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Economic History, Part VII: A Lesson in Inflation and Monetary Policy



The above chart tracks the United States’ inflation rate since January of 2000 through February of 2011 taking monthly averages. The deflation experienced between 2009 and January of 2010 is believed by many to be explained by the Phillips Curve, which “represents the relationship between the rate of inflation and the unemployment rate” (Source A).

But what exactly is inflation?

According to Investopedia, inflation is the rate at which general level of prices for goods and services is rising and purchasing power is falling. Central banks attempt to stop severe inflation as well as severe deflation in an attempt to keep the excessive growth of prices to a minimum (Source B).

So, as you can tell by the chart, it looks like the inflation rate is relatively low with respect to 2006-2008 levels. With rising prices and an increasing need for consumers to cut back at home or search for substitutes, many are clamoring for lower prices. There are several different economic policies a government can enact to reduce inflation:

  1. Monetary Policy – Increase interest rates.
    1. Raises the costs of borrowing which leads to reduced spending.
    2. Increased interest rates makes saving a more appealing prospect.
  2. Supply Side Policies – Privatization and deregulation.
    1. Make firms more competitive and more productive to keep costs low.
    2. Works in the long run and won’t necessarily bring prices down today.
  3. Fiscal Policy – Tax policies.
    1. Increasing taxes and reducing government spending will reduce aggregate demand.

Naturally, there are many other policy options to be considered as everything seems almost inextricably linked in economics, but these will do for our purposes.

But what if the U.S. government decided to simply reduce the value of our money by 20% overnight? To put this in perspective, imagine that your $1 bills were now worth 80¢, your $5s worth $4, your $20s a mere $16 and so on and so forth. Well, this is essentially what happened in 18th century France.

Granted, the monetary regime in place at the time is not the same as ours today. In 1726 France, when these events took place, the government was using a variety of gold and silver coins which didn’t indicate a specific value, like our alternate fiat money. The intent behind the French government’s actions was to lower general price levels, which they thought were too high.

What the government didn’t anticipate, however, were the adverse effects it would have due to expectations. Once the value of their specie dropped, the people lost faith in the coins and held their wares as collateral against the expectation of further diminution. Goods were worth more than the money if there were further decreases in the value of the coins. Business owners had stocked up their inventory based off of yesterday’s prices, so selling them without increasing prices would, in fact, be counterproductive and harmful to their own well-beings.

A local official in Marseille described the situation from a more personal perspective, “the diminution has suspended all business and increased the prices of foodstuffs and merchandise. We never doubted that the first diminution would have this effect…all sensible people are convinced that the third diminution will begin to have some effect and progressively things will return into balance with specie, as long as all are convinced of the King’s firm and serious intention not to increase after the diminutions, It is up to the Court to see how it can persuade foreigners and the King’s subjects that this intent is serious, firm, and unwavering.”

This graph essentially describes what took place in France. First, the government reduced the value of the money. Output and commerce suffered significant setbacks and the aggregate demand curve shifted to the left to reach point B for a significantly longer period of time than was expected by the government. This was due to a combination of expectations that the value of the money was going to continue to fall and because of the contracts which hadn’t yet been renegotiated.

To support his proposition that a law be passed reducing all leases passed since January 1720, the mayor of Nantes said, “In vain would one ask merchants to cut the prices of their wares by a third if one does not reduce by a third the leases on their shops.”

Only after the government finally came out and set an official price did France undergo market clearing and the economy reach point C on the long run aggregate supply curve, as indicated by the arrows.

So inflation, it turns out, has a great deal to do with expectations. Business owners might, for example, anticipate that transportation costs are going to increase due to rising oil prices and bring up their prices. Before you know it, all costs and prices might go on the rise, all due to expectations. Something to be careful of, however, is that history shows that prices are much easier to increase than they are to bring down.

Sources:

Source A: http://www.econlib.org/library/Enc/PhillipsCurve.html

Source B: http://www.investopedia.com/terms/i/inflation.asp

Source C: http://www.econtalk.org/archives/2009/02/meltzer_on_infl.html (podcast)

Source D: Chart Source http://www.tradingeconomics.com/economics/inflation-cpi.aspx?Symbol=USD

Source E: http://www.frbsf.org/publications/economics/letter/2009/el2009-12.html – philips curve

Source F: Policy http://www.economicshelp.org/blog/inflation/economic-policies-to-reduce-inflation/

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Posted by on April 12, 2011 in Economic History

 

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Economic History II: The Great Depression, Fiscal Policy, and the Financial Crisis of 2007

The Great Depression, Fiscal Policy, and the Financial Crisis of 2007

Click here to be taken to Part I if you haven’t read the introduction.

To this day, the Great Depression (1929-1939) remains one of the most fascinating periods of study to historians, political scientists, and economists. Despite extensive studies, however, there remains much about this time period which yet eludes us.

This serious drag in the country’s economic performance can be attributed to several events, many of which are interrelated. To begin, there was the Stock Market Crash of 1929—a product of inflated confidence in the market through most of the 1920s—which led to an approximate loss of $40 billion. Incidentally, some of the banks had fallen prey to these very same traps and lost the money they themselves had invested into the stock market. These events led to subsequent bank failures all throughout the country as debtors became unable to repay their debts. Economic growth and recovery were essentially brought to a grinding halt as the surviving banks became more cautious in their lending practices, leading to reduced expenditures and a decreased money supply (Anari, P.676). This was, in essence, a crisis of confidence.

Consumer spending was in decline, which meant there was less demand for goods in general, which led to businesses decreasing factory inputs, spurring the country’s annual unemployment rates to new heights.

When peoples’ standards of living are at stake, they expect their government to step up and take action. It was no secret how the public was dissatisfied with the president, Herbert Hoover’s, performance as the shantytowns were referred to as Hoovervilles and the newspapers used to shelter the homeless from the cold Hoover Blankets.

Hoover’s unsuccessful policies ushered Franklin D. Roosevelt into the office of presidency, a position he would hold on to for 12 years. In contrast with his predecessor, Roosevelt wasted no time in enacting his New Deal Programs. Here are some examples of how his administration tackled the problem of the day:

  1. To counter unemployment:
    1. 1933, Public Works Administration (PWA). Large-scale public works projects. Six billion dollars. Airports, dams, aircraft carriers, schools, hospitals.
    2. 1933, Civilian Conservation Group (CCC). Public works projects.
    3. 1933, Civil Works Administration (CWA). High paying jobs in construction.
  2. To combat the housing crisis:
    1. 1933, Home Owner’s Loan Corporation (HOLC). Services to refinance homes. One million people received long term loans.
    2. 1934, Federal Housing Administration (FHA). Regulated mortgages and housing conditions.
  3. Poverty upon retirement:
    1. 1935, Social Security Act (SSA). Still active. Addresses poverty among retired, wage-earning senior citizens.

The list continues, but you get the point. Essentially, Roosevelt was a president of action and direct intervention and, as a result, his popularity soared. But how successful were his efforts? Did these programs help dig the country out of its dire situation, or can the recovery be attributed to something else? How does this compare to our current financial crisis and can we learn anything from this?

P. 676 Ali Anari

The above graphs indicate exactly how rough the times were. Industrial production hit an all time low due to a combination of decreased demand, money supply shocks, and the rise in unemployment rates (Anari, p.770). As is shown on the graph, the recovery from the Great Depression began around 1934 with the U.S. economy reaching new heights upon the country’s involvement in World War II, when the economy returned to full employment (Romer P.758).

Studies conducted on the recovery, however, suggest that the New Deal was not necessarily the engine of recovery itself, but as something which cleared the way for a natural recovery (Romer P.758). In fact, many postulate that the greatest result of these policies seems to be the resurging strength of the federal government.

So flash forward about 80 years to today’s current financial crisis. Can we link the effects of the aggregate-demand stimulus of the recovery from the Great Depression to the government bailouts in 2007 and the years following?

Definitely.

The Federal Reserve Board invoked the same authority it had invoked in 1932 to aid in the stabilization of firms through monetary aid, which allowed the Fed to rescue AIG through loans, a move which is controversial to this day (Posner, p.1613 and 1629). Through the Emergency Economic Stabilization Act of 2008, the Treasury was granted $700 billion to buy mortgage-related assets along with many additional powers to deal with the crisis (Posner, p.1614).  After the fall of the Lehman Brothers, the government “began pumping liquidity into the system at unprecedented levels” in the hopes of bolstering confidence in the markets (Bartlett, A25). The financial institutions receiving government aid include, but are not limited to, automakers, banks, saving associations, credit unions, insurance companies, etc. (Bartlett, p.1633).

The government did not stop there either. Immediately upon being elected into office, President Obama began working towards securing stimulus money, accomplishing this in early 2009 (NY Times, Economic Stimulus). But has the $819 billion stimulus package requested by President Obama and passed by Congress helped or hurt us? (Yourish, Washington Post). The following is a breakdown of the tax cuts and the program’s intended recipients:

Data from NY Times

Economists have reported that the administration’s actions led to a decrease in taxes for most Americans (NY Times, Economic Stimulus). In early May of 2009, however, it was estimated that the package fell short of the administration’s optimist forecast of unemployment peaking at 8.5% and was estimated to have saved only 150,000 jobs of the promised 600,000—unemployment surpassed 10% at one point but dropped to 9% in January 2011 (Bureau of Labor Statistics). Other benefits include an increase in the rate of home sales, tax cuts to small businesses, and increased infrastructure spending similar to Roosevelt’s plans.

Much like Roosevelt’s New Deal, perceptions of the stimulus package’s effectiveness are wide-ranging and many. It is almost universally agreed, however, that the government’s actions, while not insignificantly increasing the country’s deficit, helped stem some of the worst consequences of the crisis. Economic optimism and activity have increased in recent months but perhaps all that remains now is hoping that Adam Smith’s “Invisible Hand”, the argument that free enterprise and self-interest benefit society when transactions are voluntary to both parties, proves true and that the economy arrives at optimal levels of employment and economic prosperity (Narveson, p.201).

This is not an examination of which political party’s ideologies are correct, but more so an exploration into the effectiveness of policy in times of economic crises. My data is specific to the time period of the Great Depression and our most recent circumstances, so any conclusions I would come to would be moot in the grander scheme of things, but that does not mean that there isn’t much to learn from the subject matter I have brought to light.

 

Sources:

Anari, Ali. “Bank Asset Liquidation and the Propagation of the U.S. Great Depression.” The Wharton Financial Instiutions Center.

Bartlett, Bruce. The New York Times. “How to Get the Money Moving. Dec. 24, 2008.

Narveson, Jan. “The Invisible Hand.” Journal of Business Ethics, Vol. 46, No. 3.

The New York Times. “Economic Stimulus.” Times Topics. Dec 15, 2010.

Posner, Eric A. “Crisis Governance in the Administrative State: 9/11 and the Financial Meltdown of 2008.” The University of Chicago Law Review

Romer, Christina D. “What Ended the Great Depression?” National Bureau of Economic Research, Inc. .

Yourish. The Washington Post.

http://americanhistory.about.com/od/greatdepression/tp/new_deal_programs.htm

 


 
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Posted by on April 2, 2011 in Economic History

 

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