Chapter 5
Appendix
Application
The Great Depression Bank Panics and
the Money Supply, 1930–1933
The bank failures of 1929 to 1933 highlight the destructive force of reductions in
the money supply on the economy.
In 1930, banks were failing at a higher rate than in 1929, but not dramatically
higher. Suddenly, in the final two months of 1930, the U.S. economy experienced a
bank panic, in which there were simultaneous failures of multiple banks, in this case
more than 750 banks with total deposits of $550 million. Depositors anticipated substantial losses on deposits (because at the time there was no federal deposit insurance
as there is today, which insures depositors against losses), and so they sought to shift
their holdings into currency. The result, as shown in Figure 5A2.1, was a rise in the
ratio of currency to deposits, called the currency ratio, denoted by c.
To protect themselves from a rapid outflow of deposits, banks substantially
increased their holdings of excess reserves. As a result, the ratio of excess reserves to
deposits, the excess reserves ratio, denoted by e in Figure 5A2.1, rose. Indeed, between
October 1930 and January 1931, both c and e rose, with e more than doubling.
Our money supply model analysis predicts that when e and c increase, the
money supply will contract. The rise in c reduces the overall level of multiple
deposit expansion, leading to a decline in the money supply. Increasing e reduces
the amount of reserves available to support deposits and also causes the money
supply to decrease. Thus our model predicts that the rise in e and c after the onset
of the first banking crisis would result in a decline in the money supply—a prediction borne out by the evidence in Figure 5A2.2.
As banking crises persisted through 1933, both c and e continued to rise, as our
model predicts. By the end of the crises in March 1933, the money supply (M1) had
declined by over 25%—by far the largest decline in all of American history—and it
coincided with the nation’s worst economic contraction (see Chapter 15). Remarkably,
such a dramatic decrease in the money supply occurred despite a 20% rise in the level
of the monetary base during the period, illustrating just how important changes in c
and e are during bank panics. It also highlights how depositor and bank behavior can
complicate the Fed’s critical role of conducting monetary policy.
1 Z02_MISH4317_WEB_CH05App_pp001-002.indd 1
11/11/13 11:56 AM
2 chapter 5 appendix
Figure 5A2.1
Sources: Federal Reserve
Bulletin; and Friedman, Milton and Anna
Jacobson Schwartz. 1963.
A monetary history of the
United States, 1867–1960.
Princeton, NJ: Princeton
University Press, 333.
0.40
0.08
0.35
0.07
0.30
0.06
0.25
End of Final
Banking Crisis
0.20
0.05
0.04
c
0.15
0.03
0.10
0.02
Start of First
Banking Crisis
0.05
Excess Reserves Ratio, e
With the banking panics that started in the
fall of 1930, the currency ratio, c, and the
excess reserves ratio, e,
rose substantially.
Currency Ratio, c
Excess Reserves
Ratio and Currency
Ratio, 1929–1933
0.01
e
0.0
1929
1930
1931
1932
0.0
1933
Figure 5A2.2
29
M1 and the
­Monetary Base,
1929–1933
Source: Friedman,
Milton and Anna Jacobson
Schwartz. 1963. A
monetary history of the
United States, 1867–1960.
Princeton, NJ: Princeton
University Press, 333.
Z02_MISH4317_WEB_CH05App_pp001-002.indd 2
27
26
Money Supply ($ billions)
The rise in the currency
and excess reserves
ratios, c and e, from
1930 to 1933 resulted
in a decline in the
money multiplier, which
led to a 25% fall in
M1, even though the
monetary base rose by
20% over this period.
28
25
M1
24
23
22
21
Start of First
Banking Crisis
20
19
End of Final
Banking Crisis
9
8
7
Monetary Base
6
0
1929
1930
1931
1932
1933
11/11/13 11:57 AM