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The years 1920-1921 saw the postwar slump. Prices fell by about 40% during these two years, and unemployment rose to a height of over 10%. But the depression, though steep, was short-lived. Why? Because the American economy still had a great degree of wage and price flexibility. The imbalances in the market created by the preceding inflation were soon corrected with appropriate adjustments in the structure of wages and prices to more fully reflect the new postwar supply-and-demand conditions in the market. But this postwar adjustment did not return prices to anything near the prewar levels. Prices in the United States were still almost 40% higher in 1922 than they had been in 1913. This was not surprising, since the money supply contracted by only about 9% to 13% during this period (according to Monetary Statistics of the United States by Milton Friedman and Anna Schwartz).
Following 1921, the Federal Reserve System began its great experiment with price level stabilization, which Irving Fisher praised so heartily in 1928. (See "Monetary Central Planning and the State: Part II," Freedom Daily , February 1997). That this was the Fed's goal was confirmed by Benjamin Strong, chairman of the New York Federal Reserve Bank through most of the decade and the most influential member of the Federal Reserve Board of Governors during this period. In 1925, Strong said, "It was my belief . . . that our whole policy in the future, as in the past, would be directed toward the stability of prices so far as it was possible for us to influence prices." And in 1927, he once again emphasized, "I personally think that the administration of the Federal Reserve System since the [depression] of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very policy [of price level stabilization]."
Did the Federal Reserve succeed in its policy of price level stabilization? An index of wholesale prices, with 1913 as the base year of 100, shows that the average level of prices remained within a fairly narrow band: 1922 — 138.5; 1923 — 144.1; 1924 — 140.5; 1925 — 148.2; 1926 — 143.2; 1927 — 136.6; 1928 — 138.5; 1929 — 136.5. During the entire decade, wholesale prices on average were never more than about 7% higher than in 1922. And at the end of the decade, before the Great Depression set in (1929), wholesale prices, as measured by this index, were in fact about 1.5% lower than in 1922.