Eggertsson Commodity Prices and the Mistake of 1937

Eggertsson “Commodity Prices and the Mistake of 1937” Vaughan / Economics 639 1

Mistake of 1937 • Fed doubled reserve requirements in three stages from August 1936 to May 1937. • Rationale – Unprecedented “excess” reserves in banking system. – Excess reserves → lending explosion and (i) inflation and (ii) asset bubble. • Misunderstanding about Excess Reserves: – Banks held excess reserves to self-insure against “run risk. ” • Result: “Roosevelt Recession” – Banks rebuilt excess reserves → Money multiplier and money stock↓ – Serious recession ensued (May 1937 to June 1938) ↓ M 2 = 2. 4% (mean %Δ in post-1959 recessions = ↑ 7. 3%) ↓ Industrial production = 31. 8% (mean %Δ in post-WWII recessions = ↓ 8. 4%) ↑ Unemployment rose to 19% 2 -6

Commodity Prices Misleading Fed Misread Supply Driven Increases as Coming Inflation 3 -6

Inflation not a Problem 4 -6

Roosevelt Recession Déjà Vu All Over Again, in Pictures Long-Run Aggregate Supply (Potential Output) Price Level P 1 B A P 2 NOTE MACRO MARKET FAILURE: Output below potential Short-Run Aggregate Supply (Sticky Wages) Tight money raised real interest rates, depressing interest-sensitive spending (on consumer and producer durables). AD shifted left, causing prices and real output to fall. As output fell below potential, unemployment rose above “natural” rate. Aggregate Demand (AD)1 AD 2 – Tight Money Y 2 Y 1= Yp Real Output 5 -6

Fallout from “Mistake of 1937” 6 -6