Economic Fluctuations

Question 1

Key features of Interwar Business Cycles (4)

Answer 1

1. Macroeconomic “Trend Stationarity” (or loss thereof) – persistence of shocks
2. Passing of the Kuznets Swing (Abramovitz, 1968)
3. Business Cycle Amplitudes
4. International Cycles

Question 1

1. Macroeconomic “Trend Stationarity” (or loss thereof) – persistence of shocks (6)

Answer 1

• During pre-WWI gold standard era (c. 1870-1914), some of major industrial countries (inc. UK) had trend-stationary growth paths (grow along stable LR path)
• During Interwar, underlying growth paths displaced in a persistently downward direction due to adverse shocks in the early 1920s and early 1930s
• Solomou (1996) – persistence of shocks in 1920s has several explanations
• Wage-gap – persistent, but evidence on this is unconvincing
• ER overvaluation – foreign penetration made it harder to compete in the LR (consistent with a level effect on output) – imports up from 20% of GDP (1920-21) to 25% (1922-25)
• Deflationary policy (1920s) – raises LR real indebtedness (lots post-WWI)

Question 2

2. Passing of the Kuznets Swing (Abramovitz, 1968)

Answer 2

• Pre-WWI ear saw irregular Kuznets swings in trends of some important variables, including investment, international migration & balance of trade
• Macroeconomic cycles were outcomes of these disaggregated interactions
• These cycles came to an end in the Interwar period
• Abramovitz (1968) – “The Passing of the Kuznets Cycle”
  o Cycles occurred pre-1914 due to immigration, waves in house building (dependent on immigration), railways, private demand dominance, ‘specie standard’ (i.e. Gold) and fractional reserve banking (with lots of competition)
  o Kuznets Cycles ‘belonged to a particular period in history’ (i.e. 1840-1914)
  o Controls on immigration meant the labour force no longer responded to demand, so no endogenous 20 year cycle for labour force
  o Increasing role of govt is crucial (esp. in US) – swings determined by fiscal policy
• Solomou (1996) explains phenomenon via different adjustment mechanisms in Interwar
• No migration – blocked by New World legislation (e.g. 1924 US Immigration Act) – had been associated with capital export before (e.g. Thomas (1973))
• Policy discretion (less free trade, less gold standard & less balanced budgets – eliminated transmission mechanisms)
• Agricultural production no longer central to fluctuations

Question 3

3. Business Cycle Amplitudes (10)

Answer 3

• Backus & Kehoe (1992) – economic volatility was much higher in the Interwar than pre-WWI
  o Study fluctuations in money, output & prices in 10 countries
  o Use Hodrick-Prescott method to detrend the data
  o Interwar fluctuations in real output 2-4x larger than post-war (standard deviations)
  o UK output fluctuations 1.6x greater in Interwar than pre-WWI and 2.1 greater than post-WWII (output fluctuations in Interwar > pre-WWI everywhere but Australia)
  o Price volatility is also larger in the interwar
• Solomou (1996) – suggests several reasons from literature
• Kindleberger (1983) – due to US dominance because the US is a more volatile economy
• ER volatility, but could be reverse causation & Interwar gold standard creates the most volatile period of ERs yet
• Due to different adjustment mechanisms – pre-WWI, relied on adjustment mechanisms (rules based policy – Gold Standard); Interwar, relied on discretion based policy
• No migration – blocked by New World legislation (e.g. 1924 US Immigration Act) – had been associated with capital export before (e.g. Thomas (1973))
• Collapse of overseas lending in 1930s, especially as US becomes dominant lender (but doesn’t act to stabilise in the same way that the UK did pre-WWI)
• Trade collapse in the 1930s (ct free trade & export-led growth pre-WWI)
• Real exchange rate adjustment is much less easy in Interwar
• Bayoumi & Eichengreen (1996)
  o Blanchard & Quah (1989) technique shows that shocks pre-1914 were not less prevalent, but adjustment of prices and quantities was faster (AD-AS framework)
  o Expand this VAR framework with linkages between domestic & foreign prices
  o Find that AD shocks are 2x higher & AS shocks are 3x higher in Interwar (ct pre-WWI)
  o Partly due to fact that gold standard imposed discipline on national policy makers, which they don’t have now, so aggregate demand is more variable
  o In the Interwar, AD curve is steeper (international price divergence is allowed under the policy regime) and the SRAS curve is flatter (speed of adjustment slows due to nominal inertia)

Question 4

4. International Cycles

Answer 4

• Backus & Kehoe (1992) – business cycles showed significant international co-movement in the Interwar period, whereas cycles were nation specific pre-WWI
• e.g. Output correlation UK-US is 0.01 for pre-war, but 0.74 for Interwar (latter is statistically significant at 5% level) (cf UK-Ger: 0.03 pre-war and 0.89 Interwar)
• Suggest reason is common experience of Depression (affected all countries but Germany and Japan, who were ‘largely untouched’)

Question 5

Other IW fluctuations (Solomou, 1996) - Recovery in the early 20s

Answer 5

• ‘Gradual recovery’ until the General Strike of 1926
• Export growth was significant, at 12% p.a. from 1921 to 1925 (then stopped by gold?)
• Can explain it via end of “wage gap”, which occurs in 1922 according to Solomou (1996)
• Eichengreen (2004) – some role for new industries – share of employment accounted for by new industries rose from 11% to 15% 1920-1929, whilst basics fell from 30% to 25%

Question 6

Other IW fluctuations (Solomou, 1996) - 1926 recession

Answer 6

• Solomou (1996) – due to General Strike (SR in nature)
• Morys (2014) – dates it 1925-26
  o Explores whether it is due to Return to Gold
  o Solomou & Vartis (2005) – calculate UK RER for 1913-30
   Shows that it increasing considerably 1918-21, but then falling after
   Small appreciation in 1925-26, but only partial explanation of the recession

Question 7

Other IW fluctuations (Solomou, 1996) - 1937-38 recession (4)

Answer 7

• 11% decrease in exports was the main reason for recession
• Very mild – GDP grew at 0.7% 1937-38, compared to 2% trend growth for 1929-37
• Export shock far less destabilising because openness in economy had decreased (growth increasingly domestically generated) & no gold standard contraction necessary in response
• Mild because government spending rose due to impending war

Question 8

Business cycle theory (Solomou, 1996) (6)

Answer 8

• Business cycles reflect: nature of specific shocks, changes in policy regimes & changes in structure of the economy
• Traditional view is peaks in 1920, 1929 and 1937 – Juglar cycles (Aldcroft & Fearon, 1969)
• Problems with traditional view
  o Fluctuations have irregular amplitude & duration (recessions in 1926 and 1928)
  o Pre-1914 Juglar cycles are not convincing
  o Persistence of 1919-21 means there is a lack of continuity with the past
• Business cycle causes focus on
  o Propagation – endogenous causes of the business cycle
  o Impulse – exogenous shocks causing the business cycle
  o Widely recognised that each interacts with the other (by both sides of argument)
• Business cycle theories
  o Monetary theory of business cycles – business cycles are the outcome of changes in discretionary monetary policy (via wage rigidity & expectations)
  o Real business cycle (RBC) theory – business cycles are due to real shocks that shift the supply-side of the economy
• Evidence (above) suggests that both theories are partial explanations
  o MP important in 1920-21 and 1931-32 (+ recovery) – most important when floating
  o Real factors (perhaps more) important – hours (19), strike (26) and exports (29/37)

Question 9

Exports in 1920s (3)

Answer 9

• Eichengreen (2002)
  o Finds that GB exports 78% below where expected given their reduction during WWI
• X collapse 30% 1920-21, then grow 12% p.a. 21-25, then down 25-26, then up to 1928
• Causes
  o ER – key, but doesn’t explain increase after 1921
  o Strikes (1921, 1926)
  o Exogenous demand shocks (1928)
  o Eichengreen (2002) – specialisation in wrong industries + structural shift in world trade patterns due to industrialisation of other countries