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An Overview of the Great Depression

An Overview of the Great Depression

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An Overview of the Great Depression

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  1. An Overview of the Great Depression David C. Wheelock September 20, 2007

  2. What makes a Depression Great? • Recession: When your neighbor loses his or her job. • Depression: When you lose your job.

  3. 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.

  4. 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.

  5. 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.

  6. 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.

  7. Why Did It Happen? Some Suggested Causes • The stock market crash – end of the party

  8. Stock Market Boom and Bust S&P Composite Index

  9. 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.

  10. Why Did It Happen? Some Suggested Causes • The stock market crash – end of the party • Collapse of world trade – globalization in reverse

  11. The Collapse of World Trade $ value imports of 75 countries

  12. Why Did It Happen? Some Suggested Causes • The stock market crash – end of the party • Collapse of world trade – globalization in reverse • Monetary collapse

  13. 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

  14. Commercial Bank Failures, 1920-2004

  15. 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.

  16. 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.

  17. Percent Nominal Interest Rate, 1922-33

  18. 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.

  19. Percent Real Nominal Nominal and Real Interest Rates, 1922-33

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

  21. Money and the Price Level

  22. The Real Interest Rate and Business Investment Business Investment, Billions of Dollars; Annual Data Treasury bill yield minus inflation rate

  23. Money (M2) and Output Growth, 1929-41

  24. 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

  25. 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%)

  26. 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.