Chapter 19 Big Events The Economics of Depression

Chapter 19 Big Events: The Economics of Depression, Hyperinflation, and Deficits

Introduction • Great events shape both the economy and economics • The study of macroeconomics in particular grows out of economic experiences – especially traumatic ones Great Depression: 25% of US labor force was unemployed Ø During the 20 th century many countries experienced hyperinflation Ø Over the later part of the 20 th century the budget balance in the U. S. swung from deficit to surplus, and then back to deficit Ø Looking to the future, will the social security systems remain solvent, or will they crash? Ø In this chapter we examine these issues and their influence on economic theory. 19 -2

The Great Depression: The Facts • • The Great Depression shaped many institutions in the economy, including the Federal Reserve, and also modern macroeconomics During the Great Depression: • • • [Insert Table 19 -1 here] The stock market fell by 85% GNP fell by 30% The unemployment rate rose from 3 to 25% Net investment was negative CPI fell nearly 25% 19 -3

The Great Depression: The Facts • What was the economic policy during this period? • • [Insert Table 19 -2 here] Money stock fell rapidly due to bank failures, increased currencydeposit ratio, and the failure of the Fed to take adequate expansionary measures Fiscal policy was weak • Table 19 -2: relatively large budget deficits • Attempts to balance the budget through increased taxes contractionary policies at an inopportune time 19 -4

The Great Depression: Institutional Legacies • • The Great Depression was a catalyst for important institutional changes Reorganization of the Federal Reserve Introduction of deposit insurance, Securities and Exchange Commission and social security in the US Important international spillover effects of the Great Depression because of beggar-thy-neighbor policies • High tariffs and protectionism 19 -5

The Great Depression: The Issues and Ideas • • What macroeconomic theories can explain the Great Depression? How could it have been avoided? Can it happen again? Classical economics of the time had no well-developed theory that could explain the persistent and excessive unemployment NOR any policy recommendations to solve the problem The Great Depression and the inadequacy of prevailing economic theories was the setting for John Maynard Keynes and his great work The General Theory of Employment, Interest, and Money Keynesian revolution 19 -6

The Keynesian Explanation • Essence of the Keynesian explanation of the Great Depression is contained in the simple aggregate demand model • Growth in the 1920 s based on: • • Mass production of the automobile Mass production of the radio Housing boom Collapse in the 1930 s resulted from: • • • Drying up of investment opportunities Reduction in consumption expenditures Poor fiscal policy 19 -7

The Keynesian Explanation • The Great Depression showed: • • • The private economy was inherently unstable Active stabilization policy needed to maintain a strong economy Keynesian model offered: • • • An explanation of what had happened Suggestions for policy measures that could have prevented the Great Depression Suggestions for policy measures that could prevent future depressions Vigorous use of countercyclical fiscal policy was preferred method for reducing cyclical fluctuations. 19 -8

The Monetarist Challenge • Keynesian emphasis on fiscal policy and its downplaying of the role of money was challenged by Milton Friedman and his coworkers in the 1950 s. • • They emphasized the role of monetary policy in determining the behavior of output and prices Friedman attacked the view that monetary policy was impotent during the 1930 s • He argued that the Depression was evidence of the importance of monetary factors Failure of the Fed to prevent bank failures and decline of money stock was largely responsible for the severity of the depression Monetary view came close to being accepted as the orthodox explanation of the Depression 19 -9

Money and Inflation Why do countries suffer inflation, often at high levels? • It is convenient to use the quantity theory of money: MV = PY (1) or in growth rate form: m+v=π+y (2) Putting inflation on the left-hand side, we have: π=m–y+v (3) Monetarists claim that inflation is predominantly a monetary phenomenon, as changes in velocity and output growth are small. • • 19 -10

Money and Inflation • Figure 19 -1 shows annual M 2 growth and the inflation rate of the GDP deflator for the U. S. [Insert Figure 19 -1 here] Inflation rate and money growth generally move together • Relationship is very rough, with large gaps between the growth lines that persist for years Changes in output growth or velocity, or both, affect inflation • Conclusion: Inflation is a monetary phenomenon, at least in the long run 19 -11

Hyperinflation • • Hyperinflation: very high rates of inflation around 1, 000 percent per annum Table 19 -6 shows recent extreme inflation experiences High inflation or hyperinflation often associated with excessive fiscal deficits In a hyperinflationary economy, people spend significant amounts of time minimizing inflationary damage [Insert Table 19 -6 here] 19 -12

Stopping Hyperinflation • • All hyperinflations come to an end Frequently there are unsuccessful attempts at stabilization before the final success disagreement over who should bear the cost of stabilization Economic costs of hyperinflation eventually become too great This helps form a political consensus in favor of radical reform • • • Often a new money is introduced and the tax system is reformed Exchange rate may be pegged to that of a foreign currency to provide an anchor for prices and expectations Often a coordinated attack on hyperinflation • Heterodox approach to stabilization: Monetary, fiscal, and exchange rate policies combined with income policies 19 -13

Stopping Hyperinflation: Credibility • • • High inflation results in wide-spread indexation of wages and contracts inflationary spiral A credible stabilization policy can result in quick and effective disinflation shift to a lower SR Philips curve Without credibility, disinflation will require recession • • Expectations augmented AS: π = πe + (Y-Y*) Often it’s easier to stop hyperinflation than moderate inflation • • Costs associated with hyperinflation so high that stabilization enjoys wide-spread political support and is therefore credible Stopping moderate inflation requires deficit-cutting measures redistributionary implications will be opposed by some socio-economic groups 19 -14

Disinflation and the Sacrifice Ratio • • How much output is lost because of disinflation? Sacrifice ratio: ratio of the cumulative percentage loss of GDP to the reduction in inflation that is actually achieved • Before the US disinflation of the 1980 s, economists estimated sacrifice ratios of proposed disinflation programs between 5 and 10, with the actual value was estimated to be 1. 83 (Laurence Ball) 19 -15

Deficits, Money Growth, and the Inflation Tax What is the link between budget deficits and inflation? Ø Sustained increase in money growth ultimately lead to inflation Ø High inflation tends to be associated with excesive government budget deficits • The government (CB and Treasury) can finance the deficit in two ways: Ø Sell bonds Ø Print money monetize the deficit CB prints money to buy up the debt that the Treasury is selling or • CB prints money because it targets the interest rate and it needs to accommodate the government’s fiscal expansion • 19 -16

Deficits, Money Growth, and the Inflation Tax • • Monetization of deficits is an alternative to explicit taxation Inflation acts just like a tax because people are forced to spend less than their income and pay the difference to the government in exchange for extra money This way of raising government revenue is referred to as the inflation tax or seigniorare The amount of government can raise in this way is Inflation tax = inflation rate × real money base 19 -17

Deficits, Money Growth, and the Inflation Tax • This is often non-negligible share of GDP for some countries • • • Especially in countries with high inflation rate And in LDCs will less developed banking systems as people tend to hold more cash Inflation tax easier to collect than regular tax payments in countries with poor tax compliance Inflation tax revenue falls if inflation gets excessive as people avoid holding cash Countries earn additional seigniorage revenue if their currency is held abroad dollar, euro 19 -18

Budget Deficits • • • Many developed countries owe substantial public debt U. S. federal debt in 2005: $8 trillion, $27, 000 per capita Much of is held by US residents who own Treasury bonds either directly or indirectly through banks • • • High debt tends to lead to high interest rates • • Hence debts cancels out with future tax liabilities But part of it is held by foreigners This reduces investment and thus undermines growth Debt ratio = Debt/(PY) • • Increases during recession, falls during recovery Falls because of growth in GDP and inflation alike 19 -19

Budget Deficits: Facts and Issues Outlays: • Table 19 -8 shows the outlays of the federal government since 1962 Ø Ø [Insert Table 19 -8 here] Mandatory outlays: outlays made under entitlement programs • Ex. Social Security Discretionary outlays: outlays that are governed by the congressional appropriation process • Ex. National defense expenditures 19 -20

Budget Deficits: Facts and Issues Receipts: • Table 19 -9 shows the sources of revenue and totals from 1962 -2005 • • [Insert Table 19 -9 here] Revenue sources are largely from taxes Total revenue as a share of GDP has been constant, but there has been a shift in the sources • Social security taxes and contributions have risen • Corporate income taxes have declined • Personal consumption taxes have remained stable 19 -21