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

What you will learn in this Module : 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 is a central bank—an institution that oversees and regulates the banking system, and controls the monetary base. The Federal Reserve is a central bank—an institution that oversees and regulates the banking system, and controls the monetary base. The Federal Reserve System

Mostly calm with moments of sheer panic Creation of the Federal Reserve System An Overview of the Twenty-first Century American Banking System

Crisis in American Banking at the Turn of the Twentieth Century 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

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

Crisis in American Banking at the Turn of the Twentieth Century Crisis in American Banking at the Turn of the Twentieth Century 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%. Did we learn from this? Similarities, but on a much smaller scale, to what happened in 2008 Similarities, but on a much smaller scale, to what happened in 2008.

Responding to Banking Crises: The Creation of the Federal Reserve 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

The Structure of the Fed The Structure of the Fed

The Effectiveness of the Federal Reserve System The Effectiveness of the Federal 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 1980s The Savings and Loan Crisis of 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 Financial Crisis of 2008 Back to the Future: The Financial 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 Back to the Future: The Financial Crisis of 2008 Back to the Future: The Financial Crisis of 2008

Crisis and Response Fed balance sheet Bear Stearns v. Lehman Brothers (Two investment firms key to crisis) Capital Injections The future? Back to the Future: The Financial Crisis of 2008 Back to the Future: The Financial Crisis of 2008

Figure 26.2 The TED Spread Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers The TED spread is the difference between the interest rate at which banks lend to each other and the interest rate on U.S. government debt. It’s widely used as a measure of financial stress. The TED spread soared as a result of the financial crisis that started in 2007 The TED spread is the difference between the interest rate at which banks lend to each other and the interest rate on U.S. government debt. It’s widely used as a measure of financial stress. The TED spread soared as a result of the financial crisis that started in 2007.