27-Evidence on Monetary Policy. What is a Keynsian? 1) One who activates the role of government to use fiscal policy (spending and taxation) to stabilize.

27-Evidence on Monetary Policy

What is a Keynsian?

1) One who activates the role of government to use fiscal policy (spending and taxation) to stabilize the economy.

2) One who advocates government action of any type regarding economic stability.

Economic Spectrum

Money Supply is Important Determinant of Economic Output

Government Spending (Fiscal Policy)is ImportantDeterminant of Economic Output

Free Markets Work

Government Policy Works

Monetariasts

Keynsians

X

Activist (Keynsian)Monetary Policy

Classical Gold Standard Period: 1870-1914

all major economies on gold standard international trade flourished capital flowed freely across borders

free markets reigned

Subsequent Events

World War I U.S. emerges as the dominant economy

1920’s output in U.S. expands, stock market flourishes Consumer confidence soars

World in general attempts to regain the economic stability it enjoyed before WWI based on capitalism

The Great Depression

Between 1929 and 1933 Real output in U.S. fell by 30 percent Unemployment increased from 3% to 25% Sharpe Deflation

Prices fell at rate of 10% per year

Capitalism appears doomed

The Great Depression

What caused it? Aggregate shifted left and remained. Why?

The Great Depression

Most economists during first decades after depression believed Depression was caused by either over

investment and overbuilding in 1920s, or irrational underconsumption.

Monetary policy was secondary, and of little importance.

Eccles’ Views

Eccles testifies before congress 1933 “I see no way of correcting this situation except through

government action.”

“The need is not for more money, but for more spending.”

“Because the profit motive could be expected to lead individuals, business, and financial institutions to make decisions which would further reduce spending, hence income and unemployment, the government, motivated not by profits, but by the welfare of the public must compensate by spending more.”

Eccles and Keynsianism

“[The decline in spending and investment since 1929] could have been prevented by action of Government which is the only agency which could continue to spending money without regard for profit . . . . Financial Fuel is piled up – The Government, and not the bankers must apply the torch” (Eccles 1933).

Eccles

Time Magazine Report, 1936:

“Eccles laid before a Senate committee a plan, which turned out to be nothing less than a detailed blueprint of the New Deal.”

Friedman and Schwartz

“A Monetary History of the United States, 1867-1960” Published in 1963

Showed a correlation between tight money supply and declining prices and output.

Identify four policy decisions of Fed which led to tighter money supply during great depression.

Policy Decision #1

1928: decreased bank reserves

Why did they do it? Perceived lending of banks to brokers a bad

use of credit. After failing to convince banks to stop lending

to brokers, Fed tried to raise rates. Trying to “pop” a perceived bubble in stock

prices

Policy Decision #2

1931: decreased bank reserves

Why did they do it? Speculative attack on British pound forced

U.K. to abandon gold standard Fed wanted to protect the dollar and remain

on the gold system

Policy Decision #3

1932: decreased bank reserves

Why did they do it? Low nominal interest rates Viewed Depression as the necessary purging

of financial excesses built up during the 1920’s

Did it while Congress was out of session

Policy Decision #4

Ongoing neglect of problems in U.S. banking sector Between December 1930 and March 1933, about

50% of all U.S. banks either closed or merged with other banks.

Why did they do it? Fear of creating moral hazard Viewed the weeding out week banks was a harsh

but necessary prerequisite to recovery.

Fed and banks

As Banks Failed Banks built up piles of excess reserves Fed became worried stock piles could

quickly be depleted, leading to inflation August 1936 – Fed doubled reserve

requirement Banks spent next a few years building up

excess reserves.

Interpretation

What we observe during depression Falling money supply Declining output Declining prices

But correlation does not imply causality Many economists at first strongly

disagreed with Friedman and Schwartz

Interpretation

What if declining output and prices is caused by under-consumption? Consumers and firms need less loans. Less reserves get multiplied through system Money supply drops

Economists argued low money supply was a result, not a cause of the great depression. Nominal rates were near zero! How much looser could monetary policy be?

Interpretation

Maybe monetary policy was not so loose. Recall prices were dropping during depression. nominal=real+inflation

If inflation is negative, real rates could still be positive. Borrowers have to pay back loans with dollars

that are worth more in terms of real goods.

Interpretation

How to determine cause?

In 1980s: Economists began to focus on other countries besides the U.S.

The depression was wide in scope, but the impact was not as long and not as enduring on some countries. Why?

Interpretation

Answer 1: Some countries, for some reason, did not suffer from as much under-consumption (irrational pessimism)

Answer 2: Some countries did not contract their money supply.

Interpretation

Gold Standard: Fixed Exchange rate regime

All countries on gold standard must adopt same monetary policy as U.S.

As U.S. contracted its money supply during early 1930’s, it forced other countries on the gold standard to do the same.

Gold Standard

Countries not on gold standard: Spain, China

Countries which left gold standard early U.K., Japan, several Scandinavian countries

Countries on gold standard until 1933 Italy and U.S.

Gold Standard Diehards France, Poland, Belgium, Switzerland

Gold Standard

Strong evidence suggests that countries which left gold standard early, or that were not on gold standard during depression did not suffer as severe effects in terms of dropping output and prices.

Example: China unscathed during great depression.

Stabilizing the Money Supply

Some of Roosevelt’s actions: Eliminated gold standard Declared a bank holiday

Banks were allowed to reopen only after showing they were in sound financial condition

Created FDIC

Effects of Roosevelt’s Actions

Economy grew strongly from 1933 to 1937,

Eccles (Fed Chair) lowered money supply again in 1937, causing economy to plunge back into recession

Lessons

Money supply has important effect on AD curve, inflation, output, and unemployment.

Gold standard forces countries to import monetary policy. May lead to bad outcomes

Central banks have important responsibility to maintain financial stability through good monetary policy.

Economic Spectrum

Money Supply is Important Determinant of Economic Output

Government Spending (Fiscal Policy)is ImportantDeterminant of Economic Output

Free Markets Work

Government Policy Works

Monetariasts

Keynsians

Trend in Economic Thought