Econ 640 Chapter 12

How can an investment bank experience a "run"? Briefly describe the effect the runs on Bear Stearns and Lehman Brothers had on the U.S. economy.

Because they invest in the short term in the repo​ market, the refusal of lenders to renew their repos is akin to a commercial​ bank's depositors withdrawing funds. Bear Stearns suffered a run due to financing long term loans with short term loans. The short term loans soon got cut off with Bear having no way to pay for their long term loans. Lehman Brothers suffered a run due to being invested mortgage back securitized loans specifically in Alt-A laons

In describing the performance of the Federal Reserve during the Great Depression, former Federal Reserve Chair Ben Bernanke has written: "The Fed proved far too passive during the Depression. It was ineffective in its role as the lender of last resort, failing to stop the runs that forced thousands of small banks to close." What does Bernanke mean by the Fed's "role as the lender of last resort"? How might the Fed have stopped the bank runs during the early 1930s? Why didn't the Fed take the actions you describe in your answer to part (b)?

The Fed only lends to solvent banks. However, since they waited too long all banks became insolvent. The Fed could have lent money to insolvent banks. They felt it would encourage risky behavior by bank managers since they would now think the Feb would just bail them out.

In the 1790s, Alexander Hamilton, the secretary of the Treasury, urged Congress to agree to pay off the bonds that state governments had issued to finance expenditures during the American Revolution. An opinion columnist in the Wall Street Journal notes that Hamilton's proposal, which Congress adopted, "instantly won the new nation global credibility." What kind of credibility was the columnist likely referring to? Why would this type of global credibility be particularly important to a relatively underdeveloped country, as the United States then was?

The credibility that investors would get their money back. Specifically fulfilling its sovereign debt. If you needed to import more from another country but didn't have the money now. Showing that would pay out all other debts would show you can make payments on what is owed or will make sure you will close out that payment.

At the beginning of the 2020 recession, real GDP declined by even more than it had over a comparable period at the beginning of the Great Depression. An article on barrons.com quoted economist Price Fishback of the University of Arizona as saying, "I understand why people are thinking about the Depression. But it's not similar in the following sense—we know why this is happening. In the Great Depression, we really didn't know what was going on." Why were people less likely to understand what was causing the Great Depression while it was happening than were able to understand what was causing the recession of 2020 while it was happening? Why might people knowing what was causing an economic downturn affect the length and severity of the downturn?

The great depression was caused by a variety of factors that were difficult to disentangle while 2020 was the result of lockdown due to COVID-19 pandemic knowing the cause helps reduce the uncertainty that households and firms have about the future why, and this decreases the severity of the economic downturn.

Carmen Reinhart and Kenneth Rogoff have argued that the 2007-2009 financial crisis explains not just the severity of the accompanying recession but also the slowness of the subsequent economic recovery. Michael Bordo of Rutgers University has argued that Reinhart and Rogoff's argument is incorrect. Instead, he argues that the slow recovery was due to "the unprecedented housing bust" and "uncertainty over changes in fiscal and regulatory policy." If you were attempting to evaluate the relative merits of Reinhart and Rogoff's and Bordo's arguments, what type of evidence would you look at? Is it likely that you could definitively identify the causes of the slow recovery? Briefly explain.

The historic impact of a housing crisis on the severity of a recession. The causes of past recessions and how long it took to recover from them. The historic impact of a financial crisis on the severity of a recession.

What does it mean to say that there is a bubble in the housing market? Briefly describe the effect that the bursting of the housing bubble in 2006 had on the U.S. economy.

The prices of houses increased significantly in a short period of time. As prices of new and existing homes began to decline during 2006, some homebuyers had trouble making the payments on their mortgage loans. When lenders foreclosed on defaulted mortgages, the lenders sold the homes, causing house prices to decline further.

Why does a financial crisis typically result in a recession?

There is a strong disruption in the flow of funds from lenders and borrowers. Typically when households and firms cut back on spending because it becomes difficult to borrow money.

Why might an economist consider what happened during 2007-2009 to be a financial crisis but not the events of 2020?

because the Fed's response was sufficiently effective to head off severe problems in the financial system, some economists don't believe that the events of 2020 should be labeled a "financial crisis."

How is being a lender of last resort connected to the too-big-to-fail policy?

-The​ too-big-to-fail policy and the lender of last resort have to provide liquidity to banks during bank panics -The​ too-big-to-fail policy and the lender of last resort strive to prevent systemic​ risk, where the failure of a few firms leads to the widespread failure of solvent banks.

A column in the Wall Street Journal notes that "every heavily indebted country weighs the cost of repaying debt against the loss of confidence and creditworthiness that default entails." Whose confidence is an indebted country afraid of losing? What might be the consequences of losing that confidence?

A future investor. If they have lost confidence in them then the financial security of the borrow country could be at stake impacting more than just the loan that needs to be repaid.

From mid-December 2019 to mid-January 2020, none of the most widely followed forecasts of U.S. real GDP growth for the year 2020 indicated that a recession was likely. The real GDP forecasts from the Congressional Budget Office, the Federal Reserve's Federal Open Market Committee, the Goldman Sachs investment bank, and 60 economists surveyed by the Wall Street Journal were all between 1.9 percent and 2.3 percent—comparable to the 2.3 percent increase in real GDP that the United States had experienced during 2019. The S&P 500 stock index reached a record high on February 19, 2020, despite China already reporting having more than 50,000 cases of Covid-19 and despite the National Bureau of Economic Research deciding in June 2020 that the recession had begun in February. What made the recession of 2020 so difficult to predict?

A pandemic in the United States is rare so it was not fully considered when predicting the state of the economy for 2020. There was uncertainty about whether​ Covid-19 would show up in the United States and just how widespread it might become. Recessions are often caused by structural misalignments in the economy or within financial markets that can be tracked by economists.

In their book This Time Is Different, Carmen Reinhart and Kenneth Rogoff conclude: "An examination of the aftermath of severe postwar financial crises shows that they have had a deep and lasting effect on asset prices, output, and employment." Why should a recession accompanied by a financial crisis be more severe than a recession not accompanied by a financial crisis?

A recession that includes a financial crisis is generally more complex and has more severe consequences, such as decreasing asset prices and lending, which affects the economy for a longer time period than a traditional recession.

What is a sovereign debt crisis?

A situation in which government bonds come to be considered so risky that the government may not be able to continue to borrow. If so, the government cannot spend more than the tax revenue they receive. If this happens the government will have to increase interest rates and taxes to pay off debts.

In academic research published before he entered government, former Fed Chair Ben Bernanke wrote: [In] a system without deposit insurance, depositor runs and withdrawals deprive banks of funds for lending; to the extent that bank lending is specialized or information sensitive, these loans are not easily replaced by nonbank forms of credit. What does it mean to say that bank lending is "information sensitive"? What are "nonbank forms of credit"? Why would bank lending being "information sensitive" make it difficult to replace with nonbank forms of credit? Does Bernanke's observation help explain the role bank panics played in the severity of the Great Depression?

A) Banks should be lending based on information about debtors and investments that put money into. B) Banks have economies of scale or some other advantage in evaluating the riskiness of loans. insurance firms, venture capitalists, currency exchanges, some microloan organizations, and pawn shops. C) Yes, Bernanke's observation helps to explain the role bank panics played in the severity of the Great Depression. When thousands of banks failed, it became difficult for their customers to obtain credit, thus exacerbating the severity of the Great Depression

An article in the New York Times published just after the Fed helped save Bear Stearns from bankruptcy noted: If Bear Stearns failed, for example, it would result in a wholesale dumping of mortgage securities and other assets onto a market that is frozen and where buyers are in hiding. This fire sale would force surviving institutions carrying the same types of securities on their books to mark down their positions. Why did Bear Stearns almost fail? How did the Federal Reserve rescue Bear Stearns? What is the debt-deflation process? Does this process provide any insight into why the Federal Reserve rescued Bear Stearns?

A) Because lenders refused to renew their short term loans Because lender lost faith in Bear's ability to pay back short-term loans Because Bear liquidated assets in order to pay back short-term loans. B) They were bought out by J.P. Morgan C) The​ debt-deflation process is the process of increasing bankruptcies and defaults that can increase the severity of an economic downturn. Debt deflation is the off loading of all assets to pay for any debt that might still be outstanding. Yes, it would impact any other bank, investment company, or financial entity investing in those assets they are off loading. Causing not only Bears to lose money but anyone else to follow the same fate.

A classic account of bank panics was published in 1879 by Walter Bagehot, editor of the Economist, in his book Lombard Street: "In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them." Why might one bank failure lead to many bank failures? What are the two main ways in which the government can keep one bank failure from leading to a bank panic?

A) Because of the contagion rule, if one bank is struggling other depositors from other banks will start to believe their bank will not be able to payout. B) A central bank can act as a lender of last​ resort, and the government can insure deposits. The central bank can lend as a last resort and the government instilled the insuring bank policy stating that depositors will be paid back their money regardless of the bank's failing.

Financial journalist James Stewart notes that in contrast to its actions with respect to Lehman Brothers, "the Fed did lend into continuing runs at both Bear Stearns and A.I.G., although officials argued then that those companies had adequate collateral to guarantee repayment." What does Stewart mean by "lending into continuing runs"? Why would central banks lend into runs at financial firms? Why is the issue of whether Bear Stearns and AIG held sufficient collateral important legally? Is it also important economically? Briefly explain. How does your answer to part (b) relate to the Fed's decision not to lend to Lehman Brothers in the days before its bankruptcy?

A) It means giving money to banks that are in a sustained run and to help them from going insolvent they lend early. So they do not collapse. B) The Fed is required to lend to banks that have enough collateral in case they start to default on their loans. Yes, the Fed needs some way to pay back money and need to be paid back at some point in the future to sustain flow of funds. C) Them not lending to Lehman Brothers means they were insolvent at the time they requested funds and could not be saved by the Fed.

In describing the bank panic that occurred in the fall of 1930, Milton Friedman and Anna Schwartz wrote: A contagion of fear spread among depositors, starting from the agricultural areas, which had experienced the heaviest impact of bank failures in the twenties. But such contagion knows no geographical limits. What do the authors mean by a "contagion of fear"? What did bank depositors have to fear in the early 1930s? Do depositors today face similar fears? Briefly explain. What do the authors mean when they write that "such contagion knows no geographical limits"?

A) It means the depositors became fearful that more banks would fail even without proof. B) if they need their money now they may not be paid back since the bank didn't have the money, it was wrapped up in other assets, or the bank didn't have enough capital to pay off its debts leading to the bank closing its doors. C) Contagion does not stick to one location. If all depositors start to think their bank is failing, it will impact other banks as well.

In discussing the 2007-2009 financial crisis, former Federal Reserve Vice Chair Stanley Fischer observed: "The fact that losses in what was a relatively small part of the mortgage market quickly spread through the rest of the financial system illustrates how the complex interconnections among banks and nonbanks can amplify shocks in significant and unanticipated ways." What "nonbanks" was Fischer referring to? What interconnections among banks and nonbanks was he referring to? What did he mean by writing that these interconnections can "amplify shocks"? What shocks were these interconnections amplifying?

A) Mutual Funds, Hedge Funds, and Investment Banks B) Failed pieces of mortgage-backed securities and other housing-related assets led to losses at banks and other intermediaries C) Shocks meaning the impact on the housing market while banks and nonbanks off loaded their housing investments.

Looking back at the financial crisis several years later, former Fed Chair Alan Greenspan argued: At least partly responsible [for the severity of the financial collapse] may have been the failure of risk managers to fully understand the impact of the emergence of shadow banking that increased financial innovation, but as a consequence, also increased the level of risk. The added risk had not been compensated by higher capital. How did the emergence of shadow banking increase the risk to the financial system? What does Greenspan mean that "the added risk had not been compensated by higher capital"? By holding more capital, what problems could shadow banks have potentially avoided?

A) Nonbank financial institutions are not required to maintain the equivalent of reserve requirements even​ though, like traditional​ banks, they borrow short and lend long. In the event of a nonbank financial institution​ run, there is no equivalent of the FDIC. B) They needed to increase their capital. The emergence of shadow banking increased financial system risk by operating with less regulation, creating complex financial products, and being highly interconnected with the traditional banking sector. This led to increased vulnerability during financial crises. many shadow banks didn't hold enough capital to cover their increased risk exposure, making them more vulnerable to losses and financial instability.

An article in the Wall Street Journal notes: "Higher capital requirements effectively limit how much SIFIs can borrow, and can crimp profitability." What is a SIFI? Why does the Dodd-Frank Act require SIFIs to hold more capital? Why would holding more capital limit how much a financial firm can borrow and reduce the firm's profitability?

A) Systemically important financial institutions. Their failure would potentially cause a financial crisis. B) Since the firm is required to hold onto a specified amount of investments to repay depositors or pay back loans, they are not able to reinvest their money into other investments.

A column in the Wall Street Journal by the governor of the central bank of Sweden discussing the Basel accord makes the following observation: "One clear lesson from the [2007-2009 financial] crisis is that regulatory capital requirements for the banking system were too low. In other words, leverage was too high." What are "regulatory capital requirements"? Why would regulatory capital requirements being too low result in leverage being too high? What does leverage being too high have to do with the financial crisis?

A) The amount of capital a bank or other financial institution has to hold as required by its financial regulator. B) Since banks can borrow money for investments as leverage, the investments they put money into are too risky. C) With banks having too much money on loans and being financed through short-term loans or other assets, there was not enough capital to back those investments if something did go wrong.

Former Federal Reserve Chair Ben Bernanke has observed, "Even a bank that is solvent under normal conditions can rarely survive a sustained run." What does Bernanke mean by "solvent under normal conditions"? What does he mean by a "sustained run"? Why can't a bank survive a sustained run?

A) The value of a​ bank's assets is more than the value of its​ liabilities, so its net​ worth, or​ capital, is positive. A bank normally is very trusted and credited with little risk associated with being able to pay out depositors. B) By​ "sustained run," Bernanke means a bank run that lasts for a significant period of time. A bank cannot by itself survive a sustained run because it does not have enough reserves to match the deposit withdrawals and its assets are long term and not easily liquidated.

In a blog post, former Federal Reserve Chair Ben Bernanke described the four "basic elements" of a financial crisis: "broad-based loss of confidence in banks, runs by providers of short-term funding, fire sales of bank loans and other assets, [and] disruption of credit flows." Why might each of these four elements occur during a financial crisis? Briefly explain whether each of the four elements did occur during the 2007-2009 financial crisis.

A) They are all connected to each other. B) They all occurred

In 2016, financial regulators ordered significant changes in the "living wills" prepared by five large banks. According to an article in the Wall Street Journal, the wills as submitted didn't "meet the legal standard laid out in the 2010 Dodd-Frank law, which requires that firms have credible plans to go through bankruptcy at no cost to taxpayers." Why did Congress decide to require large financial firms to have living wills? Was this requirement in the Dodd-Frank Act related to changes the act made in Section 13(3) of the Federal Reserve Act? Briefly explain.

A) To give regulators a clearer understanding of a bank's operations and to show how they would be able to go through bankruptcy at no cost to the taxpayer. B) The Fed was no longer permitted to make loans to individual companies. Under the Dodd-Frank Act, the Federal Reserve can no longer provide direct financial assistance or bailouts to specific companies.

Shortly after the Federal Reserve arranged for JPMorgan Chase to purchase Bear Stearns in March 2008, the Wall Street Journal recounted the events that led to the extraordinarily low price that JPMorgan paid for Bear Stearns: "The bank was mulling a price of $4 or $5 a share. 'That sounds high to me,' Mr. Paulson said. 'I think this should be done at a low price.'" Why did Treasury Secretary Paulson want Bear Stearns to sell for such a low price? Why was the Fed's decision to orchestrate the purchase of Bear Stearns so controversial?

A) To punish the firm's owners and managers for bad decisions, without letting them go bankrupt. In order to prevent systematic risk B) according to some economists, the action increased moral hazard in the financial system. Bear Stearns is an IB, instead of a commercial bank, so policymakers faced unexpected challenges. The Fed intervened by brokering a guaranteed deal with JP Morgan

The financial writer Sebastian Mallaby made the following observation about hedge funds: Leverage also made hedge funds vulnerable to shocks: If their trades moved against them, they would burn through thin cushions of capital at lightning speed, obliging them to dump positions fast—destabilizing prices. What does a hedge fund's trades "moving against it" mean? Why would a fund's trades moving against it cause it to burn through its capital? What is the connection between a fund's being highly leveraged and its having a "thin cushion of capital"? What does a fund's "dumping its positions" mean? Why might a fund's dumping its positions cause prices to be destabilized? Prices of what?

A) Trades "moving against it" means that whatever position the hedge fund has taken, the security is moving in the opposite direction. If they have gone long ( purchased the security ) the prices have started to fall. If they have gone short then prices have started to rise B) When trades are moving against them they have to sell the security or buy it to cover the position and trim the losses as much as possible and doing so they will burn the capital and take some losses. C)Leverage magnifies a trading​ position, reducing the ratio of capital to assets. This magnifies both gains and losses and reduces the capital​ "cushion" for losses. If leverage is 10 times and you have $10 then you can purchase up to $100. But remember only 10% fall in the price of the security will wipe out the original $10 that you have. So we can see that only a thin cushion of capital is available (only 10% of the total ) D) "Dumping its position" means covering the position as soon as possible even though the fund is making losses because fund can not afford to lose more. Because whatever margin they have they might have gone or capital are close to getting wiped out. E) Dumping means selling huge volume at any available price so it will create a mismatch between demand and supply of the security hence prices will be destabilized.

In a paper looking back at the financial crisis, former Fed Chair Alan Greenspan wrote: Some bubbles burst without severe economic consequences, the dotcom boom and the rapid run-up of stock prices in the spring of 1987, for example. Others burst with severe deflationary consequences. That class of bubbles . . . appears to be a function of the degree of debt leverage in the financial sector, particularly when the maturity of debt is less than the maturity of the assets it funds. What does Greenspan mean by "debt leverage"? Why would it matter if "the maturity of the debt is less than the maturity of the assets it funds"? Does Greenspan's analysis provide insight into why the Fed during his tenure may have been reluctant to take action against asset bubbles?

A) borrowing and purchasing assets with borrowed funds B) If the debt is not​ renewed, or rolled​ over, the asset side of the balance sheet becomes unsustainable. C) If Greenspan believes that most bubbles burst without severe economic consequences, then, yes, it would explain the Fed's action.

An article in the New York Times quotes former Fed Chair Alan Greenspan as arguing: The global house price bubble was a consequence of lower interest rates, but it was long-term interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seemingly conventional wisdom. What is a "house price bubble"? Why would long-term interest rates have a closer connection than overnight interest rates to house prices? Why would it matter to Greenspan whether low long-term interest rates were more responsible than low short-term interest rates for the housing bubble?

A) occurs when house prices move beyond their fundamental values. B) Since you typically hold onto a house for closer to 10 years. The interest rates for the long term would be more dependable than overnight interest rates. It also means that long term interest rates, if seen a stable, would indicate a strong financial relationship to houses. C) To lessen the Federal​ Reserve's responsibility under​ Greenspan's watch as Chairman for​ causing, at least​ partially, the housing bubble with low interest rates

What is meant by the "fragility" of commercial banking? Does a bank have to be insolvent to experience a run?

A...Banks borrow short to lend long and are relatively illiquid on any given day Commercial banks do not hold all cash on hand since they pay out loans and purchase other assets to "hold" money. A bank does not have to be insolvent to experience a run. A run is when people become distrusting of a bank because they do not have all of their money or enough assets to pay back all the money that is due to customers. They become insolvent once the bank becomes negative in their credit or net worth. A...No, bank runs are caused by bank​ panics, which can occur whether a bank is insolvent or not. the stability of a bank depends on the confidence of its depositors. if bad news—or even false rumors—shakes that confidence, a bank will experience a run.

In June 1930, a delegation of businessmen appeared at the White House to urge President Herbert Hoover to propose an economic stimulus package. Hoover told them: "Gentlemen, you have come sixty days too late. The depression is over." When did the Great Depression begin? Why might Hoover have reasonably expected it to be over by June 1930? Why did the Depression continue much longer?

August of 1929. Hoover did not foresee the financial panic that would ensue for the next three years, and which would magnify the impact of the recession. Failure in Fed policy and bank failures.

Why did some economists and policymakers believe that the Fed's policy actions during the 2020 recession might have increased moral hazard problems in the financial system? If the Fed's actions increased moral hazard, does that necessarily mean that the Fed shouldn't have taken the actions? Briefly explain.

By purchasing bonds of corporations that had been given the lowest investment grade rating by the bond rating agencies. Because the Fed had used emergency lending facilities twice in less than 15 years, some economists argued that firms might expect that if risky investments left them vulnerable to failure in the next crisis, the Fed would bail them out. the Fed's actions might have increased moral hazard problems in the financial system because of the need for a prompt and vigorous policy response. Without that response, the pandemic might have pushed the economy into a deeper and more prolonged recession.

Briefly discuss the policy actions the Federal Reserve and Congress took during the financial crises of 2007-2009 and 2020.

C.A.R.E.S Act. The Fed also opened Liquidity facilities that extended on the loan as a last resort. They also opened up Credit facilities that provided funds to nonfinancial firms, state , and local government by either providing grants or loans and buying their bonds.

What are "capital requirements"? What purpose do they serve?

Capital Requirements are the resources needed to invest in a new industry. Capital requirement means the funds required to invest in the new industry/ new business. It includes founding expenses, investment amount, and start-up cost. By increasing the ability of the bank to remain solvent after incurring losses and by increasing the amount the bank's owners will lose in the event of the bank's failure, thereby giving the owners a greater incentive to avoid risky investments.

What is "contagion"? What role does it play in bank panics?

Contagion is when one bank having bad rumors of a run leads to other banks experiencing a run. Bank panics is a snowball effect of banks losing credibility as depositors lose confidence in all banks. As asset prices fall, the net worth of banks is undermined, and some banks may even be pushed to insolvency.

How did the debt-deflation process contribute to the severity of the Great Depression?

Fisher argued that as banks were forced to sell assets, the prices of those assets would decline, causing other banks and investors holding the assets to suffer declines in net worth, leading to additional bank failures and to investors going bankrupt. These failures and bankruptcies would lead to further asset sales and further declines in asset prices. In addition, as the economic downturn worsened, the price level would fall—as it did in the early 1930s—with two adverse effects: Real interest rates would rise, and the real value of debts would increase.

In his memoirs, Herbert Hoover described the reaction of his Treasury secretary to the Great Depression: First was the "leave it alone liquidationists" headed by Secretary of the Treasury Mellon, who felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate." What does "liquidate" mean in this context? Can these views help explain the Fed's actions during the early years of the Great Depression? Briefly explain.

Liquidate means to let businesses go out of business. Yes, to an extent, because the Federal Reserve was acting on the predominant economic model of the time, which said that the economy will self-adjust and any attempt to intervene will either do nothing or create negative consequences.

What is the difference between a "liquidity facility" and a "credit facility"? Why did the Fed decide to use both during 2020?

Liquidity Facilities: These facilities build on the Fed's original role as a lender of last resort to the commercial banking system by extending credit to issuers of commercial paper, money market fund shares, and other assets connected to the shadow banking system and by aggressively lending in the repo market. Credit Facilities: These facilities allow the Fed to provide funds directly to nonfinancial firms and state and local governments by either granting them loans or by buying their bonds. To maintain a flow of funds through the financial system so banks and governments could still function as needed.

What role did the bank panics of the early 1930s play in explaining the severity of the Great Depression?

Many economists believe that the series of bank panics that began in the fall of 1930 greatly contributed to the length and severity of the Depression. The bank panics came in several waves: the fall of 1930, the spring of 1931, the fall of 1931, and the spring of 1933. The large number of small, poorly diversified banks—particularly those that held agricultural loans as commodity prices fell—helped fuel the panics. A bank suspension occurs when a bank is closed to the public either temporarily or permanently

What innovations did banks develop to get around ceilings on deposit interest rates?

Negotiable certificates of deposit (CDs) Negotiable order of withdrawal (NOW) accounts Automatic transfer system (ATS) accounts Money market deposit accounts (MMDAs)

Briefly summarize the four explanations of why the Federal Reserve failed to intervene to stabilize the banking system in the early 1930s.

No one was in charge. the early 1930s, power within the Federal Reserve System was much more divided The Fed was reluctant to rescue insolvent banks. The Federal Reserve was established to serve as a lender of last resort to solvent banks that were experiencing temporary liquidity problems because of bank runs. Many of the banks that failed during the bank panics of the early 1930s were insolvent if their assets were valued at market prices. The Fed failed to understand the difference between nominal and real interest rates. The Fed wanted to "purge speculative excess."

A columnist writing in the Wall Street Journal observed: "Franklin D. Roosevelt's March 1933 inaugural line 'that the only thing we have to fear is fear itself' was inspiring, but wrong. There was plenty to fear, not least the deflation that then gripped the nation." Prices fall when a country experiences deflation, so isn't deflation good for consumers? Briefly explain. What happens to real interest rates during a period of deflation? Was deflation during the early 1930s good or bad for firms? Briefly explain.

No, because borrowers would be hurt by the higher real interest rates and higher real value of debts that deflation causes. You may see interest rates go down if there is deflation. This is a move by the Federal Reserve to stimulate growth in the economy by encouraging people to borrow and spend money. It was bad for firms that were borrowers because it effectively raised interest rates.

What is currency "pegging"? What role can it play in a currency crisis?

Pegging in currency means comparing one exchange of currency to another. This means they buy one currency in exchange to see how much money it takes of one value to equal the same in another. It can lead to exchanging too much of one currency for another currency.

Why might deposit insurance encourage banks to take on too much risk? Is deposit insurance, therefore, a bad idea? Briefly explain.

Since depositors are guaranteed their money back if the bank does fail, the bank will be more willing to invest in higher-risk investments to make more of a profit. No, the risk of banks failing is low, and systemic stability is higher when you have deposit insurance coverage.

Economist Laurence Kotlikoff of Boston University has proposed that the banking system be reformed so that all banks become "limited purpose banks." As he explains: [Banks] would simply function as middlemen. They would never own financial assets or borrow to invest in anything. . . . [Limited purpose banking] effectively provides for 100 percent reserve requirements on checking accounts. This eliminates any need for FDIC insurance and any possibility of traditional bank runs. Why would 100% reserve requirements on checking accounts eliminate the need for FDIC insurance? Would depositors need to fear losing money if their bank failed?

Since the banks always had the depositor's money on hand there would be no need for a bank to have insurance on their depositor's money. The depositor would not need to worry since their money should be or would be always physically accessible. Also, the banks would not be able to lend out money meaning banks would not lose money or have the potential to lose money unless robbed.

Arthur Rolnick of the Federal Reserve Bank of Minneapolis has argued that in their account of the failure of the Bank of United States: Friedman and Schwartz provide the rationale for the policy that today is known as "too big to fail"—that there are some institutions that are so big that we can't afford to let them fail because of the systemic impact on the rest of the economy. . . . They suggest that if the Fed had rescued this bank, the Great Depression might only have been a short, albeit severe, recession. What was the Bank of United States? When did it fail? Why did it fail? Why might the Fed's failure to save the Bank of United States provide a rationale for the too-big-to-fail policy? Are there counterarguments to Rolnick's view?

a large private bank (not affiliated with the government, despite its name), it failed in 1930 on Dec 11th, it failed because it was highly invested in real estate and the rapid decline in prices and mortgage defaults. They also used bank fund to buy their own stock to keep their stock from falling. Friedman/Schwartz argue that the Bank of United States had so many deposits and was so interconnected to other banks that letting this bank fail caused a cascade of other bank failures. Yes. Some would argue that the Bank of United States was not as interconnected as​ Friedman/Schwartz argue because there is not a lot of evidence that other bank failures were tied to this particular​ bank's failure.

In his history of the Federal Reserve, Allan Meltzer of Carnegie Mellon University describes the views of Federal Reserve officials in the fall of 1930: Most of the policymakers regarded the substantial decline in short-term market interest rates . . . as the main . . . indicators of the current position of the monetary system. . . . [Policy] was "easy" and had never been easier in the experience of the policymakers of the Federal Reserve System. What does it mean to say that Fed policy is "easy"? In the context of the early 1930s, were low nominal interest rates a good indicator that policy was easy? Why might Fed officials have believed that they were?

an increasing money supply and falling interest rates In the early 1930s, low nominal interest rates were not a reliable indicator due to high deflation rates Fed officials believed low nominal interest rates indicated an easy policy as it signified an adequate supply of excess reserves for losses or loans