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Keynesian Theory of the Great Depression
Keynesian economists blame the Great Depression on the inherent instability of a market
economy. The stock market crash of 1929 caused investors to become extremely pessimistic.
The extreme pessimism of investors caused a collapse in investment spending. The decrease in
investment spending led to a multiplied decrease in Real GDP.
The federal government might have triggered a rapid recovery with proper fiscal and monetary
policy. But the federal government’s fiscal policy was not truly expansionary until the military
buildup corresponding with World War II. The Fed’s monetary policy was not intentionally
contractionary from 1929 to 1933. But the large number of bank failures caused the money
supply to decrease by 25% from 1929 to 1933. Nearly 10,000 banks failed from 1929 to 1933.
The bank failures directly decreased checkable deposits and motivated large amounts of
withdrawals from banks that did not fail.
With the coming of World War II, the government’s fiscal and monetary policy became strongly
expansionary.
Example 13: Federal government expenditures increased from $15.1 billion in 1940 to $105.5
billion in 1944. The money supply (M1) increased from $41.9 billion in 1940 to $90.7 billion in
1944. The expansionary fiscal and monetary policy finally restored full employment. The
unemployment rate dropped from 14.6% in 1940 to 1.2% in 1944.
The recovery of the economy corresponding to the expansionary fiscal and monetary policy
associated with World War II supports the Keynesian belief that proper fiscal and monetary policy
can stabilize the economy.
Classical Theory of the Great Depression
Classical economists disagree with the Keynesian interpretation of the Great Depression.
Classical economists lay the blame for the severity and length of the Great Depression on
government policy. What began as a normal downturn in the business cycle was turned into an
economic collapse by two government policy mistakes.
The Federal Reserve System failed in its roles as lender of last resort and controller of the money
supply. Nearly 10,000 banks failed causing a 25% decrease in the money supply. The decrease
in the money supply caused significant deflation. (See the table in Example 12.)
Significant deflation can have a catastrophic affect on financial markets. A deflation rate of 9% (as
occurred in 1931) means that if the equilibrium real interest rate (the rate that equalizes savings
and investment) is 4%, the nominal interest rate would have to be negative 5%. A negative
nominal interest rate is impossible. Lenders will not be willing to pay borrowers to borrow their
money. Deflation in essence causes a price floor on interest rates, leading to a surplus of savings
(or a shortage of investment). The deflation of the early 1930s caused real interest rates to
skyrocket. The real prime lending rate rose to 14% in 1931. The high real interest rates caused
investment spending to collapse.
Example 14: Real investment spending decreased by over 83% between 1929 and 1932.
The second government policy mistake was the Smoot-Hawley Tariff, enacted in 1930. This
protectionist tariff led to retaliatory tariff increases by U.S. trading partners, leading to a collapse
in international trade. (For a more detailed discussion of the relationship between the stock
market crash of 1929, the Smoot-Hawley Tariff, and the Great Depression, see the appendix at
the end of Chapter 7.) When the monetary situation was finally stabilized in 1933, the economic
recovery was hobbled by the excessive (and inconsistent) government intervention of President
Franklin Roosevelt’s New Deal.
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Monetary Policy 12 - 8