Re-Examining the Contributions of Money and Banking Shocks to the US Great Depression

This paper quantitatively evaluates the hypothesis that deflation can account for much of the Great Depression (1929–1933). We examine two popular explanations of the Depression: (1) the high-wage story, according to which deflation, combined with imperfectly flexible wages, raised real wages and reduced employment and output; (2) the bank-failure story, according to which deflationary money shocks contributed to bank failures and to a reduction in the efficiency of financial intermediation, which in turn reduced lending and output. We evaluate these stories using general-equilibrium business-cycle models, and find that wage shocks and banking shocks account for a small fraction of the Great Depression. We also find that some other predictions of the theories are at variance with the data.