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How the Great Depression lead to further spending and fiscal stimulus

The Great Depression began with Black Tuesday, on the Oct 29th 1929 when Wall Street lost $14 in a single day! Unemployment reached 25% and GNP fell by 50% in a year!

It was the belief of classical economists that this departure from the equilibrium of supply and demand would soon change and return itself to the natural equilibrium of the markets. However, John Maynard Keynes, asked ‘how long would the market wait before it settled back into the equilibrium point?’, and therefore challenged the fundamentals of Classical Economics.

‘the difficulty lies, not in the new ideas, but in escaping from the old ones’ – Keynes

‘capitalism holds the belief that the wickedest men will do the wickedest things for the greatest good of everyone’ – Keynes

He challenged Say’s Law, and suggested that without demand there was no market, and that markets do fail. He was adamant that the consumer was more important than the supplier. He believed that the government was required to control ‘aggregate demand’. He believed:

AD = C + (I-S) + (G-T) + (X-M)

AD = aggregate demand
C = consumption
I = investment
S = savings
G = government spending
T = taxes
X = exports
M = imports

He believed that through fiscal stimulus, ie government spending one could achieve a higher rate of investment and thus aggregate demand. This in turn would drive consumption, which would drive up taxes etc. It was his argument that this fiscal stimulus should come through Government Bonds, bought from the idle savings capital so as to increase investment, that would drive AD etc.

The original argument from the classical economist was that if you borrow all the money from the private savings then there is no money for future investment. However, this was overcome by the Multiplier effect, devised by Richard Kahn.

The monetary Multiplier, measures how much the money supply (this is the total amount of assets in an economy, including less liquid deposits and investments) is affected by a change in the monetary base (this is the total of highly liquid assets, notably coins and paper notes, in an economy).

Therefore if the money Multiplier is 5, and the government spends 100M, then the money supply will be 5 x this, and there will be 500M of actual money spent in the economy, assuming a Marginal Propensity to Save (MPS) of 0.8. Thus, within about 6 months, the original loan of 100M is paid back and there has been an additional stimulus for the economy of 400M.

This can be calculated with:

Multiplier = 1 / (1-MPS)

There are several things which can change this Multiplier affect. These include people’s willingness to save money which will depend on interest rates, and people’s willingness to spend/invest. It will also need to consider foreign investments made with this stimulus, and how not all GNI is GDP (ie some firms will remove profits to their own domestic market place).

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