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SQ2HanodoutGovSpAndInRates - Wars and Interest Rates in the...

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Unformatted text preview: Wars and Interest Rates in the United Kingdom, 1730-1920 Wars are traumatic—both for those who fight them and for a nation’s economy. Because the economic changes accompanying them are often large, wars provide a natural experiment with which economists can test their theories.We can learn about the economy by seeing how in wartime the endogenous variables respond to the major changes in the exogenous variables. One exogenous variable that changes substantially in wartime is the level of government purchases. Figure 3—10 shows military spending as a percentage of GDP for the United Kingdom from 1730 to 1919. This graph shows, as one would expect, that government purchases rose suddenly and dramatically during the eight wars of this period. Our model predicts that this wartime increase in government purchases—and the increase in government borrowing to finance the wars—should have raised the demand for goods and services, reduced the supply of loanable funds, and raised the interest rate.To test this prediction, Figure 3—10 also shows the inter— est rate on long—term government bonds, called (0115015 in the United Kingdom. A positive association between military purchases and interest rates is apparent in this figure. These data support the model’s prediction: interest rates do tend to rise when government purchases increase.7 One problem with using wars to test theories is that many economic changes may be occurring at the same time. For example, in World War II, while government purchases increased dramatically, rationing also restricted consumption of many goods. In addition, the risk of defeat in the war and default by the government on its debt presumably increases the interest rate the government must pay. Economic models predict what happens when one exogenous variable changes and all the other exogenous variables remain constant. In the real world, however, many exoge— nous variables may change at once. Unlike controlled laboratory experiments, the natural experiments on which economists must rely are not always easy to interpret. Interest rate (percent) Percentage of G DP 50 45 Interest rates (right scale) / 40 35 30 25 20 War of War of American Austrian Independence r wawemwtmaiw. x. tapas/“Haas, 15 Succession Wars with France Military spending 10 Seven Years War 3 3/ (left scale) Boer War ’ 3 9“?” -. , f; . i 3%: 1 Crimean War 1 5 l . i g . m , i .. g 5 ' 3’3 9- is ; 0 1730 1750 1770 1790 1810 1830 1850 1870 1890 1910 Year Military Spending and the Interest Rate in the United Kingdom This figure shows military spending as a percentage ofGDP in the United Kingdom from 1730 to 1919. Not surprisingly, military spending rose substantially during each ofthe eight wars ofthis period. This figure also shows that the interest rate tended to rise when military spending rose. Source: Series constructed from various sources described in Robert]. Barro, “Government Spending, Interest Rates, Prices, and Budget Deficits in the United Kingdom, 1701 -1 91 8,”journa/ ofMonetaIy Economics 20 (September 1987): 221 —248. ...
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