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## IV. Economic Development and Economic Policies before WWI

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**IV. Economic Development and Economic Policies before WWI**Classical 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**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.2.1 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**E**N Y N**Aggregate demand**• Consumption function: • Investment function: • Governmental expenditure: G • Aggregate demand:**Equilibrium**Aggregate 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?**Equilibrium and real interest**Basic 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**r**r1 r0 r2 I(r)+G I+G, S+T**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**David Hume**• 1711 – 1776 • Philosopher, historian • 1752: Political Discourses, especially essay Of Money • Diplomat**The Quantity Equation**Total 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 exogenous then 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**The model**Labor 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 + Gdemand 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)**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 money Classical dichotomy, money is neutral**P**AS P0 M0V W0 W0/P0 Y0 W/P Y ND N0 F(K,N) NS N**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