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Solomou interwar recession

Economy goes through a serios recession in 1920-21. There remains a persistent output gap. Employment goest from 4% mean to 10% mean.

20-21 manufacturing production -22%, export -30%, GDP -10%, unemployment 22%

This had persistent effects. This is not a worldwide phhenomenon. World had a mild recession, but not as severe as in Britain. Some other countries had a stronger recession, so we can find the measures that were casudingthe repression.

There was a demand shock to the system - deflation and output contracts.

There was a policy regime change - contraction monetary policy and the return to the gold standard. We can get a depressionfrom a supply side shock, but the prices should rise, this is inconsistent with the date. There might have been S side shock, but they were overhelmed by demand side. Supply - hours of work change in 1919 - 50hour work week to 43.5 hour working day. Optimisation after the world war and firms gave in to the trade unions. Demand shocks ususally have short term effects. Suply side effects have permanent effect (new institutions). Recently it has been argued that the demand shocks can have permanent effects to.

Demand shocks

They are existent because of the comparative evidence.

1.      Gold standard. Skandinavian and British - fast transititon to gold standard. France, Belgium return to gold at a depresiated rate (over 20 years). Rest of the europe is not concerned about the transition, they had afterwar problems. Britain goes to restrictive monetary policy and stick with it. France had restrictive policy but it defeated that as soon as problems arose. In UK deflationary price expectations.

2.      Flexible exchange rates - restrictive interest rates. This graph is and equillibrium A with a given exchange rate. If rates rised and flexible exchnange rate - aprriciation of an exchange rate:

We would expectan appreciation, but actually it appreciated a lot - monetary theory overshoot. Different markets have different adjustment rates. Assets markets are quick, but goods markets have a number of rigidities. If the government makes announcement (1919) of restricive policy we have a quick adjustment B

So initially it overshoots and then adjust slowly downwards as IS shifts. That is exactly what we observe - biggest overvaluation in 1919-21. Overshooting has been observed in other areas with flexible exchange rates. Causality - monetary policy causes overshooting erate and contraction of export that leads to the fall in gdp.

Supply side

1       hour day with no reduction in wages. 30% real wage increase. Economy was not increasing so serios rise in wage costs. Wage gap arose. This is (Broadberry) the difference between wage costs and output. This erode after second world war. Real wages are measured by rpi. It should be deflated to producer wage cost. Deflate by gdp deflator. This is a producer deflator. That will elliminate the Broadberry longterm effects as the wage gap will be elliminated by 1922. So this is a short term proble. In longterm you must consider a lock in effects, like hysterisis.

Why do we get locked in to the lower GDP level?

1.      We have to expain the persistentce phenominon by oother factors besides wage gaps.

2.      One could argue that outsiders longterm unemployed will not participate in the labour force. Not much empirical evidence in long-term unemployment.

3.      Perhaps the overshooting and wage gap together make the UK to loose its trading position and competitiveness and will change the whole world trade partners. Once the competitors have set in to the UK they will not leave. One will have the same effect in other markets and an emprical evidence. Firms might have high setup costs so they will not leave UK market, instead will adjust their markups. Import ratios are an empirical evidence. 24% of GDP was now imported instead of 20%.

4.      Multiplier effect as well because leakages (M) increased so GDP decreased permanently.

5.      1918 lots of optimism and new investment. Lots of debts is taken out with near 0 real wage rate. AS economy deflated real interest rose and real debt burden shoot up. Empirical evidence in debt to income ratio 1.6 in 1913 to 2.8 in 1920's. In France infltation is eroding some of the debt.

6.      Leglistlation meant that UK migration was restricted. SO big shocks and limited adjustment.

So combination of both supply side and demand side lead to persistence.

Depression in 1930's

Defining the depression:

1.   Length - UK complicated as there was some evidence in 1928, 1929 was revival and then 1930-33.

2.   Amplitude - at the international level quite mild depression in 1930's. But it was quite strong depression (6%). In america -28% and Germany -16%. Both employment and Industrial Production also fall less in UK.

3.   Persistence - USA very strong persistence after the recession. In UK, economy closes the output gap, no persistence.


Consumption is actually rising in the recession, so it is not driving UK into depression. In USA it is the consumption that changed. Also government expenditure does not change. But export falls a lot. UK was an open economy, most trade with primary producing economies, their depression was very high. In 1928 there is a collapse in American overseas investment. Capital is redirected from primary producers to stock market boom.

So export led depression.

International transmission mechanism also explains the amplitude through the Credit Ansalt

Monetary shocks are controversial. It might be important. Early monetary shocks might arise because Britain was on gold standard. In 1928 Fed rises interest rates becasue thought that there was a bubble. Other countries had to respond, and UK raised interest rates and there was some monetary shock.

The monetary shockcaused IS curve to shift down. Thhis caused BoP problems and monetary repercussions came in in 1931. In 1931 government is trying to defend the gold standard and risees interest rates, but then the have to devalue and they exit from the gold standard.

In 1928 there are some xprt shocks, but they are more subtle. The services component is not doing too well and trade is falling. So there is a fall in export.

Why is the depression so mild?

Historically Brittain did not do very well in 1920's so we did not have much to fall. But Germany did not do very well in 1920's but had a long way to fall. So the state of economy before recessions do not define the amplitude. Countries having deep depression usually see a big financial collapse (half of the banks go bankrupt). In UK not a single bank went to bankruptcy.

Britain policy was to exit from the gold standard and major protectionist policies and very low interest rate. Countries that make the quick policy shift have smaller depression. USA defends the gold up to 1933.

In UK the size of aggiculture is very small. (5-6% of GDP). 20% in Germany and USA. Biggest shocks happen in Aggriculture. Prices halve. This sector is in serios depression.

Historical reason oflow 20's does not follow.

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