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PRELIMINARY DRAFT , DECEMBER 31, 2012

Friedman and Schwartzs Monetary Explanation of the Great Depression:

Old Challenges and New EvidenceBy CHRISTINA D. ROMER AND DAVID H. ROMER *

* C. Romer: University of California, Berkeley, Berkeley,CA 94720-3880 (email: [email protected]);D. Romer: University of California, Berkeley, Berkeley, CA94720-3880 (email: [email protected]).

For many, Friedman and Schwartzs Mone-tary History of the United States (1963) issynonymous with the notion that monetarycontraction and errors by the Federal Reservecaused the Great Depression. Though that isone of the books conclusions, this quicksummary both sells the book short in im-portant ways and oversells its findings aboutthe 1930s.

The crucial way it sells the book short isthat the contributions of the Monetary History extend far beyond the Depression. Friedmanand Schwartz use an extensive reading of thehistorical record over nearly a century to iden-tify times when the money supply moved forreasons unrelated to current or prospectivemacroeconomic conditions. That outputmoved in the same direction as money follow-ing these crucial experiments remains someof the strongest evidence we have that mone-tary shocks have real effects.

At the same time, saying that the bookproves that monetary shocks caused the GreatDepression is a stretch. Of the monetaryshocks Friedman and Schwartz identify, thosefor the early years of the Depression are argu-ably the most tenuous. And crucially, the bookprovides scant discussion about the mecha-nism by which monetary shocks affected theeconomy. This weakness is most pressing inthe discussion of the Depression. Becausenominal interest rates fell precipitously early

in the Depression and remained low through-out, it is hard to appeal to the standard trans-mission mechanism operating through thenominal cost of credit. Y et Friedman andSchwartz provide little guidance as to howthey believe monetary contraction nonethelessled to deep output declines in this period.

This paper seeks to fill in the gap in theFriedman and Schwartz explanation of theDepression by investigating this missing

transmission mechanism. In Section I, we dis-cuss the challenge to Friedman andSchwartzs explanation provided by theanomalous behavior of nominal interest rates.Previous work has shown that expectations of deflation can explain how falling nominal in-terest rates could be consistent with a high realcost of borrowing. But we argue that the mon-etary explanation requires not just that therewere expectations of deflation, but that those

expectations were the result of monetary con-traction. Because previous work has beenlargely silent on this issue, we are left withoutevidence about a necessary link from mone-tary shocks to the Depression.

In Section II, we analyze one component of the business press in detail to see if there wasa link between monetary shocks and expecta-tions of deflation in the central years of thedownturn1930 and 1931. We find evidencethat these professional observers did indeedexpect deflation in substantial part because of Federal Reserve behavior and monetary con-

traction. This suggests that monetary shocks inthe Depression may have affected output andemployment by raising real interest rates.

I . Challenges to Friedman and SchwartzsExplanation of the Great Depression

It is useful to begin with a review of Fried-man and Schwartzs monetary explanation of the Depression and the literature that has de-veloped both challenging and supporting it.

A. Friedman and Schwartzs Explanation

The core of Friedman and Schwartzs treat-ment of the Depression (Chapter 7 of theMonetary History ) is a careful historical anal-ysis of the underlying reasons for the declinein the money stock in the early 1930s. This iswhere Friedman and Schwartz make their casethat the decline had a significant exogenouscomponent.


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Friedman and Schwartzs implicit definitionof a monetary shock is very broad: anymovement in money that is unusual given theeconomic circumstances. One shock theyidentify in the early 1930s that is easy to de-fend on these grounds is the Federal Reservesdecision to raise the discount rate by 200 basispoints in October 1931following Britains de-parture from the gold standard. Quite clearly,the resulting fall in the money stock was notan endogenous reaction to the fall in output. Itwas the result of a conscious decision moti-vated by another considerationdefendingthe gold standard.

Friedman and Schwartz also suggest thatthere were other exogenous monetary shocksbetween 1929 and 1933, though they arevague about the number and their timing.

Their argument is that the Federal Reservestood by as banking panics caused large de-clines in the money multiplier, and hence inthe supply of money, and that under either theprevious clearinghouse system or a betterfunctioning central bank, such drops in themoney supply would not have occurred.

In Chapter 7, the role of the monetary con-traction in causing the real decline is largelyimplicit. Only after Friedman and Schwartzbring in other episodes1920, 193637, andperhaps the panics under the National BankingSystemdo they have a clear case that exog-enous monetary contractions cause outputcontraction. Armed with that relationship, onecan then go back to the 1930s and say thatsince there were large exogenous monetarycontractions in this period, they likely causedmuch of the real decline.

B. The Anomalous Behavior of NominalInterest Rates

A striking feature of the Monetary History is that the approach is almost entirely reducedform. Friedman and Schwartz focus on the

evidence that output and prices fell after mon-etary shocks. They provide little discussionand virtually no evidence on the possibletransmission mechanism of monetary shocksto spending and output.

Most scholars have assumed that Friedmanand Schwartz had in mind a conventional in-terest-rate channel. In the textbook IS-LMmodel, an exogenous reduction in the moneysupply shifts the LM curve back and raises

real and nominal interest rates. Such an ac-count fits what happened following many of Friedman and Schwartzs contractionary mon-

etary shockssuch as 1920 and the panicsunder the National Banking System. But itprovides a terrible description of what hap-pened during most of 192933.

Figure 1 shows the monthly pri me commer-cial paper rate for 1925 to 1933. 1 One thingthat stands out is the sharp rise in nominal in-terest rates following the October 1931 in-crease in the discount rate. Interest rates alsorose noticeably beginning in early 1928. Asdescribed by both Friedman and Schwartz andHamilton (1987), the Federal Reserve tight-ened policy moderately in this period to try to

rein in speculation in the stock market. Sincepolicy was not responding to current or pro-spective economic growth, but rather to assetprices, this episode appears to fit Friedmanand Schwartzs definition of a monetaryshock.

However, other than these two times, thecourse of nominal interest rates during theDepression was strongly downward. Ratesplummeted following the Great Crash of thestock market in October 1929. They fell fur-ther during the first two waves of panics (Oc-tober 1930 and March 1931). After the brief rise in late 1931, they fell continuously untilFebruary 1933.

1 The data are from Board of Governors of the Federal Reserve

System (1943, Table No. 120, pp. 450-451).

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FIGURE 1: C OMMERCIAL PAPER RATE


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C. Challenges to Friedman and SchwartzsEmphasis on Monetary Shocks

The literature has responded to this anoma-lous behavior of nominal rates in two ways.One is to suggest that Friedman and Schwartzare simply wrong about the importance of monetary shocks, at least in some time peri-ods.

Temin (1982) argues that the behavior of nominal rates implies that the IS curve musthave shifted back more than the LM curve.

Temin posits an unusual drop in consumerspending as the culprit, but cannot identify acause. Romer (1989) suggests that a rise inincome uncertainty associated with the stockmarket crash may have been the source. Olney(1999) argues that particulars of the householdbankruptcy law led consumers to cut spendingto ensure their ability to pay consumer creditcharges.

We suspect that even Friedman andSchwartz would agree that nonmonetary forc-es were important in the first year of the De-pression. The contractionary monetary shockin early 1928 can likely explain why the U.S.economy was cooling off in the summer of 1929. But this modest monetary tightening isnot a plausible explanation for the catastrophicdecline in output immediately following thestock market crash in October 1929. Industrialproduction, which had declined just 1.7 per-cent between July and September of 1929, fell10.7 percent from September to December. I tfell another 17.0 percent before th e first waveof banking panics in October 1930. 2

Furthermore, as Friedman and Schwartz de-scribe, in the fall of 1929 and early 1930 theFederal Reserve increased the stock of high-powered money aggressively. By their ac-count, the Federal Reserve acted appropriate-ly, or at least within the realm of normal, for acentral bank at the time. So, for the crucialfirst year of the Depression, it seems likely

that Temins nonmonetary hypothesis is large-ly correct. To explain why nominal rates continued to

fall, one could argue that there were further ISshocks after late 1930. One candidate is thenonmonetary transmission channel for the

2The data are from the Board of Governors,

http://www.federalreserve.gov/datadownload/ , series IP.B50001.S.

panics proposed by Bernanke (1983): thebanking panics had effects on spending not

just through a decline in the money supply,but also by causing a reduction in credit sup-ply at a given level of the safe interest rate.

There is certainly some evidence that such ef-fects were present, but evidence that they werelarge enough to account for the enormous out-put decline is lacking.

There were also contractionary fiscal chang-es in the early 1930s. In particular, the passagein June 1932 of the Revenue Act of 1932,which raised taxes by roughly 2 percent of GDP, was a surely a substantial IS shock. Butit came too late to explain the dramatic fall inoutput and interest rates in 1931 and early1932.

Thus, the hypothesis that nominal rates fellbecause monetary shocks were not the mainsource of the downturn has considerable sup-port for the period immediately following thestock market crash. But scholars have not per-suasively identified large nonmonetary shocksfor the critical period from roughly late 1930to the middle of 1932.

D. An Alternative Transmission Mechanism

The other way researchers have sought toreconcile Friedman and Schwartzs monetaryhypothesis with the behavior of nominal rates

is to bring in the rapid deflation that began inlate 1929. Wholesale prices fell 17.5 percentbetween J uly 1929 and December 193 0. Theyfell another 13.9 percent over 1931. 3 If thedeflation was expected, real rates could haverisen even as nominal rates declined. Indeed,in the IS-LM framework presented in terms of real output and the nominal interest rate, ex-pected deflation enters as a shift back of the IScurve.

This insight led to a cottage industry of pa-pers seeking to identify whether the deflationof the early 1930s was expected. Hamilton

(1992), using data on commodities futuresprices, argues that it was not, at least before1931. Cecchetti (1992), using simple statisti-cal forecasts as a proxy for expectations for-mation, argues that it was. Nelson (1991), inperhaps the most convincing study of the

3The data are from the Bureau of Labor Statistics,

http://www.bls.gov/data/ , Series WPU0000000.
http://www.federalreserve.gov/datadownload/http://www.federalreserve.gov/datadownload/http://www.bls.gov/data/http://www.bls.gov/data/http://www.bls.gov/data/http://www.federalreserve.gov/datadownload/


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three, examines the business press from June1929 to December 1930, and finds that profes-sional observers were expecting severe defla-tion at least as early as the summer of 1930.

If we accept that much of the deflation wasexpected, that strengthens the Friedman andSchwartz monetary explanation. It suggeststhat real borrowing costs were high, and socould have depressed spending and output.

However, there is still an important gap. ForFriedman and Schwartzs monetary story to becorrect, it is not enough that the deflation wasexpected. If the expectations were the result of the ongoing downturn or past deflation, or of supply-side shocks to the prices of primarycommodities, there does not appear to be anymechanism by which falls in the money sup-ply could exert a contractionary effect withoutraising nominal interest rates. Thus, the mone-tary explanation of the Great Depression re-quires that the expectations of deflation weredriven by the monetary contraction. For thatreason, the rest of this paper seeks to provideevidence on the source of the expectations of deflation during the time period when mone-tary shocks are thought to have been mostpronounced.

II . New Evidence on the Monetary Trans-mission Mechanism in the Depression

There are many ways one could try to obtainevidence about the link between monetaryshocks and expected deflation during theGreat Depression. The approach that we use isto examine one component of the businesspress clo sely for the first two years of the De-pression. 4 That is, we try to obtain direct evi-dence about whether the expectations of defla-tion of well-informed contemporary observerswere driven by monetary developments.

A. Narrative Source

The particular source that we consider is The Business Week magazine, which beganpublication in September 1929. During thedownturn, Business Week sometimes dis-cussed what market participants were expect-

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Our approach follows that of Nelson (1991) and Sumner (1997),who also examine the business press to discern public expectationsduring the Depression.

ing to happen to prices. But for the most part,it simply gave its own views. So, the best wayto interpret the publication is as a well-informed observer and thought leader.

Most of Business Week s discussion of pricemovements involved commodity prices: theprices of key minerals and agricultural goods.However, the magazine was very clear that itbelieved overall prices, as well as wages,would eventually follow commodity pricesdown. For example, in May 1930 it stated,Retailers are beginning to pass on to con-sumers some of the sharp drop in raw com-modity prices (5/28/30, p. 5).

Based on Nelsons (1991) narrative workand our own survey of other publications,Business Week in the early years of the De-pression appears more moderate and moreopen to the monetary hypothesis than someother publications. Thus, if we do not find alink between monetary contraction and expec-tations of deflation in Business Week , it is un-likely to be present in other sources. On theother hand, if we do find a link, it could stillbe the case that other contemporary observersdid not see one.

B. Business Weeks Model of Deflation

One important piece of evidence that Busi-ness Week s expectations of deflation were

affected by monetary changes comes f rom itsdiscussions of the causes of deflation. 5 If ac-tual deflation was seen to be the result of monetary contraction, it is likely that expecta-tions of monetary contraction would createexpectations of deflation.

Throughout 1930 and 1931, many of theweekly ups and downs of commodity priceswere attributed to news about the availablestocks of particular commodities and othersupply-side factors. But for most of the period,credit contraction was viewed as the centralcause of overall deflation. For example, in

March 1930, Business Week had an article onthe historical precedents for commodity pricedeflation. It stated (3/12/30, p. 20):

5One needs to be careful in interpreting the word deflation. in

documents from this period. In some cases, the term clearly meansprice declines; but in others, it means policies or actions that willbring about price declines and general economic contraction. In thequotations given below, we try to make clear any time the contextsuggests the latter interpretation was meant.


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Two factors have been present in all of these pe-riods of falling commodity pricesa marked risein production and stocks of commodities on hand,and contraction in bank credit.

Relative contraction of bank credit during peri-ods of increasing production and stocks has proba-bly been the most important factor.

Likewise, in October 1931, it referred to [t]hedecline of prices and the rise in the value of money during the past two years, due to adrastic contraction of credit (10/21/31, p. 48;see also 4/8/31, p. 48, and 4/15/31, cover).

Though Business Week referred mainly tocredit, other discussions made it clear that itviewed this term as roughly synonymous, or atleast closely related, to money. In Septem-ber 1931, in an editorial discussing the causesof deflation, it said (9/9/31, p. 44):

They are symptoms of a sudden, mysterious,universal shrinkage and shortage of the money andcredit medium by which everything is exchangedand the supply of which rests sol el y in the handsof the worlds banking institutions. 6

Perhaps the clearest statement of BusinessWeek s model of the causes of deflation camein September 1931. After stating that recentcommodity price declines could not be ex-plained by supply or idiosyncratic factors, itsaid: This collapse is the consequence of aworld-wide deflation of credit which has con-tracted purchasing power and curtailed con-sumption (9/2/31, p. 48).

Business Week s discussion of the causes of some particular episodes of deflation showsthat they believed Federal Reserve policy wasan important determinant of the supply of money and credit. For example, in March1930, it stated (3/12/30, p. 20; see also2/26/30, p. 4):

The recent period of falling commodity prices, be-ginning in September, 1928, coincides with a peri-od in which the rate of expansion of bank credit inthe Federal Reserve System in this country began

to decline relative to the increase in productionlargely because of the efforts of the Federal Re-serve authorities to control security speculation.

An analysis of wage deflation in mid-1931reveals a similar link between credit contrac-

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That Business Week titled the editorial No Wampum is evi-dence itself that it equated credit and money.

tion and Federal Reserve policy. An editorialstated (8/5/31, p. 40):

The two fundamental factors affecting wagesand employment during this depression have beencredit policy of our banking system as affected byFederal Reserve operations, and trade organizingactivity . [A]ppropriate, prompt and aggressiveaction by the Reserve authorities could have checked the deflation of prices and wages.

That Business Week believed credit contrac-tion led to deflation and that Federal Reservepolicy affected credit supply is clearly goodnews for Friedman and Schwartz. It makes itplausible that expectations of deflation werealso affected by credit supplies and FederalReserve actions. The next two sections lookfor a more direct link between BusinessWeek s expectations and its perceptions of Federal Reserve policy.

C. Expectations of Deflation and FederalReserve Actions in 1930

Business Week began 1930 fairly optimisticabout the end of deflation. Its January 1 issuesaid, Prices, wages and employment will besomewhat, but not much, lower in 1930 thanin 1929 (p. 22). A week later, it even de-scribed a scenario for how there may be abuyers scramble and a sharp rise in commodi-ty prices next spring (1/8/30, p. 4). The mag-azine did not give a clear reason for this ex-pectation, however. Some of it appears to havebeen due to a general sense that the economywas bouncing back from the stock marketcrash (1/22/30, p. 4). But expectations aboutmonetary policy also seem to have played arole. At the end of January, it said: Businessrevival would probably be facilitated and notmuch endangered by a further lowering of re-discount rates. We should expect this anyweek now (1/29/30, p. 4).

As deflation continued through Februaryand March, the magazine became less san-guine. It wrote at the end of February(2/26/30, p. 4):

The unexpected commodity price deflationsince the market crash has apparently given a sec-ond and more serious shock to business itself. Thisis a deferred result of credit restriction a year ago,which still persists.

The magazine argued forcefully for more Fed-


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eral Reserve action in consecutive editorialstitled More Juice, Please (2/26/30, p. 48)and Do It Now (3/5/30, p. 48). It appearedto fear continued commodity price deflationbecause of Federal Reserve inaction, saying,Continued weakness in commodity pricesindicates plainly enough that markets are dulland doubtful. All these things show clearlythe effect of delay in credit expansion(3/12/30, p. 4).

Over the next few months, Business Week did not express clear expectations about futureprice movements. Various weeks showed arange of optimistic and pessimistic price fore-casts.

In late June, the New York Federal Reservelowered its discount rate further, and BusinessWeek was enthusiastic. In July it listed EightSolid Facts that Point to Business Upturn, of which expanding bank credit was number one.It said: This means that, so long as this ex-pansion continues, either price levels or thevolume of business activity is bound to riseor both (7/9/30, p. 5). Likewise, the nextweek it stated, Federal Reserve credit is be-ing brought into action on a larger scale.Commodity prices are firmer (7/16/30, cov-er).

Two things are apparent from this descrip-tion of the first half of 1930. One is that Busi-ness Week , at least, was not expecting muchdeflation. There were occasional weeks whenit was gloomy, but for the most part it keptexpecting the deflation to stop, and kept beingsurprised when it did not. If the magazine wasrepresentative of market participants, this lackof expected deflation suggests that some otherforce, such as Temins autonomous drop inconsumption, was driving down nominal in-terest rates in the first six months of 1930.

The other thing that is apparent is that Busi-ness Week believed that adequate monetaryexpansion would stop the decline in prices.

The two times when the Federal Reserveshowed signs of acting, the magazine expectedit to be helpful. This is strong evidence thatthe magazine used credit and monetary policydevelopments in formulating its expectationsof price movements. It also suggests that theysupported Friedman and Schwartzs notionthat alternative policies were possible andknown at the time, which would have prevent-ed the decline in credit and prices.

By the middle of J uly, Business Week was

nervous that the Federal Reserve would notcarry through with monetary expansion. Itwrote (7/16/30, p. 41):

The Federal Reserve system did not follow upthat aggressiveness of last week which had caused

a short flurry of excitement. The large increase inReserve credit at that time had encouraged hopesthat the system was setting out actively to combatdeclining prices.

In early August, it reported: [T]he FederalReserve system, instead of continuing a help-ful release of credit to counteract the creepingparalysis of deflation, has done nothing(8/6/30, p. 10).

Despite this clear concern about a lack of Federal Reserve action, Business Week did notappear to consistently expect deflation in Au-gust and September. For example, in Septem-ber it said that the available evidence suggest-ed a turning point for commodity prices was athand (9/24/30, p. 7). This suggests that otherfactors, such as its sense that prices simplycould not fall below prewar levels, were alsoaffecting its expectations (for example, 7/2/30,p. 6, and 9/17/30, p. 44).

It was only in October that Business Week became clearly gloomy about the prospect of more deflation. On October 22 it connectedthe expectations of deflation in part to FederalReserve inaction, speaking of the wave of uncontrolled deflation which financial fatal-ism and lack of business statesmanship in thiscountry let loose upon the world (10/22/30,cover). Its editorial said (p. 40):

The deflationists are in the saddle. With the three largest banks lined up on their

side and with the Federal Reserve authoritiesstanding idly by, it has become clear since themiddle of September that what was a comparative-ly mild business recession during the first half of 1930 has now become a case of world-wide reck-less deflation.

The first wave of banking panics, whichFriedman and Schwartz identify as starting inOctober 1930, did not show up in BusinessWeek until December. The failure of the Bankof the United States was reported without fan-fare in a short article in the middle of themagazine (12/17/30, p. 17). The outlooksummary on the cover said:

[T]he tidal wave of deflation has not altogether


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subsided. The bond market has been seriouslyweakened by receding investment confidence andlack of Federal Reserve support . [T]he deadlycontraction of credit continues.

Clearly, Business Week was expecting contin-ued deflation in part because of credit contrac-tion caused by the interaction of the panicsand Federal Reserve inaction. However, un-like Friedman and Schwartz, Business Week viewed the Federal Reserves inaction duringthe panic largely as a continuation of a generalpattern of inadequate response to decliningcredit availability, rather than a distinct policyfailure. 7

D. Expectations of Deflation and FederalReserve Actions in 1931

Business Week began 1931 fairly optimisticabout the end of deflation and the revival of business, in part because the Federal Reservehad lowered the discount rate at the end of December. On January 7, 1931, BusinessWeek stated (cover; dots of ellipsis in origi-nal):

Basic commodity prices seem to have exhaustedthe possibilities of further decline. Though thetangible effects of lowered Federal Reserve redis-count rates on the bond market are still to be test-ed, increasing support may be expected.

This optimism, however, gave way to pre-dictions of continued deflation as additionalFederal Reserve actions failed to materialize.In February, Business Week stated: The de-flationists are now dominant in every aspect of public and private policy. Federal Reservecredit is being steadily contracted; com-modity prices still drift downward (2/4/31,cover). In an editorial in April, it said: ag-gressive, persistent open-market operations bythe Federal Reserve Banks could have com-pelled [banks] to cut short the chronic contrac-tion of credit which has prolonged depression [and] this drifting, demoralizing deflation(p. 48; see also 4/15/31, cover).

In late April, the magazine gave one of itsclearest statements that it was expecting con-tinued deflation because of low levels of cred-

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Like Business Week , Hetzel (2012) also does not single out thepanics as a time of particularly egregious Federal Reserve policymistakes.

it and anticipated Federal Reserve inaction. Itsaid, Our idle gold hoard piles up withoutincreasing the means of payment by credit ex-pansion because of paralysis of banking poli-cy, thus prolonging price deflation (4/29/31,cover).

In May, the Federal Reserve cut its discountrate again, and Business Week began to ex-press more optimism about price movements.In June, it said of commodity prices, A dras-tic and sudden reversal of the downward trendis not impossible or unlikely. One reason itgave for this view was, Low money rates forshort term commercial loans now enforced byFederal Reserve and European central bankpolicy will stimulate speculation for the riseand encourage consumers to accumulate sup-plies somewhat in excess of future require-ments (6/10/31, p. 9).

By early J uly, Business Week was almosteuphoric at what it saw as signs of credit ex-pansion. It stated (7/8/31, cover; dots of ellip-sis in original):

Still it is increasingly evident that the explosivematerials for a major upswing of surprising speedand proportions are accumulating in the unprece-dented credit position of the Reserve system, thecurious currency situation, the continued importsof gold, the abnormally balanced condition of commodity stocks . These factors alone are au-tomatically forcing a reversal of deflation, and arebeing strengthened by decisive considerations of

domestic and international political and financialpolicy, all pointing imperatively toward credit ex-pansion and price restoration. (7/8/31, cover)

However, when the anticipated aggressiveaction failed to materialize and further bank-ing troubles began to emerge, Business Week became more concerned about the economyand the prospects for continued deflation. OnSeptember 9, it talked about the seeminglyunappeasable demand for cash, and said,Federal Reserve policy continued to maketheir assistance available only in such a wayas to increase the strain on the banks (p. 41).

The cover summary said that [t]he drasticdecline in commodity prices, resumed in Au-gust, suggesting that the magazine may havestarted expecting more deflation. It drew alink between policy inaction and this expecta-tion when it said, The wait and see schoolis still in the ascendancy, and signs of thelarge-scale effort necessary to check the pro-cess are still lacking (9/9/31, cover). In a


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similar vein, two weeks later it again linked itsexpectations of deflation to its expectationsabout monetary policy (9/23/31, cover):

The comparative steadiness of commodity averag-es is encouraging but conceals a still unstable price

situation. Persistent inaction in official and fi-nancial circles in face of continued uncontrolleddeflation becomes increasingly alarming.

When Britain went off the gold standard,Business Week became more worried thatmonetary developments would speed defla-tion. On October 7, it reported (p. 8):

In the United States the Reserve system is beingsubjected not only to the strain of these foreignwithdrawals, but to a persistently increasing inter-nal hoarding demand for currency .

All this, taken in connection with the tidal waveof wage cuts, means further deflation in this coun-try, as commodity prices decline, foreign trade isfurther hampered and cre dit becomes more costlyand scarce. (10/7/31, p. 8) 8

The magazine was enthusiastic when Presi-dent Hoover proposed various actions to try toimprove the situation. One of the proposedmeasures was a private pool of rescue funds.Private bankers would pledge to buy eligiblepaper from banks that were not members of the Federal Reserve system, and so could notuse the discount window. It stated: The pool,if entirely successful, may make financing

easier and cheaper for business, make banksbetter able and more willing to lend. Thepool offers a method whereby inflation wouldbe possible (10/21/31, p. 5). Though BusinessWeek was likely using inflation in this in-stance to refer to a range of expansionary de-velopments, it clearly conveyed the sense thatits expectations of deflation had lessened be-cause of the possible monetary expansion.

This change in their expectations was con-firmed when a few weeks later it proclaimed(11/11/31, cover):

The devastating process of commodity price defla-tion appears definitely to have ended as credit ex-pansion sets in in speculative channels and sharpreduction of supplies in some lines looms up fornext year.

8In this case, deflation clearly refers to something broader than

price declineslikely the whole process of credit contraction, outputdeclines, and falls in prices.

This episode, like the others we have dis-cussed, shows a link between expectations of deflation and monetary policy actions in oneinformed observer in the early 1930s. Theother fact that these episodes drive home is thevolatility of Business Week s expectations of deflation. It clearly changed its views aboutfuture price movements frequently. Based onour reading, a large fraction of these changesin price expectations, especially the longer-lasting ones, were due to changes in anticipat-ed monetary and credit conditions.

II I . Conclusion

This paper has sought to address an im-portant weakness in Friedman and Schwartzsmonetary explanation for the Great Depres-sion: the lack of a well-articulated and docu-mented transmission mechanism for the mone-tary shocks. Building on the previous litera-ture, we emphasize the role of expected defla-tion in raising real interest rates. Our contribu-tion is to show that for the monetary explana-tion to be correct, it is not enough that therewere expectations of deflation in the early1930sthey must be the result of the mone-tary contraction.

Our narrative analysis of the discussion of deflation in The Business Week magazinedemonstrates that such a link between mone-

tary contraction and expected deflation existedstrongly in this particular source. Importantly,perceived Federal Reserve action (or, often,inaction) was frequently given as the reasonfor the monetary contraction and the maga-zines price expectations. If this result holdsup in other narrative sources, it would provideimportant confirmation of the Freidman andSchwartz monetary explanation of the Depres-sion.

This finding may also have implications formonetary policy and the transmission mecha-nism in other time periods, such as later in the

1930s and in recent years. When nominal in-terest rates are at the zero lower bound, expan-sionary monetary policy can increase outputprimarily by raising expectations of inflationand lowering real interest rates. Based onBusiness Week s expectation formation pro-cess in the early 1930s, it appears possible thatFederal Reserve policy may indeed createsuch expectations.


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Friedman, Milton, and Anna J acobsonSchwartz. 1963. A Monetary History of theUnited States, 18671960. Princeton:Princeton University Press for NBER.

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