Understanding Macroeconomics, Expectations and Coming of Great Depression

Understanding Macroeconomics:

In a way, learning an logical discipline such as ‘Macroeconomics’ is same as to learning a new language or being started into a club. Economists’ way of thinking lets us to see the economy more clearly and sharply than ever. (Certainly, it can as well cause us to miss certain relationships that are difficult to count or tough to think of as sales and purchases, that’s why economics isn't the only social science, and we need the political scientists, the sociologists, the psychologists, the historians, and the anthropologists also.) In this chapter we will study the intellectual landmarks of economists' system of thought, in order to help you, familiarize yourself in the mental landscape of ‘Macroeconomics.’

Economics: Is It a Science?

If you are coming to economics from a background in the natural sciences then you perhaps expect economics to be something like a natural science, only less so. To the degree that it works, it works more or less as chemistry, although it doesn’t work too. Economic theories are unsettled and poorly defined. Also economists' predictions are often wrong.

If you hold these beliefs, you are half-right. Though as economics is a science, it’s not a natural science. It’s a social science. Its subject is not element or electrons, however human beings: people and how they behave. This subject matter has quite a lot of significant consequences. Some of them make economics harder than a natural science, some of them make economics easier than a natural science, and some of them just make it different.

First, because Economics is social science, debates within economics last much longer and are much less likely to end in a clear consensus than in the natural sciences. The main reason is, various people have various views of what makes a free, a good, or a well ordered culture. They look for an economy which harmonizes with their vision of what a culture must be. They do not take into account or elucidate the facts that turn out to be problematic for their individual political views. After all, People are only human.
Economists attempt to approach the objectivity that characterizes most work in the Natural sciences. After all, what is, is; and what is not, is not. Even if wishful thinking or tendency, In fact the outcomes of a single study, later studies can correct the error. However economists don’t ever approach the unanimity with which physicists embraced the theory of relativity, chemists embraced the oxygen theory of combustion, and biologists rejected Lamarckian inheritance of acquired characteristics. Biology departments don’t have Lamarckian. Chemistry departments do not have phlogistonists. But economics departments do have a extensive variety of points of view and schools of thought.

Second, the fact which states that economics is about people means that economists can’t ethically undertake large scale experiments. Economists can’t set up special circumstances in which possible sources of disturbance are reduced to a minimum, then study what happens, and generalize from results of the experiment (where sources of disturbance are not present) to what occurs in the world (where sources of disturbance are common). So the experimental method, the driver of rapid progress in many of the natural sciences, is lacking in economics. This flaw makes economics harder to do, and it makes economists’ conclusions much more tentative and subject to disagreement.

Third, the subjects economists study people have minds of their own. They monitor what is going on around them, plan for the future, and take steps to avoid future consequences that they predict and fear will be unpleasant. At times they just do what they wish for, just because they feel like doing it. So in economists’ analyses the present often depends not only on the past but also on the future, or rather on what people anticipate the future to be. Box below presents one example of this: it elaborates how people's anticipations of the future and individually their fear that there may be a depression contributed to the coming of the Great Depression of the 1930’s.

This third wrinkle makes economics in some way very hard. Natural scientists can forever assume the arrow of causality points from past to future. In economics people's prospect of the future means that arrow of causality often points the other way, from the (expected) future back to present.

Expectations and the Coming of the Great Depression:

A significant illustration of how people's expectations can change the course of economic events comes from stock market crash of 1929. The crash changed what Americans expected about the future of the economy, and the shifts in spending due to these changes in anticipations played a major role in causing the greatest economic depression in American history, the Great Depression.

On October 29, 1929, the price of shares traded on the New-York Stock Exchange suffered their biggest one day percentage drop in history.  Stock values bounced a bit in beginning, but by end of the week, they were down by more than a quarter (see Figure below). Gloom fell over Wall Street.  Many people had lost huge money.

2404_stock market.jpg


Figure: The Stock Market , 1928-1932

At that time stock rights was confined to the rich. Middle class Americans owned little stock. However, the crash affected their perceptions of the economy: bad times were coming. Since people expected the economic future to be dimmer, many cut back on spending, especially on big-ticket consumer durables. The 1920’s had been the first decade in which consumer credit had been broadly available to finance purchases of cars, refrigerators, stoves, and washing machines. With the economic future doubtful, spending on customer durables collapsed. It made intellect to borrow to purchase a customer durable only if you were sure that you could make the expenses and pay off the debt. If you thought the economic future might be bad, you had a powerful incentive to avoid credit. And in the short run the easiest way to avoid loan is not to buy large customer durables on loan.

You can possible estimate what happened in months after the crash. Most people just stopped buying big ticket items such as cars and furniture.  This gigantic drop in demand decreased new orders for merchandise. The drop in output produced lay-offs in many industries.  Even though most people's incomes had not so far changed, their anticipations of their future profits had.

The fall in demand generated by this shift in anticipations helped bring on what folks feared, and put America on the path to ‘The Great Depression.’ The Great Depression occured in large part since people expected something bad to happen. Without that pessimistic shift in expectations produced by the crash of 1929, there would have been Great Depression.

In spite of political complications, the non-experimental nature, and the peculiar problems of reason and effect in economics, the discipline stays a quantitative science. Most of the relationships which economists study come measured. So economics make heavy use of algebra and arithmetic, while sociology, political science, and most of the history do not. Economics makes serious use of arithmetic to measure economic variables of interest. Furthermore, economists use arithmetical models to relate these variables.

The American economy is complex: about 10 million firms, 130 million workers, 90 million households purchasing and selling $24 trillion worth of goods and services a year. Economists should simplify it. To understand this complex phenomenon, they limit their attention to a very few behavioural relationships cause and effect links between economic quantities and a handful of balanced conditions, i.e. situations that should be satisfied for economic movement to be stable and for demand and supply to be in equilibrium. They try to capture these behaviorals relationships and balanced conditions in straightforward algebraic equations and geometric figures. Then they attempt to apply their equations and graphs to real world, while hoping that their simplifications have not made the model a distorted and faulty guide to how real world economy works.

Economists call this procedure of decreasing the complexity and variation of the real world economy into a handful of equations ‘building a model.’ Using these to realize what’s happening in the complex real world economy has been a productive intellectual scheme. But model-building be likely to concentrate on those variables and relationships which fit with no trouble into the algebraic model. It ignores other factors.

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