The Great Depression – Cause and Effect, Essay Example

The Great Depression was the longest and most severe financial crisis in the history of the United States, lasting from 1929 until 1939. Even though the recent financial crisis has been termed as the second worst, it pales in comparison to the Great Depression in which unemployment rate exceeded 20 percent at its highest point. Industrial production declined by 47 percent and the real GDP fell by 30 in the U.S. between the peak and trough of the depression. Even though the depression was triggered by a decline in aggregate demand but numerous factors contributed towards its severity including stock market crash, bank panics, and monetary contraction (Romer).

The stock market crash of 1929 has been widely credited as the starting point of the Great Depression. As people lost investments, their uncertainty regarding the future increased. They responded by scaling back their spending activities including purchase of durable goods. The firms also responded to declining demand by suspending their capital investments. This resulted in real GDP falling rapidly in late 1929 and throughout the 1930 (Romer).

As the aggregate demand in the U.S. fell, it also led to decrease in the prices of the goods and services. This is because quantity demanded and price has a positive relationship. Because the nominal wages didn’t decline as much as the general price levels, the real wages of the workers grew and labor became a more expensive factor of production. Faced with a declining demand, the manufacturers could not afford expensive labor and thus, they responded by cutting their workforces (Bernanke). As unemployment rose, it put even greater downward pressure on the consumption activities.

Another reason was the loss of confidence in the banks as a consequence of stock market crash as well as Federal inaction on the failing banks. The bank runs resulted in loss of bank reserves such as gold and currency etc. which means the bank could not provide any more loans. This resulted in contracting money supply which negatively affected both the consumption activities by the consumers as well as the investing activities by the businesses (Wheelock). Falling consumption and investing activities meant falling GDP and lower demand for labor force.

The Fed also made the matters worse by pursuing a contractionary monetary policy. Modern economics has come to the conclusion that decreasing interest rates is a better strategy to spur growth during struggling times and this is how the Fed has dealt with the recent financial crisis and how it acted in the wake of internet bubble bust. But Fed raised interest rates during the Great Depression which made borrowing even more expensive and further reduced consumption and investing activities. It also hurt consumption in another way. The public and the businesses came to expect deflation in the future due to declining price levels which further discouraged them from borrowing. This is because they expected their incomes to fall in the future (Romer).

Thus, it is apparent to some extent that the Great Depression occurred due to inappropriate government response to the crisis which also happened because our understanding of Macroeconomics was still in its infancy. The Great Depression continues to be a topic of intense research and the lessons from the Great Depression have helped us a repeat of a crisis of a similar magnitude. The U.S. government has become a lot better at financial crisis management and is more willing to intervene in the markets when the circumstances demand.

References

Bernanke, Ben S. “The Macroeconomics of the Great Depression: A Comparative Approach.” Journal of Money, Credit and Banking February 1995: 1-28.

Romer, Christina D. “Great Depression.” Encyclopaedia Britannica 20 December 2003.

Wheelock, David C. “An Overview of the Great Depression.” St. Louis: Federal Reserve Bank of St. Louis, 2007.