The Downturn of 1920-21

1. The Downturn of 1920-21 • 1920-1921: Nominal GNP falls 23.9%, Real GNP falls 8.7%, Prices fall 15.2% • 1929-1930: Nominal GNP falls 12.3%, Real GNP falls 9.9%, Prices fall 2.4%

2. Aggregate Demand • AD = C + I + G + NX • AD = Aggregate Demand • C = Consumption • I = Investment • G = Government Spending • NX = Net Exports = Exports - Imports

3. Consumption: Joseph Schumpeter • Labor productivity rise rapidly in the 1920s, due to improvements in technology. • Real wages do not rise as rapidly as labor productivity, hence the ability to produce goods exceeded the ability to purchase these commodities. The Great Depression was simply a re-adjustment. • Evidence: Number of labor hours required to produce a unit of output in manufacturing fell 40%, but nominal wages changed very little (prices fell 20% which means real wages did rise). • Corporate profits rose, which meant that income was shifted from those that consume to those that save. • Problems: Why does consumption collapse after 1929 after the economic downturn has begun? • Why do prices not adjust? Prior to this time there was very little evidence of rigid prices.

4. More Consumption: Consumer Confidence and Peter Temin • From September of 1929 till June of 1932, about $179 billion in wealth was lost on the nations 34 exchanges. • Stock ownership, however, was limited. Only 5 million people owned any stock and perhaps 500,000 owned 75-85% of outstanding stock. • However, the decline in the stock market may have impacted expectations. • From Temin’s perspective: Consumer’s revised expectations downward in 1930, leading to a significant drop in consumption. • Problems: Why would consumers adopt a pessimistic model when the most recent experience of the nation (1920-1921) suggests the downturn was only temporary?

5. Investment: John Maynard Keynes • 1929-33: Gross investment falls to a point where dis-investment occurs. In other words, the nation’s capital stock was actually declining. • Problems: Investment began declining after the peak in 1926. The biggest portion of investment that declined was residential construction. • Why did residential construction decline? Both birth rates and immigration were falling.

6. Government Spending • 1929: Budget surplus of $1.3 billion • 1930: Budget deficit of $1 billion ($820 million more than Treasury Secretary Mellon predicted) • 1931: Budget deficit rose to $2.7 billion • After this, the federal government raised taxes in 1932, after cutting taxes in 1930. The increase in taxes played a role in intensifying the recession. It should be noted, though, that government spending did not cause the Great Depression, it simply led to its intensification.

7. The Monetarist ViewMilton Friedman and Anna Schwartz • Cause of the initial downturn: Money supply grows 3.8% in 1927 and 1928 • From 1928-29, via Fed policies to discourage speculation, the money supply is lowered so that it grows only 0.4%. • Between April, 1928 and November, 1928 the money supply fell at a rate of 1% per year. • If this was unanticipated, then this may have been sufficient to cause a downturn in business. • Note: This view was first articulated by Keynes at the onset of the Great Depression.

8. Intensification of the Downturn • Stock Market Crash of 1929 • First Banking Crisis (October 1930 – February 1931) • Second Banking Crisis (March 1931- August 1931) • Britain Abandons the Gold Standard (September,1931) • Final Banking Crisis (October 1932 – March 1933)

9. Friedman’s Argument • Friedman and Schwartz cite bank failures as the primary cause of the Great Depression. • What caused the bank failures? Public lost confidence in the ability of banks to repay deposits on demand and chose to substitute currency for demand deposits. The failure of one bank led to a “contagion of fear” until more than 9,000 banks (more than 1/3 of the nation’s total) had failed. • Had the Fed acted with more vigor in bolstering banks, Friedman and Schwartz argue the Great Depression could have been avoided.

10. Functions of Money • Medium of exchange • Unit of account • Store of value Legal Tender - prescribed by law as what may be offered and must be accepted in payment of both private and public debts.

11. Functions of a Bank • Financial intermediation - connecting savers and borrowers. • Banks borrow from savers at a low rate (but high enough to attract savings) and lend at a high rate (but low enough to attract borrowers). • Bankers profits are a function of its matching ability and its willingness to bear the risk of illiquidity. • Banks create money • Banks convert an unacceptable medium of exchange (individual’s promise to repay) into an acceptable medium of exchange (bank’s promise to pay upon demand). • The banks ability to create money means that the collective actions of banks will influence interest rates, inflation rates, and national output. • The power of banks has led to the regulation of the banking system by local and federal governments.

12. A Central Bank • Central Bank - a bank which other banks have in common. • Functions • Control the money supply • Regulate other banks and the financial system • Be the government’s bank

13. Reserve Banking • Bank reserves - assets held by a bank to fulfill its deposit obligations, or, deposits that banks have received but have not loaned out. • 100% reserve banking vs. fractional reserve banking • Fractional reserve banking - a banking system in which banks hold only a fraction of deposits as reserves. • Bank reserves are only a fraction of total deposits. • Reserve ratio = bank reserves / total deposits • Profits are made from loaning out deposits. However a bank will close its doors if it cannot meet the demands of its depositors. So the bank must balance the demands for depositors with the drive for profit.

14. Creating Money • Numerical example. • Joe deposits $1500. • Mo requests loan of $1000, which is deposited in Mo’s checking account. • Bank now has $1000 in loans, and $2500 in transaction deposits. • When a bank makes a loan, the money supply is increased. Why? The debtor now has more money and no one else has any less.

15. The Money Multiplier • The Money Multiplier - the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves. • Example: • $100 is deposited in a Bank A, with 10% reserves • Loan is made for $90, which finds its way to Bank B • Bank B now has $81 in excess reserves which it loans out • Bank C acquires a deposit of $81, which translates into excess reserves of $73.90. Etc. • Money multiplier = 1 / required reserve ratio • If the required reserve ratio = 10%; So, the money multiplier is 10

16. Constraints on Money Creation • Constraints on deposit creation • deposits: people have to be willing to substitute checks for cash. • borrowers: people have to be willing to borrow money. • regulation: the federal reserves places limits on bank lending.

17. Source for Slides • The following nine slides come from Gregory Mankiw’s “Macroeconomics, 6th ed.”

18. What is the Fed’s policy instrument? • The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates. • In fact, the Fed targets the federal funds rate – the interest rate banks charge one another on overnight loans. • Other short-term rates typically move with the federal funds rate.

19. Central bank independence • A policy rule announced by central bank will work only if the announcement is credible. • Credibility depends in part on degree of independence of central bank.

20. Inflation and central bank independence average inflation index of central bank independence

21. CASE STUDY: Monetary Tightening & Interest Rates • Late 1970s:  > 10% • Oct 1979: Fed Chairman Paul Volcker announces that monetary policy would aim to reduce inflation • Aug 1979-April 1980: Fed reduces M/P 8.0% • Jan 1983:  = 3.7% How do you think this policy change would affect nominal interest rates? CHAPTER 10 Aggregate Demand I

22. The effects of a monetary tightening on nominal interest rates short run long run model prices prediction actual outcome Monetary Tightening & Rates, cont. Liquidity preference (Keynesian) Quantity theory, Fisher effect (Classical) sticky flexible i > 0 i < 0 8/1979: i= 10.4% 4/1980: i= 15.8% 8/1979: i= 10.4% 1/1983: i= 8.2%

23. Why the multiplier is greater than 1 • Initially, the increase in G causes an equal increase in Y:Y = G. • But Y  C  furtherY  furtherC  furtherY • So the final impact on income is much bigger than the initial G. CHAPTER 10 Aggregate Demand I

24. The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals Example: If MPC = Marginal Propensity to Consume = 0.8, then An increase in G causes income to increase 5 times as much! CHAPTER 10 Aggregate Demand I