The 1920-21 Deflation: The Role of Aggregate Supply

J. R. VERNON ^*

World War I was followed by an extremely sharp deflation in 1920-1921. Most
treatments have attributed this deflation to a decline in aggregate demand. This paper,
noting that the deflation was not only large, but large relative to the accompanying
decline in real product, argues that it was caused by a decline in aggregate demand
combined with an increase in aggregate supply.

The 1920-21 recession in the United
States was brief relative to the Great De-
pression of a decade later, but it included
a remarkably sharp price deflation. The
decline in the GNP price deflator from
1920 to 1921 is the largest one-year per-
centage decline in the series in the more
than 120 years covered. This is true
whether the Department of Commerce
[ 1986 ] estimates or the recently provided
Balke and Gordon [ 1989 ] or Romer [ 1989 ]
estimates are used. These estimates pro-
duce one-year deflation figures of 18 per-
cent, 13.0 percent, and 14.8 percent, respec-
tively. The closest competitor is the 11.5
percent deflation recorded for 1931-32, the
third year of the Great Depression. ^1.

Annual data for wholesale prices tell a
similar story. Wholesale prices declined by
36.8 percent for 1920-21, the largest one-
year decline on record, going back at least
to the American Revolutionary War pe-
riod.

The 1920-21 deflation contains another
striking feature. Not only was it sharp, it
was large relative to the accompanying
decline in real product. The ratio of the
percentage decline in the GNP deflator for
1920-21 to the percentage decline in real
GNP is 2.6 using the Department of Com-
merce figures, 3.7 using the Balke and
Gordon data, and 6.3 using the Romer
data. By contrast, during 1929-30, the first
year of the Great Depression, the GNP
deflator declined by 2.7 percent and real
GNP by 9.4 percent, for a ratio of 0.3. The
ratios of the percentage decline in GNP
prices to the percentage decline in real
GNP for 1930-31, 1931-32, 1932-33, and
1937-38, the other Great Depression years
in which real GNP declined, were 1.0, 0.9,
1.2, and 0.3, respectively, all well below the
1920-21 figures.

This paper examines the 1920-21 defla-
tion. It asks why the deflation was so
sharp, both in itself and in relation to the
decline in real product. The answer, the
paper concludes, is that the deflation was
produced by a sharp decline in aggregate
demand combined with an increase in
aggregate supply, a supply increase in
which deflationary expectations played a
prominent role.

The National Bureau of Economic Re-
search dates the 1920-21 recession from a
general business peak in January 1920 to
a trough in July 1921. It was mild at first.
Wholesale prices continued to increase
until May 1920, four months past the gen-
eral business peak. By July 1920, the Fed-
eral Reserve Board's index of industrial

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