Analysis of Historical Scenarios Using IS-LM

The United States, 1929-1933

Macroeconomic Facts:

After the First World War was over in 1918 and countries returned to the Gold Standard (the size of the money supply was determined by the amount of gold held) the US began running large trade surpluses and acquired large gold stocks.
An incipient inflationary gap appeared.
In 1928, fearing inflation surges, the Fed started to contract the money supply.
In 1929, a highly speculative stock market collapsed. The Wall Street crash reduced consumption (increasing saving) and decreased investment by reducing wealth and increasing uncertainty.

Macroeconomic Policies:

The Fed continued to focus solely on inflation, disregarding the growing recession, and gradually decreased the money supply. As the slowdown continued, the money supply not needed for transaction purposes was withdrawn.
The Hoover administration passed various cuts in government spending in order to balance the federal budget, as well as imposed higher import tariffs.
Between 1931 and 1933 approximately 25% of all commercial banks in the USA failed or suspended operations. Stockholders and depositors lost resources equal to 2.4% of the GDP.
Industrial production fell by 43 percent and unemployment rose to 24 percent.
The economy only recovered from this slump by joining the Second World War.

The United States, 1945-1961

Macroeconomic Facts:

After the Second World War was over in 1945 most economists and the public were concerned about a possible return to Depression-era conditions.
Both large reductions in government spending and huge increases in unemployment, as male soldiers returned to jobs now occupied by women, were to be expected.
GDP did fall by 19 percent in 1946, but only by 2.8 percent in 1947.

Macroeconomic Policies:

Although government spending fell, private consumption on durable goods (cars and appliances) and new housing increased, fuelled in part by war-time savings.
Unemployment remained stable as many women returned to work in the home and many soldiers went to college under the GI Bill.
The recessions in this period were the results of ups and downs in military spending (Korean War: 1950-1953) and “pre-emptive” contractions in the money supply by the Fed, fearful of inflationary pressures in the economy.
Nonetheless, the Fed applied the lessons learned during the Great Depression and quickly reversed excessively tight monetary policies.
The New Deal programs of welfare, unemployment and social insurance, in conjunction with a progressive tax system worked as automatic fiscal stabilizers.
As a result, the recessions during this period were mild and short.

The United States, 1961-1970

Macroeconomic Facts:

Between 1961 and 1969, the US economy experienced the second largest expansion in its history, 106 months. Annual GDP growth averaged 4.5 percent during this period.
The Kennedy administration brought with it many Keynesian economists that studied with JFK at Harvard. The Johnson administration continued this trend.
This expansion was appeared to be largely demand-driven, with investment and consumption growing at 8 percent and 9 percent, respectively, on average.

Macroeconomic Policies:

The Fed supported large increases in the money supply.
Tax cuts on investment spending were approved in 1962.
Large income tax cuts were passed in 1964, during a period of apparent economic slowing down.
Johnson’s commitment to the “Great Society” increased federal spending on welfare and social programs.
The Vietnam War drove up government spending, especially between 1963 and 1972.
A temporary tax increase in 1968 failed to slow down the economy, as intended, precisely because it was announced as being temporary.

The United States, 1970-1980

Macroeconomic Facts:

During the 1970s the Fed applied expansionary monetary policy for a variety of reasons:

-To counter the financial collapse of the Penn Central Railroad.

-As a result of the US exit of the Bretton Woods system and the dollar-gold standard.

-To play along the political pressure brought on it by the Nixon administration.

-To help ease the slowdown produced by the two oil shocks of 1973 and 1979.

At the same time the economy experienced massive increases in the price of oil (from $3 to $12 in 1973 and from $14 to $29 in 1979.)
At the end of the decade the economy experienced stagflation, the combination of economic stagnation and inflation.

Macroeconomic Policies:

The Fed supported large increases in the money supply (see above.)
The oil shocks of 1973 and 1979 shrank business investment and increased the price of production inputs.
The 1973-1975 recession was the worst since 1930. Unemployment increased from 4.8 percent to 8.9 percent. Inflation rose from 7 percent to 12.1 percent.
The 1979 oil shock drove up inflation again; from 6.4 percent to 8.9 percent.
The Fed was partly responsible for this inflationary spiral because it continually tried to bring unemployment below its expected 5 percent “natural rate” whereas it was more likely estimated at 6 percent.

The United States, 1980-1990

Macroeconomic Facts:

During the 1980s the US economy experienced the deepest recession since the 1930s.
The Fed, after years of fueling inflation through large increases in the money supply, decided to put the brakes on and lower the public’s inflationary expectations. By doing this, the Fed managed to lower the general price level, including the price of most production inputs.
The Fed-induced 1981-1982 recession was so successful in bringing down prices and wages that the economy grew for the following eight years without fear of inflation.

Macroeconomic Policies:

Between 1981 and 1982, money growth slowed down from 9.9 percent annually to only 3.3 percent. Economic activity slowed down dramatically, so much that unemployment grew from 6 percent to 10.8 percent.
The Reagan administrations quick pace of military spending posed a challenge to the Fed’s efforts to close the recessionary gap.
Once prices were brought down, money growth resumed a more normal pace.
Private consumption and investment picked up speed in the mid 1980s, regardless of the Wall Street crash of 1987, and fueled an extended expansion.

The United States, 1990-2000

Macroeconomic Facts:

The decade started with a war-related brief economic contraction and slow job creation that cost George H.W. Bush (#41) his re-election.
From March 1991 to March 2001, W. J. Clinton presided over the longest peace-time expansion in US history. Both inflation and unemployment were very low.
This expansion ended due to collapse in technology stocks (the bursting of the “dot.com” bubble) that dramatically lowered consumer and business expectations.
The 2001 recession was brief, from March 2001 to November 2001.

Macroeconomic Policies:

The economic expansion of the late 1980s, driven by strong household consumption, physical capital investment, and massive military spending ended in 1990.
The Gulf War in Kuwait produced a brief increase in the cost of oil imports. The Fed reduced the money supply in order to avoid inflation. Although, the oil shock was not long-lasting, consumer and business confidence plummeted. Saving increased.
The expansion during the 1990s was driven by increases in general productivity thanks to the use of internet-based applications. This drove up investment in new technologies like fiber optics and wireless communications.
Simultaneously, the dramatic increase in stock prices drove up the value of stock portfolios and stimulated constant growth in consumption and investment.
The early 2000 crash in the stock markets and subsequent accounting scandals decreased household and business confidence. Luckily, the Fed quickly lowered interest rates, from 6.5% to 1% in eighteen months, producing the lowest interest rates in 40 years.

All information obtained from “Recessions and Depressions” by T.A. Knoop, Praeger, 2004.