The Great Depression and negative multiplier effect

The great depression was a period 1929-37 where major economies saw a fall in output, fall in prices, rise in unemployment and real economic hardship. It was precipitated by the stock market crash of 1929, though many other factors caused this initial crash to translate into declining output.

Response to great depression

In the Great Depression the response of classical economists was to cut government spending such as unemployment benefits to try and balance the budget. However the effect of this was to reduce AD further.

  • Keynes argued that in order to help the economy it was necessary for the government to kick start the economy by injecting money into the economy. Keynes argued for public work schemes which would employ those who were unemployed they would then be able to spend money which would create other jobs in the economy.
  • This would cause a budget deficit but it was necessary.
  • Unfortunately Keynes was largely ignored until after the war, leading to high unemployment until the Second World War
  • Ironically the countries who were most successful in overcoming the great depression were military dictatorships who spent significant amounts on military spending

Diagram showing Recession

 

depression

Paradox of Thrift:

  • In a recession Keynes noted that peoples psychology usually caused them to save more and spend less.
  • However this was exactly what the economy didn’t want, because it would reduce AD further. Therefore Keynes argued that it was the job of the govt to encourage people to spend.

Negative multiplier effect

In the great depression we also see a negative multiplier effect, where the initial fall in spending caused bigger final falls in spending, due to decline in economic growth and higher unemployment.

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