Spread of the Great Depression About a third of all US banks failed during the o

Question

Spread of the Great Depression About a third of all US banks failed during the onset of the Great Depression beta 1929 and 1933. wiping out around a quarter of the US money in circulation (Ml). Most major economies were back on a gold standard by that time. If the central banks in those countries adhered to the rules of the game, how would the monetary contraction in one country spread to other countries? If central banks did not adhere to the rules of the game, what would be the current account response under the price-specie-flow mechanism? The Transfer Problem Think of a world with two countries D and R under a fixed exchange rate regime. (You may consider an international gold standard, for instance, where the price-specie-flow mechanism is at work.) Country D (donor) surprisingly transfers

Explanation / Answer

It was believed that the main reasons of the great depression were stock market failures and bank failures and the only way to restore fiscal and monetary responsibility would be go back on the gold standard. Hence, the major economics were back on gold by that time. But it was also believed that the depression was majorly caused by this transition to the gold standard. Following the rules of the game, strict discipline of gold, major central banks showed their unwillingness to conduct a unilateral monetary policy. The Fed, also, raised its discount rates in fear of running out of its gold soon enough. Therefore what were created were only piles of paper and rising gold reserves. This was a reckless credit squeeze on the part of the Fed which pushed the county into depression. If all the central banks adhered to these rule of game then there would have been no exchange of reserves with the help of trade and capital flows, fearing the loss of reserves.

Had the economies returned to the classical gold standard, there would have been no fear of maintaining high gold reserves. In the classical gold standards, the central bank is expected to hold gold reserves to handle the demand of anyone who wants to redeem their currencies at the time of need. If all the major economies had followed this, there would have been no fear of falling reserves. And under the price-specie flow mechanism any country receiving large amounts of gold would tend to face high prices which in turn would neutralize the trade and capital flows. Similarly, any country receiving lower amount of gold would tend to face a fall in the prices.

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