Macroeconomics

F I G U R E

9 - 1 2

Price level, P

Income, output, Y

Y

AD

1

AD

2

SRAS

LRAS

A

C

B

2. ... lowers 

output in 

the short 

run ...

3. ... but in the 

long run affects 

only the price level.

1. A fall in

aggregate

demand ...

A Reduction in Aggregate

Demand

The economy begins

in long-run equilibrium at point

A. A reduction in aggregate

demand, perhaps caused by a

decrease in the money supply,

moves the economy from point

A to point B, where output is

below its natural level. As prices

fall, the economy gradually

recovers from the recession,

moving from point B to point C.

A Monetary Lesson from French History

Finding modern examples to illustrate the lessons from Figure 9-12 is hard.

Modern central banks are too smart to engineer a substantial reduction in the

money supply for no good reason. They know that a recession would ensue,

CASE STUDY

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and they usually do their best to prevent that from happening. Fortunately,

history often fills in the gap when recent experience fails to produce the

right experiment.

A vivid example of the effects of monetary contraction occurred in 

eighteenth-century France. François Velde, an economist at the Federal

Reserve Bank of Chicago, recently studied this episode in French econom-

ic history.

The story begins with the unusual nature of French money at the time. The

money stock in this economy included a variety of gold and silver coins that,

in contrast to modern money, did not indicate a specific monetary value.

Instead, the monetary value of each coin was set by government decree, and

the government could easily change the monetary value and thus the money

supply. Sometimes this would occur literally overnight. It is almost as if, while

you were sleeping, every $1 bill in your wallet was replaced by a bill worth only

80 cents.

Indeed, that is what happened on September 22, 1724. Every person in

France woke up with 20 percent less money than they had the night before.

Over the course of seven months of that year, the nominal value of the money

stock was reduced by about 45 percent.  The goal of these changes was to

reduce prices in the economy to what the government considered an appro-

priate level.

What happened as a result of this policy? Velde reports the following 

consequences:

Although prices and wages did fall, they did not do so by the full 45 percent;

moreover, it took them months, if not years, to fall that far. Real wages in fact

rose, at least initially. Interest rates rose. The only market that adjusted instanta-

neously and fully was the foreign exchange market. Even markets that were as

close to fully competitive as one can imagine, such as grain markets, failed to

react initially. . . .

At the same time, the industrial sector of the economy (or at any rate the tex-

tile industry) went into a severe contraction, by about 30 percent. The onset of the

recession may have occurred before the deflationary policy began, but it was wide-

ly believed at the time that the severity of the contraction was due to monetary

policy, in particular to a resulting “credit crunch” as holders of money stopped pro-

viding credit to trade in anticipation of further price declines (the “scarcity of

money” frequently blamed by observers). Likewise, it was widely believed (on the

basis of past experience) that a policy of inflation would halt the recession, and

coincidentally or not, the economy rebounded once the nominal money supply

was increased by 20 percent in May 1726.

This description of events from French history fits well with the lessons from

modern macroeconomic theory.

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C H A P T E R   9

Introduction to Economic Fluctuations

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François R. Velde, “Chronicles of a Deflation Unforetold,” Federal Reserve Bank of Chicago,

November 2006.

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