Milton Friedman's claim that the Great Depression was caused by monetary policy turns on the size of the rise in expected real interest rates. Why do expected real interest rates matter for Friedman's story? Referring to data from the Great Depression, do you think the rise in expected real interest rates was large enough to explain the Depression?

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The simple story about monetary policy is that a contraction in the real money supply raises nominal interest rates, causing a decline in output as the LM curve shifts to the left. The difficulty for this story during the Great Depression is that, even though the nominal money supply fell, interest rates also fell. The reasons for this is that prices fell faster than the money supply, so M/P actually rose. So how can the money supply have mattered? Because a fall in prices raised the expected real rate of interest, which would cause investment and consumption to drop (a leftward shift of the IS curve).

Was the rise in the expected real interest rate large enough to explain the collapse in investment that we see in the data? This is hard to answer. What we observe is a rise in the realized real rate of interest, which was quite modest. But we don't know how expectations were affected.

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