FROM CLASSICAL TO KENYESSIAN ECONOMICS
In the 1930s, American capitalism practically stopped working.For more than a decade, from 1929 to 1940, America's free-market economy failed to operate at a level that allowed most Americans to attain economic success. The depth economic collapse and social disarray that mired America then was unprecedented.
* By 1933, the country's GNP had fallen to barely half its 1929 level12.
* Industrial production fell by more than half, and construction of new industrial plants fell by more than 90%. Production of automobiles dropped by two-thirds; steel plants operated at 12% of capacity.
* More than 13 million Americans lost ...view middle of the document...
The decline in the stock prices of 1929 also caused a decline in the money supply
* The decline in consumer spending contributed to the decline in production.
* The decline in wealth as stock prices fell, the decline in the money supply, and the
decline in consumer spending as people reduced their debts all caused a shift to the left in aggregate demand.
Classical Economic Theory Vs. Keynesian Theory
The fundamental principle of the Classical Economic theory is that the economy corrects itself or that it is self regulating. The laissez-faire principle led the Classical economists to believe that the Great Depression was a natural consequence of the business cycle.
But as the depression started to worsen in the early 30’s many people started to doubt the correctness of the classical theory. According to this theory, the recession of 1929 should have gone away automatically in a relatively short time. Hence, no actions needed from the government. Indeed, until 1933, there were no serious policies undertaken by the government to try to end the recession.
On the other hand, John Keynes said that the depression was caused by failure of aggregate demand across the economy, which had created a new equilibrium at less than full employment which had a chance to persist indefinitely if government did not intervene. He suggested that the government should increase its spending massively to get the economy moving again.
Keynesian Economic Theory need
When the classical theory failed after 1929-1941, then following trends were noted.
* The price level was supposed to fall. Prices did indeed fall. But Keynes argued that prices did not fall enough to solve the problem of the recessionary gap
* Wages were to fall. They did fall. But, Keynes argued that wages did not fall enough to generate full employment.
* If there is a recessionary gap, prices and wages will not fall enough to end it. Interest rates will fall, but consumers and businesses will not borrow because of pessimistic expectations. The recessionary gap will persist and may even grow larger (if people’s expectations become more and more fearful).
* Government action is required because the...