IV. Economic Development and IV. Economic Development and Economic Policies before WWIEconomic Policies before WWI

Classical Model at WorkClassical Model at Work

General framework (1)

• Period of peace after destructive wars (Franco-German in Europe in 1870, civil war in the USA 1861-1865)

• Technical development (electricity, combustion engine, incandescent lamp, telephone, etc.), consequences:– Expansion of transport (both freight and personal)– Concentration of heavy industries– Development of financial institutions and financial

markets

• Effects (and costs) of colonial policies• Gold standard (see bellow)

General framework (2)

• Liberal ideology – politics and economics• Liberal trade (with repeated protectionist

attempts)• Very competitive environment

– Limited government regulation of business– Prices and wages flexible as never after– Almost no capital controls

• The governments did not have today’s policy objectives– No general social a political pressure to guarantee

economic growth and full employment

IV.1 Basic data

Real GDP, %yoy, US, UK1871-1913

Real GDP, %yoy, US, UK1871-2009

CPI, %yoy, US, UK 1871-1913

CPI, %yoy, US, UK1871-2009

Unemployment, %, US, UK1870-1913

Unemployment, %, US, UK1870-2009

US: GDP growth, CPI, unemployment1870-1913

Changes in GDP and in inflation

1870 - 1874- 1894- 1870 - 1874- 1894-1874 1894 1913 1874 1894 1913

Great Britain 2.4 1.8 1.8 1.1 -1.5 1.0France 3.3 1.2 1.7 1.0 -0.2 0.4Germany 4.5 2.1 3.3 4.2 -0.8 1.4Italy 0.7 2.1 3.3 5.3 -1.0 1.2Austria 2.5 2.4 2.4 n.a. -1.2 1.4Belgium 2.5 1.9 2.0 2.1 -1.5 1.1Netherlands 1.6 2.3 2.2 4.4 -1.3 0.6Sweden 4.8 1.2 2.7 4.5 -1.2 1.5USA 3.3 3.6 4.4 -2.7 -1.3 0.7

% change of real GDP % change in consumer prices

Lesson from the data

• Volatile growth, average growth lower compared, e.g., to ”golden” period 1950-1970

• Shorter cycle (no “great” depressions)• Inflation low and fluctuating around zero• Strong fluctuations of unemployment,

copying the cycle• Balanced budgets

Note: problems with data reliability, mainly ex-post construction (estimates)

IV.2 Theory: Classical model

IV.2.1 Aggregate supply and demand and equilibrium on

market with goods and services

Full employment product and aggregate supply

• Equilibrium on labor market: full employment N0– everybody who wants to work at given real wage, can

find and gets the job• Capital fixed in the short run: K• Production function: Y0 = F(K,N0)• Output (product) Y0 determined by full

employment N0 → full employment product (output, income, etc.), equals aggregate supply AS = Y0

• Changes in Y0 only if: – shift in labor demand/supply schedules– shifts in production function

N

P

W

DN

E

SN

0N

0P

W

N

Y

KN,F

0N

0Y

Aggregate demand• Consumption function:

• Investment function:

• Governmental expenditure: G

• Aggregate demand:

0C , 0C , rYD,CC rYD

0I , rII r

GrIr,YT-YCAD

EquilibriumAggregate supply AS• Labor market in equilibrium: employment

N0

• Production function – aggregate supply Y0

Aggregate demand Equilibrium: AD=AS, hence

“Classical” question: what ensures that – if supply is determined by full employment from labor market – AD exactly matches AS?

GrIYT-YCY

GrIr,YT-YCAD

IV.2.2 Equilibrating mechanism.

Equilibrium and real interestBasic identity (remember LII): I = S + (T – G)Remark on notation: here S is used for personal savings

only (Sp in LII)

For classical model

and when output Y is given on the supply side, then real interest r is only variable that adjusts to bring the aggregate demand to be exactly equal to given aggregate supply

Ex-ante, the identity becomes and equilibrium condition, with interest r as equilibrating variable; rewrite it as

G)Y(TrT(Y),-YSI(r)

GI(r))Y(TrT(Y),-YS

r

I+G, S+T

I(r)+G

TS0

)Y(TrT(Y),-YS

r1

r2

r0

Loanable funds interpretation

• Savings – supply of loanable funds: households and government postpone the consumption, creating funds that may be used for investment financing

• Investment plans – demand for financing, demand for loanable funds

• Real interest – price, that adjusts and equilibrates the model– If r>r0, then excess supply of loanable funds and r

decreases– If r<r0, then excess demand of loanble funds and r

increases• Remark: Say's law

IV.2.3 The quantity theory of money

David Hume

• 1711 – 1776• Philosopher,

historian• 1752: Political

Discourses, especially essay Of Money

• Diplomat

The Quantity EquationTotal expenditures in an economy – expressed in two

ways:• P.TRN, where P is aggregate price, TRN is number of

transactions in the economy• M.V, where M is nominal quantity of money, V is the

transactions velocity of money– V: rate, at which the money circulates in the economy (how

many times a unit of money changes hands)

Both expressions must be equal, quantity equation:M.V=P.TRN

Ex-post always true, identity (it is not a theory)

TRN impossible to measure, approximation by total income (product) Y:

M.V = P.Y • V – income velocity of money

The Quantity Theory

Theory seeks to answer following questions:

• How is the equilibrium amount of money in the economy determined?

• What is the impact of the money on the economy (does the change of amount of money influences output, price, employment, etc.).

Two versions of QTM

Irving Fisher• 1867-1947• American• Neoclassical Marginalist

Revolution, mathematical methods

• Introduced Austrian economic school to the USA (Theory of capital and investment, 1896-1930), intertemporality

• Quantity theory of money (1911-1935)

• Loss of credibility during Great Depression

Fisher’s QTM (1)

Two assumptions in the framework of classical model:

• In equilibrium, real output determined by full employment labor (given at the cleared labor market). Real economy independent on money supply.

• Velocity of money is given by technical features of the markets and is not in any relation to amount of money in the economy

Usual corollary (however, not stipulated by Fischer himself): “around” equilibrium (i.e. at least in the short-term) velocity V is constant

Fisher’s QTM (2)

How the quantity equation becomes a theory ? If:• V and Y is fixed with respect to money supply• Money is required for transactions• Money supply M is exogenousthen M.V = P.Y is an equation of the model (required to be valid ex-ante)

which says that in equilibrium, when output Y is given in the real sector of the economy and V is constant, the supply of money, controlled by central bank, determines the price level P only (P is proportional to M)

Corollary: “real” variables (output and its components, unemployment, etc.) are independent on the amount of money; or, change in the money supply has an impact on the price level only (but not on output)

Fisher’s QTM – develops from quantity equation, no explicit consideration of supply and demand for money

Cambridge version• Problem of Fisher’s version: aggregate approach, does

not consider the decision on the individual level (not rooted in microeconomics)

• Determinant of money demand on individual level: need to execute transactions, correlated with nominal value of total expenditures

• Demand for money: MD = k.P.Y, k – fraction of nominal value of expenditures (of nominal income), that society wishes to hold– k assumed constant

• Equilibrium: supply of money MS equals to demand, equilibrium equation

M = k.P.Y• k = 1/V, different economic interpretation, but assumed

to be constant again

Arthur Cecil Pigou• 1877 – 1959• British, Cambridge University• Brought social welfare to the

attention of economists (Wealth and Welfare, 1912)

• Theory of unemployment (1933) served to Keynes as a primary example of wrong approach

• Unjustly ridiculed by Keynes in General Theory

• The Classical Stationary State (1943) – Pigou proved that Keynes was theoretically wrong

Conclusions for QTM• Both Fisher and Cambridge versions: k (and V)

is constant• For classical model

– consistency with the logic of supply side: potential product determined in the real sector only

– consistency with Say’s law– implies money neutrality– price changes proportional to the change in stock of

money• Too many open questions (constant velocity,

inconsistency, when more profound check with microeconomic – Marshall?), decisively refuted by Keynes in General Theory, but equally decisively rehabilitated by Milton Friedman and monetarists

IV.2.4 Complete model(closed economy)

The modelLabor market and aggregate supply

• W/P = FN(K,N) demand for labor• N = NS(W/P) supply of labor• Y = F(K,N) production function

Market with goods and services

• Y = C + I + G demand and equilibrium,• consumption function• I = I(r) investment function

Financial (money) market

• M.V = P.Y price equation and equilibrium (Fisher’s

version of QTM)

rT,-YCC

Technical features• 7 equations and 7 endogenous variables:

Y, C, I, N, W/P, P, r• 3 exogenous variables: K, M, G• 1 constant: V• Equilibrium on 3 markets:

– Goods and services, labor (factor) and money (financial)

• 2 equation of labor market form an independent block, 3 equations of labor market and aggregate supply form another independent block

Static, general equilibrium model

• Time horizon “sufficiently” short for capital and total labor force fixed.

• Time horizon “sufficiently” long for the adjustment of perfectly flexible prices, thus ensuring the simultaneous equilibrium on all markets

• In particular, this applies for labor market, where there is no possibility of involuntary unemployment

• Strong theoretical assumptions, but at the end of XIX. and beginning of XX. centuries generally accepted of more or less consistent with reality

Dichotomy of the classical model

• Real sector: labor market, flexible nominal wage, production function, Say’s law

full employment equilibrium product supply side determines the product at

given price and amount of moneyClassical dichotomy, money is neutral

Y

P

W/P

NNS

ND

W0/P0

N0

F(K,N)

Y0

AS

M0VP0

W0

IV.3 Classical gold standard

Starting points

• Full employment equilibrium, QTM, money neutrality

• ExR (nominal) determined by PPP (monetary approach to ExR determination)

• In equilibrium, also interest parity holds (i.e. ExR, as determined by asset approach, equals PPP as well)

Domestic standard: money supply

• Free convertibility between gold and non-gold money guaranteed by state

• Domestic standard (norm), regulating the quantity and growth rate of money supply– i.e., amount of gold reserves determines money

supply and prices• Reserves very stable → money supply (and

price level) over time stable– However, in the short term large volatility of prices– Gold standard sensitive to (i) gold discoveries that

change price of gold; (b) all types of supply and demand shocks

International standard: fixed ExR

• Fixed price of gold in terms of each country’s currency (mint price)– After 1880: $ 20.67 or £ 4.24 per troy ounce– By implication, fixed exchange rates between each

pair of currencies in the system– Given US and UK mint prices above: 4.875 USD/£

• Two crucial commitments, internationally accepted– each Government (Central Bank) ready to buy/sell

unlimited amount of gold at mint price– free trade of gold across the borders

Arbitrage and gold points

• Free trade with gold → the same exchange rate between, e.g., $ and £, 1£=4$ (no risk and transportation costs) both in N.Y and London– If not, arbitrage

• Exchange rate remains fixed even if risk and transportation costs considered– Gold points: if risk and other costs e.g.

5%, then 1£=3.8 - 4.2 $

Price-specie-flow mechanism (P-S-F)

• Assume an exogenous change, discovery of gold → increase of money supply, two consequences– domestic price increase → domestic goods more expensive

relative to foreign goods → fall of exports, increase of imports → CA deficit

– fall of nominal interest → interest parity breached → domestic investment less attractive → non-reserve part of financial account in deficit

• Both consequences: BoP deficit, pressure on ExR– Long-term: PPP not equal to (fixed) ExR (different shifts in

domestic and foreign price levels)– Short-term: interest parity does not hold

• P-S-F: automatic BoP adjustment, both on goods and financial markets

P-S-F: goods market

• BoP deficit: outflow of official reserves, i.e. gold (remember LII.3, in modern world, official reserves settlement) → decrease of money supply → fall of prices (see QTM above) → domestic exports cheaper, imports for foreigners more expensive → increase of exports, decrease of imports → improvement of BoP deficit

• Price levels shift back until PPP again equals (fixed) ExR

P-S-F: financial markets

• The same reaction to financial account deficit as on the goods market

• Capital (investment) moving from domestic country abroad → gold moves from home country → domestic money supply decreases → fall of price level and the rest of adjustment like on goods market

• With adjustment of money supply, interest adjusts as well and interest parity holds again

Remark

• Try to trace P-S-F for another scenario:

• Technological innovation in the home country, unchanged money supply → increase of real output → price decrease

• BoP surplus

• Adjustment?

P-S-F: summary

Reaction to deficits/surpluses of BoP (provided that conditions for smooth gold standard operation are fulfilled):

• Flows of gold ensure quick adjustment to BoP imbalances

• Equilibrium in international economic/financial relations as prevailing tendency

• Fixed exchange rates maintained as all adjustment based on the central banks’ readiness to buy/sell gold at fixed price

Rules of the game• Under the validity of assumptions: P-S-F works

as automatic mechanism• In reality: main countries (UK, France,

Germany, US, Italy, etc.) agreed to play according common „rules of the game“– Country suffers BoP deficit → central bank

decreased the interest („discount“) rate (and other commercial bank decreased their lending rates as well) → facilitates the gold outflow and the efficiency of P-S-F

– With BoP surplus → central bank increases basic rate

How did it work in reality?

• Surprisingly well!• Crucial role of Bank of England (UK central

bank), almost always followed rules of game• Other central banks – quite often tried to

breach rules of the game, preventing capital flows

• Central country (Great Britain) – reserves in gold

• Many other countries – reserves in gold and British sterling

• However, as a prevailing tendency, classical gold standard worked

Consistency with classical model

Reality indeed (at least to some extent) reflected assumptions of classical model:

• price and wage flexibility, no capital controls

• small governments with balanced budget, anti-inflationary policies and stable money

Role of Government

• In theory (to lesser extent in practice) gold standard does not provide much space for active monetary policies: gold flows, when reacting to BoP surplus/deficit, just adjust money supply to money demand – again consistent with classical model

• In reality: central banks did have some space for policy options– Large gold reserves (France), allowing for gold flows

to adjust– Relatively small reserves (Britain), managing

discount rates and BoP imbalances financed by short term flows

IV.4 Policies

Multipliers - general• Intuitive interpretation: the change of (or a

direction of change from) equilibrium value of an endogenous variable when value of exogenous variable changes– Policy interpretation: exogenous variable as policy

instruments, e.g. if money supply or taxes increase, what is the impact on endogenous variables of the system

– Historically first : Richard Kahn, a student of Keynes, for particular situation – impact of governmental expenditure on output and consumption, see Lecture on Keynes

• Mathematical interpretation: partial derivative of a reduced form of the model

Multipliers – classical model (1)

• Independent set of first 2 (3) equations of the model (labor market and production function)

• Labor market forms an independent block, first 3 equations form another independent block

• Equilibrium values of output, real wage and employment influenced by amount of capital K only

• Short-term: dK = 0 → dY, dN, d(W/P) = 0

0dKNF-1

F

P

Wd

SPWNN

NK 0dKNF-1

FNdN

SPWNN

NKS

PW 0)dKFNF-1

FNF(dY KS

PWNN

NKS

PWN

Multipliers – classical model (2)

Reduced form derivatives:• Interest

• Consumption

• Investment

• Price

0IC

1-

G

r 0

IC

C

T

r

rrrr

T-Y

C

T-CY-T 1-

Cr

Cr Ir

0

C

G-

Cr

Cr Ir

0

0IC

I-

G

I 0

IC

CI

T

I

rr

r

rr

T-Yr

0kY

1

Y

V

M

P

Policy implications

Different “social demand” and different policy goals

• Economic growth and full employment were not perceived as visible targets

• Governments were not perceived as being responsible

• Classical model - limited possibilities for macro-policies:

• Fiscal policies – crowding-out of the private investment (see next slide)

• Monetary policies – only impact on general price level, but subdued to the fixed ExR regime (gold standard)

Crowding-out effect

• In the classical model, when output given on the supply side, increase of any component of aggregate demand can not cause increase of output (and employment)

• Zero efficiency of fiscal policy: increase in governmental expenditures at the cost of decrease of investment/consumption

• Value of fiscal multiplier equals zero

Money neutrality

• Change of money has an proportional impact on the price level

• Amount of money has not any consequence for real output and employment– See graphical exposition on the next

slide

• Value of money multiplier equals zero

Y

P

W/P

NNS

ND

W0/P0

N0

F(K,N)

Y0

AS

M0VP0

W0

W1

P1M1V

M1>M0

W0/P1W1/P1=

Policies of the Government

• Guarantee competitive environment– Anti-trust legislation– First regulatory attempts on financial

markets– First interest in economic cycle, but no

policy recommendations– Trade policies – period of deep trade

liberalization– Economic aspects of colonial policies– Mitigating the worst cases of poverty

Literature to Ch.IV• Snowdon, B., Vane, H., Modern Macroeconomics, Edvard

Elgar, 2005, Ch.2, pp.36-54– Basic reading to this chapter and literature there, with exception

of gold standard• Mankiw, G.N.: Macroeconomics, Worth Publishers, New

York, 1992 (and subsequent editions)– In Ch. 3 and 7, most of the features of classical model are being

discussed• Sargent, T., Macroeconomic Theory, Academic Press

1987 (2nd ed.), Ch. 1– Very difficult, mathematical approach. However, if you struggle

through (or even skip much of) mathematics, you get a very clear picture of the model, discussed in this chapter.

• Mishkin, F.S., The Economics of Money, Banking and Financial Markets, HarperCollinsPublishers, 1993 (3rd ed.), Ch. 23, pp.523-530 (there is a Czech translation)– Comprehensible explanation of QTM

• Krugman, Obstfeld (see above), pp. 470-475 and 491-496– Gold standard