"It was a supply-side shock, not deflationary monetary and fiscal policies, which initiated depression in 1920 and contributed to the subsequent slump". Discuss.

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“It was a supply-side shock, not deflationary monetary and fiscal policies, which initiated depression in 1920 and contributed to the subsequent slump”. Discuss.

Jaede Tan December 2004


During the immediate aftermath of the First World War, Britain experienced an economic boom, during which nominal wages, real G.D.P and industrial output all rose, whilst wholesale prices rocketed to three times their pre-war levels. The boom effectively lasted just over a year, starting roughly six months after the war ended, and breaking in the second quarter of 1920. Howson estimates that by the end of 1919 both industrial output and real G.D.P had risen to their 1913 pre-war levels, whilst Pigou states that between April 1919 and April 1920, nominal income rose roughly 25-35%.

Whilst the causes for the boom are generally and widely attributed to demand-side factors, such as increased consumer saving during the later years of WWI and hence a build up of effective consumer demand coming out of the war, the causes of the slump that quickly followed Britain’s post-war boom have been more widely contested. Of the many schools of thought on the issue, the two that are most widely documented are the “supply–side shock” argument and the effects of monetary and fiscal policy.

During the course of this essay I will examine the effects that both supply and demand side shocks had on the post-war British economy, concluding that both factors were important in not only causing the 1921 U.K. recession, that brought about both high unemployment and violent deflation, but also in contributing to the continuing volatility and underperformance of the British economy throughout the interwar years.

Supply side theory

Aggregate supply shows the interaction between price level and output in the economy. The aggregate supply relation is typified by the equation:

P = Pe(1+)F(1 - Y/L,z)

Where P is the price level, Pe is the expected price level,  is the mark-up a producer charges, Y/L represents labour productivity and z is a “catchall” variable that encompasses all other factors that may affect wage determination such as trade union power, unemployment benefits or a minimum wage.

This equation is given by the combination of the wage (1) and price (2) determinants within the economy

  1. W = PeF(u,z)
  2. P = (1+)W

“u” above symbolises the unemployment rate. This can be rewritten as 1 – Y/L because of the implication shown below:

u ≡ U/L = 1 – N/L = 1 – Y/L

where U is the number of unemployed workers, N is the number of employed workers, Y is output and L is the size of the labour force.

Rewriting and combining the price and wage equations we get:

P = Pe(1+)F(1 - Y/L,z)

The aggregate supply relation above implies an upward sloping aggregate supply curve. The intuition behind this is as follows:

  1. Any increase in output will lead to an increase in employment. (Y=N).
  2. Any increase in employment will cause a decrease in the unemployment rate.
  3. A lower unemployment rate will lead to higher nominal wages.
  4. Higher nominal wages lead to an increase in costs, which leads to an increase in prices.

This is shown below:

Figure 1. Upward sloping aggregate supply curve

The supply shock in post-war Britain, according to Broadberry, came as a result of bargaining by trade unions for a reduction in the number of hours worked per week. Broadberry argues that due to a shortage of consumer goods produced during the later years of WWI, consumers had been forced to save through an enforced fall in their marginal propensity to consume at a given income level. Aldcroft agrees with this stating that after an initial “lull” period immediately after the war “frustrated consumers unleashed their pent-up purchasing power”. Broadberry goes on to argue that because of this holding of savings, employees sought to improve their quality of life post-war by a reduction in the time they had to work, rather than a rise in wages.

The effect of this was to cause a massive increase in hourly real wage rate and a fall in labour productivity. Dowie calculates that due to a fall in hours worked per week of 13% and a 79% increase in wages for the normal week, coupled with a 71% rise in price level, the overall effect within the period of 1919 to 21 was for real hourly wage rate to rise by 20%. Broadberry agrees with this and also notes a sharp fall in labour productivity.

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Figure 2. A sharp rise in real wages coupled with a fall in labour productivity 

When agreeing to the reduction in the number of hours in a working week, employers had hoped to see an increase in labour productivity owing to fresher more inspired workers, with less needs for breaks, to offset the increased per hour labour factor cost. This did not materialise. Dowie seems to disagree with this, making the assumption that “the productivity offset following the hours reduction of 1919 was complete, weekly output and employer’s unit costs remaining unchanged”, although he does ...

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