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
35
Sept. 1929
30
25
20
15
10
5
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
19
20
19
25
19
30
19
35
19
40
19
45
19
50
19
55
19
60
19
65
19
70
19
75
19
80
19
85
19
90
19
95
20
00
0
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
5
4
3
2
1
0
1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933
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
6
4
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
18
17
money stock
(left scale)
40000
35000
16
15
price level
(right scale)
14
13
30000
12
25000
11
19
39
19
38
19
37
19
36
19
35
19
34
19
33
19
32
19
31
10
19
30
20000
19
29
$ millions
45000
consumer price index (1982-84 = 100)
19
50000
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
19
41
19
40
19
39
19
38
19
37
19
36
19
35
19
34
19
33
19
32
-4
19
31
0.0
19
30
-1
19
29
2.0
Money (M2) and Output Growth, 1929-41
pe r c e nt c ha nge : f our t h qua r t e r t o f our t h qua r t e r
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.