Yet there are many other policy rules to which the

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Unformatted text preview: hock to the LM curve Money supply fell 25% from 1929- 33, while unemployment rose dramatically. This supports the money hypothesis, which places primary blame for the Depression on the Federal Reserve for allowing the money supply to fall by such a large amount. Supported by Milton Friedman and Anna Schwartz. In the IS- LM model, the money hypothesis explains the depression by a contractionary shift in the LM curve. However, this runs into two problems: Page 37 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 1. Real money balances: a contractionary shift in the LM curve only happens if real money balances fall. Yet, from 1929- 31, real money balances rose slightly since the price level fell even more, therefore it could not be a cause of the depression. 2. Interest rates: if a contractionary shift in LM had triggered the Depression, we should have observed higher interest rates, yet nominal interest rates fell continuously from 1929- 33. The money hypothesis again: the effects of falling prices From 1929- 33 the U.S. price level fell 25%. Many economists blame this deflation for the severity of the Great Depression. Since the falling money supply was, plausibly, responsible for the falling price level, it could have been responsible for the severity of the Depression and making it more than just an ordinary economic downturn. To evaluate this argument we discuss how changes in the price level affect income in the IS- LM model: The stabilizing effects of deflation: in the IS- LM model, falling prices raise income. An increase in real money balances M/P causes an expansionary shift, leading to higher income. The Pigou effect is the increase in consumer spending that results when a fall in the price level raises real money balances, and thereby, consumers’ wealth. The destabilizing effects of deflation: two theories explain how falling prices could depress income rather than raise it. - First, debt- deflation theory, concerns the effects of unexpected falls in the price level. Since unexpected changes in P arbitrarily redistribute wealth, this affects spending on goods and services. Unexpected deflation enriches creditors and impoverishes debtors, so creditors spend more and debtors spend less. It seems reasonable to assume...
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