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

What you will learn in this Module: The history of the Federal Reserve System The structure of the Federal Reserve System How the Federal Reserve has responded to major financial crises

The Federal Reserve System Who monitors banks and the money supply? Central Bank The Federal Reserve is a central bank—an institution that oversees and regulates the banking system, and controls the monetary base.  

An Overview of the Twenty-first Century American Banking System Mostly calm with moments of sheer panic Creation of the Federal Reserve System Like many things in government and business, our current Federal Reserve is a product of our history. When our banks and economies went through periods of crisis, government created various laws and bureaucracy to oversee the system and protect borrowers and lenders.

Crisis in American Banking at the Turn of the Twentieth Century Money Supply Tug-of-War Trusts Speculation Pyramid Reserves Knickerbocker Trust J.P. Morgan Saves the Day The creation of the Federal Reserve System in 1913 marked the beginning of the modern era of American banking.   Though banks were federally regulated since 1864, there were still fundamental problems delivering money from large banks in big cities to smaller banks in rural communities. If a rural bank in Indiana or Wisconsin was low on reserves, the bank may fail before money could be delivered to the bank. This bank failure could spark a run on several banks, devastating local communities. Note: Details of the Panic of 1907 will not be tested on the AP exam. Cover these details only if there is a surplus of class time or a strong interest in the topic. Panic of 1907 The crisis originated in institutions in New York known as trusts, bank­ -­ like institutions that accepted deposits but that were originally intended to manage only inheritances and estates for wealthy clients. Trusts were supposed to engage only in low­ -­ risk activities = they were less regulated, had lower reserve requirements, and had lower cash reserves than national banks. However, as the American economy boomed during the first decade of the twentieth century, trusts began speculating in real estate and the stock market, areas of speculation forbidden to national banks. Less regulated than national banks, trusts were able to pay their depositors higher returns. Trusts grew rapidly. They declined to join the New York Clearinghouse, a consortium of New York City national banks that guaranteed one anothers’ soundness; that would have required the trusts to hold higher cash reserves, reducing their profits. The Panic of 1907 began with the failure of the Knickerbocker Trust, a large New York City trust that failed when it suffered massive losses in unsuccessful stock market speculation. Within two days, a dozen major trusts had gone under. Credit markets froze, and the stock market fell dramatically as stock traders were unable to get credit to finance their trades and business confidence evaporated. Fortunately, New York City’s wealthiest man, the banker J. P. Morgan, quickly stepped in to stop the panic. He worked with other bankers, wealthy men such as John D. Rockefeller, and the U.S. Secretary of the Treasury to shore up the reserves of banks and trusts so they could withstand the onslaught of withdrawals. Once people were assured that they could withdraw their money, the panic ceased. Although the panic itself lasted little more than a week, it and the stock market collapse decimated the economy. A four­ -­ year recession ensued, with production falling 11% and unemployment rising from 3% to 8%.

Responding to Banking Crises: The Creation of the Federal Reserve Frequent Bank Crises National Banking System Eliminated Centralized Control of Bank Reserves Federal Reserve’s Money Monopoly In 1913 the national banking system was eliminated and the Federal Reserve System was created as a way to compel all deposit­ -­ taking institutions to hold adequate reserves and to open their accounts to inspection by regulators. The Panic of 1907 convinced many that the time for centralized control of bank reserves had come. In addition, the Federal Reserve was given the sole right to issue currency in order to make the money supply sufficiently responsive to satisfy economic conditions around the country.

The Structure of the Fed Note: Students should know about the structure of the Fed. This section is worth a little time in class.   Strictly speaking, the Federal Reserve System consists of two parts: the Board of Governors and the 12 regional Federal Reserve Banks. Board of Governors Oversees the entire system from offices in Washington, D.C., is constituted like a government agency: its seven members are appointed by the president and must be approved by the Senate. Members are appointed for 14-year terms, to insulate them from political pressure in their conduct of monetary policy. The chairman is appointed more frequently—every four years—but it is traditional for the chair to be reappointed and serve much longer terms. 12 Regional Banks The 12 Federal Reserve Banks each serve a region of the country, providing various banking and supervisory services. Each regional bank is run by a board of directors chosen from the local banking and business community. The Federal Reserve Bank of New York plays a special role: it carries out open­ -­ market operations, usually the main tool of monetary policy. Decisions about monetary policy are made by the Federal Open Market Committee, which consists of the Board of Governors plus five of the regional bank presidents. The president of the Federal Reserve Bank of New York is always on the committee, and the other four seats rotate among the 11 other regional bank presidents. The chairman of the Board of Governors normally also serves as the chairman of the Open Market Committee.

The Effectiveness of the Federal Reserve System Potential for Bank Runs still existed Reconstruction Finance Corporation (RFC) Glass-Steagall Act of 1932 FDR’s Bank Holiday RFC takes control Creation of the Fed didn’t stop bank runs and it didn’t stop the Great Depression. A series of economic downturns and damaging bank runs instigated new laws from Congress that attempted to stabilize the banking industry and provide safeguards for the public and their deposits.   However, when the Great Depression became a distant memory and bank runs became much less common, Congress let some of the regulations of the 1930s lapse. Some of these legal lapses created problems in the 1980s and in 2008.

The Effectiveness of the Federal Reserve System Glass-Steagall Act of 1933 Commercial Banks Regulation Q Investment Banks Glass-Steagall Weakened

The Savings and Loan Crisis of the 1980s Note: the instructor and his/her students would be well-served to find a good video segment that explains the S&L crisis in the historical context of the 1980s .  Is there one or are you saying they should search for it? If you don’t know of one, I would just say the same things as above (not on AP test, etc.) Savings and Loans (Thrifts) Inflation’s effect on the S&Ls Speculation Political Interference Tax-Payers Comprehensive Oversight

Back to the Future: The Financial Crisis of 2008 Similarities to previous crises Long-term Capital Management leverage balance sheet effect vicious cycle of delevereaging Note: the instructor and his/her students would be well-served to find a good video segment that explains the subprime mortgage crisis.   To give the students a synopsis of the financial crisis of 2008, use the link below to find videos at the site of PBS’s NewsHour. Paul Solman has done several segments that explain what happened and why it happened. http://www.pbs.org/newshour/video/ http://www.pbs.org/newshour/economy/makingsense/

Back to the Future: The Financial Crisis of 2008 Subprime Lending and the Housing Bubble subprime lending securitization TED Spread Note: the instructor and his/her students would be well-served to find a good video segment that explains the subprime mortgage crisis.   To give the students a synopsis of the financial crisis of 2008, use the link below to find videos at the site of PBS’s NewsHour. Paul Solman has done several segments that explain what happened and why it happened. http://www.pbs.org/newshour/video/ http://www.pbs.org/newshour/economy/makingsense/

Back to the Future: The Financial Crisis of 2008 Crisis and Response Fed balance sheet Bear Stearns v. Lehman Brothers Capital Injections The future? Note: the instructor and his/her students would be well-served to find a good video segment that explains the subprime mortgage crisis.   To give the students a synopsis of the financial crisis of 2008, use the link below to find videos at the site of PBS’s NewsHour. Paul Solman has done several segments that explain what happened and why it happened. http://www.pbs.org/newshour/video/ http://www.pbs.org/newshour/economy/makingsense/