Good to add IS/LM Model here
World Economy – Great Depression (B)
Transmission of crises in an integrated world
• In an open economy, net exports are an element of AD (not in IS-LM). If a trading partner
experiences recession, demand for exports falls and AD falls.
• GS made things worse (Eichengreen 1992, Eichengreen and Temin 2000). Temin also argued
the spread of the financial crises is due to the GS.
• Led to greater protectionism in the world economy.
• Governments couldn’t use traditional monetary or fiscal policies.
Effect of the US Depression on the BoP of European countries
• US became the lender of the world, with American capital flowing into France, UK, Germany
(gross capital inflow from US=5%)
• US depression: US capital stops flowing to Europe AND exports to USA fell. Fall in BoP capital
account. BoP deficit.
Under a floating exchange rate scheme:
• e/r would be allowed to fall
• decrease in price of exports in terms of foreign currency AND increase in price of imports in
terms of home currency.
• CB free to pursue expansionary monetary policy.
Instead, in a fixed e/r system, prices eventually have to fall to balance BoP.
• Implements contractionary MP by raising IR
• Makes exports more competitive (boosts exports BUT imports suffer). Leads to deflation.
Sterilisation – Country pursues tight MP to attract gold reserves
• Decreases the world stock of gold, hence the world monetary mass under GS
Why?
• Under GS money supply is a FUNCTION OF GOLD STOCK
• Countries with a lot of gold should pursue expansionary MP to allow for gold to flow back
into other countries.
Forces other countries to pursue contractionary MP to keep their stock of gold secure.
USA and France were main gold hoarders. Frances share of gold reserves increased from 7% to 27%
between 1927 and 1932.
• Share of gold in UK falling – harder to keep value of £ in terms of gold
• USA had a lot of gold – could’ve implemented expansionary MP
Another transmission channel (Temin)
Wave of financial crises in 1931, transmitted from country to country AKA BANK RUNS.
• May 1931: bank run on the Credit Anstalt (people wanted their money back in cash)
• Banking crisis then spread from Austria to Hungary, Germany and other European countries.
THEN it spread to USA.
How they spread:
• Contagion of fear
• Purchase of assets by foreigners
Logic of GS prevents CB to lend to banks in distress:
• CB should lend money to banks to stop bank runs BUT CAN’T BE DONE UNDER GS
World Economy – Great Depression (B)
Transmission of crises in an integrated world
• In an open economy, net exports are an element of AD (not in IS-LM). If a trading partner
experiences recession, demand for exports falls and AD falls.
• GS made things worse (Eichengreen 1992, Eichengreen and Temin 2000). Temin also argued
the spread of the financial crises is due to the GS.
• Led to greater protectionism in the world economy.
• Governments couldn’t use traditional monetary or fiscal policies.
Effect of the US Depression on the BoP of European countries
• US became the lender of the world, with American capital flowing into France, UK, Germany
(gross capital inflow from US=5%)
• US depression: US capital stops flowing to Europe AND exports to USA fell. Fall in BoP capital
account. BoP deficit.
Under a floating exchange rate scheme:
• e/r would be allowed to fall
• decrease in price of exports in terms of foreign currency AND increase in price of imports in
terms of home currency.
• CB free to pursue expansionary monetary policy.
Instead, in a fixed e/r system, prices eventually have to fall to balance BoP.
• Implements contractionary MP by raising IR
• Makes exports more competitive (boosts exports BUT imports suffer). Leads to deflation.
Sterilisation – Country pursues tight MP to attract gold reserves
• Decreases the world stock of gold, hence the world monetary mass under GS
Why?
• Under GS money supply is a FUNCTION OF GOLD STOCK
• Countries with a lot of gold should pursue expansionary MP to allow for gold to flow back
into other countries.
Forces other countries to pursue contractionary MP to keep their stock of gold secure.
USA and France were main gold hoarders. Frances share of gold reserves increased from 7% to 27%
between 1927 and 1932.
• Share of gold in UK falling – harder to keep value of £ in terms of gold
• USA had a lot of gold – could’ve implemented expansionary MP
Another transmission channel (Temin)
Wave of financial crises in 1931, transmitted from country to country AKA BANK RUNS.
• May 1931: bank run on the Credit Anstalt (people wanted their money back in cash)
• Banking crisis then spread from Austria to Hungary, Germany and other European countries.
THEN it spread to USA.
How they spread:
• Contagion of fear
• Purchase of assets by foreigners
Logic of GS prevents CB to lend to banks in distress:
• CB should lend money to banks to stop bank runs BUT CAN’T BE DONE UNDER GS
