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Financial collapse and active monetary policy: a lesson from the Great Depression

  • Russell W. Cooper
  • Dean Corbae

We analyze financial collapses, such as the one that occurred during the U.S. Great Depression, from the perspective of a monetary model with multiple equilibria. The multiplicity arises from the presence of a strategic complementarity due to increasing returns to scale in the intermediation process. Intermediaries provide the link between savers and firms who require working capital for production. Fluctuations in the intermediation process are driven by variations in the confidence agents place in the financial system. From a positive perspective, our model matches closely the qualitative changes in important financial and real variables (the currency/deposit ratio, ex-post real interest rates, the level of intermediated activity, deflation, employment and production) over the Great Depression period, an experience often attributed to financial collapse. Further, we show how adding liquidity to the banking system through increases in the money supply is sufficient to overcome strategic uncertainty and thus avoid financial collapse.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 289.

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Date of creation: 2001
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Handle: RePEc:fip:fedmsr:289
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  1. Satyajit Chatterjee & Russell Cooper & B. Ravikumar, 1993. "Strategic Complementarity in Business Formation: Aggregate Fluctuations and Sunspot Equilibria," Review of Economic Studies, Oxford University Press, vol. 60(4), pages 795-811.
  2. Roberto Chang & Andres Velasco, 1998. "Financial Fragility and the Exchange Rate Regime," NBER Working Papers 6469, National Bureau of Economic Research, Inc.
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  8. Stephen D. Williamson, 1986. "Increasing Returns to Scale in Financial Intermediation and the Non-Neutrality of Government Policy," Review of Economic Studies, Oxford University Press, vol. 53(5), pages 863-875.
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  10. Bernanke, Ben S, 1983. "Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression," American Economic Review, American Economic Association, vol. 73(3), pages 257-76, June.
  11. Cooper, Russell & Ejarque, Joao, 1995. "Financial intermediation and the Great Depression: a multiple equilibrium interpretation," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 43(1), pages 285-323, December.
  12. Roger Lagunoff & Stacey L. Schreft, 1998. "A Model of Financial Fragility," Game Theory and Information 9803001, EconWPA, revised 30 Apr 1998.
  13. John H. Boyd & Pedro Gomis-Porqueras & Sungkyu Kwak & Bruce David Smith, 2014. "A User's Guide to Banking Crises," Annals of Economics and Finance, Society for AEF, vol. 15(2), pages 800-892, November.
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  22. Bruce Champ & Bruce D. Smith & Stephen D. Williamson, 1996. "Currency Elasticity and Banking Panics: Theory and Evidence," Canadian Journal of Economics, Canadian Economics Association, vol. 29(4), pages 828-64, November.
  23. Hamilton, James D., 1987. "Monetary factors in the great depression," Journal of Monetary Economics, Elsevier, vol. 19(2), pages 145-169, March.
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  25. Hervé Moulin, 1994. "Serial Cost-Sharing of Excludable Public Goods," Review of Economic Studies, Oxford University Press, vol. 61(2), pages 305-325.
  26. Boyd, John H & Chang, Chun & Smith, Bruce D, 1998. "Moral Hazard under Commercial and Universal Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(3), pages 426-68, August.
  27. Bryant, John, 1987. "The Paradox of Thrift, Liquidity Preference and Animal Spirits," Econometrica, Econometric Society, vol. 55(5), pages 1231-35, September.
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  29. Russell Cooper & Joao Ejarque, 1995. "Financial Intermediation and The Great Depression: A Multiple Equilibrium Interpretation," NBER Working Papers 5130, National Bureau of Economic Research, Inc.
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