GD - Christiano.pdf

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The Great Depression

Monetary Economics (Macro VI)

Marcelo Mello and Christiano Arrigoni

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References

 _{Mankiw, N. G., (2006), Macroeconomics,}

Worth Publishers.

 _{Blanchard, O. (2005), Macroeconomics,}

Prentice Hall.

 The Economist, several issues.

 _{Walton, G., and H. Rockoff, History of the}

American Economy, 10th edition, 2005.

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What caused the Great Depression?

 _{In 1929 the unemployment rate in the U.S. was}

3.2%. In 1933, it was 25.2%...

 _{What caused the depression? Shocks to the IS}

curve? Shocks to the LM curve?

 _{As shown below, the Great Depression provides}

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Data Source

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Year Unemployment rate

Real GNP Consumptio n

Investment Gov. Purchases

1929 3.2 203.6 139.6 40.4 22.0

1930 8.9 183.6 130.4 27.4 24.3

1931 16.3 169.5 126.1 16.8 25.4

1932 24.1 144.2 114.8 4.7 24.2

1933 25.2 141.5 112.8 5.3 23.3

1934 22.0 154.3 118.1 9.4 26.6

1935 20.3 169.5 125.5 18.0 27.0

1936 17.0 193.2 138.4 24.0 31.8

1937 14.3 203.2 143.1 29.9 30.8

1938 19.1 192.9 140.2 17.0 33.9

1939 17.2 209.4 148.2 24.7 35.2

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Year Nom. Int. Rate

Money Supply

Price Level Inflation Real Money Balances

1929 5.9 26.6 50.6 - 52.6

1930 3.6 25.8 49.3 -2.6 52.3

1931 2.6 24.1 44.8 -10.1 54.5

1932 2.7 21.1 40.2 -9.3 52.5

1933 1.7 19.9 39.3 -2.2 50.7

1934 1.0 21.9 42.2 7.4 51.8

1935 0.8 25.9 42.6 0.9 60.8

1936 0.8 29.6 42.7 0.2 62.9

1937 0.9 30.9 44.5 4.2 69.5

1938 0.8 30.5 43.9 -1.3 69.5

1939 0.6 34.2 43.2 -1.6 79.1

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The Spending Hypothesis

 _{One hypothesis about the causes of the GD is the}

so-called Spending hypothesis which suggests that the depression was caused by contractionary shifts in the IS curve.

 Popular view associates the depression with the stock markets crash of 1929.

 _{However, the evidence suggests that the recession}

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The Spending Hypothesis, cont.

 Several shocks to the IS curve may have exacerbated the initial reduction in spending.

 _{Shock 1: the stock market crash of 1929 may have}

caused a significant shift in the IS curve: by reducing wealth and increasing uncertainty in the economy

consumers were induced to save more rather than continue spending.

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10  _{Shock 2: Boom-bust cycle in housing. Some}

economists suggest that the decline in spending was associated with a large drop in residential investment.

 _{The 1920s were marked by boom in residential}

investment. Once the “overbuilding” became

apparent the demand for residential investment fell substantially.

 _{The slow down in residential and non-residential}

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11  Shock 3: Another possible reason for the decline

in the demand for residential investment was the large drop in immigration in the 1930s.

 _{The next slide shows data on immigration}

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Year New Arrivals Year New Arrivals

1910 1,041,570 ₁₉₂₀ 430,001

1911 878,587 ₁₉₂₁ 805,228

1912 838,172 ₁₉₂₂ 309,556

1913 1,197,897 ₁₉₂₃ 522,919

1914 1,218,480 1924 706,896

1915 326,700 1925 294,314

1916 298,826 1926 304,488

1917 295,403 1927 335,175

1918 110,618 1928 307,255

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13  _{Shock 4: Contractionary fiscal policy of the}

1930s.

 The Revenue Act of 1932 increased various taxes on middle and high-income consumers.

 _{The top income tax after the Act was signed into}

law was 63% ($1 million/year)

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14  _{Shock 5: Credit-crunch - a large number of bank}

failures (more on that later) may have

exacerbated the fall in investment by not providing enough credit to healthy firms.

 _{October 1930: Bank failures in the South and}

Midwest

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The Smoot-Hawley Tariff

 _{June 1930: the Smoot-Hawley Act was approved}

in Congress.

 _{The Smoot-Hawley Act increased the import}

tariff on a number of agricultural goods.

 Was the Smoot-Hawley Act a cause of the depression?

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The Money Hypothesis

 _{This hypothesis places primary blame for the}

depression on the Fed.

 _{The money supply fell 25% from 1929 to 1933.}

However, the price level also fell by 25% in the 1929-33 period.

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17  _{Does that mean that monetary events were}

irrelevant to explain the depression?

 _{As shown below, monetary events were very}

important in explaining the depression.

 _{The Monetary Hypothesis is associated with}

Milton Friedman and his brilliant book “A

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18  _{M1=currency +checkable deposits}

 M1=B*multiplier, where B=monetary base=currency +banks’ reserves.

 _{The multiplier depends on how much reserves}

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19  _{The monetary base, B, increased from 1929 to}

1933. This implies that the decrease in M1 came from the decrease in the money multiplier.

 Why did the multiplier decline so much?

Because of a large number of bank failures.

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20  _{Checkable deposits at failed banks became}

worthless.

 Moreover, once banks start to go bust people take their money out of the banks and fearful

banks tend to maintain a higher level of reserves in relation to deposits.

 _{These events caused to the money multiplier to}

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24  _{The Fed should have increased the money supply}

enough to more than offset the decrease in the money multiplier.

 This would have shifted the LM to the right and helped the economy get out of the depression (or even avoided the depression).

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Is deflation bad? Expansionary effects

 _{As P falls, real money balances increases, M/P. This}

effect causes the LM to shift down, which leads to higher income.

 _{The Pigou Effect: Real money balances are part of}

households’ wealth. As P falls and real money

balances rise, consumers feel richer and want to

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The destabilizing effects

of deflation: contractionary effects

 Debt-deflation theory: unexpected changes in

inflation redistribute wealth between debtors and creditors.

 Real debt is defined as Debt/P. If P falls, the debt increase in real terms. This distributes

wealth from debtors to creditors. IS shifts to the left.

 _{Why this could have had contractionary effect}

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27  _{Real effects of a financial crisis [Bernanke}

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28  How does expected changes in prices affect

income?

 _{Recall that r=i-}πe_{. Investment depends on the}

real interest rate, and the money demand depends on the nominal interest rate.

The IS-LM model:

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29  _{Suppose that initially we have}πe_{=0, and that}

suddenly everyone expects deflation, that is,

πe_<0.

 For a given nominal interest rate, the real interest rate must be higher.

↑

r=i-

π

e

↓

 The increased real interest rate for a given

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The Money Hypothesis: conclusion

 _{The money hypothesis}is not about contractions on M/P causing decreases on GDP!

 _{The money hypothesis}is about contractions on M causing deflation and this deflation causing decreases on GDP through the debt deflation and expected deflation channels!

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The Money Hypothesis: recent

discoveries

 _{From the 1980s, historian economists has}

sought to confirm the money hypothesis looking at international data.

 This is a natural course, since the great depression was a global phenomenon.

 They discovered that there was an important link between the gold standard (the

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The Money Hypothesis: recent

discoveries

 _{Conclusions from that research:}

 The monetary contraction in the US before the crash (1928) was automatically transmitted to the countries adopting the gold standard.

 The severity and duration of recessions in each country were tightly linked to the extent in

which the country remained in the gold

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Conclusion: What caused the Depression?



_{There were several negative shocks to the IS}

curve in the 1930s.



Furthermore, the Fed’s inaction may have

made a bad situation worse. The amount of

real money balances, M/P, didn’t change

during the GD (which means that the LM

curve didn’t shift) but the fact that we had

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Conclusion: What caused the Depression?



_{Besides, the international monetary system}

at that time, the gold standard, make things

worse!



The Fed’s inability to manage this system

and the importance of US economy made the

great depression a global phenomenon.



_{Countries that insisted for a longer time to}

stay within this system had the worse

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Conclusion: What are the policy lessons?

 The Fed should have increased the money supply in an attempt to change inflation expectations.

 A large increase in the growth rate of the

money supply could have reversed inflation expectations, from πe<0 to πe>0.

 Given that the nominal interest rate was so low, positive inflation expectations would have

generated low or negative real interest rates,

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Conclusion: What are the policy lessons?

 Policy makers at that time didn’t know about the IS-LM model. Imagine that: raising taxes to balance the budget in the midst of a recession with deflation!!!

 Macroeconomics as a science was at best in its infancy at that time of the Great Depression.

 In fact, some say that the Great Depression marks the birth of macroeconomics with the

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Conclusion: What are the policy lessons?

 Another important lesson: Central bank and governments must worry about financial

stability!

 The failure of a large amount of banks was an important factor deepening the recession!