The 1920-21 Deflation: The Role of Aggregate Supply

Journal article by J. R. Vernon; Economic Inquiry, Vol. 29, 1991

Journal Article Excerpt


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
.


I. INTRODUCTION

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.


II. THE 1920-1921 RECESSION

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

____________________
* Professor, University of Florida. The author
wishes to thank three anonymous referees for helpful
comments.
1. Only the Department of Commerce estimates
are available for the Great Depression years. The Balke
and Gordon [ 1989 ] estimates and the Romer [ 1989 ] es-
timates end with 1928.

-572-

production had declined by only 7 percent
from its January peak, and factory employ­
ment had fallen 7.3 percent.

The contraction then became severe. By
the year's end, industrial production had
fallen 25.6 percent below its January 1920
peak and bottomed out at 32.6 percent
below its January 1920 level in July 1921,
the general business trough. Wholesale
prices were 42.9 percent below their May
1920 peak by July 1921. Industrial produc­
tion had fallen by 32.6 percent in eighteen
months, wholesale prices by 42.9 percent
in fourteen months. The deflation elimi­
nated more than 70 percent of the rise in
wholesale prices associated with World
War I.

Civilian unemployment rose substan­
tially during the recession. According to
Lebergott [ 1964 , 512], the unemployment
rate was 1.4 percent for both 1918 and
1919, 5.2 percent for 1920, and 11.7 percent
for 1921.

The 1920-21 recession was not the first
following the end of World War I. The
economy had slowed in 1918, at about the
time of the November armistice, as the
transition was made from wartime to
peacetime production. Both industrial pro­
duction and wholesale prices declined
moderately. The National Bureau of Eco­
nomic Research dates this first post-war
recession as ...




























































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