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 unemployment 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 (exports) is closely related to American purchases of foreign production as imports. But it is exports that represents a component of aggregate demand. A decline in imports does not diectly stimulate the domestic economy.

A glance at the table below tells what was happening to the components of aggregate demand.

The above table indicates that consumer purchases fell somewhat, governments' purchases did not fall at all but there was a collapse of investment purchases. Exports fell and that represents a loss in demand for American products. Imports fell as well but that did not represent any change in the demand for American products. Although there was not much of a change in net exports that does mean that there was no effect of international trade in the depression. The decline in Exports and its effect on the economy will be considered later. It is investment purchases, the purchases of equipment and buildings and inventory, which is the dramatic case, as shown below.

Stock Market Price Decreases
As a Cause

The collapse of stockmarket prices on October 24th of 1929 was and still is a popular explanation for the beginning of the Depression but that is not likely to be valid. The fraction of the populatiion holding significant amount of stock was very small, Thus that event did not lead to any significant decline in a component of aggregate demand. It occurred as a result of the Federal Reserve System's actions trying to curb stockmarket speculations.

The Components of Aggregate Demand

Consumer purchases did fall 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 of equipment and building construction 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. More precisely it is that difference divided by (1+rate of inflation). See Real rate of interest.

The problem was that in the early 1930's the rate of inflation was negative; i.e., there was deflation instead of inflation.

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 was most likely a major factor in the collapse of investment which was the immediate cause of the Depression.

Once production declined businesses had excess capacity and no need for additional equipment even if real interest dropped.

Cause of the Deflation

To find a cause of the deflation in the early 1930's 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 the consumer price index.

The Money Supply

In a fractional reserve banking system the money supply is determined by the following relationship.

Money Supply = (Monetary Base)x(Money Multiplier)

The Multiplier depends upon a number of factors, such as banking reserve ratios and the proportions of financial assets held in various forms by the general public. See Money multiplier.

The Federal Reserve System (FED) has responsibility for monitoring the money supply and keeping it growing in line with the economy.

The U.S. had an inordinately large number of independent banks; upward of 20 thousand in the 1920s. In contrast in modern times Japan has only about one hundred independent banks. The FED in the late 1920s wanted to reduce the number of independent U.S. banks. It was keeping track of the Monetary Base and it seemed to growing properly. But unbeknownst to the FED the money multipliers were declining leading to decreases in the money supply and hence decreases in the price level. The deflation led to the extremely high real interest rates which collapsed investment purchases.

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

The International Sector

Exports did decline dramatically as shown below,

But that decline may have been an effect of the depression rather than a cause of it. The decline in Imports was certainly an effect of the depression. But when the U.S. reduced its purcases of trade partner products their economies went into decline and they reduced their purchases of American products and hence decline in Exports. In effect America exported the Depression. It went around the world.

Conclusions

The sequence of events that produced the Great Depression of the 1930s was as follows'

• The money supply started declining. The FED was unaware of this development'
• The declining money supply led to deflation in the price level.
• The deflation pushed the real interest rate to record high levels.
• Businesses decreased their purchases of equipment and structures. That virtuallly .stopped the borrowing to finance investment purchases of goods.
• Workers in the investment goods industries were laid off and thus reduced there purchases of consumer goods.
• The decline in production of consumer goods resulted in more unemployment and further declines in the economy.
• Americas reduce the purchases of the products of other countries and thus the depression got exported.
• The decline in the economies of trade partner countries results in a decline in U.S. exports and a further decline in U.S. production and more unemployment.

Appendix

The National Income Accounts
for the Great Depression Years
and Recovery in the U.S.
(1992 Prices)