Summary

As economists have learned more and more about the importance of monetary and banking forces in both the contraction and recovery phases of the Great Depression, they have recognized the importance of sound macroeconomic policies in ensuring a strong economy. The Great Depression was not a failure of capitalism of or markets, but rather a result of misguided government policies-specifically, the Federal Reserve allowing the money stock to collapse as panics engulfed the banking system. If the Fed had stepped up to the plate and ensured that banks had ample reserves to meet their costumers’ withdrawals demand, the money stock would not declined, and the economy probably would not have sharply contracted.

The Great Depression also demonstrated the importance of price stability. Deflation was an important cause of falling incomes and financial distress, as households and firms found it increasingly difficult to repay debts. Because debt contracts almost always specify repayment of a fixed-dollar sum, deflation increases the real cost of a given nominal debt.

Thus, deflation often leads to increases in loan defaults and bankruptcies, which in turn raise the number of bank failures and produces further declines in income, output and employment. Price stability is now widely accepted as a paramount goal for monetary policy because fluctuations in the price level-whethe deflation or inflation – can cause financial instability and hinder economic growth.