The Great Depression resulted, from many effects, all co-occurring. After the stock-market "crash" of 1929, the public began to distrust banks, amidst rumors that the US would abandon the gold-standard. By October 1930, the public had begun running on banks in earnest, in order to get their gold back, whilst banks still had gold in reserves; and, were still required to pay out gold on demand. Afterwards, nobody was borrowing from banks,
reducing spending. And everybody was hoarding gold, fearing abandonment of the gold-standard ("if they gave out gold, today, they might never get any back, tomorrow"),
reducing spending further. With nobody spending money, and everybody hoarding money, the amount of money in circulation ('in the stream of spending") plummeted. That caused prices to plummet ("fewer dollars chasing goods"),
i.e. deflation. Dollars were spent less often, hoarded more of the time; mathematically, MV = PQ
(equation of exchange), and the "velocity" of spending (V) fell, on the LHS, pulling down prices (P), on the RHS.
Now, the "roaring" 1920s had been funded by borrowing. Total private-sector debt had increased by
$50B (from $110B in 1921, to $160B in 1929). And, debts are not adjusted for inflation / deflation. So, when prices plummet, real debt (D/P) sky-rockets. (
Cp. real wages (W/P), or real money balances (M/P), also sky-rocket, during deflations of price levels.) And so, as soon as prices began deflating, everybody saw their real debt balances sky-rocketing. And so everybody stopped spending, to pay down debt. Again,
reducing spending further still. (From 1930-1933, total private debt declined by about 25% -- from about $160B to $120B, at rates equivalent to a quarter of GDP -- stabilizing afterwards. Meanwhile, price-levels declined by about 25%, stabilizing afterwards. The two data series -- declining nominal private debt, deflating price level -- are strongly correlated, corroborating that deflation motivated debt repayment, per Irving Fisher's "
debt-deflation" explanation.)
Meanwhile, with nobody spending, nobody was buying, nobody was selling, nobody was hiring, everybody was firing. UE increased by over
20% (from 3.2% in 1929, to 25.5% in 1933). Rising UE implies falling incomes,
reducing spending even further. That plummets price-levels further. According to Philipps Curve, on average, +2% UE generates -1%
in-flation; so
+20% UE probably
de-flated prices by
10%. Also, according to Okun's Law, on average, +2% UE generates -4% reduction in real GDP; so
+20% UE "should" have reduced real GDP by
-40%. Indeed, real GDP fell by
30%.
So, public distrust of banks (no borrowing); public hoarding of gold (no spending); debt repayment (saving); unemployment (no buying, no selling, no hiring, firing); all reinforced each other, generating a deflation in prices (P) of over
-20% (perhaps half from hoarding, half from UE; "everybody was holding what they had, and earning nothing new"); a "crash" in aggregate spending (nominal GDP) of nearly
-50%; a "crash" in production (real GDP) of about
-30%.
Note, rising UE can (easily) account for all of the fall in production (real GDP), but can account for only half of the fall in prices (P).
I.e. there was an actual decrease in the propensity to spend; the "velocity" of spending decreased; not only were people earning less, and so spending less (Philipps Curve), but also people were spending what they were earning even less than before. Note, too, that production (Q) fell twice as much as prices (P). In the short-term, potential aggregate supply is steady. So, a falling aggregate demand curve "falls back along" the aggregate supply curve, on an AS/AD plot.
Ipso facto, in the early 1930s, the US aggregate supply curve was fairly flat, having an elasticity of aggregate supply, of about
1.5 (dQ/dP = (-30%)/(-20%) = 3/2). (If you acknowledge only the fall in price level, of
-10%, attributable to the rise in UE; then the elasticity of aggregate supply "for constant spending propensity" would compute to
3. Propensity to spend reflects
psychological perceptions of money, of the general public, not
physical production capacity, of businesses & workers. Indeed, from 1933-1937, at the new lower spending propensity, the US economy recovered to pre-crash production levels, with negligible inflation in prices, implying a nearly horizontal ASC.) Perhaps that's why J.M.Keynes argued that aggregate supply curves are flat,
i.e. prices are "sticky downwards" ?
The "Great Crash" from 1929-1933 altered Americans' psychological perceptions of money, dramatically decreasing their propensity to spend (increasing their propensity to hoard). Recovery afterwards occurred under dramatically different monetary conditions: at lower prices (P), at lower velocity (V), with much more money (M) required, to motivate the same amount of production (Q), as compared to pre-crash conditions. The rate of spending per dollar per year (V) was nearly a third less, and half again more money (M) was required, for the same amount of production (Q) to be purchased. The profound psychic impact, of the GD, amongst the minds of Americans, is reflected, in the sudden shift, of the relations between those macro-economic variables; and especially in the speed of spending (V), which is the most subjectively psychological of those variables.
