The German Slump as a Real Business Cycle
Rational expectations  Real business cycles (RBC)
P
AS Observed fluctuations must be owing to AS shocks
•Factor inputs and productivity
•“Intertemporal” labor-leisure substitution
AD
Y
•Dynamic (Stochastic) General Equilibrium Growth Model
•DSGE applied to short-run fluctuations to explain Great Depression
by Fisher and Hornstein
•Representative agents weigh future utility when deciding how much to work
and how much to save/invest at present
•They ignore monetary impacts … “Money lagged output”
•Major critique of RBC-theory – the Great Depression
•Lucas/Prescott: Gone fish’n’ ???
•German slump: Hoffmann data  Ritschl data
•8 – hour day: a productivity shock
Fisher – Hornstein: DGE model of Germany, 1928-37
• All per capita variables relative to real gdp trend (in equilibrium, they
should grow at same rate)
• Measure total factor productivity (TFP) as Solow residual:
Y = A Kα L(1- α)  dA/A = TFP growth = dY/Y – α dK/K – (1 - α) dL/L
• Ignore M1 … it lagged Y
– Ignore how lower interest rate might have stimulated investment, output and
employment (recall Voth)
Note
• Wages set by collective bargaining and arbitration
Political Wage  Wages too High? (Borchardt)
• Bruening austerity policy
• Nazis broke unions (1933) – set maximum wages and limited mobility
Bruening lowered civil servant wages and tried to reduce private sector wages
• Nazi expansion with limits to consumption
Military Keynesianism?
Fisher – Hornstein Model
• Representative agent maximizes discounted utility over infinite
horizon
– Utility increase with consumption and leisure
• Leisure decreases with fraction of time spent working
– Spending on consumption (c) plus investment (x) equals income
from labor (wn) and capital (rk) plus transfers from government (s)
• Expenditure tax rate and income tax rate enter this constraint
• Per capita kapital stock increases with investment net of depreciation
• Output determined by Cobb-Douglas production function
Y = A k.25 [γtn].75
• Labor share of income averaged ¾
• Technology advanced at 1.87% annual rate (γ)
– Profit maximizing firm hires factors (n and x) so MPL = w and MPK = r
• Government spending g + s = tax revenue over horizon
• As always, Y = c + x + g
Fisher – Hornstein Simulations
• Response of employment, output, consumption, investment and real
wage to alternative values of productivity (trend or actual), fiscal
policy (trend or actual), and real wage (market clearing or actual)
I – Actual productivity with trend fiscal stance and market clearing wage
The actual decline in TFP generates patterns of employment, output,
consumption and investment similar to what happened
… but to clear labor market, real wage should have declined, not
risen, in early years of German depression
II – Actual fiscal policy with trend TFP and market clearing real wage
Predict not nearly as much contraction of employment, output,
consumption and investment as actually occurred from 1928 – 1932.
Predict investment crowded out in Nazi years, which it wasn’t.
III – Actual real wage with trend TFP and actual fiscal policy
Predict less reduction in consumption than actually occurred
… but otherwise generate patterns close to actual
Fisher – Hornstein Conclusions
• High real wage by itself generates downturn close to actual
• Reduced real wage of Nazi years does not by itself capture
investment spurt and consumption stagnation
• Combinations of actual real wages, Bruening fiscal austerity
followed by Nazi expansion, and actual TFP fail to predict
sharp decline in consumption in downturn and failure to
recover in upturn.
• More research is called for.
German Interwar Economic Pathologies: An Overview
Lost War and Revolution  Distributional Conflict
+
8 – Hour Day
Desperate Government
Hyperinflation
Stabilization
Monetary Constraints Outsized Wages
Reduced Investment
Depression and Slump
Nazi Revolution/Constraints Broken
Wages Down
Government Spending Up
“Recovery”