Monetary policy, in simple terms, is the process by which the central bank of a country controls the supply of money within the economy. In the US, the Federal Reserve establishes the monetary policy of the country with an aim to promote growth, stabilize prices and to achieve maximum employment. These goals of the monetary policy are spelled out in the Federal Reserve Act, which also empowers the Board of Governors and the Federal Open Market Committee (FOMC) to promote these objectives. These three goals have been chosen because they tend to regulate the health of the economy. “When prices are stable and believed likely to remain so, the prices of goods, services, materials, and labor are undistorted by inflation and serve as clearer signals and guides to the efficient allocation of resources and thus contribute to higher standards of living. Moreover, stable prices foster saving and capital formation, because when the risk of erosion of asset values resulting from inflation – and the need to guard against such losses – are minimized, households are encouraged to save more and businesses are encouraged to invest more “(Federal Reserve.gov, No date, p.2).
Do you always experience troubles with writing annotated bibliography for scientific articles? We at Pro-Papers can help you with that! Check out our enlightening article on the annotated bibliography writing or buy your paper online.
Though this price stability can help to achieve the maximum growth for an economy in the long run, it can cause tensions and conflicts in the short run. As a result, there could be conflicts within the goals of the monetary policy, so the Fed has to intervene to balance the situation. In such cases, the Fed chairman faces the dilemma of choosing one goal over another based on the economic situations that exist at that point in time. This conflict is the real challenge for the Fed as they should formulate the right policy that would boost growth for the economy.
Another implicit goal of the Fed is to maintain financial stability, and to ensure that disruptions within the financial sector do not spill over to other sectors within the economy. Though the modern financial sector is complex, the Fed can come up with the policies to improve the resilience of the financial sector, as well as the economy as a whole. Its actions should range from subtle to aggressive, depending on the demands of the situation.
The link between the monetary policy and the economy is the balances held in Federal Reserve banks. Depository institutions have an account with the Federal Reserve, and these institutions can trade on the balances available in their respective accounts in the federal funds market. The rate of interest in this market is determined by the Federal Reserve, and is known as the federal funds rate. The Federal Reserve has enormous amounts of influence on the federal funds maintained by banks, especially in its demand and supply. It exercises this control through the federal funds rate.
These federal funds rates are set by FOMC at a level that it thinks will create a monetary situation that is in tune with its objectives. Also, it changes the rate depending on the prevailing economic situation. However, this is a powerful tool because a small change in the federal funds rate or even an anticipation that it could change in the future, triggers a chain of events. These events can affect a range of other areas such as the short-term rates, long-term interest rates, foreign exchange value of the dollar, and even the stock prices. As a result of these changes, the amount of money left in the hands of households and businesses will also change, thereby affecting growth within the economy.
Due to the above influence, the monetary policy of the Fed is an important factor in the health of the economy. This importance is all the more increased during an economic downturn because it affects individuals and businesses in a negative manner. For these reasons, the role of the monetary policy that prevailed during the Great Depression and the Great Recession is analyzed in depth below.
In the year 1927, the US went into a mild recession. At the same time, Britain was facing intense pressure on its currency because France wanted to convert a large amount of British Pound into gold, as it was following the British Pound as the valuation standard. These factors led to a precarious internal and external economic situation, so the Fed began to ease out on its interest rate. The idea behind this move was to boost the decline in economic activity, and also to release some gold to ease out the situation for France and Britain. However, at this time, the New York stock market was deemed to be over-valued because many small investors had turned to stock investments. In the light of such a situation, did the Fed's monetary policy led to the New York stock market crash that started the Great Depression?
One argument that the Fed had constantly made was that there was no apparent sign of bubble at any time, so nobody expected the markets to crash in 1927. This argument has been backed by statistics too. One of the indicators of a stock market bubble is the price-dividend ratio. This P/D ratio is better than the often compared P/E ratio because unlike earnings, dividends are more difficult to be manipulated with creative accounting terms such as EBIT. Moreover, dividends are immune from the year-to-year changes such as “write-offs” that can affect earnings and are thus less volatile. Also changes in dividend policy need more forethoughtful decisions from the management.
In 1927, this ratio was only 23, below its average of 25. Though the share prices of companies increased in the 1920s, so did the dividends. Many companies were paying handsome dividends to investors, and this kept the ratio under control.
Writing articles isn't a simple process since there are numerous requirements, details, and features. If you don't feel like working hard on that, you can order your paper at Pro-Papers professional article writing service.
The above diagram depicts the price-dividend ratio that existed between 1927 to 1930. Therefore, at that time of easing the interest rates, the Fed had no reason to believe that a crash was coming. They raised the efforts to simply to boost the economy from recession, and to help partner countries to manage their balance of payments.
However, by January 1928, the prices began to rise rapidly. In one year, the stock market prices rose by 39 percent, and the dividend payouts also grew. This increase in both the price and the dividend balanced the dividend-price ratio to 27, which was slightly above the average of the NYSE. At this time, the Fed began to suspect some kind of speculation in the market, but it was too late.
Within the first six months of 1928, the Fed increased the discount rate from 3.5 percent to five percent.. This rise is not a normal course of action that central banks would take, and especially not the Fed, considering that only the previous year, the economy was in a mild recession. It is abnormal for the Fed to increase discount rate when the economy is coming out of a recession, so this was a wrong move. Furthermore, the Fed began to step up its open market operations, and it is estimated that the Fed sold more than three-fourths of its securities during this period (St.Louis Fed, 1992).
Overall, the Fed engaged in tight monetary policy, which was in tune with the policy followed by other countries around the world. Had Fed not followed this tight policy, it would have disrupted its balance of payments.
A big drawback with this policy was that it was very restrictive, and stifled the growth of the economy. The fact that such a policy came right after the depression began, made it worse for the economy. Due to this contractionary policy, economic activity slowed by the second quarter of 1929.
As for the stock markets, the measures taken by the Fed seemed to work for the first few months. The price-dividend ratio fell during the first half of 1929, which indicated that the stock market was getting stabilized. At this time, the Fed also came to the conclusion that the stock prices were not that over-valued, so a bubble was not possible. However, by July 1929, the prices began to rise again. In August, the Fed raised the discount rates to six percent, and soon, the stock market prices peaked in the first week of September, and then crashed by the end of October (Cogley, 1999).
The New York stock market crash was not the beginning of the Great Depression, and it was one of the consequences of it. The depression began in 1929 in countries such as Germany, Brazil and some southeast Asian countries, and it spread around the world. While it was mild in some countries such as Great Britain and France, it was most severe in the US. This severity was in part due to the deflationary monetary policy by the Fed as it reduced economic activity and caused the prices of goods to fall.
Though the New York Fed took some measures immediately after the crash, it did not work. The New York Fed attempted to ease credit conditions right away. When investors began to take their money out of the stock market, lenders also called their loans given to securities brokers. This situation to possess liquidity tightened the availability of credit. To ease this situation, the Fed requested many New York banks to take over the loans, and some of them obliged. In return, these banks were given the choice to borrow as much money as they wanted at the prevailing discount rates. At the same time, it also bought government securities to boost the flow of money into the economy. These moves taken by the Fed protected the money markets to some extent as it contained the liquidity crisis temporarily. However, this move alone was insufficient to contain the damage that was taking place in the economy because of the temporary nature of this program.
Much literature has been written in this direction, and the Fed's actions have been criticized by many economists and researchers. One of the most prominent arguments is the adherence to gold standards. This adherence limited the powers of the Fed to stabilize monetary decline during the Great depression. In fact, the depression showed the world the problems that persist with having gold as the international standard.
Due to these limitations, the Fed could not fully offset the outflow of gold and other currencies suffered by banks, and this caused the money supply contraction to accelerate. Moreover, the Reserve Banks were required to maintain a minimum of 40 percent gold reserves equivalent to their note issues, gold or other “eligible” paper against the remaining 60 percent. “Since gold outflows had reduced the System's reserve holdings, and since the System lacked other eligible paper, Fed officials asserted they could not increase Fed credit by purchasing government securities, which were not eligible collateral” (Wheelock, 1992, p. 19). Therefore, having gold as the international standard severely reduced the ability of the Fed to increase money supply within the economy,.
Also, due to having gold as the standard, the funding needed for business operations became difficult to obtain, and as a result, the output was disrupted. Furthermore, banks failed miserably, and this led to a huge decline in money supply. To understand the impact of gold, it is prudent to step back and take a brief look into the history of gold standard.
From 1791 to 1933, the US and other countries adhered to the gold standard. Under this standard, the price of gold was fixed by the market forces of money supply. In this standard, the authorities had virtually no direct control over money supply. The supply position changed if new gold deposits were identified and also, when the demand for gold increased because of the varied uses of gold. For example, when gold is used for non-monetary purposes such as for making jewelry, then the amount available for minting went down. However, these changes were not profound until the Great Depression , as the demand and supply equilibrium were balancing itself out. However, when the depression started, consumer confidence fell in the financial markets, and deflation further complicated it. Moreover, the Fed had no control over gold outflows, and this inability further complicated the situation.
As a result, the Fed was forced to make some changes, and it apparently failed in making the right choices as is evident from the events that led to the Great Depression. Under the leadership of Benjamin Strong, the head of the New York Federal Reserve Bank, the Fed resorted to open market operations. Though this operation was against the established gold standards, the Fed had to bend the rules to control the inflow and outflow of gold. Therefore, the Fed resorted to open market bond operations, and this kept the money supply stable even when the price of gold fluctuated throughout that period. However, with the death of Strong in 1928, the New York Federal Reserve lost its appetite to use this power, so it did not continue its open market operations. Therefore, the Fed no longer controlled the outflow of gold because it did not take the right steps to set it right. This lack of the right initiatives led to a further decline in money supply that eventually led to deflation.
During the depression, the money supply ebbed and flowed, and it declined by more than one third during the first four years of the depression. In 1926, M1 was $25.67 billion, and by 1928, it increased to $26.4 billion. In 1929, M1 rose marginally to $26.6 billion, and then fell to $19.9 billion by 1933. M2, on the other hand was $43.7 billion in 1926, $46.4 billion in 1928 and $46.6 billion in 1928. From these levels, it fell to $32.2 billion in 1933. Furthermore, deposits fell from $22.2 billion in 1926 to $14.8 billion in 1933 (St. Louis Fed, 1992). This decline led to high levels of deflation that in turn affected debt arrangements. Due to this decline, borrowers had to pay more money for the borrowed amount, so borrowing became less of an option for businesses and entrepreneurs.
Another measure of the liquidity position in the economy is Money Zero Maturity (MZM). It includes all the money that is a part of M2 excluding small time deposits but including the money market funds. During the Great Depression, MZM increased as the currency in circulation increased rapidly even as the overall money supply fell because people did not trust banks, and hence decided to hold money in their hands in the form of notes and coins. This sharp contraction in money supply lead to deflationary trends.
Along side this deflationary trend, banks also failed to infuse public confidence because the Fed failed in its duty to be the lender of last resort. The Fed failed to provide the emergency reserves needed for banks to lend, so the banks failed to give loans to borrowers. Due to this failure to lend, people could not borrow, and so they held on to their money. Also, the fear of falling prices and crunching credit loomed large in the minds of people, so they refused to spend. In turn, this lack of credit spiraled to a loss of demand, and eventually led to deflation.
Wish to have more spare time for outdoor activities but you've got tons of homework that seem to be an overreach? Just ask Pro-Papers for high school homework help and relax.
In one sense, the Fed contributed to the deflationary trend seen during the depression, If the Fed had been more aggressive and proactive, then it would have put more money into the hands of the banks. This extra money would have increased the purchasing power of consumers, and this could have helped to curtail the deflation. Therefore, the Fed failed to provide the monetary support needed, and its policies further depressed the economy.
Besides this failure to provide the right monetary support, the Fed completely failed to see the stock market bubble as described previously. It was constantly under the impression that everything was fine, and the economy was going through a rapid growth phase. Unfortunately, this lack of insight to spot an obvious problem led to more problems for the economy.
The next question is how this oversight of the Fed led to the stock market crash. To start with, let us assume that there was a speculative bubble in 1928. When the Fed began to tighten money supply, the stocks should have been over-valued. This argument is based on the fact that the price-dividend ratios were the same in the beginning of 1928 and in November 1929, after the crash. Under this assumption, the Fed should have taken more measures to tighten the economy to remove these speculative elements. From this argument, it can be inferred that the Fed did not do enough to contain the stock markets.
On the other hand, if the argument is that the shares were properly valued, then the fundamentals should have been sound. On the basis of this argument, the actions taken by the Fed were unnecessary. Therefore, the actions taken by the Fed only contributed to a further destabilization of the economy, rather than improving it in any way.
Though both these arguments have their own basis, the have common real problem. It is that the Fed failed to identify speculative bubbles and the risks that are associated with aggressive actions. As a result, the Fed took aggressive actions at a time when it was not needed, so it hastened the Great Depression. Had the Fed stood back and been a spectator, history could have been different.
Leave a Reply
Your email address will not be published / Required fields are marked *