What’s this unit about
Use models we have to analyse and explain economic history
What kind of crisis was the Great Depression?
Due to an AD crisis after the stock market crash
3 positive feedback mechanisms:
- pessimisms about the future - higher savings ratio
- failure of the banking systems = higher interest rates from non failed banks - worried about risks of lending
- deflation - delayed consumption
Government response to GD
Government purchases - taxation or subsidies
- hoover administration said balance the budget and not intervene
- Roosevelt stepped in and you can see government purchases increases significantly.
Effects after GD
- expectations fall, values of homes fall, increase savings and reduce consumption = cut in AD
1933 - reduction to savings to restore wealth and spending - boosting consumption
Fiscal policy in GD
Not much until WW1
Monetary policy and gold standard during GD
The new deal - increasing government spending, left gold standard and reformed the banking systems - more difficult for banks to go bankrupt = higher social confidence
Real r =
Nominal r - inflation rate
Can’t cut nominal interest rate as
Deflation means real IR is higher than nominal IR, so cut = higher real interest rate than nominal
Left gold standard because
Consumers may want to take their money out of dollars into US gold as it is more stable.
- therefore they kept nominal IR high to incentivise saving in US dollars
- but this prevented them from cutting their IR rates in order to not lose their gold reserves, so they left the Gold Standard
After WW2 + GD
Golden age of capitalism
Why golden age of capitalism?
- increased size of government - increased unemployment benefit and more welfare state concepts, automatic stabilisers, Breton woods agreements - tied exchange rates to the US dollar, so devaluations are permitted
- higher worker confidence due to above point, as well as higher union membership led to outward shift in WS curve
Golden age of capitalism p2
- post tax profits remained high = more investment and technological progress = more job creation = more employment
- higher worker power but due to accords unions refrain from using full bargaining power so employers maintain investment at sufficient levels to keep UE low
- W = lamda(1-u), higher lamda = PS +WS curve shifts up = higher wage and employment
End of golden age.
- low unemployment means workers demand drive profit rate down - pie stopped getting bigger at the same rate, so rate of increase of lamda slowed as there was now a contest of the size of rewards - so postwar accords collapsed
- lower profits = lower investment + prod = reduce rate of increase of lamda
End of golden age impact on diagram
- upward shift in WS curve
- downward shift in PS curve, as price level is increasing, pushing real wage down
- leads to big bargaining gap, increase of nominal wages, then increase prices by same amount - shifting to a new Philips curve
Ending stagflation - supply side policies
- restrictive monetary and fiscal policy - allowing unemployment to rise
- cut in unemployment benefits and reduction in trade union power = closed the bargaining gap
Owners around 1970 started taking all profits =
- rising inequality
- post tax profit rate increased
- investments only responded weakly to profit incentives
- rate of growth of capital stocks declined
After stagflation ended - great moderation occurred:
- low and stable inflation
- falling unemployment
- financial deregulation
BUT - rising household and financial sector debt
- Higher house prices
- Rising inequality = consumption funded by loans
Cons of financial deregulation
- banks extend more loans for housing and consumer demands
- buy more financial assets based on bundles of home loans
- higher leverage rates
- credit rating agencies give high ratings to assets created from subprime mortgages.
Housing market cycle
Household borrowing increases = purchases of housing increases = house price boom = higher value of collateral = higher household borrowing = …
House price curves show
- if we get a positive shock to house prices, we run away to higher prices
But, shallower price dynamic curve shows an increase in price shock would lead to prices reaching back to equilibrium = stable
What does the S curve illustrates
What happens when price increases or decreases with upper and lower bounds
- if people lose faith in price of housing, whole S could shift down - no longer crossing the lines several times, if only once - could lead to a volatile crash
Timeline of financial crisis 09
before crisis build up - lower residential investment
During crisis - consumption and all investment falls
Recovery - fiscal policies incentivised consumption which led to huge spike in consumption.
Role of banks during 09 crisis
- closer to insolvency or highly leveraged = vulnerable to fall in value of financial assets
- higher liquidity risks as banks more reluctant to lend each other money - credit crunch
- fire sale of assets
- government bail out
