It is hard to imagine that the sustained economic prosperity of the Roaring Twenties was soon followed by a severe worldwide economic depression. In 1929, the Great Depression began in the United States. By the time the economy hit rock bottom in 1933, real GDP plunged nearly 30%. Real per capita disposable income sank nearly 40%. More than 12 million people were thrown out of work; the unemployment rate soared from 3% in 1929 to 25% in 1933. Some 85,000 businesses failed. Hundreds of thousands of families lost their homes (Wheelock 2008). The money supply had fallen 35%, prices plummeted by about 33%, and more than one-third of banks in the United States were either closed or taken over by other banks (Parker 2010) . Milton Friedman and Anna Schwartz, in their 1963 book A Monetary History of the United States, 1867–1960, call this massive drop in the supply of money “The Great Contraction.” Monetarists, including Friedman, argue that the Great Depression was mainly caused by this monetary contraction, poor policy-making by the American Federal System, and continued crisis in the banking system. While there are many credited theories that provide an explanation for the Depression, this essay will focus on Monetarism and John Maynard Keynes’s argument for government stimulus in order to combat the economic downturn.

Causes For The Great Depression
In their book A Monetary History of the United States, 1867–1960, Friedman and Anna Schwartz stated that the Depression began with America’s weak banking system (Friedman et al. 1971). From 1930-1933, 10,000 banks closed. The majority of the U.S banks were small institutions. The Fed did not expect these small banks to have such a large effect on the money supply, causing the banks to heavily rely on their own resources. Friedman and Schwartz point out that the series of bank failures that occurred beginning in October 1930 worsened economic conditions in two ways. First, bank shareholder wealth was reduced as banks failed. Second, and most importantly, the bank failures were exogenous shocks and led to the drastic decline in the money supply (Parker 2010) . There are three variables that determine the money supply. These variables are the monetary base, the reserve-deposit ratio, and the currency-deposit ratio. Based on the data in the table below, money supply decreased because the money multiplier fell 38%. According to Mankiw, “Most economists attribute the fall in the money multiplier to the large number of bank failures in the early 1930’s (Mankiw 2010) ”. These bank failures altered the behavior of both depositors and banks.

The fall of the money multiplier was caused by the rise of currency-deposits and reserve deposits. The currency-deposit ratio rose due to the lack of confidence in the banking system. People feared the banks would continue to fail and began to view currency as more desirable than money deposits. The public began withdrawing deposits, draining the banks of reserves. Banks responded to their lower reserves by reducing their outstanding balance of loans, raising their reserve-deposit ratio. Bankers tried to alleviate their worries by raising their holdings of reserves well above the legal minimum. The holding of more currency by households and the holding of more reserves relative to loans by the banks caused the money multiplier to fall substantially, decreasing the money supply.
Now that it has been established on how the money supply fell, this paper will analyze Friedman’s hypothesis on how this contraction of money supply caused the Great Depression. The Money Hypothesis uses the IS-LM Model and a shock in the LM curve to explain The Depression. As shown in the graphs below, the decrease in the money supply caused an excess demand of money and excess supply of bonds. Americans did not feel comfortable purchasing bonds in the current state of the economy. The interest rates were now higher than the internal rate of return leading to a decline in investment. Aggregate Expenditure then fell by the decline in investment times the multiplier.
Diagram: Friedman Model
While this model seems like an adequate explanation for The Great Depression, the money hypothesis does contain flaws. According to Mankiw, the first problem involves real money balances. Monetary policies cause a contractionary shift in the LM curve only if real money balances fall. But, from 1929 to 1931, real money balances rose slightly because the fall in money supply overlapped with a greater fall in price. The second problem is the behavior of interest rates. If the shift of The LM curve was the cause of the Depression, higher interest rates should have occurred, yet nominal rates fell continuously from 1929 to 1933 (Mankiw 2010). A revision was made to the Money Hypothesis crediting deflation for the Depression. Many economists believe that the deflation caused the high levels of unemployment and the decrease in income. From 1929 to 1933 prices had fallen by 33%. But because the money supply determines the price levels, the contraction of the money supply could still be responsible for the severity of the Depression. In a normal period of deflation by increasing real money balances, lower prices are said to raise income and increase consumer confidence. However, according to Mankiw economists have come up with explanations on how falling prices could actually depress income, as they did during the Depression.
By using the IS-LM model as well as new variables for expected deflation^e and nominal interests rate (i) we can see how expected changes in price could affect income. In the new equation for the IS curve: Y=C(Y-T) + I(i - ^e + G when deflation becomes expected, ^e becomes negative. The real interest rate is now higher than any nominal interest rate. This increase in real interest rate and decrease in nominal interest rate decreases panned investment and shifts the IS curve to the left, reducing national income from Y1 to Y2. The reason behind this is because when firms expect deflation they become more reluctant to borrow, as they believe that they will repay these loans at a higher value. This fall in investment depresses planned expenditure, which decreases income.
Expected Deflation in the IS-LM Model

Solutions To The Great Depression
As stated before, Monetarists including Friedman and Schwartz believed that the economies performance is determined heavily on the money supply. Monetarists blame the Federal Reserve and the failure of monetary policy to offset the contractions in the money supply. As Friedman points out in Free to Choose, the Fed failed to provide emergency reserves for these banks, failing in its capacity as a lender of last resort (Freeman 1980). Throughout 1929-33, alternative policies became available to keep the stock of money from falling, and indeed could have increased it at almost any desired rate. Most of the banks that closed were non-members, and since these banks felt the opportunity cost of keeping reserves with the Fed was too great, the Fed returned the sentiment by denying them aid when they closed. Monetarists believe, that had monetary policy responded differently, the economic events of 1929–33 might not have occurred as they did. Fackler, James S. and Randall E. Parker support these monetarists’ ideas in their article, “Was Debt Deflation Operative during the Great Depression?”. Fackler and Parker used counterfactual historical simulations to show that had the Federal Reserve kept the supply of money growing with its pre October 1929 trend of 3.3 percent annually most of the Depression would have been avoided (Parker et al. ) .
Monetarists believe that had a Monetary Policy been implemented, the increase in money supply would have set off a chain of reactions ending with an increase in aggregate expenditure. (This is demonstrated in the diagram below.) By putting more money into the system there would become an excess supply of money and excess demand of bonds. The interest rate for investments would then be lowered due to the increase in bond price. An increase in investment would finally cause an increase in aggregate expenditure that is equal to the change in investment times the multiplier.

Diagram: Monetary Policy

John Maynard Keynes argued that a monetary policy would not have been an effective solution for The Great Depression. According to Keynes, a monetary policy would have failed for two reasons: the “liquidity trap” and the inelasticity of the investment curve.
Liquidity trap refers to a state in which the nominal interest rate is close or equal to zero and the monetary authority is unable to stimulate the economy with monetary policy. In such a situation, because the opportunity cost of holding money is zero, even if the monetary authority increases money supply to stimulate the economy, people hoard money. Consequently, excess funds may not be converted into new investment. More importantly, traditional monetary policy becomes ineffective in stimulating the economy because the money creation process does not function as theory predicts. Liquidity trap usually perpetuates deflation. When deflation is persistent and combined with an extremely low nominal interest rate, it creates a vicious cycle of output stagnation and further expectations of deflation that lead to a higher real interest rate, which harms private investment. “If the core demand doesn't exist to induce people to part with their money, it can't be forced through monetary policy. Trying to do so is like trying to "push on a string ("Push On a Sting Definition" 2013).
Keynes went further by saying that investment is very volatile, unpredictable, and insensitive to changes in the interest rate (Mostert et al. 2002). According to him and other economists, the slope of the investment curve must be very steep so that a major change in interest rates does not have an important effect on investment and total demand. Keynes believed that investment is solely affected by investor confidence. If investors are confident, they will continue to invest, regardless of whatever the interest rate is higher or not. If investor confidence is low, the firms will not invest at all. Since investor confidence during the Depression was low, monetary policy would fail in trying to increase investment and aggregate expenditure.

Diagram: Liquidity Trap

Diagram: Inelastic Investment Curve

Keynes successfully argued that the market and economy could not regulate itself. During recessions, consumers hold on to their money rather than spending it. Businesses were also frugal and reluctant to expand operations and hire more workers. Keynes argued that the government needed to jump-start the economy by implement fiscal policy. Instead of a monetary policy, the government should have increased their spending and lowered tax rates. By lowering taxes people had more money to spend, putting more people to work stimulating more spending and job growth. By increasing government spending, the government injects money directly into the economy. Building a bridge, hiring more teachers, or an increase in military spending also puts money into circulation, stimulating economic growth.
Diagram: Fiscal Policy

While many theories and scholars like Friedman and Keynes continue to disagree, the Great Depression allowed policy makers, scholars, and economists to learn more about macroeconomics. The Federal Reserve and Government now know better than to let the money supply fall during a contraction. Policy makers would not allow the lack of confidence causing bank runs to ruin the economy. There have been changes that help minimize events like the Depression. For example, The Federal deposit insurance makes numerous bank failures highly unlikely and fiscal policy now expands automatically during an economic downturn. While modern policy makers have been given a chance to learn from the Depression, if they do not act, one can happen again.

Reference

Chapman, Terrance. "Monetary Failures of the Great Depression." The Park Place Economist / vol. VIII. . http://www.iwu.edu/economics/PPE08/terry.pdf (accessed October 22, 2013).

Friedman, Milton, Free To Choose: Anatomy of a Crisis, video series 1980.

Friedman, Milton, and Anna Schwartz. A Monetary History of the United States, 1867–1960. Adelaide: Princeton University Press, 1971.

Investopedia, "Push On a Sting Definition." Last modified 2013. Accessed October 22, 2013. http://www.investopedia.com/terms/p/push_on_a_string.asp.

Keynes, John. The General Theory of Employment, Interest, and Money. Adelaide: The University of Adelaide, 2012. http://ebooks.adelaide.edu.au/k/keynes/john_maynard/k44g/ (accessed October 22, 2013).

Mankiw, Gregory. Macroeconomics . Worth Publishers, 2010. Mostert, JW, and AG Oosthuizen. Macro-Economics: A Southern African Perspective . Juta and Company Ltd,, 2002.
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Parker, Randall, and James Fackler. "Was Debt Deflation Operative during the Great Depression." .

Wheelock, David. The Federal Response to Home Mortgage Distress: Lessons from the Great Depression. (2008). http://research.stlouisfed.org/publications/review/08/05/Wheelock.pdf (accessed October 21, 2013).

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