Macroeconomics

1
Macroeconomics

• Lecture 8
• The Great Depression

2
Outline

• Business cycle shocks in the IS-LM model.
• The IS-LM model in action the Great Depression.

3
Business cycle shocks

• The propagation mechanism in the IS-LM model

4
Demand shocks and the business cycle
Real demand shocks
Nominal demand shocks
Fluctuations in real GDP
Shocks
IS-LM model
Propagation mechanism
5
Real demand shocks
negative demand shock
A
B
because of crowding in of I!
6
Nominal demand shocks

• Shock increase in demand for liquidity
• At given Y, R and Ms there is EDM.
• To clear the market
• Y must be lower (less transaction demand) and/or
• R must be higher (less speculative demand)
• LM curve shifts in (and/or down).

7
Nominal demand shocks
B
A
Negative demand shock
because the interest rate helps clear the money
market.
8
Summary real and nominal demand shocks
Real demand shocks
Nominal demand shocks

• C
• R
• I

Procyclical
Procyclical
Countercyclical
Procyclical
Countercyclical
Procyclical
Countercyclical investment movements are
inconsistent with empirical evidence.
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The Great Depression
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11
The unemployment rate in the US, 1929-1939
Source Revised data by Michael Derby
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Overview of Events in the US
1928
1929
1930
1933
time
Bank failures and runs.
The FED tightened monetary policy
Stock market crash

• Money supply
• down.
• Funds for
• investments
• dry up.
• Price deflation

Pushed interest up and initiated a recession.
Uncertainty about future income immediate
wealth loss
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The Start of the Recession

• By 1928, the US economy was already moving
  towards a recession when the FED tightened
  monetary policy to reduce capital outflows
• Ms falls, R increases, and Y falls.

LM shifts in

• Investment boom (residential) in the late 20s.
• Stock market boom (speculative bubble).

14
The nominal Interest in the US, 1928-39.
The rise in the interest rate might have
contributed to the subsequent stock market
crash.
Source Romer (JEPER, 1993)
15
The stock market index in the US, 1928-39.
Index 1928100
The rise in the interest rate might have
contributed to the subsequent stock market
crash.
Source Romer (JEPER,1993)
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The propagation of the stock market crash
Investment decisions are based on expectations
about future profits
Consumption decisions are based on expectations
about future income or wealth
Expected real wealth
Stock market crash
IS shifts in
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Decomposition of the change in GNP in US, 1930-33.
Fraction of change in GDP accounted for by
Source Romer (JEPER, 1993)
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Overview of Events in the US
1928
1929
1930
1933
time
Bank failures and runs.
The FED tightened monetary policy
Stock market crash

• Money supply
• down.
• Funds for
• investments
• dry up.
• Price deflation

Pushed interest up and initiated a recession.
Uncertainty about future income immediate
wealth loss
19
The banking crisis

• Uncertainty about the solvency of banks caused
  bank runs, which were not prevented by loans from
  the FED.
• This generated (endogenously) a reduction in the
  nominal stock of money.
• Investment funds dried up.
• Inwards shift in
• LM curve
• IS curve

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Deflation Pressures

• Tightening of monetary policy fall in aggregate
  demand.
• The propagation of the stock market crash through
  the fall in investment and consumption fall in
  aggregate demand
• Banking crisis fall in Ms and in investments
  funds fall in aggregate demand.

AS
P
AD0
AD1
Y
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Stabilizing Effects of Deflation
Stabilizing effects
Keynes effect
A
Pigou effect
B
The Keynes effect may not work if the economy is
in a liquidity trap!
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Destabilizing Effects of Deflation
The Fisher equation
IS shift in for given i
Expectations about continued fall in the price
level can cause a substantial contraction in
demand.
A
B
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What about economic policy?
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The role of economic policy

• The FED was inactive and did little to expand
  money supply or prevent the banking crisis. After
  1933, it expanded money supply, though.
• The US Treasury was concerned about balancing the
  budget, and actually ran a very tight fiscal
  policy in 1933.

25
Total government full-employment surplus out of
full-employment output.
Brown (AER, 1956)
26
The Money Aggregates and the CPI price index in
US, 1928-39.
Dornbusch, Fischer and Startz (2001)
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What could have been done?

• Keynes suggested an expansionary fiscal policy.
• Regulation and control of banks and bail-outs
  and the FED playing a more active role as lender
  of last resort.
• Active monetary policy earlier on though
  monetary policy seemed to have been important for
  the actual recovery, despite the potential
  liquidity trap.

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DAD-SAS (R,?,Y)
This is next!
Labour market (AS)
Goods market Keynesian Cross (IS)
AD-AS (R,P,Y)
IS-LM (R, Y) AD
Financial markets (LM)
Finished!
Foreign exchange markets
AD (Rf,Y,e, NX)
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What is next?

• Aggregate demand
• Different representations of the supply side of
  the economy (i.e., the labour market).

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The liquidity trap
Extra slides.
The Keynes effect is ineffective and so is
monetary policy.
A
When the nominal interest rate becomes
sufficiently close to zero 1) it cannot fall
further and 2) bonds and money become close
substitute, so the public is willing to hold
what ever amount of money is supplied at a given
interest rate.
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Y
Real demand shock
Y1
time
T0
T1
C
C0
Consumption moves procyclically
C1
time
T0
T1
I
I1
Investment moves countercyclically
I0
time
T0
T1
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Y
Nominal demand shock
Y1
time
T0
T1
C
C0
Consumption moves procyclically
C1
time
T0
T1
I
I1
Investment moves procyclically
I0
time
T0
T1