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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 140 120 100 GDP 80 Real GDP Investment 60 Consumption 40 20 1940 1939 1938 1937 1936 1935 1934 1933 1932 1931 1930 1929 0 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 consequences: debt deflation Price 24% lower between 1929 and 1933 Failed businesses, bankruptcy Real interest rate= nominal interest rateinflation Deflation= negative inflation Economic Indicators Year Money NNP Supply Commercial paper rate (billions, $) Real interest (%) 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 Higher reserve ratio Withdrawal of deposits 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 SEC (security exchange commission) Firewall FDIC 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” Price cooperation Industries set standards and enforced by gov’t 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 Social Security NIRA too much power in the executive branch AAA regulated agricultural production at the Federal level 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? Role of the government in economic life High wage rate: ideology Heavy handed regulation? Distributive effects Interest groups– northern businesses Work relief programs Political side “swing states”? Gaining political support House Election Results 1930 1934 1932 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