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The Great Depression and the Friedman-SchwartzHypothesis
Lawrence J. Christiano, Roberto Motto and Massimo Rostagno
1
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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
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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
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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
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