KRUGMAN'S MACROECONOMICS for AP* 26 Margaret Ray and David Anderson Module The Federal Reserve System: History and Structure

KRUGMAN'SMACROECONOMICS for AP*

26

Margaret Ray and David Anderson

ModuleThe FederalReserve System: History and Structure

What you will learnWhat you will learn

in thisin this ModuleModule::

• The history of the Federal Reserve System (created in 1913)

• The structure of the Federal Reserve System

• How the Federal Reserve has responded to major financial crises

• Who monitors banks and the money supply?

• Central Bank

The Federal Reserve The Federal Reserve is a central bank—an is a central bank—an institution that institution that oversees and oversees and regulates the banking regulates the banking system, and controls system, and controls the monetary base.the monetary base.

The Federal Reserve SystemThe Federal Reserve System

• Mostly calm with moments of sheer panic

• Creation of the Federal Reserve System

An Overview of the Twenty-firstAn Overview of the Twenty-firstCentury American Banking SystemCentury American Banking System

Crisis in American Banking at theCrisis in American Banking at the Turn of the Twentieth Century Turn of the Twentieth Century

• Money Supply Tug-of-War

• Trusts

• Speculation

• Pyramid Reserves

• Knickerbocker Trust

• J.P. Morgan Saves the Day


Panic of 1907Panic of 1907

The crisis originated in institutions in New York The crisis originated in institutions in New York known as trusts, bank - like institutions that known as trusts, bank - like institutions that accepted deposits but that were originally accepted deposits but that were originally intended to manage only inheritances and estates intended to manage only inheritances and estates for wealthy clients. for wealthy clients.

Trusts were supposed to engage only in low - risk Trusts were supposed to engage only in low - risk activities = they were less regulated, had lower activities = they were less regulated, had lower reserve requirements, and had lower cash reserve requirements, and had lower cash reserves than national banks.reserves than national banks.

However, as the American economy boomed However, as the American economy boomed during the first decade of the twentieth century, during the first decade of the twentieth century, trusts began speculating in real estate and the trusts began speculating in real estate and the stock market, areas of speculation forbidden to stock market, areas of speculation forbidden to national banks. Less regulated than national national banks. Less regulated than national banks, trusts were able to pay their depositors banks, trusts were able to pay their depositors higher returns.higher returns.


Trusts grew rapidly. Trusts grew rapidly.

They declined to join the New York Clearinghouse, a They declined to join the New York Clearinghouse, a consortium of New York City national banks that consortium of New York City national banks that guaranteed one anothers’ soundness; that would have guaranteed one anothers’ soundness; that would have required the trusts to hold higher cash reserves, reducing required the trusts to hold higher cash reserves, reducing their profits. their profits.

The Panic of 1907 began with the failure of the The Panic of 1907 began with the failure of the Knickerbocker Trust, a large New York City trust that failed Knickerbocker Trust, a large New York City trust that failed when it suffered massive losses in unsuccessful stock when it suffered massive losses in unsuccessful stock market speculation. Within two days, a dozen major trusts market speculation. Within two days, a dozen major trusts had gone under. Credit markets froze, and the stock had gone under. Credit markets froze, and the stock market fell dramatically as stock traders were unable to market fell dramatically as stock traders were unable to get credit to finance their trades and business confidence get credit to finance their trades and business confidence evaporated.evaporated.

Fortunately, New York City’s wealthiest man, the banker J. Fortunately, New York City’s wealthiest man, the banker J. P. Morgan, quickly stepped in to stop the panic. He worked P. Morgan, quickly stepped in to stop the panic. He worked with other bankers, wealthy men such as John D. with other bankers, wealthy men such as John D. Rockefeller, and the U.S. Secretary of the Treasury to Rockefeller, and the U.S. Secretary of the Treasury to shore up the reserves of banks and trusts so they could shore up the reserves of banks and trusts so they could withstand the onslaught of withdrawals. Once people were withstand the onslaught of withdrawals. Once people were assured that they could withdraw their money, the panic assured that they could withdraw their money, the panic ceased. Although the panic itself lasted little more than a ceased. Although the panic itself lasted little more than a week, it and the stock market collapse decimated the week, it and the stock market collapse decimated the economy. A four - year recession ensued, with production economy. A four - year recession ensued, with production falling 11% and unemployment rising from 3% to 8%.falling 11% and unemployment rising from 3% to 8%.

Did we Did we learn learn from from this?this?

SimilaritieSimilarities, but on s, but on a much a much smaller smaller scale, to scale, to

what what happened happened in 2008in 2008.

Responding to Banking Crises: TheResponding to Banking Crises: The Creation of the Federal Reserve Creation of the Federal Reserve

•Frequent Bank Crises

•National Banking System Eliminated

•Centralized Control of Bank Reserves

•Federal Reserve’s Money Monopoly

The Structure of the FedThe Structure of the Fed

The Effectiveness of the FederalThe Effectiveness of the Federal Reserve System Reserve System

•Potential for Bank Runs still existed

•Reconstruction Finance Corporation (RFC)

•Glass-Steagall Act of 1932 (separated investment and commercial banking activities)

•FDR’s Bank Holiday

•RFC takes control

• Glass-Steagall Act (separated investment and commercial banking activities)

• Commercial Banks

• Investment Banks

• Glass-Steagall Weakened (Repealed in 1999)

• Regulation Q – (Prohibition Against The Payment of Interest on Demand Deposits)

The Effectiveness of the Federal Reserve System

The Savings and Loan Crisis of The Savings and Loan Crisis of the 1980s the 1980s

•Savings and Loans (Thrifts)

•Inflation’s effect on the S&Ls

•Speculation

•Political Interference

•Tax-Payers

•Comprehensive Oversight

Back to the Future: The FinancialBack to the Future: The Financial Crisis of 2008 Crisis of 2008

•Similarities to previous crises

•Long-term Capital Management

•LeverageLeverage (The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged)

balance sheet effect

•vicious cycle of delevereaging

• Subprime Lending and the Housing Bubble

• subprime lending – (A type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans)

securitization (combining securities)

• TED Spread


• Crisis and Response

• Fed balance sheet

• Bear Stearns v. Lehman Brothers (Two investment firms key to crisis)

• Capital Injections

• The future?


Figure 26.2 The TED SpreadRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

The TED spread is the difference between the The TED spread is the difference between the interest rate at which banks lend to each interest rate at which banks lend to each other and the interest rate on U.S. other and the interest rate on U.S. government debt. It’s widely used as a government debt. It’s widely used as a measure of financial stress. The TED spread measure of financial stress. The TED spread soared as a result of the financial crisis that soared as a result of the financial crisis that started in 2007started in 2007.

Documents

KRUGMAN'S MACROECONOMICS for AP* 26 Margaret Ray and David Anderson Module The Federal Reserve System: History and Structure