Monetary Policy during the Great Depression

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Monetarists and Keynesians still debate the causes of the Great Depression. Monetarists Milton Friedman and Anna Schwartz, in their book A Monetary History of the United States, argued that the Great Depression was caused by the decline in the money supply, the changes in the price level, real GDP, and unemployment rate.

During the 1920s, the money supply expanded steadily, and prices were generally stable. In response to the great stock market crash of 1929, bank failures, falling real GDP, and rising unemployment, the Fed changed its monetary policy. Through the Great Depression years from 1929 to 1933, M1 declined by 27 percent. Assuming velocity is relatively constant, how will a sharp reduction in the quantity of money in circulation affect the economy? Monetarists predict a reduction in prices, output, and employment. The price level declined by 24 percent between 1929 and 1933. In addition to deflation, real GDP was 30 percent lower in 1933 than in 1929. Unemployment rose from 3.2 percent in 1929 to 24.9 percent in 1933.

Friedman and Schwartz argued that the ineptness of the Fed's monetary policy during the Great Depression caused the trough in the business cycle to be more severe and sustained. As proof, let's look at the period after 1933. The money supply grew and was followed closely by an increase in prices, real GDP, and employment.

The Great Depression was indeed not the Fed's finest hour. In the initial phase of the contraction, foreign banks were fearful and withdrew large amounts of their gold from U.S. banks. To stop the outflow of gold to other countries, the Fed raised the discount rate in 1931. As a result, banks borrowed less of their required reserves from the Fed's discount window, and the money supply fell. Later the discount rate fell, but only after the economy was deeper into the Great Depression.

What should the Fed have done? Friedman and Schwartz argued that the Fed should not have waited until 1931 to use open market operations to increase the money supply. Thus, they concluded that the Fed was to blame for not pursuing an expansionary policy, which would have reduced the severity and duration of the contraction.

Finally, although the emphasis here is monetary policy, it should be noted that both monetary and fiscal policies worsened the situation. President Hoover was attempting to balance the budget, rather than using expansionary fiscal policy.

Note:

1. ineptness n – неуместность.

B. Translate into English with a dictionary.

Сущность денег полнее всего проявляется в их функциях. Деньги выполняют следующие функции: мера стоимости, средство обращения, средство накопления и образования сокровищ, средство платежа, мировые деньги. Первой является функция меры стоимости. Именно в деньгах определяется стоимость любого товара (определяется его цена). Стоит заметить, что золото выполняет данную функцию идеально. Функция денег как средства обращения обуславливает нормальное протекание обмена товарами. Деньги становятся посредником в любом акте товарного обмена, делая этот процесс менее сложным для товаропроизводителей. Функция денег как средства накопления также представляется достаточно очевидной. Накопление денег в виде золота - это фактически накопление стоимости в наиболее ликвидной форме. Интересной является функция денег как средства платежа. Здесь важным представляется то, что процесс продажи и оплаты товара разрывается во времени. Между актом купли товара и его оплатой проходит некоторое время. Очевидно, что такая отсрочка может иметь место только в том случае, если продающий данный товар получит от покупающего его гарантии оплаты в определенное время. И, наконец, функция мировых денег. Здесь мы фактически утверждаем, что товар- деньги – это всеобщий эквивалент, который выходит за национальные границы, превращаясь в общемировое явление, выступая в международном товарном обмене и мерой стоимости, и средством обращения, и средством платежа.

LISTENING

Central Banking

Gabriel Mangano is an economics research student, specializing in monetary policy. You will hear him outlining the functions of a central bank, and discussing whether it should be independent from the government, and run by bankers, or under the control of the government.

Ex. 1. Match the central bank and the country?

– the Bank of England – the Federal Reserve Board (USA) – the Bundesbank (Germany) – the Japanese central bank – the Chinese central bank – the National Bank

Germany Belarus China the United Kingdom the USA Japan

Ex. 2.Make sure that you understand the following words and word combinations.

to implement monetary policy

interest rate ceilings and floors

a fluctuation of interest rate

upswing /downswing of the exchange rate

a bank run = a run on the bank

Ex. 3.

A. Listen to Part One of the interview about the functions of a central bank, and fill in the gaps.

The first one is actually to implement monetary policy. There are roughly three ways to do it. First (1a)……………, which means limiting, upwards or downwards, the fluctuations of the interest rate.

The second way to implement monetary policy is simply (1 b)…………… coins, banknotes.

The third one, which is a bit more modern, is those (1 c)…………… , which are simply buying and selling government bonds to and from commercial banks.

So that was the first main task of a central bank. The second one is (2) …………… I would say. [...]

The third main task, yes,(3) ……………., I would say — make sure that the commercial banks have enough liquidities, for instance, to avoid any bank run. [...]

The fourth main task of the central bank would be to (4)………………………, in case, actually, one of these commercial banks goes bankrupt and the investors, the people putting money in the bank, have to get back their money.

B. Read the six sentences below, which also summarize central banking functions, but slightly differently, and match them up with the six expressions you have written in A.

a) controlling the amount of banknotes in circulation;

b) establishing maximum and minimum lending rates, thereby controlling the credit system;

c) ensuring that banks have a sufficient liquidity ratio to allow customers to withdraw their deposits when they want ;

d) intervening on foreign exchange markets, buying or selling large amounts of the national currency, to prevent major fluctuations;

e) lending money to a commercial bank in danger of going bankrupt;

f) selling government bonds to commercial banks or buying them back, in order to alter the amount of credit the banks can offer (and thereby alter the money supply).

C. Listen to Part Two of the interview and answer the following question:

What is Gabriel Manganos opinion concerning central bank independence, and why?

Look through the following statements. Listen to the extract again, and decide whether the statements are TRUE or FALSE. Correct them if they are false.

1. Gabriel Mangano says that governments tend to increase the money supply in the months before an election, which helps reduce unemployment.

2. Mangano states that the central bank should be the branch of the government that implements monetary policy.

3. Mangano considers that the central bank should be the branch of the government that implements budgetary policy.

4. Mangano suggests that governments always have a budget deficit.

5. Mangano points out that the US Federal Reserve is not concerned with price stability.

6. Mangano is of the opinion that there should be a limit to the central bank's independence.

SPEAKING

While reading the conversation of Paul Volcker with the interviewer, jot down the main points. Based on your notes, be ready to perform as Paul Volcker in the class and answer the students’ questions about the monetary policy of the Fed in the1980-ies.

Talking with Paul Volker

Paul Volcker served as chairman of the board of governors of the Federal Reserve System from 1979 to 1987, a time when double-digit inflation was gripping the U.S. economy. Michael Parkin spoke with Mr. Volcker about his experience as chairman of the Fed and about his vision and concerns for the future of the economy.

I.:	Mr Volcker, what originally attracted you to economics?
P.V.:	I was an undergraduate immediately after the Second World War. I think a lot of people at the time got interested in economics because they hoped of the idea that after the war things must be able to work better than they had during the Depression, and they were filled with a zeal for doing better. That was part of my thinking, but just as important, economics seemed to me, of all the social sciences, to have a little more precision. I thought I could combine this practical, logical structure with an instinct for public service. In retrospect, I'm sure I overestimated the logic and coherence!
I.:	What are the economic principles that you, learned in school that have proved useful in your professional life?
P.V.:	Some economic principles are eternally useful. Economics does teach you the discipline of understanding that the direct immediate effects of some action may not be the full story — that without close analysis and study you may have unintended and unanticipated effects later on. Those later "side effects" may be greater than the immediate effects. Finally, the concept of looking at the margin — at incremental effects — is very important in terms of actual policy.
I.:	Is a background in economics, familiarity with economic principles, mandatory for a chairman of the Federal Reserve?
P.V.:	I haven't been able to detect any correlation in performance between chairmen that were economists and those who were not. The chairman doesn't have to be a trained economist if he or she has a staff of very good economists. Without that, you'd really be in trouble.
I.:	There must be as many opinions about what the Fed should be doing as there are economists. How do these controversies among macroeconomists affect the Fed's job? Are they relevant for the conduct of monetary policy?
P.V.:	Oh, I think they're relevant. The internal technical debate doesn't make that much difference. But to the extent that economists' positions on public policy influence public opinion and differ widely, you lack a consensus against which to conduct policy, in a political context, some of these different points of view become politicized. That's part of the environment in which the Fed must operate. The one advantage when you're the chairman of the federal Reserve Board is that you can sometimes influence — or can lead yourself and everyone else into thinking that you can influence — the nature of the consensus about economic policy, as it is actually reflected in public opinion.
I.:	There has certainly not been consensus about the consequences of the Fed's policy in fighting inflation during the late 1970s and early 1980s, while you were chairman. When you embarked on your war against inflation, did you expect to be presiding over the longest peacetime recovery in U.S. history?
P.V.:	I thought then, and think now, that inflation is the enemy of sustained expansion. But dealing with these things always turns out to be more difficult, more complicated, and to take longer than you expect. I guess I did misjudge how long we could put up with internal government deficits and external trade imbalances.
I.:	What were you missing?
P.V.:	In part I think there is a much more fluid international capital market than we had recognized. I would not have guessed that the United States could borrow, or that the Japanese would be willing to lend, so much money year after year without more uncertainty about the dollar. I would not have guessed that the value of the dollar could come down from its high level as much as it has without more disturbance in interest rates and inflation. We've been very fortunate in being able to manage that big a decline in the value of the dollar with as little inflation as we've had.
I.:	Did your war on inflation cost more in human terms than you had thought?
P.V.:	Stopping inflation is never easy. What I object to is that people said that the Federal Reserve caused the recession in the early 1980s and all its pain and suffering. But, in my view, we were going to have the pain anyway. It was just a question of when and how. We thought it would be less if we dealt with the inflation earlier rather than later. One of my predecessors, Bill Martin, once described the Fed's job as taking away the punch bowl just when the party's getting good. You avoid the hangover that way, or reduce it anyway.
I.:	Do you bring the punch bowl back if the party starts to fade?
P.V.:	My critique of Federal Reserve history is not that it was always too harsh and brought all these expansions to an end when they could have gone on forever. But sometimes the Fed was overeager to get the party started. Once you get in a recession, the pressures on the Fed are very strong. Even after you come out of the recession, the temptation is to overstimulate. But policy only works with a lag and the lags catch up with you. You're off to another jolly party again. We tried to avoid this last time, I think with some success.
I.:	We've talked a bit about the government's budget deficit. Did the government's need to finance its budget deficit affect your job as chairman of the Fed?
P.V.:	I do not believe that the Federal Reserve was forced into inflationary financing. In retrospect, the government's budget deficit position did not in fact appear to impair our ability to achieve a record expansion. But if you look at whether the expansion can be carried on for another seven years, you have to get concerned about our relatively low level of investment, our low productivity, and our dependence on foreign lending and investment. None of these can be dealt with by monetary policy alone. Fiscal policy gives you an expansionary thrust, which then has to be countered by tighter monetary policy — by higher interest rates. This leaves you with a vulnerable economy, increasingly dependent on money borrowed from overseas.
I.:	Our economic relationship with other countries also includes the exchange of goods and services. In recent years we have been experiencing a substantial decline in net exports. What do you see as the principal cause of the external trade deficit?
P.V.:	It's an internal imbalance between our ability to produce and our propensity to spend. Our spending is mostly consumption, personal and public. Investment is, at best just so-so a period of expansion. So a major policy challenge is to find a way of cutting consumption. On the other hand, there are imbalances in the opposite direction in other economies. The Japanese are doing a good job in beginning to deal with this problem. But it is true that there is a bias in the trading world toward less openness. If you took a snapshot of the world trading scene, you'd have to agree that the United States is by far the most open market of all, and our trading partners are more closed. How do you deal with that complaint? You can't ignore how these imbalances are aggravated by our own internal economic policies, our own consumption.
I.:	What will improve the situation?
P.V.:	We've got to contain domestic spending and we've got to see foreign markets open up so that foreign expenditure for our goods increases. Of course, just opening foreign markets wouldn't induce any change in our own spending by itself. Moreover, changing our spending pattern can't be done just by monetary policy, by high interest rates. Monetary policy won't move spending from consumption into investment. That means you've got to bring fiscal policy to bear. More taxes or less spending or both. But now you've got a lot of political choices. You'll have to make some political bargains in order to get expenditure cuts.
I.:	When a college student seeks your advice on the choice of a career, what do you suggest?
P.V.:	I'd strongly encourage him or her to consider a career in public service. There are so many important jobs for people in the government. Who do we look to for the solution of problems like AIDS? The government. Who's going to solve the drag problem, if anyone can? The government. We need young people who recognize the challenge and excitement and satisfaction of service to the public. Without their contributions, we will have a serious problem in this country.

Ex. 1. Match the words in A with their definitions in B.

1) consumption	a) The state of being legally acceptable
2) precision	b) An amount used
3) coherence	c) A period of economic decline in a country
4) correlation	d) Accuracy
5) recession	e) The action of becoming or making smth. greater in size, number, or importance
6) expansion	f) A mutual relationship
7) validity	g) Sth. (of ideas, thoughts, speech etc.) logical or consistent
8) vulnerable	h) A tendency to behave in a certain way
9) propensity	i) Exposed to being attacked or harmed

Discuss the following issues.

1. What are the functions of money?

2. What is the difference between commodity and fiat money?

3. What are the basic motives for the transactions demand, precautionary demand, and speculative demand?

4. What does the money supply of the U.S. consist of? What happens when the money supply increases?

5. What are the basic instruments of monetary policy?

6. Do you think central banks should be controlled or independent from the state? How does it work in your country?

7. What is the present day base interest rate in your country?

VOCABULARY

billn –счёт;вексель; (AmE) банкнота

utility ~ счёт за коммунальные услуги

treasury ~ – казначейский вексель

cost n (syn. expenses, expenditures) – издержки, затраты, стоимость

historical ~ – цена приобретения, уплаченная за активы в период их первоначального приобретения или строительства

replacement ~ – восстановительная стоимость

exchange n – средство, обмен

medium of ~ – средство международных расчетов

forgone interest – упущенные проценты

feen – вознаграждение; денежный взнос

monetary adj – денежный

~ base–денежная база (часть денежной массы, которая признаётся в качестве резервов банковской системы)

~ policy–денежно-кредитная политика

money n – деньги

precautionary demand for ~ – спрос на деньги для непредвиденных расходов

speculative demand for~ – спекуляционный спрос на деньги

transactions demand for ~ – спрос на деньги для совершения сделок

~ multiplier – денежный мультипликатор

fiat/token ~ – неразменные бумажные деньги, денежные знаки

IOU (I owe you) ~ –деньги, которые будут получены по необеспеченному обязательству платежа

securities n–ценные бумаги

government ~ – государственные ценные бумаги

tender n–тендер, предложение

legal ~ –законное средство платежа ( виды денег, которые кредитор обязан по закону принимать при погашении долга)

velocityn – скорость обращения денег

withdrawal penalties – несение убытков в результате отвлечения капитала

GLOSSARY

· Medium of exchange is the most important function of money. This means that money is widely accepted in payment for goods and services.

· Unit of account is another important function of money. Money is used to measure relative values by serving as a common yardstick for valuing goods and services.

· Store of value is the ability of money to hold its value over time. Money is said to be highly liquid, which means it is readily usable in exchange.

· The demand for money in the Keynesian view consists of three reasons why people hold money: (1) Transactions demand is money held to pay for everyday predictable expenses. (2) Precautionary demand is money held to pay unpredictable expenses. (3) Speculative demand is money held to take advantage of price changes in nonmoney assets.

· An excess quantity of money demanded causes households and businesses to increase their money balances by selling bonds. This causes the price of bonds to fall, thus driving up the interest rate.

· An excess quantity of money supplied causes households and businesses to reduce their money balances by purchasing bonds. The effect is to cause the price of bonds to rise, and, thereby, the rate of interest falls.

· Monetarismis the simpler view that changes in monetary policy directly change aggregate demand and thereby prices, real GDP, and employment. Thus, monetarists focus on the money supply, rather than on the rate of interest.

· Monetary baseis the stock of an economy’s most liquid financial assets.

FISCAL POLICY

The only good budget is a balanced budget.

Adam Smith of Glasgow (1776)

DISCOVERING CONNECTIONS

In the early 1980s, under President Ronald Reagan, the federal government reduced personal income tax rates by 25 percent. The goal was to expand aggregate demand and boost national output and employment in order to end the recession of 1980-1981. During the 1996 presidential campaign, one of President Bill Clinton's programs was supposed to stimulate economic growth by boosting government spending on long-term investment. This investment program included highways, bridges, fiber-optic communications networks, and education.

Examples of what are both Reagan's tax cut and Clinton's investment spending programs? Is it one of the issues that touch everyone's life?

Does an increase in government spending or a tax cut of equal amount provide the greater stimulus to economic growth? Can Congress fight a recession without taking any action? Why did Ronald Reagan think the federal government could increase tax revenues by cutting taxes?

READING

Text 1

Scan the text and find definitions of the following terms: fiscal policy, deficit, surplus. Read the text and do the tasks that follow.

Fiscal Policy

Policy aimed at changing the level of either government spending or taxes to stimulate or slow down the economy is known as fiscal policy. It was invented by the British economist John Maynard Keynes in the 1930s. Keynes believed that increased demand for goods and services should be met by expanded production. However, after a nation's economy reaches full capacity, production cannot expand. If the demand for goods and services increases, prices continue to rise and inflation occurs. In such cases, Keynes recommended a tax increase, which would reduce the demand for goods and services and relieve the pressure on prices.

Keynes maintained that governments should use fiscal policy (tax and spending programs) to stabilize the economy. He said the overall level of economic activity depends on effective demand – that is, total spending by individuals, businesses, and government.

According to Keynes, major depressions, such as the Great Depression of the 1930's, occur as a result of a drop in effective demand. He argued that in periods of depression the government should increase its spending, cut taxes, or do both to stimulate the economy. These steps would result in a government budget deficit (shortage). But Keynes said the actions could lead to higher levels of investment and nongovernment spending and to full employment.

To understand how fiscal policy works, we need to understand three basic concepts. First, the deficit. When government spending is greater than tax revenue, we have a federal budget deficit. The government is paying out more than it's taking in. How does it make up the difference? It borrows. Deficits have been much more common than surpluses. This is not to say that deficits are always bad. Indeed, during recessions, they are just what the economic doctor ordered.

Second, budget surpluses are the exact opposite of deficits. They are prescribed to fight inflation. When the budget is in a surplus position, tax revenue is greater than government spending.

Finally, we have a balanced budget when government expenditures are equal to tax revenue.

Thus, fiscal policy is the manipulation of the government budget deficit or surplus to influence the level of aggregate income (or GDP) in the economy. If aggregate income is too low (actual income is below target income), the appropriate fiscal policy is expansionary fiscal policy: increase the deficit, or reduce a surplus, which means the government spends more or takes in less. If aggregate income is too high (actual income is above target income), the appropriate fiscal policy is contractionary fiscal policy: reduce the deficit, or increase a surplus, which means the government takes in more in taxes or spends less.

Expansionary and contractionary fiscal policies are two basic types of discretionary fiscal policy.

Exhibit 1 lists these types of fiscal policy and the corresponding ways in which the government can pursue each of these options.

Exhibit 1

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