• An excessive rate of growth in a society's stock of money will cause inflation.

The Great Depression

• Real output and income in the US declined for four successive years.

• There was massive, stubborn unemployment.

  • The quantity of money in circulation fell by more than one-third.

• Many people thought that capitalism had finally failed.

  • Crises like these were the epidemic of over-production.

• In other words, the system broke down because it produced too much.

  • In reality, it was consequence of government policy, not of markets.

The incredible Japanese economy

• In no country was the experience of economic growth more remarkable than in Japan.

  • The increase in real gross domestic product was an average of 7% per year in the 1950s.

  • In the 1960s, it was an increase of 11% per year.

  • The growth rate lowered in the 1970s, but it was still high at 4.5%.

  • By the end of the 1980s, the Japanese economy was the second largest in the world.

• But then they sank into a recession in 1992.

  • Its performance was similar to that of the US in 1930.

What happens in a recession?

• Recede means to withdraw or retreat.

  • A recession is a retreat from earlier rates of growth in the total output of the economy.

  • The costs of a recession are largely the costs of disappointed expectations.

  • They entail unintended and disruptive slowdowns in the rate of economic growth.

A cluster of errors

• Recessions are the consequence of accumulated mistakes.

  • It is the consequence of a cluster of errors among participants throughout the economy.

• Investments are undertaken and goods are produced at costs that are not justified by subsequent demand.

• Supply of a good is usually produced with expectations, not with real demand.

  • During a recession, thousands of entrepreneurs have misread the price signals provided by the market process.

  • Entrepreneurial plans change when the mistakes are discovered.

• Recessions are a correction to the prior period's accumulation of mistakes.

• Why would mistakes accumulate? Why would so many people be mistaken at the same time?

• There are two things that must be explained about the Great Depression

  • The cause of cluster errors.

  • The length and severity of the depression.

Monetary mismanagement, monetary miscalculation

• Credit expansion lowers the interest rate that businessmen must pay.

  • Because the credit expansion was fueled not by increased savings, but by money creation, the boom is unsustainable.

• The "cheap credit" created by an expansion of the money supply and lowering interest rates makes unprofitable investments only appear profitable.

  • So businessmen will expand investment, expecting these activities to pay off.

  • But they have actually misread the market signals, so when they realize this, they will reverse course and cancel some projects.

• The recessionary "bust" occurs as the investment projects that were undertaken during the expansionary "boom" reveal themselves to be mistaken.

  • During a recessionary bust, there are clusters of business failures.

• In other words, monetary distortions create systematic monetary miscalculations and eventually create clusters of business failures.

• Money pervades all markets.

  • These errors of calculations can be caused by unexpected changes in the overall supply of money itself, engineered by the central bank.

• While the recovery process can be painful but quick, the Great Depression's recovery was thwarted by government policies that prevented the market from adjusting itself.

  • In 1930, the Smoot-Hawley tariff was passed, which closed down international trade, and affected agriculture.

  • This distorted consumption and investment, implementing contractions in the supply of money.

• Rather than an indictment of the market economy, the Great Depression is a lesson on how monetary policy disturbs the coordination process in the market.
  

Monetary equilibrium

• The primary reason why coordination problems occur is because of imbalances between supply and demand.

  • Excess supply leads to inflation, excess demand to deflation.

  • Ideal monetary policies will minimize the costs associated with inflation and deflation.

• Coordination is central to the economic system.

• Monetary equilibrium: the amount of money supplied equals the amount demanded, so the value of money remains stable.

  • Price stability: zero, or very low, levels of inflation or deflation.

The demand for money

• Income is a flow, an amount per time.

  • Money is a stock, an amount at a time.

• Money is not the same as income.

  • Demand is to hold an asset, not to consume it.

• The demand for money is a demand to hold money.

  • By holding money, rather than any other asset, you increase your freedom to maneuver.

  • This is because money is flexible, it is liquid.

• People add to the stock of money they hold by reducing their expenditures below their income, or by exchanging other assets for money.

• Money is the most liquid asset in a society.

  • The demand for money is a demand for liquidity.

Actual and preferred money balances

• The quantity of money supplied necessarily equals the quantity held, but not necessarily the quantity people want to hold.

  • When someone already owns the amount they want to hold, they will attempt to exchange the excess for other goods.

Monetary policy in practice

• The key interest rate is the federal funds rate, which is the rate at which commercial banks lend reserves to one another.

  • It is an attempt to increase or decrease the quantity of money in the economy.

• Although monetary policy might be effective preventing inflation, it is largely ineffective in countering recession.

  • In a recession, people tend to be pessimistic and cautious.

• A recession can create a crisis of confidence that worsens the recession by prompting a sharp increase in people's desire to hold larger amounts of ready cash.

The case for fiscal policy

• To persuade people to borrow and spend, government will talk bravely about the economic future.

  • They will only use the word "recession" in reference to the past.

  • The belief that government will restore prosperity revives confidence.

• Any threat to raise taxes in the future reduces confidence.

• Fiscal policy is simply budget policy.

  • It is using the government budget to bring about the desired levels of spending.

  • It is used to supplement monetary policy.

• The most influential proponent of fiscal policy in the century is John Maynard Keynes.

  • Keynes's loan expenditure became the fiscal policy corrective to recessions.

  • The government takes out loans and spends the money, in theory prompting people to take money out themselves.

• By the 1940s, WW2 prompted the US government to run huge budget deficits.

  • Government expenditures shot up faster than taxes could be raised.

  • So they borrowed, in theory restoring prosperity by a massive injection of government spending.

The necessity of good timing

• Timing is crucial if aggregate-demand management is to be an effective stabilizing tool.

  • Good timing is extraordinarily difficult.

  • We cannot predict when a monetary or fiscal policy will have an effect.

Once over lightly

• The Great Depression of the 1930s persuaded many observers that market-coordinated economic systems are less stable and their fluctuations less self-correcting than economists had traditionally maintained.

• In a world characterized by uncertainty, the responses of economic decision-makers to unanticipated events or revised concerns about the future may magnify initial disturbances, producing large cyclical swings in economic activity and even the possibility of sustained economic collapse.

• Economic collapse (a recession) is a sign of disappointed expectations.

  • Although many businesses suffer losses in good times and bad, a recession represents a systematic general and widespread- series of unexpected business losses.

  • Market participants misread the information provided by price signals.

  • Firms engage in monetary calculation of expected profits and losses, and choose their ventures according to what they expect would be most profitable.

  • Instead, over time, they realize losses and change their investment and hiring plans. They reverse course by cutting back output and laying off workers.

• Money pervades all markets.

  • Changes in the volume of money affect not only "the price level" but relative prices of scarce goods and services and thereby affect the monetary calculations of expected profits and losses that guide all entrepreneurs in the economy and help them better coordinate their plans with resource providers and demanders for their products.

• When monetary miscalculation of expected profits and losses is so widespread so as to represent a cluster of errors throughout the economic system, the likely culprit is an artificial lowering of the interest rate through expansion of the money supply.

  • The "boom" phase of the business cycle created by the temporarily cheaper credit cannot be sustained in the long run and will eventually generate the recessionary bust as plans adjust to the reality of unexpected but realized economic losses.

• Such widespread miscalculations and the clusters of errors that they represent would be minimized were the Fed to follow a policy of monetary equilibrium, striving to equate the amount of money supplied in the economy with the amount of money demanded.

  • A stabilizing monetary policy is one that attempts to accommodate changes in the public's demand for money by adjusting the quantity of money supplied.

• The mildness of post-World War II recessions and the rapid economic growth experienced by many market-coordinated economic systems persuaded most economists that severe recessions as well as high rates of inflation could be prevented by government policies aimed at countering fluctuations in private expenditures (aggregate demand).

• Because the Fed expands or contracts the money supply by expanding or contracting commercial bank reserves, monetary policy today is usually summarized by pointing to changes in the federal funds rate, the interest rate on the lending of reserves among banks, which the Fed explicitly "targets.

• In some circumstances, such as a deep and prolonged depression in economic activity, fiscal policy may be a useful or even necessary supplement to monetary policy.

  • An expansionary fiscal policy will be one that increases government expenditures without a matching increase in tax revenues or that cuts taxes without an equivalent reduction in government expenditures.

• Timing is crucial in any effective stabilization policy.

  • The time lags that inevitably occur between the appearance and the recognition of a problem, the recognition and the decision to take a particular action, and the action and its ultimate effects combine to make aggregate-demand management less stabilizing in practice than on paper.

• Attempts to stabilize aggregate demand through fiscal or monetary policy must entail accurate prediction if they are to be successful.

  • But economic forecasting is an undeveloped art.

  • It is made especially hazardous by the fact that the people whose behavior is to be controlled try to anticipate and adjust for the controls.

• The political delays inevitably associated with its use create especially acute timing problems for fiscal policy.