San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

The Money Supply and the Banking System
Before and During the Great Depression

A chain of events led to the catastrophic decline in output and rise in unemployment, but at the beginning of that chain was a decline in the money supply.

M1 is the money supply including currency and demand deposits (checking accounts). M2 is M1 plus the savings account deposits.

As can be seen, after 1929 all but one of the quantities declined at increasing rates. The amount of currency in circulation actually increased but it is such a small component of the money supply its increase was of no significance.

The decline in money supply led to lower prices; i.e.. a negative rate of inflation, deflation. Investment purchases are affected by the rate of interest minus the rate of inflation, the so-called real rate of interest. When there is deflation the real rate of interest is higher than the nominal rate of interest charged by lenders. So even though the nominal interest rate was declining from 1929 to 1933 businesses were experiencing record high real interest rates.

Those record high real interest caused invest purchases of equipment and material to collapses.

That was the immediate cause of the Great Depression. But the origin of the Great Depression was in the mistaken monetary policy of the Federal Reserve.

The table below shows the two aggregate measures of the money supply: M1, the sum of currency in circulation and the level of demand deposits, M2, the sum of M1 plus time deposits and a few minor amounts of funds. The table also includes other relevant statistics.

The Money Supply and
Consumer Price Index (CPI)
Before and During the Great Depression Years

  M2 M1 Demand
In circulation
YEAR ($bill) ($bill) ($bill) ($bill) (1947-49
1926 43.7 26.2 22.2 4.89
1927 44.7 26.1 22.1 4.85 74.2
1928 46.4 26.4 22.5 4.80 73.3
1929 46.6 26.6 22.7 4.75 73.3
1930 45.7 25.8 22.0 4.52 71.4
1931 42.7 24.1 20.0 4.82 65.0
1932 36.1 21.1 16.2 5.70 58.4
1933 32.2 19.9 14.8 5.72 55.3
1934 34.4 21.9 17.2 5.37 57.2
1935 39.1 25.9 21.1 5.57 58.7
1936 43.5 29.6 24.3 6.24 59.3
1937 45.7 30.9 25.3 6.45 61.4
1938 45.5 30.5 25.0 6.46 60.3
1939 49.3 34.2 28.1 7.05 59.4
1940 55.2 39.7 32.0 7.85 59.9
1941 62.5 46.5 38.1 9.61 62.9
1942 71.2 55.4 43.8 12.38 69.7
Source: Historical Statistics of the United States

As seen above, at the start of the depression in 1930 the monetary aggregates decreased; 3 percent for M1 and slightly under 2 percent for M2. The price level, as measured by the consumer price index, decreased 2.6 percent. The level of demand deposits decreased as would be expected since there was a decrease in M1 and M2. The interesting item is the decrease in currency in circulation held by the public outside of banks. This could occur if the Federal Reserve was selling government securities. This suggests that the Fed was trying to pursue tight monetary policy. The Fed had in fact been pursuing a tighter monetary policy since the spring of 1928 and continued this policy until the stock market collapse of October of 1929.

If we look at the discount rate the Federal Reserve Bank of New York was charging we get further evidence of this pursuit of tight monetary policy. In 1926 and 1927 the New York Fed's discount was in the range of 3.5 to 4.0 percent. In 1928 it was 3.5 to 5.0 percent. Then in 1929 the range shifted upward to 4.5 to 6.0 percent. In 1930 the range fell back to 2.0 to 4.5 percent. Clearly the Fed was attempting to puncture the speculative boom in the stock market. By 1930 the New York Fed's policy was having its effect. It must have immediately become apparent that the tight money policy was a mistake and the Fed tried to reverse the course but without much success. It was not easy to unpuncture a balloon.

To follow this lead as to the specific reason for the decrease in money supply in 1930 it is necessary to review some statistics on the the U.S. banking system. The money supply in 1930 could have decreased due to the collapse of many banks or it could have decreased because the banks were not making loans.

of banks
Historical Statistics of the U.S.

The above table shows that in 1929 and 1930 although the number of banks was decreasing this was part of a trend and not unusual for the period. In fact, the number of banks had been decreasing about a thousand per year since 1921. Furthermore in 1930 the value of the assets of the banks increased over the figure for 1929. Likewise the value of the banks, their net worth, increased from $9.8 billion in 1929 to $10.4 billion in 1930. Their total deposits also increased from $58.3 billion in 1929 to an all time high of $60.4 billion in 1930. The banking system saw hard times in the early years of the Great Depression but the above statistics show that this did not occur prior to the start of the depression.

What the above statistics for the banking system indicate that for one reason or another the banks were accumulating cash. This cash was funds they had available but were not loaning out either because there was insufficient demand for loans or because the banks were being cautious. Such caution would have been justified by the apparent attempt to create tight monetary policy on the part of the Fed in 1929.

There was a complicating factor of foreign financial developments impinging upon the Fed domestic policy at this time. Britain had been forced to devalue the pound in September of 1931 as a result of an attack of speculators. After the British devaluation there was fear that the dollar would be under attack next. The Fed, to stave off such speculation, wanted to raise the level of the interest rates. It did this by restricting the growth of the money supply after September, 1931. In 1932 Congress pressured the Fed to expand the money supply. The Fed did so until Congress adjourned and then tight monetary was resumed. There were some members of the Board of Governors of the Fed that believed the economic downturn and the collapse of many banks were good for the health of the financial system. This was known as the liquidationist policy of Treasury Secretary Andrew Mellon; i.e., the liquidation of the multitude of "weak" banks was a necessary condition for the recovery of the banking system.

The money multiplier was decreasing in the early 1930's because of increased cash holding by the general public and retention of increased excess reserves by the banking system. The increased holding of cash by the general public probably involved a good deal of hoarding of money which took it out of circulation. Both the holding of excess reserves by the bank and the increased holding of cash by the general public could have arisen from fear concerning the stability of the banking system. There were notable cases of bank failures in the news and the Fed did little or nothing to allay the fears generated within the banking system or among the general public. The end result was a decrease in the money supply due to a decrease in the magnitude of the money multiple such that the money supply was decreasing despite an increasing trend for the monetary base figures, the statistics that the Fed was monitoring. The monetary base is the sum of the currency in circulation and the reserves held in the Federal Reserve banks.

The contrast between what was happening to the monetary base and what was happening to the money supply is even more striking for the M2 money supply. y supply than the M1 money supply shown previously.

The decrease in the money supply led to the deflation that raised the real interest rate to extraordinary levels. Those high real interest rates collapsed investment purchases leading to the declines in production and employment; i.e., the Depression.

Thus the blame for the Great Depression lies firmly with the failures of the Federal Reserve. This is a blame not only because the Fed did not take counter measures to forestall the economic decline but also that the Fed's actions precipitated the decline in the money supply.

Once the Depression was developed the money supply was increased but that did not end the Depression. Once a balloon is punctured it is not easy to re-inflate it.

HOME PAGE OF applet-magic
HOME PAGE OF Thayer Watkins