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What role did monetary policy play in ending the Great Depression in the U.S.
In March 1933, the U.S. devalued the dollar from 20 USD to 35 USD per ounce of gold, increasing the monetary base by 12% between 1933 and 1934.
This devaluation, combined with capital flight from Europe following Hitler's rise to power, made the U.S. a "safe haven" for investors. As wealthy Europeans moved their capital to the U.S., gold reserves rose by 40% between 1934 and 1937, aiding economic recovery during the Great Depression
Caveats against monetary policy ending the Great Depression in the US.
By 1933, the U.S. economy was in a liquidity trap, where interest rates were near zero, and money expansion was ineffective in stimulating the economy. At this point, monetary policy alone wasn’t enough to push the economy forward;
Credible Reflation
According to economists like Eggertsson, Temin, and Wigmore, monetary expansion was effective during the Great Depression because it was part of a "credible" regime change that boosted inflation expectations.
Roosevelt’s goal was to return the U.S. to the 1929 price level, as expressed in his famous 1933 radio address: "If we cannot do this one way, we will do it another. Do it, we will."
The credible policy regime changed involved two main actions:
(1) Devaluing the dollar and expanding the money supply
(2) New Deal policies that aimed to stimulate the economy.
These moves contributed to rising expectations of inflation, which in turn encouraged economic recovery.
Reflationary Policies at the Zero Lower Bound
When the nominal interest rate is at zero (i=0), reflationary policies help lower real interest rates (r = i - π), making the real interest rate negative (r = -π). This lower real interest rate increases aggregate demand, leading to economic recovery by shifting the economy along the aggregate demand curve (from A to B).
Look at slides 10 - 12
Fiscal policy in the U.S: Hoover vs Roosevelt
Hoover Administration (Until March 1933):
The Hoover administration focused on achieving a balanced federal budget but still doubled federal spending on projects like the Hoover Dam to stimulate the economy.
However, these spending increases were partly offset by higher taxes, such as the Revenue Act of 1932, which raised top income tax rates, limiting the impact of fiscal expansion.
Roosevelt Administration (After 1933):
Roosevelt criticized Hoover for not balancing the budget yet doubled federal spending again, being more vocal about the need for government intervention.
In general, during the Great Depression, fiscal deficits in the U.S. remained relatively small compared to the overall size of the economy. This means the government did not run extremely large deficits despite increased spending.
Most of the fiscal deficit stemmed from automatic stabilizers (e.g., falling tax revenues and increased unemployment benefits during economic downturns), while discretionary deficits remained small, only about 1-2% of GDP.
Discretionary deficits: budget deficits that result from intentional policy decisions made by the government to either increase spending or reduce taxes.
Look at Slide 14
What is the fiscal multiplier and what was the output effect of the modest fiscal expansion?
The fiscal multiplier measures how much economic output increases for every $1 of government spending.
During Roosevelt's presidency, there were high fiscal multipliers. Econometric estimates suggest that fiscal policy was very effective during this period:
Gordon and Krenn (2010) estimated a fiscal multiplier of 1.8 for U.S. defense spending between 1939 and 1942. This means that $1 of government spending increased output by $1.80.
Almunia et al. (2010) found even higher multipliers of 2.5 in an international sample, indicating strong positive effects of defense spending on economic output.
Why did Fiscal Policy lead to the recovery from the Great Depression?
Consistent with Zero Lower Bound (ZLB) theory, government spending did not "crowd out" private investment during the Great Depression. This was because interest rates were already at or near zero, so increased public spending did not compete with private demand.
Moreover, reflation meant lower real interest rates, which encouraged spending.
Thus, modest fiscal expansion had a significant positive effect on output because high fiscal multipliers ensured that government spending effectively boosted economic activity in a low-interest-rate environment.
Look at slide 16
New Deal Policies
The New Deal policies were a broad set of programs, regulations, and reforms introduced by President Franklin D. Roosevelt in the 1930s to address the economic and social impacts of the Great Depression. These policies focused on the Three R’s:
Relief: Provided immediate support to the unemployed and poor through job creation, relief payments, and credit assistance. Programs like the Work Projects Administration (WPA) and Home Owners’ Loan Corporation (HOLC) aimed to create jobs and stabilize households.
Recovery: Focused on stimulating economic growth and restoring confidence through policies that encouraged reflation (returning price levels to pre-Depression levels) and investment.
Reform: Introduced systemic changes to prevent future economic crises. For example:
The Banking Act of 1933 (Glass-Steagall Act) established deposit insurance to restore trust in banks and separated investment banking from commercial (retail) banking to reduce financial risk.
Slide 19: Highlights Reform, we need new remedies if old remedies are not providing us with adequate improvement.
National Recovery Administration (NRA)
The National Recovery Administration (NRA) was a key New Deal program aimed at stabilizing the economy by promoting "fair practices" and reducing harmful competition. Its policies included:
Suspending antitrust laws to allow industries to form cartels and coordinate prices, wages, and production.
Establishing minimum wages and maximum working hours to protect workers as well as promoting collective bargaining, strengthening labor unions.
However, these policies led to negative supply shocks by increasing labor costs and reducing firms' incentives to invest.
Critics (Cole & Ohanian, 2004) argue that the resulting higher costs reduced production and prolonged the recession.
Supporters (Eggertsson, 2012) suggest the policies boosted inflation expectations, which encouraged spending and supported recovery.
Paradox of Toil and the Agricultural Adjustment Act
The Paradox of Toil refers to a situation at the zero lower bound (ZLB) where negative supply shocks—policies that reduce aggregate supply—can actually stimulate economic activity. This happens because:
Negative supply shocks raise inflation expectations, as reduced supply drives up prices.
At the ZLB, the nominal interest rate is fixed at zero. Higher inflation expectations lower the real interest rate (Remember real rate = nominal rate − inflation).
A lower real interest rate encourages investment and spending, boosting demand and economic activity. (Why? : it reduces the cost of borrowing and increases the incentive to spend rather than save)
Example: An example is the Agricultural Adjustment Act (AAA), which paid farmers to leave part of their land uncultivated. While this reduced agricultural output (a negative supply shock), it increased prices and inflation expectations, helping lower the real interest rate and support recovery.
Slide 21
Monetary Policy and Economic Recovery in Germany
Monetary Policy:
German monetary growth remained modest until the late 1930s.
Economic policies in Germany were cautious and avoided expansionary monetary measures seen in the US. Germany avoided a reflation strategy due to historical inflation concerns and they were just as concerned with inflation, as they were with deflation.
No significant rise in inflation expectations despite recovery.
Look at slides 22- 25
Fiscal policy in the German recovery
The fiscal policy in Germany’s recovery during the Great Depression involved significant government spending aimed at stimulating the economy. This included regional work programs and stimulus packages, as well as large-scale fiscal expansion driven by the need to re-arm in preparation for military buildup. To finance these initiatives, the German government took several steps:
Unilateral Debt Default (1933): Germany defaulted on foreign debts, freeing resources previously used for debt repayments.
Monetary Financing: Initially used hidden parallel currency for funding.
Financial Repression (1938): Forced banks to buy government bonds, ensuring consistent funding.
Extra explanation for the hidden parallel currency: the government creates a new form of currency (a "parallel currency") in addition to the official national currency, but it is not immediately visible or fully recognized by the broader economy. This "hidden" currency system allows the government to fund spending without using the official currency or relying on traditional monetary policies (like raising taxes or borrowing through bonds). It did not directly affect inflation or the money supply in the way typical currency printing would.
Looks at slide 27 - 29
Did fiscal policy contribute to the German recovery after 1933?
The role of fiscal policy in Germany's recovery after 1933 is debated by economists, with two main views:
Fiscal Policy Contributed to Recovery:
Supporters (Cohn 1992, Overy 1982) argue that fiscal expansion, including government spending on re-armament and public works, accelerated recovery. This spending helped stimulate demand, create jobs, and revitalize the economy after the Great Depression.
Fiscal Policy Was Less Significant:
Critics (Ritschl 2002, Erbe 1958) argue that the economy was already recovering and that fiscal expansion only crowded out private investment. In other words, the government’s spending may have diverted resources from private sector investment, slowing down the natural recovery process.
Quantitative Analysis:
A simulation by Fisher and Hornstein (2002) suggests that about 1/3 of Germany's recovery can be attributed to fiscal policy, implying that while fiscal expansion was helpful, other factors also played a significant role in the recovery.
How were fiscal deficits financed?
Monetary Financing via Parallel Currency (Mefo Bills):
The government set up a fake private company called Metallurgische Forschungsgesellschaft (Mefo). This company issued special bills, known as Mefo bills, which the government used to raise money.
Even though these bills looked like they were issued by a private company, the Reichsbank implicitly guaranteed that it would discount (i.e., buy back) these Mefo bills, effectively providing funding. However, this was done in a way that circumvented the legal restriction on discounting government debt.
German businesses accepted these Mefo bills as payment and since this method was off the balance sheet, it avoided international attention and scrutiny, helping Germany avoid the restrictions placed on it after the default.
Financial Repression/Silent Financing
Banks had to estimate how many government bonds they could buy and directly transfer this amount to the German treasury
This also meant that ordinary bank deposits were effectively used to fund the government, making the public indirectly finance government spending through their savings. (citizens were indirectly Reich creditors)
International Fiscal Policy Pre- and Post-1939
Before 1939:
Modest budget deficits.
Deficits largely due to automatic stabilizers (e.g., unemployment benefits).
Few countries deviated from the balanced-budget orthodoxy: traditional belief that governments should balance their budget
After 1939:
Government spending and deficits skyrocketed due to the outbreak of World War II.
Large deficits became more accepted, especially during wartime.
Traditional justification for deficits, primarily for military needs, was broadly embraced.
Look at slide 34
International Monetary Policy and Recovery After Leaving the Gold Standard
Expansionary Monetary Policies: Allowed central banks to increase money supply, stimulating economic growth.
Rising Inflation Expectations: Exit from gold raised inflation expectations, encouraging spending and investment as it was viewed as a credible regime change.
Competitiveness Gain: Currency devaluation boosted exports, aiding economic recovery.
Look at slides 36- 39
Reflation, Real Wages, and Economic Recovery
Eichengreen and Sachs (1985) suggested that leaving the Gold Standard was key in helping countries recover from the Great Depression as this lowered real wages (wages adjusted for inflation).
During the deflationary period (when prices were falling), wages were often rigid (they didn’t fall easily), so real wages actually rose even as prices were dropping. Workers were more expensive for firms to employ, leading to fewer jobs and lower production.
When countries left the Gold Standard, reflation (a rise in prices and wages) began, and this caused real wages to fall. As wages became more affordable for firms, they started hiring more workers and increasing production.
Proof: The Gold Bloc countries experienced high real wages but low industrial output, further emphasizing the negative impact of sticking to the Gold Standard.
Look at slides 41 and 42.
The Bretton Woods System (1944)
Goal: Create a stable global monetary system after WWII.
Key Features:
Capital controls to prevent destabilizing financial flows.
Independent monetary policy for countries to manage their own economies.
Prevent currency crises and balance of payments crises.
Linked U.S. dollar to gold, creating stable exchange rates. The US held majority of the gold reserves after WWII
Note: Exchange rates adjustment in case of 'fundamental disequilibrium' to facilitate external adjustment" .The Bretton Woods system allowed countries to adjust their currency exchange rates when there was a significant imbalance in their international payments or economic situation.
Bretton Woods and the macroeconomic policy trilemma
Gold standard: Stable exchange rate and capital mobility (No independent monetary policy)
Bretton woods: Stable exchange rate and independent monetary policy ( No capital mobility)
Slide 49
Institutional legacy: the “Bretton Woods” institutions
The Bretton Woods institutions refer to the global organizations created as part of the Bretton Woods Agreement in 1944, which aimed to rebuild and stabilize the global economy after World War II and to avoid another Great Depression
World Bank: Supports development by financing projects in a world with low capital mobility.
International Monetary Fund: Acts as lender of last resort among central banks to avoid BOP crises and make orderly external adjustments more likely
World Trade Organization: depoliticize trade disputes to make trade war less likely (brain child of Bretton Woods, but only established in 1995)
Bretton Woods and post-WW2 goods market reintegration
Bretton Woods system encourages international goods trade
Currencies convertible for current account transactions: A convertible currency meant that countries could exchange their currencies for another currency or gold at a fixed rate, facilitating smoother international transactions.
Fixed exchange rates for currency stability, facilitating trade: These stable exchange rates helped reduce currency fluctuations, providing greater predictability for businesses engaged in international trade.
General Agreement on Tariffs and Trade (1947): Agreement to lower global trade barriers, later superseded by the WTO (1995).
ECSC/EEC/EU, NAFTA/USMCA, ASEAN: Regional pacts to promote trade and economic cooperation within specific regions.
Capital market reintegration and the end of Bretton Woods
1950s-1960s: U.S. gold cover ratio falls due to:
Monetized U.S. budget deficits: Financing the Vietnam War & Great Society led to more dollars in circulation and reducing the proportion of USD backed by gold.
U.S. BOP deficits leading to gold outflows and fewer reserves: it was importing more than it was exporting, resulting in gold outflows.
1968: France wants to exchange its USD reserves into gold→ U.S. suspends dollar-gold convertibility.
Other central banks are no longer willing to purchase USD to stabilize their USD exchange rates ⇒ transition to a flexible exchange rate system without gold backing.
With flexible exchange rates, capital controls are no longer needed for monetary policy independence ⇒ financial markets reglobalize.
Trilemma: Capital Mobility and Monetary independence but no fixed exchange rate.
Look at slide 53
