L03: Quantity Theory of Money: Five Flaws

In Great Depression the Debt-Deflation cycle occurred which was pointed out by Fisher and later by Mian and Sufi. As some proverb say that ‘people who don’t learn from history are doomed to repeat it. For 50 years after Great Depression, people followed the lessons of history and then they forgot and everything went back to pre-Keynesian economics and Great Financial Crisis happened and reasons were almost same as of Great Depression. Before the Great Depression stock market was booming so everybody wanted to buy stocks and it was encouraged by the people who were wealthy. People were not only investing the money they had but they were also borrowing money to invest in stock market. When the stock market crashed there was lot of debt burden on the people which they had borrowed, gambled with and lost.

In Great Depression money supply was contracted by 30% which cause the prices/wages to go down. People who had huge loan couldn’t pay it back due to lower wages and they had to save more and more to repay their debt and it lead to lower consumption and lower aggregate demand. It is vicious cycle as due to decrease in aggregate demand firms will start producing less and lay-off the workers and due to unemployment the aggregate demand fell more. It is famous Paradox of Thrift. The idea was that if prices/wages go down then things will be cheaper and people will demand more but actually what happened in Debt-Deflation cycle was that price/wages goes down and people demand less because their debt is higher. Same is the thesis of Mian and Sufi that due to increase in real value of debt people couldn’t demand more and it was contrary to the standard mechanism. Similar thing was happened in Global Financial Crisis. Because of Debt-Deflation cycle the deflation didn’t bring the economy back in equilibrium as it supposed according to QTM. So, instead of going towards the equilibrium the economy will go away from the equilibrium level. It means instead of solving the problem the price deflation may make problem even worse.

Link of the Lecture: https://www.youtube.com/watch?v=zvS9DoJdZ_0&t=237s