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What is the Connection Between Keynesian Economics and the Great Depression?

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  • Written By: Osmand Vitez
  • Edited By: Kristen Osborne
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  • Last Modified Date: 31 August 2016
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The Great Depression is a phenomenon that changed the world and many nations’ views on how to handle economic situations. While classic economic theory, such as the Austrian school, espouses limited government intervention into the free market system, proponents of Keynesian economic theory believe in properly calculated government economic policies. These policies exist because free markets are unable to provide full employment and are devoid of self-balancing mechanisms. Keynesian theory was dominant in the decade leading to the Great Depression, which of course lead to the most severe economic downturn in American history.

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Keynesian economics is often thought to be somewhat anti-business in nature, as it calls for allowing governments to wield great authority. The policies are often debated, as the true cause of the Great Depression is not a single incident, but rather a number of missteps through misguided government policy. For example, some blame for the Great Depression lies on the U.S. Federal Reserve. This institution is responsible for setting the monetary policy of the economic market, primarily in the realm of monetary supply. Keynesian economics attempts to balance the demand and supply for money by using a central bank to set an interest rate that represents the cost of money. During the 1920s, America still used the gold standard. The Federal Reserve raised the discount rate to stop gold from leaving America after World War I. This had an immediate deflationary effect on the markets and began to restrict economic activity and artificially lower prices in the economic market.

Once the Great Depression was evident and in full force, Keynesian economic theory required the government to intervene through programs and other investments led by the federal policies. Tax rates also increased during this time, lowering individual incomes. This was the result of the New Deal, which created Social Security taxes — a Keynesian economics brainchild that is meant to provide retirement for elderly citizens. Monetary policy also led to a significant drop in lending, which prevented banks from providing individuals and businesses with funds to engage in economic activity.

Another significant factor of the Great Depression was the Smoot-Hawley Tariff Act. Classic economic theory believes that free trade was tantamount to a well-run economy; Keynesian economics applied the balancing act of government to regulate the market and trade with foreign nations. Smoot-Hawley was a protectionist measure to ensure that America was able to produce and sell goods manufactured within its borders. This attempted to prevent low-price goods from entering the market, which would drive down business investment and thus lower employee wages. Engaging in a protectionist economy was also thought to help stave off the Great Depression, as fewer imports meant higher domestic employment. These factors are just a few of the significant connections between Keynesian economics and the Great depression.

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