THE JOURNAL OF ECONOMIC HISTORYVOLUME52

DECEMBER1992

NUMBER 4

What Ended the Great Depression?
CHRISTINA D. ROMER
This paper examines the role of aggregate-demandstimulusin ending the Great
Depression. Plausible estimates of the effects of fiscal and monetary changes
indicatethat nearly all the observed recovery of the U.S. economy priorto 1942
was due to monetary expansion. A huge gold inflow in the mid- and late 1930sswelled the money stock and stimulatedthe economy by lowering real interest
rates and encouraginginvestmentspendingand purchasesof durablegoods. Thatmonetarydevelopmentswere crucialto the recovery implies that self-correction
played little role in the growth of real outputbetween 1933and 1942.

Between1933 and 1937 real GNP in the United States grew at an
average rate of over 8 percent per year; between 1938 and,1941 it
grew over 10 percent per year. These rates of growth are spectacular,
even for an economy pulling out of a severe depression. Yet therecovery from the collapse of 1929 to 1933 has received little of theattention that economists have lavished on the Great Depression.
Perhapsbecause the cataclysm of the early 1930swas so severe, modem
economists have focused on the causes of the downturn and of theturningpoint in 1933. Once the end of the precipitousdecline in output
has been explained, there has been a tendency to let the story drop.1
The eventual returnto full employmentis simply characterizedas slow
and incomplete until the outbreakof World War II.
In this article I examine in detail the source of the recovery from theGreat Depression. I argue that the rapid rates of growth of real output
in the mid- and late 1930s were largely due to conventional aggregatedemand stimulus, primarily in the form of monetary expansion. My
calculations suggest that in the absence of these stimuli the economy
The Journal of Economic History, Vol. 52, No. 4 (Dec. 1992). ? The Economic History
Association. All rightsreserved. ISSN 0022-0507.
The authoris Associate Professorof Economics, Universityof California,Berkeley, Berkeley,
CA 94720.
MichaelBernstein,Barry Eichengreen,RobertGordon,RichardGrossman,FredericMishkin,David Romer, PeterTemin, ThomasWeiss, David Wilcox, and two anonymousreferees provided
extremelyhelpfulcommentsand suggestions.The researchwas supportedby the NationalScience
Foundationand the Alfred P. Sloan Foundation.
1 Temin and Wigmore, "End of One Big Deflation," for example, provided a convincing
explanationfor the turningpoint in 1933but did not analyzethe process of recovery after 1934.A
notable exception to this usual pattern is Bernstein, Great Depression, which analyzed theimportanceof structuralchanges throughoutthe recovery period.

757

758

Romer

would have remaineddepressed far longer and far more deeply than it
actually did. This in turn suggests that any self-correctingresponse of
the U.S. economy to low output was weak or nonexistent in the 1930s.
The possibility that aggregate-demandstimulus was the source of therecovery from the Depression has been considered and discounted bymany studies. E. Cary Brown, for example, used a conventional
Keynesian multipliermodel and the concept of discretionary government spending to argue that fiscal policy was unimportant.His oftencited conclusion was that "fiscal policy ... seems to have been an
unsuccessful recovery device in the 'thirties-not because it did notwork, but because it was not tried."2 Milton Friedman and Anna
Schwartz stressed that Federal Reserve policy was not the source of therecovery either: "In the period under consideration [1933-1941], theFederal Reserve System made essentially no attempt to alter thequantityof high-poweredmoney."3 While they were clearly aware that
other developments led to a rise in the money supply during themid-1930s,Friedmanand Schwartzappearto have been more interested
in the role that Federal Reserve inactionplayed in causing and prolonging the Great Depression than they were in quantifyingthe importanceof monetary expansion in generatingrecovery.
The emphasis that these early studies placed on policy inaction andineffectiveness may have led the authors of more recent studies toassume that conventional aggregate-demandstimulus could not haveinfluencedthe recovery from the Great Depression. Ben Bernanke andMartin Parkinson, for example, analyzed the apparent reversion of
employment toward its trend level in the 1930s and were struck by thestrengthof the recovery. They believed, however, that "the New Dealis better characterized as having 'cleared the way' for a natural
recovery ... ratherthan as being the engine of recovery itself."4 As aresult, they argued that the trend reversion of the interwareconomy isevidence of a strong self-corrective force. J. Bradford De Long and
Lawrence Summerssounded a similartheme: "the substantialdegree ofmean reversion by 1941 is evidence that shocks to output are transitory." The only aggregate-demandstimulusthat they thought might havecontributedto the recovery was WorldWarII, and they concluded that"it is hard to attributeany of the pre-1942catch-up of the economy to
the war,"5
Despite this conventional wisdom, there is cause to believe that
aggregate-demanddevelopments, particularlymonetary changes, were
importantin fostering the recovery from the Great Depression. Thatcause is the simple but often neglected fact that the money supply
2 Brown, "Fiscal

Policy," pp. 863-66.

3Friedman and Schwartz,MonetaryHistory, p. 511.
4 Bernankeand Parkinson,"Unemployment,Inflation,and Wages," p. 212.
5 De Long and Summers,"How Does MacroeconomicPolicy?" p. 467.

Ending of the Great Depression

759(measuredas MI) grew at an average rate of nearly 10 percent per year
between 1933 and 1937, and at an even higher rate in the early 1940s.
Such large and persistent rates of money growth were unprecedentedin
U.S. economic history. The simulations I present in this paper using
policy multipliersbased on the experiences of 1921and 1938, as well as
multipliersderived from macroeconometricmodels, suggest that thesemonetarychanges were crucially importantto the recovery. According
to my calculations, real GNP would have been approximately 25
percent lower in 1937and nearly50 percentlower in 1942than it actually
was if the money supply had continued to grow at its historical averagerate. Similar simulations for fiscal policy suggest that changes in thegovernmentbudget surplusplayed little role in generatingthe recovery.
In addition to estimating the effects of the tremendous monetary
expansion duringthe mid- and late 1930s, I also examine the source of
this expansion and the transmissionmechanismthat operated between
the monetarychanges and the real economy. The increase in the money
supply was primarilydue to a gold inflow, which was in turn due todevaluationin 1933and to capitalflightfrom Europebecause of politicalinstability after 1934. My estimates of the ex ante real interest ratesuggest that, coincident with this gold inflow, real interest rates fell
precipitously in 1933 and remainedlow or negative throughoutmost of
the second half of the 1930s. These low real interest rates are closely
correlatedwith a strong reboundin interest-sensitivespending. Thus, itis plausible that expansionary monetary developments were working
througha conventional interest-ratetransmissionmechanism.
THE STRENGTHOF THE RECOVERYMy concern in this article with findingthe source of the high rates ofreal growth duringthe recovery from the Great Depression may seem
strange to those accustomed to thinkingof that recovery as slow. The
conventional wisdom is that the U.S. economy remaineddepressed forall of the 1930s and only returned to full employment following theoutbreak of World War II. The reconciliation of these two seemingly
disparateviews lies in the fact that the declines in real outputin the early
1930s, and again in 1938, were so large that it took many years of
unprecedentedgrowth to undo them and return real output to normal
levels.
For most of my analysis I examined annual estimates of real GNP
from the U.S. Bureau of Economic Analysis.6 Because this series
begins at 1929,1 extended it backwardin time, when necessary, with myrevised version of the Kendrick-KuznetsGNP series.7 The percentagechanges in real GNP shown in Figure 1 clearly demonstrate both the
6 U.S. Bureauof Economic Analysis, National Income and Product Accounts,
7 Romer, "WorldWarI," table 5, p. 104.

table 1.2, p. 6.

760

Romer
20 1I|
15 I0
50

-5-10
-IS1
19Z7

1931

1935

1939

FIGURE 1

PERCENTAGECHANGESIN REAL GROSSNATIONAL PRODUCT, 1927-1942
Sources:The datafor 1929-1942arefromthe U.S. Bureauof EconomicAnalysis, NationalIncome
and ProductAccounts, table 1.2, p. 6. The data for 1927-1928are from Romer, "WorldWar I,"
table 5, p. 104.

severity of the collapse of real output between 1929 and 1933 and thestrengthof the subsequentrecovery. Between 1929and 1933, real GNP
declined 35 percent; between 1933and 1937, it rose 33 percent. In 1938
the economy sufferedanother 5 percent decrease in real GNP, but thiswas followed by an even more spectacular increase of 49 percent
between 1938and 1942.By almost any standard,the growth of real GNP
in the four-year periods before and after 1938 was spectacular.
It is certainly the case, however, that despite this rapid growth,
output remainedsubstantiallybelow normaluntil about 1942. A simple
way to estimate trend output for the 1930sis to extrapolatethe averageannual growth rate of real GNP between 1923 and 1927 forward from1927. The years 1923 through 1927 were chosen for estimating normal
growth because they are the four most normal years of the 1920s; thisperiod excludes the recession and recovery of the early 1920s and theboom in 1928 and 1929. This was also a period of price stability,
suggestingthat output was neitherabnormallyhigh nor abnormallylow.
The resultingfigurefor normalannualreal GNP growth is 3.15 percent.
Figure 2 shows the log value of actual real GNP and trend GNP basedon this definition of normal growth. The graph shows that GNP was
about 38 percent below its trend level in 1935and 26 percent below it in1937. Only in 1942 did GNP returnto trend.
The behavior of unemploymentduring the recovery from the Great
Depression is roughly consistent with the behavior of real GNP.
Although many scholars have rightly emphasized that the unemployment rate was still nearly 10 percent as late as 1941, it had fallen quite

Ending of the Great Depression

761

7.0r''''''''l'll
6.8 -E 6.6 -c

62-

1919

1923

1927

1931

1935

1939

FIGuRE 2

ACTUAL AND TREND REAL GROSSNATIONALPRODUCT,1919-1942
Note: TrendGNP, which is shown by the dashed line, is calculatedby extrapolatingthe growthrate of real GNP between 1923and 1927forwardfrom 1927.Therefore,this series does not start
until 1927.
Source: The source for real GNP is the same as in Figure 1.

rapidlyfrom its high of 25 percent in 1933.8 It declined, for example, bymore than three percentage points in both 1934 and 1936. That full
employmentwas not reached againuntil 1942is consistent with the factthat real output remained significantlybelow trend until that year.
THE EFFECTS OF AGGREGATE-DEMAND STIMULUS IN THE
RECOVERYTo examine whether aggregate-demandstimuluscan explain the highrates of real growth duringthe recovery phase of the Great Depression,
I performed an illustrative calculation. Consider decomposing thedeviation of output growth from normal into the effect of lagged
deviations of monetaryand fiscal changes from normaland the effect of
all other factors that might influence real growth, so thatchange),_1 + Pf(fiscal change),_1 + Et (1)output change, = 83m(monetary

where f,,mand f3Pare the multipliersfor monetary and fiscal policy and(, is a residual term that includes such things as supply shocks andchanges in animalspirits. This residualterm also includes any tendency
that the economy mighthave to rightitself following a recession. Usingannual data, this decomposition is most likely to hold with a one-year
The unemploymentstatistics are from Lebergott, Manpower, table A-3, p. 512. Darby,"Three-and-a-HalfMillion," arguedthat the returnof unemploymentto its full employmentlevel
was significantlymore rapid if one counts workers on public works jobs as employed. Margo,"InterwarUnemployment,"concludedfroman analysisof the 1940census data that at least someof Darby's correctionwas warranted.

762

Romer

lag between policy changes and output changes because policy changes
do not immediately affect real output.
Withinthis framework,if one measures Pm,,38f, output deviations, andpolicy changes, it is possible to calculate what the residualterm must bein any given year. Since these yearly residualterms reflect all the factors
affecting growth other than policy, they show how fast the economy
would have grown (relativeto normal)had monetaryand fiscal changes
not occurred. A comparisonof the actual path of real output with what
outputwould have been in the absence of policy changes provides a wayof quantifyingthe importanceof policy.
To apply this decomposition to the recovery phase of the Great
Depression, I used as the measure of output change the deviation of thegrowth rate of real GNP from its average annualgrowth rate duringthe
years 1923 through 1927. For the monetary policy variable I used thedeviation of the annual (December to December) growth rate of Ml
from its normal growth rate, where normal is again defined as theaverage annualgrowthrate between 1923and 1927.9The average annual
growth rate of Ml over this period was 2.88 percent. For the fiscal
policy variable I used the annual change in the ratio of the real federal
surplus to real GNP.'0 This measure of fiscal policy assumes that thenormal change in the real federal surplus is zero.'1
9 The data on MI are from Friedmanand Schwartz,MonetaryHistory, table A-i, column7, pp.
704-34. An alternativemeasureof monetarypolicy thatmightbe consideredis the deviationof realmoney growth from normal. However, changes in nominalmoney are what shift the aggregatedemand function; changes in real money result from the interactionof aggregate-demandandaggregate-supplymovements. Since the purpose of this paper is to isolate the effects ofaggregate-demand
stimulus,it is appropriateto use a measureof monetarypolicy that only reflects
changes in demand.
10 The surplusdataare fromthe U.S. Departmentof the Treasury,StatisticalAppendix,table 2,
pp. 4-11, and are based on the administrativebudget. Because these data are for fiscal years, I
converted them to a calendar-yearbasis by averagingthe observationsfor a given year and thesubsequentyear. The data were deflatedusing the implicitprice deflatorfor GNP. The deflator
series and the real GNP series for 1929to 1942are from the U.S. Bureauof Economic Analysis,
National Income and ProductAccounts; data for 1919to 1928are from Romer, "WorldWar I."
I used the administrativebudgetdata insteadof the NIPA surplusdata because they are available
on a consistentbasis for the entireinterwarera. Whilethe two surplusseries differsubstantiallyin
some years, the gross movementsin the series are generallysimilar.I dividedthe surplusby GNP
to scale the variablerelative to the economy.
" In place of the actual surplus-to-GNPratio, the full-employmentsurplus-to-GNPratio could
be used. I did not use this variablebecause it treats a decline in revenues caused by a decline inincomeas normalratherthanas an activistpolicy. This is inappropriatefor the prewarandinterwar
eras, when raisingtaxes in recessions was usuallypreferredto lettingthe budgetslip seriouslyinto
deficit. However, the differencesbetween the full-employmentsurplusand the actualsurpluswere
so small even in the worst years of the Depression that the two measures yield similarresults.
Anotherpossible measureof fiscal policy is the weightedsurplus,which takes into accountthe factthat a surpluscaused by changesin taxes and transferswill have a differentimpactthan a surplus
caused by a change in governmentpurchases. Blinder and Solow, "Analytical Foundations,"
showed that the practical effects of such weighting are typically small and sensitive to model
specificationand the time horizonconsidered.

Ending of the Great Depression

763

Estimates of the Policy Multipliers
Deriving the policy multipliersto use in the decomposition is a far
more difficulttask than measuringthe deviation of monetary and fiscal
policy from normal. One way of deriving the multipliers is to takeestimates from a large postwar macroeconomicmodel. Another strategy
is to simply posit reasonable values for these multipliers. In my later
discussion of robustness, I show the results of both of these approaches.
However, an alternative procedure that is more in the spirit of theexercise is to use historical evidence to identify certain years when theresidualterm in equation 1 was small and when the changes in monetaryand fiscal policy were independentof movements in real output. If there
were two such episodes, one can simply infer estimates of gm and of
from the decomposition itself. 12
The recessions of 1921 and 1938 are arguably two such crucial
episodes. In both cases there were large movements in real output thathave been almost universally ascribed to monetary and fiscal policy
decisions. Friedman and Schwartz, for example, stated that "in bothcases, the subsequent decline in the money stock was associated with asevere economic decline."'3 This emphasis on monetaryfactors in 1921
and 1938 was echoed by W. Arthur Lewis and by Kenneth Roose.'4
Other authors assigned a much more importantrole to fiscal policy as
the source of these two interwar downturns. Alvin Hansen, Arthur
Smithies, Leonard Ayres, and Robert A. Gordon all attributed therecession of 1938to the decline in governmentspending.'5 Gordon also
argued that the decline in government spending after World War I and
the increase in the discount rate were the two factors that helped to tip
a vulnerable economy into a severe recession in 1920.16
Furthermore,most alternativeexplanationsthat have been advanced
for these two recessions are easily disproved;there is little evidence that
other factors (the e, in equation 1) were importantin determiningthe
behavior of real output in 1921and 1938. For example, one explanation
for the downturn in 1938 is that increases in wages due to increased
unionizationdecreased output and investment; in short, that there wasan adverse supply shock in 1937.17 An adverse supply shock, however,should have been accompanied by rising prices. This did not occur:
between 1937 and 1938 producer prices fell 9.4 percent. On the other
hand, the policy hypotheses that stress a fall in aggregate demand are
12 This methodof derivingroughestimatesof the effects of policy is an exampleof the narrative
approachdescribedin Romer and Romer, "Does MonetaryPolicy Matter?"
13 Friedmanand Schwartz,MonetaryHistory, p. 678.
14
Lewis, Economic Survey, pp. 19-20; and Roose, Economics of Recession, p. 239.
15
Hansen, Full Recovery; Smithies, "American Economy"; Ayres, Turning Points; andGordon,EconomicInstability.
16
Gordon,EconomicInstability,p. 20.
17 See, for example, Roose, Economics of Recession, p. 239.

764

Romer

consistent with the observed fall in prices. The monetaryexplanationis
also consistent with the fact that interest rates rose sharplyin early 1937
and interest-sensitivespendingsuch as constructionexpendituresplummeted in late 1937.
The main alternativeexplanationadvanced for the recession of 1921is that the tremendous pent-up demand for consumer goods thatdeveloped duringand after WorldWarI was satisfiedby 1920and firms
faced a dramaticdecline in sales.'8 The problem with this story is that
real consumer expendituresrose 4.8 percent between 1919and 1920and
6.2 percent between 1920and 1921.19Any spending story also conflicts
with the fact that interest rates rose substantiallyin 1920.
One partialexplanationfor the behavior of real output in 1921that is
hard to dismiss is the occurrence of a positive supply shock. In aprevious article I arguedthat the recovery of agriculturalproductionin
Europe caused prices of agriculturalgoods in the United States toplummetin 1920.20This, in turn, stimulatedthe productionof industries
that used agriculturalcommodities as inputs. The presence of a favorable supply shock in this episode implies that the E, in equation 1 for1921 could be positive. In the discussion of robustness that follows thesimple calculation of the multiplier,I show that even the inclusion of a
substantial positive residual in 1921 does not change the qualitative
results.
The natureof the policy changes in the years precedingthe recessionsof 1921 and 1938 indicates that these changes were independent of
movements in the real economy: the money supply and the government
surpluschangedin 1920and 1937because of active policy decisions, notbecause of endogenous responses of money growth or government
spendingto a fall in real output. Most obviously, in 1920it was the endof World War I that led to an enormous drop in real government
spending. The magnitudeof this change can be seen in the fact that the
surplus-to-GNPratio rose from -8.3 percent in 1919 to 0.5 percent in
1920.
Monetary policy changes in this episode were also quite pronounced
and largely independent. According to Friedman and Schwartz, theFederal Reserve in 1919became concerned about the lingeringinflationfrom World War I and the postwar boom.2' In response, the Federal
Reserve raised the discount rate three-quartersof a percentage point in
December. The diaries and papers of members of the Board of Governors of the Federal Reserve System that Friedman and Schwartz
analyzed suggest that the Federal Reserve did not understandthe lags
with which monetarypolicy affectedthe economy. As a result, when the
18 See, for example, Lewis, Economic

Survey, p. 19.

19 The consumptiondata are from Kendrick,ProductivityTrends,table A-Ila, p. 294.
20
21

Romer, "WorldWarI."
Friedmanand Schwartz,MonetaryHistory, pp. 221-39.

Ending of the Great Depression

765

economy failed to respond immediatelyto the increase in interest rates,
the Federal Reserve raised the discount rate another 1 1/4 percentage
points in January1920and an additionalpercentagepoint in June 1920.
Because these large increases in interest rates appear to be mainly the
result of Federal Reserve inexperience, they represent independent
monetarydevelopments ratherthan conscious responses to the current
state of the real economy.
In 1937the tighteningof fiscal policy was less dramatic,but still quite
severe. In 1936 a large bonus had been paid to veterans of World War
I. In 1937, not only was there no payment of this kind, but social
security taxes also were collected for the first time. This increase inrevenues was clearly unrelatedto developmentsin the real economy; itreflected a conscious decision to permanentlyraise taxes to finance a
pension system. The result of these two changes was that the surplusto-GNP ratio rose from -4.4 percent in 1936 to -2.2 percent in 1937.
Monetary changes in 1937 were less straightforwardthan those in1920, but still largely independent. Friedmanand Schwartz viewed themain monetary shock as the doublingof reserve requirementsin threesteps between July 1936 and May 1937.22 The Federal Reserve raised
reserve requirementsbecause it was concerned about the high level ofexcess reserves in 1936and wanted to turnthem into requiredreserves.
According to Friedmanand Schwartz, this action greatly decreased themoney supply because banks wanted to hold excess reserves. As aresult, they decreased lending so that reserves were still higherthan the
new required levels.23 Friedman and Schwartz viewed the resulting
change in the money supply as independent because the Federal
Reserve was not responding to the real economy: it inadvertently
contracted the money supply because it misunderstoodthe motivationof bankers.24
The independence of policy movements in 1920 and 1937 and theabsence of additionalcauses of the recessions of 1921and 1938 suggestthat these two episodes can be used to estimate multipliersfor monetaryand fiscal policy. To do this calculation, I merely substituted therelevant data for 1921and 1938into equation 1 and then solved the two
equation system for 83fand Pm Table 1 shows the calculation.
22

Ibid., pp. 543-45.

23 The fact thatinterestrates rose substantiallyin 1937addscredenceto the view thatlendingfell

because banks restrictedloans and not because the demandfor loans declined.
24
In additionto the change in reserve requirements,the Treasuryin 1936began sterilizingthe
gold inflow. This resultedin a substantialslowingin the growthrate, thoughnot an actualdecline,of the stock of high-poweredmoney. This switch to sterilizationappearsto be part of the same
policy mistakethat led to the increasein reserve requirements.Accordingto Chandler,America's
Greatest Depression, pp. 177-181, the Treasuryundertookthe sterilizationat the behest of theFederal Reserve, which feared that an unsterilizedgold inflow would exacerbate the excess
reserves problem.Chandlercited as evidence that the Treasurydid not mean to affect the money
supply the fact that they were greatlyconcernedby the resultingrise in interestrates in 1937.

766

Romer
TABLE 1CALCULATION OF THE POLICY MULTIPLIERS

Substitutingdata into equation 1 and setting Et equal to zero yields:
0.0554 = Pm (-0.0424) + 8f(0.0878)
1921:
1938: -0.0772 = Pm (-0.0877) + 8y (0.0218)

Solving two equationsfor two unknownsyields:(-0.0554)(0.0218)

P

=

823

=

-0.233- (0.0878)(-0.0772)(-0.0424)(0.0218) - (-0.0877)(0.0878)=- 0.0772 - 8m(-0.0877)
0.0218

Note: The intermediatecalculationspresenteddifferslightlyfrom the final multipliersbecause ofrounding.
Source: See the text.

Using this approach, the estimated multiplierfor monetary policy is
0.823 and the estimated multiplierfor fiscal policy is -0.233. The signsof the two multipliers are what would be expected. f3f is negative
because the fiscal policy variable is based on the federal surplus; anincrease in the fiscal policy measureis contractionary.The magnitudeof
the monetary policy multiplier is quite reasonable. It implies that a
growth rate of MI that is one percentagepoint lower than normalresults
in real output growth that is 0.82 percentagepoints lower than normal.
As I describe in more detaillater, this result is consistent with the effects
of monetaryfactors found in large macromodels.The magnitudeof the
fiscal policy multiplier is quite small. It implies that a rise in thesurplus-to-GNPratio of one percentagepoint lowers the growth rate ofreal output relative to normalby 0.23 percentagepoints. The reason forthis small multiplieris the fact that the deviation of real output growthfrom normal was slightly smaller in 1921 than in 1938, but the fiscal
policy shock was nearly four times as large in 1920 as in 1937.
Consequently, it would be very difficultto attributemost of the declines
in output in 1921 and 1938 to fiscal policy.
Simulations
Armed with these multipliers, it is possible to calculate the likely
effects of monetary and fiscal developments during the mid- and late
1930s. As I have set up the analysis, the multiplier times the policy
measure lagged one year shows the effect of policy on the deviation of
output growth from normal in a given year. If one subtracts this effectof unusual policy from the actual growth rate of real output, one is left
with estimates of what the growthrate of outputwould have been under

767

Ending of the Great Depression
7.0

E

|

1

X

1

1

1

1

1
/'

Real GNP~~~Actual

6.8
6.8-

E

GNPUnderNormal
6.6 - Fiscal Policyg%
. 6.6

6-

4

6.2

1933

1935

1937

1939

1941

FIGURE 3

ACTUAL OUTPUTAND OUTPUT UNDER NORMALFISCAL POLICY, 1933-1942
Note: The dashedline shows the pathof the log-valueof real GNP underthe assumptionthat fiscal
policy was at its normallevel throughoutthe mid- and late 1930s;the solid line shows the path ofactualreal GNP.
Sources: The calculationof outputundernormalfiscal policy is describedin the text. The source
for real GNP is the same as in Figure 1.

normal policy. Accumulatingthese growth rates of real output undernormalpolicy and then addingthem to the level of output in a base year
yields a series of the levels of output under normalpolicy.
The difference between the path of actual output and the path of
outputundernormalpolicy shows how much slower the recovery would
have been in the absence of expansionarypolicy. In calculatingthe pathof real output under normal policy I used 1933 as the base year. This
path shows what output would have been under normal policy after
1933, without taking into account the fact that the Depression wasprobably caused to a large extent by serious policy mistakes. This
procedure is appropriatebecause the purpose of this article is not toargue that policy did not contributeto the downturnof the early 1930s,
but rather that policy was central to the recovery in the mid- and late
1930s. In calculating the effects of unusual policy, I did the analysis
separately for monetary and fiscal policy. In one experiment I asked
what output would have been if fiscal policy had been normal butmonetary policy had followed its actual historical path. In a second, I
held monetary policy to its normallevel and let fiscal policy follow its
actual path.
Figure3 shows the experimentfor fiscal policy. The great similarityof
actual real GNP and GNP under normal fiscal policy indicates that
unusual fiscal policy contributedalmost nothing to the recovery fromthe Great Depression. Only in 1942 is there a noticeable difference
between actual and hypothetical output, and even in this year thedifference is small.

768

Romer

C

L

-2

1923

1927

1931

1935

1939

FIGURE 4

CHANGESIN SURPLUS-TO-GROSSNATIONAL PRODUCTRATIO, 1923-1942
Note: The changes are shown lagged one year because this is the form in which they enter mycalculation.
Sources: The surplusdata are from the U.S. Departmentof the Treasury,Statistical Appendix,
table 2, pp. 4-11. The text describesadjustmentsthat I madeto the base data. The source for real
GNP is the same as in Figure 1.

The small estimated effect of fiscal policy stems in part from the factthat the multiplier based on 1921 and 1938 is small, but it is more
fundamentallydue to the fact that the deviations of fiscal policy fromnormalwere not large duringthe 1930s. This fact can be seen in Figure
4, which shows the change in the surplus-to-GNPratio (lagged oneyear). The change in this ratio in the mid-1930swas typically less than
one percentagepoint and was actuallypositive in some years, indicatingthat fiscal policy was sometimes contractionaryduring the recovery.
Even in 1941, the first year of a substantial wartime increase in
spending, the surplus-to-GNPratio only fell by six percentage points.
Figure 5 shows the experimentfor monetary policy.25This time thepaths for actual GNP and GNP under normal monetary policy aretremendously different. The difference in the two paths indicates that
had the money growth rate been held to its usual level in the mid-1930s,
real GNP in 1937 would have been nearly 25 percent lower than it
actually was. By 1942 the difference between GNP under normal andactual monetary policy grows to nearly 50 percent. These calculations
suggest that monetary developments were crucial to the recovery. If
money growth had been held to its normallevel, the U.S. economy in
25 McCallum,"Could a MonetaryBase Rule?" also used a simulationapproachto analyze theeffects of monetaryfactors in the 1930s.McCallum'sfocus, however, was on whethera monetarybase rulecould have preventedthe GreatDepression,ratherthanon whetheractualmoneygrowth
fueled the recovery.

Ending of the Great Depression
7.0 1

1

1

1

1

1

1

1

769
X

Actual Real GN

6.8

E
6.6-

.9

GNP Under Normal
A,-MonetaryPolicy

6.4 ,/

6.2 1933

1935

1937

1939

1941

FIGURE 5ACTUAL OUTPUTAND OUTPUT UNDER NORMALMONETARYPOLICY, 1933-1942
Note: The dashed line shows the path of real GNP underthe assumptionthat the money growthrate was held to its normalpre-Depressionlevel throughoutthe mid-and late 1930s;the solid line
shows the path of actual real GNP.
Sources: The calculationof output under normalmonetarypolicy is described in the text. The
source for real GNP is the same as in Figure 1.

1942 would have been 50 percent below its pre-Depressiontrend path,rather than back to its normallevel.26
The source of this large estimatedeffect of monetarydevelopments is
not hard to find. As I point out in greater detail in the following
discussion, the monetarypolicy multiplierestimatedfrom 1921and 1938
is not implausiblylarge: it is roughlyof the magnitudefound in postwar
macromodels. The large estimated effects of monetary developments
are due to the extraordinarilyhighrates of money growthin the mid- andlate 1930s. The monetarypolicy variable(laggedone year) is graphedin
Figure 6. As can be seen, the deviations of the money growth rate fromnormalwere enormous in the mid- and late 1930s. For most years these
deviations were over 10 percent. It is not at all surprising,therefore, tofind that had this deviation from normalbeen held at zero, the recovery
from the Depression would have been dramaticallyslower.
Robustness
The results of these simulations are quite robust. Monetary policy
was so expansionary during the recovery, and fiscal policy so nonexpansionary, that changing the multipliers substantially would not
make monetarypolicy unimportantand fiscal policy crucial. For exam26 Oniecould start the simulationsin 1929 to estimate the role of monetary developments incausingthe Depression.Whilethis procedureis not strictlycorrect,because some of the monetary
developmentsin the early 1930s were clearly endogenous, the results confirmthe conventional
wisdom:monetaryforces hadlittle effectduringthe onset of the GreatDepressionin 1929and 1930,
but were the crucialcause of the deepeningof the Depressionin 1931and 1932.

Romer

770
16

8
C

4-

4

:? 0
-4
-8-

-16l

1923

1927

1931

1935

1939

FIGURE 6

DEVIATIONSOF MONEY GROWTHRATE FROMNORMAL, 1923-1942
Notes: The normalmoney growthrate is definedas the averagegrowthrate of MI between 1923
and 1927.The deviationsare shown laggedone year because this is the form in which they enter
my calculation.
Source: The data on MI are from Friedmanand Schwartz,MonetaryHistory, table A-1, column
7, pp. 704-34.

pie, assumingthat there was a substantialpositive supply shock in 1921
decreases the monetarypolicy multiplierand increases the fiscal policy
multiplier.27Even with an extreme change, however, such as cuttingthe
monetary policy multiplier in half and quadruplingthe fiscal policy
multiplier,real GNP in 1942would have been roughly 25 percent lower
than it actually was had monetarypolicy been held to its normal level
during the mid- and late 1930s. This result still suggests that theaggregate-demand stimulus of monetary policy was crucial to therecovery. In the case of fiscal policy, quadruplingthe multiplierleads tothe conclusion that real GNP would have been 6 percent lower in 1942
than it actually was had the change in the surplus-to-GNPratio been
held to zero. This increases the apparentrole of fiscal policy, but not
dramatically.
Another way to evaluate the robustness of the calculations is to use
policy multipliers derived from the estimation of a postwar macromodel. The Massachusetts Instituteof Technology-University of Pennsylvania-Social Science Research Council (MPS) model is the main
27
The assumptionthat e, in equation 1 is large and positive can be includedin the calculation
shown in Table 1 by simplysubtractingthe residualfromthe changein outputin 1921.This reflects
the fact that in the absence of the supply shock, the effect of the monetaryand fiscal contraction
wouldhave been larger.An increasein the effectivecontractionof GNP in 1921woulddecreasethe
estimate of fjam and increase the estimate of f3. For example, if e, in 1921were 0.0554, then thechangein real GNP less the supplyshock wouldbe -0.1108, doublethe actualchangein realGNP.
Redoingthe calculationwith this changeresultsin a monetarypolicy multiplierof 0.644 anda fiscal
policy multiplierof -0.951.

Ending of the Great Depression

771

forecastingmodel currentlyused by the Federal Reserve Board. In thismodel, the short-runmultiplierfor monetarypolicy is 1.2, slightlylarger
than the multiplier derived from the 1921 and 1938 episodes; themultiplierfor fiscal policy is -2.13, roughly ten times larger than thatderived from the 1921 and 1938 episodes.28
Using the multipliersfrom the MPS model in place of those derived
from my calculation increases the apparent importance of monetary
policy-real GNP in 1942 would have been roughly 70 percent lower
than it actually was had monetary policy been held to its normal
course-and increases the role for fiscal policy-real GNP in 1942
would have been 14 percent lower than it actually was had fiscal policy
been held to its normallevel. Essentially all of this effect of fiscal policy,
however, comes from the last year of the simulation;real GNP in 1941
would have been only 1 percent lower than it actuallywas if fiscal policy
had been held to its normallevel. Thus, using policy multipliersderived
from a much differentprocedurethan I used in my illustrative calculation leads to the same conclusion that monetarypolicy was crucialto therecovery from the Great Depression and fiscal policy was of little
importance.29

One characteristicof most multipliersderived from large macromodels is that the effects of aggregate-demandpolicy on the level of real
output are forced to become zero in the long run. This is certainly thecase in the MPS model in which the long-runbehavior of the economy
is assumed to follow the predictions of a Solow growth model. In my
simulations,both with my own multipliersand with those from the MPS
model, I only considered the short-runmultipliersand did not requirethat the positive effects of an expansionaryaggregate-demandshock on
the level of real output be eventually undone. I did this because the28 These multipliersare reportedin the U.S. Boardof Governorsof the FederalReserve System,"Structureand Uses of the MPS QuarterlyEconometricModel," tables 1 and 2. The monetary
policy shock used in the MPS simulationis a permanentincrease in the level of MI of 1 percent
over the projectedbaseline. This is equivalentto the shock I consideredin my simulations,which
is a one-time deviation in the growth rate of MI from its normalgrowth rate. I used the MPS
multiplierderivedfromthe full-modelresponse(case 3 of table2). The fiscal shock used in the MPS
simulationis a permanentincreasein the purchasesof the federalgovernmentby 1 percentof real
GNP over the baseline projection.This differsfrom the shock I considered,which is a change inthe surplus-to-GNPratio, because tax revenues will rise in response to the induced increase in
GNP. To make the MPS multiplierconsistent with my measureof fiscal policy, I assumed themarginaltax rate to be 0.3 and then calculated the change in the surplus-to-GNPratio that
correspondedto a 1 percent increase in federalpurchases.The MPS multiplierthat I adjustedin
this way is based on the full-modelresponse, with MI fixed (case 4 of table 1).
29 Weinstein, "Some MacroeconomicImpacts," performeda similarcalculationfor monetary
policy using multipliersderivedfrom the Hickman-Cohenmodel and found a largepotentialeffectof the monetaryexpansionin 1934and 1935.However, he emphasizedthat the NationalIndustrial
Recovery Act acted as a negative supply shock and counteractedthe monetaryexpansion. While
the NIRA may indeed have stunted the recovery somewhat, it does not follow from this thatmonetarypolicy was unimportantto the recovery. In the absence of the monetaryexpansion, thesupplyshock could have led to continueddeclineratherthanto the rapidgrowthof realoutputthat
actuallyoccurred.

772

Romer

constraintthat the long-runeffects of policy are zero is simply imposeda prioriin most models; availableevidence indicates that the real effects
of policy shifts are in fact highly persistent.30
Provided that we do not assume that the positive effects of expansionary policy are quickly reversed (that is, within a year or two),
allowing for negative feedback effects from a policy stimuluswould not
substantially diminish the role of policy in generating the high real
growth rates observed in the mid- and late 1930s. This is true for two
reasons: in the first few years of the expansion there would have been
no negative feedback effects from previous policy expansions, and there
were progressively largermonetarygrowth rates toward the end of therecovery. Furthermore,there is no supportfor the view that the effects
of policy shifts are counteracted rapidly. In the MPS model, forexample, the effects of both fiscal and monetary shocks do not start tobe counteracted substantially until twelve quarters after the shocks.
Thus, even underthe assumptionthat policy does not matterin the longrun, we would still find that policy was importantfor the eight to ten
years that encompassed the recovery phase of the Great Depression.
THE SOURCE OF THE MONETARYEXPANSION

That economic developments would have been very differentin themid- and late 1930s had money growth been held to its normal level isevident from the calculations above. But to go further and argue that
aggregate-demandstimulus actually caused the recovery, it must be
shown that the rapid rates of monetary growth were due to policy
actions and historicalaccidents, and were not the result of higheroutput
bringingforth money creation. This is easy to do.
The main way that the money supply might grow endogenously isthrough demand-inducedchanges in the money multiplier. If, in response to a boom, banks raise the deposit-to-reserveratio and customers accept a higher deposit-to-currencyratio, a given supply of highpowered money can support a larger stock of MI. Neither of thesechanges, however, occurred during the recovery from the Great Depression. The deposit-to-reserveratio fell steadily in the mid- and late
1930s, from 8.86 in January 1933 to 4.67 in December 1942. The
deposit-to-currencyratio rose initially in the recovery as the banking
system regainedcredibility,but remainedfairly constant from 1935until
1941, and then fell sharply in late 1941 and 1942.31
Since the behavior of both these ratios suggests that the money
multiplier fell during the recovery from the Great Depression, theobserved rise in MI must have been due to even largerincreases in thestock of high-poweredmoney during this period. This increase in the
30 See, for example, Romerand Romer, "Does MonetaryPolicy Matter?"
31 The data are from Friedmanand Schwartz,MonetaryHistory, table B-3, pp. 799-808.

Ending of the Great Depression

773

stock of high-powered money was also not endogenous. There is noevidence that the Federal Reserve increased the stock of high-poweredmoney to accommodate the higher transactions demand for money
caused by increased output. Instead, the Federal Reserve maintaineda
policy of caution throughoutthe recovery and even stopped increasing
Federal Reserve credit to meet seasonal demands in the mid- and late
1930s.32

The source of the huge increases in the U.S. money supply duringthe
recovery was a tremendous gold inflow that began in 1933. Friedman
and Schwartz stated that the "rapidrate [of growth of the money stock]in the three successive years from June 1933 to June 1936 . . . was aconsequence of the gold inflow producedby the revaluationof gold plus
the flightof capital to the United States. It was in no way a consequenceof the contemporaneous business expansion."33 The monetary gold
stock nearly doubled between December 1933 and July 1934 and thenincreased at an average annual rate of nearly 15 percent between
December 1934 and December 1941. Arthur Bloomfield agrees withFriedmanand Schwartz that "the devaluationof the dollar, for technical reasons, was . . . the direct cause of much of the heavy net gold
imports of $758 million in February-March, 1934."35 Thus, the initialgold inflow was the result of an active policy decision on the part of the
Roosevelt administration.
Both these studies, however, attributed most of the continuing
increases in the U.S. monetarygold stock throughoutthe later 1930sto
political developments in Europe. Bloomfield pointed out that thecontinued gold inflow was caused primarily by huge net imports offoreign capital into the United States; the United States ran persistentand large capital account surplusesin the mid- and late 1930s.36He thenargued that "probably the most importantsingle cause of the massive
movement of funds to the United States in 1934-39 as a whole was the
rapid deteriorationin the internationalpolitical situation. The growing
threat of a European war created fears of seizure or destruction of
wealth by the enemy, imposition of exchange restrictions, oppressive
war taxation. . . . Huge volumes of funds were consequently transferred in panic to the United States from Western European countries
likely to be involved in such a conflict."37Friedmanand Schwartz weremore succinct when they concluded: "Munichand the outbreakof war
in Europe were the main factors determiningthe U.S. money stock in
32
33

Ibid., pp. 511-14.
Ibid., p. 544.

The data are from Chandler,America's GreatestDepression, p. 162.
Bloomfield,CapitalImports, p. 142.
36 Accordingto Bloomfield,CapitalImports,p. 269, the United States also ran a small current
account surplusin every year except 1936.
37 Ibid., pp. 24-25.
34

3'

774

Romer

those years [1938-1941],as Hitler and the gold miners had been in 1934
to 1936. ,38
Finally, the Roosevelt Administration'sdecisions to devalue and not
to sterilize the gold inflow were clearly not endogenous. Barrie Wigmore showed that Roosevelt spoke favorably of devaluationin January
1933.39 Since this was many months before recovery commenced,
Roosevelt could not have been responding to real growth. Indeed, G.
GriffithJohnson's analysis of the Roosevelt administration'sgold policy
suggested that, if anything, the Treasury was trying to counteract the
Depression througheasy money, ratherthan tryingto accommodatethe
recovery.40Johnson and Wigmorealso showed that Roosevelt's desire
to encourage a gold inflow was not based on a conventional view of themonetary transmissionmechanism, but ratheron the view that devaluation would directly raise prices and reflationwould directly stimulate
recovery.4'
The fact that the continuing gold inflow of the mid-1930s was notsterilized appears to be partly the result of technical problems with thesterilizationprocess. The Gold Reserve Act of 1934set up a stabilization
fund and made explicit the role of the Treasury in intervening in theforeign exchange market. However, because the stabilizationfund wasendowed only with gold, it was technically able only to counteract agold outflow, not a gold inflow.42As a result, sterilizationwould haverequired an active decision to change the new operating procedures.
Such a decision was not made because Roosevelt believed that an
unsterilizedgold inflow would stimulatethe economy throughreflation.
The devaluation and the absence of sterilizationthus appear to havebeen the result of active policy decisions and a lack of understanding
about the process of exchange marketintervention.To the degree that
active policy was involved, it was clearly aimed at encouragingrecovery, not simply at respondingto a recovery that was alreadyunder way.
Combinedwith the fact that political instabilitycaused much of the gold
inflow in the late 1930s, these findingsindicate that the increase in themoney supply in the recovery phase of the Great Depression was notendogenous. Since the simulationresults showed that the large deviations of money growth rates from normal account for much of therecovery of real output between 1933 and 1937 and between 1938 and
1942, it is possible to conclude that independent monetary developments account for the bulk of the recovery from the Great Depression
in the United States.
38 Friedman and Schwartz,

Monetary History, p. 545.

39 Wigmore,"Was the Bank Holiday of 1933?"p. 743.

4 Johnson, Treasury and Monetary Policy, pp. 9-28.
41 Johnson, Treasuryand MonetaryPolicy, pp. 14-16;and Wigmore,"Was the BankHolidayof
1933?"p. 743.
42 Johnson,

Treasury and Monetary Policy, pp. 92-114.

Ending of the Great Depression

775

THE TRANSMISSIONMECHANISM

The argumentthat monetary developments were the source of therecovery can be made more plausible by identifying the transmission
mechanism.It is generallyassumed that the usual way an increase in themoney supply stimulates the economy is through a decline in interest
rates. An increase in the money stock lowers nominal interest rates;with fixed or increasingexpected inflation,this decline in nominalrates
implies a decline in real interest rates. A fall in real interest rates
stimulates purchases of plant and equipment and durable consumer
goods by lowering the cost of borrowingand by reducing the opportunity cost of spending.
For this mechanismto have been operatingin the mid- and late 1930s,
the rapid money growth could not have been immediately and fully
offset by increases in wages and prices. If wages and prices increased as
rapidlyor more rapidlythan the money supply, real balances would nothave increased and there would have been no pressure on nominalinterest rates. The real money supply did in fact rise at a very rapidrate
duringthe second half of the 1930s:MI deflatedby the wholesale priceindex increased by 27 percent between December 1933 and December
1936and by 56 percent between December 1937and December 1942.43
This suggests that prices and wages did not fully adjustto the rapidrates
of money growth. The fact that nominal interest rates fell during therecovery is consistent with this increase in real balances. The commercial paper rate, for example, fell from an average value of 2.73 in 1932
to 0.75 in 1936.44
For the interest-ratetransmissionmechanismto have been operatingin the mid- and late 1930s, it would also have to have been the case thatthe rapid money growth rates generated expectations of inflation. By
1933 nominal interest rates were already so low that there was little
scope for a monetary expansion to lower nominalrates further. Therefore, the main way that the monetary expansion could stimulate theeconomy was by generatingexpectations of inflationand thus causing a
reduction in real interest rates. Such expectations of inflation are notinconsistent with the existence of the wage and price inertia. Indeed, avery plausible explanationis that the rapid money growth rates did not
immediately increase wages and prices by an equivalent amount because of internallabor markets, governmentregulations, or managerial
43 To calculatereal money I subtractedthe logarithmof the producerprice index (PPI)from thelogarithmof Ml. The data on the PPI are from the U.S. Bureauof Labor Statistics, Historical
Data. Because Ml is only available seasonally adjusted, I also seasonally adjustedthe PPI byregressingit on monthlydummyvariablesand a trend.
44 The commercialpaperratedataare fromthe U.S. Boardof Governorsof the FederalReserve
System, Bankingand MonetaryStatistics, 1943,pp. 448-51, and 1976,p. 674. They cover four- to
six-monthprime commercialpaperand are not seasonallyadjusted.

776

Romer
40
NominalRate20-

00.-20-40-

Ex Post RealRate
%99

931

F3

35

s37

G9

94

FIGURE 7

NOMINAL AND EX POST REAL COMMERCIAL PAPER RATES, 1929-1942

Note: The data are quarterlyobservations.
Sources: The commercialpaper rate data are from the U.S. Board of Governorsof the Federal
Reserve System, Banking and Monetary Statistics, 1943, pp. 448-51, and 1976, p. 674. The
calculationof the ex post real rate is describedin the text.

inertia.45However, consumers and investors realized that prices would
have to rise eventually and therefore expected inflation over the
not-too-distanthorizon.
Regression estimates of the ex ante real interest rate suggest that thiscondition is met in the recovery phase of the GreatDepression. Frederic
Mishkin showed using the Fisher identity that the difference between
the ex ante real rate that we want to know and the ex post real rate that
we observe is unanticipated inflation.46 Under the assumption ofrational expectations, the expectation of unanticipatedinflation using
informationavailableat the time the forecast is made is zero. Therefore,
if one regresses the ex post real rate on currentand lagged information,
the fitted values provide estimates of the ex ante real rate.
To apply this procedure I first calculated ex post real rates bysubtractingthe change in the producer price index over the following
quarter(at an annualrate) from the four-to-sixmonth commercialpaper
rate.47 These ex post real rates, along with the nominal commercial
paperrate, are shown in Figure7. I then regressed the ex post real rates
on the current value and four quarterly lags of the monetary policy
variable described in the multipliercalculations (but disaggregatedto
quarterly values), the percentage change in industrial production,
inflation, and the level of the nominal commercial paper rate. To
account for possible seasonal variationI also included a constant term
" O'Brien,"A BehavioralExplanation,"providedone such explanationfor wage rigidityduring
the 1930s.
4 Mishkin, "The Real InterestRate."
47 In this calculationneitherseries was seasonallyadjusted.

Ending of the Great Depression

777

TABLE 2REGRESSIONUSED TO ESTIMATEEX ANTE REAL INTERESTRATESExplanatoryVariable
MonetaryPolicy Variable
Lag 0
Lag 1
Lag 2
Lag 3
Lag 4
NominalCommercialPaperRate
Lag 0
Lag 1
Lag 2
Lag 3
Lag 4
InflationRate
Lag 0
Lag 1
Lag 2
Lag 3
Lag 4
Changein IndustrialProduction
Lag 0
Lag 1
Lag 2
Lag 3
Lag 4
QuarterlyDummyVariables
Quarter2
Quarter3
Quarter4
Constant

Coefficient

T-Statistic

0.044-0.4630.182-0.196
0.352

0.29
-3.02
1.09
-1.20
2.30

0.834
0.191
1.181
0.954
-1.079

0.25
0.04
0.22
0.18
-0.32

-0.3960.129-0.0140.111-0.031

-2.54
0.81
-0.09
0.72
-0.21

-0.0260.045-0.1200.012-0.036

-0.47
0.78
-2.00
0.22
-0.67

1.497
-6.9615.271-1.804

0.27
-1.76
0.97
-0.44

Notes: The dependentvariableis the quarterlyex post real interestrate. The sampleperiodusedin the estimationis 1923:1to 1942:2.The R2 of the regressionis .52.
Source: See the text.

and three quarterly dummy variables. I ran this regression over the
sample period 1923:1to 1942:2.48
The results are shown in Table 2. The explanatory variables I
included in the regression explain a substantial fraction of the total
variationin the ex post real interest rate: the R2 of the regression is .52.
Of the individualexplanatoryvariables, the one of most interest is themonetary policy variable. If the conventional transmissionmechanism
was operating, the monetary policy variable should be negatively
correlatedwith the ex post real rate. As can be seen, this is clearly thecase: the first lag of the monetarypolicy variable enters the regression
with a coefficient of -0.463 and has a t-statistic of -3.02.
48The monetarypolicy variablewas disaggregatedby convertingthe quarterlygrowthrates ofMl duringthe recovery to annualrates and then subtractingoff the averageannualgrowthrate of
MI in the mid-1920s.The industrialproductionseries is from the U.S. Boardof Governorsof theFederalReserve System, IndustrialProduction,table A. 11, p. 303.

Romer

778
40I

30-

so

Q

o 20
10
020-

-

929

131

1933

135

1937

139

194

FIGURE 8

EX ANTE REAL COMMERCIALPAPERRATES, 1929-1942
Note: The data are quarterlyobservations.
Source: The regressionused to estimateex ante real rates is given in Table 2 and describedin thetext.

The fitted values of the regression, which provide an estimate of theex ante real rate, are graphedin Figure 8. These estimates suggest thatex ante real rates dropped precipitously at the start of the monetary
expansion in 1933 and remained low or negative for the rest of thedecade (except for the rise during the monetary contraction of 1937/38).49 Indeed, the drop in real rates between the contractionary andexpansionaryphases of the GreatDepression is remarkable:ex ante real
rates fell from values often over 15 percent in the early 1930s to values
typically between -5 and - 10 percent in the mid-1930sand early 1940s.
While one cannot be sure that actualex ante real rates droppedthe sameamount as these estimates or that the drop was caused by monetary
developments, the regression results certainly suggest that the expansionary monetary developments of the mid- and late 1930s did have asubstantial impact on real interest rates.50 Thus, this aspect of theconventional monetary transmissionmechanism appears to have been
operatingin the recovery phase of the Great Depression.
For expansionary monetary developments to have stimulated the49 The estimates are strikinglyrobustto variationsin the specificationof the regression.I tried
many variants of the basic regression, such as excluding contemporaneousvalues of the
explanatoryvariables,extendingthe sampleperiodto include 1921,and leaving out the seasonal
dummyvariables.None of these changesnoticeablyalteredthe estimatesof the ex ante real rate.
so Some of the inflationin 1933and 1934could have been due to the NIRA, which encouraged
collusionaimedat raisingprices, ratherthanto monetarypolicy. However, the NIRA was declared
unconstitutionalin 1935and its policies were ones that would tend to cause a one-timejump in theprice level ratherthan continuedinflation.Thus, thoughsome of the initialfall in real interestrates
could have been due to the NIRA, the continuednegativerealrates in the mid-andlate 1930smust
have been due to other causes.

779

Ending of the Great Depression
0.4

I

I

I
II

I

a6

0.2

o 04 6
0'
.C

'

I

I

I

I

A

~~~~~~~~~~12

I

I

20

FixedInvestment

1

1

1

1

1

1

1

~~~~~~~~~~4
1 -20/~~~~~~~~~~ ~~~~~~~~~

C-)c-0.4'/

economyin the mid- and late 193RealInterestRate
--0.6

1932

1930

1934

n

1I

I

I

1936

I

1938

1940

y

I -12

FIGURE 9

REAL FIXED INVESTMENTAND EX ANTE REAL RATES, 1930-1941
Sources: Data on real fixed investmentare fromthe U.S. Bureauof EconomicAnalysis, Natiernal
Income and ProductAccounts, table 1.2, p. 6. The estimationof ex ante real rates is describedin
the text.

economy in the mid- and late 1930s, real interest rates not only had tofall, but investment and other types of interest-sensitivespendinghad torespond positively to this drop. Figure 9 shows the annual percentagechanges in real total fixed investment and Figure 10 shows the changes
0.3 wl

l

l

7

l

l

l l l l l
20
ConsumerExpenditures16
on DurableGoods
Arg
l

c

0.20\

|

01

V2

F

4-

I-

o

CR

.c-o.1
o-0.2

aRel

I/I~~~~~~~~1%

-4

-A

-

Interest

Re
-0.3

I

1930 1932

1934

I

-I

1936

I

1938

I

I

-' -12

1940

FIGURE 10

REAL CONSUMEREXPENDITURESON DURABLE GOODSAND EX ANTE REALRATES, 1930-1941
Sources: Data on real consumer expenditureson durable goods are from the U.S. Bureau of
EconomicAnalysis, National Income and ProductAccounts, table 1.2, p. 6. The estimationof ex
ante real rates is describedin the text.

780

Romer
TABLE 3

CORRELATION BETWEEN SPENDING AND REAL INTEREST RATES, 1934-1941

Ex Ante Real Rate
Lag 0
Lag 1
Lag 2

Percentage Change
in Real Fixed
Investment

Percentage Change
in Real Consumer
Expenditures on
Durable Goods-0.687-0.292-0.052-0.746-0.238-0.030Sources: The sources are the same as for Figures 9 and 10.

in real consumer expenditures on durablegoods.51 In both figures theannualaverages of the estimates of the ex ante real interest rate are also
shown. These graphs suggest that there was a very strong negative
relationship between real interest rates and the percentage change inspendingin the mid- and late 1930s. Fixed investment and the consumption of durablegoods both turnedupward soon after the plunge in real
rates in 1933. Over the next four years, real rates remainednegative andspending grew rapidly. In 1938 the recovery was interrupted, as real
rates turned substantiallypositive and spendingfell sharply. Startingin
1939 real rates fell again, and the rapidgrowth of spending resumed.
The relationship between spending and interest rates can be quantified by computing the correlations between the percentage change in
fixed investment or consumer spendingon durablesand the level of theex ante real rate. Table 3 shows these correlationsestimated over theperiod 1934 to 1941. The table shows that there is a strong negative
contemporaneous correlation between interest rates and the growth
rates of investment and consumer spendingon durablegoods duringthe
recovery phase of the Great Depression. There is also a moderately
strong negative correlationbetween the percentage change in spending
and interest rates lagged one year.
A negative relationship also exists between quarterly data on constructioncontracts and real interest rates. The contracts data show thefloor space of new buildingsfor which contracts were drawn up during
the quarter.52One might reasonably expect the volume of such contracts to respond quickly to movements in interest rates because they
involved plannedratherthan actual expenditures. And indeed, over theperiod 1933:2to 1942:2the contemporaneouscorrelation between the" These data are from the U.S. Bureauof Economic Analysis, National Income and ProductAccounts, table 1.2, p. 6.
52
The Dodge constructioncontractseries for residential,commercial,and industrialstructures
is availablein Lipsey and Preston,SourceBook, series A8, p. 73; series A17, pp. 95-96; and series
A19, pp. 100-101. I used the version that shows the floor space of each type of buildingwithout
seasonaladjustment.The datafor 27 states was splicedonto datafor 37 states in 1925.I seasonallyadjusted the series by regressingthe logarithmof contracts on a trend, a constant, and threequarterlydummyvariables.

Ending of the Great Depression

781

percentagechange in constructioncontracts and the ex ante real rate is-0.4. The low interest rates of the mid-1930s and the early 1940s
correspond to periods of rapid increase in construction contracts.
These correlationscannot prove that the fall in interest rates caused
the surge in investment, durablegoods expenditures, and construction.
They do, however, suggest that there is no obvious evidence that theconventional transmission mechanism for monetary developments
failed to operate duringthe mid- and late 1930s. One piece of evidence
that suggests a more causal link between the fall in interest rates and therecovery is the lag in the reboundof consumer expenditureson services
comparedwith those on durables. Expenditureson durablesincreased
between 1933and 1934,but real consumerexpenditureson services did
not turn around until 1935. This suggests that it was not a surge of
optimismthat was pullingup all types of consumerexpendituresin 1934,
but rathersome force, such as a fall in interest rates, that was operating
primarilyon durablegoods.54
CONCLUSIONS

Monetarydevelopments were a crucial source of the recovery of the
U.S. economy from the Great Depression. Fiscal policy, in contrast,
contributedalmost nothing to the recovery before 1942. The very rapid
growth of the money supply beginningin 1933appearsto have lowered
real interest rates and stimulatedinvestment spendingjust as a conventional model of the transmissionmechanismwould predict. The money
supply grew rapidly in the mid- and late 1930s because of a huge
unsterilized gold inflow to the United States. Although the later gold
inflow was mainly due to political developments in Europe, the largest
inflow occurredimmediatelyfollowing the revaluationof gold mandated
by the Roosevelt administrationin 1934. Thus, the gold inflow was due
partly to historicalaccident and partlyto policy. The decision to let thegold inflow swell the U.S. money supply was also, at least in part, an
independent policy choice. The Roosevelt administrationchose not tosterilize the gold inflow because it hoped that an increase in themonetary gold stock would stimulatethe depressed economy.
53 For this calculation,I seasonallyadjustedthe ex ante real interestrate series by regressingit
on a constant and three quarterlydummyvariables.
54 The conventionalmonetarytransmissionmechanismneed not have been the only way that
expansionarymonetary developments stimulatedreal growth during the mid- and late 1930s.
Recent studies, such as Bernanke,"NonmonetaryEffects," have emphasizedthat debt-deflation
could have been an importantsource of weakness in the bankingsector, and that bankingfailures
could have hurtreal outputby reducingthe amountof creditintermediation.If this was indeedthe
case, then the inflationgeneratedby the tremendousincreasein the money supplystartingin 1933
could have had a beneficialeffecton the financialsystem. By reducingthe real value of outstanding
debts, the inflationmay have strengthenedthe solvency of banksand businesses and hastenedthe
recovery of the financialsystem.

782

Romer

That monetary developments were very important, whereas fiscal
policy was of little consequence even as late as 1942, suggests aninterestingtwist on the usual view that WorldWarII caused, or at least
accelerated, the recovery from the Great Depression. Since the economy was essentially back to its trend level before the fiscal stimulus
started in earnest, it would be difficult to argue that the changes ingovernment spending caused by the war were a major factor in therecovery. However, Bloomfield's and Friedmanand Schwartz's analyses suggested that the U.S. money supply rose dramaticallyafter war
was declaredin Europe because capitalflightfrom countriesinvolved in
the conflict swelled the U.S. gold inflow. In this way, the war may haveaided the recovery after 1938by causingthe U.S. money supply to growrapidly. Thus, World War II may indeed have helped to end the Great
Depression in the United States, but its expansionarybenefits worked
initially through monetary developments rather than through fiscal
policy.
The findingthat monetarydevelopmentswere crucial to the recovery
confirmsor complements a numberof analyses of the end of the Great
Depression. Most obviously, it supportsFriedmanand Schwartz's viewthat monetary developments were very importantduring the 1930s. It
suggests, however, that Friedman and Schwartz's emphasis on theinaction of the FederalReserve after 1933is somewhat misplaced. Whatmattered is that the money supply grew rapidly;the fact that this rise
was orchestratedby the Treasuryratherthan the Federal Reserve is ofsecondary importance.The findingthat fiscal policy contributedlittle to
the recovery echoes Brown's findingthat fiscal policy was not obviously
expansionary duringthe mid-1930s.
My analysis also supports studies that emphasize the devaluation of
1933/34as the engine of recovery. Peter Teminand Wigmorearguedthat
the devaluationsignalledthe end of a deflationarymonetaryregime andthat this change in regime was crucial to improvingexpectations.55In
this explanationit was the changein expectations that broughtabout theturning point in the spring of 1933. My work bolsters Temin andWigmore's conclusion by showing that the deflationary regime wasindeed replaced by a very inflationary monetary policy. This may
explain why the regime shift was viewed as credible. More importantly,
it can explain why the initial recovery was followed by continued rapid
expansion. Without actual inflationand actual declines in real interest
rates, the recovery stimulatedby a change in expectations would almost
surely have been short-lived. In the same way, this article also bolsters
the argumentof Barry Eichengreenand Jeffrey Sachs that devaluation
55

Temin and Wigmore, "End of One Big Deflation." The importanceof devaluationis also

discussed in Temin, Lessons from the Great Depression.

Ending of the Great Depression

783

can stimulaterecovery by allowing expansionarymonetary policy."6It
shows that in the case of the United States, devaluation was indeed
followed by salutaryincreases in the money supply.
On the other hand, my findingsappearto dispute studies that suggestthat the recovery from the Great Depression was due to the selfcorrective powers of the U.S. economy in the 1930s. I find that
aggregate-demandstimulus was the main source of the recovery fromthe Great Depression. Thus, the Great Depression does not provide
evidence that large shocks are rapidly undone by the forces of mean
reversion. Rather, it suggests that large falls in aggregate demand aresometimes followed by large rises, the combinationof which leaves the
economy back on trend.
56 Eichengreenand Sachs, "ExchangeRates."

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