Financial Collapse: A Lesson from the Great Depression

Abstract We analyze financial collapses, such as the one that occurred during the U.S. Great Depression, from the perspective of a monetary model with multiple equilibria. The multiplicity arises from the presence of a strategic complementarity due to increasing returns to scale in the intermediation process. Intermediaries provide the link between savers and firms who require working capital for production. Fluctuations in the intermediation process are driven by variations in the confidence agents place in the financial system. From a positive perspective, our model matches quite closely the qualitative changes in important financial and real variables (the currency/deposit ratio, ex post real interest rates, deflation and production) over the Great Depression period, an experience often attributed to financial collapse. Further, we assess whether the policy prescription advocated by Friedman and Schwartz, adding liquidity to the banking system through increases in the money supply, would have overcome strategic uncertainty and thus avoided a financial collapse.

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