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
government’s involvement in the economy.
• Useful for learning important macroeconomic
concepts.
 Some Concepts

• Gross Domestic Product (GDP): Comprehensive

measure of the nation’s 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?

• Realoutput (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  decline in
expenditures
• Customer relationships broken 
harder to borrow
• Money supply contraction
 Commercial Bank Failures, 1920-2004

4500
4000
3500
3000
2500
2000

1500
1000
500

19201925193019351940194519501955196019651970197519801985199019952000
 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 Fed’s Monetary Policy

• Fed officials did not watch (or even

measure) the money supply. But, why didn’t
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
 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 Real

2 Nominal

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

money stock
16
40000 (left scale)

15
price level
35000
$ millions (right scale)
14

30000 13

12
consume
25000
11

20000 10

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
 The Real Interest Rate and Business
Investment

Business Investment, Billions of Dollars; Annual Data Treasury bill yield minus inflation rate
12.0 14

10.0 11

8.0 8
Business Investment

6.0 5

4.0 2

Real Interest Rate

2.0 -1

0.0 -4

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941
 Money (M2) and Output Growth, 1929-41

percent change: fourth quarter to fourth quarter

40

30

20

10

0
M2
-10

GNP
-20

-30
1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941
 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.