Nominal Wage Stickiness and Aggregate Supply
in the Great Depression
WITH KEVIN CAREY
The problem of explaining why the world economy collapsed in the 1930s has provided a difficult challenge to economists for more than six decades. Thus, it is particularly exciting that in the last few years there has developed something of a new consensus about the sources of the Great Depression. The distinctive claim of this emerging view—which is based on the research of a number of scholars and has been given an authoritative treatment by Eichengreen —is that the proximate cause of the world depression was a structurally flawed and poorly managed international gold standard.
A brief synopsis of the “gold standard theory” of the Depression is as follows. For a variety of reasons, including among others of desire of the Federal Reserve to curb the U.S. stock market boom, monetary policy in several major countries turned contractionary in the late 1920s—a contraction that was transmitted worldwide by the gold standard [Hamilton 1987, 1988; Temin 1989].1 What was initially a mild deflationary process began to snowball when the banking and currency crises of 1931 instigated an international “scramble for gold.” Sterilization of gold inflows by surplus countries, substitution of gold for foreign exchange reserves, and runs on commercial banks all led to increases in the gold backing of money and, consequently, to sharp, unintended declines in national money supplies
Reprinted with permission from The Quarterly Journal of Economics, vol. III, no. 3 (August
1996), 853–83. Copyright © by the President and Fellows of Harvard College and the Massa-
chusetts Institute of Technology.
We thank Ilian Mihov for research assistance, and Olivier Blanchard, Bo Honore, James
Powell, Peter Temin, Mark Watson, and two anonymous referees for comments. The National
Science Foundation provided research support.
1 In its emphasis on monetary factors the gold standard theory is complementary to the
seminal analysis of Friedman and Schwartz . However, in its focus on the international
finance and international political economy aspects of the story, the new view adds an impor-
tant dimension that was not fully explored by Friedman and Schwartz.