Lecture 7 - The Spread of the Great Depression

Question 1

GOLD STANDARD LITERATURE

Answer 1

Gold standard = monetary authority fixed gold price of local unit of account

Domestic money freely convertible into gold at this price

Two countries had fixed exchange rates

Question 2

Gold coverage ratio

Answer 2

= (Fixed gold price * Quantity monetary gold) / Monetary base

CB targeted coverage ratio by setting interest rates

Coverage ratio below target => Raise interest rate
1) Gold inflow
2) Lower monetary demand
=> Coverage ratio increases

• Global gold supply fixed (inflows and outflows had to offset each other)
• Goal keep money supply in proportion to gold reserves

Question 3

Interwar Gold-exchange Standard

Answer 3

WW1: Gold Standard suspended

Genoa conference 1922: Resumption of Gold standard, CB encouraged to hold some FX reserves

Reasons:

1) Avoid deflation (Economy growth > Gold growth)
2) Keeps gold in vaults (lower transaction costs)

Still however macroeconomic policy trilemma: no independent monetary policy

Question 4

Great Depression Initiated by two Rule Game Violations

Answer 4

1) US raised interest rates despite high coverage ratio (1928)

2) France sterilised massive gold inflows in late 1920s (did not expand monetary base)

Forces other CB to raise rates too

Gave rise to global monetary contractions

Question 5

Break point 1931: International investors begin to doubt stability of gold standard

Answer 5

Results in a run on CB

Results in interest rate hikes and exists from the Gold Standard System

Question 5

Break point 1931: International investors begin to doubt stability of gold standard

Answer 5

Results in a run on CB

Results in interest rate hikes and exists from the Gold Standard System

2 Effects on CB reserve management:

1) Flight from FX reserves (total reserves now only gold again)

2) Scramble for gold (to increase gold coverage ratio to cover against insurance of future bank loans)

==> Consequence: even more global monetary contraction

Question 6

Gold Standard fully disintegrates after 1931

Answer 6

After Sterling bloc devalued, it received gold inflows

=> No further devaluations were expected (safe haven)

=> Increase in price competitiveness increased NX

New rule of game violation: Sterling bloc sterilizes gold inflows

=> Countries staying on gold end up on the contractionary side of asymmetry problem

Question 7

Causes of the Global Banking Crisis (1931)

Answer 7

1) Financial fragility: high debt levels

=> WW1 overextension of farms
=> Roaring 20s: rising debt levels

2) Second recession year

=> Fallen incomes => harder to service debt
=> Fallen asset prices => weaker balance sheets

3) Contagion

=> Worsening of expectations
=> Cross-border financial exposure

Question 8

Was the Gold Standard the Source of the Global Banking Crisis

Answer 8

Fixed exchange rate regime meant that CB had conflicts between being a LOLR and exchange rate stabilisation

Either:

1) Save banks by providing liquidity

=> Would increase pressure on exchange rate, currency crisis

2) Defend fixed exchange rate by increasing interest rates

=> Aggravates liquidity problems of banks

Question 9

Great Depression in Germany

Answer 9

Since 1929: Germany needs export surplus to earn FX to service foreign debt and reparations

=> Either increase NX or default

How to pay for reparations? Austerity

1) Exacerbate recession to attain reparation relief

2) Boost NX by improving Germany’s competitiveness through internal devaluation

=> These where to only two options, as international loans came with very strict conditions

Question 10

Germany’s austerity measures (1929)

Answer 10

Led to a large fiscal contraction : nominal expenditures cut by 30%

=> Large negative demand shock

=> However, did not work:

• Export surplus only rose because imports fell
• No export opportunities due to global trade war
• Gold exit hurts Germany’s competitiveness
• Fiscal contraction not offset by rising exports

==> Severe output contraction in Germany
==> Nazi party gains popularity
==> Current gvt. can only implement austerity measures, further undermines political support

Question 11

Germany’s crisis of 1931

Answer 11

Banking problems: foreign depositors withdraw money from berlin banks

=> Germany’s banks have payment difficulties
=> Initially Reichsbank acts as a LOLR, but the employs monetary contraction
=> Banking crisis erupts

Fiscal problems: Questions about Germany’s willingness to pay

=> Reichsbank reserves decline
=> Begin of currency crisis

Lausanne conference ends reparation payments and recovery from the great depression begins

• Brünings however understimated the political risks of his policies
• Allowed parties such as the NSDAP to gain popularity

Question 12

Disintegration of the World Economy

Answer 12

Capital controls led to lasting financial markets disintegration

Global depression was accompanied by a global trade war

=> Goods markets disintegration
=> US tariffs support domestic farmers (led to retaliatory responses)
=> Trade war intensified post 1931: Gold remainers try to offset losses of competetiveness through gold leavers through tariffs