Question: Monetarists and Keynesians still debate the causes
Monetarists and Keynesians still debate the causes of the Great Depression. Monetarists Milton Friedman and Anna Schwartz, in their book A Monetary History of the United States, argued that the Great Depression was caused by the decline in the money supply, as shown in Exhibit 9(a).
During the 1920s, the money supply expanded steadily, and prices were generally stable. In response to the great stock market crash of 1929, bank failures, falling real GDP, and rising unemployment, the Fed changed its monetary policy. Through the Great Depression years from 1929 to 1933, M1 declined by 27 percent. Assuming velocity is relatively constant, how will a sharp reduction in the quantity of money in circulation affect the economy? Monetarists predict a reduction in prices, output, and employment. Between 1929 and 1933, the price level declined by 24 percent. In addition to deflation, real GDP was 27 percent lower in 1933 than in 1929. Unemployment rose from 3.2 percent in 1929 to 24.9 percent in 1933. Friedman and Schwartz argued that the ineptness of the Fed’s monetary policy during the Great Depression caused the trough in the business cycle to be more severe and sustained.
The Great Depression was indeed not the Fed’s finest hour. What should the Fed have done? Friedman and Schwartz argued that the Fed should have used open market operations to increase the money supply. Thus, they concluded that the Fed was to blame for not pursuing an expansionary policy, which would have reduced the severity and duration of the contraction. As shown in part (b), this was not the case for the Great Recession of 2007–2009. From the beginning, the Fed followed an expansionary policy and sharply increased the money supply.
Finally, although the emphasis here is monetary policy, parts (c) and (d) contrast fiscal policy during the two periods using the federal deficit as a percentage of GDP. During the Great Depression, there was a slight budget surplus until 1931 when the budget turned into a slight budget deficit before reaching a deficit of 5.9 percent of GDP in 1934. In contrast, fiscal policy was more expansionary by running deficits from the beginning of the recession in 2007 to an estimated 10 percent of GDP in 2009.
Required:
1. Explain why monetarists believe the Fed should have expanded the money supply during the Great Depression.
2. The Keynesians challenge the Friedman–Schwartz monetarists’ monetary policy cure for the Great Depression. Use the AD-AS model to explain the Keynesian view. (Hint: Your answer must include the investment demand curve.)
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