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BIG EVENTS: THE ECONOMICS OF DEPRESSION, HYPERINFLATION, AND DEFICITS Solutions to the Problems in the Textbook : Conceptual Problems: 1.a. The Keynesian explanation for the Great Depression concentrates on the fall of investment spending and reduction in aggregate consumption. The decrease in aggregate demand was reinforced by restrictive fiscal policy as the government tried to balance the budget. 1.b. The monetarists' explanation for the Great Depression concentrates on the decline in money supply. The Fed failed to prevent the large number of bank failures and consumers lost confidence in the banking system. This led to an enormous increase in the currency-deposit ratio, causing a decrease in the money multiplier. The resulting severe decline in the supply of money then lead to the economic downturn. 1.c. Both explanations given above fit the facts and there is no inherent conflict between them; in fact, they complement one another quite nicely. The combination of inept fiscal and monetary policy may have turned what could have been an average recession into a major depression. 1.d. The Great Depression is one of the most drastic economic events in recent history and any theory that can adequately explain its causes (or find remedies to prevent similar occurrences in the future) will attract attention. Some economists argue that the Great Depression proves that the economy is inherently unstable and requires a long time to adjust back to a full-employment equilibrium. Others argue that it proves that government policy is often misguided and that it may be better to rely on market forces to bring us back to an equilibrium. 2. In the long run no major inflation can persist without rapid money growth, since the inflation rate is equal to the growth rate of money supply adjusted for the trend in real output and changes in velocity. In the short run, however, changes in output growth and velocity are quite unpredictable and affect the inflation rate. Such short-run fluctuations can be caused by supply shocks or policy changes. 3.a. The key question for governments desiring to reduce inflation is how cheaply (in terms of lost output) they want to achieve a desired inflation rate. A gradual strategy attempts a slow and steady return to a low inflation rate by reducing monetary growth slowly in an attempt to avoid a significant increase in unemployment. This approach takes a lot longer than the cold-turkey approach that attempts to reduce inflation quickly by immediately and sharply reducing monetary growth. While inflation and inflationary expectations will be reduced faster, a higher level of unemployment leading to a decrease in the level of output will result in the short run until the economy has time to adjust back to the full- employment level of output. Which strategy will be chosen by policy decision-makers also depends on how fast wages and prices are believed to adjust to their equilibrium level. 27
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