Depression Econometrics: A FAVAR Model of Monetary Policy During The Great Depression

The prominent role of monetary policy in the U.S. interwardepression has been conventional wisdom since Friedman andSchwartz [1963]. This paper presents evidence on both thesurprise and the systematic components of monetary policybetween 1929 and 1933. Doubts surrounding GDP estimates forthe 1920s would call into question conventional VAR techniques.We therefore adopt the FAVAR methodology of Bernanke, Boivin,and Eliasz [2005], aggregating a large number of time series into afew factors and inserting these into a monetary policy VAR. Wework in a Bayesian framework and apply MCMC methods toobtain the posteriors. Employing the generalized sign restrictionapproach toward identification of Amir Ahmadi and Uhlig [2008],we find the effects of monetary policy shocks to have beenmoderate. To analyze the systematic policy component, we backout the monetary policy reaction function and its response toaggregate supply and demand shocks. Results broadly confirmthe Friedman/Schwartz view about restrictive monetary policy, butindicate only moderate effects. We further analyze systematicpolicy through conditional forecasts of key time series at criticaljunctures, taken with and without the policy instrument. Effects areagain quite moderate. Our results caution against a predominantlymonetary interpretation of the Great Depression.[...]