Deflation in the Great Depression

After the collapse of the stock market in 1929, the US economy

plunged into an economic depression. As the first two

columns of Table 1 show, the unemployment rate soared

from 3.2% in 1929 to 24.9% in 1933, and output growth

was strongly negative for four years in a row. From 1933 on,

the economy recovered slowly, but by 1940 the unemployment

rate was still high at 14.6%.

The Great Depression has many elements in common

with the Great Recession. A large increase in asset prices

before the crash: housing prices in the recent crisis, stock

market prices in the Great Depression, and the amplification

of the shock through the banking system. There are

also important differences. As you can see by comparing the

output growth and unemployment numbers in Table 1 to the

numbers for the Great Recession in Chapter 1, the decrease in

output and the increase in unemployment were much larger

then than in the Great Recession. In this box, we focus on

just one aspect of the Great Depression: the evolution of the

nominal and real interest rates and the dangers of deflation.

As you can see in the third column of the table, in the face

of rising unemployment, the Fed decreased the nominal rate,

measured in the table by the one-year T-bill rate, although it

did this slowly and did not quite go all the way to zero. The

nominal rate decreased from 5.3% in 1929 to 2.6% in 1933.

At the same time, as shown in the fourth column, the decline

in output and the increase in unemployment led to a sharp

decrease in inflation. Inflation, equal to zero in 1929, turned

negative in 1930, reaching -9.2% in 1931, and -10.8%

in 1932. If we make the assumption that expected deflation

was equal to actual deflation in each year, we can construct

a series for the real rate. This is done in the last column of

the table and gives a hint for why output continued to decline

until 1933. The real rate reached 12.3% in 1931, 14.8% in

1932, and still a high 7.8% in 1933! It is no great surprise

that, at those interest rates, both consumption and investment

demand remained very low, and the depression worsened.

In 1933, the economy seemed to be in a deflation trap,

with low activity leading to more deflation, a higher real interest

rate, lower spending, and so on. Starting in 1934, however,

deflation gave way to inflation, leading to a large decrease in

the real interest rate, and the economy began to recover. Why,

despite a high unemployment rate, the US economy was able

to avoid further deflation remains a hotly debated issue. Some

point to a change in monetary policy, a large increase in the

money supply, leading to a change in inflation expectations.

Others point to the policies of the New Deal, in particular

the establishment of a minimum wage, thus limiting further

wage decreases. Whatever the reason, this was the end of the

deflation trap and the beginning of a long recovery.

For more on the Great Depression:

Lester Chandler, Americas Greatest Depression (1970,

HarperCollins), gives the basic facts. So does the book by John A.

Garraty, The Great Depression (1986, Anchor).

Did Monetary Forces Cause the Great Depression? (1976,

W. W. Norton), by Peter Temin, looks more specifically at the

macroeconomic issues. So do the articles from a symposium on

the Great Depression in the Journal of Economic Perspectives,

Spring 1993.

For a look at the Great Depression in countries other than

the United States, read Peter Temins Lessons from the Great

Depression (1989, MIT Press).

T Table 1 1 Table 1

Unemployment, Output Growth, Nominal Interest Rate, Inflation, and Real

Year

Unemployment Rate (%)

Output Growth Rate (%)

Inflation Rate (%)

One-Year Nominal Interest Rate (%), r

One-Year Real Interest Rate (%), r

1929

3.2

- 9.8

5.3

0.0

5.3

1930

8.7

-7.6

4.4

-2.5

6.9

1931

15.9

14.7

3.1

-9.2

12.3

1932

23.6

-1.8

4.0

-10.8

14.8

1933

24.9

9.1

2.6

-5.2

7.8

1. Consider the data in the Focus Box, Deflation in the Great

Depression.

a. Do you believe that output had returned to its potential

level in 1933?

b. Which years suggest a deflation spiral as described in

Figure 9-3?

c. Make the argument that if the expected level of inflation

had remained anchored at the actual value of inflation

in 1929, the Great Depression would have been less

severe.

d. Make the argument that a substantial fiscal stimulus in

1930 would have made the Great Depression less severe.

2. Consider the data in the Focus Box, Deflation in the Great

Depression.

a. Calculate real interest rates in each year, assuming that the expected level of inflation is last years

rate of inflation. The rate of inflation in 1928 was -1.7%.

Do the changes in real interest rates explain the data on

real output growth and unemployment better than when

you make the assumption the expected rate of inflation is

the current years rate of inflation?