Monetary Policy Impact: A DD Analysis
Understanding Causality with Differences-in-Differences
The differences-in-differences (DD) methodology provides evidence of causality. It compares changes in outcomes over time between a treatment group and a control group. Ideally, both groups would have followed similar trends without the treatment. This method mimics a natural experiment: the treatment group receives an intervention (e.g., a specific monetary policy), and the control group does not. The core assumption is that both groups would have followed parallel paths if the intervention had not occurred.
DD Analysis of Monetary Policies During the Great Depression
The DD methodology is applied to analyze the effects of different monetary policies during the Great Depression. Two different Federal Reserve districts implemented contrasting monetary policies: the “easy money” policy in the 6th district and the “tight money” policy in the 8th district. Both districts were located within the same state (Mississippi), controlling for external factors that might affect the banking sectors differently.
By observing the number of bank failures in each district before and after the implementation of these policies, we can use DD to estimate the treatment effect. The treatment effect is the difference in outcomes between the two groups, attributable to the intervention. This comparison showed that the “easy money” policy likely prevented more bank failures compared to the “tight money” policy, as evidenced by the differing number of bank failures in the two districts following the onset of the Great Depression.
The Crucial Assumption of Parallel Trends
The assumption of parallel trends is crucial in DD analysis. This assumption is validated by showing that the trends in bank failures in both districts were similar before the intervention. This suggests that any divergence after the intervention can be attributed to the differing monetary policies rather than other factors. This helps establish a causal link between the policy implemented and the observed outcomes.
Visualizing the DD Analysis: A Graphical Approach
The graph illustrates the differences-in-differences (DD) analysis used to evaluate the effects of monetary policies during the Great Depression. It focuses on the number of banks in business in two different Federal Reserve districts, the 6th and the 8th, from 1930 to 1934.
Key Elements of the Graph
- Lines Representing the Districts: The solid blue line represents the 8th district, and the solid yellow line represents the 6th district. These lines show the actual number of banks in operation in each district over the years.
- 6th District Counterfactual (Dashed Line): The orange dashed line represents the counterfactual scenario for the 6th district—what would have likely happened to the number of banks if the 6th district had followed a “tight money” policy similar to the 8th district instead of its “easy money” policy.
Time Points of Interest
- Caldwell Collapse (1930): This marks a significant economic event that negatively impacted banks, prompting different responses from the districts’ Federal Reserves.
- 8th Abandons Tight Money (1933): Indicates when the 8th district switched from a tight money policy to an easy money policy, aligning with the policy of the 6th district.
Analysis of the Graph
- Pre-Treatment Period (Before 1931): Both districts show similar trends in the number of banks until the Caldwell Collapse, supporting the DD assumption of parallel trends before the treatment.
- Post-Treatment Divergence (1931-1933): After the Caldwell Collapse, the number of banks in the 8th district decreases more sharply than in the 6th district, which follows the counterfactual trend closely until 1933. This divergence is where the treatment effect is observed.
- Treatment Effect: The shaded area between the actual number of banks in the 6th district and its counterfactual projection quantifies the treatment effect of the easy money policy. It shows that several banks were presumably saved from failing compared to what would have occurred under a tight money policy.
- Convergence Post-1933: After the 8th district abandons the tight money policy in 1933, the trends in both districts begin to converge, showing similar rates of decline. This indicates that the policies become more aligned, and the distinct impacts of the previous policies diminish.
This graph is a classic example of how DD can visually and quantitatively demonstrate the impact of policy interventions. It compares real-world outcomes against a hypothetical scenario (counterfactual), allowing researchers to infer causality from observational data.