Fundamental cause – contraction in spending i.e. aggregate demand.
Decline in production as inventory level at manufacturers and merchandisers increased.
Transmitted to rest of the world mainly through the gold standard.
Variety of other factors also fuelled the downturn in various countries.
Major causes are discussed here.
Stock Market Crash
Decline in output occurred in the U.S. during the summer of 1929.
Stemmed from tight U.S. monetary policy aimed at limiting stock market speculation.
Stock price rose more than four times from the low in 1921 to the peak 1929.
In 1928 and 1929, Federal Reserve raised interest rates to help prevent rapid rise in stock price.
But the opposite happened. Production in interest-sensitive spending areas such as construction and automobile was reduced.
By the fall 1929, U.S. stock prices reached to the highest level.
Stock market crash occurred on October 29, 1929.
Many stockholders lost more than $40 billion dollars.
Reduced American aggregate demand substantially.
Banking Panic and Monetary Contraction
Depositors lost their confidence in the solvency of banks.
Demanded their deposits back in cash.
Banks had to liquidate their loans and advances.
Process of hasty liquidation caused some solvent banks to fail.
The U.S. experienced this panic from the fall of 1930 through the fall of 1932.
There was a very big shake in the American banking system.
By 1933, one-fifth of the existing banks failed to continue their business.
Panic caused a dramatic rise in the amount of currency people held relative to their bank deposit.
This rise in currency-to-deposit ratio was the key reason of decline in money supply by 31% between 1929 and 1933.
Federal Reserve could do little in this situation. They also raised interest rates in September 1931.
Decline in money supply caused by Federal Reserve decisions had a severe contractionary effect on output.
People, at that time, considering the prevailing situation expected deflation and they feared that they would not be able to repay debts because of expected low wages and profits in future.
This reduced in both consumer spending and business investment spending.
Also, failure of many banks disrupted lending that made very little fund available for investment.
The Gold Standard
Each country set a value of its currency in terms of gold and took monetary actions to defend the fixed price.
Federal Reserve allowed or caused the huge declines in the American money supply partly to preserve the gold standard.
Gold standard was a key factor in the transmission of the American decline to the rest of the world.
Under the gold standard, imbalances in trade or asset flows gave rise to international gold flows.
For example, in the mid-1920s intense international demand for American assets such as stocks and bonds brought large inflows of gold to the United