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A Look Into the Monetary Policies During the Great Recession and the Great Depression - Part 15

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7 Impact of the Great Depression on the US and World Economy

The impact of the Great Depression was seen across different facets of the society, from political to social to economic. Politically, the federal government began to play a more prominent role in the country and socially, the depression changed the face of the society. Despite these different facets, the economic impact was the most profound. It helped to bring about new theories and economic policies all around the world.

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7.1 Keynesian and Other Theories

The Great Depression had a huge impact on the US and world economy. In fact, it led to many new schools of thought  that are being debated even today! One of the biggest areas that won with the depression was macroeconomics. The impact of the depression led to a massive and in-depth research into macroeconomic policies, and its consequences on the future. Also, this depression was the root cause for John Maynard Keynes to write his classic The General Theory of Employment, Interest and Money in 1936. The crux of the book is an attempt by Keynes to explain the widespread unemployment that prevailed around the world as a result of the depression. In fact, the quasi-general equilibrium analysis put forth by Keynes became the basis for later macroeconomics, and it led to the many theories that followed since then.

Before writing the book, Keynes saw a gap between the theory of the exchange of goods and monetary theory, so to fill this gap, he introduced a new direction in monetary economics. Until then, monetary theory had focused only on the quantity of price and the velocity of its circulation. However, the elasticities of demand and supply did not even find the mention in the monetary theories that existed then. “Pre-keynesian monetary theory was also wedded to a rather mechanical doctrine of equilibrium and to the basic assumption of the neutrality of money as the medium of exchange. The great insight of Keynes, that money links the present with the future and is therefore linked to all elements of uncertainty which beset the predictions of the future course of events, was of no concern to earlier monetary theorists” (Rothermund, 1996, p.3). Though the original creator of this thought was Carl Menger, it was later copied by Knut Wicksell, and Keynes borrowed it from him.

To set right this shortcoming in monetary economics, Keynes focused on the demand side of money rather than the supply side, in his book. He argued that in the demand side of monetary theory, the preference for liquidity had an impact on the supply of funds available. He opined that in countries like India, there was a high demand for liquidity and this had helped to create real wealth over several decades. At the same time, this preference also determined the supply and demand of money supply in an economy.

This argument threw a new light on the established principles of money supply because the existing theory believed that supply would always create a demand. However, this was proved wrong during the depression, according to Keynes. The wages of the people during the depression fell, but the real wages went up because of the falling prices. At the same time, employers did not use the additional money they saved from the wages towards investment. Rather, they had a preference for liquidity, and this led to an imbalance in the money supply. To overcome this preference, Keynes believed that interest rates could be used as a tool. Likewise, he argued that a reduction in wages without any change in the supply side of money would have the same impact on the interest rates had there been an increase in money supply without a decrease in wages.

While some argued that this would lead to inflation, Keynes believed that inflation would occur only when there was full employment, and during the depression, there was no possibility of it. This theory yet again broke away from the established principles of macroeconomic theory, and paved the way for a new direction in this field.

Other than Keynes, the Great Depression led to other theories too. The depression was the single biggest economic downfall the world has seen, and this led researchers to delve deep into its causes and consequences. Even Bernanke has said that “to understand the Great Depression is the Holy Grail of macroeconomics” (2000, p.1). The many debates and models about the depression that came up since then is unprecedented.

7.2 Expansion of the Federal Government

Another impact is that the Great Depression led to a massive expansion in the size of the US Federal government. As economic output declined and unemployment levels rose, the US public demanded help from the Federal government. In return, the government enacted a new legislation called the New Deal under which it created many projects that were aimed towards the development of infrastructure. These programs built the infrastructure of the country, and at the same time, it provided employment for thousands of people around the country. From an economic standpoint, the federal government became a major player in the economic world with these programs. In 1929, the federal government's impact on the GDP was a mere 1.3 percent, and this rose to 7.1 percent by 1939. The federal government also began to involve itself in areas that it had no role before such as securities legislation, social security, welfare security, infrastructure development and electricity generation and transmission (Hall and Ferguson, 2009). Therefore, the current role of the federal government that many sections of the society complain about today, had its roots in the Great Depression.

7.3 Protectionism and Competitiveness

Another important impact of the depression was put forth by Joan Robinson, and this was the policy of “beggar-thy-neighbor” (Dunkley, 2004).  The depression left a deep fear in the minds of people all over the world, so many countries set a policy of protectionism and devaluation to gain the most out of international trade, even if it came at the cost of the development of other countries. This was a downright selfish attitude, but the countries nevertheless believed that it was essential to safeguard their economic interests.

One way of correcting trade imbalances is currency devaluation, as it makes exports cheaper and imports more expensive. This devaluation was a better strategy when compared to protective tariffs, export subsidies and import duties. Furthermore, the value drops at the beginning, but over time, increases to a point that was higher than the beginning. Since this recovery is in the pattern of letter “J,” it is popularly known as the J-Curve Theory. The downside is that the elasticity of demand for products made and exported in these countries will go down, while the imports will continue to remain the same. As a result, inflow with demand will reduce, and in the long run, will have no benefit for the country.

Despite these downsides, many governments continued to devalue their currency. One of the most prominent countries that resorted to devaluation was the US, when it devalued the dollar in 1933. The idea behind this move was not to balance payments or any external problems, rather the idea was to inflate the economy and kick start it again.

Another problem associated with protective policies is the reaction of the neighbors. Many countries retaliated by banning the exported goods of its neighbors, and this led to a contraction in trade. Unemployment levels went up again and the economy tanked further. Moreover, neighboring countries suspended debt services to each other, and this led to a worldwide contraction of credit. Therefore, the depression prolonged for a longer time than it should have, making it difficult for people around the world to live. This kind of protectionism failed completely, and it is a lesson to the world that it is important to give and take during good and bad times, so that everyone benefits from the shared resources.

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7.4 Creation of an International Standard for Currencies

The great depression forced countries to choose the right international standard for their currencies. There were three broad choices – following the British Pound, going with the US Dollar and opting for gold standard. The British colonial countries in Asia and Africa, Norway, Sweden, South Africa and Portugal followed the British currency. Latin American countries, Canada and the US stuck with the US dollar, while the remaining countries such as Japan opted for the gold standard. These countries had to come up with some of the strictest policies pertaining to foreign exchange controls including placing an embargo on the export of gold. This choice polarized countries to some extent during and after the depression.

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