Monetary Policy during the Great Depression Applicable Concept: Keynesians versu

Question

Monetary Policy during the Great Depression Applicable Concept: Keynesians versus monetarists onetarists and Keynesians still debate the causes of the Great Depression. Monetarists Milton Friedman and Anna Schwartz, in their book A Monetary History of the United States, argued that the Great Depression was caused by the decline in the money supply, as shown in Exhibit 10(a). The accompanying parts (b), (c), and ( present changes in the price level, real GDP, and unem- ployment rate. During the 1920s, the money supply expanded steadily, and prices were generally stable. In response to the great stock market crash of 1929, bank failures, falling real GDP, and rising unemployment, the Fed changed its monetary policy. Through the Great Depression years from 1929 to 1933, M1 declined by 27 percent. Assuming velocity is relatively constant, how will a sharp reduction in the quantity of money in circulation affect the econ omy? Monetarists predict a reduction in prices, output, and employment. As Exhibit 10(b) shows, the price level declined by 24 percent between 1929 and 1933. In addi tion to deflation, Exhibit 10(c) shows that real GDP was 27 percent lower in 1933 than in 1929. Unemployment rose from 3.2 percent in 1929 to 24.9 percent in 1933 supply. Thus, they concluded that the Fed was to blame for not pursuing an expansionary policy, which would have reduced the severity and duration of the contraction. Finally, although the emphasis here is monetary policy, t should be noted that both monetary and fiscal policies worsened the situation. President Herbert Hoover attempted to balance the budget, rather than using expansionary fiscal policy. Friedman and Schwartz argued that the ineptness of the Fed's monetary policy during the Great Depression caused the trough in the business cycle to be more severe and sustained. As proof, let's look at the period after 1933. The money supply grew and was followed closely by an increase in prices, real GDP, and employment ANAL Y ZE THE S SUE lain why monetarists believe the Fed should have expanded the money supply during the Great Depression. The Great Depression was indeed not the Fed's fines hour. In the initial phase of the contraction, foreign banks were fearful and withdrew large amounts of their gold from U.S. banks. To stop the outflow of gold to other countries, the Fed raised the discount rate in 1931. As a result, banks bwed less of their required reserves from the Fed's discount window, and the money supply fell Later the discount rate fell, but only after the economy was deeper into the Great Depression. 2. The Keynesians challenge the Friedman-Schwartz monetarists' monetary policy cure for the Great Depression. Use the AD-AS model to explain the Keynesian view. What should the Fed have done? Friedman and Source: Milton Friedman and Anna J. Schwartz, A Monetary Princeton University Press, 1963) should not have waited untilistory of the United States, 1867-1960 (Princeton, N.J 1931 to use open market operations to increase the money

Explanation / Answer

1) Monetarists believed that the Fed should have expanded the money supply during the Great depression.

During the Great depression demand for goods was lower than the production of goods. Goods remained unsold which depresses the economy. Fed should have prevented this problem by increasing money supply. Increase in money supply would reduce interest rate on bonds. This will encourage consumers to hold less bonds and more money. This will increase the demand for money which further increases the demand for goods. This could help solve the problem of the great depression.

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