Reading Notes / Study Questions
The Great Contraction, 1929-1933
Vaughan / Economics 639 / American University
Fall 2012
Reading Notes
 The book is chapter seven from A Monetary History of the United States, 1867-1960. So it contains
occasional references material covered earlier in A Monetary History.
 Recall from principles of macroeconomics that national income equals national output. Moreover,
“money” when used to modify income or output means nominal. So “money income” is the same
thing as nominal output. To avoid confusion, I will use upper case to denote nominal magnitudes and
lower case to denote real magnitudes.
 Friedman and Schwartz (F&S) use the equation of exchange as an analytical framework. This
equation states:
Mxv=Pxy
where M is the money supply, v is the velocity of money (average number of times each dollar of the
money stock is spent per period on nominal output, P is the general price level, and y the real output
level. (Note: P x y is nominal output (Y).) This equation is an identity; it says total nominal
spending (left-hand side) equals total nominal output (right-hand side). The equation of exchange can
be restated in rate of change form as:
%
M + %v  %P + %y
Here is a link to more discussion:
http://ingrimayne.com/econ/Money/Equation.html

Every chapter (except 1 and 13) in A Monetary History has the same structure as this book. F&S start
by discussing general trends in M, v, P, and y (or M, v, and Y). Then, they use historical events to
infer why variables moved as they did.
After discussing M, v, P, and y, F&S break the money supply down into its components. If you need
a refresher on money-supply components, here is a short background essay by Anna Schwartz:
http://www.econlib.org/library/Enc/MoneySupply.html
The essay is taken from the Concise Encyclopedia of Economics, a great reference tool for F&S in
general. Here is the link:
http://www.econlib.org/library/CEECategory.html
The level of the money supply depends, broadly speaking, on two factors: the monetary base (also
called high-powered money) and the money multiplier. The money multiplier, in turn, depends on
three factors: reserve requirements set by monetary authority, the public’s demand for currency and
the banking sector’s demand for (excess) reserves. Other things equal, the level of the money supply
rises with the level of the monetary base and the size of the money multiplier. The money multiplier,
in turn, rises when reserve requirements fall, the public’s demand for currency falls, or the banking
sector’s demand for (excess) reserves falls.
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 F&S indicate use net national product (NNP) to measure of output. NNP (NNP) is the total market
value of all final goods and services produced by citizens of an economy during a given period of time
(Gross National Product or GNP) minus depreciation. Depreciation (also known as consumption of
fixed capital) measures the amount of GNP that must be spent on new capital goods to maintain the
existing physical capital stock. Put another way, NNP is the amount of output that can be consumed in
a given year without reducing the amount that can be consumed in the future.
 Current output, current income, money income – three different terms for the same idea:
 Banking panics arise when many depositors simultaneously lose confidence in banks and demand
their deposits in cash. Banks, which typically hold only a small cash reserve, must then sell loans to
obtain the necessary liquidity. Many loans are illiquid and “fire sales” lead to considerable losses –
potentially turning illiquidity into insolvency (i.e., failure).
 Velocity (also called income velocity) is the rate at which each dollar of the money stock is spent
each period (quarter or year) on nominal output. Formally:
Velocity = Nominal Output / Money Supply
For example, nominal GDP for 2008:Q3 was $14,412.8 (billions, seasonally adjusted annual rate),
and average M2 was $7,727.2 (July, August, and September 2008, billions, seasonally adjusted,
averaged), implying velocity was 1.87. In words, each dollar of M2 was spent 1.87 times on nominal
output. Velocity can be measured with different definitions of nominal output (or money): NNP for
2008:Q3 was $12,641.6, so the F&S velocity measure was 1.64. Velocity is inversely related to
money demand, other things equal. To see why, assume money-market equilibrium (Money Demand
= Money Supply). The equilibrium condition implies the velocity equation can be rewritten:
Velocity = Nominal Output / Money Demand

Intuition: If the public holds smaller money balances, it must spend those balances like “hot
potatoes” (i.e., smaller money demand means higher velocity, nominal output held constant).
The Quantity Theory of Money (QTM) is a long-run theory of the price level. It starts with the
equation of exchange, M v = P y (an identify) and then adds three assumptions:
 In the long run, velocity is stable. That is, it depends on society’s payment institutions/habits,
which tend to change slowly over time (barring reckless monetary policy, financial crisis, etc.).
So the level/growth rate of velocity is exogenous.
 In the long run, real output is determined by real factors, not nominal ones (like the money
supply). True, early in a country’s development, movement from barter to money produces
significant economic growth (because of reductions in the transactions cost of exchange). But
once a country has money, the supply of it only determines the number of zeros on price tags.
For example, in basic economics we learn demand for “x” (where “x” is any consumption good)
depends on: (i) the relative price of “x,” (ii) real income, and (iii) taste for “x” (which depends on
the intrinsic nature of “x,” not money). Now, the relative price of “x” (in terms of “y”) is Px/Py
(where Px, Py are nominal prices of “x” and “y”). Further, real income is money income (I)
divided by nominal prices (so if you spend all income on x, you could have (I/Px) units. If
nominal prices and incomes double: 2 Px/ 2 Py = Px / Py (i.e., relative prices do not change) and
2 I / 2 Px = I / Px (i.e., real income does not change), real consumption does not change. A more
formal way of expressing this is Money is neutral. That is, money is a social contrivance to
facilitate exchange. At a micro level, real demand for a good depends on relative prices, real
income, and tastes – none affected by money. At a macro level, the volume of real output is
determined by the level of technology and quantity/quality of factors of production (real factors)
– none affected by money. So the level and growth rate of real output are exogenous.
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
The money supply can be controlled by the monetary authority. Of course, the monetary
authority may cede control – as under a gold standard. But the point is that “M” is exogenous as
well (but controlled).
If “v” and “y” are given, then the price level “P” will reflect whatever the monetary authority
does with the money supply. This is the Quantity Theory of Money.

The Gold Standard is a monetary standard in which currencies are exchangeable into a specific
quantity of gold at a fixed rate. Countries on the standard pledge to exchange gold for their currency
on demand. Under a gold standard, the currency component of high-powered money cannot expand
unless the country’s gold reserve expands. If country A buys more from abroad than it sells (i.e.,
imports > exports, a current account deficit), it must ship gold to pay the difference. As gold reserves
declines, country A’s high-powered money and ultimately its money stock decline. Over the long
run, the price level in country A will fall with its money supply until the higher prices of goods in
other countries correct the trade imbalance (i.e., cause country A’s imports to fall and exports to rise.)
Here are two references.
http://www.econlib.org/library/Enc/GoldStandard.html
http://eh.net/encyclopedia/article/officer.gold.standard

F&S often speak in terms of reference peaks and troughs. A full business cycle has two phases—
expansion and contraction. Expansions are measured from “reference trough” to “reference peak.”
Similarly, contractions are measured from reference peak to reference trough. A full cycle can
measured from peak to peak or from trough to trough. Interestingly, business cycles are dated, not by
the federal government, but by the National Bureau of Economic Research. The NBER has dated
cycles back to 1854. Their website includes lots of interesting data and business cycle studies. The
link is:
http://www.nber.org/
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F&S talk about the negative impact the 1929 stock-market crash had on the macro-economy through
the wealth channel. Many economists believe the recent bear market had a similar impact on the U.S.
economy.
F&S argue the wave of bank failures depressed U.S. economic activity through the impact on the
money supply – which fell by over one-third between 1929 and 1933. More recent research by Ben
Bernanke (Princeton professor, now Chairman of the Board of Governors of the Federal Reserve
System) suggests the failures had an additional negative effect by disrupting the flow of credit. Many
firms obtain financial capital from banks that could not obtained anywhere else. Thus, the failures
depressed business investment.
Friedman and Schwartz characterize the Discount rates of the early 1920s as the highest in the history
of the Federal Reserve. That characterization is no longer true. The Discount rate peaked at 14
percent in 1981.
Several places in the book F&S discuss the relationship between the Discount rate and gold flows.
Think about it this way, if the Fed raises the discount rate, other things equal, market interest rates
will rise in the U.S. Foreigners will respond by purchasing high-yield U.S. securities with gold. So,
gold flows into the U.S.
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Study Questions
1. Friedman and Schwartz (F&S) assert that the contraction of 1929-33 was the most severe in their
sample period and very likely in U.S. history. What evidence do they adduce in support of this
assertion? What is the only other U.S. contraction that comes close in severity to the Great
Contraction?
2. According to F&S, what impact did the contraction have on views about the potential for monetary
policy to serve as a tool for promoting economic stability? In their opinion, was this change in views
justified?
3. Between 1929 and 1933, what happened to the money stock, velocity, the price level, and real output?
What happened to the proximate determinants of the money supply? (This question refers to the
cumulative four-year movement.)
4. Did the stock market crash of 1929 provoke a banking panic? What event(s) sparked the first banking
crisis (1930)? What impact did this crisis have on the nature of the contraction?
5. What caused most of the failures of the early 1930s—poor loans and investments made in the 1920s
or runs? Explain.
6. Through what two channels did the failures depress economic activity? Which channel was more
important?
7. What do F&S believe would have happened in 1930 to the banking system and the economy had the
Federal Reserve not been created? How did the existence of the Federal Reserve “directly” and
“indirectly” make things worse?
8. Between 1929 and 1933, what happened to the proximate determinants of the money supply? What
role the banking panics play in the changing values of these determinants? (This question refers to
the cumulative four-year movement.)
9. According to F&S, what explains the Federal Reserve’s relative indifference to the wave of bank
failures in the 1930s?
10. What evidence do F&S rely on to argue that the world-wide depression of the 1930s originated in the
U.S.? Did the Fed play by the gold standard rules in the early 1930s? What effect did the Fed’s
policy (or lack thereof) have on economic activity in other countries?
11. How did the Federal Reserve react to Britain’s departure from the gold standard? What impact did
this policy response have on the U.S. economy?
12. Why did the Fed finally start purchasing government securities in 1932? Did these purchases turn the
economy around or end the wave of bank failures? Why or why not?
13. F&S argue that the open-market purchases of 1932 would have had a much different effect had they
been undertaken in any of three earlier windows. What were these windows? Why would the openmarket purchases have made a difference in these three windows but not in 1932?
14. What was free gold? How did concerns over free gold affect Federal Reserve policy in the early
1930s? Were these concerns justified (according to F&S)?
15. Why, according to F&S, was monetary policy so inept during the Great Contraction? Who was
Benjamin Strong? Why is he important to F&S story of the Great Contraction?
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