Topic 5: The Great Depression

Question 1

causes of great depression

Answer 1

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)

Question 2

main causes and mechanisms of great depression

Answer 2

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)

Question 3

what was the gold standard

Answer 3

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

Question 4

what happened to countries that experienced gold inflows (to PL)

Answer 4

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

Question 5

what happened to countries that experienced gold outflows (to PL)

Answer 5

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

Question 6

what happened to exporter countries when it experienced gold inflows

Answer 6

price level rises, international competitiveness deteriorates, trade surplus drops

Question 7

what happened to importer countries when they experienced gold outflows

Answer 7

price level drops, international competitiveness improves, trade deficit drops

Question 8

what was the price specie flow mechanism meant to do

Answer 8

eliminate trade imbalances

Question 9

how did interest rates equilibrate for exporter countries when there were gold inflows

Answer 9

lower interest rates so AD rises so price level rises so trade surplus drops
lower interest rates also slow down gold inflows

Question 10

how did interest rates equilibrate for importer countries when there were gold outflows

Answer 10

raise interest rates so AD falls so price level drops so trade deficit drops
higher interest rates slow down gold outflows

Question 11

how are trade imbalances managed nowadays?

Answer 11

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)

Question 12

problem with gold standard (asymmetric adjustment)

Answer 12

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

Question 13

which were main countries experiencing gold inflows

Answer 13

france and US

Question 14

what did france and US not do despite high gold inflows

Answer 14

did not expand money supply sufficiently

these policy actions and other technical problems with gold standard caused global deflation

Question 15

why were countries in the gold standard restricted and what did some countries do

Answer 15

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)

Question 16

what happened to countries that exited gold standard earlier

Answer 16

output recovered faster (did better in the great depression)

Question 17

what did fear of exiting gold standard do to US

Answer 17

triggered deposit withdrawals and bank runs so:
us outlawed possession of gold which raised gold price which depreciated currency

Question 18

how did deflation lead to depression (3 mechanisms name them)

Answer 18

downward rigidity in wages

high real interest rates

high real debt burden

Question 19

what is downward rigidity in wages mechanism

Answer 19

prices fall and nominal wages stay the same, real wages rise, unemployment rises (but real wages did not rise much)

Question 20

high real interest rates mechanism for great depression cause

Answer 20

nominal interest rates cannot drop below 0, expected deflation leads to high real rates which leads to investment and consumption drop

Question 21

high real debt burden mechanism

Answer 21

debt is in nominal terms, deflation raises debt in real terms which led to bankruptcies and bank panics

Question 22

why was the high real debt mechanism bad in US

Answer 22

there was a credit boom in the 1920s in the US, and so the deflation in 1929-33 caused debt burdens to rise

Question 23

financial accelerator mechanism for high real debt to households and firms

Answer 23

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

Question 24

financial accelerator mechanism for high real debt to banks

Answer 24

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

Question 25

what effects did bank structure have on how bad country was hit

Answer 25

less diversified bank structures had more failures (e.g. US)

countries where banks had equity holdings in firms had more bank failures since banks had more risk (e.g. germany)

Question 26

what is deposit insurance and why did it have opposition

Answer 26

insurance to customers on their deposits introduced in 1933
fear was that it would create moral hazard