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Laissez-faire<br />

If the economy is self-regulating and automatically adjusts to Natural Real GDP, what<br />

macroeconomic policy should the government follow? The answer is “laissez-faire”, do nothing,<br />

leave it alone, do not interfere with the economy.<br />

Appendix: The Stock Market Crash of 1929, the Smoot-Hawley Tariff, and the<br />

Great Depression<br />

Classical theory, with its laissez-faire approach to economic policy, was the dominant economic<br />

theory in industrialized nations from the time of Adam Smith until the Great Depression of the<br />

1930s. The Great Depression officially started in August of 1929. But popular culture marks the<br />

beginning of the Great Depression with the stock market crash of October, 1929.<br />

In reality, the stock market did not crash in 1929. It is true that the Dow Jones Industrial Average<br />

(DJIA) decreased dramatically in late 1929, with some historically large daily decreases in<br />

October. But the real crash in stock prices occurred after 1929.<br />

The DJIA peaked at 381 on September 3, 1929. This was the culmination of a massive run-up in<br />

stock prices that began in 1924. The peak DJIA of 381 was almost four times as high as the DJIA<br />

had been in January of 1924. From this peak, the DJIA dropped over the next couple of months<br />

to 199 on November 12. Especially large losses occurred on October 24 (“Black Thursday”) and<br />

October 29 (“Black Tuesday”).<br />

However, the DJIA of 199 on November 12, 1929, though a decrease of almost 50% from the<br />

peak, was still double the DJIA as of January, 1924. The stock market rallied through the rest of<br />

1929 and into 1930, ending May of 1930 at around 270. The unemployment rate jumped to<br />

around 9% by the end of 1929, but had dropped back down to around 6% by May, 1930.<br />

On June 17, 1930, President Herbert Hoover signed into law the Smoot-Hawley Tariff. This law<br />

increased the average tariff rate on dutiable goods to almost 60 percent. Other nations responded<br />

with retaliatory tariff increases. U.S. exports and imports both decreased by over 60 percent<br />

between 1929 and 1933.<br />

With the passage of the Smoot-Hawley Tariff, stock prices began to fall again. The DJIA fell from<br />

around 270 at the end of May, 1930 to a low of 41 on July 8, 1932. The DJIA would not reach the<br />

peak of 381 again until November of 1954.<br />

With the passage of the Smoot-Hawley Tariff, the unemployment rate began a rapid rise. The<br />

unemployment rate, which was around 6% in May of 1930, reached 25% in 1933.<br />

Study Guide for Chapter 7<br />

Chapter Summary for Chapter 7<br />

According to classical economic theory, a market economy is self-regulating and will<br />

automatically adjust to the ideal quantity of total output. Natural Real GDP is the ideal quantity of<br />

total output.<br />

Karl Marx said that market economies would be unstable, because of inadequate demand.<br />

Classical theory argues that inadequate demand cannot be a problem in a market economy, due<br />

to Say’s Law: supply creates its own demand.<br />

FOR REVIEW ONLY - NOT FOR DISTRIBUTION<br />

Flexible interest rates in the credit market cause any consumer savings to be exactly offset by<br />

business investment. Classical theory argues that flexible interest rates, wages, and prices will<br />

cause the economy to be self-regulating.<br />

7 - 9 Classical Economic Theory

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