...
The Great Depression and the Friedman-Schwartz
Hypothesis
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!
Log, US GNP
6
5.5
5
4.5
4
3.5
1900
1910
1920
1930
1940
Years
1950
1960
1970
1980
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 on
the Interest Rate
• In Recent Years: Interest In Understanding Monetary Policy in a Low Interest
Rate 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 Depression?’, 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
real gnp
consumption
investment
0.25
1
0.65
0.2
0.9
0.6
0.15
0.8
0.55
0.1
0.7
0.5
0.05
1925
1930
1935
Total manhours (incl. military)
1925
1930
1935
GNP deflator
1930
1935
real M1
1925
1930
1935
currency to deposits
1.4
1
1
1925
1.3
0.9
0.9
1.2
1.1
0.8
0.8
1925
1930
1935
Short term rate
1
1925
1930
1935
real DOW
0.4
4
1
3
0.8
2
0.6
1
0.4
1925
1930
1935
reserves to deposits
0.35
0.3
0.25
0.2
1925
1930
1935
Spread, BAA and AAA
1925
1930
wage
1935
1925
1930
1935
0.55
0.4
5
0.5
4
0.3
0.2
1925
1930
1935
3
0.45
2
0.4
1
1925
1930
1935
Traditional Spending Transmission
Mechanism
Real
Wage
Rise
in
Real
Wage
Labor Demand
Curve
Drop in Employment
Employment
Modern Spending Transmission
Mechanism
Real
Wage
Labor Demand Curve
(Markup,Capacity
utilization,….)
No
Change
in Real
Wage
Drop in Employment
Employment
...
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 Real
Activity.
• Need Model That Can Come to Terms with Bank Reserves, Currency, Bank
Deposits, 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
0
1
Yjt
1
λf,t
dj
¸λf,t
52
...
Private Agents in the Model
• Final Goods-Producing Firms:
Yt =
∙Z
0
1
Yjt
1
λf,t
dj
¸λf,t
• Intermediate
Firms:
½ Goods-Producing
1−α
1−α
α
α
K
(z
l
)
−
Φz
if
K
(z
l
)
> Φzt
t jt t jt
t
t jt t jt
Yjt =
, 0 < α < 1,
0,
otherwise
zt = µz zt−1.
– Profits:
PjtYjt − P rtk Kjt − (1 + Rt) Wtljt.
– Price-setting:
with probability 1 − ξ p : Pjt chosen optimally
with probability ξ p : Pjt = π t−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, a0, 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
...
Entrepreneur of Type ω,
Where Eω=1.
Bank
Households
Lend Funds
to Banks
• Irving Fisher Debt-Deflation: Exists Because Households Receive Fixed
Nominal 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
∞
X
Etj
β l−t{u(Ct+l − bCt+l−1) − z(hj,t+l )
l=0
∙³
Pt+l Ct+l
Mt+l
´θt+l ³
Pt+l Ct+l
h
Dt+l
´1−θt+l ¸1−σq
}
−υ t+l
1 − σq
¸λw,t
∙Z 1
1
(hj ) λw,t dj
, 1 ≤ λw,t < ∞.
l=
0
63
...
Private Agents in the Model, cont’d
• Monetary and Fiscal Authorities
– Exogenous Government Spending Requirement.
– Taxes.
– Monetary Policy: Money
Growth Feeds Back on Shocks:
µ Base
¶
b
X¡
¢
Mt+1
µi,t + 1
log
=µ
b
Mt
i
– 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
b
Habit persistence parameter
ξw
Probability of Not Reoptimizing Wage in Given Quarter
Panel B: Goods Producing Sector
µz
Growth Rate of Technology (APR)
ξp
Probability of Not Reoptimizing Price Within Quarter
δ
Depreciation rate on capital.
α
Power on capital in production function
Panel C: Entrepreneurs
γ
Quarterly Entrepreneurial Survival Probability
µ
Fraction of Realized Profits Lost in Bankruptcy
F (ω̄)
Percent of Businesses that go into Bankruptcy in a Quarter
V ar(log (ω)) Variance of log of idiosyncratic productivity parameter
Panel E: Policy
τ
Bank Reserve Requirement
τl
Tax Rate on Labor Income
x
Growth Rate of Monetary Base (APR)
1.03−0.25
0.63
0.70
1.50
0.50
0.02
0.36
97.00
0.120
0.80
0.07
0.100
0.04
1.610
76
...
Steady State Properties of the Model, Versus US Data
Variable
Model US, 1921-29
k
1
8.35
10.8
y
i
0.20
0.24
y
c
0.73
0.67
y
g
0.07
0.07
y
N
2
(’Equity
to
Debt’)
0.999
1-1.25
K−N
Percent of Goods Output Lost to Bankruptcy
0.371%
Percent of Aggregate Labor and Capital in Banking 1.00% 1%3
Inflation (APR)
0.11% -0.6%4
US, 1964-200
9.79
0.25
0.57
0.19
1-1.252
2.5%5
4.27%6
78
...
Money
Variable
Model
Monetary Base Velocity
9.77
M1 Velocity
3.92
Currency / Demand Deposits 0.28
Currency / Monetary Base
0.70
Curr. / Household D. Deposit 2.30
1921-1929 1964-2002
12
16.6
3.5
6.5
0.2
0.3
0.55
0.73
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, σ εx
• Monetary Policy Response:
µxt = ρµµx,t−1 + φεx,t
• There are 8 × 4 = 32 Parameters to be Estimated
• Monetary Policy
µ b ¶
X¡
¢
Mt+1
µi,t + 1
log
=µ
b
Mt
i
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 Shock
Processes
• 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:
³ ´
b
Xt = ( log NPtt+1
)
log(l
)
R
∆ log(Yt)
log
(π
t
t
t
Yt
³ ´
log PWtYtt log( YItt ) log(Vt1) log( CYtt ) Pte log(dct) log(drt ) )0
• Here,
Nt+1˜Net Worth,
Rtb˜Short Term Interest Rate
Vt1˜Velocity of M1
P e˜Premium
dc˜Currency to Deposit Ratio
dr ˜Reserves to Deposit Ratio
• Representation of Xt :
Xt = α + τ zt + τ sΨt + τ̄ zt−1 + τ̄ sΨt−1.
3
...
State-Observer System
• State, ξ t
⎛
z̃t
⎜ z̃t−1 ⎟
⎟
ξt = ⎜
⎝ Ψt ⎠ .
Ψt−1
• Law of Motion of State:
⎛
⎞
⎡
⎞
z̃t+1
A 0
⎜ z̃t ⎟
⎢
⎜
⎟ = ⎢I 0
⎝ Ψt+1 ⎠
⎣0 0
Ψt
0 0
Bρ
0
ρ
I
⎤⎛
⎞
⎛
⎞
0
BD
z̃t
⎟ ⎜
⎟
⎜
0⎥
⎥ ⎜ z̃t−1 ⎟ + ⎜ 0 ⎟ ϕ̂t+1,
0 ⎦ ⎝ Ψt ⎠ ⎝ D ⎠
Ψt−1
0
0
ξ t+1 = F ξ t + vt+1.
7
...
• Observer Equation
yt = Hξ t + wt,
where
H =
£
s¤
b̄
τ τ̄ τ̂ τ .
s
• 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
Figure 5: Actual and Fitted Data, Converted to Levels
Log, real net worth
Log, Price Level
-7
0
-7.5
-0.1
-8
-8.5
0.3
-0.2
0.2
-0.3
0.1
Policy Rate
Log, Real Wage
Log, Output
-7.6
0.1
0
-0.1
-0.2
4
3
2
1
Log, Hours Worked
-7.7
-7.8
-7.9
Log, Investment
Log, M1
-1.1
-1.2
-1.3
-1.4
-1.5
-1.5
-2
-2.5
-3
Premium (APR)
1925
-1.8
-2
-2.2
-2.4
1930
1935
Log, Money Base
-0.3
-0.4
-0.5
-0.6
1925
1930
1935
Log, bank reserve to deposit ratio
Log, Currency to Deposit ratio
-1
-1.2
-1.4
-1.6
-1.8
5
4
3
2
1
Log, Consumption
-1
-1.2
-1.4
-1.6
-1.8
1925
1930
1935
1925
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.
1930
1935
Figure 7: Estimated Economic Shocks
Money Demand, θt
1
2
1
-2
0.9
Fraction
0
0.95
0.9
0.8
0.7
0.6
-4
1930
1935
Labor Market Power, ζ
1.2
1
0.8
1925
1930
1935
1930
1935
Liquidity Demand, υ
t
% dev. from steady state
1.4
1925
200
1
0.85
1925
1930
1935
Riskiness of Entrepreneurs, σt
1
0.5
0.4
0.99
0.985
0.3
0.98
0.2
1925
1930
1935
0.95
0.9
-200
-400
1935
t
1.05
0
1930
Financial Wealth Shock, γ
t
400
Technology Shock, ε t
0.995
1925
Fraction
1925
ratio to steady state
Banking Money Demand Shock, ξ t
Fraction
% dev. from steady state
Firm Markup, λf,t
1925
1930
1935
1925
1930
1935
Liquidity Preference Shock
Working Capital
Loans
Drop
Demand Deposits
Drop
Consumption
Drops
Liquidity
Shock
Time
Deposits
Fall
Entrepreneur
Loans Fall
Net Worth
Falls
Investment
Falls
Financial
Accelerator
Output
Drops
Asset
Price Falls
Debt
Deflation
Price Level
Drops
Rental
Rate
Of Capital
Falls
Response to One-Standard Deviation Innovation to Liquidity Preference, υ t
Household Currency Relative to SS
Household Deposits Relative to SS
1
1.01
ratio
ratio
0.995
1.005
0.99
0.985
0.98
1
Household Time Deposits Relative to SS
Consumption
1
0
Percent
ratio
0.995
0.99
0.985
-0.5
0.98
-1
Interbank Loan Rate
Investment
-1
Percent
APR
5.9
5.8
5.7
-3
-4
Output
0
Percent
-2
-0.5
-1
-1.5
5
10
quarters
15
20
Figure 9: Model Response with Only υt Shocks, and Data
Log, real net worth
Log, Price Level
0
-7
-7.5
0.3
-0.2
-8
0.2
0.1
-0.4
-8.5
Policy Rate
-7.6
-7.7
-7.8
-7.9
Log, Investment
Log, M1
-2
-2.5
-3
Premium (APR)
Log, Money Base
-1.8
-2
-2.2
-2.4
-2.6
-0.4
-0.6
Log, Currency to Deposit ratio
-1
-1.2
-1.4
-1.6
-1.8
5
4
3
2
1
1930
1935
Log, bank reserve to deposit ratio
-1
-1.2
-1.4
-1.6
-1.8
1925
1930
1935
Notes:
Results Correspond to Those in Figure 5,
Except Model Simulation Only Includes
Estimated υ Shocks
t
1925
Log, Consumption
-0.2
-1.1
-1.2
-1.3
-1.4
-1.5
-1.5
Log, Real Wage
Log, Output
0.1
0
-0.1
-0.2
4
3
2
1
Log, Hours Worked
1925
1930
1935
Dynamic Response to a v Shock - benchmark (*); no entrepreneur (o)
investment
percent deviation from unshocked path
percent deviation from unshocked path
consumption
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
-1
-1.2
0
5
10
quarters
15
1
0
-1
-2
-3
-4
-5
20
0
0.5
0
-0.5
-1
-1.5
-2
0
5
10
quarters
10
quarters
15
20
price of installed capital, in units of C
1
percent deviation from unshocked path
percent deviation from unshocked path
output
5
15
20
0.5
0
-0.5
-1
-1.5
-2
-2.5
-3
-3.5
0
5
10
quarters
15
20
...
Counterfactual Experiment
• Identify Alternative Monetary
a Particular Class
µ bPolicy
¶ Within
X¡
¢
Mt+1
µi,t + 1
log
=µ
b
Mt
i
µit = θ0εi,t + θ1εi,t−1 + θ2µi,t−1
• Trade-off:
– Immediate Monetary Response
– Delayed Monetary Response
Selected Quantities in Baseline and Counterfactual,
1929IV - 1939IV
Counterfactual
Growth, APR
Baseline Delayed Response Immediate Response
Real Output
-0.7
1.0
1.0
Inflation
-2.5
3.5
1.0
Monetary Base
5.3
12.0
10.7
M1
0.3
7.4
5.1
400(max R − min R)
-3.6
-3.6
-5.8
95
Figure 12: Baseline Estimated Policy (Solid Line) and Counterfactual Policy (Dotted Line)
Log, real net worth
1.8
1.6
1.4
1.2
1
0.8
0.6
Log, Price Level
Log, Hours Worked
-2.55
0.2
7
-2.6
6
0
-2.65
-0.2
-2.7
5
-2.75
4
Log, Output
Log, Real Wage
Log, Investment
0
2.15
-0.1
2.1
-1.5
-2
-2.5
Premium (APR)
3
-0.35
2
-0.4
1
-0.45
0
Log, Currency to Deposit ratio
-1
-1.2
-1.4
1930 1932 1934 1936 1938
Log, Money Base
-0.2
-0.4
-0.6
-0.8
-1
-1.2
1930 1932 1934 1936 1938
0.2
0
2
-0.3
0.6
0.4
2.05
Log, Consumption
Log, M1
0.8
2.2
-0.2
Policy Rate
-0.2
Log, bank reserve to deposit ratio
-1.4
-1.6
-1.8
-2
-2.2
-2.4
1930 1932 1934 1936 1938
...
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