1. The Great Depression in the United States From A Neoclassical Perspective Harold L. Cole and Lee E. Ohanian

2. The Great Depression, 1929 – 1939 What explains its scale and duration? The 1933 – 39 recovery period witnessed significant increases in money supply, total factor productivity, the elimination of deflation, no more bank failures According to neoclassical theory, output should have returned to trend around1936. But output remained 25%-30% below trend throughout the 1930’s.

3. Neoclassical Growth Model (drop time subscripts) Maximize Σ β t u(c,l) Maximize discounted utility from consumption and leisure Subject to y = zf(k,xn) >= c + i Output exceeds c + investment n + l = 1 Hours of work + leisure = 1 k = (1-δ) k -1 + i kapital stock and δeprec. x = (1+γ)x -1 Labor productivity γrowth z = random technology shocks Introducing fiscal shocks, y = zf(k,xn) >= c + i + g Introducing money shocks complicates things Cash in advance assumption: m >= pc

4. Cole and Ohanian consider the following shocks Technology shock  Real Business Cycle? Fiscal shock  Tax disincentive to work Trade shock  World in depression Monetary shock  Lucas-Rapping intertemporal substitution of leisure for work Financial intermediation shock  Bank failures Reserve requirements Inflexible nominal wages and increased real wages Real wages rose in manufacturing But real wages declined in other sectors

5. Technology Shocks? Perhaps initially Shocks that reduce the productivity of capital and labor. – Prescott (1986) finds technology shock accounts for 70% of post- WWII business cycle fluctuations  Real business cycle paradigm Cobb-Douglas production function y = zf(k,xn) = zk θ (xn) (1-θ) θ = 1 / 3 γ = 1.9 % n growth rate = 1% z = Actual total factor productivity in each year Model predicts a smaller decline in 1929-1933 output than actually occurred. Output should have returned to trend by 1936 per model. – It actually remained below trend by 25% during the recovery.

6. Correction for decline in capital stock during depression Use the actual capital stock in 1934—20% below trend. Output still should have returned to trend by 1937. It did not. Problem: “Actual” capital stock ignores idle capacity – There was lots of idle capacity both in descent and recovery phases of the depression. – This complicates estimates of total factor productivity

7. Fiscal Shocks? A little Decreased government spending increases consumption, decreasing the marginal rate of substitution of consumption for leisure  Leisure increases  Hours of work decreases To explain the depression, government spending should have decreased 1929 – 33: government spending decreased modestly After 1933: government spending increased by 12% above trend. But hours of work remained below trend. Taxes rates essentially stayed the same during 1929-33 but increased for the rest of decade. From 3.5% to 8.3% on labor and from 29.5% to 42.5% on capital. Feeding this into the model Labor input falls by 4% Only 20% of the weak recovery is explained.

8. Trade Shocks? No Tariffs caused world trade to fall 65% b/w 1929-1932. Lucas(1994) argues that trade was such a small share of US output that it could not possibly have any explanatory relevance. Even if import elasticity of substitution was very low, it would have only taken a short time for domestic producers to adjust. Trade shocks do not account for output deviation from trend during the recovery.

9. Monetary Shocks? Maybe for the decline Friedman and Schwartz: declines in the supply of the money stock have preceded declines in output for a century A large decline in M1 preceded the 1929-33 output decline. The real money stock fell less than the nominal money stock. 1933 – 1939: The real money stock increased during recovery The variation in real money stock is consonant with the variation in real output.  money non-neutrality  something keeps prices from changing in sync with money supply.

10. Is non-neutrality an equilibrium outcome? Lucas and Rapping (1969) and Lucas (1972): cyclical fluctuations explained by leisure/labor substitution and unexpected changes in real wages. If real wages are high, workers opt for more labor and less leisure. – Rapid decline in money supply led to real wage falling below expected level in 1930. » Workers chose more leisure...Gone fish’n’ » Could account for the decline in output, 1929-1933. – For rest of the decade the real wage was at or above expected level » This should have resulted in less leisure and more work, returning output to 1929 level. » This did not happen.

11. Money, deflation and debt deflation (per Fisher)? Deflation transfers nominal wealth from debtors to creditors Debtors’ decrease in net worth leads to reduced borrowing, reduced business expansion and reduced consumption. This could partly explain the 1929-1933 decline (qualitatively) The quantitative aspect for the recovery period remains unchartered.

12. Intermediation Shocks? Only briefly Bernanke (1983): bank failures  negative changes in output. Cole and Ohanian report low loss of output due to this source Output reduction (1929-1933) attributable to finance, insurance and real estate = 4.7%. Reserve Requirements? Not much 1936-37: Reserve reqm’t raised from 10% to 15% to 17.5% to 20%  Weak recovery to these increases via reduced lending? But output rose by 12% during this period. The downturn started in 10/1937 or 14 months after first increase in reserve requirements. Interest rate increases were very small and transitory during this period and for the rest of the decade. It is therefore questionable that increased reserve requirements can explain the weak recovery.

13. Inflexible Nominal Wages? Real wage too high? Manufacturing real wages rose above trend between 1929-1933 and were 16% above trend by 1939. Nonmanufacturing wages fell 15% between 1929 - 1933 and remained 10% below trend in 1939.  Mixed signals Money illusion and nominal contracts can’t explain the weak recovery

14. Cole and Ohanian’s Postulate: Blame the New Deal National Industrial Recovery Act (NIRA) – Cartelization of the US manufacturing sector. – Monopolists earn more by producing less Manufacturing wages were set in the same political/ administrative manner. Qualitatively this shock seems promising in explaining why output was so much and so consistently below trend from 1934-1939.