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Banking/financial crises
Long history: 1819, 1838, 1857, 1893, 1907 Bank runs
fractional reserve Suspension of payments
No federal level deposit insurance
A new Central Bank
We had First bank of the United States, 1791-1811 Second bank of the US, 1816-1836
Charter renewal vetoed by President Jackson in 1832
New one: the Federal Reserve Permanent charter 12 districts Board of Governors
What does the central bank do? Modern days
Lender of last resort Monetary policy Regulation of banks
Money stock/interest rate
How does the central bank control money supply? Open market operation Buy/sell bonds Demand/supply of bonds That changes interest rate
Other factors: How much currency do people hold?
Money creation
Money is not just cash in your pocket (currency) Includes demand deposits, traveler’s checks Saving deposits, small time deposits, money
market mutual funds, etc Currency to deposit: creates extra money in
the banking system Through money multiplier
Gold standard
1900, Gold Standard Act Globally, it means a fixed exchange rate
Everything is tied to gold Benefits? Costs?
Inflexibility in money supply Fluctuations outside of economic force
Transmission mechanism
US productivity increase Same amount of money, more goods Prices fall US goods cheaper Britain buys more US goods Gold inflow for US, outflow for Britain
Trade imbalances
US running a trade surplus, Britain deficit Gold inflow for US, outflow for Britain US price level goes up, Britain down US goods more expensive, Britain goods
cheaper US buys more British goods
Built-in mechanism to balance trade
Gold Standard: Summary
Money supply tied to gold In general, expect deflation Built-in mechanism to balance trade
Relies on inflation when gold flows in A country has no control over price level
fluctuations International forces will create business cycles
On top of domestic factors
Interest rate
With free flow of capital, money goes where the return is high
If interest rate is high, capital flows in If interest rate is low, capital flows out
Stock Market Crash of 1929
Similar to South Sea Bubble 10/24/1929, 10/29/1929, black Thu/Tue But has some “fundamentals”
Stock price and fundamental factors? Fundamentals? Profitability, dividend How are they related?
Future profitability
Booming economies of 1920’s
Was there “bubble”?
No Booming economy New Federal Reserve System, confidence
Yes Economic boom might have initiated the bubble
but not sustainable Dividend growth not as high Speculation
What caused the crash?
Increased supply of new stocks? Smoot-Hawley tariff?
Should’ve hurt export industries Small proportion
International stock markets? Recessions?
Industrial production went down
NY Fed responded
To avoid the overall financial crisis NY Fed open up discount window Outside creditors demanded payment
Could cause widespread bankruptcy Which in turn hurts the banking system
Repercussions
The Stock market crash does not equal to the Great Depression
Less than 5% held stock Continued to trade after the crash
Large volumes through 1933 Historical evidence: stock market crash did
not always lead to recession
10/1929 Stock market crash
10/1930 Bank failures in Midwest and South
12/11/1930 Bank of the US in NY failed
5/1931 Failure of Kreditanstalt (largest in Austria)
7/1931 Closing of German banks
9/1931 Britain left Gold Standard
4/1932 Large Scale Open Market Operations
3/1933 Banking panic of 1933
4/1933 US off Gold Standard
Economic Indicators: 1929-1940
0
20
40
60
80
100
120
140
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
1940
GDP
Real GDP
Investment
Consumption
Features of the Great Depression Monetary contraction
Deflation Caused by
Distrust of banking system Contraction in monetary money stock Expectation
Breakdown of banking system Bank runs/failures Channels to create money disrupted
High unemployment 25% at one point Definition varies after new deal
International aspect Smoot Hawley Tariff
Other countries followed Gold Standard fell apart
Commitment to GS became burdensome
Monetary Contraction
Because the contraction of money supply At first, bursting the bubble
Tighten credit to curb speculation Mechanism?
Did not increase money supply when they should Inexperience? Forming expectations of deflation
Deflation
But the Fed did not extend more credit That means deflation persisted
Price 24% lower between 1929 and 1933 consequences: debt deflation
Failed businesses, bankruptcy Real interest rate= nominal interest rate-
inflation Deflation= negative inflation
Economic Indicators
Year Money Supply
NNP Commercial paper rate
Real interest
(billions, $) (%)
1929 46.6 90.3 5.78 5.88
1930 45.7 76.9 3.55 8.15
1931 42.7 61.4 2.63 15.46
1932 36.1 44.8 2.72 14.99
1933 32.2 42.7 1.67 3.03
Banking crises
Confidence in banking Withdrawal of deposits
Higher reserve ratio Reinforces the decrease in money supply
More credit to save the banks? Solvent banks faced crises too Not about insolvency, more about confidence Lender of last resort!
Summary: Monetary Contraction At first, expectation Federal Reserve inaction Reinforced by lack of confidence in banking
system Household behavior– hoarding cash Bank’s response– raise reserve ratio
So far…
The stock market crash was only the beginning
Recessions and the Fed’s missteps Expectation of falling price level
High real interest rate– investment falling Deflation– low consumption
Collapse of financial system But there was no “macroeconomics” yet
International Aspects
The Great Depression was a world wide phenomena
(hindsight) the earlier a country left GS, the sooner the recovery
Remember
The circular adjustment Trade surplus Money supply increase (gold flow in) Price increase Export decrease Or trade deficit, gold outflow, price decrease,
export decrease
France and Britain
This mechanism broke down French gold inflow, Britain outflow But French did not inflate Thus more gold outflow for Britain, then
finally go off gold standard
Why?
Commitment to GS requires Tight control of monetary policy
Remember lower interest rate=expansionary monetary policy
If US lowers interest rates Expand money supply Price level rise US $ worth less
(cont’d)
US $ worth less Under GS
Say, US $ converts to 0.1 ounce of gold But it’s only worth 0.05 ounce in the open market What would you do? “Speculative attacks” The Fed could maintain GS so long as it meets the
demand of speculators But if it runs out of gold…
That means, US will have to keep the money supply low (interest rate high)
Economy suffers Key: it was the commitment of GS that really
fettered the monetary policy of the Fed
Recovery
1933 FDR inaugurated Hoover
“enlightened” conservative Small government, high wages, etc
FDR … the only thing we have to fear is fear itself Debt financed new deal Influenced by Keynes Reshaped the role of government
Two new deals
First new deal Banking (FDIC), securities market (SEC),
Abandon GS, centralized power for Fed, NIRA, price support
Second new deal Some of the first new deal acts ruled
unconstitutional Social security, unemployment insurance, Wagner
act, work relief program
First New Deal 1933-35
Banking reform Glass-Steagall act
Firewall FDIC
SEC (security exchange commission) Information disclosure
AAA (Agriculture Adjustment Adm.) Price support (floor) reduction in output
First New Deal (cont’d)
National Industrial Recovery Act (NIRA) Industry codes of “good behavior”
Industries set standards and enforced by gov’t Price cooperation
Price floor, abstain from price cutting High wages Shorten the work week Sanctioned trade union PWA Public Works Adm
What was the diagnosis? Effectiveness?
Second New Deal
NIRA and AAA ruled unconstitutional NIRA too much power in the executive branch AAA regulated agricultural production at the
Federal level Social Security
At first an insurance Then Pay-as-you-go
Unemployment insurance
Wagner Act Labor union encouragement
Work relief program WPA Works Progress Adm. Hire, educate workers Public projects Limit 30 hrs/week
Soil conservation and domestic allotment act (continuation of AAA) Lower quantity to control price
Fair labor standards act Minimum wage
Effectiveness?
Has to evaluate each individual policies Examples:
Public Works: stimulated local economy AAA & soil conservation: not as effective
Issues with the New Deal
Effectiveness? Economic sense? Heavy handed regulation?
Role of the government in economic life High wage rate: ideology
Distributive effects Interest groups– northern businesses
Work relief programs Political side
“swing states”? Gaining political support
House Election Results1930 1932
1934 1936
Dust Bowl
Dust bowl of 1930’s through 40’s Drought
Sterile the arable land Carried ton of fertile soil away
Loss in productivity (crop) $400 million annually Destruction and Damaging crop, livestock,
building, human health
A Coordination Problem
As much man-made disaster as a natural one Erosion techniques available but not used
Small farms: externality Large farms: internalization
But Homestead Act created large number of small farms