Lecture 6 - The US Great Depression

Question 1

GREAT CRASH TO GREAT DEPRESSION

Answer 1

1st Panic: Black Thursday 1929
2nd Panic: Black Friday 1929

Consequences of crash: recession in real economy speeds up due to:

1) Investment behaviour
2) Household consumption behaviour

=> Wealth effect (small)
=> Bigger consumer uncertainty effect (consumer delay big purchases)

Question 2

Spending hypothesis

Answer 2

Great Depression caused by a drop in autonomous consumption demand

• Secular stagnation thesis: demand decline due to slowdown in population growth
• Construction slowdown since 1920s

Question 3

Monetary hypthesis

Answer 3

Friedman & Schwartz = monetary contraction caused Great Depression in the US

Money supply collapsed over course of three banking crises

Banks fail => Deposit money destroyed

M1(decreases) = Currency + Deposits (decrease)

• Fed failed to stabilize money supply
• Should have acted as a lender of last resort to prevent bank runs

Question 4

Why no Fed Intervention to 3 banking crises

Answer 4

Bagehot rule = lend freely at penalty rates against good collateral

• Idea was that solvent banks could survive temporary liquidity crises
• Prevents self-fulfilling prophecies: Bad expectation => Bank failure => Validation of expectations

No fed response due to
- Death of high fed official
- Less experienced people took charge
- Outdated doctrines and regional differences among Fed districts

Question 5

Criticism monetary hypothesis

Answer 5

Spending hypothesis proponents:
- Something must have depressed demand
- Risk free rates decreased

Fed policy was in fact mildly expansionary:
- Decreased discount rate
- Slow expansion of monetary base (however too little to offset credit crunch, banks lent out less than they could)

Question 6

Credit Crunch Hypothesis

Answer 6

When banks fail borrowers cannot easily find new bank that provides them with the same amount of credit at the same interest rate (due to loss of accumulated knowledge)

Leads to less credit and higher spreads
- Also less loans because of balance sheet channel

Credit spreads rise after each banking crisis (credit falls by more than deposits do)

Summary (banking crisis):
Money supply (decreases) & Spreads (Increase) => Output (decreases) & Risk-free rate (decreases)

Question 7

Transmission Mechanisms

Answer 7

Monetary shocks transmitted to real economy through

1) Rigid prices
2) Sticky wages
3) Nominally fixed debt contracts

Production declines most severe for goods with rigid prices

Protracted deflation

Question 8

Contractionary Effect of Protracted Deflation

Answer 8

1) Ex ante real interest rate increases
- Little effect due to unanticapated deflation

2) Wage deflation
- Real wages increase
- Firms higher less workers
- Was present

3) Debt deflation
- More difficult to repay debt
- Wealth redistribution from borrowers to creditors
- Implies that lower aggregate demand when creditors have lower propensity to consume