The Effects of Proximate Determinants of the Money Supply in the Interwar Period

Abstract

Recent studies of the role of monetary policy in the interwar period and the Great Depression of 1929-33 typically focus on the money supply or the monetary base.' For several reasons, however, it is instructive to study the separate impact of money's three proximate determinants. In this paper we focus on the interwar period and present empirical evidence on the importance of the three proximate determinants of the money supply in explaining fluctuations in output and prices. We define the interwar period as July 1922-June 1938 for reasons explained in Beard and McMillin [2]. As developed by Friedman and Schwartz [15] and extended by Cagan [10], changes in the M2 stock of money can be attributed arithmetically to changes in three proximate determinantsthe monetary base, the ratio of currency to deposits (the currency ratio) and the ratio of reserves to deposits (the reserve ratio).2 The three proximate determinants are affected by different economic forces or react differently to the same variables. Each is under the immediate control of different economic agents. Changes in any one of the three proximate determinants can have, and have had, important effects on the stock of money. Cagan [10] analyzed in detail the contribution of changes in each of the three proximate determinants to cyclical fluctuations in the rate of change in the money stock over the long period 1877 to 1954. The base and the reserve ratio were each responsible for about one-fourth of these variations; the currency ratio was the most important single contributor, being responsible for roughly one-half of the variations. While the contribution of the currency ratio varied from cycle to cycle, major deviations occurred at times of financial panics when it often played a dominant role. Cagan found that the establishment of the Federal Reserve reduced the relative importance of changes in the reserve ratio and increased the relative importance of changes in the base. While the amplitude of cyclical movements in the reserve ratio fell after 1914 and the ratio itself trended downward, there was a sharp increase in the reserve ratio in the 1930s.