Disequilibrium Dynamics during the Great Depression

Abstract

We test the flexibility of wages and prices in the U.S. before World War II using a simple two-market disequilibrium model. We test the model for four different tatônnement adjustment mechanisms and we find that the equilibrium restriction is strongly rejected in all cases. Hausman specification tests reject the equilibrium restriction but do not reject three of the disequilibrium specifications. Parameter estimates imply that the persistence of the Great Depression is not attributable to nominal rigidities but was caused by the system becoming dynamically neutral. We compute estimates of excess aggregate demand from 1892 to 1940 and find that a model in which adjustment obtains in prices in the goods market and in quantities in the labor market provides the best description of the data.