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Lecture 3

ECON 2200E Lecture 3: Econ test 3

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ECON 2200E

Econ test 3 Chapter 10: 1929 – 1933 – the Great Depression and Hoover’s Response ▪ Peak unemployment 25%, economy shrinking about 10% annually, prices fell Historical Explanations for the Great Depression ▪ Agricultural Problems – Sharp decline in the price of agricultural goods domestically, and farmers found it difficult to repay their loans post WWI. It is unlikely that agricultural problems caused the Great Depression. First, if agricultural problems were a primary cause of the Great Depression, the Depression would have started earlier in the 1920s. Second, we would have experienced nation-wide depressions during the Second Industrial Revolution when farm prices were plummeting, but we did not ▪ Uneven Distribution of Wealth – 1920s the rich became richer, but the standard of living also increased for the poor. Income gap grew as the gains to the rich outweighed the gains to the poor. Some argued the poor didn’t have enough money to spend on goods and services, which led to a decrease in firm investment and layoffs of workers. First, it is unlikely this caused the Great Depression, though since many examples of wealth inequality exist over time and between countries, yet these examples are not associated with Great Depression. Second, Calvin Coolidge gave large tax cuts to low and middle-income families in 1924 to increase their disposable income ▪ Over-Extension of Credit and Installment Buying – Many Americans purchased too much on credit. During 1928 and 1929, firms continued producing new goods, but some individuals could not afford them, and this led to layoffs in consumer good industries. This is unlikely to have caused the Great Depression because credit has been “over-extended” many times since then and we have not faced another great depression because of it. For example, credit card debt these days. Unlikely this alone caused the Great Depression but more than likely it may have increased the magnitude ▪ Buying Stocks on Margin – Individuals paid brokers a small fraction of the cost of a stock, and brokerages lent individuals the remaining amount. If the stock market continued, these individuals could have made capital gains, but a stock market crash would bankrupt these individuals. Buying stocks on the margin is an unlikely cause of the Great Depression. Something else would have to cause the stock market to crash for speculative buyers to lose most wealth ▪ Stock Market Crash of 1929 – Most historians agree that the stock market crash of 1929 is the primary cause of the Great Depression. When the stock market crashed many individuals lost their entire savings. Firms found it more difficult to obtain future financing through issuing stocks, and this difficulty in financing contributed to the Depression. Economic Explanations of the Great Depression ▪ Economists offer two explanations for the Great Depression o The Keynesian Explanation ▪ States that a collapse in the desire for a new capital formation occurs because consumption falls. If individuals become over-extended in credit as explained previously, they must make larger installment payments and reduce current consumption. ▪ The fall in consumption causes firms to reduce output, and hence, investment demand collapses. At current interest rates, a surplus of saving exists, since firms want to borrow less money than individuals want to save. John Maynard Keynes believed excess saving was “draining” on the economy and that it caused the Great Depression. He also believed that the government could replace some of the fall in investment by spending more and reducing taxes ▪ The problem is that interest rates must eventually fall if there is a surplus of saving. With this, competitive pressures cause lenders to offer lower interest rates and firms to respond by borrowing more. • However interest rates rose from 1929-1931 • Second deflation occurred, which increased the value of each dollar over time and encouraged lenders to hoard cash rather than lend it to firms. This led to a positive rate of return that was risk-free compared with lending to firms, and this hoarding decreased the amount of funds available to firms o The Monetarist Explanation ▪ States that contractionary monetary policy leads to a fall in the supply of saving. In the short run, as the Federal Reserve contracted the money supply, dollars and coins flowed out of the financial system. • Caused both saving and investment to decrease, and with fever funds available for firms to borrow, interest rates rose. The Fed’s attempt to Curb Speculation in the Stock Market ▪ Over the 1920s the Federal Reserve lowered the discount rate, the interest rate the Federal Reserve charges banks to borrow from it, making it cheaper for banks to borrow reserves from the Fed. Led to expansionary monetary policy • In 1928 and 1929, it reversed this policy. To reduce the speculative boom in the stock market, the Fed raised the discount rate from 5% in 1928 go 6% in 1929, and it greatly reduced its holdings of government bonds through open-market sales. The intent was to reduce credit away from “speculators” and toward “productive” activities. Instead, these actions caused severe contractionary monetary policy, reducing the money supply, meaning individuals had less money available to purchase goods and service, causing the price for all goods and services to fall. • Stock market began to slow in early October 1929, and panic quickly set in that led to a mass sell-off beginning October 29, 1929 – Black Tuesday o Prices continued to drop over many months. People thought many times that the market had to rebound, but then it would drop by more. Eventually the market bottomed out, falling approximately 70%. • Had the Federal Reserve used less severe contractionary policy to slow the speculative boom in the stock market, the market would not have crashed as hard as it did, and stock prices would not have fallen for nearly 3 years. o The stock market crash in 2008 was shorter and less severe because the Federal Reserve instead conducted heavy expansionary policy, partially stimulating the economy and partially leading to higher priced because of inflation Further Contractionary Monetary Policy and Bank Runs • Speculation that US was going to abandon its gold standard so foreigners pulled their gold out of US banks, causing it to flow out of the US and the US money supply decreased o Caused short-run interest rates and unemployment to rise, and prices and output to fall o Increasing short-run interest rates increased the cost of borrowing for US firms, which responded by decreasing investment and laying off workers. Short-run unemployment rose and prices and output fell. • Open-market purchases, or the purchase of government bonds by the Federal Reserve, would have instead combated deflationary pressure and mitigated bank failures. Decreasing the discount rate, as was done in the 1920s, would have done the same • Deflation caused individuals to hoard cash and prices to fall. Firms found it hard to obtain financing with lenders hoarding cash. Many firms also had existing loans to pay off but could not do so, as the prices for their goods and services fell. Many firms resorted to bankruptcy or went out of business • First bank runs in Nashville, TN • Banks that did not fail recalled loans and held more excess reserves, decreasing the money supply by more. Had the Federal Reserve acted as a lender of last resort and lowered the discount rate, bank failures would have been significantly fewer. • During the Great Depression, approximately 1/3 of banks failed. An Eventual Collapse of Investment Demand • Fewer firms in operation increased unemployment by more and led to a lower demand for loans. The decrease in investment demand led to a decrease in the real interest rate from 1931 to 1931 • Strong evidence exists for the Monetarist explanation for the cause of the Great Depression, but the Keynesian explanation better describes the later period. o Both explanations lead to a lower quantity of saving and therefore quantity of dollars borrowed by firms for investment purposes. ▪ Monetarist – focuses on a decrease in individuals’ willingness to save money ▪ Keynesian focuses on a decrease in firms’ willingness to borrow money o Consumption also decreased as real incomes fell and unemployment increased • Federal Reserve did not act as a lender of last resort and believed banks failed because of poor management. Ironically, the Fed’s poor management caused the depression. o Claim persistent deflation increased the burden of debt carried by business and consumers. The Presidency of Herbert Hoover (1929 – 1933) • President while economy quickly fell, but believed like most economists of the time that things would eventually work themselves out. • Didn’t believe in unemployment benefits because he thought they encouraged higher unemployment. • Believed in a balanced budget, feeling that the government should attempt to finance its expenditures • Classical economic theory – stated markets naturally regulated themselves free of intervention, and prices naturally adjusted to allocate resources efficiently. Promoting Unemployment through Volunteerism and Labor Unions • Hoover first addressed the crisis though promoting volunteerism and urged Americans to donate what they could to charities. • Urged business leaders to not lay off employees or lower wages, but failed to realize that it was only natural for wages to fall during periods of deflation. If businesses did not reduce wages, their real cost of labor rose, and firms responded by decreasing their quantity demanded for labor. • Norris-La Guardia Act of 1932 – effectively promoted labor unions through outlawing yellow-dog contracts, where employers required employees to sign a contract agreeing not to join a labor union. Also outlawed court injunctions against nonviolent labor disputes such as strikes, boycotting, and picketing. o Labor unions bargained for higher wages typically, higher wages during deflation caused greater unemployment o Lower employment led to reduced output and higher prices nationwide Picking Up After the Fed – A lender of Last Resort • Emergency Relief and Construction Act (ERA) 1932 – created the Reconstruction Finance Corporation (RFC), an independent agency of the federal government, which provided nearly $2 billion in aid to state and local governments. o States used this aid to make loans to banks, railroads, mortgage associations and other businesses. o Act served as a major step away form laissez-faire practices toward increased government involvement in the economy. • As banks failed the money supply decreased by even more • Money supply = currency plus demand deposits o Currency – hard cash that the public holds o Demand deposits- money in checking accounts o Because banks lend, the money supply is greater than simply the number of physical dollars in the economy. Because banks lend a fraction of deposits they receive, the US is on a fractional reserve system. o As banks failed, demand deposits decreased and even greater deflationary pressure plagues the economy. • To some extent the RCF mitigated some banking failures through providing loans to banks and other organizations, therefore curbing deflation. o However, the RCF was somewhat limited since federal law required the RFC to release publicly which banks received its help. The United States Becomes More Isolationist • Hawley-Smoot Tariff Act of 1930 – significantly increased tariffs to an unbelievable 60% (highest import tax in US history). o All else equal, these higher tariffs stimulated short-run domestic production and created inflationary pressure, as consumers substituted from foreign to domestic production o This angered other countries and they retaliated by increasing their tariffs on US goods, resulting in lower US exports causing domestic production to fall and deflationary pressure. Had uncertain effects on short-run US production Helping Farmers out • Agricultural Marketing Act of 1929 that created a federal farm board. • Gave some loans to farmers but mostly purchased various agricultural goods • In the short-run, when the government purchased agricultural goods, it stored them in silos and did not redistribute them to the poor with the intent to keep them off the market, which increased prices to help farmers. o All else equal, these higher prices reduced the amount of food consumers purchases, leading to more people going hungry o Farmers responded in the long-run by growing more food. Fiscal Policy • ERA of 1932 expanded public works during the Great Depression. • Made Hoover the first president to engage in large amounts of public spending • $2.25 billion of federal loans and grants to states to administer relief programs • Led to the construction of the Hoover Dam • Stimulated aggregate demand, attempting to increase output and reduce unemployment • Hoover also believed in a balanced budget so with increased government spending came higher taxation. o Revenue Act of 1932 was incredibly damaging o Individuals become more tax sensitive so the government would have maximized tax revenues by decreasing rates during this time, not increasing them o Increased the magnitude of the fall in output and rise in unemployment over the short-run o Investment became less profitable Popular Opinion Turns against Hoover • Hoovervilles developed • Bonus army- made up of 17,000 WWI veterans marches in DC and demanded immediate payment of bonuses promised to them no sooner than 1945. Hoover used tanks to clear marchers Chapter 11 – 1933 to 1939 – The Dust Bowl and Roosevelt’s New Deals • FDR’s New Deal programs Dust Bowl (Dirty Thirties) • Increase in investment demand to become wheat farmers put an upward pressure on interest rates, but it was a prosperous period for those who grew wheat. • Europe rebuilt farms post war and increased tariffs on US production • Also technology advances lowered price of wheat • Artificial light allowed industry to operate all night if need be, increasing production • Farmers began defaulting on loans as Fed reduced money supply Cause of the Dust Bowl • Top national environmental disaster created by humans in less than a decade • Buffalo grass pulled to farm wheat • Drought • Oklahoma, Colorado, Kansas, New Mexico, and Texas o Boise City, OK was the center • Storms would come and pick up the dirt • May 9 1934 – dust storm form Texas to new york • April 14, 1935 – largest dust storm - Black Sunday Consequences of the Dust Bowl and Dust Storms • Frequent • Took paint off cars and houses • Allowed cattle to escape because of accumulation around fence poles • Nature grew freely because grazing animals left • Blistered faces or ankles • Blinding • Dust pneumonia, leading to sickness and death • Suicide rates skyrocketed • Exodusters- 25% of the population in the southern plains that chose to uproot their homes and find better life o Most traveled to California – California called them Okies o Supply of labor increased, work wages fell, and hatred grew among natives • Some wheat farmers living outside of the Dust Bowl profited - Dust bowl caused price of wheat to increase because such limited supply – buyers of wheat are price insensitive, having inelastic demand, the increased price per bushel raised revenue more than the decreased quantity sold lowered revenue. Market Failure and Government Intervention • Farmers did not account for the external cost of their actions o Negative externalities – behaviors that result in external costs on bystanders o When a negative externality is present in a market, market failure exists. ▪ The market allocates more than the efficient amount of a good or service than socially optimal. ▪ Society as a whole would be better off by producing less • Roosevelt did not initially know what to do about Dust Bowl o Hugh Bennett – pioneer in the field of soil conservation, made director of the Soil Conservation Service in 1933 • The Soil Conservation and Domestic Allotment Act of 1936 was an effective piece of legislation against the Dust Bowl o Taught better practices to farmers in certain districts o Subsidized farmers who practiced these techniques by providing them with free gasoline and buying back dust bowl land o Inefficient policy, but the government sometimes paid farmers to not grow anything at all First New Deal (1933 – 1934) • First 100 days • Fireside Chats over the radio to inform Americans • Roosevelt’s Alphabet Soup Reestablishing Confidence in the Financial System • FDR knew he must address bank runs and heal a barely-functioning financial system • March 5, 1933 – officially closed all banks for four days, during which the federal government oversaw the inspection of banks • Banking Act of 1933 (Glass-Steagall Act) creating the Federal Deposit Insurance Corporation (FDIC). o FDIC insured demand deposits for each account up to $2,500. Soon increased to $5,000. If a bank lacked sufficient reserves to honor withdrawals, the federal government would provide that money • National Housing Act of 1934 created the Federal Savings and Loan Insurance Corporation (FSLIC) to insure deposits in savings and loan corporations. Also created the Federal Housing Administration (FHA) that promoted small loans to future homeowners and stimulated some building during the Depression. o Guaranteed mortgage loans of up to 30 years, meaning if a bank made a loan to a homebuyer, but the homebuyer could not pay off the loan, the FHA would compensate the lending bank for part of the loss if the home sold for less than the amount of the loan • Securities Act of 1933 required firms to disclose balance sheets, profit and loss statements, and compensations to officers within corporations; also required independent auditors to verify these reports • Securities Exchange Act of 1934 regulated secondary trading of stocks and created the SEC that acted as a watchdog for insider trading and shady accounting practices Providing Aid to Farmers • To help farmers, Roosevelt passed the Agricultural Adjustment Act of 1933, replacing the Farm Board with the Agricultural Adjustment Administration (AAA) o Set acreage allotments and production quotas, and paid subsidies to farmers to reduce production o Prevented drops in farm prices at a high cost and lots of waste • Sharecroppers did not enjoy most of these gains; white land owners did • Supreme court killed this program in 193 Establishing Monopolization over Goods, Services, and Labor • National Industrial Recovery Act of 1933 (NIRA) created the National Recovery Administration (NRA), which allowed firm managers to meet and set agreed-upon minimum industry prices. o Act conversely allowed industry to monopolize through cartels, and these cartels reduced output and increased prices to increase profit. Because these cartels produced less, their demand for labor was lower, therefore reducing employment o Also promoted labor unions through allowing leaders to meet with management and collectively bargain for higher wages; higher labor prices induced firms to hire even fewer individuals, leading to additional unemployment in the short and long runs o Supreme court said NRA’s scope was too broad, it declared it unconstitutional in 1935 (Schechter v. US) Increases in Government Spending • National Industrial Recovery Act 1933 also created the Public Works Administration (PWA) that increased federal spending on large-scale public works projects. o Gave unemployed 30-35 hours or work a weeks building roads, highways, bridges, dams, airports, warships, hospitals, and schools o Operated until 1943, when the government stared allocating resources towards WWII production • Federal Emergency Relief Administration of 1933 (FERA) provided large amounts of federal support to local relief agencies through grants and loans to states. Promoted spending on smaller, local projects such as sewers, sidewalks, and city halls. Aimed to alleviate unemployment through creating jobs for unskilled labor o Replaced by the Works Progress Administration (WPA) • Civilian Conservation Corps (CCC) and the Tennessee Valley Authority (TVA). o CCC provided unskilled manual labor jobs relating to the conservation and development of natural resources. Labored in government camps reforesting, fighting forest fires, controlling flooding, and draining swamps. o TVA authorized the construction of a series of dams to provide power and flood control to those living in the Tennessee River Valley. • Kudzu planted • Stimulated aggregate demand, combating deflation and reducing unemployment in the short run. The Aggregate Economic Effects of the National Industrial Recovery Act • NIRA as a whole did combat inflationary pressure in both the short
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