Answers to Study Questions
The Great Contraction, 1929-1933
Vaughan / Economics 639 / American University
Fall 2012
Study Questions
1. Friedman and Schwartz (F&S) assert 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?
 U.S. Net National Product (NNP) in current prices fell by more than ½. NNP in constant prices
by more than 1/3rd. Implicit prices fell by more than 1/4th. Monthly wholesale prices fell by more
than 1/3rd.
 From August 1929 to March 1933, the money stock fell by over 1/3rd (the longest period over
which the money stock declined and the largest decline in U.S. history).
 More than 1/5th of U.S. commercial banks (holding nearly 1/10th of deposits) suspended
operations because of financial difficulties. Adding voluntary liquidations, mergers, and
consolidation bring the decline to well over 1/3rd
The only other contraction in U.S. history that comes close is 1839-1843.
[Answer on pp. 11-2.]
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?
“The contractions shattered the long-held belief, which had been strengthened in the 1920s, that
monetary forces were important elements in the cyclical process and that monetary policy was a
potent instrument for promoting economic stability. Opinion shifted almost to the opposite extreme,
that „money does not matter‟; that it is a passive factor which chiefly reflects the effects of other
economic forces; and that monetary policy is of extremely limited value in promoting stability.”
“The evidence summarized in the rest of this chapter (sic, book) suggest that these judgments are not
valid inferences from the experience.” [p. 13]
3. Between 1929 and 1933, what happened to velocity?
Velocity fell by nearly 1/3rd. [p. 15]
4. Did the stock market crash of 1929 provoke a banking panic? What impact did it have on the
rate of economic decline? If the crisis had come to an end in late 1930 or early 1931, would it
have ranked as severe by U.S. historical standards? What event(s) sparked the first banking
crisis (1930)? What impact did this crisis have on the nature of the contraction? … on the
health of the banking sector?
The stock market crash did not provoke a banking panic, but it did coincide with a stepping up in the
rate of economic decline. The contraction would have been ranked as one of the more severe in U.S.
history. Agriculture distress and, then, the failure of Bank of United States produced the first bank
panic. This panic, in turn, led to rises in public holdings of currency and bank holdings of reserves
(both of which put downward pressure on the money supply). The first banking crisis did not have a
pronounced impact on the contraction, but it did leave the banking sector somewhat more fragile.
[Banks dumped corporate bonds to build up their liquidity positions. The resulting fall in bond prices
reduced bank capital and made banks more susceptible to future runs.]
[Answer on pp. 21-2, pp. 25-26, p. 31, and p. 32.]
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5. 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?
A concerted effort by banks to restrict convertibility of deposits into currency would have occurred.
The Fed directly made things worse by reducing the concern of larger banks (who previously had
taken the lead in organizing restrictions) in stopping runs. The Fed indirectly made things worse by
fostering the belief that Fed discounting was supposed to take care of systemic liquidity needs.
[Answer on p. 30.]
6. How did the Federal Reserve react to Britain’s departure from the gold standard? What
impact did this policy response have on U.S. banks and the money stock?
The New York Reserve Bank raised its Discount Rate in two steps from 1.5 percent to 3.5 percent.
“The move intensified internal financial difficulties and was accompanied by a spectacular increase in
bank failures and runs on banks.” [p. 39]
“The money stock fell by 12 percent from August 1931 to January 1932, or at an annual rate of 31
percent – a rate of decline larger by far than for any other comparable span in the 53 years for which
we have monthly data, and in the whole 93-year period for which we have a continuous series on the
money stock.” [p. 40]
“The decline in output and prices became even more virulent.” [Bernanke, p. 234]
7. Between 1929 and 1933, what happened to the money supply and its proximate determinants?
What role the banking panics play in the changing values of these determinants? (For the
proximate determinants of the money supply, focus on the impact that each would have had on
the money supply, all other things equal.)
 The money stock declined by 35 percent.
 Other things equal, the rise in high-powered money would have produced a 17.5 percent increase
in the money stock.
 Other things equal, the decline in the deposit-currency ratio (D/C) would have produced a 37
percent decline in the money stock.
 Other things equal, the decline in the deposit-reserve ratio (D/R) would have produced a 20
percent decline in the money stock.
[Answer on pp. 64-66.]
8. Through what two channels did the failures depress economic activity? Which channel was
more important?
First, the failures led to capital losses for bank owners and depositors. F&S put the cumulative loss
from 1930 to 1933 at $2.5 billion, compared with an $85 billion decline in the value of preferred and
common stock over that period. Second, the failures led consumers to withdraw deposits (D/C ↓) and
banks to strengthen their liquidity positions (D/R ↓), both of which served to reduce the money
multiplier. The end result was a 35 percent decline in the money stock.
[Answer on pp. 93-94.]
9. Did poor loans and investments made in the 1920s cause most of the bank failures in the early
1930s? Explain.
Poor loans and investments may have played some role in the first banking panic, but overall runs
were the cause of most of the failures. These runs led banks to dump assets at fire-sale prices to
obtain liquidity. The resulting losses, particularly in bond portfolios, weakened capital positions and
led to suspensions.
[Answer on pp. 99-100.]
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10. According to F&S, what explains the Federal Reserve’s relative indifference to the wave of
bank failures in the 1930s?
“The major reason the System was so belated in showing concern about bank failures and so inactive
in responding to them was undoubtedly limited understanding of the connection between (sic, among)
bank failures, runs on banks, contraction of deposits, and weakness of the bond markets.” Other
factors:
 Fed officials had no feeling of responsibility for non-member banks (bulk of failures).
 Failures were concentrated among small banks. The most influential figures in the System were
big-city bankers.
 The few large banks that failed were regarded as the product of bad management.
[Answer on pp. 104-6.]
11. 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?
“The U.S. gold stock rose during the first two years of the contraction and did not decline,
demonstrating…that other countries were being forced to adapt to our monetary policies rather than
the reverse.” [p. 109] The U.S. did not play by the gold-standard rules in the early 1930s.
Specifically, the U.S. did not permit the inflow of gold to expand the money stock. “The result was
that other countries not only had to bear the whole burden of adjustment.” [p. 109]
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?
Under direct and indirect pressure from Congress, the System purchased $1 billion in securities
between April and June 1932. These purchases did temporarily halt the decline in the money stock
but were inadequate to prevent a subsequent relapse some months later. The purchases did not
sufficiently stimulate the economy because they were too little, too late.
[Answer on p. 50, p. 149, p.160.]
13. F&S argue 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? Explain what
would have happened in each window had the Fed pursued the open-market purchases.
(i) The first ten months of 1930 – The purchases would have reduced the likelihood of a banking
crisis by (a) reducing the severity of the contraction and (b) increasing bank reserves (i.e.,
increasing bank ability to meet the outflow).
(ii) The first eight months of 1931 – Even if the deposit ratios had fallen as they did, the increase in
high-powered money occasioned by the purchases would have meant no change in the money
supply rather than a 5 percent decline.
(iii) The four months following Britain‟s departure from gold in 1931 – Even if the deposit ratios
had fallen as they did, the increase in high-powered money occasioned by the purchases would
have cut the decline in the money supply in half. [And only a moderate change in the depositcurrency ratio would have meant no change no change in the money supply rather than a 12
percent decline.]
[Answer on pp. 160-174.]
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14. What was the free-gold problem? How did concerns over free gold affect Federal Reserve
policy in the early 1930s? Were these concerns justified (according to F&S)?
Free gold was the amount of gold held by the Federal Reserve about the amount necessary to cover
40 percent of Federal Reserve Notes outstanding. The other 60 percent had to be backed by either
gold or eligible paper. The System did not have enough eligible paper to cover outstanding notes
(because currency withdrawals put so many notes in circulation). The lack of free gold, supposedly,
kept the System from engaging in discounting and open-market operations on a sufficient scale to
counteract the monetary contraction. F&S argue this was nothing more than an ex post justification
for policies followed, not an ex ante reason for them.
[Answer on pp. 174-86.]
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?
Friedman and Schwartz trace the seeds of the Great Contraction to the death of Federal Reserve Bank
of New York President Benjamin Strong in 1928. Strong‟s death altered the locus of power in the
Federal Reserve System and left it without effective leadership. F&S maintain Strong had the
personality, confidence and reputation in the financial community to lead monetary policy and sway
policy makers to his point of view. F&S believe Strong would not have permitted the financial panics
and liquidity crises to persist and affect the real economy. Instead, after Governor Strong died, the
conduct of open market operations changed from a five-man committee dominated by the New York
Federal Reserve to that of a 12-man committee of Federal Reserve Bank governors. Decisiveness in
leadership was replaced by inaction and drift. [Note: answer is paraphrase of paragraph in Parker,
“Overview of the Great Depression.” Answer is discussed on in F&S on pp. 186-207.]
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