Temin Critique: DSGE Generally/Cole-Ohanian Particularly• General equilibrium with rational expectations okay for studying

long-run growth...but not for short-run fluctuationsFrictions Upward sloping SRAS

Demand shocks matter• DSGE focuses on total factor productivity (TFP)

– Must recognize constraints of gold standard, monetary contraction, and price deflation when studying Great Depression

– DSGE abstracts from money and sticky wagesThe model appears only to rephrase questions as changes in TFP.

• Cole and Ohanian– Treat data loosely...not clear where they got their productivity series– Assert a 23% decline (in depression’s descent) is “similar” to 38%– Conclude what can’t otherwise be explained must come from “idiosyncratic

and unexplained productivity shocks”...and then point to NIRA• Prescott-Kehoe/Cole-Ohanian Agenda

Stealth call for minimal government

Gauti Eggertsson

Was the New Deal (= NIRA) Contractionary?Great Expectations

A world of• Monopoly power• Sticky prices and wages• Deflationary shocks• Zero lower bound (ZLB)

NIRA (a supply restriction) reduced “natural output” but increased actual output.

• Cole and Ohanian find a possible answer to the weak recovery from 1933 – 1939 in the cartelization of the US manufacturing sector.

Villain NIRA• Individual firms could not set prices below cartel

established floors• Manufacturing wages were also set in a political/

administrative manner.• Cole and Ohanian: output was much and consistently

below trend from 1934-1939.– Eggertsson berates them for ignoring the “mistake of

1937” which had nothing to do with NIRA– Eggertsson berates them for assuming 1929 output was

at trend rather than 10% above trend

• Roosevelt’s clearly articulated goal was to reflate prices to pre- depression levels within 1-3 years

• Reflationary Quote from Roosevelt“We are agreed in that our primary need is to insure an increase in the general level of commodity prices. To this end simultaneous actions must be taken both in the economic and the monetary fields.”

• Roosevelt made his reflationary talk credible – Expanded the government through deficit spending– Abandoned gold standard discipline• Dollar devaluation• Monetary expansion by Fed• Cartelization (NIRA) and price floors (AAA)

Changing Expectations

• Eggertsson credits strong recovery to a shift in expectations about future policy

30% output collapses 39% output expansion

• FDR’s commitment to inflate price level triggered recovery

Eggertsson’s Model With Distortionary “Wedges “Representative household utility function• Dixit-Stiglitz consumption of differentiated products

• Introduces monopoly power into modeled economyLabor supply by industryβ = time preference discountθ = substitution elasticity between products > 1

• Intertemporal budget constraint“Complete” financial markets no limit on borrowingNominal interest rate links current and future periods• i >= 0

Real interest rate enters household optimization condition• Arbitrage between current and future utility

Labor marketReal Wage = (1 + ω1)(MPL/MUc)ω1 = “Labor market markup” regulations favoring labor

Nominal Profits increase with “monopoly markup” = ω2

Policies encouraging collusion between monopolistic competitors

Always maximize profit

Eggertsson’s Model With Distortionary “Wedges “

SolutionsFlexible price solution: Cole-Ohanian Okay if Prices Flexible

p = [θ/(θ – 1)] [W /(1 – ω2 )]AS: (θ – 1)/θ = [(1 + ω1 )/(1 – ω2 ) ] MPL/MUc

• For efficiency, set markups to eliminate distortion owing to monopoly power of firms

(1 + ω1 )/(1 – ω2 ) = (θ – 1)/θ• Optimum is independent of i M-policy ineffectiveness

Sticky price solution (each firm’s prices fixed for random period)

π = f(πe ,expected output growth, policy wedge)Policy wedge = (1 + ω1 )/(1 – ω2 )

The greater the policy wedge, the greater is π and the greater is πe • For efficiency… policy matters

i = 1/β - 1

Eggertsson’s Insights• Policy wedges reduce output in flexible price economy …

but increase it in the face of sticky prices and “emergency” conditions

• “Emergency” conditions:– Zero lower bound– Grinding deflation

Solution: Commit to higher inflationConclusions• Depression was driven by high real interest rates• Dramatic recovery (1933-37) driven by New Deal• Mistake of 1937 kept economy from recovering to trend

before WWII (Eggertsson’s trend treats 1929 as 10% above trend)

Recovery shift in expectations.Shift in expectations policy regime change.• Policy regime change: elimination of “dogmas” –Gold standard and other deflationary policies

• Following regime change, demand was stimulated by inflation expectations and low real interest rates

What ended the Depression?Great Expectations and the End of the Depression

Hoover• Gold standard• Balanced Budget• Small Government• Tax increases to make

up for loss of tax collection

Government Policies (Dogmas)Roosevelt

• Elimination of the Gold Standard

• Reflation• Low Real Interest Rates• Government Deficit

• Small Government Dogma:• Balanced Budget Dogma:• For simplicity, the “gold standard” dogma is excluded from the model, but President Hoover was a strong supporter of the gold

standard. This dogma can be added without changing the results because the US government held gold in excess of the monetary base at the time, so this constraint was not binding

• Hoover Regime:

The Model

• Roosevelt Regime:

The Model

• Roosevelt regime committed to a lower nominal interest rate, higher prices, permanent increase in money supply– Roosevelt’s comments become credible when the public observes

a huge increase in government spending• Data suggests that 70-80% of the recovery is because of

inflationary expectations– The other 20-30% in explained by the National Industrial Recovery

Act (NIRA) and other reflationary policies• Changes in expectations of future money supply had more

of an effect than Government spending• Elimination of old Dogmas explains change in expectations– In absence of regime change the economy would have

continued to falter

Eggertsson’s Conclusions

Cole and Ohanian Strike Again:How Gov’t Prolonged the Depression, WSJ, 2/2/09

• Why wasn’t the depression followed by a vigorous recovery like every other cycle? – Productivity grew rapidly after 1933– Price level was stable– Real interest rates were low– Liquidity was plentiful

Villain: National Industrial Recovery Act, NIRA• Why the recession in the depression

– Rising wages– Sit-down strikes

Villain: National Labor Relations Act, NLRA• Temin observation (regarding DSGE): workers may not care to

maximize GDP as much as they want to enjoy some leisure.

• Confusing communication about future price objectives reversed the tide of the recovery in 1937-1938

• To blame:– U.S. Federal Reserve– President of the United States– Key administration officials

• Due to deliberate change in policy or confusing signals?• Small changes in the public’s beliefs about the future

inflation target of the government can lead to large swings in inflation and output– Effective communication essential at zero interest rates

• Contractionary spirals do not occur at positive interest rates – central banks can cut interest rates

• When interest rate is zero, there is a vicious feedback effect between expectations of deflation, high real interest rate, deflation, and contraction of economic activityThe evolution of monetary aggregates is completely irrelevant at zero interest rates, except in their role in influencing the expectations about future money supply at the time at which the interest rates are expected to be positive

• Actions including fiscal policy, gold interventions and NIRA had an effect on economy due to their effect on expectations, 1933-1937

• 1937: Fear of excessive inflation– Increase reserve requirements– Influenced how government officials communicated policy

• Change in communication Policy People expect deflation

Contractionary Spirals

“Emergency Conditions” and Self-Financing Fiscal Stimulusde Long and Summers, March 2012

Fiscal Policy in a Depressed Economy

• Fiscal multiplier is high when economy is depressed and interest rate is at zero lower bound– Monetary authority wants to accommodate expansion• Normal reaction function is suspended

– Fiscal expansion may be boosted by expectation of inflation Negative real rate at ZLB

• Hysteresis effect: expansion out of depression offsets decline in long-run productivity because of extended unemployment

“Natural” output greater than it otherwise would be• PV of tax revenues from short-run and long-run increases in

GDP offset a transitory fiscal deficit