...

The Great Depression and the Friedman-SchwartzHypothesis

Lawrence J. Christiano, Roberto Motto and Massimo Rostagno

1

...

Background• Want to Construct a Dynamic Economic Model Useful for the Analysis of

Monetary and Fiscal Policy in a Large Economy Such as the Euro Area or U.S.• Would Like a Model That Can be Used to:

– Identify the Fundamental Shocks Driving Historical Data– Identify the Mechanisms Responsible for Propagating the Shocks– Serve as a Laboratory For Evaluating Alternative Strategies for Responding

to Shocks.• We Expand a Standard Monetary Business Cycle Model to Incorporate

Multiple Shocks, Financial Frictions and a Banking Sector.• We Use our Model to Address one of the Biggest Policy Questions:

– What Shocks Caused the US Great Depression?– What Mechanisms Propagated the Shocks?– Could the Monetary Authorities have Mitigated the Severity of the Great

Depression By Reacting in a Different Way to the Shocks?

10

...

• Great Depression is a Perfect Testing Ground for Our Model– It Was a Big Deal!

1900 1910 1920 1930 1940 1950 1960 1970 1980

3.5

4

4.5

5

5.5

6

Log, US GNP

Years

13

...

• Great Depression is a Perfect Testing Ground for Our Model– Big Question: What Shocks?∗ Exogenous Monetary Contraction in 1920s (Bernanke, Hamilton)∗ Increased Money Demand in Late 1920s (Alexander Field).∗ Deposit Withdrawals (Fear of Bank Closures and Dollar Devaluation).∗ Stock Market Collapse.∗ Institutional Changes, Especially New Deal (Cole and Ohanian).

– What Propagation Mechanisms?∗ Stock Market Collapse (Mishkin, Romer).∗ Nominal Wage and Debt Rigidities (Irving Fisher, Bordo et al).∗ Banking System (Friedman and Schwartz).∗ Policy Mistakes at Fed (Friedman and Schwartz, Cecchetti).

24

...

What We Do, and What We Find• Incorporate Various Shocks and Propagation Mechanisms into a Single

Dynamic General Equilibrium Model.• Combine the Model with Data from 1920s and 1930s.• Determine Which Shocks and Propagation Mechanisms Were Crucial.• Results:

– A Liquidity Preference Shock is Important in Contraction Phase (Surprise,consistent with Alex Field?)

– Financial Frictions∗ Somewhat Important for Investment∗ Not Important Enough to Have a Major Impact on Aggregate Output and

Employment (Surprising!)– Increased Market Power of Workers Responsible for Duration of Great

Depression.• A More Responsive Monetary Policy Could Have Substantially Reduced the

Severity of the Great Depression.

35

...

The Great Depression and the Zero Lower Bound onthe Interest Rate

• In Recent Years: Interest In Understanding Monetary Policy in a Low InterestRate Environment:– Can Monetary Policy Resist Deflation and Output Collapse?– What Sort of Monetary Policy Can do This?

• Interest Rates Near Zero In Most of the 1930s– Analysis of Monetary Policy in 1930s Must Confront Zero Lower Bound

Constraint– Policy We Consider Avoids Zero Lower Bound By Committing to

Temporarily High Future Money Growth.– Credibility Issues (Eggertsson-Woodford, Krugman).

42

...

Previous Quantitative Anlyses of Great Depression• Bordo-Choudhri-Schwartz, ‘Could Stable Money Have Averted the Great

Contraction?’, EJ, 1995.• Bordo, Erceg and Evans, ‘Money, Sticky Wages, and the Great Depression,’

AER, 2000.• McCallum ‘Could a Monetary Base Rule Have Prevented the Great Depres-

sion?’, JME, 1990.• Sims, Christopher, ‘The Role of Interest Rate Policy in the Generation and

Propagation of Business Cycles: What Has Changed Since the 30s?’ 1999.

43

...

Outline• A Quick Look at the Data.• The Model.• Model Estimation

– Calibration of Some Model Parameters– Maximum Likelihood Estimation of Other Parameters– Model Fit.

• Evaluating Alternative Monetary Policies.

44

1925 1930 1935

0.7

0.8

0.9

1

real gnp

1925 1930 19350.05

0.1

0.15

0.2

0.25investment

1925 1930 1935

0.5

0.55

0.6

0.65

consumption

1925 1930 1935

0.8

0.9

1

Total manhours (incl. military)

1925 1930 1935

0.8

0.9

1

GNP deflator

1925 1930 1935

1

1.1

1.2

1.3

1.4

real M1

1925 1930 1935

1

2

3

4

Short term rate

1925 1930 1935

0.4

0.6

0.8

1

real DOW

1925 1930 1935

0.2

0.25

0.3

0.35

0.4currency to deposits

1925 1930 1935

0.2

0.3

0.4

reserves to deposits

1925 1930 19351

2

3

4

5

Spread, BAA and AAA

1925 1930 1935

0.4

0.45

0.5

0.55wage

Labor Demand Curve

Real Wage

Employment

Rise in Real Wage

Drop in Employment

Traditional Spending Transmission Mechanism

Labor Demand Curve (Markup,Capacity utilization,….)

Real Wage

Employment

No Change in Real Wage

Drop in Employment

Modern Spending Transmission Mechanism

...

The Data• GNP Falls Over 30%, 1929 to 1933• Investment:

– Falls 80%– I/Y Goes From 0.25 (P) to 0.06 (T)

• Consumption:– Falls 25%– C/Y initially rises from 0.68 in 1929IV to 0.77 in 1931IV and then falls

back to 0.68 in 1933IV• Employment: Drops Less than GNP (i.e., Productivity Falls) and Never Fully

Recovers• Price Deflator: Drops and Never Fully Recovers

45

...

The Data, cont’d• What Started It?

– Was it the Fed?– Probably Not (Note: M1/P Roughly Constant, R Drops)– Whatever it Was, it was Something that Hit Investment Hard

• Stock Prices Collapsed: Was that What Hurt Investment?• ‘Flight to Quality’: Banks Accumulate Reserves, Households Accumulate

Currency• General Economic Uncertainty: Rises Big Time Starting 1931, With Bank

Panics.• Real Wage Rose Continually: A Reason for the Long Duration of the

Depression?

46

...

Model Features Suggested by Examination of Data• Need a Good Model of:

– Investment,– Employment,– Market Power, Especially for Labor Suppliers.

• Need a Model that Allows for Interaction Between Financial Factors and RealActivity.

• Need Model That Can Come to Terms with Bank Reserves, Currency, BankDeposits, etc.

• Model is a Marriage of Three:– Christiano, Eichenbaum and Evans, ‘Nominal Rigidities and the Dynamic

Effects of a Shock to Monetary Policy’, forthcoming, JPE.– Bernanke-Gertler-Gilchrist, Handbook of Macroeconomics, 1999, Credit

Market Frictions.– Chari-Christiano-Eichenbaum JMCB, 1995, Banking Structure.

50

...

Private Agents in the Model• Goods-Producing Firms

– Intermediate Goods, Final Goods and Capital Goods• Entrepreneurs: Own and Rent Out Capital• Banks• Households• Monetary and Fiscal Authorities.

51

...

Private Agents in the Model• Final Goods-Producing Firms:

Yt =

∙Z 10

Yjt1

λf,tdj

¸λf,t

52

...

Private Agents in the Model• Final Goods-Producing Firms:

Yt =

∙Z 10

Yjt1

λf,tdj

¸λf,t• Intermediate Goods-Producing Firms:

Yjt =

½tK

αjt (ztljt)

1−α − Φzt if tKαjt (ztljt)1−α > Φzt

0, otherwise, 0 < α < 1,

zt = µzzt−1.

– Profits:PjtYjt − Prkt Kjt − (1 +Rt)Wtljt.

– Price-setting:with probability 1− ξp : Pjt chosen optimally

with probability ξp : Pjt = πt−1Pj,t−1.

53

...

Private Agents in the Model, cont’d• Producers of Physical Capital

– Buy Investment Goods and ‘Old’ Capital and Make K̄t+1 :K̄t+1 = (1− δ)K̄t + F (It, It−1).

54

...

Private Agents in the Model, cont’d• Entrepreneurs

– Buy K̄t+1 at end of t and Rent it out in t + 1– Borrowing:

Bt+1 = QK̄ 0,tK̄t+1 −Nt+1 ≥ 0.– Capital Services:

Kt+1 = ut+1K̄t+1,

– Capital Utilization costs:a(ut+1)K̄t+1, a

0, a00 > 0,

• Net worth– Nt+1 = past net worth + earnings from renting capital + market value of

physical capital - repayments of past debt to bank.• total net worth is kept low because random fraction of entrepreneurial wealth

is destroyed• entrepreneurs receive a ‘costly state verification’ contract from the bank

58

...

Households Lend Funds

to Banks Bank

Entrepreneur of Type ω, Where Eω=1.

• Irving Fisher Debt-Deflation: Exists Because Households Receive FixedNominal Return on Time Deposits.

60

...

Private Agents in the Model, cont’d• Banks:

– Issue Liabilities (Time Deposits) Used to Finance Entrepreneurs– Issue Liabilities (Demand Deposits) Used to Finance Working Capital

Loans to Firms• Households: Supply Labor, Consume, Hold Demand and Time Deposits

Ejt

∞Xl=0

βl−t{u(Ct+l − bCt+l−1)− z(hj,t+l)

−υt+l

∙³Pt+lCt+lMt+l

´θt+l ³Pt+lCt+lDht+l

´1−θt+l¸1−σq1− σq

}

l =

∙Z 10

(hj)1

λw,t dj

¸λw,t, 1 ≤ λw,t

...

Private Agents in the Model, cont’d• Monetary and Fiscal Authorities

– Exogenous Government Spending Requirement.– Taxes.– Monetary Policy: Money Base Growth Feeds Back on Shocks:

log

µMbt+1Mbt

¶= µ

Xi

¡µi,t + 1

¢– Agnostic About Nature of Monetary Policy∗ Could Be Taylor Rule, McCallum Rule, Something Else.....

66

...

Private Agents in the Model• Goods-Producing Firms

– Intermediate Goods, Final Goods and Capital Goods• Entrepreneurs: Own and Rent Out Capital• Banks• Households• Monetary and Fiscal Authorities.

67

...

Steps in the Analysis• Select Parameter Values for the Model..

– Parameters that Control Nonstochastic Part of the Model– Parameters Governing Exogenous Shocks and Monetary Response.

• Evaluate Model Empirically.• Counterfactual Policy Analysis.

72

...

Selection of Model Parameters• ‘Nonstochastic’ Parameters

– Match Various Long-Run Averages• Use Evidence on the Shocks in the 1920s and 1930s to Parameterize Exogenous

Shocks.

75

...

Model Parameters (Time unit of Model: quarterly)Panel A: Household Sector

β Discount rate 1.03−0.25b Habit persistence parameter 0.63ξw Probability of Not Reoptimizing Wage in Given Quarter 0.70

Panel B: Goods Producing Sectorµz Growth Rate of Technology (APR) 1.50ξp Probability of Not Reoptimizing Price Within Quarter 0.50δ Depreciation rate on capital. 0.02α Power on capital in production function 0.36

Panel C: Entrepreneursγ Quarterly Entrepreneurial Survival Probability 97.00µ Fraction of Realized Profits Lost in Bankruptcy 0.120

F (ω̄) Percent of Businesses that go into Bankruptcy in a Quarter 0.80V ar(log(ω)) Variance of log of idiosyncratic productivity parameter 0.07

Panel E: Policyτ Bank Reserve Requirement 0.100τ l Tax Rate on Labor Income 0.04x Growth Rate of Monetary Base (APR) 1.61076

...

Steady State Properties of the Model, Versus US DataVariable Model US, 1921-29 US, 1964-200

ky 8.35 10.8

1 9.79iy 0.20 0.24 0.25cy 0.73 0.67 0.57gy 0.07 0.07 0.19N

K−N (’Equity to Debt’) 0.999 1-1.252 1-1.252

Percent of Goods Output Lost to Bankruptcy 0.371%Percent of Aggregate Labor and Capital in Banking 1.00% 1%3 2.5%5Inflation (APR) 0.11% -0.6%4 4.27%6

78

...

MoneyVariable Model 1921-1929 1964-2002

Monetary Base Velocity 9.77 12 16.6M1 Velocity 3.92 3.5 6.5Currency / Demand Deposits 0.28 0.2 0.3Currency / Monetary Base 0.70 0.55 0.73Curr. / Household D. Deposit 2.30

79

...

Shocks Incorporated Into Model• Eight Shocks:

– Monopoly Power of Firms– Monopoly Power of Households– Demand for Reserves By Banks– Two Household Money Demand Shocks– Shock to Riskiness of Entrepreneurs– Aggregate Technology Shock– Shock to Rate of Destruction of Entrepreneurial Wealth

80

...

Parameterization of Shocks• Each Shock, Say xt, Has 4 Parameters• Representation:

xt = ρxt−1 + εx,t, σεx• Monetary Policy Response:

µxt = ρµµx,t−1 + φεx,t

• There are 8× 4 = 32 Parameters to be Estimated• Monetary Policy

log

µMbt+1Mbt

¶= µ

Xi

¡µi,t + 1

¢

81

...

Solution to Model• Matrices, A, B

z̃t = Az̃t−1 +BΨt.

z̃t ~Core set of 23 Endogenous Variables

Ψt˜ Exogenous Variables, Stacked

1

...

Estimation of Parameters of Exogenous ShockProcesses

• Data Used in Estimation:– Net Worth (Measured by Value of the DOW)– Inflation– log, hours– Short Term Interest Rate– Output– Real Wage– Investment– Velocity of M1– Consumption– Risk Premium (Baa - Aaa Bond Returns)– Currency to Deposit Ratio– Bank Reserves to Deposit Ratio

2

...

Stochastic Model• Data:

Xt = ( log³Nt+1PtYt

´log (πt) log(lt) R

bt ∆ log(Yt)

log³

WtPtYt

´log( ItYt) log(V

1t ) log(

CtYt) Pet log(d

ct) log(d

rt) )

0

• Here,Nt+1˜Net Worth,Rbt˜Short Term Interest RateV 1t ˜Velocity of M1Pe˜Premiumdc˜Currency to Deposit Ratiodr˜Reserves to Deposit Ratio

• Representation of Xt :Xt = α + τzt + τ

sΨt + τ̄ zt−1 + τ̄sΨt−1.

3

...

State-Observer System• State, ξt

ξt =

⎛⎜⎜⎝z̃tz̃t−1ΨtΨt−1

⎞⎟⎟⎠ .• Law of Motion of State:⎛⎜⎜⎝

z̃t+1z̃t

Ψt+1Ψt

⎞⎟⎟⎠ =⎡⎢⎢⎣A 0 Bρ 0I 0 0 00 0 ρ 00 0 I 0

⎤⎥⎥⎦⎛⎜⎜⎝

z̃tz̃t−1ΨtΨt−1

⎞⎟⎟⎠+⎛⎜⎜⎝

BD0D0

⎞⎟⎟⎠ ϕ̂t+1,

ξt+1 = Fξt + vt+1.

7

...

• Observer Equation

yt = Hξt + wt,

where

H =£τ τ̄ τ̂ s b̄τs ¤ .

• Estimate by Maximum Likelihood, Given Parameters of Nonstochastic Part.

8

...

Results of Model Fit• Overall, Model Fit Seems ‘Reasonable’• Places Where Model ‘Misses’

– Understates Fall in Labor Productivity– Overstates Rise in Real Wage– Understates Fall in Consumption.

• Shocks Seem ‘Reasonable’

86

-8.5

-8

-7.5

-7

Log, real net worth

-0.3-0.2-0.1

0

Log, Price Level

0.1

0.2

0.3

Log, Hours Worked

1234

Policy Rate

-0.2-0.1

00.1

Log, Output

-7.9

-7.8

-7.7

-7.6

Log, Real Wage

-3

-2.5

-2

-1.5

Log, Investment

-1.5-1.4-1.3-1.2-1.1

Log, M1

1925 1930 1935-0.6

-0.5

-0.4

-0.3

Log, Consumption

1925 1930 193512345

Premium (APR)

1925 1930 1935-1.8-1.6-1.4-1.2

-1

Log, Currency to Deposit ratio

1925 1930 1935

-1.8-1.6-1.4-1.2

-1

Log, bank reserve to deposit ratio

Figure 5: Actual and Fitted Data, Converted to Levels

-2.4-2.2

-2-1.8

Log, Money Base Notes: (i) Dotted, Solid Line - Model, Actual Data.(ii) Results Obtained by First Adding Actual Data Sample Mean to Results Displayed in Figure 4 and then Aggregating to Levels.(iii) Currency-Deposit, Reserves-Deposit Ratio, Premium Reproduced from Figure 4.

1925 1930 1935

-4

-2

0

2

Firm Markup, λf,t%

dev

. fro

m s

tead

y st

ate

1925 1930 1935

0.9

0.95

1

Banking Money Demand Shock, ξ t

Frac

tion

1925 1930 1935

0.6

0.7

0.8

0.9

1

Money Demand, θt

Frac

tion

1925 1930 1935

0.8

1

1.2

1.4

Labor Market Power, ζ t

ratio

to s

tead

y st

ate

1925 1930 1935-400

-200

0

200

400

Liquidity Demand, υ t

% d

ev. f

rom

ste

ady

stat

e

1925 1930 19350.85

0.9

0.95

1

1.05

Financial Wealth Shock, γt

Frac

tion

1925 1930 1935

0.98

0.985

0.99

0.995

1

Technology Shock, ε t

Figure 7: Estimated Economic Shocks

1925 1930 1935

0.2

0.3

0.4

0.5

Riskiness of Entrepreneurs, σt

Liquidity Shock

Time Deposits Fall

Entrepreneur Loans Fall

Investment Falls

Asset Price Falls Net WorthFalls

Debt Deflation

Consumption Drops

Output Drops

Price LevelDrops

Financial Accelerator

Demand Deposits Drop

Working Capital Loans Drop

Rental Rate Of Capital Falls

Liquidity Preference Shock

1

1.005

1.01Household Currency Relative to SS

ratio

0.98

0.985

0.99

0.995

1Household Deposits Relative to SS

ratio

-1

-0.5

0

Consumption

Per

cent

0.98

0.985

0.99

0.995

1Household Time Deposits Relative to SS

ratio

5.7

5.8

5.9

Interbank Loan Rate

AP

R

-4

-3

-2

-1

Investment

Per

cent

Response to One-Standard Deviation Innovation to Liquidity Preference, υt

5 10 15 20

-1.5

-1

-0.5

0

quarters

Output

Per

cent

-8.5

-8

-7.5

-7

Log, real net worth

-0.4

-0.2

0

Log, Price Level

0.1

0.2

0.3

Log, Hours Worked

1234

Policy Rate

-0.2-0.1

00.1

Log, Output

-7.9

-7.8

-7.7

-7.6

Log, Real Wage

-3

-2.5

-2

-1.5

Log, Investment

-1.5-1.4-1.3-1.2-1.1

Log, M1

-0.6

-0.4

-0.2Log, Consumption

12345

Premium (APR)

1925 1930 1935-1.8-1.6-1.4-1.2

-1

Log, Currency to Deposit ratio

1925 1930 1935

-1.8-1.6-1.4-1.2

-1

Log, bank reserve to deposit ratio

Figure 9: Model Response with Only υt Shocks, and Data

1925 1930 1935-2.6-2.4-2.2

-2-1.8

Log, Money Base Notes: Results Correspond to Those in Figure 5, Except Model Simulation Only Includes Estimated υt Shocks

0 5 10 15 20

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4consumption

perc

ent d

evia

tion

from

uns

hock

ed p

ath

quarters0 5 10 15 20

-5

-4

-3

-2

-1

0

1investment

perc

ent d

evia

tion

from

uns

hock

ed p

ath

quarters

0 5 10 15 20-2

-1.5

-1

-0.5

0

0.5

1output

perc

ent d

evia

tion

from

uns

hock

ed p

ath

quarters

Dynamic Response to a v Shock - benchmark (*); no entrepreneur (o)

0 5 10 15 20-3.5

-3

-2.5

-2

-1.5

-1

-0.5

0

0.5price of installed capital, in units of C

perc

ent d

evia

tion

from

uns

hock

ed p

ath

quarters

...

Counterfactual Experiment• Identify Alternative Monetary Policy Within a Particular Class

log

µMbt+1Mbt

¶= µ

Xi

¡µi,t + 1

¢µit = θ

0εi,t + θ1εi,t−1 + θ

2µi,t−1

• Trade-off:– Immediate Monetary Response– Delayed Monetary Response

Selected Quantities in Baseline and Counterfactual,1929IV - 1939IV

CounterfactualGrowth, APR Baseline Delayed Response Immediate Response

Real Output -0.7 1.0 1.0Inflation -2.5 3.5 1.0Monetary Base 5.3 12.0 10.7M1 0.3 7.4 5.1400(maxR−minR) -3.6 -3.6 -5.8

95

0.60.8

11.21.41.61.8

Log, real net worth

-0.2

0

0.2

Log, Price Level

-2.75-2.7

-2.65-2.6

-2.55

Log, Hours Worked

4

5

6

7

Policy Rate

-0.2

-0.1

0

Log, Output

2

2.05

2.1

2.15

2.2

Log, Real Wage

-2.5

-2

-1.5

Log, Investment

-0.20

0.20.40.60.8

Log, M1

-0.45

-0.4

-0.35

-0.3

Log, Consumption

0

1

2

3

Premium (APR)

1930 1932 1934 1936 1938

-1.4

-1.2

-1

Log, Currency to Deposit ratio

1930 1932 1934 1936 1938-2.4-2.2

-2-1.8-1.6-1.4

Log, bank reserve to deposit ratio

Figure 12: Baseline Estimated Policy (Solid Line) and Counterfactual Policy (Dotted Line)

1930 1932 1934 1936 1938

-1.2-1

-0.8-0.6-0.4-0.2

Log, Money Base

...

Concluding Remarks• Fit A Model to 1920s and 1930s data

– Liquidity Preference Shock Important in Contraction– Increased Worker Bargaining Power Important in Delaying Recovery– Financial Frictions:∗ Exacerbate Fall in Investment∗ But, Not Enough to Have a Major Impact on Aggregate Output and

Employment

• Question:– Could the Great Depression Have Been Substantially Mitigated Under an

Alternative Monetary Policy?– Answer: Yes.

102