Chapter 8 The level of overall economic activity
1. Using national income statistics to measure economic well-being
Sri Lanka
2022
In 2022, Sri Lanka experienced a severe economic crisis despite previously recording positive GDP figures, highlighting the limitations of using GDP as a measure of economic welfare. The country faced fuel shortages, food scarcity, and extremely high inflation, which significantly reduced living standards. This demonstrates that GDP fails to account for income distribution, non-market activities, and the quality of life, as economic output alone does not accurately reflect the hardships faced by households. Furthermore, GDP ignores sustainability, since earlier growth was partly driven by unsustainable debt. While GDP remains useful for measuring total output, the Sri Lankan case demonstrates that it is an incomplete indicator of welfare, underscoring the need for alternative indicators.
2. Assumptions and implications of the monetarist/new classical and Keynesian models
Keynesian model
The Great Depression
1930s
The Great Depression of the 1930s provides a strong real-world example supporting Keynesian assumptions and challenging monetarist and new classical views. During this period, despite extremely low interest rates, investment and consumption remained weak, as households and firms lacked confidence and chose to save rather than spend. This reflects a liquidity trap, where changes in the money supply and interest rates have little effect on aggregate demand, contradicting the monetarist assumption that markets are self-correcting and that monetary policy is always effective. As a result, the economy remained stuck in prolonged recession and high unemployment, showing that prices and wages were sticky in the short run, another key Keynesian assumption. The implication is that relying solely on monetary policy was insufficient to restore full employment, supporting the Keynesian view that demand-side intervention is necessary during deep downturns to stabilise the economy and reduce the severity of recessions.
Monetarist/New classical
The Volcker disinflation
1979-1982
USA
The Volcker disinflation in the United States between 1979 and 1982 provides strong real-world evidence supporting monetarist and new classical assumptions. Faced with persistently high inflation, the Federal Reserve under Paul Volcker significantly reduced money supply growth and sharply increased interest rates. Although this led to a short-term rise in unemployment and a recession, inflation fell dramatically and remained low thereafter. This supports the monetarist assumption that inflation is primarily a monetary phenomenon and that controlling the growth of money supply is effective in stabilising prices. Furthermore, the eventual recovery without sustained government spending suggests that markets are capable of self-correction in the long run, consistent with the new classical view that prices and wages are flexible and that economies tend toward their natural level of output. The implication is that monetary policy is effective in managing inflation, and discretionary fiscal intervention may be unnecessary or even destabilising in the long run.