizes the tendency of capitalism to
create unbalanced accumulations of wealth, leading to overaccumulations of capital and a
repeating cycle of devaluations through economic crises. Marx saw recession and depression
as unavoidable under free-market capitalism as there are no restrictions on accumulations of
capital other than the market itself.


ce? ses??e?

ess ?

Monetarists, including Milton Friedman and current Federal Reserve System chairman Ben
Bernanke, argue that the Great Depression was mainly caused by monetary contraction, the
consequence of poor policymaking by the American Federal Reserve System and continued
crisis in the banking system.[13][14] In this view, the Federal Reserve, by not acting, allowed
the money supply as measured by the M2 to shrink by one-third from 1929 to 1933, thereby
transforming a normal recession into the Great Depression. Friedman argued that the
downward turn in the economy, starting with the stock market crash, would have been just
another recession.[15] However, the Federal Reserve allowed some large public bank failures
± particularly that of the New York Bank of the United States ± which produced panic and
widespread runs on local banks, and the Federal Reserve sat idly by while banks collapsed.
He claimed that, if the Fed had provided emergency lending to these key banks, or simply
bought government bonds on the open market to provide liquidity and increase the quantity
of money after the key banks fell, all the rest of the banks would not have fallen after the
large ones did, and the money supply would not have fallen as far and as fast as it did.[16]
With significantly less money to go around, businessmen could not get new loans and could
not even get their old loans renewed, forcing many to stop investing. This interpretation
blames the Federal Reserve for inaction, especially the New York branch.[17]

One reason why the Federal Reserve did not act to limit the decline of the money supply was
regulation. At that time the amount of credit the Federal Reserve could issue was limited by
laws which required partial gold backing of that credit. By the late 1920s the Federal Reserve
had almost hit the limit of allowable credit that could be backed by the gold in its possession.
This credit was in the form of Federal Reserve demand notes. Since a "promise of gold" is
not as good as "gold in the hand", during the bank panics a portion of those demand notes
were redeemed for Federal Reserve gold. Since the Federal Reserve had hit its limit on
allowable credit, any reduction in gold in its vaults had to be accompanied by a greater
reduction in credit. On April 5, 1933 President Roosevelt signed Executive Order 6102
making the private ownership of gold certificates, coins and bullion illegal, reducing the
pressure on Federal Reserve gold.[18]


Main article: Causes of the Great Depression$Debt deflation

Irving Fisher argued that the predominant factor leading to the Great Depression was over-
indebtedness and deflation. Fisher tied loose credit to over-indebtedness, which fueled
speculation and asset bubbles.[19] He then outlined 9 factors interacting with one another
under conditions of debt and deflation to create the mechanics of boom to bust. The chain of
events proceeded as follows:

Œ.? Debt liquidation and distress selling

‰.? Contraction of the money supply as bank loans are paid off
º.? A fall in the level of asset prices
è.? A still greater fall in the net worths of business, precipitating bankruptcies
§.? A fall in profits
D.? A reduction in output, in trade and in employment.
7.? Pessimism and loss of confidence
.? Hoarding of money
.? A fall in nominal interest rates and a rise in deflation adjusted interest rates.†Œ]

During the Crash of 1929 preceding the Great Depression, margin requirements were only
10%.[20] Brokerage firms, in other words, would lend $9 for every $1 an investor had
deposited. When the market fell, brokers called in these loans, which could not be paid back.
Banks began to fail as debtors defaulted on debt and depositors attempted to withdraw their
deposits en masse, triggering multiple bank runs. Government guarantees and Federal
Reserve banking regulations to prevent such panics were ineffective or not used. Bank
failures led to the loss of billions of dollars in assets.[21] Outstanding debts became heavier,
because prices and incomes fell by 20±50% but the debts remained at the same dollar
amount. After the panic of 1929, and during the first 10 months of 1930, 744 US banks
failed. (In all, 9,000 banks failed during the 1930s). By April 1933, around $7 billion in
deposits had been frozen in failed banks or those left unlicensed after the March Bank

Bank failures snowballed as desperate bankers called in loans which the borrowers did not
have time or money to repay. With future profits looking poor, capital investment and
construction slowed or completely ceased. In the face of bad loans and worsening future
prospects, the surviving banks became even more conservative in their lending.[21] Banks
built up their capital reserves and made fewer loans, which intensified deflationary pressures.
A vicious cycle developed and the downward spiral accelerated.

The liquidation of debt could not keep up with the fall of prices which it caused. The mass
effect of the stampede to liquidate increased the value of each dollar owed, relative to the
value of declining asset holdings. The very effort of individuals to lessen their burden of debt
effectively increased it. Paradoxically, the more the debtors paid, the more they owed.[19] This
self-aggravating process turned a 1930 recession into a 1933 great depression.

Macroeconomists including Ben Bernanke, the current chairman of the U.S. Federal Reserve
Bank, have revived the debt-deflation view of the Great Depression originated by



Main article: Causes of the Great Depression$ eynesian explanation

British economist John Maynard Keynes argued in X    

   that lower aggregate expenditures in the economy contributed to a massive
decline in income and to employment that was well below the average. In such a situation,
the economy reached equilibrium at low levels of economic activity and high unemployment.
Keynes basic idea was simple: to keep people fully employed, governments have to run
deficits when the economy is slowing, as the private sector would not invest enough to keep
production at the normal level and bring the economy out of recession. Keynesian economists
called on governments during times of economic crisis to pick up the slack by increasing
government spending and/or cutting taxes.

As the Depression wore on, Roosevelt tried public works, farm subsidies, and other devices
to restart the economy, but never completely gave up trying to balance the budget. According
to the Keynesians, this improved the economy, but Roosevelt never spent enough to bring the
economy out of recession until the start of World War II.[25]


Main article: Causes of the Great Depression

Many economists have argued that the sharp decline in international trade after 1930 helped
to worsen the depression, especially for countries significantly dependent on foreign trade.
Most historians and economists partly blame the American Smoot-Hawley Tariff Act
(enacted June 17, 1930) for worsening the depression by seriously reducing international
trade and causing retaliatory tariffs in other countries. While foreign trade was a small part of
overall economic activity in the United States and was concentrated in a few businesses like
farming, it was a much larger factor in many other countries.[26] The average   rate
of duties on dutiable imports for 1921±1925 was 25.9% but under the new tariff it jumped to
50% in 1931±1935.

In dollar terms, American exports declined from about $5.2 billion in 1929 to $1.7 billion in
1933; but prices also fell, so the physical volume of exports only fell by half. Hardest hit
were farm commodities such as wheat, cotton, tobacco, and lumber. According to this theory,
the collapse of farm exports caused many American farmers to default on their loans, leading
to the bank runs on small rural banks that characterized the early years of the Great


Main article: Causes of the Great Depression$ ew classical approach

Recent work from a neoclassical perspective focuses on the decline in productivity that
caused the initial decline in output and a prolonged recovery due to policies that affected the
labor market. This work, collected by Kehoe and Prescott,[27] decomposes the economic
decline into a decline in the labor force, capital stock, and the productivity with which these
inputs are used. This study suggests that theories of the Great Depression have to explain an
initial severe decline but rapid recovery in productivity, relatively little change in the capital
stock, and a prolonged depression in the labor force. This analysis rejects theories that focus
on the role of savings and posit a decline in the capital stock.


Main article: Causes of the Great Depression$Austrian School explanations

Another explanation comes from the Austrian School of economics. Theorists of the
"Austrian School" who wrote about the Depression include Austrian economist Friedrich
Hayek and American economist Murray Rothbard, who wrote i  X  
(1963). In their view and like the monetarists, the Federal Reserve, which was created in
1913, shoulders much of the blame; but in opposition to the monetarists, they argue that the
key cause of the Depression was the expansion of the money supply in the 1920s that led to
an unsustainable credit-driven boom.

One reason for the monetary inflation was to help Great Britain, which, in the 1920s, was
struggling with its plans to return to the gold standard at pre-war (World War I) parity.
Returning to the gold standard at this rate meant that the British economy was facing
deflationary pressure.[28] According to Rothbard, the lack of price flexibility in Britain meant
that unemployment shot up, and the American government was asked to help. The United
States was receiving a net inflow of gold, and inflated further in order to help Britain return to
the gold standard. Montagu Norman, head of the Bank of England, had an especially good
relationship with Benjamin Strong, the ‘  head of the Federal Reserve. Norman
pressured the heads of the central banks of France and Germany to inflate as well, but unlike
Strong, they refused.[28] Rothbard says American inflation was meant to allow Britain to
inflate as well, because under the gold standard, Britain could not inflate on its own.

In the Austrian view it was this inflation of the money supply that led to an unsustainable
boom in both asset prices (stocks and bonds) and capital goods. By the time the Fed belatedly
tightened in 1928, it was far too late and, in the Austrian view, a depression was inevitable.

According to the Austrians, the artificial interference in the economy was a disaster prior to
the Depression, and government efforts to prop up the economy after the crash of 1929 only
made things worse. According to Rothbard, government intervention delayed the market's
adjustment and made the road to complete recovery more difficult.[29]

Furthermore, Rothbard criticizes Milton Friedman's assertion that the central bank failed to
inflate the supply of money. Rothbard asserts that the Federal Reserve bought $1.1 billion of
government securities from February to July 1932, raising its total holding to $1.8 billion.
Total bank reserves rose by only $212 million, but Rothbard argues that this was because the
American populace lost faith in the banking system and began hoarding more cash, a factor
quite beyond the control of the Central Bank. The potential for a run on the banks caused
local bankers to be more conservative in lending out their reserves, and this, Rothbard argues,
was the cause of the Federal Reserve's inability to inflate.[30]


ce? ses??e?
ess$e  y??e??ce?

e ?
ess? y ?
e#s ?μ ?

Two economists of the 1920s, -addill Catchings and -illiam Trufant Foster, popularized a
theory that influenced many policy makers, including Herbert Hoover,Henry A. -allace,
Paul Douglas, and Marriner Eccles. It held the economy produced more than it consumed,
because the consumers did not have enough income. Thus the unequaldistribution of wealth
throughout the 1920s caused the Great Depression.[31][32]

According to this view, wages increased at a rate lower than productivity increases. Most of
the benefit of the increased productivity went into profits, which went into thestock market
bubble rather than into consumer purchases. Say's law no longer operated in this model (an
idea picked up by Keynes).

As long as corporations had continued to expand their capital facilities (theirfactories,

warehouses, heavy equipment, and other investments), the economy had flourished. Under
pressure from the Coolidge administration and from business, the Federal Reserve Board kept
the discount rate low, encouraging high (and excessive) investment. By the end of the 1920s,
however, capital investments had created more plant space than could beprofitably used, and
factories were producing more than consumers could purchase.

According to this view, the root cause of the Great Depression was a global overinvestment
in heavy industry capacity compared to wages and earnings from independent businesses,
such as farms. The solution was the government must pump money into consumers' pockets.
That is, it must redistribute purchasing power, maintain the industrial base, but reinflate
prices and wages to force as much of the inflationary increase in purchasing power into
consumer spending. The economy was overbuilt, and new factories were not needed. Foster
and Catchings recommended[33] federal and state governments start large construction
projects, a program followed by Hoover and Roosevelt.

Franklin D. Roosevelt, elected in 1932 and inaugurated March 4, 1933, blamed the excesses
of big business for causing an unstable bubble-like economy. Democrats believed the
problem was that business had too much money, and theNew Deal was intended as a
remedy, by empowering labor unions and farmers and by raising taxes on corporate profits.
In addition, excess price and entry competition, integrated banking, and the sheer size of
corporations were viewed as contributing factors.[34] Regulation of the economy was a
favorite remedy to this problem.


ess??e?e?Ses ?s?
-c?? ve
s ?s??cs?ye
s ? s?se??e?ey?eves??e?

Various countries around the world started to recover from the Great Depression at different
times. In most countries of the world recovery from the Great Depression began in 1933.[1] In
the United States recovery began in the spring of 1933.[1] However, the U.S. did not return to
1929 GNP for over a decade and still had an unemployment rate of about 15% in 1940, albeit
down from the high of 25% in 1933.
There is no consensus among economists regarding the motive force for the U.S. economic
expansion that continued through most of the Roosevelt years (and the sharp contraction of
the 1937 recession that interrupted it). According to Christina Romer, the money supply
growth caused by huge international gold inflows was a crucial source of the recovery of the
United States economy, and that the economy showed little sign ofself-correction. The gold
inflows were partly due to devaluation of the U.S. dollar and partly due 
to deterioration of the
political situation in Europe. In their book, i ‘
Milton Friedman and Anna J. Schwartz also attributed the recovery to monetary factors, and
contended that it was much slowed by poor management of money by theFederal Reserve
System. Current Chairman of the Federal Reserve Ben Bernanke agrees that monetary factors
played important roles both in the worldwide economic decline and eventual recovery.[37]
Bernanke, also sees a strong role for institutional factors, particularly the rebuilding and
restructuring of the financial system,[38] and points out that the Depression needs to be
examined in international perspective.[39] Economists Harold L. Cole and Lee E. Ohanian,
believe that the economy should have returned to normal after four years of depression except
for continued depressing influences, and point the finger to the lack of downward flexibility
in prices and wages, encouraged by Roosevelt Administration policies such as theNational
Industrial Recovery Act.[40] Some economists hava called attention to the expectations of
reflation and rising nominal interest rates that Roosevelt's words and actions portended.[41][42]


Economic studies have indicated that just as the downturn was spread worldwide by the
rigidities of the Gold Standard, it was suspending gold convertibility (or devaluing the
currency in gold terms) that did most to make recovery possible.[43] -hat policies countries
followed after casting off the gold standard, and what results followed varied widely.

Every major currency left the gold standard during the Great Depression. Great Britain was
the first to do so. Facing speculative attacks on the pound and depleting gold reserves, in
September 1931 the Bank of England ceased exchanging pound notes for gold and the pound
was floated on foreign exchange markets.

secve †èè]?

Great Britain, Japan, and the Scandinavian countries left the gold standard in 1931. Other
countries, such as Italy and the United States, remained on the gold standard into 1932 or
1933, while a few countries in the so-called "gold bloc", led by France and including Poland,
Belgium and Switzerland, stayed on the standard until 1935±1936.
According to later analysis, the earliness with which a country left the gold standard reliably
predicted its economic recovery. For example, Great Britain and Scandinavia, which left the
gold standard in 1931, recovered much earlier than France and Belgium, which remained on
gold much longer. Countries such as China, which had a silver standard, almost avoided the
depression entirely. The connection between leaving the gold standard as a strong predictor
of that country's severity of its depression and the length of time of its recovery has been
shown to be consistent for dozens of countries, including developing countries. This partly
explains why the experience and length of the depression differed between national


ce?„     Ô Ô  
ce??sc ss?e?ss e??e??e ?÷ 


? ??c
??Œè‰ ?F
 ?e#s ?

The common view among economic historians is that the Great Depression ended with the
advent of -orld -ar II. Many economists believe that government spending on the war
caused or at least accelerated recovery from the Great Depression. However, some consider
that it did not play a great role in the recovery, although it did help in reducing

The massive rearmament policies leading up to -orld -ar II helped stimulate the economies
of Europe in 1937±39. By 1937, unemployment in Britain had fallen to 1.5 million. The
mobilization of manpower following the outbreak of war in 1939 finally ended

America's late entry into the war in 1941 finally eliminated the last effects from the Great
Depression and brought the unemployment rate down below 10%.[48] In the United States,
massive war spending doubled economic growth rates, either masking the effects of the
Depression or essentially ending the Depression. Businessmen ignored the mountingnational
debt and heavy new taxes, redoubling their efforts for greater output to take advantage of
generous government contracts.

Productivity soared: most people worked overtime and gave up leisure activities to make
money after so many hard years. People accepted rationing and price controls for the first
time as a way of expressing their support for the war effort. Cost-plus pricing in munitions
contracts guaranteed businesses a profit no matter how many mediocre workers they
employed or how inefficient the techniques they used. The demand was for a vast quantity of
war supplies as soon as possible, regardless of cost. Businesses hired every person in sight,
even driving sound trucks up and down city streets begging people to apply for jobs. New
workers were needed to replace the 11 million working-age men serving in the military.[48]

The majority of countries set up relief programs, and most underwent some sort of political
upheaval, pushing them to the left or right. In some states, the desperate citizens turned
toward nationalist demagogues²the most infamous being Adolf Hitler²setting the stage for
-orld -ar II in 1939.


ess?? s

Australia's extreme dependence on agricultural and industrialexports meant it was one of the
hardest-hit countries in the -estern world, amongst the likes of Canada and Germany.
Falling export demand and commodity prices placed massive downward pressures on wages.
Further, unemployment reached a record high of 29% in 1932,[49] with incidents of civil
unrest becoming common. After 1932, an increase in wool and meat prices led to a gradual


 ? ?


Harshly impacted by both the global economic downturn and theDust Bowl, Canadian
industrial production had fallen to only 58% of the 1929 level by 1932, the second lowest
level in the world after the United States, and well behind nations such as Britain, which saw
it fall only to 83% of the 1929 level. Total national income fell to 56% of the 1929 level,
again worse than any nation apart from the United States. Unemployment reached 27% at the
depth of the Depression in 1933.[50] During the 1930s, Canada employed a highly restrictive
immigration policy.[51]


See also: Economic history of Chile

Chile initially felt the impact of the Great Depression in 1930, when GDP dropped 14
percent, mining income declined 27 percent, and export earnings fell 28 percent. By 1932
GDP had shrunk to less than half of what it had been in 1929, exacting a terrible toll in
unemployment and business failures. The League of Nations labeled Chile the country
hardest hit by the Great Depression because 80 percent of government revenue came from
exports of copper and nitrates, which were in low demand.

Influenced profoundly by the Great Depression, many national leaders promoted the
development of local industry in an effort to insulate the economy from future external
shocks. After six years of government austerity measures, which succeeded in reestablishing
Chile's creditworthiness, Chileans elected to office during the 1938±58 period a succession of
center and left-of-center governments interested in promoting economic growth by means of
government intervention.

Prompted in part by the devastating earthquake of 1939, the Popular Front government of
Pedro Aguirre Cerda created the Production Development Corporation (Corporación de
Fomento de la Producción, CORFO) to encourage with subsidies and direct investments an
ambitious program of import substitution industrialization. Consequently, as in other Latin
American countries, protectionism became an entrenched aspect of the Chilean economy.


Main article: Great Depression in France

The Depression began to affect France around 1931. France's relatively high degree of self-
sufficiency meant the damage was considerably less than in nations like Germany. However,
hardship and unemployment were high enough to lead to rioting and the rise of the socialist
Popular Front.


"e?y ??sees?


Germany's -eimar Republic was hit hard by the depression, as American loans to help
rebuild the German economy now stopped.[52] Unemployment soared, especially in larger
cities, and the political system veered toward extremism.[53] The unemployment rate reached
nearly 30% in 1932.[54] Repayment of the war reparations due by Germany were suspended in
1932 following the Lausanne Conference of 1932. By that time Germany had repaid 1/8th of
the reparations. Hitler's Nazi Party came to power in January 1933.


e??s?e?" c?
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s ?s c?s?r?e
es †§§]?

The Great Depression did not strongly affect Japan. The Japanese economy shrank by 8%
during 1929±31. However, Japan's Finance Minister Takahashi Korekiyo was the first to
implement what have come to be identified as Keynesian economic policies: first, by large
fiscal stimulus involving deficit spending; and second, by devaluing the currency. Takahashi
used the Bank of Japan to sterilize the deficit spending and minimize resulting inflationary
pressures. Econometric studies have identified the fiscal stimulus as especially effective.[56]

The devaluation of the currency had an immediate effect. Japanese textiles began to displace
British textiles in export markets. The deficit spending, however proved to be most profound.
The deficit spending went into the purchase of munitions for the armed forces. By 1933,
Japan was already out of the depression. By 1934 Takahashi realized that the economy was in
danger of overheating, and to avoid inflation, moved to reduce the deficit spending that went
towards armaments and munitions. This resulted in a strong and swift negative reaction from
nationalists, especially those in the Army, culminating in his assassination in the course of the
February 26 Incident. This had a chilling effect on all civilian bureaucrats in the Japanese
government. From 1934, the military's dominance of the government continued to grow.
Instead of reducing deficit spending, the government introduced price controls and rationing
schemes that reduced, but did not eliminate inflation, which would remain a problem until the
end of World War II.

The deficit spending had a transformative effect on Japan. Japan's industrial production
doubled during the 1930s. Further, in 1929 the list of the largest firms in Japan was
dominated by light industries, especially textile companies (many of Japan's automakers, like
Toyota, have their roots in the textile industry). By 1940 light industry had been displaced by
heavy industry as the largest firms inside the Japanese economy.[57]


Main article: Great Depression in Latin America

Because of high levels of United States investment in Latin American economies, they were
severely damaged by the Depression. Within the region, Chile, Bolivia and Peru were
particularly badly affected.


Main article: Great Depression in the Netherlands

From roughly 1931 until 1937, the Netherlands suffered a deep and exceptionally long
depression. This depression was partly caused by the after-effects of the Stock Market Crash
of 1929 in the United States, and partly by internal factors in the Netherlands. Government
policy, especially the very late dropping of the Gold Standard, played a role in prolonging the
depression. The Great Depression in the Netherlands led to some political instability and
riots, and can be linked to the rise of the Dutch national-socialist party NSB. The depression
in the Netherlands eased off somewhat at the end of 1936, when the government finally
dropped the Gold Standard, but real economic stability did not return until after World War

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ess †§]?

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svsy's?e ?
ess? ss?
e??e?Sve? ?y?e



??Œº7-º †D]?


ess??S ?

As world trade slumped, demand for South African agricultural and mineral exports fell
drastically. The Carnegie Commission on Poor -hites had concluded in 1931 that nearly
one-third of Afrikaners lived as paupers. It is believed that the social discomfort caused by
the depression was a contributing factor in the 1933 split between the "gesuiwerde" (purified)
and "smelter" (fusionist) factions within the National Party and the National Party's
subsequent fusion with the South African Party.[61]



Having removed itself from the capitalist world system both by choice and as a result of
efforts of the capitalist powers to isolate it, the Great Depression had little effect on the
Soviet Union. A Soviet trade agency in New York advertised 6,000 positions and received
more than 100,000 applications.[62] Its apparent immunity to the Great Depression seemed to
validate the theory of Marxism and contributed to Socialist and Communist agitation in
affected nations. Many -estern intellectuals, like New York Times reporter -alter Duranty,
looked upon Soviet Union with sympathies, ignoring criticisms about Soviet famine that
killed millions of people.[63] President Roosevelt also looked upon Soviet Union with
sympathies, favoring closer diplomatic and economic ties between two countries.[64]



The effects on the industrial areas of Britain were immediate and devastating, as demand for
British products collapsed. By the end of 1930 unemployment had more than doubled from 1
million to 2.5 million (20% of the insured workforce), and exports had fallen in value by
50%. In 1933, 30% of Glaswegians were unemployed due to the severe decline in heavy
industry. In some towns and cities in the north east, unemployment reached as high as 70% as
ship production fell 90%.[65] The National Hunger March of September±October 1932 was
the largest[66] of a series of hunger marches in Britain in the 1920s and 1930s. About 200,000
unemployed men were sent to the work camps, which continued in operation until 1939.[67]

Scs ? ? ?y?e?B s?

s ??e?cs?s ?s ? ?

s?cce?y?s??ce? s ?Œº‰†D]?




Bee? es ?
?" ve
?s" ?c
s? e?y?
ses ?e
e? se?y?
cse?se ?

President Herbert Hoover started numerous programs, all of which failed to reverse the
downturn.[69] In June 1930 Congress approved the Smoot-Hawley Tariff Act which raised
tariffs on thousands of imported items. The intent of the Act was to encourage the purchase
of American-made products by increasing the cost of imported goods, while raising revenue
for the federal government and protecting farmers. However, other nations increased tariffs
on American-made goods in retaliation, reducing international trade, and worsening the
Depression.[70] In 1931 Hoover urged the major banks in the country to form a consortium
known as the National Credit Corporation (NCC).[71] By 1932 unemployment had reached
23.6%, and it peaked in early 1933 at 25%,[72] a drought persisted in the agricultural
heartland, businesses and families defaulted on record numbers of loans,[73] and more than
5,000 banks had failed.[74] Hundreds of thousands of Americans found themselves homeless
and they began congregating in the numerous Hoovervilles that had begun to appear across
the country.[75] In response, President Hoover and Congress approved the Federal Home Loan
Bank Act, to spur new home construction, and reduce foreclosures. The final attempt of the
Hoover Administration to stimulate the economy was the passage of the Emergency Relief
and Construction Act (ERA) which included funds for public works programs such as dams
and the creation of the Reconstruction Finance Corporation (RFC) in 1932. The RFC's initial
goal was to provide government-secured loans to financial institutions, railroads and farmers.
Quarter by quarter the economy went downhill, as prices, profits and employment fell,
leading to the political realignment in 1932 that brought to power Franklin Delano Roosevelt.


?y?cs ?Œº§ ?


Shortly after President Roosevelt was inaugurated in 1933, drought and erosion combined to
cause the Dust Bowl, shifting hundreds of thousands of displaced persons off their farms in
the Midwest. From his inauguration onward, Roosevelt argued that restructuring of the
economy would be needed to prevent another depression or avoid prolonging the current one.
New Deal programs sought to stimulate demand and provide work and relief for the
impoverished through increased government spending and the institution of financial
reforms. The Securities Act of 1933 comprehensively regulated the securities industry. This
was followed by the Securities Exchange Act of 1934 which created the Securities and
Exchange Commission. Though amended, key provisions of both Acts are still in force.
Federal insurance of bank deposits was provided by the FDIC, and the Glass-Steagall Act.
The institution of the National Recovery Administration (NRA) remains a controversial act to
this day. The NRA made a number of sweeping changes to the American economy until it
was deemed unconstitutional by the Supreme Court of the United States in 1935.

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?º?? eye?y ?e?e
e?e? ??e?
?cs?e?y?e? †7D]?

Early changes by the Roosevelt administration included:

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á? Se? ?
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se?es ??c
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c? sesses??

These reforms, together with several other relief and recovery measures, are called theFirst
New Deal. Economic stimulus was attempted through a new alphabet soup of agencies set up
in 1933 and 1934 and previously extant agencies such as theReconstruction Finance
Corporation. By 1935, the "Second New Deal" added Social Security (which did not start
making large payouts until much later), a jobs program for the unemployed (the -orks
Progress Administration, -PA) and, through the National Labor Relations Board, a strong
stimulus to the growth of labor unions. In 1929, federal expenditures constituted only 3% of
the GDP. The national debt as a proportion of GNP rose under Hoover from 20% to 40%.
Roosevelt kept it at 40% until the war began, when it soared to 128%.

By 1936, the main economic indicators had regained the levels of the late 1920s, except for
unemployment, which remained high at 11%, although this was considerably lower than the
25% unemployment rate seen in 1933.

?eye?‰??º?? eye?? se?

In the spring of 1937, American industrial production exceeded that of 1929 and remained
level until June 1937. In June 1937, the Roosevelt administration cut spending and increased
taxation in an attempt to balance the federal budget.[77] The American economy then took a
sharp downturn, lasting for 13 months through most of 1938. Industrial production fell almost
30 per cent within a few months and production of durable goods fell even faster.
Unemployment jumped from 14.3% in 1937 to 19.0% in 1938, rising from 5 million to more
than 12 million in early 1938.[78] Manufacturing output fell by 37% from the 1937 peak and
was back to 1934 levels.[79] Producers reduced their expenditures on durable goods, and
inventories declined, but personal income was only 15% lower than it had been at the peak in
1937. As unemployment rose, consumers' expenditures declined, leading to further cutbacks
in production. By May 1938 retail sales began to increase, employment improved, and
industrial production turned up after June 1938. [80] After the recovery from the Recession of
1937±1938, conservatives were able to form a bipartisan conservative coalition to stop
further expansion of the New Deal and, when unemployment dropped to 2%, they abolished
WPA, CCC and the PWA relief programs. Social Security, however, remained in place.

There has always been debate among politicians and scholars as to whether New Deal
policies lengthened and deepened the Depression. One small voluntary response survey from
85 PhD holding members of the Economic History Society, which the author stated may not
be representative of all economic historians, showed that there were statistically different
opinions between economic historians who taught or studied economic history and those that
taught or studied economic theory. The former were in consensus that the New Deal did not
lengthen and deepen the depression, while the latter were more evenly divided.[81]


The crisis had many political consequences, among which was the abandonment of classic
economic liberal approaches, which Roosevelt replaced in the United States with Keynesian
policies. These policies magnified the role of the federal government in the national
economy. Between 1933 and 1939, federal expenditure tripled, and Roosevelt's critics
charged that he was turning America into a socialist state.[82] The Great Depression was a
main factor in the implementation of social democracy and planned economies in European
countries after World War II. (see Marshall Plan). Although Austrian economists had
challenged Keynesianism since the 1920s, it was not until the 1970s, with the influence of
Milton Friedman that the Keynesian approach was politically questioned.[83]


The rise of the Technocracy movement occurred around the transition time of the Hoover
administration into that of Franklin Roosevelts administration. The Technocrats advocated a
Non-market economics system based on Energy accounting, which was also a non political
approach (biophysical economics) to governance.[84] Technocracy held that all politics and all
economic arrangements based on the Price system (i.e., based on traditional economic theory)
were antiquated. Also that building a successful modern government could be based on
engineering principles. "Production for use," a term they used, was meant as a contrast to
production for profit in the capitalist system. Production for use became a slogan for many of
the radical-left movements of the era also. Upton Sinclair, among others, affirmed his belief
in "production for use" and the Technocrats briefly made common cause with Sinclair, and
even Huey Long, in California. But the Technocrats were not of the political left, as they held
every political and economic system, from the left to the right, to be unsound. As a mass
movement its real center was California where it claimed half a million members in 1934.
Technocracy counted among its admirers such men as the novelist H.G. Wells, the author
Theodore Dreiser and the economist Thorstein Veblen. Among the collection of movements
of the 1930s, the Technocracy movement survives into the present day.[85]

The U.S. Depression has been the subject of much writing, as the country has sought to re-
evaluate an era that caused emotional as well as financial trauma to its people. Perhaps the
most noteworthy and famous novel written on the subject is  X
 , published
in 1939 and written by John Steinbeck, who was awarded both the Nobel Prize for literature
and the Pulitzer Prize for the work. The novel focuses on a poor family of sharecroppers who
are forced from their home as drought, economic hardship, and changes in the agricultural
industry occur during the Great Depression. Steinbeck's     is another
important novel about a journey during the Great Depression.  X  
  is a
novella written by Alon Bersharder about a sad, disgruntled temporary worker, making the
title both a homage to the historical event and a pun. Additionally, Harper Lee's 
 is set during the Great Depression. Margaret Atwood's Booker prize-winning
  i   is likewise set in the Great Depression, centering on a privileged
socialite's love affair with a Marxist revolutionary. The era spurred the resurgence of social
realism, practiced by many who started their writing careers on relief programs such as the
Federal Writers' Project; that experience and its effects is described in the history 
 i , by David Taylor (2009).

V'    '

There have been other downturns called a "Great Depression," but none has been as
worldwide for so long. British economic historians used the term "Great depression" to
describe British conditions in the late 19th century, especially in agriculture, 1873±1896, a
period also referred to as the Long Depression.[86] Several Latin American countries had
severe downturns in the 1980s. Finnish economists refer to the Finnish economic decline
around the breakup of the Soviet Union (1989±1994) as a great depression. Kehoe and
Prescott define a great depression to be a period of diminished economic output with at least
one year where output is 20% below the trend. By this definition Argentina, Brazil, Chile,
and Mexico experienced great depressions in the 1980s, and Argentina experienced another
in 1998±2002. This definition also includes the economic performance of New Zealand from
1974±1992 and Switzerland from 1973 to the present, although this designation for
Switzerland has been controversial.[87][88]

The economic crisis in the 1990s that struck former members of the Soviet Union was almost
twice as intense as the Great Depression in the countries of Western Europe and the United
States in the 1930s. [89][90] Average standards of living registered a catastrophic fall in the
early 1990s in many parts of the former Eastern Bloc - most notably, in post-Soviet states.[91]
Even before Russia's financial crisis of 1998, Russia's GDP was half of what it had been in
the early 1990s.[90] Some populations are still poorer today than they were in 1989 (e.g.
Ukraine, Moldova, Serbia, Central Asia, Caucasus). The collapse of the Soviet planned
economy and the transition to market economy resulted in catastrophic declines in GDP of
about 45% during the 1990±1996 period [92] and poverty in the region had increased more than

? ?   ???   ? ?   


??   ? ?    ?   ?  ?  ?     ?
A.? Classical Theory believes that full-employment is the employment level the economy will
return to, and tends to remain at in the long run. Graphically, the pure Classical theorists
would have a vertical AS curve that shows the same GDP (GDP*) associated with full-
employment, at each price-level in the economy.
B.? Keynesian Theory holds that unemployment is the normal state of the economy and
significant government intervention is required if employment/output targets are to be
reached. In this view, AS is horizontal.
C.? The Classical reasoning:
Œ.? Say͛s law: Supply creates its own Demand. This reflects the ͞simple circular-flow

model, that had firms employing all the resources (which are owned by
households) and the costs of these inputs is the income people use to buy all of the
output firms produce.
‰.? Abstinence Theory of Interest: To a great extent, it is the interest rate that
influences people͛s savings. Money they do not spend (savings) becomes part of the
supply in the market for loanable funds. The quantity (horizontal axis) is dollars lent
out; the price of loanable funds is the interest rate. Business investment spending (I)
is also dependent on the interest rate, which will cause S=I in the long run.
º.? Classical theorists held that wages and prices would change proportionately. For
example, imagine the prevailing salary is $Œ, a year, and firms have hired so
many people at that cost because demand is very high, causing output to increase 
and more labor hired shrinks the pool of those unemployed. This becomes an
expansion that is not sustainable, above long-run potential AS, which is vertical. All
the spending in the economy and the input costs getting passed on to consumers
both cause prices to rise. High prices in the product market signal AD to shift left
and high wage rates (input costs) cause layoffs (firm decrease output).
In a recession Classical theorists believed a ‰ reduction in wages (to $,) would
mean a ‰ decrease in prices as well. Through wage-price flexibility, output could be
maintained at the long run level.

D.? Keynesian critique of Classical Theories

(John Maynard Keynes μ-ΏD)

Œ.? Say͛s Law  Does better describing the conditions in which it was written (Œth
Century France) than industrialized economies. Modern economies have
decentralized production but often profit makers are remote and far from the
production. Many employees never buy their firm͛s products, and wages have an
effect on costs, but not the firm͛s revenue (total sales). There are many ways to
increase Demand more effectively than to push for more output to be produced.
‰.? Abstinence Theory of Interest  to the idea that I=S at the market clearing interest
rate, Keynes argued that Investors and savers have different motivations. Rather
than just the interest rate, their decision on how much to save or invest depends on
other factors:
i.? Savings may be based on a regular amount being put aside for retirement. It
may be for a purchase in the near future (car, house, college fund)
ii.? Investment depends on firms͛ expectations about GDP, Prices, Industry

º.? Wage-Price Flexibility  monopoly power of suppliers restricts flexibility in prices.

Unions restricts flexibility in wages. In deflation, debt worsens (becomes more
costly to the debtor in real terms). Because people are more aware of nominal than
real savings, any decrease in the price-level would have to be dramatic to cause
consumption to increase. (The Classical notion of the Pigou Effect stated that falling
prices increase asset value and make people feel wealthier and consume more)

Central Keynesian Conclusions:

Œ.? AD determines Real GDP

‰.? In the short run, AD can be adjusted to achieve target GDP and unemployment
levels with prices not changing (fixed, flat prices)
º.? When operating at a level other than capacity GDP (Y*) there are no forces to
automatically restore Y*
Usually, either unemployment (low Demand) or inflation (high Demand) exist.

One of the major implications of Keynesian conclusion is that government

involvement (through active fiscal policy) is essential to achieve Y*. Therefore some economists

regard Keynes as a modern-day ͞mercantilist referring to the theory that governments should be
responsible for economic welfare.

II. AS-AD Analysis

A. Aggregate Demand-Aggregate Supply (AD-AS) Analysis

Œ. AD is the measure of entire planned spending on final goods and services at each level of
prices and RGDP.

i. The AD-AS graph is similar to the Demand and Supply for a single good. However,
on the horizontal axis is RGDP (real output, instead of Quantity of the single good) and the vertical
axis is the price level (tracked by an index like the CPI).

ii. At the equilibrium price level (where AD and AS cross) real output that AD plans
to purchase equals the output AS plans to produce.

iii. AD is determined by the four spending sectors. In other words these are AD͛s

Œ. Consumption is influenced by several factors. Some of the most

important are Disposable Income (which will change if taxes change), Availability of credit (indicated
by the interest rate, which is determined in the market for loanable funds-meaning credit), and
consumer expectations.

‰. Investment spending depends largely on interest rates, government

policies regarding business, and expectations.

º. Government expenditures are often    to the budget, although

Congress and the President can make substantial changes in the level and type of spending that goes
on. They may implement new spending programs that are to be automatically countercyclical, or

eliminate existing ͞automatic stabilizers. The automatic stabilizer would be any policy that

a.) Is Countercyclical:

It would lead to expansionary fiscal policy (such as Government spending increases) in bad
economies and contractionary fiscal policies (like tax increases) in good economies.

b.) Is Automatic

It fluctuates (without any new legislation needed) in immediate response to a change in income.
Examples: Income-Security payments (G rises when Y falls), progressive income tax system (T rises
when Y rises).

è. Net Exports are influenced by:

i. Trade Policy. Existence of tariffs or quotas on imports will decrease the imports
flowing into a country. So if a U.S. trading partner restricts the quantity of a certain good they will

import from us, that ͞quota will decrease our exports. The same is true if this trading partner

imposes a ͞tariff, a tax on the imported goods.

ii. Exchange rates. If the dollar is cheaper relative to foreign currencies, our exports
will increase because US producers (who want to be paid in dollars) are now making goods that the
rest of the world finds cheaper.

Net Exports (X-M) will also increase because M (imports) decreases in this example since foreign
goods have become more expensive due to the fact that the dollar does not go as far in purchasing
the foreign currency.

iii. Politics. Sometimes laws abroad will limit the profitability and income US
producers can make there by requiring that part of the production be owned by companies in their

A demand shock will shift the entire AD curve if there is a curve in C, I, G, or Xn.

Some positive shocks to aggregate demand would be: Tax cut for individuals (C increases), Interest
rate cute (C and I increase), or G increasing. Shocks that would shift AD to the left including
worsening consumer expectations (C decreases) or consumers buying more imports (Xn decreases).
B. Why does AD slope downward?

Œ. Downward Sloping Due to:

i.The wealth effect

If the nominal value of everyone in a country͛s Assets=A, then Real Assets would be expressed as
A/P or nominal assets over the price level (P). Moving down (to a lower price level) in the AD
diagram is associated with more output demanded since the real value of people͛s wealth (assets)
has increased. Some of that increase in purchasing power will stimulate increased goods and
services purchases, thus moving horizontally in response to the fall in Prices

ii. The Interest Rate Effect

Real Money balances M/P increase with a fall in P, meaning the real value of the money supply (to
be detailed in Chapter ŒŒ) increases and banks have more to lend out. The increase in loanable funds
decreases the price of those funds: the interest rate. This means more output demanded (horizontal
movement in the AD response to the falling Price level) as consumer loans and business debt
increase to finance more purchases. Remember the low (falling) inflation, or even deflation, enables
banks to charge lower nominal interest rates and still get a stable real interest rate on loans.

iii. International effect

Ceteris Paribus, if prices are falling in the U.S. for domestically produced goods, we͛ll be buying
fewer imports (increasing Aggregate Quantity Demanded)

iv. Multiplier Effect

Detailed in Chapter Œ, it amplifies the other effects because of the ͞rounds of spending that occur
when an exogenous shock, positive or negative, to some spending sector plays out over the near
future. For example, if the government raises taxes, that will restrain consumer spending, and C is a
major portion of expenditures. But the story doesn͛t end there, because the lost spending is lost
revenue for many businesses and individuals who will in turn cut back a bit on their own spending
and some saving. But these people who have responded to the revenue loss now set off the next
group of businesses and individuals who would have received the spending, and they respond just
the same. It may be more intuitive to think of a positive exogenous shock, like a stock market boom.
C. Aggregate Supply

As measures the entire desired output of final goods and services at each level of prices and RGDP.
The shocks that can shift AS are

Œ. Input costs, and the availability of resources.

‰. Capacity of capital and other factors of production

º. Investment plans (inversely related to the interest rate)

Directly relates to the level of capacity utilization

è. Technology.

§. Productivity

D. Expectations  about a variety of indications including the price level, consumer spending,
and industry conditions.

7. Gov͛t policies. An increase in regulations and laws hindering and putting conditions on
private sector output will be a negative shock to AS while deregulation would be a positive shock.

The book adds to these: Excise and Sales taxes and import prices as shifters, which, along with those
listed above, comprise shift factors for SAS or Short-run AS.

LAS or Long-run AS can only be shifted by a real change in $ of available inputs ((‰) above, or (è) and
(§) above which make existing inputs produce at a higher level of potential output.

Therefore ‰, è and § shift both SAS and LAS, which is easiest to draw with a kinked AS where both
the diagonal and vertical portions shift right.

D. The Upward slope of the AS curve is due to diminishing productivity of resources. As prices
rise and firms strive to take in more profits by producing more output, they have to hire more
factors of production. The additional labor is not as productive as the original workers who have
been working there longer and were the first people the company decided to hire due to their skills.
The additional workers decrease the average productivity per worker, making costs rise as output
In the opposite direction, moving down along an AS curve, less demand putting downward
pressure on prices signals to suppliers they should produce less. They layoff workers who are
generally the less productive, less senior, lower skilled of their workers. The increase in average
productivity lowers costs to the firm and makes them willing to offer the decreased level of output
at lower prices.

E. The AS curve is best understood as having three distinct ͞ranges the first being horizontal,
the second diagonal, and the third vertical. The vertical portion is the full-employment range, and it
follows a vertical line straight up from the potential output level (the RGDP* if the economy is at the
natural rate of unemployment).

AD can increase through the full-employment range, but it will only raise prices, not RGDP.

Bottlenecks are associated with the diagonal portion; the economy can produce more, but
producers experience productivity loss and thus higher costs that are getting passed on to
consumers. RGDP and the price level both increase as AD moves to the right through this region.

The horizontal portion is ͞Unemployment where output can be increased by whatever amount AD
requires with no increase in prices.

- j   

A microeconomic law that states that, all other factors being equal, as the price of a good or service
increases, consumer demand for the good or service will decrease and vice versa.
 is an economic law that states that consumers buy more of a good when
its price decreases and less when its price increases (ceteris paribus).

The greater the amount to be sold, the smaller the price at which it is offered must be in order
for it to find purchasers.

Law of demand states that the amount demanded of a commodity and its price are inversely
related, other things remaining constant. That is, if the income of the consumer, prices of the
related goods, and tastes and preferences of the consumer remain unchanged, the consumer¶s
demand for the good will move opposite to the movement in the price of the good.

"If the price of the good increases, the quantity demanded decreases, while if price of the
good decreases, its quantity demanded increases."

c  ? 
" " #$#%  ?


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In economics, a
 is a factor of proportionality that measures how much an
endogenous variable changes in response to a change in some exogenous variable.

That is, suppose a one-unit change in some variable r causes another variable  to change by
 units. Then the multiplier is .


á? Œ Common uses
m? Œ.Œ Money multiplier
m? Œ.‰ Fiscal multipliers
m? Œ.º Keynesian multiplier
á? ‰ General method
á? º History
á? è References

† Ô

Two multipliers are commonly discussed in introductory macroeconomics.

† c  

Main article: Money multiplier

See also: Fractional-reserve banking

In monetary macroeconomics and banking, the    

  measures how much the
money supply increases in response to a change in the monetary base.

The multiplier may vary across countries, and will also vary depending on what measures of
money are considered. For example, consider M2 as a measure of the U.S. money supply, and
M0 as a measure of the U.S. monetary base. If a $1 increase in M0 by the Federal Reserve
causes M2 to increase by $10, then the money multiplier is 10.


Main article: Fiscal multiplier

Multipliers can be calculated to analyze the effects of fiscal policy, or other exogenous
changes in income and spending, on aggregate output.

For example, if an increase in German government spending by ¼100, with no change in

taxes, causes German GDP to increase by ¼150, then the
  is 1.5. Other
types of    
  can also be calculated, like multipliers that describe the effects of
changing taxes (such as lump-sum taxes or proportional taxes).


Keynesian economists often calculate multipliers that measure the effect on aggregate
demand only. (To be precise, the usual     
  formulas measure how much the
IS curve shifts left or right in response to an exogenous change in income or spending.)
Opponents of Keynesianism have sometimes argued that Keynesian multiplier calculations
are misleading; for example, according to the theory of rational expectations, it is impossible
to calculate the effect of deficit-financed government spending on demand without specifying
how people expect the deficit to be paid off in the future.

Ô  '( ?  ?  ?

( (

& (CPI) is a measure estimating the average price of consumer goods
and services purchased by households. A consumer price index measures a price change for a
constant market basket of goods and services from one period to the next within the same
area (city, region, or nation).[1] It is a price index determined by measuring the price of a
standard group of goods meant to represent the typical market basket of a typical urban
consumer.[2] Related, but different, terms are the United Kingdom's CPI, RPI, and RPIX. It is
one of several price indices calculated by most national statistical agencies. The percent
change in the CPI is a measure estimating inflation. The CPI can be used to index (i.e., adjust
for the effect of inflation on the real value of money: the medium of exchange) wages,
salaries, pensions, and regulated or contracted prices. The CPI is, along with the population
census and the National Income and Product Accounts, one of the most closely watched
national economic statistics.

Two basic types of data are needed to construct the CPI: price data and weighting data. The
price data are collected for a sample of goods and services from a sample of sales outlets in a
sample of locations for a sample of times. The weighting data are estimates of the shares of
the different types of expenditure as fractions of the total expenditure covered by the index.
These weights are usually based upon expenditure data obtained for sampled decades from a
sample of households. Although some of the sampling is done using a sampling frame and
probabilistic sampling methods, much is done in a commonsense way (purposive sampling)
that does not permit estimation of confidence intervals. Therefore, the sampling variance is
normally ignored, since a single estimate is required in most of the purposes for which the
index is used. Stocks greatly affect this cause.

The index is usually computed yearly, or quarterly in some countries, as a weighted average
of sub-indices for different components of consumer expenditure, such as food, housing,
clothing, each of which is in turn a weighted average of sub-sub-indices. At the most detailed
level, the elementary aggregate level, (for example, men's shirts sold in department stores in
San Francisco), detailed weighting information is unavailable, so elementary aggregate
indices are computed using an unweighted arithmetic or geometric mean of the prices of the
sampled product offers. (However, the growing use of scanner data is gradually making
weighting information available even at the most detailed level.) These indices compare
prices each month with prices in the price-reference month. The weights used to combine
them into the higher-level aggregates, and then into the overall index, relate to the estimated
expenditures during a preceding whole year of the consumers covered by the index on the
products within its scope in the area covered. Thus the index is a fixed-weight index, but
rarely a true Laspeyres index, since the weight-reference period of a year and the price-
reference period, usually a more recent single month, do not coincide. It takes time to
assemble and process the information used for weighting which, in addition to household
expenditure surveys, may include trade and tax data.

Ideally, the weights would relate to the composition of expenditure during the time between
the price-reference month and the current month. There is a large technical economics
literature on index formulae which would approximate this and which can be shown to
approximate what economic theorists call a true cost of living index. Such an index would
show how consumer expenditure would have to move to compensate for price changes so as
to allow consumers to maintain a constant standard of living. Approximations can only be
computed retrospectively, whereas the index has to appear monthly and, preferably, quite
soon. Nevertheless, in some countries, notably in the United States and Sweden, the
philosophy of the index is that it is inspired by and approximates the notion of a true cost of
living (constant utility) index, whereas in most of Europe it is regarded more pragmatically.

The coverage of the index may be limited. Consumers' expenditure abroad is usually
excluded; visitors' expenditure within the country may be excluded in principle if not in
practice; the rural population may or may not be included; certain groups such as the very
rich or the very poor may be excluded. Saving and investment are always excluded, though
the prices paid for financial services provided by financial intermediaries may be included
along with insurance.

The index reference period, usually called the base year, often differs both from the weight-
reference period and the price reference period. This is just a matter of rescaling the whole
time-series to make the value for the index reference-period equal to 100. Annually revised
weights are a desirable but expensive feature of an index, for the older the weights the greater
is the divergence between the current expenditure pattern and that of the weight reference-

) )
 ?  ? *


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In economics, a   
   or simply   ) is a
redistribution of income in the market system. These payments are considered to be
nonexhaustive because they do not directly absorb resources or create output. Examples of
certain transfer payments include welfare (financial aid), social security, and government
subsidies for certain businesses (firms).

( ÿ  X  
 c )
Expenditures made in the private sector by all levels of government, such as when a
government entity contracts a construction company to build office space or pave highways.

x? ?Ô? ?


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ce's?  „      Ô ?Secc?cce
 ??e??e ?See?e's? e??
?s ess ?÷+


x  Ô
(or xÔ Theory) is a class of macroeconomic models in which
business cycle fluctuations to a large extent can be accounted for by real(in contrast to
nominal) shocks. (The four primary economic fluctuations are secular (trend), business cycle,
seasonal, and random.) Unlike other leading theories ofthe business cycle, it sees recessions
and periods of economic growth as the efficient response to exogenous changes in the real
economic environment. That is, the level of national output necessarily maximizes  
utility, and government should therefore concentrate on the long-run structural policy
changes and not intervene through discretionaryfiscal or monetary policy designed to
actively smooth economic short-term fluctuations.

According to RBC theory, business cycles are therefore "real" in that they do not represent a
failure of markets to clear, but rather reflect the most efficient possible operation of the
economy, given the structure of the economy. It differs in this way from other theories of the
business cycle, like Keynesian economics and Monetarism, which see recessions as the
failure of some market to clear.

RBC theory is associated with freshwater economics (the Chicago school of economics, in
the neoclassical tradition), and is rejected and harshly criticized by other schools within
mainstream economics, notably Keynesians.


á? Œ?B sess?yces?
á? ‰?Sy(e?Fcs?
á? º?!e?B sess?yce?e
? º Œ?
? º ‰?S
á? è?
á? §?See?s?
á? D?!ee

†  Ô
If we were to take snapshots of an economy at different points in time, no two photos would
look alike. This occurs for two reasons:

Π? y?vce?eces?e#?s se?
?e ??s ?sss?e?
‰ ? e
? c s?
e ? s?ve??
sss??e ?
y?sse ?


A common way to observe such behavior is by looking at a time series of an economy¶s

output, more specifically gross national product (GNP). This is just the value of the goods
and services produced by a country¶s businesses and workers.

Figure 1 shows the time series of real GNP for the United States from 1954-2005. -hile we
see continuous growth of output, it is not a steady increase. There are times of faster growth
and times of slower growth. Figure 2 transforms these levels into growth rates of real GNP
and extracts a smoother growth trend. A common method to obtain this trend is the Hodrick-
Prescott filter. The basic idea is to find a balance between the extent to which general growth
trend follows the cyclical movement (since long term growth rate is not likely to be perfectly
constant) and how smooth it is. The HP filter identifies the longer term fluctuations as part of
the growth trend while classifying the more jumpy fluctuations as part of the cyclical

Observe the difference between this growth component and the jerkier data. Economists refer
to these cyclical movements about the trend as  
 . Figure 3 explicitly captures
such deviations. Note the horizontal axis at 0. A point on this line indicates at that year, there
is no deviation from the trend. All other points above and below the line imply deviations. By
using log real GNP the distance between any point and the 0 line roughly equals the
percentage deviation from the long run growth trend.


-e call relatively large positive deviations (those above the 0 axis) peaks. -e call relatively
large negative deviations (those below the 0 axis) troughs. A series of positive deviations
leading to peaks are booms and a series of negative deviations leading to troughs are

At a glance, the deviations just look like a string of waves bunched together²nothing about
it appears consistent. To explain causes of such fluctuations may appear rather difficult given
these irregularities. However, if we consider other macroeconomic variables, we will observe
patterns in these irregularities. For example, consider Figure 4 which depicts fluctuations in
output and consumption spending, i.e. what people buy and use at any given period. Observe
how the peaks and troughs align at almost the same places and how the upturns and
downturns coincide.


-e might predict that other similar data may exhibit similar qualities. For example, (a) labor,
hours worked (b) productivity, how effective firms use such capital or labor, (c) investment,
amount of capital saved to help future endeavors, and (d) capital stock, value of machines,
buildings and other equipment that help firms produce their goods. -hile Figure 5 shows a
similar story for investment, the relationship with capital in Figure 6 departs from the story.
-e need a way to pin down a better story; one way is to look at some statistics.



* ] 
By eyeballing the data, we can infer several regularities, sometimes called stylized facts. One
is persistence. For example, if we take any point in the series above the trend (the x-axis in
figure 3), the probability the next period is still above the trend is very high. However, this
persistence wears out over time. That is, economic activity in the short run is quite
predictable but due to the irregular long-term nature of fluctuations, forecasting in the long
run is much more difficult if not impossible.

Another regularity is cyclical variability. Column A of Table 1 lists a measure of this with
standard deviations. The magnitude of fluctuations in output and hours worked are nearly
equal. Consumption and productivity are similarly much smoother than output while
investment fluctuates much more than output. Capital stock is the least volatile of the

Yet another regularity is the co-movement between output and the other macroeconomic
variables. Figures 4 - 6 illustrated such relationship. We can measure this in more detail using
correlations as listed in column B of Table 1. Procyclical variables have positive correlations
since it usually increases during booms and decreases during recessions. Vice versa, a
countercyclical variable associates with negative correlations. Acyclical, correlations close to
zero, implies no systematic relationship to the business cycle. We find that productivity is
slightly procyclical. This implies workers and capital are more productive when the economy
is experiencing a boom. They aren¶t quite as productive when the economy is experiencing a
slowdown. Similar explanations follow for consumption and investment, which are strongly
procyclical. Labor is also procyclical while capital stock appears acyclical.

Observing these similarities yet seemingly non-deterministic fluctuations about trend, we

come to the burning question of why any of this occurs. It¶s common sense that people prefer
economic booms over recessions. It follows that if all people in the economy make optimal
decisions, these fluctuations are caused by something outside the decision-making process.
So the key question really is:

† x   Ô    

Economists have come up with many ideas to answer the above question. The one which
currently dominates the academic Real Business Cycle Theory literature was introduced by
Finn E. Kydland and Edward C. Prescott in their seminal 1982 work    i 
i  !   . They envisioned this factor to be technological shocks i.e., random
fluctuations in the productivity level that shifted the constant growth trend up or down.
Examples of such shocks include innovations, bad weather, imported oil price increase,
stricter environmental and safety regulations, etc. The general gist is that something occurs
that directly changes the effectiveness of capital and/or labour. This in turn affects the
decisions of workers and firms, who in turn change what they buy and produce and thus
eventually affect output. RBC models predict time sequences of allocation for consumption,
investment, etc. given these shocks.

But exactly how do these productivity shocks cause ups and downs in economic activity?
Let¶s consider a good but temporary shock to productivity. This momentarily increases the
effectiveness of workers and capital. Also consider a world where individuals produce goods
they consume. The problem with this reasoning is that on aggregate level, this shock would
average out.

Individuals face two types of trade offs. One is the consumption-investment decision. Since
productivity is higher, people have more output to consume. An individual might choose to
consume all of it today. But if he values future consumption, all that extra output might not
be worth consuming in its entirety today. Instead, he may consume some but invest the rest in
capital to enhance production in subsequent periods and thus increase future consumption.
This explains why investment spending is more volatile than consumption. The life cycle
hypothesis argues that households base their consumption decisions on expected lifetime
income and so they prefer to ³smooth´ consumption over time. They will thus save (and
invest) in periods of high income and defer consumption of this to periods of low income.
The other decision is the labor-leisure trade off. Higher productivity encourages substitution
of current work for future work since workers will earn relatively more per hour today
compared to tomorrow. More labor and less leisure results in higher output today. greater
consumption and investment today. On the other hand, there is an opposing effect: since
workers are earning more, they may not want to work as much today and in future periods.
However, given the pro-cyclical nature of labor, it seems that the above ³substitution effect´
dominates this ³income effect´.

Overall, the basic RBC model predicts that given a temporary shock, output, consumption,
investment and labor all rise above their long-term trends and hence formulate into a positive
deviation. Furthermore, since more investment means more capital is available for the future,
a short-lived shock may have an impact in the future. That is, above-trend behavior may
persist for some time even after the shock disappears. This capital accumulation is often
referred to as an internal ³propagation mechanism´ since it converts shocks without
persistence into highly persistent shocks to output.

It is easy to see that a string of such productivity shocks will likely result in a boom.
Similarly, recessions follow a string of bad shocks to the economy. If there were no shocks,
the economy would just continue following the growth trend with no business cycles.

Essentially this is how the basic RBC model qualitatively explains key business cycle
regularities. Yet any good model should also generate business cycles that quantitatively
match the stylized facts in Table 1, our empirical benchmark. Kydland and Prescott
introduced calibration techniques to do just this. The reason why this theory is so celebrated
today is that using this methodology, the model closely mimics many business cycle
properties. Yet current RBC models have not fully explained all behavior and neoclassical
economists are still searching for better variations.

It is important to note the main assumption in RBC theory is that individuals and firms
respond optimally all the time. In other words, if the government came along and forced
people to work more or less than they would have otherwise, it would most likely make
people unhappy. It follows that business cycles exhibited in an economy are chosen in
preference to no business cycles at all. This is not to say that people like to be in a recession.
Slumps are preceded by an undesirable productivity shock which constrains the situation. But
given these new constraints, people will still achieve the best outcomes possible and markets
will react efficiently. So when there is a slump, people are choosing to be in that slump
because given the situation, it is the best solution. This suggests laissez-faire (non-
intervention) is the best policy of government towards the economy but given the abstract
nature of the model, this has been debated.

A pre-cursor to RBC theory was developed by monetary economists Milton Friedman and
Robert Lucas in the early 1970s. They envisioned the factor that influenced people¶s
decisions to be misperception of wages²that booms/recessions occurred when workers
perceived wages higher/lower than they really were. This meant they worked and consumed
more/less than otherwise. In a world of perfect information, there would be no booms or

† Ô   
Unlike estimation, which is usually used for the construction of economic models, calibration
only returns to the drawing board to change the model in the face of overwhelming evidence
against the model being correct; this inverts the burden of proof away from the builder of the
model. Since RBC models explain data ex post, it is very difficult to falsify any one model
that could be hypothesised to explain the data. RBC models are highly sample specific,
leading some to believe that they have little or no predictive power.


Crucial to RBC models, "plausible values" for structural variables such as the discount rate,
and the rate of capital depreciation are used in the creation of simulated variable paths. These
tend to be estimated from econometric studies, with 95% confidence intervals. If the full
range of possible values for these variables is used, correlation coefficients between actual
and simulated paths of economic variables can shift wildly, leading some to question how
successful a model which only achieves a coefficient of 80% really is.

† Ô

Real Business Cycle Theory is a major point of contention within macroeconomics (Summers
1986): RBC theory categorically rejects Keynesian economics and real effectiveness of
monetarism, which are the pillars of mainstream macroeconomic policy, while such noted
mainstream economists as Larry Summers and Paul Krugman categorically reject RBC
theory in turn:

u(My view is that) real business cycle models of the type urged on us by †Ed] Prescott have
nothing to do with the business cycle phenomena observed in the United States or other
capitalist economies.u (Summers ŒD)

Instead, economists in the Keynesian tradition believe that the business cycles observed in the
United States and other capitalist economies in the 20th century are often due to demand side
issues, as in the theory of effective demand, rather than the supply-side only of RBC theory.

By way of specific criticism of RBC theory as avanced by Prescott, (Summers 1986) lists

á? Prescott uses incorrect parameters (one third of household time devoted to market activity
rather than one sixth; historical real interest rates of è rather than Œ );
á? absence of independent evidence for the technology shocks that supposedly cause the
business cycle, and notably being unable to point to technological causes of observed
á? Prescott,s models ignore prices, and its predictions on asset prices are rejected by Œ years
of data by Prescott,s own work;
á? Prescott ignores exchange failures (e.g., failures of factories to trade their goods for workers -
labor), which are central to Keynesian accounts of the causes of the Great Depression,
among other crises.

Instead, credit crunches, a   and  cause, rather than the   causes proposed
by RBC theory, are proposed as better explanations of the business cycle, notably according
with observed recessions, as in the work of (Eckstein and Sinai, 1986).