An Overview of the Great Depression

David C. Wheelock September 20, 2007

What makes a Depression Great?

Recession: When your neighbor loses his or her job. Depression: When you lose your job.

Why study the Great Depression?

Worst economic disaster of the 20th century. Cause or causes are still debated. A defining event, especially for the governments involvement in the economy. Useful for learning important macroeconomic concepts.

Some Concepts
Gross Domestic Product (GDP): Comprehensive measure of the nations output of final goods and services. Real GDP: GDP measured at a fixed price level (i.e., inflation adjusted). Nominal GDP: GDP measured at current prices. Recession: Sustained decline in real GDP (approximately two quarters). Officially declared by NBER committee. Depression: Very severe recession.

More Concepts
Inflation: A sustained increase in the general price level (often calculated in terms of the Consumer Price Index (CPI)). Deflation: A sustained decrease in the general price level. Money Stock: The stock of assets that serve as media of exchange (e.g., coin, currency, checking accounts). Real Interest Rate: Measure of the cost of borrowing adjusted for inflation/deflation.

How Great was the Great Depression?

Real

output (GDP) fell 29% from 1929 to 1933.

Unemployment increased to 25%

of labor force.
Consumer prices fell 25%;

wholesale prices 32%.

Some 7000 banks failed.

Why Did It Happen? Some Suggested Causes

The stock market crash end of the party

Stock Market Boom and Bust

S&P Composite Index
35

Sept. 1929
30

25

20

15

10

July 1932
0 Jan-21

Jan-23

Jan-25

Jan-27

Jan-29

Jan-31

Jan-33

Jan-35

Jan-37

Jan-39

The Stock Market Crash

The timing of the crash (Oct. 1929) is suggestive. Possible channels: Destruction of wealth Increased uncertainty Role of banks Conclusion: Probably had some effect, but not big enough by itself.

Why Did It Happen? Some Suggested Causes

The stock market crash end of the party

Collapse of world trade globalization in reverse

The Collapse of World Trade

$ value imports of 75 countries

Why Did It Happen? Some Suggested Causes

The stock market crash end of the party

Collapse of world trade globalization in reverse Monetary collapse

Bank Failures
7000 banks failed -- many during panics Number of banks fell from 25,000 in 1929 to 15,000 by 1934 Possible Channels: Loss of deposits p decline in expenditures Customer relationships broken p harder to borrow Money supply contraction

Commercial Bank Failures, 1920-2004

4500 4000 3500 3000 2500 2000 1500 1000 500 0

19 20 19 25 19 30 19 35 19 40 19 45 19 50 19 55 19 60 19 65 19 70 19 75 19 80 19 85 19 90 19 95 20 00

Banking Panics
Bank depositors lost confidence bank runs Banks lost gold, currency and other reserve assets Loss of reserves caused banks to reduce loans and
deposits (causing money stock to fall)

Contracting money stock reduced spending Reduced spending led to lay-offs (increased
unemployment), falling prices (deflation) and lower output.

The Feds Monetary Policy

Fed officials did not watch (or even measure) the money supply. But, why didnt they respond to bank panics? Most failed banks were small, nonmember banks. Interest rates were falling and few banks borrowed at the discount window.

Nominal Interest Rate, 1922-33

Percent

0 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933

But Were Interest Rates Really Falling?

Deflation caused the real interest rate (i.e., the real cost of borrowing) to rise sharply:
i(nominal) inflation rate = i(real) e.g., 2%  (10%) = 2% + 10% = 12% Firms stopped investing in new buildings, equipment, etc. Bankruptcies increased as borrowers lacked the incomes to repay their debts. Banks failed because borrowers defaulted on their loans.

Nominal and Real Interest Rates, 1922-33

Percent

14 12 10 8 6 4 2
Nominal Real

0 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933

Recovery
Rapid money supply growth (end of banking panic, gold inflows) rising price level falling real interest rate and increased spending.

Money and the Price Level

55000 20 19 50000 18 45000 17

$ millions

40000

money stock (left scale) price level (right scale)

16 15 14 13 12

35000

30000

25000 11 20000 10

19 31

19 30

19 35

19 38

19 39

19 32

19 33

19 34

19 29

19 36

19 37

consumer price index (1982-84 = 100)

The Real Interest Rate and Business Investment

Business Investment, Billions of Dollars; Annual Data
12.0

Treasury bill yield minus inflation rate

14

10.0

11

8.0

Business Investment

6.0

4.0

Real Interest Rate

2.0 -1

0.0

-4

19 31

19 36

19 37

19 32

19 33

19 34

19 35

19 38

19 39

19 40

19 41

19 30

19 29

Money (M2) and Output Growth, 1929-41

percent change: f ourt h quart er t o f ourt h quart er

40 30 20 10 0 M2 -10 -20 -30 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 GNP

Recovery
Rapid money supply growth (end of banking panics, gold inflows) rising price level, falling real interest rate and increased spending. FDR and the New Deal? Restored confidence in banking system (FDIC) Early years marked by regulation/reform, little new spending (alphabet programs, e.g., NRA, WPA, PWA, CCC, etc.) Later years saw increased spending

Recovery
Rapid money supply growth (end of banking panics, gold inflows) rising price level, falling real interest rate and increased spending. FDR and the New Deal? Restored confidence in banking system (FDIC) Early years marked by regulation/reform, little new spending (alphabet programs, e.g., NRA, WPA, PWA, CCC, etc.) Later years saw increased spending World War II (when unemployment finally fell below 10%)

Could It Happen Again?

The Depression was not a failure of capitalism or markets, but rather a failure of the Federal Reserve. Monetary policy should maintain price stability avoid deflation and inflation. The Fed should respond to financial crises that increase the demand for money or threaten to disrupt the payments system.