The German Slump as a Real Business CycleRational expectations Real business cycles (RBC)

•Dynamic (Stochastic) General Equilibrium Growth Model•DSGE applied to short-run fluctuations to explain Great Depression by Fisher and Hornstein

•Representative agents weigh future utility when deciding how much to work and how much to save/invest at present•They ignore monetary impacts … “Money lagged output”

•Major critique of RBC-theory – the Great Depression•Lucas/Prescott: Gone fish’n’ ???

•German slump: Hoffmann data Ritschl data•8 – hour day: a productivity shock

P

Y

AS

AD

Observed fluctuations must be owing to AS shocks• Factor inputs and productivity• “Intertemporal” labor-leisure substitution

Fisher – Hornstein: DGE model of Germany, 1928-37 • All per capita variables relative to real gdp trend (in equilibrium, they

should grow at same rate)• Measure total factor productivity (TFP) as Solow residual:

Y = A Kα L(1- α) dA/A = TFP growth = dY/Y – α dK/K – (1 - α) dL/L• Ignore M1 … it lagged Y

– Ignore how lower interest rate might have stimulated investment, output and employment (recall Voth)

Note• Wages set by collective bargaining and arbitration

Political Wage Wages too High? (Borchardt)• Bruening austerity policy• Nazis broke unions (1933) – set maximum wages and limited mobility

Bruening lowered civil servant wages and tried to reduce private sector wages

• Nazi expansion with limits to consumptionMilitary Keynesianism?

Fisher – Hornstein Model• Representative agent maximizes discounted utility over infinite

horizon– Utility increase with consumption and leisure

• Leisure decreases with fraction of time spent working

– Spending on consumption (c) plus investment (x) equals income from labor (wn) and capital (rk) plus transfers from government (s)• Expenditure tax rate and income tax rate enter this constraint

• Per capita kapital stock increases with investment net of depreciation• Output determined by Cobb-Douglas production function

Y = A k.25 [γtn].75 • Labor share of income averaged ¾ • Technology advanced at 1.87% annual rate (γ)

– Profit maximizing firm hires factors (n and x) so MPL = w and MPK = r

• Government spending g + s = tax revenue over horizon• As always, Y = c + x + g

Fisher – Hornstein Simulations

• Response of employment, output, consumption, investment and real wage to alternative values of productivity (trend or actual), fiscal policy (trend or actual), and real wage (market clearing or actual)

I – Actual productivity with trend fiscal stance and market clearing wageThe actual decline in TFP generates patterns of employment, output, consumption and investment similar to what happened… but to clear labor market, real wage should have declined, not risen, in early years of German depression

II – Actual fiscal policy with trend TFP and market clearing real wagePredict not nearly as much contraction of employment, output, consumption and investment as actually occurred from 1928 – 1932.Predict investment crowded out in Nazi years, which it wasn’t.

III – Actual real wage with trend TFP and actual fiscal policyPredict less reduction in consumption than actually occurred … but otherwise generate patterns close to actual

Fisher – Hornstein Conclusions• High real wage by itself generates downturn close to actual• Reduced real wage of Nazi years does not by itself capture

investment spurt and consumption stagnation• Combinations of actual real wages, Bruening fiscal austerity

followed by Nazi expansion, and actual TFP fail to predict sharp decline in consumption in downturn and failure to recover in upturn.

• More research is called for.

German Interwar Economic Pathologies: An Overview Lost War and Revolution Distributional Conflict

+ 8 – Hour Day Desperate Government

HyperinflationStabilization

Monetary Constraints Outsized WagesReduced Investment

Depression and SlumpNazi Revolution/Constraints Broken

Wages DownGovernment Spending Up

“Recovery”