Coffeeland: The Next Episode

Coffeeland is a small open economy on a gold standard.   It produces and exports coffee and imports all other goods.   In the first episode, foreign investors used equity to fund a railroad to a central plateau perfect for growing coffee.   There were two scenarios, one where coffee prices remained high, and everything worked out well both for Coffeeland and the investors.   The other scenario involved low coffee prices.   Things went bad for both the people of Coffeeland and the investors.

The next version of the story had the "railroad boom" funded by debt.   First by 20 year bonds and then by 1 year CDs, both sold to foreign investors.   In the happy, high coffee price scenario, all the investors receive their money back, principal and interest.   And the people of Coffeeland have higher real and nominal wages, and higher real and nominal income.

In the unhappy, low coffee price scenario, there is a finanical crisis.   The railroad cannot repay its debt.   The foreign investors lose.  And the people of Coffeeland suffer at first mass unemployment and then permanently lower real wages and real income.   The problem, however, was not the debt-financed boom.   It was rather the low coffee prices.

For the final episode, there is only one small change.   Rather than issue one year CDs, the Coffeeland bank funds its loans with checkable deposits.   It pays sufficient interest so that foreign investors are willing to hold enough checkable balances to fund all of the renewable 5 year loans that the Coffeeland Railway needs to fund construction.

Now, the railway boom is funded almost entirely by newly-created money.   The quantity of money in Coffeeland rises.   As before, the Railway company purchases steel rails, picks, shovels, and axes overseas. They also withdraw gold coin from the Coffeeland bank, which imports it from foreign lands.   As the Railway hires workers from the coffee plantations, nominal and real wages rise.   Again, coffee production falls, and due to the higher real and nominal wages, imports of consumer goods rise.   With the steel rails, picks, shovels, and axes all being imports as well, Coffeeland has a significant trade deficit.   However, despite the increase in the quantity of money, both deposits (held by the foreign investors) and the imported gold coin, there is no inflation.   Coffeeland is so small that its purchases of consumer goods has no appreciable impact on their prices.

Once the railroad is complete, most of the railroad workers are laid off, but they are employed in the new, more productive plantations in on the interior plateau.   Coffee productions and exports rise, which allows the Coffeeland Railway to pay back its loans and the Coffeeland Bank to pay off the foreign investors, principal and interest.   And they live happily ever after.

But, there is the unhappy scenario where coffee prices fall.   There is again a terrible depression and mass unemployment.   Only when nominal wages and real wages fall does employment recover, but real output and real income remain low.   Further, the Coffeeland Railway can never repay its loans.  And the Coffeeland bank fails as well.  It is unable to pay off the foreign depositors.

Was the depression causes by the "railroad boom?"   No.   Was the fact that the railroad boom was funded by money creation rather than CDs, 20 year bonds, or equity make any difference?  No.   Did the creation and destruction of money in Coffeeland impact the price level?  No.  

Suppose we develop a large data base looking at the economic performance of many countries like Coffeeland?   Would they really tell us much about the Great Recession?