Transcript III. Economic Development and Economic policies before WWI

IV. Economic Development and
Economic Policies before WWI
Classical Model at Work
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)
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 today’s policy
objectives
– No general social a political pressure to guarantee
economic growth and full employment
IV.1 Basic data
Real GDP, %yoy, US, UK
1871-1913
Real GDP, %yoy, US, UK
1871-2009
CPI, %yoy, US, UK
1871-1913
CPI, %yoy, US, UK
1871-2009
Unemployment, %, US, UK
1870-1913
Unemployment, %, US, UK
1870-2009
US: GDP growth, CPI, unemployment
1870-1913
Changes in GDP and in
inflation
Great Britain
France
Germany
Italy
Austria
Belgium
Netherlands
Sweden
USA
% change of real GDP
% change in consumer prices
1870 187418941870 187418941874
1894
1913
1874
1894
1913
2.4
1.8
1.8
1.1
-1.5
1.0
3.3
1.2
1.7
1.0
-0.2
0.4
4.5
2.1
3.3
4.2
-0.8
1.4
0.7
2.1
3.3
5.3
-1.0
1.2
2.5
2.4
2.4
n.a.
-1.2
1.4
2.5
1.9
2.0
2.1
-1.5
1.1
1.6
2.3
2.2
4.4
-1.3
0.6
4.8
1.2
2.7
4.5
-1.2
1.5
3.3
3.6
4.4
-2.7
-1.3
0.7
Lesson from the data
• Volatile growth, average growth lower
compared, e.g., to ”golden” period 19501970
• 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)
IV.2 Theory: Classical model
IV.2.1 Aggregate supply and
demand and equilibrium on
market with goods and services
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
W
 
 P 
W
 
 P 0
Y
NS
E
ND
N0
N
FN, K 
Y0
N0
N
Aggregate demand
• Consumption function:
C  CYD, r  , CYD  0 , Cr  0
• Investment function:
I  Ir  , Ir  0
• Governmental expenditure: G
• Aggregate demand:
AD  CY - TY, r   Ir   G
Equilibrium
Aggregate supply AS
• Labor market in equilibrium: employment
N0
• Production function – aggregate supply Y0
Aggregate demand AD  CY - TY, r Ir   G
Equilibrium: AD=AS, hence
Y  CY - TY  Ir   G
“Classical” question: what ensures that – if
supply is determined by full employment
from labor market – AD exactly matches
AS?
IV.2.2 Equilibrating
mechanism.
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
I(r)  SY - T (Y),r   T(Y)  G
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
SY - T (Y),r   T(Y)  I(r) G
SY - T (Y),r   T(Y)
r
r1
r0
r2
I(r)+G
S0  T
I+G, S+T
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 r>r0, then excess supply of loanable funds and r
decreases
– If r<r0, then excess demand of loanble funds and r
increases
• Remark: Say's law
IV.2.3 The quantity theory of
money
David Hume
• 1711 – 1776
• Philosopher,
historian
• 1752: Political
Discourses,
especially essay Of
Money
• Diplomat
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.V=P.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
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
Irving Fisher
• 1867-1947
• American
• Neoclassical Marginalist
Revolution, mathematical
methods
• Introduced Austrian economic
school to the USA (Theory of
capital and investment, 18961930), intertemporality
• Quantity theory of money
(1911-1935)
• Loss of credibility during
Great Depression
Fisher’s 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
Fisher’s 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)
Fisher’s QTM – develops from quantity equation, no explicit
consideration of supply and demand for money
Cambridge version
• Problem of Fisher’s 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
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
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 Say’s 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
IV.2.4 Complete model
(closed economy)
The model
Labor market and aggregate supply
• W/P = FN(K,N)
• N = NS(W/P)
• Y = F(K,N)
demand for labor
supply of labor
production function
Market with goods and services
• Y=C+I+G
• C  CY - T ,r 
• I = I(r)
demand and equilibrium,
consumption function
investment function
Financial (money) market
• M.V = P.Y
price equation and
equilibrium (Fisher’s version of QTM)
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
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
Dichotomy of the classical model
• Real sector: labor market, flexible
nominal wage, production function,
Say’s law
 full employment equilibrium product
 supply side determines the product at
given price and amount of money
Classical dichotomy, money is neutral
P
AS
P0
M0V
W0
W0/P0
W/P
Y0
Y
ND
N0
NS
F(K,N)
N
IV.3 Classical gold standard
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)
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
International standard: fixed ExR
• Fixed price of gold in terms of each country’s
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
Arbitrage and gold points
• Free trade with gold → the same
exchange rate between, e.g., $ and £,
1£=4$ (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 1£=3.8 - 4.2 $
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
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
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
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?
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
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
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
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
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
IV.4 Policies
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
Multipliers – classical model (1)
• Independent set of first 2 (3) equations of the
model (labor market and production function)
FNK
W
d 
dK  0
S
P 1 - FNN N W P
dN 
NSW P FNK
1 - FNN N
S
WP
dK  0 dY  (
FN NSW P FNK
1 - FNN N
S
WP
 FK )dK  0
• 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
Multipliers – classical model
Reduced form derivatives:
r
C
• Interest
 Y -T
T
Cr  I r
0
r
1
0
G
Cr  I r
•
Consumption

C
Cr 
 -CY-T  10

T
 Cr  Ir 
•
Investment
I I r CY-T

0
T Cr  I r
•
Price
P V
1
 
0
M Y kY
(2)
C
Cr
0
G
C r  Ir
I
- Ir

0
G Cr  I r
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 macropolicies:
• 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)
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
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
P
AS
M1>M0
P1
W1
M1V
P0
M0V
W0
W1/P1= W0/P0
W/P
W0/P1
Y0
Y
ND
N0
NS
F(K,N)
N
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
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