Econ History Final
Explain why Cole and Ohanian think the NIRA prevented recovery from the Great Depression. (selected as a quiz question)
According to Cole and Ohanian, the key depressing element of the policy is the link between wage bargaining and monopolies. These policies reduced output, consumption, and investment by 13% compared to their competitive steady state levels. Their model accounts for half of the weak Y recovery and explains why initial recovery stalled in 1930. Rather than leading to recovery, NIRA increased the bargaining power of labor union and the ability of firms to collude with paying high wages, which prevented normal recovery by creating rents and inefficient frictions that raised wages and restricted employment. Just as adoption of these policies coincided with persistence of depression through late 1930s, the abandonment of these policies coincided with strong economic recovery of 1940s GD Recover = weak & real wages in several sectors rose significantly above trend → opposite of what Neoclassical data predicts of a strong recovery w/ low real wages. 1. Linked collusion with high paying wages. 2. Kept wages high despite output being low → Committed to keeping prices and wages high at the expense of output and employment. 3. ND cartelization policies were designed to limit competition, impose barriers to entry, & increase labor bargaining power. 1. fiscal stimulus deters growth w/ enhanced labor bargaining power. Policies play role in slow recovery, because enhanced labor bargaining power depresses aggregate output & employment. 2. Repeal anti-trust restrictions for industries that agreed to raise wages and collectively bargain. 3. Industry incumbents agreed on "code of conduct" which kept wages & profits high & discouraged entry from new firms. 4. Model indicates New Deal policies reduced competition & investment roughly 14% relative to their competitive balanced growth path levels → so the model accounts for roughly half of the continuation of the GD between 1934-1939. 5. New Deal labor and industrial policies didn't lift the U.S. out of the Great Depression, but instead the joint policies increased labor bargaining power, linked collusion w/ paying high wages, impeded the recovery by creating an inefficient insider-outsider friction that raised wages significantly and reduced employment → Recovery would have been stronger if wages in key sectors had been lower. Chabot's Notes: • Caused monopoles which cut output and raise prices • Creates a monopsony, raises wages; thus hires fewer people; marginal cost goes up so produce less (ie less output) • Raising wages in NIRA industries gives incentives to non-NIRA industries to stop working and search for high paying job (higher the wage differential, the longer the people are willing to wait)
Was the Deflation of the Great Depression Anticipated? How do we know? Why do inflation expectations matter? (this was selected as a quiz question)
Hamilton: • No, Deflation was not anticipated. • Futures prices were well above spot prices for most commodities during most of the Great Depression; evidently the spectacular declines in agricultural prices caught many people by surprise. • Evidence: o Implications of the futures data for expectations about aggregate prices. It is reasonable to treat the futures price of a commodity as the market's best guess as to the future spot price of that commodity. Decompose aggregate price changes into anticipated and unanticipated components. o Movements in aggregate prices that are correlated with commodity futures prices are assumed to have been anticipated by people at the time. o Movements in aggregate prices that are correlated with the error that the futures markets made in forecasting commodity prices are assumed to have been unanticipated by people at the time. o The results suggest that, during the first year of the Great Depression, people anticipated stable prices, meaning that the initial deflation of the Great Depression was largely unanticipated. o In subsequent years, people anticipated significant deflation, though never as severe as was actually observed. Overall, between September 1929 and January 1933, the average rate of deflation was 5.5percent more severe at an annual rate than the commodity market anticipated. o In the second and third years of the Great Depression, people anticipated drops in consumer prices about half as severe as were actually experienced. Cechetti: • Yes, Deflation was anticipated and beginning in late 1930, and possibly as early as late 1929, deflation could have been anticipated at horizons of 3-6 months. This implies, in turn, that short-run ex ante real interest rates were very high during this period. • Evidence: o Simple models of price expectations, based on either univariate time-series representations or on the information contained in interest rates, suggest that the persistence in the inflation process could have led agents to believe that the deflation would continue once it began. Three evidence to suggest the conclusion that the deflation could have been anticipated: • Deflation was within the recent experience of the people living in 1929 (4 cases of deflation between Civil War and Great Depression) • Changes in the price level were positively auto-correlated during the interwar years. This implies that simple rules of thumb would have led to the expectation of continued deflation during the period. • Data on interest rates can be used to extract estimates of both ex ante real interest rates and expected inflation. While nominal interest rates were low, the data suggest that real interest rates were very high from 1927 to early 1933. This implies that people expected the deflation to continue. ARMA Models: • Data: quarterly consumer price data over sample periods beginning in 1919 and ending either in 1928 or in 1940 • Once a deflation begins, it is expected to continue at least briefly. The MA(2) model suggests that, if a deflation were to begin unexpectedly, it would be forecast to continue for two quarters at between onehalf and three-quarters the initial rate. • The conclusion is that inflation during the entire interwar period was substantially serially correlated and that, once a deflation started, it should have been expected to continue for at least 3-6 months. Measuring Expected Inflation from Interest Rates: • Given that nominal interest rates declined steadily from October 1929 to February 1933, with only a brief rise in late 1931 and early 1932, this implies that deflation was anticipated during 1930 and 1931. By the end of 1929, deflation was anticipated, although expectations were a fairly moderate 2-3%. However, as the 1930's began, the price declines were expected to persist, and the absolute size of the anticipated deflation increased. For the first three quarters of 1931, these methods all generated expectations of deflation that exceed 5% Although the econometric evidence suggests that some deflation could have been anticipated, actual price declines were even greater. There was still unanticipated deflation between 1930 and 1933. The estimates suggest that at most 3/4 of the deflation could have been anticipated • Inflation expectations matter because they affect real interest rates
According to Clemens and Williamson which factors attracted British capital and which factors did not? (selected as a quiz question)
The three local fundamentals that mattered most were schooling, natural resources and demography. Essentially Britain was sending its money where it could earn the highest return and that was where the fundamentals served to raise capital's productivity. Did: youth dependency/population growth, net migration, schooling (primary school enrolment), urbanisation, natural resources 1. Essentially, smart population with growing working aged members via birth or migration 2. Natural resources to make into productive goods capital was not attracted to neediest countries but rather, chased migration, resources and educated, young populations. Did Not: market failure: import duties/tariffs, colonial affiliation, monetary regime (gold standard or not), exchange rate variance, terms of trade, distance from London
How was gold standard adherence linked to deflation during the great depression?
a. 1- When the speculators attacked the US dollar in 1931, the Fed had to raise interest rates so that these speculators would find it more beneficial to hold US dollar than to exchange for Gold. This tightened monetary policy in a time that needed monetary policy ease. i. Tightened monetary policy leads to lower investment rates, spending on durable goods and fewer loans made, thus decreasing the money supply and leading to deflation b. 2- Countries on Gold standard were often forced to contract their money supplies because of policy developments in other countries, not because of domestic events. The gold standard prevents credible deposit insurance and links national price levels with dangerous symmetry due to one world interest rate. Nations on gold were susceptible to contagious deflation during depression. This fall in money supply caused the depression to become an international phenomenon, according to Bernanke. When United States left the Gold Standard in 1933, the country began to grow strongly
16. According to Romer, what ended the Great Depression? What evidence does she use?
a. According to Romer, recovery of real output in the mid and late 1930's was largely due to conventional aggregate demand stimulus in the form of monetary expansion. The increase in money supply was due to gold inflow caused by the devaluation of the US dollar in 1933 and capital flight in Europe after 1934 as a result of political instability leading up to WWII. b. This lowered real interest rates and encouraged investment spending and purchase of durable goods (increase in interest-sensitive spending) c. *Romer's evidence included the growth rate of money supply, devaluation of the US dollar, real output, gold inflow that lowered real interest rates, and derived policy multipliers for fiscal and monetary policy* • Examined GNP from 1927-1943 and regressed output change to isolate effects of all government policies (i.e. expansionary policies) • Compared output under normal policy and actual output to show there would have been a slower recovery without expansionary policy • Simulation suggest that without tremendous increase in the money supply, economy would have been 50% below its pre-Depression trend level in 1942
13. How did banking panics lower output during the great depression? Through what specific channels did bank failures lower output?
a. Banking panics were the source of continued decline in production after stock market crash - they have direct impact on money supply. 1) ratio of deposits to currency fell, money supply fell. 2) consumer uncertainty into pessimism → fall in consumption and investment. b. *Banking panics caused lower output because it reduced wealth on bankholders, decreased the money supply, and increased the cost of information between borrower and lender.* The bank runs caused banks to increase the amount of liquid cash flow and decrease amount of debt. By doing so, banks are less willing to lend money. They would only lend to people whom they can trust. A good way of gauging if an investment project is good is by requiring the borrowers to put some of their wealth in as part of the collateral. The more willing they are to do so, the more likely the borrower will accomplish what he proposes to do. The reduction of wealth of borrowers from debt deflation meant that borrowers no longer have as much wealth to put their skin in the game. This cuts out opportunities that may have been available in better economic times. c. When banks fail, money supply decreases. As a result, there is deflation, and prices fell. However, nominal wages did not fall at the same rate as price levels. *The employers responded by cutting their workforces.* France and Switzerland had significantly higher nominal wages than the other three countries These two countries also had significantly lower output levels. d. Banks also have nominal assets hedged against deflation. As banks fail and deflation increases, *borrowers' wealth goes down and cannot repay their loans. The result is a huge spike of bad loans and defaults.* Banks' nominal claims were replaced by real claims (such as property). The deflation also hurt the value of the properties' values. Banks became more inclined to just hold cash, and as a result, the lender wants to find out more information about the borrower before loaning out the money. This increases the cost of credit information, and credit became expensive and difficult to obtain
5. The deflation of the great depression lowered the value of firms and household's collateral. Explain how this had real effects on lending and investment
a. Calomiris and Bernanke argue that deflation created a rise in the real value of long term debt, leading to financial distress such as debt deflation, which *reduced firms' and borrowers' net worth.* i. This caused the *destruction of intermediaries*, eroding the net worth of banks, causing some to fail and others to tighten credit to avoid being run ii. led to a decrease in investment, through an increase in the marginal cost of funding iii. reduced the creditworthiness of borrowers iv. increased credit costs for firms v. precipitated a liquidity squeeze. b. A decrease in the net worth of individuals and firms mean that they were less able to 'put skin in the game', put in their wealth as collateral for loans from banks, and be trustworthy borrowers. This decreased the opportunities for investment and lending by banks and individuals that would have been available in better economic times. c. As deflation rose, borrowers were also less able to pay loans because *deflation rose real interest rates*. This resulted in a *spike of bad loans* and defaults, leading to an increase in the *cost of credit information* for banks and credit became more difficult and expensive to obtain. Due to asymmetric information, as the equity stake of firm "insiders" was eroded, the marginal cost of external finance rose, as banks had to find more information on borrowers before lending out money. d. The fall in consumer and producer net worth therefore led to a decline in efficiency of the economy's financial allocation mechanism.
8. Clemens and Williamson discuss two explanations for the high level of British overseas investment in rich countries. Be able to explain the "capital market failure" explanation of British investment in rich countries and the "Unproductive Capital View (Rational)" explanation of British investment in rich countries.
a. Capital market failure view: • Predicts that wealth bias can be explained by market segmentation (int'l borrowing constraints) or departures from purchasing power parity (exchange rate movements), and borrowing does not increase in wartime • Tariffs, effective distance from London and other distributions choked off demand for foreign savings • Adverse selection, herding, foreign bias, un-enforcable property rights, the absence of a stable monetary standard, and colonial intervention through the application of force stopped the supply of foreign savings b. Unproductive capital view: • In this view, investors are behaving rationally and exhibit no bias (i.e. Investors are rational). • Predicts that wealth bias can be explained by endowments of immobile third factors, and borrowing increases in wartime • These third factors include education, immigration, human capital, natural resources, demography, etc. • Returns to capital in poor countries have a greater covariance with the return of world portfolio a. The article rejects capital market failure view in favor of the unproductive capital view
12. How does Christina Romer explain the huge drop in consumption during the Great Depression? What evidence does she use to support her theory?
a. Christina Romer tested the hypothesis that uncertainty decreased consumption during the Great Depression by showing the differential behavior of consumer spending on durable and perishable goods in the month following the crash, and looked at the correlation between consumer spending on different types of goods and stock market variability in pre-war era. b. The uncertainty hypothesis predicts that in general there should be an inverse relationship between consumer spending on durable goods and uncertainty about future income. In her research, she found that there is a statistically significant negative relationship between consumer spending on durables and stock market variability. She also found that the negative effect of the stock market variability is more than strong enough to account for the entire decline in real consumer spending on durables in late 1929 and 1930. c. Many variations and uncertainty in forecasts of future income, so consumers and producers immediately cut their spending on irreversible durable goods d. Stock market boom → Fed tightened monetary policy; stock market crash → collapse in durable goods purchases
20. Is the post-WWII business cycle less volatile? How do Davis and Romer answer this question?
a. Davis: The NBER's pre-WWI chronology of annual peaks and troughs states that the US has spent 45.8% of the time in a recession. He uses a new index: Davis' (2004) annual industrial production index. The new index alters more than 40% of the peaks and troughs, and removes cycles long considered the most questionable. Goes down from 45.8% in recession to 22% in recession. b. Davis finds that volatility prewar and postwar was very similar c. Romer: One of the generalizations about the US economy is that the prewar economy was substantially more volatile than the postwar economy. Romer states that this generalization is actually a figment of the data. To affirm this, she looks at the Frickey index. The postwar replications of Frickey's index are more volatile than the true index of industrial production because the Frickey-like series are based very heavily on the production of materials. Thus she finds that the methods used to construct the historical series exaggerate cyclical fluctuations in industrial production. When this exaggeration is taken into account, there is very little stabilization b/w the pre 1914 and post 1947 eras. When consistent industrial production data are compared, there is very little dampening of business cycle fluctuations between the pre 1914 and post 1947 periods (takes out GD) d. Romer also finds that prewar and postwar cycles were more similar than thought
17. Was the government spending multiplier large during the Great Depression? Does the type of government spending matter (AAA vs relief spending)?
a. During the Great Depression, we witnessed relatively small government spending multipliers. Fishbeck and Kachanoyskaya found that all but the estimate for AAA grants are statistically significantly. The type of government spending does matter. Relief spending doesn't crowd out a lot of private spending so multipliers should be large. With AAA grants, you would expect the opposite. b. Government spending multiplier during the Great Depression varied depending on the type of government spending. They used panel data to measure the multiplier during the depression. multiplier ranges on average from 0.4-0.96, which is lower than expected. but they find what type of government spending matters. c. The 1930s fiscal stimulus programs were combos of new spending and taxes that had little impact on stimulus (Deficit/GDP did not change much). Fed gov't sought to combat the GDP through sharp increases in federal spending. Despite relatively small multipliers during the Great Depression, the New Deal transformed the way the government responds to downturns. Growth in the size of the federal gov't during the ND & WWII made fiscal stimulus possible during the post-war era. d. The type of gov't spending does matter b/c of the different effects it can have on crowding out private spending. e. AAA (farm grants): i. Under AAA, gov't spending "crowds out" private spending, leading to a low multiplier, b/c it employs resources that are already in use. (increase prices) ii. low and often negative multiplier f. Relief Spending: i. Under relief spending, there is only a little crowding out of private spending b/c it puts to work unemployed resources, leads to higher multiplier. ii. More productive than the private spending it replaces iii. Encourages migration into the treated state. iv. Produces social overhead capital (Roads, Public health, Hoover Dam). g. When you take out AAA spending, multiplier is higher than it appears otherwise.
3. Explain how 1931-33 banking panics lowered the money supply? / Explain how banking panics lowered the money supply during the Great Depression?
a. Friedman and Schwartz wrote that as banks fail, the ratio between deposit and currency fell, and money supply falls as well b. As banks began to fail from banking panics and bank runs, banks become more weary in lending money, in fear of another bank run. c. Depositors are worried that by depositing their wealth into the bank, the wealth may disappear if the bank experiences a bank run and fails. So depositors would prefer to hold cash than deposit. d. These two factors contribute in decreasing money supply. e. As money supply decreases, deflation increases, providing depositors extra incentive to hold cash, thus forming a vicious cycle.
7. What evidence do Bordo, Eichengreen and Kim use to claim there was an earlier period of international financial integration comparable to today? (list specific examples)
a. General metrics / Metrics of globalization: i. Net capital flows ii. Persistence of current account deficits iii. Low Saving-investment correlations iv. Negligible differentials of covered interest parity b. Specific examples: c. greater credibility of policymakers' commitment to stable monetary & fiscal policies as manifested in adherence to gold standard i. gold standard provided a signal that the borrowers followed the same rules as lenders in the metropolitan centers and hence were unlikely to default d. most British and French investment went to former colonies where the British/French heritage was strong -> imp determinant of the extent and persistence of British/French capital exports i. these countries shared a common language, culture, legal system, and accounting system ii. by comparison, today's capital recipients tend to be very different from capital exporters e. much of the capital flowing to the New World went to finance railroads and other infrastructure; these investments require long term commitments f. prewar (British) investments were on traded-goods-related sectors, so it went into export-related infrastructure & natural-resource related projects that in the normal course of events generated a stream of foreign exchange revenues sufficient to pay the money back - it did not give rise to balance-of-payments problem g. markets were less structured & institutionalized and adjustment was less constrained by policy & powerful interest groups the need to reallocate resources b/w sectors producing traded & nontraded goods could be accommodated easily h. Flexibility of the 19th century economies
11. Bordo and Kydland (1995) model the Gold Standard as a game between countries that wished to borrow and their lenders (the bond market). Bordo and Rockoff (1996) latter described the gold standard served as a "good housekeeping seal of approval". Explain how adherence to the gold standard served as a strategy in a game between nations that wished to borrow and the bond market?
a. Government can print money and inflate away its debt; creates an incentive problem i. Thus, foreign lenders recognize this and are unwilling to lend unless government can commit to paying back real value of debts b. Government has 3 choices: tax its citizens directly, roll over debt by borrowing on bond market, inflate past bondholders debt/default on debt c. Future governments will always try to inflate away past debt (which is essentially taxing) d. Bond markets know this as time inconsistency and therefore, won't lend funds i. Time inconsistency problem: if government could default more over time, they wouldn't need to tax citizens as much, but at the same time, people would be less willing to hold future government debt. e. But in an infinite period game, borrowing is possible f. Borrowers will use a tit-for-tat strategy, punishing governments for inflating or defaulting by having a high cost of capital or refusing access to capital g. IMPORTANT***: The gold-standard equilibrium strategy consists of the government committing to prudent fiscal policy and a stable currency by standing ready to convert local currency into gold on demand. In response, the international bond market rewards the government that ties its currency to gold with a low cost of capital relative to identical borrowers who do not commit to gold convertibility h. The essence of the gold standard was that each country would define the price of gold in terms of its currency and keep that price fixed i. Punishment implies: P (on gold) > P(off gold), given all else equal, an arbitrage opportunity i. All else equal: bonds of nations on gold should have higher price / lower expected return j. However, the "good housekeeping seal of approval" requires collective action by bondholders to forego the implied arbitrage (i.e. requires capital market collectively forgoing current expected profits to punish gov't that abandon gold) i. Because the debt of bad company has a higher interest rate, but there's no incentive for people to pay it back cuz there's no punishment. So people don't invest in the country's bond that has a higher interest rate
10. Know how to solve the Diamond-Dybvig model:
a. If the bank wants to maximize total aggregate consumption in the good equilibrium how much will the bank choose to invest in the illiquid investment yesterday? i. $2 b. Given that the bank chooses to maximize total aggregate consumption in the good equilibrium, what is the aggregate consumption (add consumption today and tomorrow) in the "Good" no bank-run equilibrium and the "bad" bank-run equilibrium? i. Good: 2+2R Bad: 2+2L
15. What evidence do Richardson and Troost use to argue that the Federal Reserve could have mitigated banking panics during the great depression? // What evidence is there that the Fed could have mitigated the severity of the banking panics by acting as a lender of last resort before 1933?
a. Looked at a group of Mississippi banks that operated in a single regulatory and economic environment but were exposed to different Federal Reserve policy regimes i. 6th Federal Reserve District operated under Atlanta Fed regime (southern banks) ii. 8th Federal Reserve District operated under St. Louis Fed regime (northern banks) b. Atlanta: championed monetary activism and the extension of aid to ailing banks c. St. Louis: tight discount window because it adhered to the doctrine of real bills, limited lending d. Results: aggressive discount lending would have helped banks survive the initial banking panic of the Great Depression e. In Atlanta, banks survived at higher rates, lending continued at higher levels, commerce contracted less, and recovery began earlier i. If St. Louis followed the same policy as Atlanta, bank failure rates would've been lower, commercial lending would've remained higher, and the contraction wouldn't have been as severe f. When policies converged rates of suspension and liquidations also converged g. Adoption of policies like those in the 6th district would have been beneficial and relatively cheap: The Fed missed the chance to take inexpensive action that could have stemmed the initial wave of banking panics and altered the course of the contraction
9. Were British investors irrational when they chose to invest much of their savings outside of the UK? What can explain the large fraction of foreign assets in Victorian British portfolios?
a. No, British investors weren't being irrational. They chose to invest in oversea assets in order to diversify the risks of their portfolio. b. So diversification is a likely explanation for the high level of Victorian overseas investment. i. 3 tests: 1. Mean-variance frontier: found that if you add another variable, frontier moves out, which means that you will get a higher expected return with the same, if not less, amount of risks 2. Spanning test 3. Spanning test with short restrictions ii. The utility test shows that investors can gained a lot of utility by investing in a different asset class, or a different country from what they were already investing in 1. Utility test consists of: makeup of the portfolio, risk averseness, and impatience of the investors
14. What actions could the Federal Reserve have taken to mitigate the damage of the great depression?
a. Not tighten the monetary policy b. Lend more money to banks to prevent bank runs c. Encourage banks to extend loans to their counterparties d. Leave the gold standard earlier e. Fed could have averted the first wave of banking panics and prevented later panics through suspending gold requirements and discounting bills by banks, thereby allowing banks experiencing runs to get much needed cash. f. *The failure of the Fed to offset the decline in money multipliers and money supply with open market operations and loans to banks through the discount window (i.e. lender of last resort) led to a drastic decline in economic activity.* Otherwise, the Fed could have enable solvent but illiquid institutions to survive bank runs. BUT could Fed open market operations alone, unaccompanied by changes in monetary and regulatory regimes (eg leaving gold, government intervention to assist banks, suspension of convertibility) might not have revered an economic decline - the Fed's pursuit of domestic objectives was limited by its commitment to maintain a credible long run link to gold and by its view of what policies that entailed.
21. Why does Romer think the observed moderation of the business cycle is a "figment" of the data? According to Romer, have monetary policy shock dampened economic volatility in the post-WWII era?
a. Romer says that the generalization that the pre-war economy was more volatile than the post war is a figment of the data. There are inconsistencies between historical and modern data series that account for the dampening of cyclical fluctuations between pre and post war eras - Romer proposes that the Frickey index and FRB manufacturing index are incomparable since although both are based on commodities, Frickey is pre-war and FRB being post-war uses different commodities. b. To make consistent data, Romer constructs two post war replications of Frickey's index: 1. an exact replication of the index extended to post-war (Exact replication index), and 2. an adjustment of this modern series to account for modern commodities and technology (FRB materials index). c. Comparing these 4 indexes, she finds that the great moderation is a figment of the data since i. Frickey index exaggerates antebellum volatility ii. the two post-war Frickey indices show cyclical volatility that is similar to, and only slightly smaller than, the pre-war Frickey index. Hence there is no dramatic dampening of business cycle fluctuations when consistent data is compared. iii. Moreover, the Frickey indexes for post war over-state volatility compared to FRB manufacturing index, which is the true index of production, because they are based on production of materials rather than total industrial production (FRB manufacturing) - therefore, a substantial part of the apparent stabilization of the post war index is due to improvements in the data, and comparing inconsistent data of Frickey and FRB d. Therefore, using consistent data indicates that volatility has not really declined across pre to post war periods; stabilization is a figment of the data.
19. Bernanke suggests three possible causes for the great moderation; structural change, improved macroeconomic policies, and good luck. Be able to discuss the arguments in favor of each.
a. Structural Change: The transformation of the economy from agriculture/manufacture based to service base means that economy is not as volatile. Improvements in the economy's ability to absorb economic shocks b. Improved Macroeconomic policies: The increased role that Federal Reserve and government play in balancing and absorbing economic shocks allow the economy to grow. Output Volatility and Inflation volatility move together. Monetary policy help curb inflation volatility, and that leads to lower output volatility. Monetary policy used to control inflation through raising interest rates after no longer being fettered by the gold standard c. Good luck: shocks that are hitting the economy are smaller and less frequent. d. If it is indeed good luck, we cannot expect current situation to continue - may even return to volatility of 70s. But if Great Moderation result of structural change or improved policymaking, then increase in stability more likely to persist. Bernanke thinks that improvements in monetary policy over time have played a crucial role in Great Moderation, and good luck is not the primary cause
18. What is the "great moderation" in post-WWII macroeconomic data?
a. The Great Moderation is the decline in GDP and inflation volatility since WWII. In many countries, real output and inflation expectations became more stable, more predictable and less volatile or variable b. There are three possible causes cited for the fall of volatility: improvements in monetary policy (such as the use of policy to control inflation through raising interest rates), structural changes in economies (such as technological advancement, improving economy's ability to absorb economic shocks), and good luck. c. Many economists suggest or question whether there is a causal link between the adoption of activist monetary policy and structural changes in the economy and reduced volatility. The argument for or against the Great Moderation is somewhat dependent on the data that is used. Output or time series data for the period before WWII is poor. The NBER data shows that recessions are less frequent, shorter, and shallower post-WWII. The Davis index however, shows that NBER overstates volatility and recessions in the pre-war era, and there is less difference between pre-war and post-war eras due to different types of data d. While some, such as Bernanke, propose that the Great Moderation occurred as a result of activist monetary policy (and Taylor Rule stabilization policy), others such as Davis and Romer argue that it is due merely to inconsistent data; the Great Moderation in fact does not exist, and volatility has not changed much from pre-war to post-war era (besides idiosyncratic volatility in the interwar period from the 1921 recession and great depression)
6. Was the late 19th century international capital market geographically integrated?
a. Yes, Bordo, Eichengreen, and Kim would suggest that international capital markets were integrated. b. Using the Feldstein-Horioka coefficient, which looks at the correlation between national savings and investment), they found a very low correlation during the time of the classical GS, and thus concluded that pre-war cap mrkts were integrated. Taylor (1996) expanded on this and found that capital markets were well integrated prior to the World Wars, ceased to be integrated during the wars, and gradually became integrated again following the wars. c. Further evidence includes covered interest parity, purchasing power parity, and current account deficits that cap markets pre-war were integrated.
1. Were the banking panics of the national banking era (1863-1913) the result of or cause of economic recessions? How do we know? // Were the banking panics of the national banking era (1863-1913) predictable? How do we know?
a. [Gorton] shows that panics occur as features of severe recessions which change perceptions of risk. Banks often hold paper claims to firms, and when depositors perceive these firms to be failing in a crisis (perhaps due to crop failures), they by extension expect banks to fail. This is due to asymmetric information between bankers and depositors. b. *He compared the normal behaviour of depositors to that exhibited during panics, and looks at the deposit-currency ratio, using the Baumol Tobin model. c. By the CCBUS measure, panics tend to correspond to the largest values of the liability* e. Shows that during national banking era, whenever the information measure of the liabilities of failed businesses reached a critical level, so did perceptions of risk, leading to a banking panic. f. Panics were predictable on the basis of prior information, and capital losses were not unanticipated. He finds that the perceived risk variable is statistically significant and determines that when knowledge of prior information is factored in, people switch from deposit to currency, pulling out their money in order to avoid capital loss i. therefore, panics are connected to occurrence of other events which change perceptions of risk - because consumers feel that consumption in the economy is falling or companies are failing. 1. Perceptions of risk were based on the liability of firms, and caused banking panics. Therefore, bank runs did not cause recessions, but recessions caused runs g. Bank runs were not themselves the cause of recessions because he argues that there is no reason why a rational person would take out their illiquid assets earlier than expected, to harm business
Was the Federal Reserve fettered by the Gold Standard? How do we know? (quiz question)
• Bernanke said yes o Paper compares the countries • Romer tests it o They look at future prices o The Fed wasn't fettered; they could do a lot more o Currency traders didn't seem to mind
How was national banking during the National Banking Era (1863-1913) similar to free banking during the "free banking era" (1837-1861). How was it different? (selected as a quiz question)
• The free banking period came right after the abolishment of the Second Bank of the United States, and was followed by the national banking era at the start of the Civil War. • The national banking system was created to fund the civil war and was modeled on the free banking system. How are they similar: 1. In neither of these eras was there a central bank. 2. Lots of bank panics occur during both eras a. Bankers in the two systems also responded similarly to banking panics - in free banking, several bankers had a coordinated response to reassure noteholders that their banks were solvent, and they engaged in joint suspension of payments. There was a similar response by bankers to runs on banking system in the subsequent national banking era 3. Currency issued by banks in both systems was backed by gold/silver and redeemable for specie on demand except for legal tender notes in national banking system (greenbacks), not redeemable for gold. How are they different: 1. Free banking era: a. A defining characteristic of the free banking system is wildcat banks - banks which would give out currency and abscond with gold, or be located in remote locations b. The free banking system involved state chartered banks, and it was relatively easy to enter the system as long as the requirements of the state's free banking laws were met, such as minimum capital and depositing bonds or securities to back notes that were issued. c. No unified currency, each bank issued its own notes, which often traded at discounts especially at long distances from the issuing bank. 2. National banking era: a. Nationalized banks so they don't have to follow state rules b. The national banking era on the other hand had a dual banking system of both state and nationally chartered banks, since a national banking system was created where banks could apply for a national charter. i. Becoming national banks also required them to buy US government bonds - they had to back notes with Treasury securities, whereas in the free banking system, acceptable securities were state or US bonds, and some early banks also used real estate and mortgage c. emergence of a unified, stable national currency, which gained ground especially after a law to tax state bank issued notes. In this system, if banks did not convert on demand, government could sell bank's bonds to pay the noteholder
2. Explain how the gold standard served as a "good housekeeping seal of approval". Did capital markets reward countries on gold with lower capital costs?
● Government can print money and inflate away its debt; creates an incentive problem ● Thus, foreign lenders recognize this and are unwilling to lend unless government can commit to paying back real value of debts ● Government has 3 choices: tax its citizens directly, roll over debt by borrowing on bond market, inflate past bondholders debt/default on debt ● Future governments will always try to inflate away past debt (which is essentially taxing) ○ Bond markets know this as time inconsistency and therefore, won't lend funds ● But in an infinite period game, borrowing is possible ● Borrowers will use a tit-for-tat strategy, punishing governments for inflating or defaulting by having a high cost of capital or refusing access to capital ● *The gold-standard equilibrium strategy consists of the government committing to prudent fiscal policy and a stable currency by standing ready to convert local currency into gold on demand. In response, the international bond market rewards the government that ties its currency to gold with a low cost of capital relative to identical borrowers who do not commit to gold convertibility* ● The essence of the gold standard was that each country would define the price of gold in terms of its currency and keep that price fixed ● P (on gold) > P(off gold), given all else equal ● However, it requires collective action by bondholders to forego the implied arbitrage
Bordo and Kydland (1995) model the Gold Standard as a game between countries that wished to borrow and their lenders (the bond market). Bordo and Rockoff(1996) latter described the gold standard served as a "good housekeeping seal of approval". Explain how adherence to the gold standard served as a strategy in a game between nations that wished to borrow and the bond market? (selected as a quiz question)
● Government can print money and inflate away its debt; creates an incentive problem ● Thus, foreign lenders recognize this and are unwilling to lend unless government can commit to paying back real value of debts ● Government has 3 choices: tax its citizens directly, roll over debt by borrowing on bond market, inflate past bondholders debt/default on debt ● Future governments will always try to inflate away past debt (which is essentially taxing) ○ Bond markets know this as time inconsistency and therefore, won't lend funds ● But in an infinite period game, borrowing is possible ● Borrowers will use a tit-for-tat strategy, punishing governments for inflating or defaulting by having a high cost of capital or refusing access to capital ● IMPORTANT***: The gold-standard equilibrium strategy consists of the government committing to prudent fiscal policy and a stable currency by standing ready to convert local currency into gold on demand. In response, the international bond market rewards the government that ties its currency to gold with a low cost of capital relative to identical borrowers who do not commit to gold convertibility ● The essence of the gold standard was that each country would define the price of gold in terms of its currency and keep that price fixed ● P (on gold) > P(off gold), given all else equal ● However, it requires collective action by bondholders to forego the implied arbitrage
