Econ 323-2 Final

Benjamin Chabot and Christopher Kurz (2010) "That's Where the Money Was. Foreign Bias and English Investments in the United States"

Hypothesis/Main point(s): - London's capital markets systematically discriminated against domestic industry by ignoring good domestic investments and investing in "inferior" projects overseas - People were not rational in investing abroad Data used: - Chabot's data included over 4,000 assets (these included US and British securities==>US included to better reflect true options that were available to investors at the time) Conclusions: - Victorian investors sent capital abroad because they were able to diversify which increased returns while decreasing their risk - They were investing rationally, not biased or ignorantly

Christina D. Romer (1992) "What Ended the Great Depression?"

Hypothesis/Main point: - estimates of effects of fiscal and monetary changes indicate that nearly all the observed recovery of the US economy before 1942 was because of AD stimulus in the form of monetary expansion Conclusion: - monetary developments = crucial source of recovery for US - fiscal policy contributed almost nothing before 1942

Were the banking panics of the national banking era (1863-1913) the result of or cause of economic recessions? How do we know?

According to Gorton, the banking panics of the national banking era were the results of economic recessions rather than the cause of economic recessions. This recession hypothesis states that panics occur as people expected banks to fail in times of severe recessions. It is a manifestation of consumption smoothing behavior on the part that of cash-constrained agents, resulting from perceived risk based on prior informations. That is, if depositors believe that a bank would fail or that they would lose their deposits, then depositors would cause a bank run and therefore cause a banking panic. Since banks have claims over firms and when these firms fail, then when people would think the bank would fail as well, causing a self-fulfilling bank run.

According to Romer, have monetary policy shocks dampened economic volatility in the post-WWII era?

According to Romer, monetary policy shocks have dampened many recessions and countered some economic shocks entirely. However, she does point out that there were several instances in which monetary policy may have induced a recession though contractionary policy in times of high inflation and unrestricted economic growth. At the same time, she studies the output loss per recession across time periods (pre-1914, interwar, and post WWII) and found that the output loss per recession has relatively been the same pre-1914 and post WWII. Romer used several data tables including the one noted above, data on the length of each recession, and data on volatility, and ultimately concludes that while monetary policy has been able to lessen the effect of some recessions, some recessions were caused by monetary policy mistakes, and that the economy is as volatile as the pre-1914 era.

Explain how the gold standard served as a "good housekeeping seal of approval." Did capital markets reward countries on gold with lower capital costs?

According to the economists, the gold standard signaled to foreign investors a commitment to honoring a commitment to bound economic policies. For instance, it implied that a country would follow prudent monetary and fiscal policies, would only run large fiscal deficits in emergencies and war, and would not default on foreign debts. It lowered costs of borrowing, and kept the price of currency in terms of gold fixed (cannot inflate or deflate currency--fixed exchange rates). Thus, the gold standard created a good housekeeping seal of approval since it lowered costs for those who adhered to the gold standard for a long time and those that did not get off gold standard even in times of emergency. It certified countries as trustworthy, and reduced information asymmetry between the creditor and debtor.

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.

Bernake suggests in his speech three reasons for the Great Moderation seen in post WWII. He cites structural changes to the economy such as changes in economic institutions, improved technology, and general business practices have led to the economy's ability to absorb negative shocks and promote stability. Another reason could be the refined macroeconomic practices such as monetary and fiscal policies. Monetary policy and Fed policies, in particular, have been able to control inflation by raising interest rates in times of uncontrolled economic expansion and lowering interest rates to stimulate the economy in times of downturn or recessions. Another reason could be just plain luck--economic recessions and negative shocks have become smaller and less frequent than the rest of economic history.

Was the 19th century international capital market geographically integrated?

Bordo, Eichengreen, Kim believe that the pre-1914 economic markets were more integrated in certain aspects than it is today. Particularly in homogenous assets such as railroad bonds and government securities, the world was far more integrated prior to WWI than it is today. They use the mean absolute value and variance ratio of current accounts to GDP, real interest parity, and covered interest parities as data for their conclusions. The authors also used the Feldstein-Horioka Coefficient, which looks at correlation between national savings and investment. If capital markets are integrated, then there would be a low correlation bc investment can be financed by foreign capital flow.

What ended the Great Depression?

Christina Romer believes that the effects of fiscal and monetary policies accounted for nearly all of the recovery prior to 1942. More specifically, the monetary expansion prior to 1942 was to be credited for the economic recovery. The huge inflow of gold to the US in the late 1930s stimulated the economy by lowering real interest rates, and thus encouraging investment, as well as the purchase of durable goods. In addition, the devaluation of 1933/ 1934 is the engine of recovery, as it signaled the end of the deflationary regime, and brought about expansionary monetary policy. Romer simulates in the paper that policy multipliers based on 1921, 1938, as well as multipliers from macroeconomic models. They examined annual estimates of real GNP from the US Bureau of economic analysis, as well as revised the Kendrick-Kuznets GNP series. In addition, Romer used money growth rate and data on durable spending. Their conclusion is that self correction and fiscal policy played little role in the growth of real output prior to 1942. Rather, it is monetary changes and policy that played a crucial role on the economic recovery.

Fishbeck, Price and Valentina Kachanovskaya (2015) "The Multiplier for the States in the Great Depression"

Hypothesis/Main point: - Expect nonAAA would have higher positive effects than all other grants on income - Expected AAA grants to have negative effects on income Conclusion: - AAA grants had much smaller effect on multipliers - Non AAA grants had no positive effect on private employment

The Great Moderation" Speech by Ben Bernanke

Hyp/Main points: - Over past 20yrs, substantial decline in macroeconomic volatility = the great moderation - 3 reasons: 1) Structural change - changes in economic institutions, tech, business practices etc have improved economy's ability to absorb economic shocks. 2) Improved macroeconomic policies - esp monetary policy - raising interest rates to control inflation 3) Good luck- shocks hitting the economy became smaller and more infrequent

Was the Fed fettered by the Gold Standard?

For the most part, the gold standard was detrimental to the US economy during the great depression. As shown by Bernanke, the gold standard prevented the expansion of the money supply and bank monetary policies, thus limiting the Fed's ability to stimulate the economy during the Great Depression. The Fed was forced to adhere to the Gold Standard, which affected the international money supply, forcing countries on gold standard to tighten policies in order to deal with rising interest rates. At the same time, the Fed could not devalue currency without risking loss of confidence on the commitment to the gold standard and a run on their currency. Thus, the gold standard stopped governments from responding to bank panics with activist monetary policy and acting as a credible lender of last resort. Data also show that the nations on gold standard were susceptible to constant deflation during the great depression, and countries who leave GS were able to respond more quickly to depressions (such as Britain and Japan). It is important to note that while the GS was detrimental, it was not all to blame for the GD since the Fed could have adhered to the GS and as shown by Romer, could have intervened during the GD to speed up recovery.

G. Gorton (1988) "Banking Panics and Business Cycles," Oxford Economic Papers 40 (December 1988)

Hypotheses/Main points: 1) Seasonal hypothesis = panics caused by extreme seasonal fluctuations 2) Failure hypothesis = unexpected failure of large financial institution leads to panics... Major bank failure ==> distrust in solvency of all banks ==> depositors pulling out money 3) Recession hypothesis = Panics occur as features of severe recessions bc depositors expect banks to fail during severe recessions - Commonality throughout all is information asymmetry between banks and depositors ==> inherent mistrust between banks and depositors Data used: - Baumol Tobin model = 1) Real cost of a trip to bank, 2) Real rate of return promised at time t-1 3) Real capital loss 4) Real income earned during time t-1 5) Subjective rate of time preference (patient v impatient) 6) Information set available at time Information: Bank Panics occurs when depositors demand such large scale deposits that bank can only respond by suspending convertibility of deposits into currency, issuing clearinghouse loan certificates, or both —> occur just after business cycle peaks, Conclusions: -panics are systematic events linked to the business cycle; manifestation of consumption smoothing behavior on the part of cash in advance constrained agents, resulting from changes in perceived risk predictable on the basis of prior information -depositors panic when the liabilities signal is strong enough —> critical levels, perceptions of risk increased and caused banking panic - Panic resulted from changes in perceived risk predictable on the basis of prior information - Recession hypothesis most accurate ==>Banks have claims over firms, so when firms fail, people think banks are at higher risk

Bordo and Rockoff (1996) "The Gold Standard as a `Good Housekeeping Seal of Approval'"

Hypothesis/Main point: - Adherence to the gold standard was a sign of financial rectitude bc it implied that a country would follow prudent monetary and fiscal policy, would only run large fiscal deficits during emergencies, and would not default on foreign debt -countries with low records of adherence were charged more than than those with good records - Hypothesis is that the gold standard was a credible commitment that bound policy actions over time Information: -members expected to adhere to convertibility except in times of emergency (would resume after solving the emergency) -faithful adherence to gold standard lowered costs of loans from Europe —> signaled that the country would follow prudent monetary and fiscal policy without large fiscal deficits; would minimize currency risk (avoid default on loans) -policy would keep the price of currency in terms of gold fixed—ensured fixed exchange rates and fixed price3 of gold meant there was a nominal anchor to the international monetary system -became international standard by 1880 Data used: - 9 capital importing countries including: 1) Group 1 = followed gold fully 2) Group 2 = contingency rule (USA); suspend convertibility but returned to original parity after emergency 3) Group 3 = Shadowed gold but didn't adhere i.e. followed conservative fiscal/monetary policy 4) Group 4 = adhered to gold intermittently and an altered parities - These groups were compared to the return on british consuls Results: betas significantly less than one for those who strictly adhered to gold standard (on regression against yields on gold bonds) Betas of those with poor adherence considerably higher than those who did adhere to gold Where commitment was high, rates were low and opposite for those where commitment was low Conclusions: - Strong evidence for good housekeeping seal - find correspondence between gold standard adherence and low country risk as measured by betas -interest rates on long term bonds in countries whose commitment was high were charged significantly lower rates (only slightly above British Consol rate); those who had low commitment were charged higher rates - Long term commitment to GS mattered ==> countries that remained on the GS throughout classical era were charged lower rates than those with mixed adherence to GS

Christina Romer (1990): "The Great Crash and the Onset of the Great Depression"

Hypothesis/Main point: - Argues that the collapse of stock prices in October 1929 generated temporary uncertainty about the future income which led consumers to forgo purchases of durable goods Data used: - Shows that the differential behavior of consumer spending on durable and perishable goods in the month following the crash is consistent with the uncertainty hypothesis - Looks at the correlation between consumer spending on different types of goods and stock market variability in pre-war era Conclusions: - There is indeed a statistically significant negative relationship between consumer spending on durables and stock market variability - 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 - Evidence backs up uncertainty hypothesis

Gary Richardson & William Troost, 2009. "Monetary Intervention Mitigated Banking Panics during the Great Depression: Quasi-Experimental Evidence from a Federal Reserve District Border, 1929-1933"

Hypothesis/Main point: - Atlanta V St. Louis Feds. Atlanta championed monetary activism and aid to ailing banks. St. Louis eschewed expansionary initiatives - Hypothesis that aid to ailing banks and monetary activism led to an earlier recovery from recession than a lack of monetary activism and aid to banks Data used: - Used a group of banks that operated in a single regulatory economic environment but utilized different Fed Reserve policy regimes - Mississippi northern half = St. Louis Fed (noninterventionist) and Mississippi southern half = Atlanta Fed (interventionist) - St. Louis followed Real Bills doctrine that the supply of credit should retract during recession - Atlanta followed Bagehot's rule that during financial panics, central banks should act as lenders of last resort and extend credit to institutions afflicted by illiquidity Conclusion: - Less banks failed in the Atlanta, under policy that followed Bagehot's rule

Hsieh, Chang-Tai and Christina D. Romer. "Was The Federal Reserve Constrained By The Gold Standard During The Great Depression? Evidence From The 1932 Open Market Purchase Program,"

Hypothesis/Main point: - Claims U.S. adherence to the gold standard was not a fundamental constraint on monetary policy Conclusion: - Paper supports the view that the American Great Depression was largely the result of inept policy, not the inevitable consequence of a flawed international monetary system - Conventional measures show virtually no sign of expectations of devaluation

Christina Romer "The Nation in Depression."

Hypothesis/Main point: - Examines the similarities and differences of the US experience during the depression compared to other countries - Evaluates causes of depression and recovery - Contraction in foreign countries stemmed from US contraction while contraction in US is solely due to domestic factors Data used: - Annual data on industrial production of 24 countries - Output decline across countries Conclusions: - American depression was caused by adverse shocks in aggregate demand ==> worsening unemployment and deflation - Domestic monetary policy was the cause of the onset of the recession that became the Great Depression; 1) Stock market crashed bc Fed raised rates and 2) Outflow of gold due to GS compounded effects of crash - Consumer spending declined due to stock mrkt crash - Decline continued bc of banking panics which caused fall in money supply which led to consumer pessimism - US banks were small and undiversified which made them susceptible to failure - Recovery came when Fed abandoned GS and implemented expansionary monetary policy - Agg demand shocks caused depression and led to recovery from depression - Although intl elements were present, at each stage of GD, American shocks and policy decisions determined the path of the GD

Dwyer, Gerald - "Wildcat Banking, Banking Panics, and Free Banking in the United States." Federal Reserve Bank of Atlanta Economic Review

Hypothesis/Main point: - From 1837-65, a free banking system existed in the US...free banking = banks needed no approval for entry, just min. funds...banknotes issued by bank were redeemable on demand for specific quantity of gold/silver...guarantee of banknotes value = value of bank's assets - Wildcat banking = unsound banks located themselves in inaccessible areas so people couldn't redeem notes -Hypothesis explored = Was free banking so bad that it would have been better to have no banks (did noteholders suffer substantial losses from holding free bank notes?) Data used: - Case studies of free banks in various states - Loss rates on notes in free banks - # of banks entering and exiting market - discount rates on notes outstanding - Correlation of free banks by location and population - Comparison of state bond prices for various states Conclusions: - Free banking wasn't free of problems, but wasn't disaster people make it out to be - Performance improved over time after troubled start (probably bc of laws adopted after initial problems) - Little evidence of imprudent or reckless banks - External factors affected banks and led to bank panics - No real answer to hypothesis

Ben Bernanke (2004) "Money, Gold, and the Great Depression,"

Hypothesis/Main point: - Gold Standard caused the Great Depression - 4 major errors by the Fed 1) Tightening monetary policy in 1928-29 2) GS 3) Ambivalence in policy implementation 4) Fed's ongoing neglect of US banking problems Data used: - Used a lot of Friedman and Shwartz's arguments Conclusion: - GS has everything to do with Great Depression - Leaving GS was key to recovering from GD as confirmed by US experience

Alquist R. and B. Chabot (2011) "Did Gold Standard Adherence Reduce Sovereign Borrowing Costs?"

Hypothesis/Main point: - Gold-standard adherence was negatively correlated with the cost of capital i.e. adherence to GS led to lower borrowing costs Data used: - Data set with over 55,000 monthly sovereign bond returns - Formed leveraged portfolio that mimicked return associated with purchasing all bonds issued by counties off GS and shorting all bonds issued by countries on GS Conclusion: - Adherence to the gold standard did not reduce the cost of capital. Conditional on British risk factors, the returns of bonds issued by countries on and off gold are statistically indistinguishable from one another. - No evidence in favor of good housekeeping hypothesis, thus, the paper disagrees with Bordo and Rockoff's 1996 paper on housekeeping seal of approval

Hamilton, James D. "Was the Deflation during the Great Depression Anticipated? Evidence from the Commodity Futures Market"

Hypothesis/Main point: - Paper explores the validity of the assumption that, if deflation was anticipated, the falling nominal yield could have coincided with a rising real yield, accounting for plummeting consumption and investment spending - U.S. Federal Reserve failed to provide the banking system with needed reserves and emergency liquidity, contributing to the banking panics. Moreover, unanticipated deflation may have forced otherwise solvent debtors into bankruptcy Data used: - Paper examines the implications of the futures data for expectations about aggregate prices Conclusions: - Results suggest that people didn't anticipate the initial deflation that the GD brought. In subsequent years, people anticipated significant deflation - I conclude that decreases in particular relative prices, rather than in overall consumer prices, are key to understanding bank panics in 1930. - In the second and third years of the Great Depression, people anticipated drops in consumer prices about half as severe as were actually experienced. This perception would certainly discourage new borrowing and investing. Additionally, bankruptcy risk would also worsen - Both factors are likely to have contributed to the severity of the Great Depression

Charles Calomiris, (1993) "Financial Factors in the Great Depression"

Hypothesis/Main point: - Reviews the literature on the role of financial factors in GD and draws lessons relevant for the study of the GD and macroeconomics Conclusions: - Non-monetary propagation hypothesis has 3 implications which distinguish it from Friedman Schwartz etc monetarist positions 1) Financial propagation view: implies money supply shock will have larger effect if occurs in highly leveraged economy or economy with fragmented, undiversified banks (like US at the time) 2) Fed OMOs could not have reversed econ. decline at any time like F&S claimed; Fed was too tied to GS and policy that entailed GS adherence 3) different methods of increasing monetary supply (eg expansionary open market operations vs. reductions in discount rate by Fed) might have had v. different consequences for recovery - New view of Bernanke showed that monetary shocks and other disturbances during the early phases of the Depression had long run-effects largely because they affected the institutional structure of credit markets and the balance sheets of borrowers

Cole, Harold and Lee Ohanian (2006) "New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis"

Hypothesis/Main point: - Some economists suspect that Roosevelt's "New Deal" cartelization policies, which limited competition in product markets and increased labor bargaining power, kept the economy depressed after 1933 - paper simulates the model during the New Deal and compares output, employment, consumption, investment, wages and prices from model, to existing data on the depression/recovery Conclusion: - New Deal policies accounted for 50% of the weak recovery - Key element doing this was not monopoly per se but the linking of collusion with paying high wages

Bordo, Eichengreen, Kim - "Was There Really an Earlier Period of International Financial Integration Comparable to Today?"

Hypothesis/Main point: - The global capital markets were well integrated prior to the World Wars, slumped during the Wars, and have now returned/become more integrated than before the Wars. Data used: - Looked at mean absolute value and variance ratio of current accounts to GDP - Feldstein-Horioka Coefficient: Coefficient looks at correlation between national savings and investment; If capital markets are integrated ==> low correlation bc investment can be financed by foreign capital flow - Real interest parity and covered interest parities Conclusions: - Some aspects of the pre 1914 economy remains unsurpassed, but some aspects of the economy is now SUPER connected, more connected than ever - Only a slender suite of assets were as integrated in pre-1914 as it is today - Asymmetric info led to institutional developments that have impacts on modern day financial institution - We are in a second era of globalization: 1st was globalizing industrial revolution, 2nd is globalizing information and communication technology

Ben Bernanke (1995): "The Macroeconomics of the Great Depression: A Comparative Approach"

Hypothesis/Main point: - There are 2 impacts of falling money supplies and falling price levels 1) deflation induced financial crisis 2) increase in real wages to above market-clearing levels Data used: - Looked at the money supply of 6 different countries. - Looked at Wages, Manufacturing production of countries on and off gold, comparing the performance of two; Added a banking panic dummy into the dataset as well to control the effect of bank runs. Conclusion: - Money Supply is a major driving force behind the great depression - Monetary shocks have 2 long lasting effects: 1) Induced financial crisis - Debt deflation ==> redistributes wealth away from borrower... when borrowers lose wealth, they dont put as much of their own money into investments... if the borrower does not contribute as much of his own money to fund the project, there is a higher chance the borrower does not act in the interest of the lender... with this chain reaction, banks are less willing to make loans and invest - Bank and capital stability ==> debt deflation impairs banks capital and economic efficiency... when debt deflation happens, borrowers cant pay back nominal debt..bank's nominal claims then become real claims (property)...deflation hurts the property values, thus hurting the bank's real claims...All of this leads to selectivity in terms of who bank loans to and banks are more inclined to hold cash 2) Stick nominal wages

Michael A.Clemens and Williamson, Jeffrey G. "Wealth Bias in the First Global Capital Market Boom, 1870-1913"

Hypothesis/Main point: - Wealth bias = countries of higher GDP drawing more capital than labor rich low-GDP countries - This paper focuses on what pulled British capital to some countries and not others - The unproductive domestic markets dominates global capital markets failure view in terms of explaining wealth bias Definitions: - Global capital market failure view = Wealth bias can be explained by constraints on borrowing; also said borrowing doesn't increase during wartime - Unproductive domestic capital view = Wealth bias can be explained by endowments of "immobile third factors"; also said borrowing does increase during wartime Data used: - Panel data for 34 countries that received 92% of British capital - Dependent var = capital exported to a given country during as a % of British total capital exports within given time period - Tested for: Immobile third factors (unproductive domestic capital view) = 1) Youth dependency/population growth, 2) net migration, 3) Schooling (primary school enrollment), 4) Urbanization, and 5) Natural resources And global capital market constraints (global capital market failure view) = 1) Import duties/tariffs, 2)colonial affiliation, 3) Gold standard or not, 4) exchange rate variance, 5) terms of trade and 6) distance from London Conclusions: - During first globalization boom in pre-war era, there was wealth bias in GB) which can be described by unproductive domestic capital view - Global capital markets view as descriptor for wealth bias rejected by evidence ==> intl. capital markets had second order effect on GB capital distribution - "Immobile third factors" AKA "fundamentals" mattered most

Cecchetti, Stephen G. "Prices during the Great Depression: Was the Deflation of 1930-1932 Really Anticipated?"

Hypothesis/Main point: - Will show that 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 Data used: - Data on both prices and interest rates used to show that deflation could be anticipated - 3 pieces of evidence used to prove that deflation could have been anticipated 1) Deflation was within the recent experience of the people living in 1929 2) Changes in the price level were positively auto-correlated during the interwar years. 3) 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, data suggest that real interest rates were very high from 1927 to early 1933 Conclusion: - Simple models of price expectations suggest that the persistence in the inflation process could have led agents to believe that the deflation would continue once it began - There was still unanticipated deflation between 1930 and 1933. The estimates suggest that at most 3/4 of the deflation could have been anticipated

Hugh Rockoff "Review of A Monetary History of the United States"

Hypothesis/Main point: - review by Hugh Rockoff of Milton Friedman and Anna Schwartz's book "A Monetary History of the United States, 1867-1960" Data used: - 3 examples are cited to reinforce this hypothesis 1) Contrast between 1879-1896 and 1896-1914 in terms of price level behavior 2) Contrast between World War I and World War II in terms of the behavior of the price level 3) Impact of restrictive actions taken by the Federal Reserve system in 1937 Conclusion: - Although the central thesis is "money matters," Friedman and Schwartz follow a large number of closely related threads. These range from the determinants of the greenback price of gold after the Civil War, to the relative effects of mild inflation and mild deflation on long-term economic growth, to the effects of deposit insurance on the stability of the banking system, and so on.

Bernanke, Ben (1982), "Nonmonetary Effects of the Banking Crisis in the Propagation of the Great Depression," American Economic Review 72.

Hypothesis/Main point: -The failed financial system led the borrower and lender to seek out more information about each other - As cost of information increases, credit became expensive and difficult to obtain Data used: - Created a Table of all the bank failures and the ratio of commercial bank loans to personal income - Cannot observe directly the effects of the banking troubles on CCI Conclusion: - The effect of bankruptcies on CCI = debt is hard to manage -- principal agent issue 1) Banks need to borrow to put skin in game as method to see how committed borrower is 2) Debt crisis and deflation eroded borrower's wealth and collateral relative to debt burden 3) Banks were only lending to people they knew before

Bordo and F. E. Kydland, "The Gold Standard as a Rule: An Essay in Exploration"

Hypothesis/Main points: - Gold standard cuts capital cost for countries that adhere to the standard completely - GS was good commitment mechanism ==> commitment to debt Data used: - Looked at list of countries on the GS and noted 1) when they suspended gold convertibility and the reason for suspension 2) Noted if there was a change in parity - Looked at inflation rates within these countries including inflation persistence and credibility bands Conclusion: - GS rule proved to be a successful commitment mechanism for England, US, France in preventing default on debt and ensuring that paper money issues during periods of wartime suspension were not permanent - GS was great commitment mech. in pre war era because: 1) Allowed nations to have access to revenue in times of wartime emergency 2) Gold emerged as a way of certifying contracts 3) GS served as intl. rule; countries pegged currency to gold and thus became part of a fixed exchange rate system

D. W. Diamond and P. H. Dybvig, (1983), Bank runs, deposit insurance, and liquidity

Hypothesis: - Bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits - Gives the first explicit analysis of the demand for liquidity and the "transformation" service provided by banks. Uninsured demand deposit contracts are able to provide liquidity but leave banks vulnerable to runs Conclusions: - There is a contract which achieves the unconstrained optimum when government deposit insurance is available. Deposit insurance is shown to be able to rule out runs without reducing the ability of banks to transform assets - The real damage from bank runs is primarily from the direct damage occurring when recalling loans interrupts production. This implies that much of the economic damage in the Great Depression was caused directly by bank runs. - Deposit insurance > Contracts which the bank alone can enforce ==> implies potential benefit of gov intervention in banking markets

Romer, Christina (1999) "Changes in business cycles: evidence and explanations"

Hypothesis: -Government control of AD in postwar era has dampened many recessions and counteracted some shocks entirely. However, the FED has also created a moderately sized recession in efforts to reduce inflation, thus leading to an equally volatile economy post WWII Data: -economic data on volatility of annual movements -output loss across time periods -data on length of recessions across time periods Conclusions: -Cycles between the post and prewar era have not changed -policy induced recessions exist due to mistakes in trying to keep inflation stable, increasing of interest rates in times of economic prosperity may have induced some moderate recessions (limit expansion for the sake of keeping prices relatively constant)

Romer, Christina (1986) "Is the stabilization of the post war economy a figment of the data?"

Hypothesis: -prewar and postwar economy are comparable; postwar great moderation is just a figment of the data and that there is no actual increased stability of the economy Data: -looks at industrial production data (GNP) -Frickey's index--found methodical errors that exaggerate the stability of the prewar era (excessively volatile in prewar) and used index for post war era Conclusions: -when comparing the consistent industrial production data, there is very little damping of business cycle fluctuations between pre 1914 and post 1947 periods -Frickey's data and methods are flawed, it suggests that estimates on industrial production in prewar era is a bad proxy for total production -decline in wage and price flexibility between pre and post war eras may explain why stabilizers in the post war has not yielded a dramatically more stable economy -cycles before and after the GD are equally severe and we can no longer conclude that the stabilization policies of the government is obviously effective

Is the post-WWII business cycle less volatile? How do Romer answer this question? Why does Romer think the observed moderation of the business cycle is a "figment" of the data?

Romer believes that post WWII business cycles have not become less volatile and challenges the notion of the Great Moderation. Rather, she argues that the pre-1914 and post-WWII economies are comparable and that the business fluctuations are similar in magnitude. The economist studied GNP and industrial production data, and conclude Frickey's index and methods are flawed. Particularly, the estimates for prewar production using Frickey's index exaggerated volatility, and when applied to the post war data, the volatility is comparable. Furthermore, the cycles before and after the war are comparable in severity, and concludes that government practices have not been as effective in reducing volatility.

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.

The fall of money supply ultimately caused deflation across the United States during the Great Depression, causing widespread decline in values of firm and household collateral. If deflation is bad enough and price levels fall, then loans will ultimately go bad, causing banks to fail. Since the equity (collateral) of a firm lowers during deflation, then separating equilibrium may not be achievable, and banks are unable to find an optimal interest rate and collateral bundle. Because of this, and cost of lending and banks cost of being a credit intermediary skyrockets when there is deflation, then banks will loan less and invest less on firms, thus causing lending and investment to plummet as seen during the Great Depression.

How was gold standard adherence linked to deflation during the great depression?

The GS tied countries to a fixed price and money supply. This prevented the government from pursuing an activist monetary policy or acting as a lender of last resort. Thus, the GS prevented the increase in Money supply (inflation) and in the time of frequent banking panics and runs, there was persistent deflation. The GS prevented credible deposit insurance and linked national price levels with dangerous levels of asymmetry. Thus, the GS fettered the Fed and prevented inflation during the GD.

What is the "great moderation" in post-WWII macroeconomic data?

The Great Moderation describes the moderation and smoothing out of economic volatility after WWII. Overall, the output has become less volatile, and more predictable in most economies, and at the same time, the volatility of inflation expectations have also declined. In particular, post WWII recessions have become less frequent, the average output loss per recession has decreased (mostly due to the interwar period Great Depression), and thus each recession has become smaller and less devastating to the economy, and periods of economic growth have increased.