A Tourist Brings $200 To A Hotel...

Organizations and Markets:

A rich tourist came to a small town in the middle of the financial crisis. Nobody in town had the money to pay back debts owed to other people. He went into the local hotel, placed a 200-dollar bill on the counter and went upstairs to check out what kind of rooms the hotel had to offer. In the meantime the hotel manager grabbed the bill, walked over to the butcher and used the bill to pay his debt. The butcher then took the bill to the cattle farmer and paid his debt to him. Next, the cattle farmer took the bill to the cattle feed supplier and paid his debt there. The cattle feed supplier then paid his debt to the local prostitute. The local prostitute brought the bill back to the hotel and paid her debt to the hotel manager. The hotel manager put the bill back on the counter. Then the rich tourist returns down the stairs and proclaims that he didn’t like the any of the rooms. He grabs the bill and leaves the city. A pity, but more importantly, the town was now debt free and optimism was back.

In the beginning of the story, everyone is bankrupt in the sense that nobody can pay their debts and then a temporary increase in the money supply facilitates transactions and in the end, all is hunky dory.   How is this story similar to Krugman's baby-sitting coop example?  What is the function of money here?

Econbrowser: The gold standard and the Great Depression

Econbrowser: The gold standard and the Great Depression:

"Under a pure gold standard, the government would stand ready to trade dollars for gold at a fixed rate. Under such a monetary rule, it seems the dollar is 'as good as gold.'

Except that it really isn't-- the dollar is only as good as the government's credibility to stick with the standard. If a government can go on a gold standard, it can go off, and historically countries have done exactly that all the time. The fact that speculators know this means that any currency adhering to a gold standard (or, in more modern times, a fixed exchange rate) may be subject to a speculative attack. ...A gold standard only works when everybody believes in the overall fiscal and monetary responsibility of the major world governments and the relative price of gold is fairly stable. And yet a lack of such faith was the precise reason the world returned to gold in the late 1920's and the reason many argue for a return to gold today. Saying you're on a gold standard does not suddenly make you credible."

Ben Bernanke and Harold James found that there was a strong correlation between going off the gold standard and economic recovery during the great depression (NBER working paper version here). The gold standard causes deflation during recessions and limits monetary policy. That is also its main advantage the rest of the time. It prevents inflation by limiting monetary policy as long as governments stick with it, but they don't.

In the following graph, what would be inflation and what would be deflation if the US were on a gold standard?

 Click on graph to see full size.

Usually countries try to lower interest rates during a severe recession, but several countries dramatically raised a basic interest rate (the discount rate) in 1931 during the Great Depression in a failed attempt to preserve the gold standard.  Krugman:

[The graph] shows discount rates in the US, Britain, and Germany in the late 20s and early 30s, and highlights the way attempts to defend the gold standard led to perverse monetary policies at what was arguably a crucial moment.

The good news is that we don’t have a gold standard now, and thus aren’t as perverse. In truth, though, Asian crisis countries did raise rates in the 1990s

 Brad Delong points out that a major lesson of the Great Depression is that the sooner each of the biggest economies left the gold standard, the sooner they began recovery.  The arrows indicate ending the gold standard: