Re-Examining the Contributions of Money and Banking Shocks to the U.S. Great Depression

This paper quantitatively evaluates the hypothesis that deflation can account for much of the Great Depression (1929-33). We examine two popular explanations of the Depression: (1) The “high wage” story, according to which deflation, combined with imperfectly flexible wages, raised real wages and reduced employment and output. (2) The “bank failure” story, according to which deflationary money shocks contributed to bank failures and to a reduction in the efficiency of financial intermediation, which in turn reduced lending and output. We evaluate these stories using general equilibrium business cycle models, and find that wage shocks and banking shocks account for a small fraction of the Great Depression. We also find that some other predictions of the theories are at variance with the data. ∗This paper is forthcoming in the NBER Macro Annual 2000. We thank Andy Atkeson, Ben Bernanke, Narayana Kocherlakota, Ken Rogoff, Art Rolnick, and our discussants Michael Bordo and Mark Gertler for helpful comments. We thank Daniel Hammermesh for CPS wage data and Jonathon Parker for estimates of compositional wage changes. Special thanks go to Ed Prescott for many discussions about the Great Depression. We have also benefited from the outstanding research assistance of Jesus Fernandez-Villaverde. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.