The Classical Model and the Great Depression

The Classical Model and the Great Depression

As you all know, the Great Depresssion was a recession without parallel, not just in the United States, but throughout much of the world. The figure below illiustrates just how large and unusual the decline in output was during the the early 1930s. Not surprisingly, in view of Okun's Law, unemployment suffered much the same fate. In 1929, unemployment in the United States was 3.2 percent; in 1933 it was 24.9 percent, and it was still touching 20 percent in 1938. (See The American Experience, in the readings below).

U.S. GNP Per Capita 1890-1940.
Graph Source: "Sliding into the Great Depression", Brad DeLong, UC Berkeley.

In class, I have tried to make the case that the classical model had a very hard time explaining the Great Depression and providing helpful policy solutions. In the classical model, such a sustained decline in output can only be the result of a massive leftward shift of the labor demand curve or the labor supply curve, caused by a change in work preferences, technology, or labor market incentives. There were certainly changes in policy that were unhelpful to businesses, and could have induced a leftward shift in the labor demand curve. But the fact that real wages rose during the early years of the depression (the nominal price level fell by more than the nominal wage level) implies that a classical economist must predict at least as large a leftward shift in the labor supply curve. I have a very hard time identifying any plausible causes of such a large leftward shift in the labor supply curve, especially as I have to think also of a mechanism that could keep the labor supply curve shifted to the left for so many years.In fact, classical economists had an equally hard time, The Classical Economist's Experience, below, presents a list of quotes and headlines from some of the foremost economists of the 1920s.

I also have a hard time making sense of the classical equilibrium concept that at all points in time the level of unemployment is consistent with all workers having just the amount of work that they find optimal given the going wage.The Case Studies of Unemployment in the readings below provides examples of the sort of depression-era experiences that lead me to this skepticism.

Online Reading

The American Experience: Timeline of the Depression	Case Studies of Unemployment in the Great Depression
The Classical Economist's Experience: Predicting a rosy future as the world collapsed	Labor Market Shocks in the Great Depression