Great Expectations and the End of the Depression Flashcards
What ended the Great Depression in the United States?
This paper suggests that the recovery
was driven by a shift in expectations. This shift was triggered by FDRs policy actions. On the monetary policy side, Roosevelt abolished the gold standard and announced an explicit policy objective of inflating the price level to pre-Depression
levels. On the fiscal policy side, Roosevelt expanded real and deficit spending which helped make
his policy objective credible. The key to the recovery was the successful management of expectations
about future policy.
The regime change generates an endogenous shift in expectations due to a coordination of monetary
and fiscal policy. How did this coordination end the Great Depression?
By engineering a shift in
expectations from “contractionary” (i.e., the private sector expected future economic contraction and deflation) to “expansionary” (i.e., the public expected future economic expansion and inflation). The expectation of higher future inflation lowered real interest rates, thus stimulating demand, while the expectation of higher future income stimulated demand by raising permanent
income.
It is hard to overstate how radical the regime change [taking currency off of the gold-standard] was. “This is the end of Western civilization,”
declared Director of the Budget Lewis Douglas.2
During Roosevelt’s first year in office,
several senior government officials resigned in protest. Which three almost universally
accepted policy dogmas of the time were violated?
-The gold standard
-The principle of balanced
budget
-The commitment to small government.
Interestingly, the end of the gold standard
and the monetary and fiscal expansion were largely unexpected, since all these policies violated
the Democratic presidential platform.
This dramatic turning point, the defining moment of the recovery,
requires a careful description. What cannot explain the turning point?
The turning point cannot be explained by contemporaneous changes in the money supply.
Despite the fact that neither the nominal interest rate nor the money supply changed much at the turning point, the paper argues that the elimination of the policy dogmas drastically changed
the systematic part of monetary policy, i.e., the framework that governed the policy setting going
forward. What is meant by this? What changed?
What changed was expectations about how the interest rate and the money supply
would be set in the future, leading to a dramatic change in inflation expectations.
Why was the Roosevelt administration success where the Hoover administration struggled?
The Hoover Administration is constrained by the policy dogmas (i.e., the gold standard, balanced budget, and small government dogmas), while the Roosevelt Administration
is not. The elimination of the policy dogmas triggers a swift change in expectations.
Milton Friedman and Anna Schwartz (1963), and a large literature that followed, suggest that the recovery from 1933–1937 was driven primarily by money supply increases. Nominal interest
rates, however, were close to zero during this period. According to the model in this paper, why isn’t this true?
According to the model in this paper, a higher money supply increases demand only through lower interest rates, so at the zero lower bound it is only through the expectation of future money supply, and thus future interest rates, that the money supply affects spending.
Through the expectation channel, how is the main point of
Friedman and Schwartz is confirmed in this paper?
Appropriate monetary policy was essential to
end the Great Depression, and could have prevented it altogether. The twist is that this could be
achieved only through the correct management of expectations, not contemporaneous increases in the money supply per se. Furthermore, in contrast to Friedman and Schwartz, fiscal policy
plays a prominent role in the analysis in this paper, mainly by influencing expectations about the
future money supply.
