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Rethinking the Great Depression

Rethinking the Great Depression. ECO 473 – Money & Banking Dr. D. Foster. Myth vs. Reality of the Great Depression. The myths: Capitalism failed. Markets failed. Government intervention was necessary. The New Deal saved capitalism. Growth in the 1920s was illusory.

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Rethinking the Great Depression

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  1. RethinkingtheGreat Depression ECO 473 – Money & Banking Dr. D. Foster

  2. Myth vs. Reality of the Great Depression The myths: • Capitalism failed. • Markets failed. • Government intervention was necessary. • The New Deal saved capitalism. • Growth in the 1920s was illusory. • Herbert Hoover was a do-nothing President. The reality:

  3. Myth vs. Reality of the Great Depression What happened in the 1920s?: • Increased auto ownership. • The country became increasingly electrified. • Increased income. • Stock market boom.

  4. Myth vs. Reality of the Great Depression What happened in the 1920s?: • Increased auto ownership. • The country became increasingly electrified. • Increased income. • Stock market boom. Problem areas: wheat, coal What precipitated the Great Depression? • Failure to maintain the gold standard. • Collapse of sound monetary policy.

  5. The Gold Standard $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $4.86 = £1 $50 mill. £10.29mill. • American firms export goods to England … tractors. Value = $50 m. • British firms export goods to U.S. … fish & chips. Value = £10.29 m. • At exchange rate of $4.86 = £1, the £ earned by U.S. firms will just trade for the $ earned by the British firms. • Suppose that British exports fall by 23% and that there is only £8 mill available in foreign exchange market (to buy $).

  6. £8 mill. $50 mill. The Gold Standard $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $4.86 = £1 • Now, American exporters can’t exchange all of their £10.29 mill. for $. • They can only exchange £8 mill. at the going exchange rate. . . . receiving $38,880,000. But, they aren’t going to lose here… • They would cash the rest out in gold: £2.29 mill. = 538,823 oz. • They would redeem in U.S. for dollars: 538,823 oz. = $11,120,000 • Total value received = $50,000,000

  7. The Gold Standard $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $4.86 = £1 £10.29 mill. $50 mill. • The flow of gold from England to U.S. won’t persist over time. M•V=P•Y  gold =  MS  MS =  P deflation  gold =  MS  MS =  P inflation • U.S. exports fall, British exports rise; trade flows balanced.

  8. Confounding The Gold Standard In England, deflation means an economic slowdown and a (hopefully) mild recession (unemployment). M•V=P•Y To counteract these effects, the Bank of England can raise interest rates. This will attract foreign investment (capital inflows) that will offset the trade imbalance and end the outflow of gold. • If it persists, higher interest rates will cause a recession.

  9. Confounding The Gold Standard In the U.S., expanding the money supply means inflation and falling exports. M•V=P•Y To counteract these effects, the Federal Reserve can “sterilize” gold inflows by acquiring the gold (buy with taxes or sell securities). This prevents inflation and protects exporting firms. • This counteracts what the British are trying to do . . .

  10. Stress on the Gold Standard WWI - Combatant countries go off gold standard to spending. Gold rushes into the U.S. as countries buy war material. Post-WWI, gold stocks insufficient for existing price levels. Worldwide deflation (i.e., depression) is required. Victors can ease burden by acquiringgold stocks. Burden on losers is unsustainable. Eventually, U.S. lends gold to Germany.

  11. Stress on the Gold Standard The Gold Exchange Standard: U.S. & U.K. hold gold Other countries hold gold, $, £ U.K. recession restores gold value by 1925. France devalues currency; gold inflows. 1927 - France redeems pounds; more gold inflows. Fed lowers i; gold flows from U.S.; burden on U.K. lessened. 1927 - 9% of world’s gold; 1929 - 17%; 1931 - 22% Gold inflows sterilized and MS in France was constant.

  12. The Gold Standard Collapses • U.S. monetary policy is erratic: • 1927 - lowers i (3.5%) and gold flows out. • 1928 - raises i to stop gold outflows. • By Sept. 1929, i up to 6%; gold inflows 1929/1930. • After crash, i lowered; down to 1.5% in April 1931. • Gold outflows 1931; raised i to 3.5%. • March 1932 Fed begins OMO which stops deflation. • OMO stop in July 1932. • Devaluation concerns drive gold outflow Jan-Mar 1933.

  13. Why did the depression last until 1932? Herbert Hoover • Commerce Secretary in the 1920s. • Rallied business leaders in 1922. • Believed solution was to maintain wages & prices. • How a Depression becomes “Great” • Smoot-Hawley tariffs kick off trade war (1930). • Congress increases taxes to cover deficits (1932). • Hoover’s policy erodes business profits and raises unemployment. • Banks fail en masse in 1931-1932. Why didn’t it end?

  14. RethinkingtheGreat Depression ECO 473 – Money & Banking Dr. D. Foster

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