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The Depression of the 1930's and Its Origins or Causes

The terrible, terrible conditions which occurred in the United States and the rest of the world in the 1930's are known as the Great Depression. This depression was not only an economic catastrophe, it was social and political catastrophes as well. Its origins then and even now are not entirely clear. The document is an attempt to tell the story of the Depression in terms of statistics in the form of graphs and tables.

The first statistic for demonstrating the decline of the economy into depression is the unemployment rate.

As the above graph indicates the economy descended from full employment in in 1929 where the unemployment rate was 3.2 percent into massive unemployment in 1933 when the unemployment rate reached 25 percent. The first question is why was there such high unemployment in 1933. The answer is that the economy was not producing (because it could not sell) as much output as it was capable of producing. The output of an economy is measured by its Gross Domestic Product and the graph below shows the decline in production from its high point in 1929 to its low point in 1933.

The decline in GDP, while dramatic, is not so spectacular as the explosion in the unemployment rate. This is because the umemployment rate represents what is not produced that could be produced. A graph showing the percentage of the labor force employed would look much the same as the GDP graph. While the Depression was a catastrophe it is well to keep in mind that at worst 75 percent of the labor force was employed. But, the important question is why production had fallen off so much in 1933 compared with 1929. Here it is instructive to look at the components of the demand for the nation's output. The output is purchased by consumers, business investors, governments and foreign buyers as exports. The purchases of U.S. output by foreign buyers is offset by American purchases of foreign production as imports. A glance at the table below tells what was happening to the components of demand.

YEAR GDP CON

SUMP

TION INVEST

MENT GOVERN

MENT

PUR

CHASES EXPORTS IMPORTS NET

EXPORTS 1929 790.9 593.9 92.4 105.4 35.6 46.3 -10.7 1930 719.7 562.1 59.8 116.2 29.4 40.3 -10.9 1931 674.0 544.9 37.6 121.2 24.4 35.2 -10.8 1932 584.3 496.1 9.9 117.1 19.1 29.2 -10.1 1933 577.3 484.8 16.4 112.8 19.2 30.4 -11.2

The above table indicates that consumer purchases fell somewhat, governments' purchases did not fall but there was a collapse of investment purchases. Exports fell but imports fell as well so that there was not much of a change in net exports. It is investment purchases, the purchases of equipment and buildings and inventory, which is the dramatic case, as shown below.

Consumer purchases fell also but this may have been an effect of the Depression rather than a cause of it. People's incomes fell and quite naturally they reduced their purchases. It is therefore reasonable to look into the collapse of investment purchases for an explanation of the causes of the Depression. The collapse of investment purchases can be considered the immediate cause of the Depression. The next question is why did investment purchases collapse so dramatically.

Interest rates affect investment. They are not the only thing that determines the amount of investment and are not necessarily even the most important determinant of investment but they do affect investment and so interest rates need to be considered. The important thing concerning the affect of interest rates on investment is that it is not the nominal interest rate that is important but instead the interest rate relative to the rate of inflation, the so-called real interest rate. The real interest rate is roughly the difference between the nominal rate and the rate of inflation. The problem in the early 1930's was that the rate of inflation was negative; i.e., there was deflation instead of inflation.

YEAR PRICE

INDEX RATE OF

INFLATION

% NOMINAL

INTEREST

RATE

% REAL

INTEREST

RATE

% 1929 13.12 -1.15 5.85 7.00 1930 12.60 -3.96 3.59 7.87 1931 11.34 -10.00 2.64 14.04 1932 10.05 -11.38 2.73 15.92 1933 9.78 -2.96 1.73 4.54

As the above table shows the nominal interest rate was declining over the course of the decline but because the rate of inflation was negative the real interest rate was much higher than the nominal interest rate. The following graph shows the trends.

The high real interest rate which came as a result of deflation could have been a major factor in the collapse of investment which was the immediate cause of the Depression. To find a cause of the deflation in the early 1930s we should look at monetary policy and the money supply during those years. Here is the record of the quantites of money before and during the decline into the Depression.

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 significance of the money supply is its correlation with the price level. Here is the correlation of M2 with te consumer price index.

For more details on the money supply and the Depression see Monetary Policy and the Money Supply

Appendix

The National Income Accounts

for the Great Depression Years

and Recovery in the U.S.

(1992 Prices)