IV. Economic Development and Economic Policies before WWI

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IV. Economic Development and Economic Policies
before WWI

• Classical Model at Work

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General framework (1)

• Period of peace after destructive wars
  (Franco-German in Europe in 1870, civil war in
  the USA 1861-1865)
• Technical development (electricity, combustion
  engine, incandescent lamp, telephone, etc.),
  consequences
• Expansion of transport (both freight and
  personal)
• Concentration of heavy industries
• Development of financial institutions and
  financial markets
• Effects (and costs) of colonial policies
• Gold standard (see bellow)

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General framework (2)

• Liberal ideology politics and economics
• Liberal trade (with repeated protectionist
  attempts)
• Very competitive environment
• Limited government regulation of business
• Prices and wages flexible as never after
• Almost no capital controls
• The governments did not have todays policy
  objectives
• No general social a political pressure to
  guarantee economic growth and full employment

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IV.1 Basic data
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Real GDP, yoy, US, UK1871-1913
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Real GDP, yoy, US, UK1871-2009
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CPI, yoy, US, UK 1871-1913
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CPI, yoy, US, UK1871-2009
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Unemployment, , US, UK1870-1913
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Unemployment, , US, UK1870-2009
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US GDP growth, CPI, unemployment1870-1913
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Changes in GDP and in inflation
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Lesson from the data

• Volatile growth, average growth lower compared,
  e.g., to golden period 1950-1970
• Shorter cycle (no great depressions)
• Inflation low and fluctuating around zero
• Strong fluctuations of unemployment, copying the
  cycle
• Balanced budgets
• Note problems with data reliability, mainly
  ex-post construction (estimates)

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IV.2 Theory Classical model
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IV.2.1 Aggregate supply and demand and
equilibrium on market with goods and services
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Full employment product and aggregate supply

• Equilibrium on labor market full employment N0
• everybody who wants to work at given real wage,
  can find and gets the job
• Capital fixed in the short run K
• Production function Y0 F(K,N0)
• Output (product) Y0 determined by full employment
  N0 ? full employment product (output, income,
  etc.), equals aggregate supply AS Y0
• Changes in Y0 only if
• shift in labor demand/supply schedules
• shifts in production function

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E
N
Y
N
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Aggregate demand

• Consumption function
• Investment function
• Governmental expenditure G
• Aggregate demand

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Equilibrium

• Aggregate supply AS
• Labor market in equilibrium employment N0
• Production function aggregate supply Y0
• Aggregate demand
• Equilibrium ADAS, hence
• Classical question what ensures that if
  supply is determined by full employment from
  labor market AD exactly matches AS?

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IV.2.2 Equilibrating mechanism.
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Equilibrium and real interest

• Basic identity (remember LII) I S (T G)
• Remark on notation here S is used for personal
  savings only (Sp in LII)
• For classical model
• and when output Y is given on the supply side,
  then real interest r is only variable that
  adjusts to bring the aggregate demand to be
  exactly equal to given aggregate supply
• Ex-ante, the identity becomes and equilibrium
  condition, with interest r as equilibrating
  variable rewrite it as

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r
r1
r0
r2
I(r)G
IG, ST
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Loanable funds interpretation

• Savings supply of loanable funds households
  and government postpone the consumption, creating
  funds that may be used for investment financing
• Investment plans demand for financing, demand
  for loanable funds
• Real interest price, that adjusts and
  equilibrates the model
• If rgtr0, then excess supply of loanable funds and
  r decreases
• If rltr0, then excess demand of loanble funds and
  r increases
• Remark Say's law

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IV.2.3 The quantity theory of money
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David Hume

• 1711 1776
• Philosopher, historian
• 1752 Political Discourses, especially essay Of
  Money
• Diplomat

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The Quantity Equation

• Total expenditures in an economy expressed in
  two ways
• P.TRN, where P is aggregate price, TRN is number
  of transactions in the economy
• M.V, where M is nominal quantity of money, V is
  the transactions velocity of money
• V rate, at which the money circulates in the
  economy (how many times a unit of money changes
  hands)
• Both expressions must be equal, quantity
  equation
• M.VP.TRN
• Ex-post always true, identity (it is not a
  theory)
• TRN impossible to measure, approximation by total
  income (product) Y
• M.V P.Y
• V income velocity of money

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The Quantity Theory

• Theory seeks to answer following questions
• How is the equilibrium amount of money in the
  economy determined?
• What is the impact of the money on the economy
  (does the change of amount of money influences
  output, price, employment, etc.).
• Two versions of QTM

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Irving Fisher

• 1867-1947
• American
• Neoclassical Marginalist Revolution, mathematical
  methods
• Introduced Austrian economic school to the USA
  (Theory of capital and investment, 1896-1930),
  intertemporality
• Quantity theory of money (1911-1935)
• Loss of credibility during Great Depression

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Fishers QTM (1)

• Two assumptions in the framework of classical
  model
• In equilibrium, real output determined by full
  employment labor (given at the cleared labor
  market). Real economy independent on money
  supply.
• Velocity of money is given by technical features
  of the markets and is not in any relation to
  amount of money in the economy
• Usual corollary (however, not stipulated by
  Fischer himself) around equilibrium (i.e. at
  least in the short-term) velocity V is constant

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Fishers QTM (2)

• How the quantity equation becomes a theory ? If
• V and Y is fixed with respect to money supply
• Money is required for transactions
• Money supply M is exogenous
• then M.V P.Y is an equation of the model
  (required to be valid ex-ante) which says that in
  equilibrium, when output Y is given in the real
  sector of the economy and V is constant, the
  supply of money, controlled by central bank,
  determines the price level P only (P is
  proportional to M)
• Corollary real variables (output and its
  components, unemployment, etc.) are independent
  on the amount of money or, change in the money
  supply has an impact on the price level only (but
  not on output)
• Fishers QTM develops from quantity equation,
  no explicit consideration of supply and demand
  for money

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Cambridge version

• Problem of Fishers version aggregate approach,
  does not consider the decision on the individual
  level (not rooted in microeconomics)
• Determinant of money demand on individual level
  need to execute transactions, correlated with
  nominal value of total expenditures
• Demand for money MD k.P.Y, k fraction of
  nominal value of expenditures (of nominal
  income), that society wishes to hold
• k assumed constant
• Equilibrium supply of money MS equals to demand,
  equilibrium equation
• M k.P.Y
• k 1/V, different economic interpretation, but
  assumed to be constant again

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Arthur Cecil Pigou

• 1877 1959
• British, Cambridge University
• Brought social welfare to the attention of
  economists (Wealth and Welfare, 1912)
• Theory of unemployment (1933) served to Keynes as
  a primary example of wrong approach
• Unjustly ridiculed by Keynes in General Theory
• The Classical Stationary State (1943) Pigou
  proved that Keynes was theoretically wrong

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Conclusions for QTM

• Both Fisher and Cambridge versions k (and V) is
  constant
• For classical model
• consistency with the logic of supply side
  potential product determined in the real sector
  only
• consistency with Says law
• implies money neutrality
• price changes proportional to the change in stock
  of money
• Too many open questions (constant velocity,
  inconsistency, when more profound check with
  microeconomic Marshall?), decisively refuted by
  Keynes in General Theory, but equally decisively
  rehabilitated by Milton Friedman and monetarists

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IV.2.4 Complete model(closed economy)
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The model

• Labor market and aggregate supply
• W/P FN(K,N) demand for labor
• N NS(W/P) supply of labor
• Y F(K,N) production function
• Market with goods and services
• Y C I G demand and equilibrium,
• consumption function
• I I(r) investment function
• Financial (money) market
• M.V P.Y price equation and equilibrium
  (Fishers version of QTM)

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Technical features

• 7 equations and 7 endogenous variables
• Y, C, I, N, W/P, P, r
• 3 exogenous variables K, M, G
• 1 constant V
• Equilibrium on 3 markets
• Goods and services, labor (factor) and money
  (financial)
• 2 equation of labor market form an independent
  block, 3 equations of labor market and aggregate
  supply form another independent block

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Static, general equilibrium model

• Time horizon sufficiently short for capital and
  total labor force fixed.
• Time horizon sufficiently long for the
  adjustment of perfectly flexible prices, thus
  ensuring the simultaneous equilibrium on all
  markets
• In particular, this applies for labor market,
  where there is no possibility of involuntary
  unemployment
• Strong theoretical assumptions, but at the end of
  XIX. and beginning of XX. centuries generally
  accepted of more or less consistent with reality

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Dichotomy of the classical model

• Real sector labor market, flexible nominal wage,
  production function, Says law
• full employment equilibrium product
• supply side determines the product at given
  price and amount of money
• Classical dichotomy, money is neutral

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P
AS
P0
M0V
W0
W0/P0
Y0
Y
W/P
ND
N0
F(K,N)
NS
N
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IV.3 Classical gold standard
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Starting points

• Full employment equilibrium, QTM, money
  neutrality
• ExR (nominal) determined by PPP (monetary
  approach to ExR determination)
• In equilibrium, also interest parity holds (i.e.
  ExR, as determined by asset approach, equals PPP
  as well)

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Domestic standard money supply

• Free convertibility between gold and non-gold
  money guaranteed by state
• Domestic standard (norm), regulating the quantity
  and growth rate of money supply
• i.e., amount of gold reserves determines money
  supply and prices
• Reserves very stable ? money supply (and price
  level) over time stable
• However, in the short term large volatility of
  prices
• Gold standard sensitive to (i) gold discoveries
  that change price of gold (b) all types of
  supply and demand shocks

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International standard fixed ExR

• Fixed price of gold in terms of each countrys
  currency (mint price)
• After 1880 20.67 or 4.24 per troy ounce
• By implication, fixed exchange rates between each
  pair of currencies in the system
• Given US and UK mint prices above 4.875 USD/
• Two crucial commitments, internationally accepted
• each Government (Central Bank) ready to buy/sell
  unlimited amount of gold at mint price
• free trade of gold across the borders

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Arbitrage and gold points

• Free trade with gold ? the same exchange rate
  between, e.g., and , 14 (no risk and
  transportation costs) both in N.Y and London
• If not, arbitrage
• Exchange rate remains fixed even if risk and
  transportation costs considered
• Gold points if risk and other costs e.g. 5,
  then 13.8 - 4.2

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Price-specie-flow mechanism (P-S-F)

• Assume an exogenous change, discovery of gold ?
  increase of money supply, two consequences
• domestic price increase ? domestic goods more
  expensive relative to foreign goods ? fall of
  exports, increase of imports ? CA deficit
• fall of nominal interest ? interest parity
  breached ? domestic investment less attractive ?
  non-reserve part of financial account in deficit
• Both consequences BoP deficit, pressure on ExR
• Long-term PPP not equal to (fixed) ExR
  (different shifts in domestic and foreign price
  levels)
• Short-term interest parity does not hold
• P-S-F automatic BoP adjustment, both on goods
  and financial markets

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P-S-F goods market

• BoP deficit outflow of official reserves, i.e.
  gold (remember LII.3, in modern world, official
  reserves settlement) ? decrease of money supply
  ? fall of prices (see QTM above) ? domestic
  exports cheaper, imports for foreigners more
  expensive ? increase of exports, decrease of
  imports ? improvement of BoP deficit
• Price levels shift back until PPP again equals
  (fixed) ExR

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P-S-F financial markets

• The same reaction to financial account deficit as
  on the goods market
• Capital (investment) moving from domestic country
  abroad ? gold moves from home country ? domestic
  money supply decreases ? fall of price level and
  the rest of adjustment like on goods market
• With adjustment of money supply, interest adjusts
  as well and interest parity holds again

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Remark

• Try to trace P-S-F for another scenario
• Technological innovation in the home country,
  unchanged money supply ? increase of real output
  ? price decrease
• BoP surplus
• Adjustment?

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P-S-F summary

• Reaction to deficits/surpluses of BoP (provided
  that conditions for smooth gold standard
  operation are fulfilled)
• Flows of gold ensure quick adjustment to BoP
  imbalances
• Equilibrium in international economic/financial
  relations as prevailing tendency
• Fixed exchange rates maintained as all adjustment
  based on the central banks readiness to buy/sell
  gold at fixed price

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Rules of the game

• Under the validity of assumptions P-S-F works as
  automatic mechanism
• In reality main countries (UK, France, Germany,
  US, Italy, etc.) agreed to play according common
  rules of the game
• Country suffers BoP deficit ? central bank
  decreased the interest (discount) rate (and
  other commercial bank decreased their lending
  rates as well) ? facilitates the gold outflow and
  the efficiency of P-S-F
• With BoP surplus ? central bank increases basic
  rate

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How did it work in reality?

• Surprisingly well!
• Crucial role of Bank of England (UK central
  bank), almost always followed rules of game
• Other central banks quite often tried to breach
  rules of the game, preventing capital flows
• Central country (Great Britain) reserves in
  gold
• Many other countries reserves in gold and
  British sterling
• However, as a prevailing tendency, classical gold
  standard worked

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Consistency with classical model

• Reality indeed (at least to some extent)
  reflected assumptions of classical model
• price and wage flexibility, no capital controls
• small governments with balanced budget,
  anti-inflationary policies and stable money

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Role of Government

• In theory (to lesser extent in practice) gold
  standard does not provide much space for active
  monetary policies gold flows, when reacting to
  BoP surplus/deficit, just adjust money supply to
  money demand again consistent with classical
  model
• In reality central banks did have some space for
  policy options
• Large gold reserves (France), allowing for gold
  flows to adjust
• Relatively small reserves (Britain), managing
  discount rates and BoP imbalances financed by
  short term flows

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IV.4 Policies
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Multipliers - general

• Intuitive interpretation the change of (or a
  direction of change from) equilibrium value of an
  endogenous variable when value of exogenous
  variable changes
• Policy interpretation exogenous variable as
  policy instruments, e.g. if money supply or taxes
  increase, what is the impact on endogenous
  variables of the system
• Historically first Richard Kahn, a student of
  Keynes, for particular situation impact of
  governmental expenditure on output and
  consumption, see Lecture on Keynes
• Mathematical interpretation partial derivative
  of a reduced form of the model

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Multipliers classical model (1)

• Independent set of first 2 (3) equations of the
  model (labor market and production function)
• Labor market forms an independent block, first 3
  equations form another independent block
• Equilibrium values of output, real wage and
  employment influenced by amount of capital K only
• Short-term dK 0 ? dY, dN, d(W/P) 0

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Multipliers classical model (2)

• Reduced form derivatives
• Interest
• Consumption
• Investment
• Price

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Policy implications

• Different social demand and different policy
  goals
• Economic growth and full employment were not
  perceived as visible targets
• Governments were not perceived as being
  responsible
• Classical model - limited possibilities for
  macro-policies
• Fiscal policies crowding-out of the private
  investment (see next slide)
• Monetary policies only impact on general price
  level, but subdued to the fixed ExR regime (gold
  standard)

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Crowding-out effect

• In the classical model, when output given on the
  supply side, increase of any component of
  aggregate demand can not cause increase of output
  (and employment)
• Zero efficiency of fiscal policy increase in
  governmental expenditures at the cost of decrease
  of investment/consumption
• Value of fiscal multiplier equals zero

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Money neutrality

• Change of money has an proportional impact on the
  price level
• Amount of money has not any consequence for real
  output and employment
• See graphical exposition on the next slide
• Value of money multiplier equals zero

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P
AS
M1gtM0
P1
M1V
W1
P0
M0V
W0
W0/P0
Y0
W0/P1
W1/P1
Y
W/P
ND
N0
F(K,N)
NS
N
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Policies of the Government

• Guarantee competitive environment
• Anti-trust legislation
• First regulatory attempts on financial markets
• First interest in economic cycle, but no policy
  recommendations
• Trade policies period of deep trade
  liberalization
• Economic aspects of colonial policies
• Mitigating the worst cases of poverty

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Literature to Ch.IV

• Snowdon, B., Vane, H., Modern Macroeconomics,
  Edvard Elgar, 2005, Ch.2, pp.36-54
• Basic reading to this chapter and literature
  there, with exception of gold standard
• Mankiw, G.N. Macroeconomics, Worth Publishers,
  New York, 1992 (and subsequent editions)
• In Ch. 3 and 7, most of the features of classical
  model are being discussed
• Sargent, T., Macroeconomic Theory, Academic Press
  1987 (2nd ed.), Ch. 1
• Very difficult, mathematical approach. However,
  if you struggle through (or even skip much of)
  mathematics, you get a very clear picture of the
  model, discussed in this chapter.
• Mishkin, F.S., The Economics of Money, Banking
  and Financial Markets, HarperCollinsPublishers,
  1993 (3rd ed.), Ch. 23, pp.523-530 (there is a
  Czech translation)
• Comprehensible explanation of QTM
• Krugman, Obstfeld (see above), pp. 470-475 and
  491-496
• Gold standard