The Effect of Credit Supply Shocks on Economic Activity - The Interwar Period

Abstract

There is little question that financial factors played a role in the amplification and extension of shocks during the Great Depression. The specific mechanisms through which financial factors affected real economic activity, as well as their timing and extent, nevertheless remain a source of controversy. This paper uses a new generation of macroeconomic models that allows for significant disruptions of financial intermediation to examine empirically the timing and extent to which financial factors contributed to the interwar period business cycles through changes in the supply of credit. Results illustrate that disruptions of financial intermediation, through changes in the supply of credit and the cost of capital, were a primary mechanism for the propagation, amplification, and extension of shocks throughout the interwar period. Findings therefore suggest that conventional monetary policy would have been insufficient to offset the decline in output due to financial factors.