I. Introduction
A. Objectives
1. Describe the origins of recent US recessions
2. Describe what happens to the money supply, interest rates, and aggregate expenditure as the economy contracts
3. Describe what happens in the labor markrt during a recession.
4. Compare the applications of the flexible wage and sticky wage theories during a recession.
5. Describe the onset of the Great Depression in the US in 1929.
6. Describe what happened to the US economy during the depths of the Great Depression.
7. Assess the likeliuhood of another Great Depression in the US.
B. Topics to be covered
1. Three recent recessions
2. The labor market in recession
3. Will there be another Great Depression?
II. Three Recent Recessions
A. The three most recent slumps in the United States occurred in 1974-1975, 1982, and 1990-1991.
B. Recessions can be triggered by a number of different shocks.
C. The 1974-1975 recession was the result of OPEC's large increase in oil prices.
1. Real GDP fell and the price level soared as OPEC's actions shifted the SAS curve to the left.
D. The recession of 1982 (The "Volcker" recession) was caused when the Federal Reserve (unexpectedly) adopted a contractionary monetary policy to lower the high inflation rate.
1. The AD curve fell short of the expected AD curve, and real GDP and the inflation rate both dropped.
E. In 1990 the Gulf crisis doubled the price of oil and boosted uncertainty about the profitability of investment.
1. Thus the SAS curve shifted left due to the higher price of oil.
2. The AD curve also shifted left due to the cut back in investment. Real GDP and the inflation rate began to fall.
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A. Although the cause of recent US recessions differ, recessions have some common factors.
1. Although at the start of a recession interest rates may rise, fall, or remain steady,
a. as the recession progresses interest rates begin to fall.
2. In the OPEC recession of 1974-1975, the real money supply decreased.
a. Initially the fall in real GDP decreased the demand for money slightly,
b. but as the fall in GDP became larger the decrease in the demand for money became large.
c. Therefore, initially interest rates rose (when the fall in the supply of money exceeded the fall in demand)
d. but then fell (when the fall in demand outstripped the fall in supply).
3. In the Volcker recession of 1982, the real money supply decreased.
a. Initially the demand for money rose slightly (as real GDP continued to rise) and interest rates sky-rocketed.
b. Eventually real GDP fell sharply, which:
i. reduced the demand for money and
ii. caused interest rates to decline.
4. In the 1990-1991 recession, the real money supply:
1. did not change during the first year and then
2. increased in the second.
3. The demand for money fell in both years due to the fall in real GDP.
4. As a result, the interest rate fell in both years.
B. Real GDP falls in a recession and
1. the component that falls the most is investment.
2. Investment falls because interest rates may increase and
3. profit expectations worsen.
C. Unemployment increases in a recession.
III. The Labor Market in Recession
A. In a recession, such as the OPEC recession of the 1970s, the short-run production function shifts down.
1. In the OPEC recession, the short-run production function shifted down because:
a. less oil was available and
b. firms responded to the higher price of oil by conserving their use of it.
B. In a recession, economists concur that the demand for labor shifts left.
C. In the sticky wage view of the labor market,
1. the decrease in the demand for labor reduces employment as firms cut back on the amount of labor they employ.
2. This is illustrated to the right where the wage remains at W and employment fall from L to L'.
a. The reduction in the level of employment creates unemployment.
D. In the flexible wage theory of the labor market,
1. the labor supply curve is highly responsive to changes in the wage rate.
2. Hence the fall in demand for labor creates a large drop in employment, as illustrated to the right.
a. Here even though the wage drops only a bit from W to W',
b. the level of employment falls a lot from L to L'.
c. Unemployment increases because there is more turnover than normal from declining sectors to advancing ones.
E. Most economists thank the labor market is better characterized by sticky wages.
1. Other economists disagree.
2. This dispute has not yet been resolved by empirical tests.
IV. Will There Be Another Great Depression?
A. In early 1929 unemployment was at 3.2 percent.
1. In October 1929, the stock market fell by a third in two weeks.
2. The following four years were a terrible economic experience: the Great Depression.
B. In 1930,:
1. the price level fell by about seven percent (deflation) and
2. real GDP declined by also about seven percent.
C. Over the next three years:
1. several adverse shocks hit aggregate demand and
2. real GDP declined by almost 30 percent and
3. the price level declined by more than 25 percent
4. from their 1929 levels.
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A. The 1920s were a prosperous era
1. but as they drew to a close increased uncertainty affected:
a. investment and
b. consumption demand for durables.
2. Some uncertainty was international in scope as:
a. Britain was declining and
b. new economic powers such as Japan were emerging.
3. Some uncertainly was domestic, as
a. firms were unsure how long a boom in capital goods and housing would continue.
4. The stock market crash of 1929 also heightened uncertainty.
B. The uncertainty caused investment to fall, which lowered:
1. the AD curve and
2. real GDP in 1930.
C. To this point, the Great Depression was still similar to an ordinary recession.
1. Economists disagree over what changed the recession into the Great Depression.
a. Some economists think that continued falls in investment and consumption were the primary cause that lowered the AD curve and created the Depression.
b. Other economists (such as Milton Friedman) assert that inept monetary policy was the primary cause of the fall in aggregate demand.
2. Banks failed in an unprecedented amount during the depression.
a. The main initial reason was loans made in the 1920s that went sour.
b. Bank failures fed on themselves:
i. People seeing one bank fail took their money out of other banks and
ii. caused the other banks to fail.
c. The massive number of bank failures caused a huge contraction in the money supply
i. that was not offset by the Federal Reserve.
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A. It is unlikely that a Great Depression could recur today.
B. There are four reasons for this:
1. Bank deposit insurance.
a. Deposits in banks now are insured by the Federal Deposit Insurance Corporation so that
i. depositors need not fear that if their bank fails they will lose their deposit.
ii. Hence depositors do not withdraw their money from their bank when they see another bank fail,
iii. so bank failures do not feed on themselves.
2. The Federal Reserve is a "Lender of last resort".
a. The Fed today realizes that in an economic collapse, it should lend to banks that need reserves
i. to keep the banking system from collapsing.
3. Taxes and government spending.
a. The government accounts for a larger share of aggregate expenditures.
b. This spending is not reduced when a downturn strikes,
i. so aggregate demand today does not decline as much in a recession.
c. Additionally, taxes and transfer payments operate as automatic stabilizers.
i. They moderate the fall in disposable income from a recession.
4. Multi-income families.
a. A much larger proportion of families today have two people working.
b. Thus when one spouse loses a job:
i. the household's income does not fall to zero, so
ii. the household's consumption demand is more stable.
Summary of the lecture
Key Concepts
Questions for Review
1. What four features of today's US economy make a Depression less likely now than it was in 1929.