ECON 2200 Chapter Notes - Chapter 23: Monetary Policy, Monetarism, Bank Reserves

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9 Feb 2017
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The Great Depression: Part 2 (Chap 23, continued)
I. How do economic historians explain the Great Depression?
A. The Monetarist Interpretation: Friedman & Schwartz, A Monetary History of the US (1963)
This interpretation focuses on events between 1929 and 1933.
Primary cause: Decline in M (Table 23.2)
o Bank failures/panics  Surviving banks increased reserve holdings
Loans decreasing
In early 1930s, total bank deposits ↓ (result of runs and fewer banks in
general) and reserve holdings of surviving banks ↑.
M decreases (column 1, Table 23.2)
Y decreases (column 2, Table 23.2)
As output fell, unemployment went up, income of households and firms
decreases, and loans decrease (never ending cycle)
Note column 3, Table 23.2: Rising M-to-GDP ratio Monetarists view
this as evidence of hoarding.
Federal Reserve’s role: Monetarists claim that the Fed’s failure to exercise basic central
bank functions increased the depth and duration of the recession that became the Great
Depression. Monetary policy tended to be procyclical rather than countercyclical,
especially in 1929-1932. exercised contractionary monetary policy instead of
expansionary
Changes in Discount Rate:
1. August 1929: Fed increased DR
Effort by the Fed to reduce bank loans for margin purchases of stock (note
that the economy was showing signs of recession in spring/summer of
1929)
2. November 1931: Fed increased DR again.
Sept. 1931 England left the gold standard (2nd wave of bank crisis)
3. March 1933: Fed increased DR again. 3rd and worst wave of bank crisis
Result: All of the Fed’s increases in the DR only exacerbated the decrease the
money supply and led to surviving banks to increase reserve holding further;
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made it very expensive for banks to use the Fed as a lender of last resort
(believed that it would have been better if the Fed just did nothing)
Open Market Operations:
1. Fed made modest (small) purchases of Treasury bonds (increase M) in
October 1929, December 1930 and August 1931. (Arguments for larger
purchases were rejected by the Fed’s Board of Directors.)
This appears to have been an effort by the Board to appease advocates of
monetary expansion
2. August 1932: Fed purchased $1.1 billion in Treasury bonds. significant
purchase but…
Friedman and Schwartz: “Too little, too late.”
What was the Fed thinking?
o Fed failed to grasp magnitude of the crisis; focused on nominal (rather than real)
interest rate. (See Table 23.2)
Fed seems to have believed that an increase in the money supply wasn’t necessary
because the nominal IR was falling and low
o 1928 death of Benjamin Strong (President of NY Fed District Bank) Leadership
void at the Fed following his death.
There were Fed officials (esp. from NY fed district bank) who argued for an
increase in M, but they did not typically get their way
o Power struggle between NY Federal Reserve District Bank and the Fed’s Board
of Directors
o 1932 Federal Reserve Annual Report indicates that the Fed Board of Directors
was:
concerned that buying bonds would drain Fed’s gold reserves.
concerned that buying bonds would reduce borrowing by commercial
banks at the Fed’s discount window.
Fed is more concerned with maintaining its own solvency and preserving
the gold standard than with assisting the banking system (worried that the
Fed’s bank reserves will go down if they keep buying bonds from banks);
Monetarists believe that the Fed took a bad situation and made it worse
- somewhat concerned that M would create inflation.
B. The Keynesian Interpretation: Keynes, The General Theory (1936); more recently Temin, Did
Monetary Forces Cause the Great Depression? (1976)
This interpretation focuses on events in 1929 and 1930. first couple years are critical
Primary cause: sudden decline in C (&/or I) Keynes tended to focus on the decrease in I
(modern Keynesians focus on the decline in C)
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