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Page 1: 1 The Great Depression 2 The worst economic contraction was the Great Depression of the 1930s. The worst economic contraction was the Great Depression

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The Great The Great DepressionDepression

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The Great DepressionThe Great Depression The worst economic contraction was the Great The worst economic contraction was the Great

Depression of the 1930s.Depression of the 1930s. Real GDP fell nearly 30% from the peak in August 1929 to Real GDP fell nearly 30% from the peak in August 1929 to

the trough in March 1933.the trough in March 1933. The unemployment rate rose from 3% to nearly 25%.The unemployment rate rose from 3% to nearly 25%. Thousands of banks failed, the stock market collapsed, Thousands of banks failed, the stock market collapsed,

many farmers went bankrupt, and international trade was many farmers went bankrupt, and international trade was halted.halted.

There were really two business cycles in the Great There were really two business cycles in the Great Depression.Depression.

A contraction from August 1929 to March 1933, followed by an A contraction from August 1929 to March 1933, followed by an expansion that peaked in May 1937.expansion that peaked in May 1937.

A contraction from May 1937 to June 1938.A contraction from May 1937 to June 1938. By May 1937, output had nearly returned to its 1929 peak, By May 1937, output had nearly returned to its 1929 peak,

but the unemployment rate was high (14%).but the unemployment rate was high (14%). In 1939 the unemployment rate was over 17%.In 1939 the unemployment rate was over 17%.

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American Business CycleAmerican Business Cycle Recessions were common from 1865 to Recessions were common from 1865 to

1917, with 338 months of contraction and 1917, with 338 months of contraction and 382 months of expansion. 382 months of expansion.

Compare it with 56 months of expansion Compare it with 56 months of expansion and only 122 months of contraction from and only 122 months of contraction from 1945 to 2001.1945 to 2001.

The longest contraction on record was 65 The longest contraction on record was 65 months, from October 1873 to March 1879.months, from October 1873 to March 1879.

The longest expansion was 120 months The longest expansion was 120 months between March 1991 and March 2001.between March 1991 and March 2001.

http://www.nber.org/cycles/

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http://www.dallasfed.org/research/swe/2005/swe0502.pdf

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55Source: http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html

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Permanent ComponentsPermanent Components

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The United States Business Cycle, 1890-1940The United States Business Cycle, 1890-1940

Source: http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html

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The United States Business Cycle, 1950-1990The United States Business Cycle, 1950-1990

Source: http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html

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http://oregonstate.edu/Dept/pol_sci/fac/sahr/pc166514.htm

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http://oregonstate.edu/Dept/pol_sci/fac/sahr/pc1915ff.htm

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11http://oregonstate.edu/Dept/pol_sci/fac/sahr/pl1665.htm

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Huge increase in unemployment rate, of course, means a huge decrease in Y. Among the components of GDP, investment dropped precipitously. Government spending did not compensate for the expenditure drops, at all.

What Happened During the Great Depression?

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What Happened During the Great Depression?

Real money balances were relatively constant. Nominal interest rates dropped but deflation meant real interest rates were high.

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Roaring TwentiesRoaring Twenties

Extensive innovations in technology and Extensive innovations in technology and business practices.business practices.

Rapid growth in American economic Rapid growth in American economic dominance.dominance.

Euphoria.Euphoria.Stock market rise (by 9/29 it was 40% Stock market rise (by 9/29 it was 40%

above its fundamental value).above its fundamental value).

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Crash of October 1929Crash of October 1929

The urban legend is: stock market crashed The urban legend is: stock market crashed in October 1929 and that triggered the in October 1929 and that triggered the Great Depression.Great Depression.

The Stock Market Crash was not the The Stock Market Crash was not the cause but the effect of economic downturn cause but the effect of economic downturn and monetary policy of the Fed.and monetary policy of the Fed.

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Economy before 10/29Economy before 10/29The US economy was already slowing The US economy was already slowing

down by the fall of 1929 largely as a result down by the fall of 1929 largely as a result of monetary tightness.of monetary tightness. Industrial production started to decline in JulyIndustrial production started to decline in JulyConstruction permits fell sharply in August Construction permits fell sharply in August

and September.and September.Automobile sales dropped sharply in OctoberAutomobile sales dropped sharply in October Interest rates in US and abroad were risingInterest rates in US and abroad were rising

http://www.federalreserve.gov/boarddocs/speeches/2002/20021015/default.htm#pagetop

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Stock Market Non-Crash of ‘29Stock Market Non-Crash of ‘29

Stock prices did not collapse in 1929 but only Stock prices did not collapse in 1929 but only began to plummet when the depth of the general began to plummet when the depth of the general economic decline became apparent. economic decline became apparent. Stock prices in April 1930 were still about the same Stock prices in April 1930 were still about the same

level as in January 1929; and someone who bought level as in January 1929; and someone who bought stock in early 1928 and sold in October 1930 would stock in early 1928 and sold in October 1930 would have almost broken even. have almost broken even.

Only as the bad economic news kept rolling in, in the Only as the bad economic news kept rolling in, in the fall of 1930, did stock prices finally fall below 1928 fall of 1930, did stock prices finally fall below 1928 levels.levels.

http://www.federalreserve.gov/boarddocs/speeches/2002/20021015/default.htm#pagetop

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Monetary TighteningMonetary Tightening In 1928, while the inflation rate was actually In 1928, while the inflation rate was actually

slightly negative and the economy was only slightly negative and the economy was only barely emerging from a mild recession, the Fed barely emerging from a mild recession, the Fed began to raise interest rates.began to raise interest rates.

The New York Fed's discount rate, at 3.5 percent The New York Fed's discount rate, at 3.5 percent in January 1928, reached 6 percent by August in January 1928, reached 6 percent by August 1929, its highest value since 1921.1929, its highest value since 1921.

Rates on term stock-exchange loans peaked in Rates on term stock-exchange loans peaked in that month at almost 9 percent, and the rate on that month at almost 9 percent, and the rate on call loans exceeded 10 percent in early August. call loans exceeded 10 percent in early August. For short periods the rates on these loans For short periods the rates on these loans sometimes spiked above 20 percent. sometimes spiked above 20 percent.

http://www.federalreserve.gov/boarddocs/speeches/2002/20021015/default.htm#pagetop

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Why Did the Fed Tighten?Why Did the Fed Tighten?

To prick the stock market bubble.To prick the stock market bubble.As early as the mid-1920s, various As early as the mid-1920s, various

policymakers and commentators policymakers and commentators expressed concern about the rapidly rising expressed concern about the rapidly rising stock market and sought so-called stock market and sought so-called corrective action by the Federal Reserve.corrective action by the Federal Reserve.

http://www.federalreserve.gov/boarddocs/speeches/http://www.federalreserve.gov/boarddocs/speeches/2002/20021015/default.htm#pagetop2002/20021015/default.htm#pagetop

Administrator
The corrective action was not forthcoming, however. According to some authors, this was in large part because of the influence of Benjamin Strong, long-time Governor of the Federal Reserve Bank of New York and America's pre-eminent central banker of that era. Strong resisted attempts to aim monetary policy at the stock market, arguing that raising interest rates sufficiently to slow the market would have highly adverse effects on the rest of the economy.
Administrator
However, Strong died from tuberculosis early in 1928, and the Fed passed into the control of a coterie of aggressive bubble-poppers, of whom the most determined was probably Board Governor Adolph Miller. Miller was supported in his objective by another fervent enemy of "speculation"--and Miller's neighbor and close friend--Herbert Hoover, soon to be President. Under Miller's influence the debate within the Federal Reserve System shifted from whether to try to stop stock-market speculation to how best to do it. The Board in Washington favored "direct pressure," which in practice meant threatening New York City banks that made loans to brokers with being cut off from the discount window. Strong's successor at the New York Fed, George Harrison, argued correctly that the availability of alternative sources of credit made this approach ineffectual and pushed for higher interest rates instead. Ultimately, frustrated by the ineffectiveness of direct pressure, the Board in Washington came around to Harrison's view.
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Money SupplyMoney Supply

Deflation, like inflation, tends to be closely Deflation, like inflation, tends to be closely linked to changes in the national money linked to changes in the national money supply, defined as the sum of currency supply, defined as the sum of currency and bank deposits outstanding, and such and bank deposits outstanding, and such was the case in the Depression. Like real was the case in the Depression. Like real output and prices, the U.S. money supply output and prices, the U.S. money supply fell about one-third between 1929 and fell about one-third between 1929 and 1933, rising in subsequent years as output 1933, rising in subsequent years as output and prices rose.and prices rose.

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Milton Friedman and Anna J. SchwartzMilton Friedman and Anna J. Schwartz

A Monetary History of the United States, A Monetary History of the United States, 1867-1960 1867-1960 (1963). (1963).

Four errors by the Fed.Four errors by the Fed.1.1. Tightening from 1928 on.Tightening from 1928 on.2.2. Sticking to gold standard and raising interest Sticking to gold standard and raising interest

rates when USD was “attacked.” (1931)rates when USD was “attacked.” (1931)3.3. Stopped easing monetary policy in 1932 Stopped easing monetary policy in 1932

because nominal interest rates were low.because nominal interest rates were low.4.4. Ignored the problems in the banking sector.Ignored the problems in the banking sector.

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Monetary Tightening in 1928Monetary Tightening in 1928

Commodity prices were declining sharply, little Commodity prices were declining sharply, little hint of inflation. hint of inflation.

Fed was concerned that bank lending to brokers Fed was concerned that bank lending to brokers and investors was fueling a speculative wave in and investors was fueling a speculative wave in the stock market. When the Fed's attempts to the stock market. When the Fed's attempts to persuade banks not to lend for speculative persuade banks not to lend for speculative purposes proved ineffective, Fed officials purposes proved ineffective, Fed officials decided to dissuade lending directly by raising decided to dissuade lending directly by raising the policy interest rate.the policy interest rate.

http://www.federalreserve.gov/boarddocs/speeches/http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm2004/200403022/default.htm

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Gold StandardGold Standard Fixed exchange rates are subject to speculative Fixed exchange rates are subject to speculative

attack if investors doubt the ability of a country attack if investors doubt the ability of a country to maintain the value of its currency at the legally to maintain the value of its currency at the legally specified parity. specified parity.

In September 1931 scared speculators In September 1931 scared speculators exchanged British pounds for gold in return. exchanged British pounds for gold in return. Faced with the heavy demands of speculators for gold Faced with the heavy demands of speculators for gold

and a widespread loss of confidence in the pound, the and a widespread loss of confidence in the pound, the Bank of England quickly depleted its gold reserves. Bank of England quickly depleted its gold reserves. Unable to continue supporting the pound at its official Unable to continue supporting the pound at its official value, Great Britain was forced to leave the gold value, Great Britain was forced to leave the gold standard, allowing the pound to float freely, its value standard, allowing the pound to float freely, its value determined by market forces.determined by market forces.

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Gold StandardGold Standard With the collapse of the pound central banks as well With the collapse of the pound central banks as well

as private investors converted a substantial quantity as private investors converted a substantial quantity of dollar assets to gold in September and October of of dollar assets to gold in September and October of 1931, reducing the Federal Reserve's gold reserves. 1931, reducing the Federal Reserve's gold reserves.

The speculative attack on the dollar also helped to The speculative attack on the dollar also helped to create a panic in the U.S. banking system. create a panic in the U.S. banking system. Fearing imminent devaluation of the dollar, many foreign Fearing imminent devaluation of the dollar, many foreign

and domestic depositors withdrew their funds from U.S. and domestic depositors withdrew their funds from U.S. banks in order to convert them into gold or other assets. banks in order to convert them into gold or other assets.

The worsening economic situation also made depositors The worsening economic situation also made depositors increasingly distrustful of banks as a place to keep their increasingly distrustful of banks as a place to keep their savings and bank panics proliferated.savings and bank panics proliferated.

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Fed’s DilemmaFed’s DilemmaTo keep the gold standard means to protect To keep the gold standard means to protect

the dollar by raising interest rates and the dollar by raising interest rates and making dollar attractive to hold.making dollar attractive to hold.

To support the banking system means to To support the banking system means to provide funds to the banks under attack and provide funds to the banks under attack and be lender-of-last-resort by flooding the be lender-of-last-resort by flooding the system with money and keeping interest system with money and keeping interest rates low.rates low.

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Fed’s DilemmaFed’s Dilemma Fed decided to ignore the plight of the banking Fed decided to ignore the plight of the banking

system and focused only on stopping the loss of system and focused only on stopping the loss of gold reserves to protect the dollar. gold reserves to protect the dollar.

The attack on the dollar subsided and the U.S. The attack on the dollar subsided and the U.S. commitment to the gold standard was commitment to the gold standard was successfully defended. successfully defended.

Fed chose to tighten monetary policy despite the Fed chose to tighten monetary policy despite the fact that macroeconomic conditions--including an fact that macroeconomic conditions--including an accelerating decline in output, prices, and the accelerating decline in output, prices, and the money supply--seemed to demand policy ease.money supply--seemed to demand policy ease.

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Easing or Not EasingEasing or Not Easing Congress began pressure the Federal Reserve to ease monetary Congress began pressure the Federal Reserve to ease monetary

policy. The Fed increased money supply between April and June of policy. The Fed increased money supply between April and June of 1932. 1932.

Interest rates fell and the decline in prices and economic activity Interest rates fell and the decline in prices and economic activity halted. Some Fed officials viewed the Depression as the necessary halted. Some Fed officials viewed the Depression as the necessary purging of financial excesses built up during the 1920s. Other purging of financial excesses built up during the 1920s. Other officials, noting the very low level of nominal interest rates, officials, noting the very low level of nominal interest rates, concluded that monetary policy was in fact already quite easy and concluded that monetary policy was in fact already quite easy and that no more should be done. that no more should be done. The ongoing deflation meant that the real cost of borrowing was very The ongoing deflation meant that the real cost of borrowing was very

high because any loans would have to be repaid in dollars of much high because any loans would have to be repaid in dollars of much greater value. Thus monetary policy was not in fact easy at all, despite greater value. Thus monetary policy was not in fact easy at all, despite the very low level of nominal interest rates. the very low level of nominal interest rates.

When the Congress adjourned in July 1932, the Fed reversed the When the Congress adjourned in July 1932, the Fed reversed the policy. By the latter part of the year, the economy had relapsed policy. By the latter part of the year, the economy had relapsed dramatically.dramatically.

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Banking SectorBanking Sector As depositor fears about the health of banks grew, runs As depositor fears about the health of banks grew, runs

on banks became increasingly common. Deposit on banks became increasingly common. Deposit insurance was virtually nonexistent, so that the failure of insurance was virtually nonexistent, so that the failure of a bank might cause depositors to lose all or most of their a bank might cause depositors to lose all or most of their savings. savings.

A series of banking panics spread across the country, A series of banking panics spread across the country, often affecting all the banks in a major city or even an often affecting all the banks in a major city or even an entire region of the country. entire region of the country.

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Banking SectorBanking SectorBetween December 1930 and March Between December 1930 and March

1933, when President Roosevelt declared 1933, when President Roosevelt declared a "banking holiday" that shut down the a "banking holiday" that shut down the entire U.S. banking system, about half of entire U.S. banking system, about half of U.S. banks either closed or merged with U.S. banks either closed or merged with other banks. other banks.

Surviving banks, rather than expanding Surviving banks, rather than expanding their deposits and loans to replace those their deposits and loans to replace those of the banks lost to panics, retrenched of the banks lost to panics, retrenched sharply.sharply.

Administrator
The Federal Reserve had the power at least to ameliorate the problems of the banks. For example, the Fed could have been more aggressive in lending cash to banks (taking their loans and other investments as collateral), or it could have simply put more cash in circulation. Either action would have made it easier for banks to obtain the cash necessary to pay off depositors, which might have stopped bank runs before they resulted in bank closings and failures. Indeed, a central element of the Federal Reserve's original mission had been to provide just this type of assistance to the banking system. The Fed's failure to fulfill its mission was, again, largely the result of the economic theories held by the Federal Reserve leadership. Many Fed officials appeared to subscribe to the infamous "liquidationist" thesis of Treasury Secretary Andrew Mellon, who argued that weeding out "weak" banks was a harsh but necessary prerequisite to the recovery of the banking system. Moreover, most of the failing banks were relatively small and not members of the Federal Reserve System, making their fate of less interest to the policymakers. In the end, Fed officials decided not to intervene in the banking crisis, contributing once again to the precipitous fall in the money supply.
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Banking CrisisBanking Crisis

Because bank deposits are a form of money, the Because bank deposits are a form of money, the closing of many banks greatly exacerbated the closing of many banks greatly exacerbated the decline in the money supply. decline in the money supply.

People hoarded cash. Hoarding effectively People hoarded cash. Hoarding effectively removed money from circulation, adding further removed money from circulation, adding further to the deflationary pressures. to the deflationary pressures.

Shutting down of the U.S. banking system also Shutting down of the U.S. banking system also deprived the economy of an important source of deprived the economy of an important source of credit and other services normally provided by credit and other services normally provided by banks.banks.

Administrator
Monetary Base remained relatively constant.As banks started to fail, people preferred to hold cash rather than deposits; C/D rose.Banks, in order to cushion themselves for panic attacks, increased excess reserves; ER/D rose.As a result M declined by a fourth.Financial system stopped channeling savings into investments.
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Bank PanicsBank Panics ““Many of the banks that failed during the

panics appear to have been at least as financially sound as banks that were able to use alternative resolution strategies. This result supports the idea that the disruptions caused by the banking panics may have exacerbated the economic downturn.” Mark Carlson.” Mark Carlson

http://www.federalreserve.gov/pubs/feds/2008/200807/200807pap.pdfhttp://www.federalreserve.gov/pubs/feds/2008/200807/200807pap.pdf

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Bank Consolidation and Bank Consolidation and Number of BanksNumber of Banks

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Shrinking of BanksShrinking of Banks

There were 12,343 commercial banks and 2815 There were 12,343 commercial banks and 2815 savings institutions in 1990. On March 31, 2009 savings institutions in 1990. On March 31, 2009 there were 7037 commercial banks and 1209 there were 7037 commercial banks and 1209 savings institutions.savings institutions.

Number of failed institutions were in the single Number of failed institutions were in the single digits in the years 1995-2007. 878 institutions digits in the years 1995-2007. 878 institutions failed between 1990 and 1994. 25 institutions failed between 1990 and 1994. 25 institutions failed in 2008 and 21 in Q1 of 2009.failed in 2008 and 21 in Q1 of 2009.

http://www.fdic.gov/bank/statistical/stats/2009mar/FDIC.pdfhttp://www.fdic.gov/bank/statistical/stats/2009mar/FDIC.pdf

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Great DepressionGreat DepressionGovernments tried to balance budgets, Governments tried to balance budgets,

further slowing down the economy.further slowing down the economy.Huge deflation made bank collateral Huge deflation made bank collateral

worthless in defaults.worthless in defaults.Bank failures triggered bank panics.Bank failures triggered bank panics.Financial system ground to a stop.Financial system ground to a stop.Falling prices provided incentives to Falling prices provided incentives to

postpone investment.postpone investment.

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Great DepressionGreat Depression Gold standard restricted countries to expand Gold standard restricted countries to expand

money supply only when they acquired gold money supply only when they acquired gold as a result of trade surpluses.as a result of trade surpluses.

Those countries that abandoned the gold Those countries that abandoned the gold standard (Scandinavian countries, Japan) standard (Scandinavian countries, Japan) slipped away from the Great Depression.slipped away from the Great Depression.

To acquire gold, countries passed To acquire gold, countries passed protectionist policies (Smoot-Hawley in US).protectionist policies (Smoot-Hawley in US).

Administrator
Perhaps the most fascinating discovery arising from researchers' broader international focus is that the extent to which a country adhered to the gold standard and the severity of its depression were closely linked. In particular, the longer that a country remained committed to gold, the deeper its depression and the later its recovery
Administrator
Great Britain and Scandinavia, which left the gold standard in 1931, recovered much earlier than France and Belgium, which stubbornly remained on gold. As Friedman and Schwartz noted in their book, countries such as China--which used a silver standard rather than a gold standard--avoided the Depression almost entirely.
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Gold Standard and TradeGold Standard and Trade

Smoot-Hawley was passed in June 1930.Smoot-Hawley was passed in June 1930.Eichengreen and Irwin show that those Eichengreen and Irwin show that those

countries that clung to the gold standard countries that clung to the gold standard resorted most to protectionism.resorted most to protectionism.

http://papers.nber.org/papers/w15142http://papers.nber.org/papers/w15142http://www.economist.com/http://www.economist.com/

businessfinance/displaystory.cfm?businessfinance/displaystory.cfm?story_id=14082148story_id=14082148

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Trade Shrank to 1/4Trade Shrank to 1/4thth Between Between Jan. 1929 and Mar. 1933Jan. 1929 and Mar. 1933

0

500

1000

1500

2000

2500

3000Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Imports of 75 Countries. Source: E. Ray Canterbury, A Brief History of Economics,(World Scientific, Singapore: 2001), p. 209.

Administrator
When the Federal Reserve raised interest rates in 1928 to fight stock market speculation, it inadvertently forced tightening of monetary policy in many other countries as well. This tightening abroad weakened the global economy, with effects that fed back to the U.S. economy and financial system.
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Ideologies/Policies That Ideologies/Policies That Exacerbated the Great DepressionExacerbated the Great Depression

Gold StandardGold StandardClassical theoryClassical theoryFiscal Conservatism (Balanced Budgets)Fiscal Conservatism (Balanced Budgets)Smoot-Hawley ProtectionismSmoot-Hawley ProtectionismTight Money (high interest rate) from bank Tight Money (high interest rate) from bank

failuresfailuresWhat is it? How does it operate? How did What is it? How does it operate? How did

it contribute to the downfall?it contribute to the downfall?

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Friedman suggested, the economy can grow faster than normal for a period until it reaches the point where it would have been without the crisis, when it reaches its full potential again.If the shortfall in demand persists it can do lasting damage to supply, reducing the level of potential output (scenario 2) or even its rate of growth (scenario 3). If so, the economy will never recoup its losses, even after spending picks up again. In a recession firms shed labour and mothball capital. If workers are left on the shelf too long, their skills will atrophy and their ties to the world of work will weaken. When spending revives, the recovery will leave them behind. Output per worker may get back to normal, but the rate of employment will not.

World Economic Outlook: cost of 88 banking crises over the past four decades. On average, seven years after a bust an economy’s level of output was almost 10% below where it would have been without the crisis.

http://www.economist.com/specialreports/displayStory.cfm?story_id=14530093

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Regulatory Legacy of DepressionRegulatory Legacy of Depression

The experience of the Depression helped forge a The experience of the Depression helped forge a consensus that the government bears the important consensus that the government bears the important responsibility of trying to stabilize the economy and the responsibility of trying to stabilize the economy and the financial system, as well as of assisting people affected financial system, as well as of assisting people affected by economic downturns. by economic downturns.

Dozens of our most important government agencies and Dozens of our most important government agencies and programs, ranging from social security (to assist the programs, ranging from social security (to assist the elderly and disabled) to federal deposit insurance (to elderly and disabled) to federal deposit insurance (to eliminate banking panics) to the Securities and eliminate banking panics) to the Securities and Exchange Commission (to regulate financial activities) Exchange Commission (to regulate financial activities) were created in the 1930s, each a legacy of the were created in the 1930s, each a legacy of the Depression. Depression.

http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htmhttp://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm

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Historical Development of the Historical Development of the Banking IndustryBanking Industry

Outcome: Multiple Regulatory AgenciesOutcome: Multiple Regulatory Agencies1.1. Federal ReserveFederal Reserve2.2. FDICFDIC3.3. Office of the Comptroller of the CurrencyOffice of the Comptroller of the Currency4.4. State Banking AuthoritiesState Banking Authorities

iciici

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1.1. The government should not sit on its The government should not sit on its hands.hands.

2.2. Prudent policy has to rely on all the toolsPrudent policy has to rely on all the tools1.1. Monetary policyMonetary policy2.2. Quantitative easingQuantitative easing3.3. Fiscal policyFiscal policy4.4. Banking policyBanking policy

3.3. Don’t let debates over reform block Don’t let debates over reform block policies for recoverypolicies for recovery