Modern Macroeconomics.pdf

80 Modern macroeconomicsarising from ‘changes in economic institutions that lowered the normalor steady state market hours per person over 16’ (Prescott, 1999; see alsoChapter 6).With respect to those explanations that emphasize the decline in aggregatedemand, much of the recent research on the Great Depression has movedaway from the traditional emphasis placed on events within the USA andfocuses instead on the international monetary system operating during theinterwar period. Because the Great Depression was such an enormous internationalmacroeconomic event it requires an explanation that can account forthe international transmission of the depression worldwide. According toBernanke (1995), ‘substantial progress’ has been made towards understandingthe causes of the Great Depression and much research during the last 20years has concentrated on the operation of the international Gold Standardduring the period after its restoration in the 1920s (see Choudri and Kochin,1980; Eichengreen and Sachs, 1985; Eichengreen, 1992a, 1992b; Eichengreenand Temin, 2000, 2002; Hamilton, 1988; Temin, 1989, 1993; Bernanke,1993, 1995, 2000; Bernanke and James, 1991; Bernanke and Carey, 1996;James, 2001).The heyday of the Gold Standard was in the 40-year period before the FirstWorld War. The balance of payments equilibrating mechanism operated viawhat used to be known as the ‘price specie flow mechanism’. Deficit countrieswould experience an outflow of gold while surplus countries wouldreceive gold inflows. Since a country’s money supply was linked to thesupply of gold, deficit countries would experience a deflation of prices as thequantity of money declined while surplus countries would experience inflation.This process would make the exports of the deficit country morecompetitive and vice versa, thus restoring equilibrium to the internationalpayments imbalances. These were the ‘rules of the game’. The whole mechanismwas underpinned by a belief in the classical quantity theory of moneyand the assumption that markets would clear quickly enough to restore fullemployment following a deflationary impulse. This system worked reasonablywell before the First World War. However, the First World War createdhuge imbalances in the pattern of international settlements that continued toundermine the international economic system throughout the 1920s. In particularthe war ‘transformed the United States from a net foreign debtor to acreditor nation’ and ‘unleashed a westward flow of reparations and war-debtrepayments … the stability of the inter-war gold standard itself, therefore,hinged on the continued willingness of the United States to recycle its balanceof payments surpluses’ (Eichengreen, 1992a).To both Temin (1989) and Eichengreen the war represented a huge shockto the Gold Standard and the attempt to restore the system at the old pre-war