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

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  • Russell W. Cooper
  • Dean Corbae

Abstract

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.

Suggested Citation

  • Russell W. Cooper & Dean Corbae, 2001. "Financial collapse and active monetary policy: a lesson from the Great Depression," Staff Report 289, Federal Reserve Bank of Minneapolis.
  • Handle: RePEc:fip:fedmsr:289
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Nabi, Mahmoud Sami & Rajhi, Taoufik, 2002. "The Effect of Financial Liberalization on the Economic Development Process in case of Inefficient Banking," MPRA Paper 24514, University Library of Munich, Germany.
    2. Russell W. Cooper, 2002. "Estimation and Identification of Structural Parameters in the Presence of Multiple Equilibria," NBER Working Papers 8941, National Bureau of Economic Research, Inc.
    3. Huberto M. Ennis & Todd Keister, 2001. "Optimal policy with probabilistic equilibrium selection," Working Paper 01-03, Federal Reserve Bank of Richmond.
    4. Antoine Martin, 2006. "Liquidity provision vs. deposit insurance: preventing bank panics without moral hazard," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 28(1), pages 197-211, May.
    5. Nabi, Mahmoud Sami & Rajhi, Taoufik, 2002. "Banking Efficiency and the Economic Transition Process," MPRA Paper 24496, University Library of Munich, Germany.
    6. Timothy J. Kehoe & Edward C. Prescott, 2002. "Great Depressions of the Twentieth Century," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 5(1), pages 1-18, January.
    7. John Bryant, 2005. "Fiat Money and Coordination: A "Perverse" Coexistence of Private Notes and Fiat Money," Eastern Economic Journal, Eastern Economic Association, vol. 31(3), pages 377-381, Summer.
    8. Korhonen, Tapio, 2001. "Finnish monetary and foreign exchange policy and the changeover to the euro," Research Discussion Papers 25/2001, Bank of Finland.
    9. Harrison, Sharon G. & Weder, Mark, 2006. "Did sunspot forces cause the Great Depression?," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1327-1339, October.
    10. Timothy J. Kehoe & Edward C. Prescott(), 2007. "Great depressions of the twentieth century," Monograph, Federal Reserve Bank of Minneapolis, number 2007gdott.

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    Keywords

    Depressions ; Monetary policy;

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