Catastrophic Collapse of Investment and the Great

Depression

Robert Barsky

Miles KimballUniversity of Michigan and NBER

Very preliminary discussion prepared for seminar at Michigan, April 11, 2007. Please do not circulate.

Executive Summary: Model• Study Great Depression in standard New

Keynesian sticky price model with capital• Provides interesting synthesis of:

– Consensus monetary view of Depression emanating from Friedman and Schwartz

with– Earlier arch-Keynesian real theories based on

collapse of investment, building cycles, “floors and ceilings”, self-fulfilling prophecies, etc.

• Has elements of the nonlinear, catastrophe-theoretic development of the latter by Hicks, Kaldor, Goodwin, Kalecki, Varian, etc. but– Money remains the driving variable– Model is modern, recognizable, and totally standard

Executive Summary, cont. Empirical Facts

• Gross Investment really did collapse essentially to zero

• Sharp drop in wage bill – Indicates sharp decline in rental rates on capital

• Strongly deflationary environment with very high real interest rates until 1933

• Then sharp turn towards inflation, low real rates• Rental rates and investment didn’t show strong

recovery until at least 1935

Bottom Line Explanation of Depression and Recovery

• Very high real rates confronted low rental rates on capital – Former due to tight money and deflation– Latter due both to low output and possibly high

inherited capital stock

• This lead to complete investment collapse, apparently hitting between 1931 and 1932

• Turn toward inflation in 1933 plus depreciation of capital eventually reignites investment, but wasn’t enough to do it quickly

Elements

• NRR curve – net rental rate on capital

• MP curve – real interest rate as function of output– Easiest case: LM curve from constant

elasticity money demand function

• Phase diagram to endogenize inflation

When and Why Did Investment Leave Great Depression Models?

• Friedman and Schwartz– Persuasive – Highly aggregative; no discussion of components of

GNP– Emphasis on why money stock collapsed, not how it

caused fall in output

• Temin– Pointed out drop of gross investment to near-zero in

1932 but– Found autonomous fall in consumption, not

investment (don’t confuse impulse with propagation!)

• Bernanke a partial exception– But emphasis is on financing, not implications of

investment per se

The Net Rental Rate

•r=R-δ •N=Y1/γ(1-α)K-α/(1-α)Z-1 (IRTS Cobb Douglas production function)•RK/WN=α/(1-α) (constant cost shares )•W=–UN/UC = W(N(Y,K,Z),λ) (labor

supply)

•Rental Market for Capital (no adjustment costs, investment smoothing)•Rental rate R = “marginal cost product of capital” (sticky prices, demand-constrained

Y

r

The Net Rental Rate Curve

r=0–

NRR

Ymin

(I=Imin)

Note: Curve would be steeper if elasticity of substitution between K and L were less than unity

•Recall that both N and W are increasing in Y

Here gross investment is zero (or at some fixed minimum)

•Low Y → low of Investment

Wage Bill

700

750

800

850

900

950

1000

1925 1930 1935 1940 1945

TOTWAGESAL/DEFLATOR

Total Real Wage and Salary Payments

•Capital essentially fixed over short period•Indicator of Net Rental Rate

Gross Investment CollapseGross Investment Collapse

0

5

10

15

20

25

30

35

24 26 28 30 32 34 36 38 40 42 44 46

GROSSCAPFORM_REAL

-8

-4

0

4

8

12

24 26 28 30 32 34 36 38 40 42 44 46

NETCAPFORM_REAL

2

4

6

8

10

12

14

24 26 28 30 32 34 36 38 40 42 44 46

New Manufacturing Capital Expenditure, Real

Gross Investment Collapse: Building Index and Building Permits

0

50

100

150

200

250

300

1925 1930 1935 1940 1945

BUILDING_TOT_INDEX

0

100

200

300

400

1925 1930 1935 1940 1945

Building Permits, Chicago

0

40

80

120

160

200

1925 1930 1935 1940 1945

BUILDPERM_SC_IND

0

40

80

120

160

200

1925 1930 1935 1940 1945

BUILDPERMIT_REAL

Y

r Multiple Short Run Equilibria

MP

–πe

r=0–

Ymin

(I=Imin)

Ynatural

NRR

Selection Criterion: Stay put unless the equilibrium you are at disappears

Depression: Predisposing Factors From 1920s

• Low inflation or deflation (Makes MP curve high)

• Technology revolution• “Overbuilding”? (Makes NRR curve low)

-“liquidationist" viewpoint– Long expansionary period– Easy money?

– Over-optimism about growth rates?

Y

r Unexpected Monetary Contraction

MP

–πr=0–

Ymin

(I=Imin)

NRR

Y

r Expected DeflationMP

–πr=0–

Ymin

(I=Imin)

Ynatural

NRR

Y

r Hysteresis: A Monetary Restoration May Not Restore the Original Equilibrium

MP

–πr=0–

Ymin

(I=Imin)

Ynatural

NRR

Y

r Further, Modest Monetary or Fiscal Expansions Provide No Escape

Ymin

(I=Imin)

MP

–πr=0–

Monetary Expansion Shifts MP Right or Down

Fiscal Expansion Shifts Ymin Right

NRR

Y

r An Escape by Monetary Policy Alone Can Cause a Jump Above the Natural Level of Output

MP

–πr=0–

Ymin

(I=Imin)

Ynatural

NRR

Y

r The Skillful Way Out Involves a Monetary Restoration Plus a Fiscal Expansion

MP

–πr=0–

Ymin’=C+Imin+G’ Ynatural

NRR

Endogenizing Inflation: The Phase Diagram in the Neighborhood of the Steady State in the Absence of an Investment Collapse

x (real moneybalances)

steady-stateinflation

dx/dt =0

dπ/dt =0 π=0(different positions possible)

π

The Phase Diagram with Coexisting Blue (Normal) and Red (Depression) Dynamics Shown

x (real moneybalances)

steady-stateinflation

dx/dt =0

dπ/dt =0 π=0(different positions possible)

Collapse Boundary

π

ReignitionBoundary

The Phase Diagram with Only the Blue (Normal) and Red (Depression) Saddle Paths Shown

x (real moneybalances)

steady-stateinflation

dx/dt =0

dπ/dt =0 π=0(different positions possible)

Collapse Boundary

π

collapse values of x

ReignitionBoundary

Assume log money follows random walk with constant drift

Lessons From Phase Diagram• Nonlinearity

– Need sufficiently large monetary expansion to get to the reignition boundary

– Nothing happens to investment and output until then

• Hysteresis – Dynamics depend on where you start from – Probably need inflationary boom to reach reignition

region

• Mundell and Keynes effects – Keynes effect will restore full-employment in long run– Low but rising inflation means Mundell will eventually

switch from harmful to helpful

Using a Fiscal Expansion to Shift the Reignition Boundary

x (real moneybalances)

steady-stateinflation

dx/dt =0

dπ/dt =0 π=0(different positions possible)

Collapse Boundary

π

collapse values of x

ReignitionBoundary

•Moves boundary to left of of p-dot=0 locus

•Avoids need for inflationary boom