The Great Depression

In this literature review, we will first focus on the Great Depression, before turning to the current economic recession. The Great Depression A large amount of literature including research and text books, exist on the subject of the Great Depression. It is considered by many economists as the worst economic crisis in American History. Statistics suggest that from the business cycle peak in 1929 to the trough in 1933, the real Gross Domestic Product (GDP) contracted by 39%.

From 1929 to 1933, the unemployment rate rose from 3.2% to 25% any may who had jobs were only able to work part-time. By 1933, 50% of American banks had failed. From 1929 to 1933, the consumer price index (CPI) fell by -25%. The Dow Jones industrial average fell -89. 2% between September 1929 and March 1933. Net investment was negative from 1931 to 1935 and the economy experienced a sharp decline in aggregate real income, then there were massive defaults and bankruptcies by business and households (Bernanke. S, 2004, White, 2009). But what caused the great depression?

Or rather, why did the recession of 1929 turn into a depression? Calomiris (1983) remarks there is still very little consensus amongst economist on this question. Before Maynard Keynes (1936) General Theory of Employment, Interest and Money, economist relied on the Classical approach both to manage and explain the Great Depression. However, the classical theory could not explain a lot of the data at the time; for instance, it could not explain the protracted unemployment (Keynes, 1936).

This signified the need for a new theory of macroeconomics. Such a theory was provided by Keynes. The essence of Keynes theory is contained in the simple aggregate demand model. Keynes identified the collapse of the growth in the 1920s as part of the problem. In his opinion, the collapse of growth led to a reduction in investment opportunities and a downward shift in investment demand. The unprecedented levels of unemployment could also be explained by the collapse of aggregate spending.

Keynes along with Irvin Fischer (1933) also identified the financial markets as important sources and propagators of economic decline during the Great Depression (Calomoris, 1983). However, the exact nature of this connection is still a hot topic of debate, and this is where much of the literature on the great depression can be found. According to Keynes theory of aggregate demand, monetary policy had no causal role in the Great Depression (Mishkin, 2007). Mishkin (2007 p 588) argues that this assumption was based on three pieces of evidence.

He states that during the Great Depression; interest rates on U. S treasury securities were extremely low (Below 1%). To the early Keynesians, the low nominal interest rate meant that the monetary policy was easy – expansionary (Hamilton, 1987). The second assumption was underpinned by the lack of empirical evidence on the co-movement between nominal interest rates and investments spending. While the third assumption was based on the fact that surveys by macroeconomists carried on businessmen indicated that their decision to invest was not influenced by market interest rates (Mishkin, 2007).

In 1963, Friedman and Schwartz published the Monetary History of the United States in which they outlined a theory implicating money supply as the major cause of the Great Depression. In their opinion, what transformed the recession of 1929 into a depression were the imprudent policies by the Federal Reserve, which led to the stock market crash; and to the waves of banking failures which reduced the money multiplier and the money stock (Bernanke, 1983a; Friedman and Swartz, 1963). The figure 1 below shows the close correlation between GDP and the money stock.