Topic 5: The Great Depression Flashcards
causes of great depression
large drop in output from major countries
drop in prices in major countries (deflation)
large drops in exports and imports (international trade)
large bank failures (12.9% of banks failed in 1933 vs 2-3% in 1920s)
main causes and mechanisms of great depression
mismanaged gold standard which lead to deflation
deflation led to depression (downward rigidity in wages, high real interest rates, high real debt burdens which caused bankruptcies and bank panics)
what was the gold standard
value of each country’s currency fixed in terms of gold
ratio of currency to monetary authorities’ gold reserves must lie within limits
countries that experienced gold inflows:
money supply rises
price level rises
because price of gold goes down in the country, so in order to maintain the gold standard they had to increase money supply which made the local currency worth less so PL rises as ratio of currency to gold had to me in a certain limit
country that experienced gold outflows:
money supply drops
price level drops
because price of gold goes up in that country so had to decrease money supply to maintain gold standard which made currency worth more so PL decreases
what happened to countries that experienced gold inflows (to PL)
countries that experienced gold inflows:
money supply rises
price level rises
because price of gold goes down in the country, so in order to maintain the gold standard they had to increase money supply which made the local currency worth less so PL rises as ratio of currency to gold had to me in a certain limit
what happened to countries that experienced gold outflows (to PL)
country that experienced gold outflows:
money supply drops
price level drops
because price of gold goes up in that country so had to decrease money supply to maintain gold standard which made currency worth more so PL decreases
what happened to exporter countries when it experienced gold inflows
price level rises, international competitiveness deteriorates, trade surplus drops
what happened to importer countries when they experienced gold outflows
price level drops, international competitiveness improves, trade deficit drops
what was the price specie flow mechanism meant to do
eliminate trade imbalances
how did interest rates equilibrate for exporter countries when there were gold inflows
lower interest rates so AD rises so price level rises so trade surplus drops
lower interest rates also slow down gold inflows
how did interest rates equilibrate for importer countries when there were gold outflows
raise interest rates so AD falls so price level drops so trade deficit drops
higher interest rates slow down gold outflows
how are trade imbalances managed nowadays?
tariffs to influence imports/exports
floating exchange rates
importer country (trade deficit) - currency depreciates when exports are too low so international competitiveness improves (the currency itself devalues)
fixed exchange rates
fix relative to another country
importer country (trade deficit) - if exports are too low, prices/wages within the country drop (engineer deflation - cause economy to contract so prices go down)
problem with gold standard (asymmetric adjustment)
price specie flow mechanism relies on symmetric adjustment across countries
countries that experienced gold outflows must reduce money supply (raise rates) otherwise they run out of gold reserves
countries that experiences inflows of gold do not have to expand money supply (lower rates) as gold inflows can be sterilized by being added to gold reserves of country
there was a bias towards DEFLATION
which were main countries experiencing gold inflows
france and US
what did france and US not do despite high gold inflows
did not expand money supply sufficiently
these policy actions and other technical problems with gold standard caused global deflation
why were countries in the gold standard restricted and what did some countries do
restricted in how much they could expand money supply since lower interest rates would trigger gold outflows to country could run out of gold reserves
therefore some countries exited gold standard to better stimulate their economy (UK exited first)
what happened to countries that exited gold standard earlier
output recovered faster (did better in the great depression)
what did fear of exiting gold standard do to US
triggered deposit withdrawals and bank runs so:
us outlawed possession of gold which raised gold price which depreciated currency
how did deflation lead to depression (3 mechanisms name them)
downward rigidity in wages
high real interest rates
high real debt burden
what is downward rigidity in wages mechanism
prices fall and nominal wages stay the same, real wages rise, unemployment rises (but real wages did not rise much)
high real interest rates mechanism for great depression cause
nominal interest rates cannot drop below 0, expected deflation leads to high real rates which leads to investment and consumption drop
high real debt burden mechanism
debt is in nominal terms, deflation raises debt in real terms which led to bankruptcies and bank panics
why was the high real debt mechanism bad in US
there was a credit boom in the 1920s in the US, and so the deflation in 1929-33 caused debt burdens to rise
financial accelerator mechanism for high real debt to households and firms
debt burdens rise - bankruptcies and less new lending - foreclosures and sales of collateral - collateral values drop - more bankruptcy and less new lending - econ activity drops - incomes drop - debt burdens rise
financial accelerator mechanism for high real debt to banks
losses on loas that default - equity capital drops - concerns about solvency - bank runs - concerns about solvency and runs cause less new lending - bank failures and less new lending - econ activity drops
