Deflation and Monetary Contraction in the
Great Depression: An Analysis by Simple Ratios
WITH ILIAN MIHOV
RECENT RESEARCH INTO THE CAUSES of the Great Depression has ascribed a central role to the worldwide collapse in national money supplies, which led to sharp contractions in aggregate demand and falling prices during the late 1920s and early 1930s. The bulk of the worldwide monetary contraction, in turn, has been attributed by most recent authors to the technical flaws and poor management of the international gold standard, which a majority of the world’s countries adopted (or returned to) during the latter part of the 1920s.1
The evidence for the culpability of monetary factors in general, and the gold standard in particular, is on the whole quite compelling. Perhaps the most persuasive element of the brief for the prosecution is the finding that countries that abandoned the gold standard early (thereby allowing for reflation of domestic money and prices) were the first to recover from the Depression (Choudhri and Kochin, 1980; Eichengreen and Sachs, 1985, 1986; Bernanke and James, 1991). It is also noteworthy that the phenomena of monetary contraction, deflation of prices, and severe declines in output and employment began almost simultaneously in virtually every country that had “returned to gold.” The global nature of these events argues strongly against explanations specific to individual countries, such as (for example) the once-popular notions that “overproduction” of consumer durables or housing during the 1920s in the United States was a cause of the crash.
Although the view that monetary factors were dominant in the Depression now commands wide assent, the relative importance of specific sources of the declines in national price levels and money stocks is still being debated. In particular, within the overall context of the gold standard story, a number of possible deflationary factors have been noted. As explained in
The authors would like to thank the National Science Foundation for research support and
Refet Gurkaynak for excellent research assistance.
1 See Eichengreen (1992) for a detailed historical analysis. The gold standard of the interwar
period is more precisely referred to as the “gold exchange” standard, reflecting the fact that
convertible foreign exchange was used by many countries to supplement gold reserves. We
discuss the implications of this practice below.