On Monday, February 14, I discussed the debate over why British output fell after 1919 (see Maddison's data on the website). I discussed one hypothesis that was popular initially: the British return to the gold standard. I modeled the gold standard as a target price level. I argued that in WWI, G and M went up, and assumed that the economy was in a medium run equilibrium by 1919. Then, G fell dramatically, pushing the economy into a recession in the short run. On top of that, Britain went back to the gold standard, which required a further shift left in AD by reduction in M. I described two scenarios. Scenario #1 was the 'fast return', where they move AD back by enough in the short run so that the short run price level corresponds to the gold standard target. In scenario #2, 'slow return', you only move AD back enough so that the Gold Standard is restored in the new medium run equilibrium. 

I said a lot hinged on how long it takes Pe to fall (an immediate adjustment has the consequence that a fall in M produces no recession). I said that under the Gold Standard, one might have expected Pe to fall right away, because it had been a historical pattern in Britain to go off the gold standard in war time and then resume after the war. However, WWI was special because a debate occurred about the gold standard, with Keynes very persuasively arguing that going back to the gold standard was counterproductive: he argued that it would create a recession and would produce no comparable benefits. (See – not required! - Keynes’ (1932) 'The Economic Consequences of Mr. Churchill' in his book, Essays in Persuasion).
Churchill on the other hand, argued that the gold standard was the bedrock of a well-ordered society, to abandon it was a big mistake (for one thing, people who had made loans to the British government would see the value of the money owed to them erode with a higher price level, so that an effect of not going back to the gold standard would be to partially default on British debt, a dishonorable thing in the view of some). Also, other European countries did not go back to the old gold standard. Although in the end Churchill won the debate, these events would have created room for British citizens to doubt that Britain would go back to the gold standard, and this would have made Pe very slow to adjust. For this reason, I argued that the AD-AS model assumption that Pe is fixed in the short run is not a bad approximation when thinking about this period.

I argued that ultimately, there is a shortcoming (I called it a 'fatal flaw') in the gold standard hypothesis: British output remained down way too long to correspond to the notion of the short run in our model. Monetary gyrations, according to the model, can only have short run effects, and their effects disappear in the medium run. So, I turned to the alternative hypothesis about Britain: the new unemployment system instituted after the war (for further discussion see the – not required! - Broadberry, S.N. (1990) 'The Emergence of Mass Unemployment: Explaining Macroeconomic Trends in Britain During the Trans-World War I Period', Economic History Review, vol. 43.) That shifts the AS curve left, and creates a longer term fall in output. Problem is, it moves the price level up...in the wrong direction from the point of view of the gold standard. This would have required even more monetary contraction, according to the model, in order to return to the gold standard.

I also discussed the US Great Depression (see graphs on website). The analysis went like this: P and Y went down together....must have been AD shock. Fundamentally, i went down with Y....must have been an IS shock. I/Y went down like crazy and C/Y went up....must have been a problem on the investment side. I argued that with our model we have to conclude it was an Ibar shock, with an accelerator effect to make I/Y go down (otherwise, I/Y might be predicted to rise). Evidence that businesses soured on their investment projects is supported by the stock market, whose value fell around 80 percent from 1929 to 1933. The stock market assigns a value to firms, and an important component of their value is the value of their investment opportunities. I said one reason that businesses soured on investment was that they may have decided that the improved investment opportunities they had seen in the 1920s had been overestimated.