1. The Great Depression in the United States From A Neoclassical Perspective Harold L. Cole and Lee E. Ohanian By Alex Macri

2. O&C are interested in explaining the weak recovery during the Great Depression According to neoclassical theory, the period’s significant increases money supply total factor productivity, and the elimination of deflation and bank failures, output levels should have returned output to trend around 1936. In reality, output remained 25%-30% below trend throughout the 1930’s. O&C embark upon a quest for possible explanations.

3. Working in reverse, they explore a number of shocks which can account for the failure of output to return to trend and contrast the theoretical results with historical reality. The following shocks and their respective analysis follows: Technology Shocks: Shock that reduces the productivity of capital and labor. Prescott(1986) has found this shock to account for 70% of postwar business cycle fluctuations.

4. Cobb Douglas function assumes production function was in steady state in 1929. Assume labor grows at 1.0% and technology at 1.9% per year Cobb Douglas plus models for output predicts a smaller decline in 1929-1933 output then the decline that actually occurred. Output should have returned to trend by 1936 per model. It actually remained below trend by 25%

5. O&C attempt to explain the 25% disparity by correcting for the fact that in their model falls less than in the actual data. (their model may underestimate the loss of capital stock which actually occurred during the Depression.) To address this they use the actual capital stock available in 1934 which is 20% below trend. With this correction, output should have returned to trend by 1937. It did not.

6. Fiscal Shocks: Christiano and Eichenbaum (1992) argue that government is a significant explanatory variable in postwar recoveries Braun (1994) and McGrattan (1994) argue that tax shocks also fit the bill. Government reduction in purchases increases private consumption and increases leisure. The converse also holds. After 1933, Government expenditure increased by 12% above trend for rest of decade. Consumption should have increased. It did not.

7. Taxes rates essentially stayed the same during 1929-33 but increased for the rest of decade. From 3.5% to 8.3% on labor and from 29.5% to 42.5% on capital. Feeding this into the model labor input falls by 4% and only 20% of the weak recovery is explained. Trade Shocks: Tariffs caused world trade to fall 65% b/w 1929- 1932. Did they account for the 1929-1933 output decline? Lucas(1994) argues that trade was such a small share of US output during this period that it could not possibly have any explanatory relevance.

8. Crucini and Kahn (1996) argued that many of the imports were intermediate inputs which could not be readily substituted with domestic equivalents. This could lead to production disturbances. O&C do not find evidence that import elasticity of substitution was very low, but even if it was, it would have only taken a short time for domestic producers to adjust; shorter than the decade long recession. Trade Shocks therefore do not account for output deviation from trend during the recovery.

9. Monetary Shocks: Many economists including Friedman assert that declines in the supply of the money stock have preceded declines in output for a century in the US. O&C provide data tables which support the assertion that a large decline in M1 preceded the 1929-33 decline. They also provide data tables which show that the real money stock fell >> then the nominal money stock. The variation in real money stock is consonant with the variation in real output. This indicates money non neutrality, which is in turn indicative of some mechanism that prevents nominal prices from changing in sync with money supply.

10. The business cycle theory needs to demonstrate this interference with an equilibrium outcome. Lucas and Rapping (1969) and Lucas (1972) models attempted to do this. Their model’s cyclical fluctuations are explained by leisure/labor substitution and unexpected changes in wages. If real wages are high, workers opt for less labor and vice versa. Rapid decline in money supply led to real wage falling below expected level in 1930. Workers chose more leisure. This could account for the decline in output during 1929- 1933.

11. For the rest of the decade the real wage was at or above expected levels. This should have resulted in less leisure and more production returning output to 1929 level. This did not happen. The Fisher debt deflation model which transfer nominal wealth from debtors to creditors; the real wealth is higher in deflation which benefits the creditor in real terms. Debtors’ decrease in net worth leads to lowered borrowing, business expansion and consumption rates. This could partly explain the 1929-1933 decline (qualitatively). The quantitative aspect for the recovery period remains unchartered.

12. Intermediation Shocks: Building on Lucas Rapping (1969) Bernanke (1983) found statistically significant evidence that bank failures lead to negative changes in output. The problem with this conclusion is that at least some of the bank failures may have been endogenous to the model. O&C find that the real output reduction (1929-1933) attributable to finance, insurance and real estate = 4.7%. O&C find low loss of output due to intermediation

13. Reserve Requirements: Fed increased them from 10% to 15% in 08/1936 to 17.5% in 03/1937 to 20% in 05/1397. Some attribute weak recovery to these increases via reduced lending. But output rose by 12% during the period in question. The second downturn started in 10/1937 or 14 months after first increase in reserve requirements. interest rate increases were very small and transitory during this period and for the rest of the decade.

14. It is therefore questionable that increased reserve requirements can explain the weak recovery. Inflexible Nominal Wages: Nonmanufacturing wages fell 15% between 1929 - 1933 and remained 10% below trend in 1939. Manufacturing wages rose above trend between 1929-1933 and were 16% above trend by 1939. O&C have reservations that monetary illusion and nominal contracts can explain this weak

15. recovery. Inflexible Nominal Wages: Nonmanufacturing wages fell 15% between 1929 - 1933 and remained 10% below trend in 1939. Manufacturing wages rose above trend between 1929-1933 and were 16% above trend by 1939. O&C have reservations that monetary illusion and nominal contracts can explain the extent to which wages remained above trend

16. O&C find a possible answer to the weak recovery in the cartelization of the US manufacturing sector. This arose out of the creation of the NIRA Individual firms could not set prices below cartel established floors If they did other cartel firms would exert pressure and the NIRA chief would publicly berate the “offending” firm Manufacturing wages were set in the same political/administrative manner.

17. O&C postulate that qualitatively this shock seems promising in explaining why output was so much and so consistently below trend from 1934-1939. O&C conclude by stating that they are currently in the process of researching and quantifying the NIRA shock to employment, investment, consumption, output and wages.