Unit 16 — Boom and Bust

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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.

    1. 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.
    2. 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.

    1. 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).
    2. If the amount of leakages equals the amount of injections, then the circular flow (i.e., aggregate demand for GDP/GNP) will remain constant. It will be in equilibrium.
    3. If the injections are larger than the leakages, aggregate demand for GDP/GNP will grow, and vice versa.

Audio and Transcripts

Meet the Series Experts

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Douglas Elliot

Douglas Elliot

Fellow at the Brookings Institution, specializing in the regulation of financial institutions and markets.

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Robert Heilbroner

Robert Heilbroner

Economist who regarded himself as a social theorist, integrating disciplines of history, economics, and philosophy.

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Dimitri B. Papadimitriou

Dimitri B. Papadimitriou

Economist and expert on the works of 20th-century economist Hyman P. Minsky, whose alternative theories for why the U.S. economy has periodic booms and busts have gained 21st-century recognition.

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Paul Samuelson

Paul Samuelson

First American economist to win the Nobel Prize in Economics, cited for doing “more than any other contemporary economist to raise the level of scientific analysis in economic theory.”

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Willard Thorp

Willard Thorp

Economist who served as adviser in domestic and foreign affairs for presidents Franklin D. Roosevelt, Harry S. Truman, and Dwight D. Eisenhower.

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  1. Economist Barnard J. notes that high inflation is boosting interest rates. Increasingly, consumers seem to be purchasing imported goods rather than American-made goods. Which phase of the business cycle is Barnard MOST LIKELY to be observing?

    Recession

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  2. Economics student Sylvia B. was recently overheard making the comment, “Well, if you’ve seen one business cycle, you’ve pretty much seen them all.” Which of the following is the MOST ACCURATE appraisal of Sylvia’s observation?

    It is totally unsubstantiated, since business cycles are all highly individualistic.

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  3. Most economists today—even those who totally disagree with Marxist philosophy — hold a certain respect for Marx’s economic perspectives. This is MOST LIKELY because:

    Marx was the first to conceptualize a business cycle in which good times eventually produced bad, and vice versa.

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  4. Which of these BEST summarizes the economic costs to society for tolerating a given level of unemployment? It is the difference between:

    real GNP and the potential GNP.

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  5. If the aggregate supply curve is S1, full employment of the economy’s resources will occur when:

    chart chart

    total real output is $2,000 billion.

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  6. If the aggregate supply curve shifts to S2:

    chart chart

    the demand for money will decrease and interest rates will fall..

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Glossary

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Key Terms