Tuesday, March 25, 2008

Mankiw On Current Recession

Prof. Mankiw reminds us of the difference between the Great Deflation of the 1930s and the current recession. Let me sum him up shortly.

He says that the two effects of falling prices on economy:

(1) Falling prices bring the economy to the equilibrium

(a) An increase in M/P

For any given supply of money M, a lower price level implies higher real money balances M/P. An increase in real money balances leads to higher income.

(b) The Pigou effect

Falling prices increase real money balances and consumers should feel wealthier and spend more. This increase in consumer spending should cause higher income.

(2) Falling prices don't bring the economy to the equilibrium

(a) Debt-deflation theory

The unanticipated changes in the price level redistribute wealth between debtors and creditors: unexpected deflation enriches creditors and impoverishes debtors.

This redistribution of wealth affects spending on goods and services. In response to the redistribution from debtors to creditors, debtors spend less and creditors spend more. It seems reasonable to assume that debtors have higher propensities to spend than creditors, and then debtors reduce their spending by more than creditors raise theirs. The net effect is a reduction in spending and lower national income.

(b) An decrease in expected inflation

People's expectation that the price level will fall in the future leads to a negative expected inflation, πe. The real interest rate is now higher at any given nominal interest rate.

Approximately expressed,

(Real interest rate) = (nominal interest rate) - (expected inflation)

This increase in the real interest rate depresses planned investment spending and national income because when firms come to expect deflation they become reluctant to borrow to buy investment goods because they believe they will have to repay these loans later in more valuable dollars.

The fall in income reduces the demand for money, and this reduces the nominal interest rate that equilibrates the money market. The nominal interest rate falls by less than the expected deflation, so the real interest rate rises.

Mankiw says that most economists believe that the mistakes that led to the Great Depression are unlikely to be repeated. Is that true?

I don't think so. Even though the Great Depression is unlikely to be repeated again, we cannot say that our economy is also unlikely to undergo a recession.

As Mankiw says, many economists believe that the Great Deflation was responsible for the depth and length of the Depression and the presence of a falling money supply. Right, but can the Fed always control money supply? That's the question. Remember that the Fed can control only base money(currency+deposit), but not money supply.

How the Fed should control or affect money supply is a basic question in monetary macroeconomics left at our hands.

The link:
Greg Mankiw's Blog: 2008 = 1929?


FrostFire said...

I noticed his ariticle before your presenting this post. This is a topic intriguing me since I began to learn some macroeconomics. I am interested in the topic not for the Great Depression happened 80 years ago in US but for the long-lasting slump in Japan. In fact, though US suffered from a deflation in 1930s, however, it did not last so long: the inflation rate became positive shortly after Roosevelt's New Deal, miraculously! As a result, US did not experience what we observe in Japan: a liquidity trap. It is really surprising that Japan's interest rate has been maintaining near zero, such a low level, for that long. Some economists put the blame on the drasticly strengthening of Japanese yen during 1970s to 1980s, which, as they point out, distorted Japan's domestic nominal wages, which in turn depressed Japan's domestic price level and put Japan into a liquidity trap. it seems that in this case it is the fall of wages that eventually depressed the prices. Recently, I suddenly got a feeling: the world exactly acts in a quite different way as what I learned from macroeconomics. In the macroeconomics system, economists try to come up with a logical chain like this: A changed, which caused a change in B, which in turn induced a change in C, which ..., which eventually resulted in the change in Z. You see, the mechanism we learned is like this. But I think the world per se acts in a way that cannot be described in a chain form. It must act in a more complicated way.

I always think the macroeconomic system is very much similar to the systems examined in thermal physics. First, both sort of system have a series of "state variables" for describing the state of the system. In thermal physics, they are temperature, pressure, volume, and etc. In macroeconomics, they are Y, P, i, π, and etc. Second, both field are concerned about both the equilibria and the routes to equilibria.

However, the two fields analyze their respective objections in quite a different way. Macroeconomists strive to find a logic chain to link those "state variables" one by one, whereas physicists devote to find a "state function" that can illuminate the interaction of the variables. Why cannot we give the "state space" of the macroeconomic system directly and find out its "state function"? What is the difficulty encountered in macroeconomics when we try to study in that way?

Taro said...

Dear frostfire,

Thank you very much for your insightful comment on the long lasting recession in Japan and way of macroeconomic thinking.

To tell the truth, I have thought about the way of macroeconomic thinking just as you are thinking before,


>But I think the world per se acts in a way that cannot be described in a chain form. It must act in a more complicated way.

I agree with you, but as J. Robinson said "a full-scale map is not useful", I don't think that a complicated model is also so useful. Why macroeconomists think by using as simple a model as possible is that they can concentrate on central issues behind the problems at hand.

(I don't know about thermal physics,so I cannot mention correctly)As you know, macroeconomics have used much of physics idea(especially dynamic system)and so we can find so easily similar ways of thinking between the two fields of study.

However, one important difference is that macroeconomics has a special idea that a future variable determines a present variable. I guess that there's no such idea in physics.

Such idea is, you know, said "forward-looking solution". It seems somewhat strange, but when we think about recession, as once Krugman wrote, an idea that an expectation of variable determines present variable is so important because people live not only in the present but also in the future and they should formulate their expectation by using available information at the present.

Anyway, I'm not sure I could answer your question, but when we think like a way of optimal control, we have to think of what variable should be state variable or not. Sorry I'm afraid that I cannot reply to your good question, though.