The Factors in the Drastic Money Supply Drop from 1929 to 1933

In Jeff Hummel’s Monetary Theory and Policy class recently, he assigned an interesting computational problem that shed light on the main factors driving the drop in the U.S. money supply between 1929 and 1933. He used a problem from Greg Mankiw’s Intermediate Macro text. The problem didn’t give magnitudes but I assume everything was in billions of dollars.

The money supply was $26.5 billion in 1929 and $19.0 billion in 1933. That’s a drop of 28 percent.

Here was the first question. What would have happened to the money supply in 1933 if the currency-deposit ratio had risen the way it did but the reserve-deposit ratio had remained constant? (The c/d ratio rose because people tried to convert their demand deposits to currency; the r/d ratio rose because banks were trying to have reserves available for people trying to convert their demand deposits to currency. Both factors caused the money supply to fall.)

M = (cr + 1)/(cr + rr) times B,

where M is the money supply,

B is the monetary base = currency held by the public (C) plus bank reserves (R)

cr is C/D, where D is demand deposits

rr is R/D.

In August 1929,

C = $3.9 billion

D = $22.6 billion

B = $7.1 billion

R = $3.2 billion.

To make sure the formula worked, I plugged the numbers in for August 1929.

cr = C/R = 3.9/22.6 = of 0.17

rr = R/D = 3.2/22.6 = 0.14.

So plug and chug.

M = (0.17 + 1)/(0.17 + 0.14) times 7.1

= 1.17/0.31 times 7.1

= 3.8 * 7.1

= 27.0 (close enough)

By 1933, cr had risen to 0.41 and rr had risen to 0.21.

So if rr had stayed at 0.14, the only other thing we need to know is B in 1933. That was $8.4 billion.

So M would have been (0.41 + 1)/(0.41 + 0.14) times 8.4

= 1.41/0.55 times 8.4

= $21.5 billion.

In other words, rather than falling from 26.5 to 19, the money supply would have fallen to 21.5.

Next question:

What would have happened to the money supply if the reserve–deposit ratio had risen but the currency–deposit ratio had remained the same?

R/D rose to 0.21. Assume C/D stays at 0.17.

Then M = (0.17 + 1)/(0.17 + 0.21) times 8.4

= 1.17/0.38 times 8.4

= 3.08 * 8.4

= $25.9 billion.

So the money supply would have fallen from 26.5 to 25.9, a drop of only 2.3 percent.

In part (c), which mattered more? The increase in the currency/deposit ratio.


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Alan Blinder’s Tin Ear on Inflation

I’m taking Jeff Hummel’s Masters’ course in Monetary Theory and Policy. Two lectures ago, he discussed the costs of inflation and highlighted Greg Mankiw’s discussion of it in Greg’s Intermediate Macro text. Greg covered many of the bases but the tone of his treatment suggests that he doesn’t think high inflation, even when it exists, is much of a problem. He compares the views of the public and the views of economists on the issue and finds the views of the public deficient.

Jeff disagreed and highlighted three areas that Greg left out. One is that inflation presents a “signal extraction” problem, making it difficult for people to know whether and by how much relative prices have changed. The second is that high inflation virtually always tends to be variable, and for a given mean inflation rate, variable inflation is more destructive than constant inflation. The third is that inflation is a tax. Greg dealt with that issue but focused on the deadweight loss from the tax rather than the DWL plus government revenue from the tax. When you look at how non-economists think about other taxes, you see that they care about the fact that the government is getting revenue from them. That seems like a reasonable concern, whether the revenue generator is a sales tax or an inflation tax.

Greg did note that inflation creates apparent capital gains (I call them “phantom gains”) that are not gains at all. You buy a stock for $100, inflation is 10%, you’re in a 20% capital gains tax bracket, the stock holds its real value at $110 a year from now, you sell the stock for $110, and you pay $2 in capital gains tax. You’re left with $108, which, inflation-adjusted, is worth $98.18, which is less than what you paid for it a year ago.

I assume that Greg focused on the capital gains tax rather than income taxes because Reagan and Congress, in the Economic Recovery Tax Act of 1981, implemented indexing of tax brackets for inflation, effective in 1985. But there are a few things to note. First, other things besides the capital gains tax are not adjusted for inflation. The thresholds after which you pay taxes on your Social Security income have not been adjusted for inflation in 3 decades. Second, the income cutoff beyond which you can’t contribute to a Roth IRA is not adjusted for inflation. Third, many state governments have not adjusted their tax brackets for inflation.

The discussion in class reminded me of two people. The first is Princeton University economist Alan Blinder.

Blinder, even more than Greg Mankiw, missed people’s upset about inflation in his 1987 book, Hard Heads, Soft Hearts. I reviewed it in Fortune, November 9, 1987. Here’s part of what I wrote on the issue.

In discussing employment and inflation, Blinder says we worry too much about inflation. He estimates that for every percentage-point reduction in the inflation rate, we must accept a two point or so increase in the unemployment rate for one year. Blinder says that is too high a price to pay, and launches into an argument about the true cost of inflation, which, he says, noneconomists tend to exaggerate. If inflation is running at an 8% rate while real wages are rising by 2%, people’s money wages will increase by 10%. The noneconomists among them will attribute the whole 10% gain to their own increased productivity [DRH note: I’m not sure he’s right; I never met this mythical non-economist] and will feel that inflation robbed them of the other 8%. They weren’t robbed at all, Blinder argues: 2% is all they were entitled to, and 2% is what they got.

That argument is incomplete, however. Before 1985 people were being robbed because individual income taxes were not indexed: Inflation kept bumping people into higher margin tax brackets, thus enabling the Treasury to steal some of the income they were entitled to. Blinder acknowledges this difficulty and says at one point that a failure to index the tax system can impose “sizable costs.” But then he turns around and says that unless you are an economist or accountant, this cost “will leave you yawning.”

Where was Blinder during the late 1970s? I knew people with only a high school education who noticed instantly that an 8% increase in their hourly rate translated into only a 6% or so increase in their take-home pay, not enough to stay abreast of inflation. They didn’t yawn when that happened–they got mad, which is one reason taxes ended up being indexed.

By the way, in writing this, I had in mind a discussion I had with a high school graduate named Chrissy Morganello, who was a secretary to three other faculty members and me from 1975 to 1979, when I was an assistant professor of economics at the University of Rochester’s Graduate School of Management.

Here, by the way, is Blinder’s first rate article on “Free Trade” in David R. Henderson, ed., The Concise Encyclopedia of Economics.

Next up: Alice Rivlin’s blasé attitude about high inflation in the 1970s.





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Hummel on Posner and Garrison on Keynes

I followed a recent email discussion about Judge Richard Posner’s 2009 article in the New Republic in which he tried to revive John Maynard Keynes’s contributions to macroeconomic understanding.

Jeff Hummel, as per usual, had some cogent comments:

I read this and found it somewhat interesting. Posner does a fairly good job explicating Keynes’s General Theory (although I think I did a more persuasive job of making Keynes’s theories plausible when I taught intermediate and graduate macro). But except for Posner’s complaints about mathematics and his emphasizing the distinction between risk and uncertainly, I think he was quite unfair to mainstream economists. Posner is obviously grossly unfamiliar with the actual views of mainstream macroeconomists . For example, a fall in money’s velocity is precisely equivalent to what Keynes means by hoarding or passive saving, and nowadays nearly all macro and monetary economists, including even Austrians such as George Selgin, Lawrence H. White, and Steve Horwitz accept that negative velocity shocks can cause recessions. Almost the only major features of Keynes’s theory that aren’t incorporated in New Keynesian approaches are an interest-inelastic consumption function, full price rigidity, and a self-generating deflationary cycle.

I still consider the best exposition of Keynes’s views is in Roger Garrison’s Time and Money: The Macroeconomics of Capital Structure. It is the only exposition I’ve seen (I haven’t read Skidelsky) that shows how the more socialist parts of The General Theory smoothly integrate with the rest of Keynes’s views. Garrison also offers one of my favorite quotations about Keynes, not in his book, but in an article. He writes that Keynes argued:

Wage rates (1) will not fall because of unions or wage rigidities inherent in the market process, or (2) will fall but without making matters any better and possibly making matters worse because of the accompanying fall in the price level, or (3) should not be allowed to fall because of considerations mentioned in (2).

And then in a footnote, Garrison adds:

Keynes appears to be adopting a strategy usually confined to the legal profession: “My client didn’t borrow your urn; it was in perfect condition when he returned it: and it was already broken when you lent it to him.

See Keynes’s bio and Keynesian Alan Blinder’s entry on Keynesian Economics in The Concise Encyclopedia of Economics.


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