Catastrophic Collapse of Investment and the Great Depression

1. Catastrophic Collapse of Investment and the Great Depression Robert Barsky Miles Kimball University of Michigan and NBER Very preliminary discussion prepared for seminar at Michigan, April 11, 2007. Please do not circulate.

2. Executive Summary: Model • Study Great Depression in standard New Keynesian sticky price model with capital • Provides interesting synthesis of: • Consensus monetary view of Depression emanating from Friedman and Schwartz with • Earlier arch-Keynesian real theories based on collapse of investment, building cycles, “floors and ceilings”, self-fulfilling prophecies, etc. • Has elements of the nonlinear, catastrophe-theoretic development of the latter by Hicks, Kaldor, Goodwin, Kalecki, Varian, etc.but • Money remains the driving variable • Model is modern, recognizable, and totally standard

3. Executive Summary, cont. Empirical Facts • Gross Investment really did collapse essentially to zero • Sharp drop in wage bill • Indicates sharp decline in rental rates on capital • Strongly deflationary environment with very high real interest rates until 1933 • Then sharp turn towards inflation, low real rates • Rental rates and investment didn’t show strong recovery until at least 1935

4. Bottom Line Explanation of Depression and Recovery • Very high real rates confronted low rental rates on capital • Former due to tight money and deflation • Latter due both to low output and possibly high inherited capital stock • This lead to complete investment collapse, apparently hitting between 1931 and 1932 • Turn toward inflation in 1933 plus depreciation of capital eventually reignites investment, but wasn’t enough to do it quickly

5. Elements • NRR curve – net rental rate on capital • MP curve – real interest rate as function of output • Easiest case: LM curve from constant elasticity money demand function • Phase diagram to endogenize inflation

6. When and Why Did Investment Leave Great Depression Models? • Friedman and Schwartz • Persuasive • Highly aggregative; no discussion of components of GNP • Emphasis on why money stock collapsed, not how it caused fall in output • Temin • Pointed out drop of gross investment to near-zero in 1932 but • Found autonomous fall in consumption, not investment (don’t confuse impulse with propagation!) • Bernanke a partial exception • But emphasis is on financing, not implications of investment per se

7. The Net Rental Rate • Rental Market for Capital (no adjustment costs, investment smoothing) • Rental rate R = “marginal cost product of capital” (sticky prices, demand-constrained • r=R-δ • N=Y1/γ(1-α)K-α/(1-α)Z-1(IRTS Cobb Douglas production function) • RK/WN=α/(1-α) (constant cost shares ) • W=–UN/UC = W(N(Y,K,Z),λ)(labor supply)

8. r The Net Rental Rate Curve • Recall that both N and W are increasing in Y • Low Y → low of Investment NRR Note: Curve would be steeper if elasticity of substitution between K and L were less than unity r=0– Y Here gross investment is zero (or at some fixed minimum) Ymin (I=Imin)

9. Wage Bill • Capital essentially fixed over short period • Indicator of Net Rental Rate

10. Gross Investment Collapse Gross Investment Collapse

11. Gross Investment Collapse: Building Index and Building Permits

12. r MultipleShort Run Equilibria MP Selection Criterion: Stay put unless the equilibrium you are at disappears NRR r=0– –πe Y Ynatural Ymin (I=Imin)

13. Depression: Predisposing Factors From 1920s • Low inflation or deflation (Makes MP curve high) • Technology revolution • “Overbuilding”? (Makes NRR curve low) -“liquidationist" viewpoint • Long expansionary period • Easy money? • Over-optimism about growth rates?

14. r Unexpected Monetary Contraction MP NRR r=0– –π Y Ymin (I=Imin)

15. r Expected Deflation MP NRR –π r=0– Y Ynatural Ymin (I=Imin)

16. Hysteresis: A Monetary Restoration May Not Restore the Original Equilibrium r MP NRR r=0– –π Y Ymin (I=Imin) Ynatural

17. Further, Modest Monetary or Fiscal Expansions Provide No Escape r MP Monetary Expansion Shifts MP Right or Down Fiscal Expansion Shifts Ymin Right NRR r=0– –π Y Ymin (I=Imin)

18. An Escape by Monetary Policy Alone Can Cause a Jump Above the Natural Level of Output r MP NRR r=0– –π Y Ynatural Ymin (I=Imin)

19. The Skillful Way Out Involves a Monetary Restoration Plus a Fiscal Expansion r MP NRR r=0– –π Y Ynatural Ymin’=C+Imin+G’

20. Endogenizing Inflation: The Phase Diagram in the Neighborhood of the Steady State in the Absence of an Investment Collapse π steady- state inflation dx/dt =0 π=0 (different positions possible) dπ/dt =0 x (real money balances)

21. The Phase Diagram with Coexisting Blue (Normal) and Red (Depression) Dynamics Shown π steady- state inflation dx/dt =0 Reignition Boundary π=0 (different positions possible) dπ/dt =0 Collapse Boundary x (real money balances)

22. The Phase Diagram with Only the Blue (Normal) and Red (Depression) Saddle Paths Shown π Assume log money follows random walk with constant drift steady- state inflation dx/dt =0 Reignition Boundary π=0 (different positions possible) dπ/dt =0 Collapse Boundary x (real money balances) collapse values of x

23. Lessons From Phase Diagram • Nonlinearity • Need sufficiently large monetary expansion to get to the reignition boundary • Nothing happens to investment and output until then • Hysteresis • Dynamics depend on where you start from • Probably need inflationary boom to reach reignition region • Mundell and Keynes effects • Keynes effect will restore full-employment in long run • Low but rising inflation means Mundell will eventually switch from harmful to helpful

24. Using a Fiscal Expansion to Shift the Reignition Boundary π • Moves boundary to left of of p-dot=0 locus • Avoids need for inflationary boom steady- state inflation dx/dt =0 π=0 (different positions possible) dπ/dt =0 x (real money balances) collapse values of x Reignition Boundary Collapse Boundary