The Impact of The Great Depression on Monetary Policy

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It is quite remarkable how economic thought has developed over time and how major events have affected these changes. With respect to monetary policy, it is amazing how attitudes towards it took a virtual U-turn after the difficulties of the 1930s. This period of transition, which occurred in 1930s America, is particularly important because the policies and ideas that were produced, had ramifications throughout the globe. But to understand how these attitudes were developed, one needs to understand economic thought prior to the Great Depression, particularly economists attitudes towards monetary policy.

Pre-Great Depression View of Monetary Policy

The view held by economists of the time, was that monetary policy was a tool which could be used to attain economic goals. There was great confidence placed in the Federal Reserve’s ability to use monetary policy to achieve these goals. However it was in this climate that the Great Depression occurred, and suddenly economists were caught off guard by this seemingly undetected catastrophe. In fact the impact on policy makers was similar to the current “Credit Crunch”, which similarly caused policy makers to question their approaches. Often it takes a “shock to the system” to cause economies to evolve. For instance one can note how financial regulation greatly increased and improved after the Enron Scandal. Economists of the 1930s could not explain the Great Depression, they could not explain why it happened and why monetary policy was powerless to avert it.

It was in this confusion that John Maynard Keynes entered the scene and gave an explanation for monetary policy’s shortcomings as well as an alternative; fiscal policy. Keynes was a revolutionary and his views have influenced economic thought till today, in fact his ideas formed the creation of an economics school of thought; Keynesian Economics. Keynes’ views are outlined in the book he authored, The General Theory of Employment, Interest & Money. According to Keynes, the failure of monetary policy was explainable through his theory of “liquidity preference”. He stipulated that in times of high unemployment, liquidity preference is absolute or almost absolute, therefore changes to the money supply would have no effect on interest rates. This supposedly explained monetary policy’s failure to lift the economy out of depression. Additionally Keynes’ opinion of interest rates was that they were ineffective in stimulating investment. After discrediting monetary policy’s adequacy; Keynes offered fiscal policy as the new tool to use. Now government spending and taxation would be used to stimulate investment and saving. Thus the Great Depression caused a massive shift in opinion away from monetary policy towards fiscal policy as the primary tool of central banks. The repurcussions of this were huge, as central banks throughout the globe based their policies on the Fed’s model.

The Usage of Cheap Money Policies

Monetary policy still had a role, albeit a minor one, in assisting fiscal policy by keeping interest rates low. Opinion therefore still believed interest rates had some effect on stimulating investment (albeit a weak one), despite Keynes’ views on this. In this climate cheap money policies began to be used around the globe. A cheap money policy is when a central bank adopts a policy of attempting to keep the interest rate pegged at a low level. It became apparent however that it was not possible to keep the interest rate pegged for more than short periods; any attempt to keep it pegged by continuously increasing the money supply resulted in inflation. Thus cheap money policies failed wherever they were implemented leaving inflation as the end result. In the United States this led to the Federal Reserve – Treasury Accord in 1951 to abolish the use of these flawed policies.

The Revival of Monetary Policy As A Major Tool

It was only two decades later in the 1960s that economic opinion began to review its position on monetary policy which ultimately led to its revival. This revival was driven by the Chicago economist, Milton Friedman, who is viewed as the father of the modern school of monetary economics. This revival was due to various factors, firstly there was a re-evaluation of monetary policy’s role during the Great Depression. Originally economists such as Keynes argued that the Fed used an aggressive expansionary monetary policy during the Great Depression which was ineffective. It only became apparent later that the Fed actually used a deflationary policy and the money supply fell by approximately a third during the Great Depression. In The Role of Monetary Policy, Friedman explained that the depression testifies the power of monetary policy rather than its inadequacy.

In other words the Great Depression is a historic example of how an economic downturn can escalate if monetary policy is not used in the correct manner. He further explained the limitations to fiscal policy; it was effective but worked with time lags which meant that it was challenging to implement by policy makers. Furthermore using taxation became problematic due to political factors which made it difficult to implement in a timely manner. In other words governments would be tempted to misuse it around elections and may not use it to benefit the economy in the best way possible. This is due to a conflict of interest, e.g. the government may refrain from increasing taxation around elections even if this is what is needed, or may stimulate investment through government spending before an election to win votes.

Friedman outlined what he believed were the uses and limitations of monetary policy, and emphasized that policy makers needed to know these limitations when using it. These ideas influenced economists opinions on monetary policy till today. The shifts in opinion about monetary policy in post Great Depression America, demonstrate how significant calamities can develop economic thought over time.

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