Temin Critique: DSGE Generally/Cole-Ohanian Particularly
• General equilibrium with rational expectations okay for studying
long-run growth...but not for short-run fluctuations
Frictions  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 wages
The 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
Changing Expectations
• 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)
• Eggertsson credits strong recovery to a shift in
expectations about future policy
• 1929 − 1933
1933 − 1937
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 economy
Labor supply by industry
β = time preference discount
θ = substitution elasticity between products > 1
• Intertemporal budget constraint
“Complete” financial markets  no limit on borrowing
Nominal interest rate links current and future periods
• i >= 0
Real interest rate enters household optimization condition
• Arbitrage between current and future utility
Eggertsson’s Model With Distortionary “Wedges “
Labor market
Real 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
Solutions
Flexible 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 inflation
Conclusions
• 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)
What ended the Depression?
Great Expectations and the End of the Depression
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
Government Policies (Dogmas)
•
•
•
•
Hoover
•
Gold standard
Balanced Budget
•
Small Government •
•
Tax increases to make
up for loss of tax
collection
Roosevelt
Elimination of the Gold
Standard
Reflation
Low Real Interest Rates
Government Deficit
The Model
• 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:
Eggertsson’s Conclusions
• 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
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
• 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 activity
The 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
“Emergency Conditions” and Self-Financing Fiscal Stimulus
de 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