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intervention. The panics caused a dramatic rise in the amount of currency people wished to hold relative to their bank deposits. This rise in the currency-to-deposit ratio was a key reason why the money supply in the United States declined 31 percent between 1929 and 1933. In addition to allowing the panics to reduce the U.S. money supply, the Federal Reserve also deliberately contracted the money supply and raised interest rates in
September 1931, when Britain was forced off the gold standard and investors feared that the United States would devalue as well. Scholars believe that such declines in the money supply caused by Federal Reserve decisions had a severe contractionary effect on output. A simple picture provides perhaps the clearest evidence of the key role monetary collapse played in the Great Depression in the United States. Figure 1 shows the money supply and real output over the period 1900 to 1940. In ordinary times, such as the 1920s, both the money supply and output tend to grow steadily. But, in the early 1930s, both plummeted. The decline in the money supply depressed spending in a number of ways. Perhaps most importantly, because of actual price declines and the rapid decline in the money supply, consumers and business people came to expect deflation – that is, they expected wages and prices to be lower in the future. As a result, even though nominal interest rates were very low, people did not want to borrow because they feared that future wages and profits would be inadequate to cover the loan payments. This hesitancy, in turn, led to severe reductions in both consumer spending and business investment spending. The panics surely exacerbated the decline in spending by generating pessimism and a loss of confidence. Furthermore, the failure of so many banks disrupted lending, thereby reducing the funds available to finance investment. The gold standard Some economists believe that the Federal Reserve allowed or caused the huge declines in the American money supply partly to preserve the gold standard. Under the gold standard, each country set a value of its currency in terms of gold and took monetary actions to defend the fixed price. It is possible that had the Federal Reserve expanded greatly in response to the banking panics, foreigners could have lost confidence in the United States’ commitment to the gold standard. This could have led to large gold outflows and the United States could have been forced to devalue. Likewise, had the Federal Reserve not tightened in the fall of 1931, it is possible that there would have been a speculative attack on the dollar and the Unites States would have been forced to abandon the gold standard along with Great Britain. While there is debate about the role the gold standard played in limiting U.S. monetary policy, there is no question that it was a key factor in the transmission of the American decline to the rest of the world. Under the gold standard, imbalances in trade or asset flows gave rise to international gold flows. For example, in the mid-1920s intense international demand for