Thayer Watkins
Silicon Valley
& Tornado Alley

The Money Supply and the Banking System
Before and During the Great Depression

A chain of events led to the catastrophic decline in output and rise in unemployment, but at the beginning of that chain was a decline in the money supply. The table below shows the two aggregate measures of the money supply: M1, the sum of currency in circulation and the level of demand deposits, M2, the sum of M1 plus time deposits. The table also includes other relevant statistics.

The Money Supply and
Consumer Price Index (CPI)
Before and During the Great Depression Years

      Demand Currency Consumer
  M2 M1 Deposits in circulation Price
YEAR ($bill) ($bill) ($bill) ($bill) (1947-49
1926 43.7 26.2 22.2 4.89
1927 44.7 26.1 22.1 4.85 74.2
1928 46.4 26.4 22.5 4.80 73.3
1929 46.6 26.6 22.7 4.75 73.3
1930 45.7 25.8 22.0 4.52 71.4
1931 42.7 24.1 20.0 4.82 65.0
1932 36.1 21.1 16.2 5.70 58.4
1933 32.2 19.9 14.8 5.72 55.3
1934 34.4 21.9 17.2 5.37 57.2
1935 39.1 25.9 21.1 5.57 58.7
1936 43.5 29.6 24.3 6.24 59.3
1937 45.7 30.9 25.3 6.45 61.4
1938 45.5 30.5 25.0 6.46 60.3
1939 49.3 34.2 28.1 7.05 59.4
1940 55.2 39.7 32.0 7.85 59.9
1941 62.5 46.5 38.1 9.61 62.9
1942 71.2 55.4 43.8 12.38 69.7
Source: Historical Statistics of the United States

As seen above, at the start of the depression in 1930 the monetary aggregates decreased; 3 percent for M1 and slightly under 2 percent for M2. The price level, as measured by the consumer price index, decreased 2.6 percent. The level of demand deposits decreased as would be expected since there was a decrease in M1 and M2. The interesting item is the decrease in currency in circulation held by the public outside of banks. This could occur if the Federal Reserve was selling government securities. This suggests that the Fed was trying to pursue tight monetary policy. If we look at the discount rate the Federal Reserve Bank of New York was charging we get further evidence of this pursuit of tight monetary policy. In 1926 and 1927 the New York Fed's discount was in the range of 3.5 to 4.0 percent. In 1928 it was 3.5 to 5.0 percent. Then in 1929 the range shifted upward to 4.5 to 6.0 percent. In 1930 the range fell back to 2.0 to 4.5 percent. Apparently the Fed was attempting to puncture the speculative boom in the stock market. By 1930 the New York Fed's policy was having its effect. It must have immediately become apparent that the tight money policy was a mistake and the Fed tried to reverse the course but without much success. It was not easy to unpuncture the balloon.

To follow this lead as to the specific reason for the decrease in money supply in 1930 it is necessary to review some statistics on the the U.S. banking system. The money supply in 1930 could have decreased due to the collapse of many banks or it could have decreased because the banks were not making loans.

of banks
Historical Statistics of the U.S.

The above table shows that in 1929 and 1930 although the number of banks was decreasing this was part of a trend and not unusual for the period. In fact, the number of banks had been decreasing about a thousand per year since 1921. Furthermore in 1930 the value of the assets of the banks increased over the figure for 1929. Likewise the value of the banks, their net worth, increased from $9.8 billion in 1929 to $10.4 billion in 1930. Their total deposits also increased from $58.3 billion in 1929 to an all time high of $60.4 billion in 1930. The banking system saw hard times in the early years of the Great Depression but the above statistics show that this did not occur prior to the start of the depression.

What the above statistics for the banking system indicate that for one reason or another the banks were accumulating cash. This cash was funds they had available but were not loaning out either because there was insufficient demand for loans or because the banks were being cautious. Such caution would have been justified by the apparent attempt to create tight monetary policy on the part of the Fed in 1929.

The money multiplier was decreasing in the early 1930's because of increased cash holding by the general public and retention of increased excess reserves by the banking system. Both of these could have arisen from fear concerning the stability of the banking system. There were notable cases of bank failures in the news and the Fed did little or nothing to allay the fears generated within the banking system or among the general public. The end result was a decrease in the money supply due to a decrease in the magnitude of the money multiple such that the money supply was decreasing despite an increasing trend for the monetary base figures, the statistics that the Fed was monitoring. The monetary base is the sum of the currency in circulation and the reserves held in the Federal Reserve banks.

The contrast between what was happening to the monetary base and what was happening to the money supply is even more striking for the M2 money supply than the M1 money supply shown previously.

The decrease in the money supply led to the deflation that raised the real interest rate to extraordinary levels. Those high real interest rates collapsed investment purchases leading to the declines in production and employment; i.e., the Depression.

Thus the blame for the Great Depression lies firmly with the failures of the Federal Reserve. This is a blame not only because the Fed did not take counter measures to forestall the economic decline but also that the Fed's actions precipitated the decline in the money supply.

Once the Depression was developed the money supply was increased but that did not end the Depression. Once a balloon is punctured it is not easy to re-inflate it.

HOME PAGE OF applet-magic
HOME PAGE OF Thayer Watkins