Monetary disturbance or financial market collapse: tests of two theories of the Great Depression

The monetary disturbance theory of the Depression, explained by Friedman and Schwartz (1963) asserts that the Depression was so deep and long because the Federal Reserve pursued a tight monetary policy. More recently, Bernanke (1983) has shown that financial market crisis also lowered output in the 1930s. It is probable that the decline in the money supply caused the credit market problems, but this may not be the main or the only avenue through which the money supply affected output. This paper shows that monetary aggregates have substantial explanatory power over output once the credit market collapse has been taken into account.