ECONOMICS U$A
Episode 4

BOOMS AND BUSTS
PURPOSE:
To show how successive schools of economic thought struggled unsuccessfully to give a satisfactory explanation of business cycles until John Maynard Keynes showed that shifts in aggregate demand were the primary cause of these fluctuations.

OBJECTIVES:
1. Classical economists did not have a satisfactory explanation for business cycles. Instead, they viewed them as temporary phenomena brought on by financial panics. They believed that the natural forces in the economy would always bring about an equilibrium between total supply and demand for goods in the economy.

2. There were two other more satisfactory explanations of business cycles which provided partial explanations of why the economy could find itself with high levels of unemployment and large inventories of unsold goods.
a) Karl Marx provided a theory of mass unemployment in the context of his view of the capitalist system as the exploiter of the working classes.
b) Joseph Schumpeter explained business cycles as a natural by-product of growth and innovation. Economic growth, he maintained, resulted in periodic overproduction and subsequent retrenchments.

3. It was not until the mid-1930s that John Maynard Keynes developed the concepts necessary to understand how the economy could move toward and remain at a less-than-full-employment equilibrium. One of the key concepts developed by Keynes was aggregate or total demand.

4. In very simple terms, aggregate demand is the sum of all the goods and services that buyers are willing to purchase at a given price level.
a) Shifts in aggregate demand are affected by the circular flow. The circular flow of income has leakages (savings, taxes, and imports) and injections (investment, government spending and exports).
b) If the amount of leakages equals the amount of injections, then the circular flow (i.e., aggregate demand for GNP) will remain constant-it will be in equilibrium.
c) If the injections are larger than the leakages, aggregate demand for GNP will grow, and vice versa.

KEY ECONOMIC CONCEPTS:
circular flow, investment, imports, leakages, taxes, aggregate supply,
injections, government spending, aggregate demand, savings, exports, classical economics, Keynesian economics.

Contemporary Issues
Booms and Busts

In early 2003 there was a gap of about 3% between actual GDP and potential GDP – what the economy could produce if it were at full employment. This "output gap" was the key reason behind the rise in the unemployment rate from 3.9% in 2000 to around 6% in 2003. What are the costs to the economy associated with operating below potential? Is this because of a shortfall in aggregate demand or aggregate supply? What can the government do to close the output gap?

For a complete transcript of this video program download TVpdf#4

Men Out of Work
(Says' Law)
Booms and busts. What makes the economy so unstable? Before WWI economists had no theory to explain the periodic downturns in the economy. Several theories were put forth.

Theory One was that the system is self-maintaining, self-correcting. In the early 20th century businessmen still clung to a theory called Says Law which said that when they produced a commodity they automatically created a demand for that product. But in early in 1914, it was obvious something was wrong. Unemployment was climbing, prices were falling and factories were closing. The slump had no apparent cause that was evident to the Wilson administration.

The prevailing point of view seemed to be that the business cycle was correcting an imbalance and that by intervening you might only make things worse.

Comment and Analysis by Richard Gill
Using examples of bonnet production, Analyst Richard Gill explains the concept of Says Law, named after the 19th century French economist JB Say.

Say said that in total, supply always creates its own demand. Fluctuations in the economy were seen as temporary.

The Triumph of Capitalism (Marx and Schumpeter)
Karl Marx was the first economist to conceive of a self generated cycle in which good times produced eventual bad times and the bad times produced good times. During the times of economic depression, Marx’s followers were quick to point out the failure of Capitalism.

Where Karl Marx had looked at the bust side of the cycle and forecast destruction, Joseph Schumpeter looked at the boom side and called it regeneration. Capitalism was by its nature intrinsically dynamic. The essence of Capitalism was to invent, innovate, to risk.

Karl Marx saw economic fluctuations as increasing evidence of the failure of the system. Joseph Schumpeter saw these same business cycles as evidence of economic growth and the success of the system.

Comment and Analysis b y Richard Gill
Analyst Richard Gill explains that both Karl Marx and Joseph Schumpeter differed from the classical economists who held that depressions were temporary and uncharacteristic. While Marx saw the laboring class suffering under the Capitalist system, Schumpeter saw that the laboring classes were actually the greatest beneficiaries of Capitalist mass production.
The Great Depression
President Herbert Hoover presided over the onset and first few years of the Great Depression, a period where the nouveau rich became poor and the poor became poorer.

Responding to the Great Depression, President Hoover depended of the advice held by both reputable economists and government officials at that time. That theory held that a hands off approach to the economy was the best medicine. Over and over again Hoover would say that "Recovery is just around the corner". And leading economists of the era believed that the price system would make the necessary adjustments. If things were going well people would make profits, and if they weren’t they wouldn’t make profits and that would help in the adjusting process.

As the 1920’s faded and with them the memories of prosperity, the 1930’s brought a growing awareness that there was a serious split between traditional economic theories and present economic reality At the same time, British economist John Maynard Keynes was building a theory that dealt with the total purchasing power of the economy, aggregate demand and asking whether this was in proper balance with aggregate supply. His answers transformed modern economics and pointed to a path out of the depression. For President Herbert Hoover, the theories of John Maynard Keynes would come too late and the fate of the country would now rest in the hands of a new President, Franklin Delano Roosevelt.

Comment and Analysis by Richard Gill
Richard Gill explains that Keynes idea was revolutionary for the times. What Keynes said was that if you had a fall in investment spending, this might not lead to a rise but a fall in consumption spending. Total demand—consumption demand plus investment demand –might fall. It even might be a multiplied fall once the process got started.