1. 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

2. 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.

3. 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

4. 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) Changing Expectations

8. 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

9. Labor market Real Wage = (1 + ω 1 )(MPL/MU c ) ω 1 = “Labor market markup”  regulations favoring labor Nominal Profits increase with “monopoly markup” = ω 2  Policies encouraging collusion between monopolistic competitors Always maximize profit Eggertsson’s Model With Distortionary “Wedges “

10. Solutions Flexible price solution: Cole-Ohanian Okay if Prices Flexible p = [θ/(θ – 1)] [W /(1 – ω 2 )] AS: (θ – 1)/θ = [(1 + ω 1 )/(1 – ω 2 ) ] MPL/MU c For efficiency, set markups to eliminate distortion owing to monopoly power of firms (1 + ω 1 )/(1 – ω 2 ) = (θ – 1)/θ Optimum is independent of i  M-policy ineffectiveness Sticky price solution (each firm’s prices fixed for random period) π = f(π e,expected output growth, policy wedge) Policy wedge = (1 + ω 1 )/(1 – ω 2 ) The greater the policy wedge, the greater is π and the greater is π e For efficiency… policy matters i = 1/β - 1

11. 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)

13. 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 What ended the Depression? Great Expectations and the End of the Depression

14. Hoover Gold standard Balanced Budget Small Government Tax increases to make up for loss of tax collection Government Policies (Dogmas) Roosevelt Elimination of the Gold Standard Reflation Low Real Interest Rates Government Deficit

15. 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

16. Roosevelt Regime: The Model

17. 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 Eggertsson’s Conclusions

19. 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.

20. 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

21. 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 Contractionary Spirals

22. “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