The End of the Great Depression 1939-41: Policy Contributions and Fiscal Multipliers

This paper is about the size of fiscal multipliers and the sources of recovery from the Great Depression. Its baseline result is that 89.1 percent of the 1939:Q1-1941:Q4 recovery can be attributed to fiscal policy innovations, 34.1 percent to monetary policy innovations and the remaining -23.2 percent to the combined effect of the basic VAR dynamic forecast and innovations in non-government components of GDP. Traditional Keynesian multipliers assume that there are no capacity constraints to impede a fiscal-driven expansion in aggregate demand. On the contrary, we find ample evidence of capacity constraints in 1941, particularly in the second half of that year. As a result our preferred government spending multiplier is 1.80 when the time period ends in 1941:Q2 but only 0.88 when the time period ends in supply-constrained 1941:Q4. Only the 1.80 multiplier is relevant to situations like 2009-10 when capacity constraints are absent across the economy. Two sets of new insights emerge from a review of contemporary print media. We document that the American economy went to war starting in June 1940, fully 18 months before Pearl Harbor. We also detail the bifurcated nature of the 1941 economy, with excess capacity in its labor market but capacity constraints in many of the key manufacturing industries. By July 1941, the American economy was in a state of perceived national emergency.