Lecture 13: The Great Depression

Transcription

1 Lecture 13: The Great Depression November 1, 2016 Prof. Wyatt Brooks

2 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

3 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

4 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

5 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

6 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

7 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) 6

8 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

9 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

10 100 Hours Worked per Working Age Person Early 1970s 98 Early 1980s Great Recession Quarters since Start of Recession AGGREGATE DEMAND AND AGGREGATE SUPPLY 9

11 100 Hours Worked per Working Age Person Early 1970s 98 Early 1980s Great Recession Quarters since Start of Recession AGGREGATE DEMAND AND AGGREGATE SUPPLY 10

12 100 Hours Worked per Working Age Person Great Depression AGGREGATE DEMAND AND AGGREGATE SUPPLY 11

13 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

14 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

15 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

16 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

17 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

18 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? AGGREGATE DEMAND AND AGGREGATE SUPPLY 17

19 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

20 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

21 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

22 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

23 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

24 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

25 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) 24

26 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 20 th century, though they are now considered out of the mainstream Mainstream economists criticize its lack of falsifiability (theories cannot be tested)

27 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.)

28 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

29 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