Terms for Understanding the Great Depression

David Wheelock: Let me talk about, or put us on the same platform, I suspect it’s been a few years since some of us had Econ 101 in college, so it might be helpful to go back and review a few macroeconomic concepts just so we’re all kind of on the same page as we go on talking about the Great Depression.

Gross domestic product is a comprehensive measure of the output of goods and services in an economy over a particular period of time. We talk about usually in the United States... well, in the United States, we measure gross domestic product on a quarterly basis, so we would say over a span of a quarter or over the span of a year, the U.S. economy produced X dollars’ worth of output and that of course, everything produced from your output as providers of educational services, measured by your salaries paid by the school districts, to the production of automobiles and computers and and everything else that’s valued in dollar terms in the economy goes into the calculation of gross domestic product.

We make a distinction in economics between real GDP and nominal GDP. GDP measured at a fixed price level is what we refer to as real GDP, so if we measure the output of goods and services at two points in time, say, in the year 2012 and then again in the year 2013, we want to get a measure of how much the economy is growing or expanding from one year to the next. Well, we want to get a pure measure that’s unaffected by changes in the price level.

So for example, if we have a burst of inflation, prices are going up, but we’re producing no more output in terms of physical quantities of goods and services: That would be no change in real GDP, but it would be an increase in nominal GDP. So nominal GDP measures the outputs of goods and services in today’s dollars, regardless when that is—when today is.

So it’s going back to my comparison between 2012 and 2013, we take GDP measured in 2012 dollars and compare that with GDP measured in 2013 dollars, and that change would be the change in nominal GDP. The change in real GDP, however, would measure that change in output in a constant price level, say Year 2012 dollars. So we take output of goods and services measured in 2012 dollars in 2012, and compare that with output of goods and services in 2012 dollars measured in 2013: That gives us a measure of how much the economy has expanded in real terms.

And the real term is important because that’s what matters for standard of living. Ultimately our goal as policymakers is to see the economy’s... to see our standard of living grow, and that’s a reflection of how much we have available in terms of goods and services to consume, and that fundamentally is a real economic concept and not one that we want to have contaminated by inflation or deflation or other changes like that are not capturing the real changes of physical quantities.

Now, a recession is sometimes thought of as a shorthand as just simply two quarters of contraction of real GDP. So if the economy is like balloon and it’s shrinking from one quarter to the next, and then from that quarter to this subsequent quarter — in other words, two consecutive quarters — that’s sometimes as a shorthand considered to be a recession. In fact, a recession is officially defined by the National Bureau of Economic Research, which is a private organization funded privately. They have an economics team that is called their Business Cycle Dating Committee and they are the ones who officially designate whether the economy is in a recession or not. And they look beyond simply GDP to look at employment and other measures to gauge whether the economy is in a recession.

And then a depression — again, there’s no hard and fast rule here — but it would be considered a very severe recession.

Some more useful terms:

Inflation, I’ve already mentioned, is a sustained increase in the general level of prices. We’re not talking about individual prices here — you know, the price of gasoline goes up one day and goes down the next day, the price of computers may go down over the course of a year — but what matters is the general level of prices or in some sense the average level of prices across the economy broadly. Often, but not only, is it measured in terms of the Consumer Price Index. So an increase in the Consumer Price Index over time is an indication of inflation.

Deflation, which has not happened very much in our lifetimes, is a sustained decline in the general level of prices and that decline turns out to be important for my story about the about the Great Depression. So I’ll get to it in a minute.

The money stock is, for our purposes here, is the stock of assets that serve as a medium of exchange. Typically we think in terms of coin and currency and checking accounts would be a narrow definition of the money stock; sometimes more broadly it would include other forms of deposit, savings accounts, time deposits and perhaps even broader assets than that. The money stock and changes in the money stock turn out to be very important also in our story about the Great Depression.

Another real versus nominal distinction that is also important for the Great Depression is the distinction between real interest rates and nominal interest rates. Nominal interest rate is the interest rate you see stated on your loan contract or in the newspaper when you’re comparing CD rates across alternative banks. It’s just that: It’s the nominal stated rate of interest. The real interest rate, however, takes account of changes in the price level, so if prices are rising rapidly, the real cost of borrowing is actually lower, going to be lower than the nominal rate of interest.

I think it’s easier to think of it in terms of your income level. So if you’re borrowing to buy a new car, and suppose the loan interest rate is 6.5, but you’re expecting a 10% raise this year, that’s going to make it much easier to pay off that car loan than if you’re expecting a 10% cut in your salary this year. So the real interest rate takes account of that expected change in income or change in prices. That turns out to be very important for our story of the Great Depression.

Originally recorded July 11, 2013