Gold and the Great Depression:
(a) Origins of the Depression. In tracing the origins of the Great Depression, Berkeley economist Christina Romer argues that the U.S. suffered a large fall in aggregate demand following the 1929 stock market crash. For starters, explain how the crash could have induced such an effect. Knowing that the U.S. was on the gold standard at the time, explain in the AA-DD model how the Federal Reserve would be expected to respond to this shock? What is the effect of this policy on output?
(b) When one looks at movements in the money supply and interest rates in 1930-1931, it appears that the Fed overreacted to the fall in aggregate demand (perhaps because it wanted to convince the markets of its commitment to the gold standard, perhaps because it made a mistake, perhaps for some other reason). What would happen to U.S. output and interest rates in this case? [Hint: whatever policy you had the Fed follow in part (a), now make it twice as large.] In turn, what would happen to U.S. gold reserves as a result of this policy?
(c) Golden Fetters. Berkeley economist Barry Eichengreen emphasizes the central role of the gold standard in explaining why the Depression spread outward from the U.S. to the rest of the world. Given your answer to part (b), explain how foreign central banks would react to the Feds action under the gold standard? Using the AA-DD model, illustrate the impact on output in the foreign country.
(d) As the Depression deepened, many countries chose to abandon the gold standard. In light of your answer to part (c), explain why countries that left the gold standard early recovered more rapidly from the Depression.