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? • 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
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
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.
Percent Nominal Interest Rate, 1922-33
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.
Percent Real Nominal Nominal and Real Interest Rates, 1922-33
Recovery • Rapid money supply growth (end of banking panic, gold inflows) rising price level falling real interest rate and increased spending.
The Real Interest Rate and Business Investment Business Investment, Billions of Dollars; Annual Data Treasury bill yield minus inflation rate
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.