Transcript 27-Evidence on Monetary Policy

27-Evidence on Monetary
Policy
What is a Keynsian?
1)
One who activates the role of
government to use fiscal policy
(spending and taxation) to stabilize
the economy.
2)
One who advocates government
action of any type regarding economic
stability.
Economic Spectrum
Free Markets Work
Monetariasts
X
Government
Spending
(Fiscal Policy)
is Important
Determinant of
Economic Output
Activist (Keynsian)
Monetary Policy
Keynsians
Government Policy Works
Money Supply is
Important
Determinant of
Economic Output
Classical Gold Standard
Period: 1870-1914

all major economies on gold standard
international trade flourished
capital flowed freely across borders

free markets reigned


Subsequent Events

World War I
U.S. emerges as the dominant economy

1920’s

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

output in U.S. expands, stock market flourishes
Consumer confidence soars
World in general attempts to regain the
economic stability it enjoyed before WWI
based on capitalism
The Great Depression

Between 1929 and 1933



Real output in U.S. fell by 30 percent
Unemployment increased from 3% to 25%
Sharpe Deflation


Prices fell at rate of 10% per year
Capitalism appears doomed
The Great Depression

What caused it?

Aggregate shifted left and remained. Why?
The Great Depression

Most economists during first decades
after depression believed

Depression was caused by either over
investment and overbuilding in 1920s, or
irrational underconsumption.

Monetary policy was secondary, and of little
importance.
Eccles’ Views

Eccles testifies before congress 1933

“I see no way of correcting this situation except through
government action.”

“The need is not for more money, but for more spending.”

“Because the profit motive could be expected to lead
individuals, business, and financial institutions to make
decisions which would further reduce spending, hence income
and unemployment, the government, motivated not by profits,
but by the welfare of the public must compensate by spending
more.”
Eccles and Keynsianism
“[The decline in spending and investment
since 1929] could have been prevented by
action of Government which is the only
agency which could continue to spending
money without regard for profit . . . .
Financial Fuel is piled up – The
Government, and not the bankers must
apply the torch” (Eccles 1933).
Eccles

Time Magazine Report, 1936:
“Eccles laid before a Senate committee a
plan, which turned out to be nothing less
than a detailed blueprint of the New Deal.”
Friedman and Schwartz

“A Monetary History of the United States, 18671960”

Published in 1963

Showed a correlation between tight money
supply and declining prices and output.

Identify four policy decisions of Fed which led to
tighter money supply during great depression.
Policy Decision #1

1928: decreased bank reserves

Why did they do it?
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
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Perceived lending of banks to brokers a bad
use of credit.
After failing to convince banks to stop lending
to brokers, Fed tried to raise rates.
Trying to “pop” a perceived bubble in stock
prices
Policy Decision #2

1931: decreased bank reserves

Why did they do it?

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Speculative attack on British pound forced
U.K. to abandon gold standard
Fed wanted to protect the dollar and remain
on the gold system
Policy Decision #3
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1932: decreased bank reserves

Why did they do it?

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Low nominal interest rates
Viewed Depression as the necessary purging
of financial excesses built up during the
1920’s
Did it while Congress was out of session
Policy Decision #4

Ongoing neglect of problems in U.S. banking
sector


Between December 1930 and March 1933, about
50% of all U.S. banks either closed or merged
with other banks.
Why did they do it?


Fear of creating moral hazard
Viewed the weeding out week banks was a harsh
but necessary prerequisite to recovery.
Fed and banks

As Banks Failed

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Banks built up piles of excess reserves
Fed became worried stock piles could
quickly be depleted, leading to inflation
August 1936 – Fed doubled reserve
requirement
Banks spent next a few years building up
excess reserves.
Interpretation

What we observe during depression

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Falling money supply
Declining output
Declining prices
But correlation does not imply causality
Many economists at first strongly
disagreed with Friedman and Schwartz
Interpretation

What if declining output and prices is
caused by under-consumption?


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
Consumers and firms need less loans.
Less reserves get multiplied through system
Money supply drops
Economists argued low money supply was a
result, not a cause of the great depression.


Nominal rates were near zero!
How much looser could monetary policy be?
Interpretation

Maybe monetary policy was not so loose.
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
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Recall prices were dropping during depression.
nominal=real+inflation
If inflation is negative, real rates could still
be positive.

Borrowers have to pay back loans with dollars
that are worth more in terms of real goods.
Interpretation

How to determine cause?
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In 1980s: Economists began to focus on
other countries besides the U.S.

The depression was wide in scope, but
the impact was not as long and not as
enduring on some countries. Why?
Interpretation

Answer 1: Some countries, for some
reason, did not suffer from as much
under-consumption (irrational pessimism)

Answer 2: Some countries did not
contract their money supply.
Interpretation

Gold Standard: Fixed Exchange rate regime

All countries on gold standard must adopt
same monetary policy as U.S.

As U.S. contracted its money supply during
early 1930’s, it forced other countries on the
gold standard to do the same.
Gold Standard

Countries not on gold standard:
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Countries which left gold standard early
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U.K., Japan, several Scandinavian countries
Countries on gold standard until 1933
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Spain, China
Italy and U.S.
Gold Standard Diehards

France, Poland, Belgium, Switzerland
Gold Standard

Strong evidence suggests that countries
which left gold standard early, or that were
not on gold standard during depression did
not suffer as severe effects in terms of
dropping output and prices.

Example: China unscathed during great
depression.
Stabilizing the Money Supply

Some of Roosevelt’s actions:
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Eliminated gold standard
Declared a bank holiday

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Banks were allowed to reopen only after
showing they were in sound financial
condition
Created FDIC
Effects of Roosevelt’s Actions

Economy grew strongly from 1933 to
1937,

Eccles (Fed Chair) lowered money
supply again in 1937, causing
economy to plunge back into recession
Lessons

Money supply has important effect on AD
curve, inflation, output, and unemployment.

Gold standard forces countries to import
monetary policy.


May lead to bad outcomes
Central banks have important responsibility
to maintain financial stability through good
monetary policy.
Economic Spectrum
Free Markets Work
Monetariasts
Government
Spending
(Fiscal Policy)
is Important
Determinant of
Economic Output
Money Supply is
Important
Determinant of
Economic Output
Trend in Economic Thought
Keynsians
Government Policy Works