1     

The Great Depression Bank Panics and the Money Supply, 1930–1933The bank failures of 1929 to 1933 highlight the destructive force of reductions in the money supply on the economy.

In 1930, banks were failing at a higher rate than in 1929, but not dramatically higher. Suddenly, in the final two months of 1930, the U.S. economy experienced a bank panic, in which there were simultaneous failures of multiple banks, in this case more than 750 banks with total deposits of $550 million. Depositors anticipated sub-stantial losses on deposits (because at the time there was no federal deposit insurance as there is today, which insures depositors against losses), and so they sought to shift their holdings into currency. The result, as shown in Figure 5A2.1, was a rise in the ratio of currency to deposits, called the currency ratio, denoted by c.

To protect themselves from a rapid outflow of deposits, banks substantially increased their holdings of excess reserves. As a result, the ratio of excess reserves to deposits, the excess reserves ratio, denoted by e in Figure 5A2.1, rose. Indeed, between October 1930 and January 1931, both c and e rose, with e more than doubling.

Our money supply model analysis predicts that when e and c increase, the money supply will contract. The rise in c reduces the overall level of multiple deposit expansion, leading to a decline in the money supply. Increasing e reduces the amount of reserves available to support deposits and also causes the money supply to decrease. Thus our model predicts that the rise in e and c after the onset of the first banking crisis would result in a decline in the money supply—a predic-tion borne out by the evidence in Figure 5A2.2.

As banking crises persisted through 1933, both c and e continued to rise, as our model predicts. By the end of the crises in March 1933, the money supply (M1) had declined by over 25%—by far the largest decline in all of American history—and it coincided with the nation’s worst economic contraction (see Chapter 15). Remarkably, such a dramatic decrease in the money supply occurred despite a 20% rise in the level of the monetary base during the period, illustrating just how important changes in c and e are during bank panics. It also highlights how depositor and bank behavior can complicate the Fed’s critical role of conducting monetary policy.

Application

Chapter 5 Appendix

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2     chapter 5 appendix

Figure 5A2.1

excess reserves ratio and Currency ratio, 1929–1933With the banking pan-ics that started in the fall of 1930, the cur-rency ratio, c, and the excess reserves ratio, e, rose substantially.

0.10

0.40

0.30

0.20

0.019311929 1930 19331932

Cur

renc

y R

atio

, c

0.05

0.35

0.25

0.15

0.02

0.08

0.06

0.04

0.0

0.01

0.07

0.05

0.03

Excess R

eserves Ratio, e

c

e

Start of FirstBanking Crisis

End of FinalBanking Crisis

Sources: Federal Reserve Bulletin; and Fried-man, Milton and Anna Jacobson Schwartz. 1963. A monetary history of the United States, 1867–1960. Princeton, NJ: Princeton University Press, 333.

Figure 5A2.2

M1 and the Monetary Base, 1929–1933The rise in the currency and excess reserves ratios, c and e, from 1930 to 1933 resulted in a decline in the money multiplier, which led to a 25% fall in M1, even though the monetary base rose by 20% over this period.

9

01931 193319301929 1932

29

Mon

ey S

uppl

y ($

bill

ions

)

6

21

8

23

7

22

19

20

26

28

27

24

25M1

Monetary Base

Start of FirstBanking Crisis

End of FinalBanking Crisis

Source: Friedman, Milton and Anna Jacobson Schwartz. 1963. A monetary history of the United States, 1867–1960. Princeton, NJ: Princeton University Press, 333.

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