What caused the worldwide collapse in output from 1929 to 1933? Why was the recovery from the trough of 1933 so protracted for the U.S.? How costly was the decline in terms of welfare? Was the decline preventable? These are some of the questions that have motivated economists to study the Great Depression. In this paper, the authors review some of the economic literature that attempts to answer these questions.Depressions

Dean Corbae

Satyajit Chatterjee

English

Research Papers in Economics

 
 
 
WORKING PAPER NO. 06-12 
MONETARY AND FINANCIAL FORCES IN THE  
GREAT DEPRESSION   
 
Satyajit Chatterjee  
Federal Reserve Bank of Philadelphia  
and 
Dean Corbae  
University of Texas, Austin  
 
  
June 2006 
 
 
  
 
 
 
 
 
 
 
 
 
 
 
 
 
Monetary and Financial Forces in the Great Depression 
 
Satyajit Chatterjee 
Federal Reserve Bank of Philadelphia 
Dean Corbae 
University of Texas, Austin 
 
June 2006 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Prepared for the New Palgrave Dictionary of Economics. We would like to thank 
Lawrence Christiano, Charles Evans and Lee Ohanian for constructive comments.  The 
views expressed in this paper are those of the authors and do not necessarily reflect those 
of the Federal Reserve Bank of Philadelphia or of the Federal Reserve System. The paper 
is available free of charge at www.philadelphiafed.org/econ/wps/index.html
 
 
 
 
 Monetary and Financial Forces in the Great Depression
by Satyajit Chatterjee and Dean Corbae
What caused the worldwide collapse in output from 1929 to 1933? Why was the recovery
from the trough of 1933 so protracted for the U.S.? How costly was the decline in terms of
welfare? Was the decline preventable? These are some of the questions that have motivated
economists to study the Great Depression.
Cole and Ohanian (1999) document that U.S. per capita GNP fell 38% below its long-run
trend path (of 2% per annum growth) from 1929 to 1933. Real per capita nondurables
consumption fell nearly 30%, durables consumption fell over 55%, and business investment
fell nearly 80%. On the input side, total employment fell 24% and total factor productivity
(TFP) fell 14%. On the nominal and ¯nancial side, the GNP de°ator fell 24%; per capita M1
(currency plus deposits) fell 30%; M1 velocity fell 32%; the per capita monetary base rose
9%; the currency/deposit ratio rose over 160% (Friedman and Schwartz (1963, Table B3));
the loan/deposit ratio fell 30% (Bernanke (1983, Table 1)); and ex-post real commercial
paper rates rose from 6% in 1929 to a peak of 13.8% in 1932.
What caused the Depression? For the U.S., Friedman and Schwartz (1963, p. 300) argued
that it was the decline in the stock of M1 { a consequence of Fed tightening and of a
fall in the money multiplier induced by banking panics. According to Eichengreen (1992),
international adherence to the gold standard transmitted the U.S. monetary contraction
to other industrialized countries. Speci¯cally, high interest rates and low prices in the U.S.
attracted foreign in°ows of gold (in 1932 the U.S. and France held over 70% of the world gold
reserves), which the Fed largely sterilized (i.e., sold domestic government debt and bought
money). The out°ow of gold from foreign countries implied that gold-backed money supplies
of those countries had to decline in order to meet their cover ratios. Further evidence (see
Bernanke and James (1991), Table 4) for the importance of the gold standard in transmitting
the contraction comes from the experience of countries like Britain, which suspended the gold
1standard in 1931 and recovered by 1932; from Spain, which never was on it and had a much
less severe contraction than those on the gold standard; and from France, which was one of
the last major countries to leave it and still faced declining industrial production past the
1933 trough. As Bernanke (1995, p. 3) puts it: \The new gold-standard research allows
us to assert with considerable con¯dence that monetary factors played an important causal
role, both in the worldwide decline in prices and output and in their eventual recovery."
Much of this evidence is problematic in that it is in the nature of correlations between
endogenous variables { a fact that makes it challenging to establish causality. Did the decline
in M1 cause the decline in aggregate output or { as Temin (1976) argued early on { did M1
and aggregate output decline in response to some other common shock? If the \monetary-
cum-exchange- rate-policy" explanation is indeed correct, we ought to be able to demonstrate
its correctness in a reasonably calibrated, dynamic stochastic general equilibrium (DSGE)
model. To paraphrase Lucas (1993, p. 271): \If we know what a depression is, we ought to
be able to make one." The challenge of \making" a Depression has been taken up by various
researchers and constitutes a noteworthy recent development in Depression research.
The conventional explanation of why money a®ected output is sticky nominal wages { goods
prices fell as a result of the monetary contraction but nominal wages adjusted slowly and
the ensuing increase in the real wage depressed the demand for labor. Bordo, Erceg, and
Evans (2000) \test" this explanation by calibrating a one-sector stochastic macro model with
four-quarter nominal wage rigidity and ¯nd that 70% of the output decline from 1929-1933
can be accounted for by feeding in the negative innovations to the actual M1 money supply
process during that period. One criticism of their \test" is that the real-wage rise in the
model was calibrated to mimic actual real-wage data in the manufacturing sector when there
is evidence that nonmanufacturing real wages may actually have fallen during the 1929-1933
downturn. Cole and Ohanian (2000) re-examine the sticky-wage hypothesis in a multisector
model and found much less support for it.
A second criticism of Bordo et al. is that they do not take into account the evidence on
2aggregate labor productivity and TFP, both of which declined between 1929-33. Ohanian
(2002) argues that only about a third of the decline in labor productivity and/or TFP can be
plausibly accounted for by mismeasurement of factor inputs. By itself, a decline in TFP could
account for a substantial fall in aggregate output, consumption, and investment. Unless a
decline in TFP can be viewed as an endogenous response to the monetary shock (through, for
example, aggregate increasing returns), the decline leaves less scope for a purely monetary
explanation. Using a DSGE model where money is nonneutral due to imperfect information,
Cole, Ohanian, and Leung (2005) show that the decline in M1 accounts for only one-third
of the decline in output from 1929-1933, while the e®ect of an exogenous decline in TFP
accounts for two-thirds. They use a misperceptions model of monetary nonneutrality because
nonneutrality due to nominal wage rigidity generates counterfactual labor productivity.
Sticky wages and monetary misperceptions are not the only mechanisms through which
money can a®ect real output. Irving Fisher (1933) pointed out that the unanticipated fall
in prices during 1929-33 led to bankruptcies because it increased the real value of nominal
debt of households, ¯rms, and ¯nancial intermediaries. This \debt-de°ation" hypothesis was
analyzed by Mishkin (1978) for households and formalized by Bernanke and Gertler (1989)
for ¯rms. More generally, Bernanke (1983) argued that the reduction in borrower net worth
increased the cost of obtaining external ¯nance, while bank failures and tightened credit
standards hampered the e±cient allocation of capital. However, a quantitative DSGE model
featuring this mechanism has yet to be implemented for the Depression. Such a model holds
out the promise of explaining some portion of the puzzling decline in TFP during 1929-33
as an endogenous response to a misallocation of capital.
One of the most striking facts of the Depression was the reduction in the money multiplier
from 1929 to 1933 associated with the °ight from bank deposits to currency. Cooper and
Corbae (2002) construct a model in which households have the option of saving in the form
of currency or bank deposits and in which bank deposits ultimately fund working capital
for businesses. Because of increasing returns in the intermediation technology associated
3with ¯xed veri¯cation costs, their model admits multiple equilibria. In the good equilibrium
the return on bank deposits is high, households hold low amounts of currency, and output
is high. In the bad equilibrium, the return on bank deposits is low, households substitute
into currency, and output is low. A shift from the good to the bad equilibrium replicates
many of the salient nominal changes that occurred between 1929 and 1933. Although not
quantitative, their work formalizes the idea that output, credit and money supply responded
negatively to a loss in con¯dence { much as Irving Fisher (1933, p. 343) suggested it did.
Why was the recovery from the trough of 1933 so protracted for the U.S.? As noted by
Cole and Ohanian (1999), aggregate U.S. output was still below trend in 1939. The answer
cannot be the gold standard or M1 because the U.S. left the gold standard in 1933 and
the U.S. money stock recovered rapidly thereafter. One explanation o®ered is that the
National Industrial Recovery Act (NIRA) encouraged businesses to accept high real wages
of industrial workers. Cole and Ohanian (2004) embedded labor bargaining into a DSGE
model and quantitatively explored the e®ect of the NIRA giving more weight to workers
in the bargaining process post-1933. Their model is reasonably successful in producing a
slow recovery. Adverse labor market interventions also appear to have played a role in other
industrialized countries such as Germany, France, the U.K. and Italy (Kehoe and Prescott
(2002)).
How costly was the Depression in terms of the welfare? Real per capita consumption of
nondurables fell 30 percent in the U.S. but it is not known how this decline was distributed
across households. Chatterjee and Corbae (forthcoming) analyzed how households that can
self-insure against uninsured earnings losses would fare through a depression. They found
that the welfare cost of living in a world with a small likelihood of a Depression-like event
is quite large { somewhere between 1 to 7 percent of consumption in perpetuity depending
on the completeness of asset markets. Much of this cost is associated with the increased
variability of individual consumption streams.
Was the Depression preventable? First, if the\monetary-cum-exchange-rate-policy" expla-
4nation is correct, the right monetary policy could have prevented the decline. Christiano,
Motto, and Restagno (2003) estimate a DSGE model with many shocks but ¯nd that a liq-
uidity preference shock inducing households to hold currency instead of deposits played the
most important role in the contraction phase of the Depression. They then specify a policy
rule that raises the monetary base as a function of liquidity shocks and run a counterfactual
experiment where they ¯nd that output would have declined only 6 % if such a reaction
function had been in place. Second, if a portion of the decline in output was the result of
a banking collapse stemming from a shock to con¯dence then { as shown by Cooper and
Corbae (2002) { an announcement by the monetary authority that it stands ready to supply
liquidity to the banking system might have moderated the decline. Finally, with regard to
the slow recovery in the U.S., the only credible explanation o®ered is adverse labor market
intervention. If this explanation is correct, we know what not to do to prolong a severe
decline in output.
1 References
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of the Great Depression,"American Economic Review, 73 (3), pp. 257-76.
2. Bernanke, B. (1995). \The Macroeconomics of the Great Depression: A Comparative
Approach,"Journal of Money, Credit, and Banking. 27 (1), pp. 1-28.
3. Bernanke, B. and M. Gertler (1989). \Agency Costs, Net Worth, and Economic Per-
formance,"American Economic Review. 79 (1), pp. 14-31.
4. Bernanke, B. and H. James (1991). \The Gold Standard, De°ation, and Financial
Crisis in the Great Depression: An International Comparison,"Financial Markets and
Financial Crises, R. Glenn Hubbard, ed., Chicago: University of Chicago Press.
5. Bordo, M., C. Erceg, and C. Evans (2000) \Money, Sticky Wages, and the Great
5Depression,"American Economic Review, 90 (5), pp. 1447-63.
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pression Unemployment,"forthcoming Journal of Monetary Economics.
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Friedman-Schwartz Hypothesis,"Journal of Money, Credit, and Banking, 35 (6), pp.
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Depression: A General Equilibrium Analysis,"Journal of Political Economy, 112 (4),
pp. 779-816.
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Depression: A Productivity Puzzle,"NBER Working Paper 11237.
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Depression,"Journal of Economic Theory, 107 (2), pp. 159-190.
13. Eichengreen, B. (1992) Golden Fetters: The Gold Standard and the Great Depression,
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615. Friedman, M. and A. Schwartz (1963). A Monetary History of the United States,
1867-1960. Princeton: Princeton University Press.
16. Kehoe, T. and E.C. Prescott (2002). Great Depressions of the Twentieth Century.
Special Issue of the Review of Economic Dynamics, 5(1).
17. Lucas, R. (1993). \Making a Miracle,"Econometrica, 61 (2), pp. 251-72.
18. Mishkin, F. (1978) \The Household Balance Sheet and the Great Depression,"Journal
of Economic History, 38 (4), pp. 918-37.
19. Ohanian, L. (2002) \Why did Productivity Fall So Much During the Great Depres-
sion?,"Federal Reserve Bank of Minneapolis Quarterly Review, 26 (2), pp. 12-17.
20. Temin, P. (1976) Did Monetary Forces Cause the Great Depression? New York: W.W.
Norton and Company.
7

Agency Costs, Net Worth,

De°ation and the International Great Depression: A Productivity Puzzle,&quot;NBER Working Paper 11237.

Did Monetary Forces Cause the Great Depression?

Golden Fetters: The Gold Standard and the Great Depression,

Making a

New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis,&quot;Journal of Political Economy,

Re-examining the Contributions of Money and Banking Shocks to the U.S.

The Debt-De°ation Theory of

The Great Depression and the Friedman-Schwartz

The Great Depression in the United States from a Neoclassical Perspective,&quot;Federal Reserve Bank of

The Macroeconomics of the Great Depression: A Comparative

Why did Productivity Fall So Much During the Great Depression?,&quot;Federal Reserve Bank of

Monetary and financial forces in the Great Depression

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Monetary and financial forces in the Great Depression

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