Liquidity Shocks and the Great Depression: Comment on "The Great Depression and the Friedman-Schwartz Hypothesis"

This ambitious and intriguing paper by Lawrence Christiano, Roberto Motto, and Massimo Rostagno (2003, this issue of JMCB) (hereafter CMM) addresses the two central questions about the U.S. Great Depression: Why was the Depression so severe (real GNP per adult fell 38% relative to the trend between 1929 and 1933), and why was the recovery from the Depression so weak (output remained 27% below trend in 1939)? CMM propose a provocative answer to the first question and reach conclusions about the second question similar to those in recent studies of New Deal labor and industrial policies. Since the primary contribution of the paper is to propose a new, quantiatively important shock for 1929-33, I will focus my discussion on their analysis of the first question.

Because of its remarkable severity and duration, accounting for the Great Depression (1929-33) requires either very large and persistent shocks within a standard business cycle model or an alternative model in which shocks have much larger and more persistent effects than in a standard model. Recent analyses have followed the first approach by identifying abnormally large shocks during the depression and analyzing the consequences of those shocks in standard models. These studies have focused either on productivity shocks (see Cole, Ohanian, and Leung 2003) or shocks that affect the gap between the marginal rate of substitution between consumption and leisure and the real wage (see Bordo, Erceg, and Evans, 2000, Mulligan, 2002). Chari, Kehoe, and McGrattan (2003) show that a standard business cycle model can account for much of the Great Depression when both of these shocks are included in a standard model, with productivity playing the major role.

Both of these theories have strengths, but both also face significant challenges. Astrength of the productivity explanation is that there are negative Solow residuals in the U.S. and in other countries that are large enough to account for most of the Depression, even after correcting for mismeasurement of factor inputs such as capital utilization. The challenge facing this explanation is that the source of these productivity shocks is a mystery. It is implausible that they are technological regress, and there is no generally accepted alternative explanation. The productivity hypothesis does not fundamentally explain what factors caused the Depression.

There is also no generally accepted explanation for the labor gap hypothesis. It seems implausible that it is an increase in the preference for nonmarket activities. Perhaps the most common interpretation is that the gap is the consequence of unexpected deflation combined with imperfectly flexible wages, which drives up real wages and reduces employment and output. The challenge facing this interpretation is that real wages are below their trend levels, rather than above their trend levels, after correcting measured wages for compositional changes in the quality of workers. Moreover, this theory does not account for the behavior of labor productivity (it counterfactually predicts that productivity should have increased) or differences in the severity of the Depression across countries (it counterfactually predicts that the countries with the biggest deflations had the biggest depressions).

Given the challenges facing the existing theories, it is interesting to pursue alternative explanations of the Depression. CMM do this by developing a fully articulated model that differs significantly from standard business cycle models and by focusing on a liquidity preference-money demand shock rather than on productivity shocks or high real wages. Hereafter, I will refer to the new shock as a money demand shock.

1. The Model

The model is much more complex and has more shocks than standard business cycle models. This additional complexity broadens the model's ability to potentially account for the data, but on the other hand, makes it harder to understand how the model works. I will therefore first review the main features of the environment, and then, given the paper's focus on the money demand shock, I will qualitatively describe how a money demand shock affects the economy.

Households provide heterogeneous labor services, which allow each household to set its own wage. Otherwise...