The Term Structure of Interest Rates and the Demand for Money during the Great Depression

Abstract

New estimates of the term structure of interest rates are used to investigate movements of and along the U.S. money demand function during the period 1920-38. The entire term structureand not just its short end-is found to be important to the interwar demand for money function. Therefore, the low short-term interest rates of the early 1930s cannot be identified as evidence of easy money. Instead, the widened spread between shortand long-term interest rates is evidence of the liquidity crisis proposed by Friedman and Schwartz, F&S, (10) in their explanation of the Great Depression. This finding critically depends on use of new, correctly-measured term structures of interest rates. The received estimates, which are widely recognized to be crude approximations, mask the important role played by the term structure in the monetary dynamics of the inter-war period.