History question. Economics 110B: .Reparations payments, principal cause of hyperinflation,

Econ 110 16 question exam on ucd canvas.

Class: ECN 110B A01-A04 WQ 2021

There are 90 minutes to complete the exam.

Here is a reading that our teacher gave us: https://www.theguardian.com/money/2016/may/14/zimb…

And here is a practice test with the answer key.

Practice Midterm II
Economics 110B UC Davis
Suggested Answers
1.Reparations payments by Germany to the Allies depended heavily on which one of the
following
a. imports of gold
b. inflation rates
c. the birth rate
d. Low US interest rates
e. technological change
Some might argue that inflation could be a good answer too. In fact Germany used
hyperinflation (and printing money to do it) as a last resort to help fund the deficits that
reparations created. When they went through hyperinflation and then stabilized the
economy was in a bad state an unable to pay as per the terms of the treaty of Versailles.
Germany subsequently re-negotiated the reparations with the Dawes Plan in 1924.
2. The principal cause of hyperinflation in places like Germany between the wars is likely to
be
a. Commodity price shocks
b. High growth in GDP per capita and “overheating” of the economy
c. Reparations payments and government budget deficits
d. Nominal rigidities
e. Expectations of lower growth
3. The gold standard in the period between the two world wars was weak when compared to
the gold standard prior to World War I because of which of the following
a. The loss of British leadership at the international level
b. Lack of paper money
c. Controls on capital flows
d. Immigration
e. Nations could not commit to play by the rules of the game and nations could
not borrow gold in times of crisis from other countries
4. The Marshall Plan worked mainly by
a. restoring European infrastructure
b. subsidizing jobs and wages so as to decrease leisure
c. promoting free markets or at least urging a less “mixed economy”
d. increasing the money supply
e. promoting meetings of European finance ministers and heads of state to keep the
peace
1. This question is about the gold standard and the Great Depression
a. What key vulnerabilities existed in the gold exchange standard in the 1920s? (3 sentences
max.)
countries lacked credibility
countries did not cooperate
countries backed their currencies with foreign exchange reserves that were in turn convertible to
gold since there was not enough gold to back all currencies. Foreign exchange reserves are only
credible if the country issuing them is credible.
Some countries did not play by the rules of the game. France especially allowed a large surplus to
continue and instead of lowering interest rates, allowing the money supply to increase and prices
to rise it “sterilized” gold inflows. It amassed a huge share of global gold in the late 1920s.
b. If nations lack credibility to maintain the gold standard: what do capital markets do to them
and what do nations have to do to convince markets they have credibility? Give an example of
country that lacked credibility in the 1930s. How did this affect the exchange rate policy of this
country in the short and long-run? (4-5sentences max.)
If a nation lacks credibility markets might expect a larger depreciation or a higher
probability of a depreciation –investors will need to be “compensated” with higher interest
rates. (This is related to the covered interest parity condition r* = r + [E(e)-e].
In order to have an equilibrium if E(e) goes up, then nations must raise interest rates to
attract capital and gold – otherwise their gold reserves will be exhausted and they will be
forced off the gold standard.
In 1931 it was questionable whether Britain would stay on the gold standard. They were not
enthusiastic about raising interest rates in response to the banking crisis that started in
Austria and spread to Germany. Eventually people began withdrawing gold from Britain
and put the gold standard in jeopardy. First the response was to raise interest rates and
borrow from the US. They could not borrow too much though and they decided to limit the
rise in interest rates. Eventually they went off the gold standard in September 1931 causing
a depreciation in the pound sterling relative to other gold countries.
c. If nations had cooperated in the 1930s like they had prior to World War I how would this have
helped them maintain the gold standard between 1929 and 1933? (4 sentences max.) How would
monetary policy coordination have helped limit how deep the Great Depression was?
If a currency is under threat then markets are demanding gold in exchange for the
currency. Markets act like people in a bank panic. If nations could borrow gold and reserves
from other central banks they could calm the panic and stay on the gold standard. If all
nations had lowered interest rates, say in 1930, then no one country would have lost gold or
capital and at the same time they could have expanded the money supply, raised prices
(together! Remember the exchange rate equals the ratio of the price levels. For the US and
Britain we would have Price Level in the USA = ($/Pound)*Price level in Great Britain),
stopped deflations and made a recovery.
d. At the start of the downturn that became the Great Depression, many nations had fixed
exchange rates via the gold standard, free capital flows. What would they have liked to do what
with their monetary policy to stabilize output or to keep GDP from going down in say in 1929 and
1930? Would this be possible? What policy change could help escape from the Great Depression
in this case. (one paragraph max.)
They would have liked to lower interest rates or equivalently raise the money supply and
hence prices. But you cannot do this if you do not have control over the interest rate as per
the – see the interest parity condition. Usually nations were forced to raise rates since
markets tried attacking currencies or grew skeptical currencies would keep their pegs.
making for further interest rate rises. This was too much deflation and depression to handle
for many countries and so countries abandoned the gold standard and the commitment to
fixed exchange rates.
Going off the gold standard and depreciating helped in many ways:
1) Boosting exports
2) Raising the price level and lowering the real value of debts
3) Raising the price level and lowering the real wage – making hiring of workers easier
and more profitable. With more employment there would be more output and more
output per person.
4) Lowering interest rates and making investment less expensive. Investment creates
demand and hence GDP grows.
f. Why did the gold standard make countries more prone to banking and financial crises
in the early 1930s? What other factors made them vulnerable to banking crises?
During a banking panic, the proper response for a central bank is to act as a lender of last
resort (LOLR). LOLR means that as depositors as for liquidity, the central bank lend cash
to local banks. The goal is to let depositors know their money is safe and that they need not
panic.
Lending money to banks requires increasing the money supply to cover such demand.
However, the ratio of money to the gold stock should remain roughly constant in order to
make the commitment to the gold standard credible. Moreover, the gold standard requires
the money supply stay constant. Printing more money will lead to depletion of the gold
(and/or foreign exchange) reserves which will lower the credibility of a currency and
increase the likelihood of a “speculative” attack on the currency. The attack would quickly
drain the country of gold and force the country off the gold standard. That is at odds with
the objective of staying on the gold standard. Therefore countries cannot both save their
banking system and maintain the gold standard.
2.
2. If many people believe economic growth is slow these days compared to the past what
period can people look to see much faster growth- especially in western Europe?
The period 1950-1973 or so witnessed extremely high growth by historical standards.
What institutional features mattered most for maintaining peace between labor and capital
in the 1950-1975 period?
Remember that capital and labor were playing a game. Capital agreed to invest and
make workers more productive. This would eventually, in the medium run raise
wages. Labor agreed to keep wages down so that profits could rise and support
further investment.
1) Workers monitored managers to know managers were sticking to the bargain.
Co-determination works councils…
2) Governments offered social services and low taxes in return for keeping the
bargain. We called these bonding mechanisms.
3) International trade was encouraged with the EPU and the ECSC amongst others.
Trade allowed for specialization and economic growth.
What do you think caused growth to slow down after 1975 in western Europe? Explain
whether the Marshall plan acted as a kick start for economic growth in Europe in the
1950s.
Probably the best explanation is that nations grew quickly and exhausted the potential for
catch-up growth. Usually relatively poor countries grow faster than rich countries if they
have the right institutions for growth.
The Marshall Plan tried to encourage Europe to use to market to allocate resources and
not turn towards communism. It used financial leverage to
1) Eliminate the distributional struggles over who would be taxed to pay for a
government deficit or a trade deficit.
2) By matching funds and withdrawing them when nations implemented policies
that were not pro-market.
The Marshall Plan was not that big and did not provide enough resources to
boost investment, re-build infrastructure or pay for necessary imports like raw
materials and energy.