Question

Explain how the great depression impacted the circular flow and explain how the new deal tried to revive the circular flow.

Answer 1

The Circular Flow of Income during the Great Depression

So far, we have told this story in terms of individual markets. The circular flow helps us see how these markets come together in the aggregate economy. When we looked at the markets for housing and beef, we saw that a decrease in demand for housing led to a decrease in demand for labor and, hence, to lower labor income. We also saw that as income earned in the housing market decreased, spending decreased in the beef market. Such linkages are at the heart of the circular flow of income. Household spending on goods and services is made possible by a flow of income from firms. Firms’ hiring of labor is made possible by a flow of revenue from households. Keynes argued that this was a delicate process that might be prone to malfunction in a variety of ways.

Households are willing to buy goods and services if they have a reasonable expectation that they can earn income by selling labor. During the Great Depression, however, household expectations were surely quite pessimistic. Individuals without jobs believed that their chances of finding new employment were low. Those lucky enough to be employed knew that they might soon be out of work. Thus households believed it was possible, even likely, that they would receive low levels of income in the future. In response, they cut back their spending.

Meanwhile, the willingness of firms to hire labor depends on their expectation that they can sell the goods they manufacture. When firms anticipate a low level of demand for their products, they do not want to produce much, so they do not need many workers. Current employees are laid off, and there are few new hires.

Through the circular flow, the pessimism of households and the pessimism of firms interact. Firms do not hire workers, so household income is low, and households are right not to spend much. Households do not spend, so demand for goods and services is low, and firms are right not to hire many workers. The pessimistic beliefs of firms and workers become self-fulfilling prophecies

The new deal helped to revive the circular flow based on the below:

These included the authorization by the Secretary of Agriculture

(1) to secure voluntary reduction of the acreage in basic crops through agreements with producers and use of direct payments for participation in acreage control programs;

(2) to regulate marketing through voluntary agreements with processors, associations or producers, and other handlers of agricultural commodities or products;

(3) to license processors, association, and others handling agricultural commodities to eliminate unfair practices or charges;

(4) to determine the necessity for and the rate or processing taxes;

While firms make factor payments to the households, the latter engage in consumer expenditure and buys goods from firms Households also invest their surplus savings in financial institutions. These institutions are also known as financial intermediaries since they in turn lend or invest the household savings they have received in equity and debt securities issued by firms. Insurance companies, both life and general, form part of the financial institutions sector. They play a vital role in channelizing surplus funds of households to various productive enterprises. The third sector in this model is government. It receives its revenues in the form of direct and indirect taxes, from firms and households. In turn it makes various kinds of factor and transfer payments to households and also provides funds to firms in the form of subsidies and purchases. Finally there is the external or foreign sector. With respect to foreign countries, we have export of manpower [migration] to foreign countries. These non residents in turn make remittances to the home country, resulting in precious foreign exchange coming in. Foreign exchange is also earned when a country exports its goods to foreign countries. On the other hand when a country imports goods from outside, it has to expend its foreign exchange in paying for these goods. So long as a country earns more foreign exchange than it needs to pay out, it can be said to have a favourable Balance of Payments.