Financial and Monetary History of the United States Economics 344:01 Professor Eugene N. White Fall 2010

Lecture 1 Why is this course important? Ben Bernanke (2000): “To understand the Great Depression is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also—to the extent that is not always fully appreciated—the experience of the 1930s continues to influence beliefs, policy recommendations and research agendas.”

Why should an economics major find recent events confusing?

Or perhaps you think it is all madness…

And there is a simple remedy…..

Big Questions following the Financial Crisis of 2008 and Recession of ! Failing Financial Institutions---Why? Fix Them? Mortgage Defaults and Foreclosures—Why? What Broader Effects Could These Have? What Should the Federal Reserve Do? Congress Do? What Guidelines? History is Key –Bailout Institutions? Households? –Cut Interest Rates? Raise Interest Rates? –Tax the Banks? –Cut Executives’ Compensation? –Tax Breaks or Increased Spending?

Objective: What should the well- educated Wall Street Banker know? History provides an understanding for how and why we have today’s institutions and regulations. History provides a laboratory for different regimes and policies----successes and mistakes History provides a better understanding of how markets and financial institutions work. ……and you will sound smart at cocktail parties and job interviews.

Start with the basics What’s the current definition of money? Is it changing? Money has three functions –Unit of account –Means of exchange –Store of Value What’s the point of the EMU? How do debit cards change money?

Stores of Value Money Bonds Stocks (Equities) Other Financial Instruments…… BUT WHAT DO THEY DO? HINT: Risk and Return—How to Manage a Portfolio (or what the managers of the Harvard University Endowment forgot).

Financial System—the Modern Flow of Funds Borrowers Savers Financial Markets Financial Institutions FlowsReturns

But what do financial markets and institutions provide? Primary markets Secondary markets Intermediaries Liquidity Risk-Sharing Information

Key Problem of Asymmetric Information It Raises Transaction Costs (1) Adverse Selection---Solution: Screening (2) Moral Hazard---Solution Monitoring Solutions: Screening and monitoring are very costly for individuals. Financial institutions specialize in the collection of information to screen and monitor, and thereby gain economies of scale and scope. This activity lowers costs and they become efficient providers. Varied forms of intermediation are responses to various informational problems.

Do these problems matter? Higher transaction costs in finance mean that there are higher interest rates, and…. Interest Rate (percent) Savings, Investment I S1 S2

Some Big Eternal Issues What monetary (exchange rate) regime should be adopted? (Gold? Paper money?/ Fixed or Floating?) How should a government manage fiscal shocks? –Does Fiscal Stimulus Work? –What is the sustainable level of debt for a government? Should the government regulate financial intermediaries? –What is the optimal architecture for a financial system? –How does the financial system drive growth? –How integrated are financial markets? –Is the financial system unstable? Should there be a central bank? What should it do? –What instruments should a central bank use? –What should be its objectives?