The Great Depression Flashcards
When and what was the Great Depression?
The Great Depression is the most famous financial crisis in history, which started in the US
It took place around the years 1929-1939
What happened during the Great Depression?
- Huge deflation in the American economy
- Very high levels of unemployment
- Very big losses in GDP
What was the build up to the Great Depression?
Similar to the Minsky model: new innovations created economic boom and overoptimism in the US –> The economy boomed due to the new industrial revolution → people got rich
People believed in progress and that it would never end
Financial imbalances before the crisis in the US
- Things are going really well, but you also get financial imbalances → maybe people get a little too optimistic.
- Stock market and house prices go up a lot
- High credit growth on household level
- Financial innovations: consumer loans and installment loans (for cars)
NB: Today we know that these are factors that we should be worried about → but they did not then.
What is Friedman & Schwartz argument on what went wrong in the Great Depression? (the monetary hyphotesis)
The authors made an extremely influential book on the Great Depression and what went wrong → monetary factors.
They put the blame of the debt and the severity and the fact that we have a depression on the Federal Reserve (US central bank)
—> It got so bad, because the FED repeatedly took policy steps that either reduced the supply of money in the economy or did not intervene when banks failed and reduced the amount of money-supply.
–> When there is less money, then prices drop. When prices drop, then people expect that prices will keep on dropping and then have no incentive to spend money (because they believe it will be cheaper tomorrow) –> increasing deflation –> defamatory mindset keeps decreasing business activity –> bad circle
What should the FED have done during the Great Depression according to Friedman & Schwartz?
Increased the money supply (cut rates, buy stuff) –> make prices fall –> stop the deflation from growing
Why was there such a big deviation between how well countries handled the Great Depression (hint: Gold Standard)
The Gold Standard is the key explanatory factor for the different performances in the 1930s.
- The countries that remained on gold longer (e.g. US and France) → worse output.
- The countries that left gold quickly (e.g. UK and Japan) → recovered faster from the crisis.
The gold standard is a monetary regime that does not allow you to be flexible: you are bound to gold. So you can not just increase the money supply (because the money is gold). So you are bound → your central bank can not do what they want to do (support the market with liquidity and put money into the system).
What happens to unemployment in deflation times? (hint: sticky wages)
Nominal wages are sticky/downward rigid
- They don’t move downwards towards the normal equilibrium as models would predict.
Why? → because people hate getting lower wages, people have long term-contracts etc.
What is the consequence of that?
If you have stickiness in the price of wage, then adjustment will happen over the quantity of labour. The demand of labor will not be high enough to adjust for the supply of labor → more unemployment
What happened during the Great Depression?
- Deflation
- Prices fall
- Business get less profit
- They can’t afford to pay people the same wage –> but people don’t want lower wage –> instead many get fired.
How can non-monetary factors help explain
Monetary factors alone can’t explain why the Great Depression caused subsequent and persistent falls in output
Therefore non-monetary factors are important
Argument: When banks break down, you lose a lot more than capital –> you also lose important information capital –> this I harder to replace than capital.
What ended the Great Depression in the US?
President Rosevelt and his policy turn-around
What did Rosevelt do?
Monetary decisions:
- Suspended the Gold Standard –> made a regime-change that allowed for inflation and gold-inflow –> decreased the interest rates finally
- New Deal: A program that helped inflate the economy
Changed people’s expectations:
- Made a credible commitment: bluntly told people the governments plans and what he needed them to do, and that this time the government would help the finances stay stable.