The Great Depression

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TheGreat Depression

Tableof Contents

Introduction 3

Before the Great Depression 3

The Great Depression Cycles 4

Decline in Spending 4

Black Thursday (Stock Market Crash) 1929 6

Bank Runs and the Monetary System Contraction 8

Financial Decline 11

Monetary Contraction 12

The Gold Standard 13

1937 Recession 15

Conclusion 15

References 17

Introduction

TheGreat Depression lasted from 1929 to 1939 and it was depicted as themost severe in the U.S. economic history. The conventional dating ofthe downturn places it near the middle of the year. However, thepopular position held is that nothing happened until the stock marketcrash was experienced. From the period of 1928 to 1929, the stockprices had significantly increased, but collapsed suddenly inOctober Black Thursday, October 24th1929. There is no doubt that the Great Depression caused a difficultsituation in the economy and led to massive economic losses. In theeconomic history of the U.S. the downturn was depicted as the longestdecline (Eichengreen,2015).It is important to note that it is after the decline that the role ofthe government in economic development came into the limelight.Immediately Franklin Roosevelt was elected as the president, he cameup with new changes in the economy pertaining to government spending.The primary aim of the policy was to hire millions of the unemployedworkers and this explains why the policy was termed as the “NewDeal”, essentially, political change occurred in this period.

Before the GreatDepression

Duringthe 1920’s, the period is also referred to as the Roaring Twenties,the U.S. economy was flourishing. At the time, organizations focusedon increased production to meet the high demand in the market(Tavlas, 2016). Typically, there was mass production in themanufacturing, telecommunication, movie, and chemical sectors.Further, the government concentrated on building infrastructure tosupport new technologies, and due to the increased employment, mostpeople moved to cities to acquire jobs in industries. High employmentrates led to high income in the market and high investment andspending, the high income in the market catalyzed the opening ofbanks at a rate of 4-5 banks in a day.

Cycles

Thereis a perception that the crisis was a single business cycle, however,economists argue that it consisted of two main cycles. In August1929, the contraction phase of the first cycle began and it lasteduntil March 1933 (Tavlas, 2016). The second cycle commenced in May1927 and the recovery started in June 1938 the contraction phaselasted more than one year. In fact, it is only after the GreatDepression that the concepts of macroeconomics received moreattention and treated as a distinct field of study. This explains whysome economists portend that in order to understand the GreatDepression macroeconomic concepts must first be understood. Thereare different views on what caused the Depression. However,economists tend to agree on a combination of different factors likethe slump in the stock market, tight monetary policies, and overallbad banking structure.

Decline in Spending

Economistsagree that a decline in aggregate demand was one of the primarycauses of the Great Depression. This is true because in the downturnperiod, there was a huge decline in the output and prices (Duignan,2013). The figure below shows the decline in the GNP.

Figure1: A decline in GNP by 29% from 1929-33 owing to the major economicdownturn

Figure2 below shows the wholesale price index in the U.S. the deflationarymovement is denoted as one of the major elements of the GreatDepression.

Figure2: Wholesale price index (1926-100) based on statistics from theBureau of Statistics

Basedon economic principles, aggregate demand shock leads to a reductionin the aggregate demand of goods and services at a given price level(Duignan, 2013). The shock is connoted by a downward shift and ashift to the left of the aggregate demand curve. More particularly,in the short run the economy moves away from the full employmentoutput and the prices remain unchanged. The implication is that thedecline in aggregate demand causes a recession or depression.However, since organizations will not continue producing below theirnormal capacity, the economy will stay at this level (Eichengreen,2015). Nevertheless, organizations will eventually respond bylowering their prices to counter the low demand until the economyreaches equilibrium. At equilibrium, output is at full employment butprice levels remain relatively low due to the low stock marketprices.

MaynardKeynes argues that low aggregate expenditure contributed immensely tothe decline in income and high rates of unemployment and in turn ledto a decline in spending. If income is not spent on consumption,spending will likely remain the same as income is spent in anotherway. In addition, investment is another element of spending. Totalspending will be the same if investment is replaced by consumption.According to Keynes, the solution to the high unemployment rate wasto increase government spending and raise the demand of output(Duignan, 2013). The policy would increase demand because in order tomeet the demand, more people will be employed.

Highemployment rate will mean that more people will have more income tospend. At the same time, increased demand triggers increased salesand consequently profitability which also encourages investment.Thus, there is no single policy that will be in place to prevent adepression, there must be a continued formulation of supportingpolicies an aspect that lacked before the Great Depression. Accordingto the monetary explanation, the Depression was as a result of poorpolicies which could not allow flexibility. The monetaristperspective goes further to depict that a contraction in the monetarysystem could not allow a readjustment in the consumption or demand inthe economy (Fellows &amp Wells, 2013). The resultant impact of thetight monetary policies was that as money supply failed to grow intandem with demand, spending in the market reduced significantly asmost people cut-back their demand uncertain of their future incomesand this led to the slump in the economy.

Black Thursday (StockMarket Crash) 1929

Inthe late 1920s, the stock market had become increasingly speculativeand stock market prices had become dangerously unstable. The stockmarket is unique in such a way that a small hitch can immediatelyalter the prices. The stock market encompasses securities which arehighly income elastic. Thus, the stock market is mainly governed bytrust and income levels. High level of trust and income will mostlikely catapult the growth of the stock market. However, insituations where there is low income and no trust, the stock marketwill most likely decline. At the same time, there are two importantcharacteristics of the stock market crash that need to be explainedin a bid to understand the impact of the stock market crash (Fellows&amp Wells, 2013). The first is the direction in which macroeconomicvariables are moving in relation to the direction of aggregateeconomic activity and the second is the timing of the marketvariables in relation to business cycles.

Afterthe stock market crashed the Great Depression came. However, untilthe autumn of 1929, the economic downturn was limited and therecession was modest. It is also possible to state that up to Octoberthere was nothing serious that had happened. In fact, in 1924 to1927, the economy had already undergone other recessions, however,unlike the 1929, the other recessions were mild and manageable.Between 1921 and 1929, prices in the stock market increased graduallyand investors perceived it as a viable option to grow theirinvestments. Peak prices were attained in 1929 (Eichengreen,2015).At the time, the rise in prices was seen as an investmentopportunity the Dow-Jones industrial average went up from 191 to ashigh as 300 in December of 1928 and attained the peak of 381 inSeptember 1929.

Figure3: New York stock prices in 1926 to 1938 based on data collected fromthe stock market

Asillustrated in the figure above, the stock market from 1926 to 1929was based on speculations. A deeper analysis of the prevailingcircumstances at the time shows that access to credit, interest ratesand the mood of the economy contributed to the heightened speculationand this lead to the stock market crash. There was reduced demand inthe market as the prices in the stock market significantly reduced.In fact, the economy faced a dramatic reduction in the consumption ofdurable goods as more people tried to save for the unforeseeablefuture. Also, there was reduction in business investments. A goodexplanation to the decline in consumption is that consumers were notcertain about future incomes. With low consumption, real output inthe country fell sharply.

Accordingto Tavlas (2016), the decline in the stock market was not the primarycause of the depression. In fact, a healthy economy can easily regainfrom a slump in the stock market. However, a sharp decline in thestock market prices was converted into a catastrophe owing to the badmonetary policies held by the government. While many people can arguedifferently, one fact that stands out is that while the stock marketprices negatively impacted the production and employment levels inthe market. Further, the stock market prices affected householdwealth and reduced consumption leading to further depressed aggregatedemand.

Bank Runs and theMonetary System Contraction

Inaddition to the reduced demand in the market in 1930, increased wavesof bank runs further made issues worse. In the period starting 1930to 1933, the U.S. financial system was faced with chaotic conditionsthat played a major role in disrupting the operations of the economy.At the time, there were waves of bank failures which led to acomplete shutdown of about 11,000 banks out of the total 25,000 whichoperated in the economy (Tavlas,2016).Essentially, every borrower except for the government was adverselyaffected cases of high default rates and bankruptcy were reported.Most often, banking panics come about when depositors lose confidenceand trust in banks and as a result they demand their money in cashsimultaneously. The impact of a banking system panic cannot beforfeited in an economy. The banking rush causes money to flow in theeconomy abruptly in in return the banks lose their credibility in theeconomy. As more people rush to withdraw their money, banks faceunprecedented closure as they lose their profit making ability and inturn they are forced to shut down rendering thousands of employeesjobless. Collapse of the financial system impairs economy developmentas no credits are given any longer, and this on most occasions maylead to a crisis.

Accordingto some economists, the period between 1929 and 1933 did not exhibituniformity in lieu to the stages of contraction. In fact, during thisperiod there were distinct and disjointed steps that made the periodunique and hard to manage. Freidman depicts that the period prior tothe economic crash and this was the time between 1929 and 1930 and itwas characterized by the stock market crash. Within this time theFederal Reserve responded by introducing an increase in money supplyin the economy (Tavlas,2016).However, it is important to note that there was a prior decline inthe supply of money and banks did not take steps to liquidate theirloans or depositors to demand their money in cash.

Thesecond stage is the first banking panic which covered the finalquarter of 1930 and this is the time the economy worsened. The thirdstage was seen in the first quarter of 1931 and this is the time whensigns of revival were seen and the early stages of the second bankingcrisis in March 1931. Another outbreak of the banking panic was seenin the first quarter of 1932. At the time, the Federal Reservereceived a response of Britain’s departure from gold. In the secondquarter of 1932, in a bid to revive the economy, the Federal Reserveundertook an open-market purchase. It is during this time that therewas a revival of the real economy. However, as the problems in thefinancial system continued, the real economy declined again in thefinal six months and this was later evidenced as a collapse of thefinancial system.

Thestock market prices peak in 1929 persisted for about nine months andended in 7thSeptember. In 1930 to 1931 alone, the U.S. experienced about fourdifferent shocks and episodes of the banking panic. There were slightpanics in the early periods of 1933 which led to the banking holidaygiven by President Roosevelt in 1933. The break was meant to ensurethat all banks closed and only reopened after a review of theirsolvency rates. It is also illustrated that by 1931, almost a fifthof all banks in the economy had closed down. An attempt by theprevailing government to salvage the economy proved insignificantowing to the continued crisis in the banking sector. The primarycause of the crisis has been linked to the poor banking structure atthe time (Duignan,2013).Economists argue that the banks stood no chance in prevailing overthe circumstances that had impacted their performance. Despite thefact that banks had tried everything possible, the policies andstructures they operated within were not strong enough to supportthem in times of crisis.

Thebanking structure weakness has been attributed to the large number ofindependent units in the economy at the time. For example, when asingle bank failed, others’ assets were frozen while depositors onthe other hand had rights to go and ask for their money in cash. Thestructure of the banking system catalyzed a continued failure owingto the domino effect of the policies and regulations. Currently,there are different policies that guide asset freezing andliquidation of banks. Further, in the modern society, the centralbanks or the Federal Reserve Bank has a right to protect depositorsand investors equally which explains why there are no banking panicsin the modern economy. In fact, following clearly set down proceduresaid in the running of the financial system, and these policies aremuch reliable and stronger as opposed to the past three decades.

From1930 to 1933, the U.S. financial system was in turmoil. The bankswere able to operate synchronously and predict adverse developments.In trying to explain the impact of the financial crisis in thebanking sector, Friedman depicts that there was a massive decline inthe wealth of the shareholders in the banking system and a rapiddecline in the supply of money in the economy. However, there areresearchers who argue that a decline in the money supply in theeconomy has nothing to do with a decline in aggregate demand in theeconomy. Some critics portend that there is no strong link betweenmonetary system and a country’s aggregate output.

Oneof the mainly held propositions on the impact of the financial systemon output is held by Bernanke who argues that since financial marketsare incomplete, intermediation borrowers and lenders, there is a needfor lenders and borrowers to have non-trivial information gatheringservices. The impact of collecting such information is that there isan increase in real costs of intermediation (Duignan,2013).In such environments, borrowers will find credits expensive and moredifficult to access in the long run. The researcher depicts it is theimpact of this credit squeeze that led to a decline in aggregateoutput in the economy. However, the flipside of this explanation isthat it does not offer complete link between the monetary system andthe Great Depression.

Financial Decline

Thetwo major factors that affected the financial system between 1930 and1933 were loss of confidence in the financial sector and particularlyin the banking sector and the widespread of insolvency of debtorsacross the economy. At the time, a wide range of financialinstitutions across the economy faced numerous challenges. Insurancecompanies, mutual savings bank, and building loan societies were notspared either. However, of utter consideration is the commercialbanking sector which held about 39.6% of all the financial assets inthe economy. The dominance in the financial sector was mainlycharacterized by smaller banks and this is linked to the regulatoryenvironment in the U.S. between 1930 and 1933 which spread fear inestablishing larger banks. However, the entire financial system wasin jeopardy as both small and large banks suffered the same fate. Infact, the debt ratios rose to about 9% in 1929 and went up to about20% in 1933. The high default rates made it impossible for the banksto manage their operations. The financial crisis also went as far asimpacting homeowners in the economy. There is no doubt that bankpanics impact the normal flow of credits and in turn affect theperformance of the real economy.

Monetary Contraction

Althoughthere was a problem in the financial system, the Federal Reserve didvery little to prevent an escalation of the problem. In fact, if theFederal Reserve could have taken an initiative, it could have stemmedthe panic and prevented a continued decline in the money supply.There was a sharp decline in the money supply from 1929 to 1933during this period a substitution of monetary expansion strategiesshould have prevented the severity of the contraction and itsduration. There was an equal impact in the aggregate output owing tothe decline in the money supply in the economy (Ohanian, 2013).Moreover, there was a deliberate reduction in the money supply by theFederal Reserve by the increase of its interest rates. The strategycame about when Britain was forced off the gold standard and a fearthat there was going to be a further slump in the economy.

Further,people were not read to borrow despite the fact that nominal interestrates were low they majorly feared the inadequacy of their futurewages and profits. Consequently, there was a massive reduction in therate of consumer spending and business investment spending. There waspessimism all over the economy pertaining to the unstable financialsystem. Moreover, the failure of so many banks made it impossible toincrease lending and increase funds for investments. With a poorlyfunctioning financial system, it was harder to revive the collapsingeconomy.

The Gold Standard

Thereare two primary exchange rate systems: fixed and flexible financialexchange rate systems. A flexible exchange rate system connotes onein which exchange rates are not officially fixed but impacted by theforces of demand and supply in the market. On the other hand, a fixedexchange rate system is characterized by rates sets by a governingbody. The gold standard is all about maintaining the exact value ofcurrency in relation to the gold in the market. Similarly, it islinked to the perception of the customers. If there is willingness tobuy or sell gold, then the Federal Reserve would try to reduce thedemand in a bid to increase its value. Thus, the gold standardoperates within the premise of a fixed exchange rate system.Researchers have tried linking between the mismanaged gold standardand the deflation rates in 1930s.

Someresearchers have found that there is a strong link between theinterwar gold standard mismanaged and the deflation rates. Forexample, Temin argues that structural flaws in the gold standardmanagement process in addition to the policies dictated the adoptedrules and this in turn impact the international monetary contractionand deflation in the world. There are those who argue that thosecountries that avoided the use of gold standards recovered from thedepression as opposed to those who remained. For example, the UnitedKingdom recovered early as compared to the U.S. since UK hadabandoned the gold standard earlier than the U.S. The main problemsassociated with the gold standard as discussed by Bernanke include:asymmetry between surplus and deficit in countries, pyramiding ofreserves, and insufficient power of the central banks

Takinginto consideration the economic problems and the structural flaws inthe gold standard, there is no doubt that even the slightestdeflationary impulse would have led to many problems in the overallgrowth of the economy. Major economies like U.S. and France which hadabout 60% of all the gold would take deflationary measures in a bidto protect their economies from further speculations (Richardson,2014). Their moves would lead to a massive outflow in golds andcentral banks would be compelled to raise their discounts and deflateagain. The three core channels linking depression and deflation asarticulated by Bernanke were: real wages, real interest rates, andthe financial crisis.

Adecline in the overall prices in the market will triggerorganizations to reduce their real wages. In turn, spending willdecline as people will have little money or no money to spend, andthis will reduce investments and production in an economy. The impactof real interest rates is somewhat the same. Taking intoconsideration as standard IS-LM model, a contraction in the monetarysystem will lead to a shift in the LM curve to the left and this willraise the real interest rates and reduce spending (Ohanian, 2013).The financial crisis also affects an economy negatively and this islinked to the poor measures adopted by the central banks to curb adecline in money supply. In fact, a financial crisis can lead to adeflation which will also induce a depression.

Deflationin the U.S. led to external demand of American goods owing to theirlow costs however, the low income reduced the American demand forforeign goods. As a result, the U.S. economy started to contractseverely and there was an outward flow of gold to other countries. Ina bid to counteract the outflow of gold and trade surplus, differentcentral banks tried to raise their interest rates. Monetary policieswere the most ideal strategy to inhibit further contractions. Inessence, there was a strong connection between adherence to the goldstandard and the severity of deflation and depression in the economy.

1937 Recession

Inthe second half of 1936, there was a sharp increase in the productionprices. At the same time, there was an increase in industrial commonstocks from 114 to about 154. Monetary expansion started in 1933 inwhich the economy registered a 42% increase in the supply of money.The reason for the increase in supply of money was linked to thetensions across Europe which was the resultant factors to the SecondWorld War. However, in August 1937, there was a downward trend inthe market and this is what led to the Black Tuesday in October 19and brought down the industrial share to about 102. Just likeindustrial production, product prices fell sharply and the FederalReserve declined from 116 to about 106 (Richardson, 2014). Accordingto economists, the spurt exhibited in 1936 was mainly linked toinventory accumulation in the market. Unfortunately, inventoryaccumulation indicators were undermined by the government which wasstruggling to prevent the inflow of gold and stabilizing the marketand this led to a further decline in the Federal Reserve index.

Conclusion

TheGreat Depression, the U.S. was hit with massive unemployment rates.In a span of about 4 years, from 1929, the unemployment rate had hitabout 25%. Approximately 35 million in the economy added to theunemployment group in the economy. Between 1929 and 1933, there was areduction of income by about 40%. At the same time, the economy wasmarred by high deflation which reduced prices by about 10% on good.By the end of 1934, about a million families had lost their homes andfarms owing to delinquency of loans and additional 273,000 evictedfrom their homes, and the real estate development dropped by recordhigh 80%. The problem was further catalyzed by severe droughts whichhit other regions in the country and impacting agricultural produce.Owing to the tuff economic times, a wide range of companies closed orreduced their operations as a measure of cutting on costs. Between1929 and 1939, the role of the government changed dramatically asCongress passed several policies which banned the link betweencommercial banks and investment banking. Similarly, PresidentRoosevelt created the Federal Deposit Insurance Corporation whoseprimary mandate was to insure all deposits in banks.

TheGreat Depression came about due to a number of issues. Essentially,it was created with a combination of factors that included: thecollapse of the stock market, unreliable banking structure and tightmonetary policies that did not allow flexibility and adoptionstrategies to mitigate the failed economy. The crash in the stockmarket put a lot of pressure on the struggling banks causing acollapse of about 11,000 banks in the economy. With only a littlebanks operating, it was impossible to increase supply of money in theeconomy to support the collapsing economy. There disjoint between theFederal Reserve and central banks was another major problem thathindered the support of the failing economy.

References

Duignan,B. (2013).&nbspTheGreat Depression.New York: Rosen Pub.

Eichengreen,B. J. (2015).&nbspHallof mirrors: , the great recession, and theuses-and misuses-of history.

Fellows,N., &amp Wells, M. (2013).&nbspTheGreat Depression and the Americas 1929-39.Cambridge: Cambridge University Press.

Ohanian,L. (2013). Understanding economic crises: the great depression andthe 2008 recession.&nbspEconomicRecord,&nbsp86,2-6. http://dx.doi.org/10.1111/j.1475-4932.2010.00667.x

Richardson,G. (2014). Categories and causes of bank distress during the greatdepression, 1929–1933: The illiquidity versus insolvency debaterevisited.&nbspExplorationsin Economic History,&nbsp44(4),588-607. http://dx.doi.org/10.1016/j.eeh.2007.01.001

Tavlas,G. (2016). New Perspectives on the Great Depression: A ReviewEssay.&nbspInternationalFinance,&nbsp19(3),353-374. http://dx.doi.org/10.1111/infi.12094