The Great Misperception: The Money Multiplier and the Great Depression

The Fed was a bystander, not an active money shredder

Note: any and all opinions are entirely my own and do not necessarily reflect those of the Cleveland Fed, the FOMC, or any other person or entity within the Federal Reserve System. I am speaking exclusively for myself in this post (as well as in all other posts, comments, and other related materials). No content whatsoever should be seen to represent the views of the Federal Reserve System.

---

While researching another topic, I came across this EconLog post by the venerable Scott Sumner. Sumner’s own monetary history of the Depression is a very worthwhile read, but here he makes a great point about how the seminal work on the Great Depression — Friedman and Schwartz’s A Monetary History of the United States — is often misunderstood, or at least not fully understood, in its criticism of the Fed. The Fed did not shrink the money supply. Instead, it allowed it to shrink, a mistake no less serious, but an importantly different story. The money supply did not contract primarily because of the monetary base, but because of the money multiplier.

The M2 money supply contracted by nearly a third during the Great Contraction between 1929 and 1933. A third is enormous: recall %p = %m + %v - %y. If %m is negative 30, we can see why the price level fell so much during the contraction (nearly 1:1, as it happened). 

But where does the money supply come from? It increases with deposits, but would decrease if currency and deposits were converted into currency held by the public, vault cash, or to reserves at the Federal Reserve. What essentially happened during the Great Contraction is that bank failures led the public to increase their currency holdings, while banks held more money in reserves as the Fed proved unwilling to step in to create the reserves themselves (i.e. through open market operations). 

We can formalize the way the money supply is determined by the way money is held in the money multiplier. The multiplier is the extent to which the monetary base (currency in circulation + in vaults + in reserves) is expanded due to the alchemy of the banking system. We can construct a money multiplier as follows:

(1 + C/D)/[(C/D)+(ER/D)+(RR/D)]

C/D is the currency-deposit ratio, ER/D is the excess reserves-deposit ratio, and RR/D is the required reserves-deposit ratio. If we multiply this whole thing by H, high-powered money (the monetary base), we have the money supply. Here’s H during the period:

H definitely should have grown much more than it did, as Friedman and Schwartz argue in the concluding segment of “The Great Contraction”, but it hardly shrank and actually grew considerably during the contraction. In fact, H grew 150% from January 1930 to January 1940. As Sumner points out, the mistake of the Fed was not that it had cut the monetary base, or even that it had prevented the monetary base from rising. Instead, it didn’t raise the monetary base enough, and caused rearrangements in the multiplier that pulled the money supply down.

The Fed’s primary failure at least during the Great Contraction was in allowing so many banks to fail during the sequence of panics that occurred in the early 1930s and not sufficiently expanding reserves. The public increased cash holdings relative to deposits reflecting a distrust in banking, which ultimately only makes the panic worse as depositors run. Additionally, banks increased the amount of excess reserves held at the Fed as they began to realize the Fed would not step in to provide adequate help when they needed it. From page 348 of A Monetary History:

The banks had discovered in the course of two traumatic years that neither legal reserves nor the presumed availability of a “lender of last resort” was of much avail in time of trouble, and this lesson was shortly to be driven home yet again. Little wonder that the reserves they found it prudent to hold exceeded substantially the reserves they were legally required to hold. 

My point (and Sumner’s) is just that the Federal Reserve did not cut the monetary base, nor did they actively prevent its increase, during the Great Contraction. Instead, it stood idle when action would have dulled the sharpness of the contraction and later depression. Had more aggressive action been taken, bank failures would surely have been less severe had they occurred at all, and the increase in high powered money would have counteracted any other drop in the multiplier.