Download Lecture 13: The Great Depression

Lecture 13:
The Great Depression
November 1, 2016
Prof. Wyatt Brooks
Finishing the Equity Premium
 Equity Premium:
 How much higher is the average return on
stocks than on safe assets (US Treasury bonds)
 Answer: Huge.
 Why does it matter?
 Individual: Retirement savings all in stock (?)
 Society: Inequality? Wealthier individuals tend to
investment more in stocks than poorer (r > g)
AGGREGATE DEMAND AND AGGREGATE SUPPLY
1
Explaining the Equity Premium
 People are highly risk averse?
 For this to be true, need them to be incredibly risk

averse
For example, you would take $51,300 for sure instead
of a coin flip for $50,000 or $100,000
 Maybe institutional investment
 Many very large saving entities (like pension funds
and the SS trust fund) are required to save in US
Treasuries, driving the returns down
 We don’t know. Called the “equity premium puzzle”
AGGREGATE DEMAND AND AGGREGATE SUPPLY
2
Background on the Great Depression
 How did it start?
 What is a “bank run”?
 What role does social psychology play in bank
runs?
 What do bank runs do to the money supply?
 How did the Federal Reserve react?
3
Causes of the Great Depression
 Bank failures caused a huge decrease in the
supply of money
 A decline in the quantity of money causes prices
and wages to fall
 A fall in prices and wages causes a fall in the
amount that gets produced in the short run
 We will discuss this more later
AGGREGATE DEMAND AND AGGREGATE SUPPLY
4
Role of Federal Reserve
in Banking Crises
 Suppose a banking crisis reduces the supply of
money
 Then the Federal Reserve can increase the
supply of money
 Open Market Operations
 If they can do this perfectly, they can minimize
the effect of the banking crisis on the economy
AGGREGATE DEMAND AND AGGREGATE SUPPLY
5
“You’re right. We did it. We’re very sorry. But
thanks to you, we won’t do it again.”
- Ben Bernanke to Milton Friedman (Nov. 8, 2002)
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Size of Great Depression
 In the Great Depression the Federal Reserve
didn’t do this
 Led to a severe recession
 We can compare it to the Great Recession where
the Fed did intervene to increase money
AGGREGATE DEMAND AND AGGREGATE SUPPLY
7
What did these recessions look like?
Recessions typically have several features in
common:




Big, persistent decline in employment
Losses in GDP
Tiny losses in total consumption
Really big losses in investment and trade
AGGREGATE DEMAND AND AGGREGATE SUPPLY
8
Hours Worked per Working Age Person
100
Early 1970s
98
Early 1980s
96
94
92
Great Recession
90
88
0
3
6
9
12
15
18
Quarters since Start of Recession
AGGREGATE DEMAND AND AGGREGATE SUPPLY
9
Hours Worked per Working Age Person
100
Early 1970s
98
Early 1980s
96
94
92
Great Recession
90
88
0
3
6
9
12
15
18
Quarters since Start of Recession
AGGREGATE DEMAND AND AGGREGATE SUPPLY
10
Hours Worked per Working Age Person
100
95
90
85
Great Depression
80
75
70
0
5
10
15
20
25
AGGREGATE DEMAND AND AGGREGATE SUPPLY
30
35
40
11
Reaction of Monetary Policy
What happened in the Great Depression?
 Federal Reserve reduced money supply
 Didn’t bail out banks
What happened in the Great Recession?
 Federal Reserve greatly increased money supply
 Coordinated big bank bailouts/acquisitions
AGGREGATE DEMAND AND AGGREGATE SUPPLY
12
Fiscal Policy
Fiscal policy: Choice of taxes and government
spending by the Federal government
 During recessions, the government can cut taxes
or increase spending to stimulate the economy
 Increases debt, but should be paid off when the
economy exits the recession
AGGREGATE DEMAND AND AGGREGATE SUPPLY
13
Reaction of Fiscal Policy
What happened in the Great Depression?
 Huge spending programs, with a long delay
 Huge tax increases
What happened in the Great Recession?
 Stimulus immediately, mostly in the form of tax
cuts, though some spending (cash for clunkers!)
 Also, big transfer payments to the unemployed
AGGREGATE DEMAND AND AGGREGATE SUPPLY
14
Economic Regulation
 Government plays an important role in regulating
many aspects of the economy
 For example: Try to regulate the banking sector
to reduce the likelihood and severity of banking
crises
 May also have industry-specific regulations, that
have the goal of helping the economy
 May use trade barriers to protect domestic
industries
AGGREGATE DEMAND AND AGGREGATE SUPPLY
15
Reaction of Regulation
What happened in the Great Depression?
 Sweeping banking reforms
 Big increases in import tariffs
 Big New Deal programs
What happened in the Great Recession?
 Banking reforms: Dodd-Frank
 Auto Industry Bailouts
AGGREGATE DEMAND AND AGGREGATE SUPPLY
16
Stabilization
 The economy exhibits a business cycle
 Periodic recessions and expansions
 Recessions are bad, so maybe the economy can
be “stabilized”
 “Smooth out” the business cycle
 Broad debate: What role can/should the
government play in stabilization?
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17
Three Perspectives on Stabilization
 Keynesian
 Government action plays an important role in
helping the economy exit recession
 Real Business Cycle
 Government action can do very little to affect
total economic activity
 Austrian Theory of the Business Cycle
 Government action is the fundamental cause of
recessions and business cycles
AGGREGATE DEMAND AND AGGREGATE SUPPLY
18
Keynesian Interpretation of Recession
 The economy experiences some disturbance
(e.g., bank failures, dust bowl, mortgage crisis)
 Demand goes down, which means prices should
go down
 Prices go down (deflation) and quantities go
down (reduced GDP)
 However, prices are rigid: they cannot fall fast
enough
 Therefore, quantities fall even more than they
would otherwise
Keynesian Solution
 The problem is that prices need to fall by more
than they can
 Two solutions
 Increase the supply of money, so that prices
don’t need to fall by as much
 Increase government spending to “replace”
decreased demand
 Either or both of these solutions can help the
economy to exit the recession faster
Real Business Cycle Theory
 Keynesian policy only works if prices are rigid
 Money and government spending cannot affect
the economy if prices are not rigid
 Difficult to find evidence of these rigidities
 This implies that stabilization is ineffective
 E.g., Fed policy cannot turn unemployed
construction workers in NV into nurses in IL
 All recessions are due to changes in the “real
economy”
 Sometimes called “supply side” economics
Ed Prescott
 Nobel Prize, 2004
 Professor at Arizona State
 Leader of the Real Business
Cycle school of thought
 Argues that Fed policy and
fiscal policy have almost no
role in stabilization
RBC vs. New Keynesian
 RBC:
 Quantitative RBC models can match all
aspects of the business cycle ignoring money
 NK models rely on nominal rigidities, which
have limited evidence
 New Keynesian:
 Empirically, it seems that stabilization policies
have some effect
 RBC has no implications for policy
“But this long run is a misleading guide to
current affairs. In the long run we are all
dead. Economists set themselves too easy, too
useless a task, if in tempestuous seasons they
can only tell us, that when the storm is long
past, the ocean is flat again.”
J. M. Keynes, Tract on Monetary Reform (1923)
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Austrian Theory
of the Business Cycle
 A heterodox school of thought on business
cycles and the role of the Fed is the Austrian
School of macroeconomics
 Leading figures include F. A. Hayek and Ludwig
von Mises
 Influential in the early 20th century, though they
are now considered out of the mainstream
 Mainstream economists criticize its lack of
falsifiability (theories cannot be tested)
Austrian Theory of the Business Cycle
 The Fed is the source of the business cycle
 The Fed prints money, which distorts the rate at
which people calculate the present value of
investments
 In particular, by lowering interest rates, people
invest too much
 The things they invest in are bad uses of
resources
 Eventually, people realize their investments are
bad, leading to a recession, causing the Fed to
print more money (and on and on….)
Arguments for the Austrian Theory
 … the story sounds pretty familiar:
 Recessions often preceded by asset bubbles
(tech stocks, houses, European debt)
 The “mal-investment” story seems to describe
the run up to the housing crisis
 Many people think the Fed kept interest rates
low too long during the 2000s, which
encouraged mortgage lending
Arguments against Austrian Theory
 Story assumes people are constantly fooled by
monetary authority
 Does not match consumption and investment
patterns during booms and busts
 Argument depends on a “capital-driven” business
cycle (big increases in capital during booms, the
opposite during busts). In reality, they are
“productivity-driven”.
 Methodology: Austrians do not use mathematical
models, making their arguments difficult to
formalize