Question

1 - Oct 29, 1929 "Black Tuesday" - The US stock market had started sliding down in September and there was a milder panic 5 days before, but on Oct 29 the market plunged 12% in one day. This crash wiped out many people's life savings and many firms filed for bankruptcy. The Federal Reserve had been warning people about irrational exuberance and rampant speculation for 4-5 years before.

2 - Bank collapses - 700 banks failed in 1929 and 3000 more in 1930. In 1932, a new banking panic led to the loss of more than 1/3 of all banks in the country.

3 - The Smoot-Hawley Tariff - In 1930 Congress raised import tariffs to record levels in an attempt to protect US jobs. However, this sparked retaliatory trade measures from European countries. Over the next 4 years our exports dropped by 2/3.

4 - Drought hit the plains states starting in 1930 and continued with dust storms in 1931 through 1939. By the time normal rainfall resumed, 35-125 million acres had lost its topsoil and could not be used for farming the way it had been.

5 - In response to all this, the Federal Reserve tightened the money supply in 1929, 1932, and 1937, leading to deflation. This deflation made it even harder for homes and firms to repay their debts, and made the banking collapses and tariff impacts worse.

A - Identify whether each of these shocks is PRIMARILY (pick one) an aggregate demand or an aggregate supply shock. Draw the impact each had in the Keynesian AD/SRAS graph.

Answer 1

Part 1) The US stock market crash affected aggregate demand. In other words, it is an aggregate demand shock. The reduction in the savings of the people, as well as bankruptcy of businesses, reduce demand as people lose money and job. As a result, the aggregate demand curve shifts down to the left.

RAS AD Output

Part 2) The bank collapse is also an aggregate demand shock. In response to the reduction in the savings of people, aggregate demand will decline. Moreover, as banks fail the amount of funds available for businesses to borrow also declines which raise their cost i.e., interest rate. As a result, investment also declines. So, the aggregate demand curve shifts down to the left.

RAS AD Output

Part 3) Increase in import tariff and a reduction in exports due to retaliation by European countries is also an aggregate demand shock. As a result, the aggregate demand curve shifts down to the left.

RAS AD Output

Part 4) The fact that drought has ensured less farming is a supply side shock. Due to the reduction in the production of food-grains the aggregate supply curve will shift upward to the left signifying reduced output and higher prices.

Sv ,Demana

Part 5) Reduction in money supply is an aggregate demand shock. For a given income level a reduction in money supply ensures that people start to withdraw money from speculative balances. As a result, bond prices decline while yield (interest rate) increases. Increase in the interest rate reduces investment as firms find it expensive to borrow for the purchase of plant and machinery. Decline in investment results in decline in aggregate demand. As a result, aggregate demand curve shifts downward to the left.

RAS AD Output