Chapter Twelve

A Permanently High Plateau

The Federal Reserve System

The Federal Reserve

The Federal Reserve is the central bank of the United States, and like other modern central banks it has control over the nation's money supply. While the Federal Reserve was created by the U.S. government, and is subject to the oversight of congress, for the most part it operates independently of the government. It has been given some extraordinary powers, and is meant to use them in order to promote maximum employment, stable prices, and moderate long-term interest rates.

Open Video Transcript

Economic growth can be uneven, with periods of faster or slower growth, due to the unevenness of innovation and improvements in productivity. But quite separate from that, growing economies started to experience instability, with a boom-and-bust cycle seemingly driven by financial panics. This business cycle had a predictable pattern in GDP, with expansions, peaks, recessions, troughs, and then back to expansions. But the timing and length of each cycle was unpredictable, leading to long periods of heightened unemployment, which rises during recessions. --The Panic of 1907 looked to be yet another financial panic to be followed by yet another recession, except this time J.P. Morgan and other bankers stepped in and provided credit markets with the critical loanable funds they needed for banks and other financial institutions to stay afloat and keep the economy running. Congress set up a committee to investigate the possibility of creating a central bank to fill that role for every panic, and hopefully avoiding them all together. The quest to solve the problem of the business cycle had begun. --On December 23rd, 1913, the Federal Reserve was established. The United States was deeply resistant to a central bank for most of its history, a fact chronicled in rhyme in Lin-Manuel Miranda’s musical about Alexander Hamilton. Many today are still deeply mistrustful of the Federal Reserve, and it isn’t too surprising. The Federal Reserve is, quite frankly, the most powerful bank in the world, with the ability to impact the daily lives of regular people around the entire globe, and of course especially here in America. So, who and what are they?--The Federal Reserve is a central bank, which means it acts as a bank for banks. The Fed, as it is often called, stores bank reserves. When you deposit money at a bank, the bank will keep some of it in reserve, but it will use the rest to make loans. The fraction the bank keeps in reserve is sent to the Federal Reserve for safe keeping but is still available to the bank if they need it. By centralizing the system of reserves for all banks nationwide, the Fed took over the role of the clearinghouses which would coordinate lending from one bank to another bank, which was critical to managing a panic. The Fed was also positioned to run a check clearing system, so that payments which transferred funds from one bank to another would be processed quickly and dependably because the Fed now linked all banks together. In exchange for taking over these profitable tasks for which the Fed collects fees, banks in the system are each given shares in the Federal Reserve, allowing them to share in some of those profits. Banks are also given a say in who would run the Fed’s regional banks. Because the Fed’s operations turn a profit, it operates without any funding from the government. In fact, each year the Fed gives many tens of billions of dollars in profits to the U.S. Treasury, making it a source of revenue for the government. --In order to carry out their operations, the U.S. was broken up into 12 districts which would each be served by a regional branch of the Federal Reserve. Remember, this is all happening in 1913, so the map here reflects the distribution of the population at the time. Instead of changing the districts over time, regional banks have opened sub-branches in places where the population ended up growing to better serve those places. So, if you wanted to open up a new bank in Phoenix, you would be required to charter through the Federal Reserve Bank of San Francisco, and they would keep your reserves and regulate your activities as determined by the people in charge at the Fed’s headquarters in Washington, D.C.While it isn’t so important now, geography was very important to the banking system back in 1913 and for a long time afterward. Reserves tended to flow out of rural banks towards city banks, and eventually towards New York. When a rural area had a downturn, perhaps driven by farm yields, banks had a hard time pulling reserves back the other way fast enough to meet the demands of their customers, and a bank run would ensue. With this new Federal Reserve System, districts were drawn in a way to make sure rural and city banks both had easier access to reserves. --The people in charge of the Federal Reserve are called the Board of Governors. There are seven seats on the board of governors, one of which acts as the chairperson of the Federal Reserve. Each of those people is appointed by the President of the United States and confirmed by the U.S. Senate. Each of the 12 district banks has its own president who is selected by the Board of Governors in conjunction with the private banks who were members of the Federal Reserve. So, if you opened that bank in Phoenix, you would have a little say in who serves as the president of the Federal Reserve Bank of San Francisco. Typically, each of these people are nominated from the world of banking and have experience working in the administration of a private bank. These days, however, the most important decisions are made by a combination of these people who form the Federal Open Market Committee. The FOMC is a 12-person committee that includes the 7 people on the board of governors along with the president of the Federal Reserve Bank of New York. Since New York is financial capital of the U.S., the New York Fed president is always on the FOMC. Then, four of the other district bank presidents rotate each year, serving one-year terms on the committee. The Federal Open Market Committee is really important, and their decisions have massive impacts on the economy, but we will save those details for a later video. First, we need to understand why the Federal Reserve is so powerful. --The Federal Reserve has been given the superpower we all wish we had. We all wish that we could snap our fingers and suddenly we’d have an extra $100 billion in our bank account. The Federal Reserve can actually do that. The Fed was given a monopoly over the printing of money. It did away with that old system where each bank printed their own cash. Now, the only legal tender in the United States is the Federal Reserve Note, the paper money printed by the Fed and distributed to banks. The Fed was also given regulatory powers over the banks it served, which combined with the monopoly over the printing of money means that the Fed effectively controls the supply of money in the United States. The purpose of the Federal Reserve was to stabilize an increasingly unstable financial system which was vulnerable to panics and bank runs. With a Central Bank at the helm, clothed in immense power, panics could be calmed with quick and decisive action. In fact, they are required by law to do it. The law which created the Fed outlined three goals for them: maximum employment, stable prices, and moderate long-term interest rates.

Reserve Requirements

At every bank, there is just a pile of cash that isn't being used for anything. Customers often withdraw money from their accounts in order to pay for things, but they usually followed that up with another deposit from a paycheck. And so, collectively, there is a pool of deposits which are never going to be withdrawn. The goal of a bank is to make a profit, and the way they make those profits is by lending out that pool of money to borrowers who will then repay it with interest. Prior to the Federal Reserve, rules differed about what percentage of deposits a bank was allowed to use to make loans with. These different reserve ratios contributed to uncertainty about the stability of a bank when just a few of its investments went belly up.

Open Video Transcript

Fractional Reserve Banking is when banks only keep a small percentage of deposits on hand, as is the case with banks in the United States and most of them around the world. The alternative is full reserve banking, which is when a bank keeps all deposits on hand and is essentially just a safekeeper of your money. If you had a piggy bank as a kid, it was likely operating as a full reserve bank, unless it was coming to life like in Toy Story or something and making loans with your deposits of coins. Fractional reserve banking has important implications for the supply of money and the stability of the financial system. When you deposit money at a bank, they only keep a fraction of it in their reserves, and they use the rest to make loans. For example, a bank might only keep 10% of customers deposits in reserve. When you spend money from your account, or withdraw it as cash, the bank gives you money out of those reserves. And since normally a bank sees a steady stream of deposits, keeping just 10% is plenty to handle the spending and withdrawals their customers typically do. But consider what happens to the other 90% of your money, which the bank uses to make loans. If the bank loans the money to an entrepreneur who is starting a new business, that entrepreneur is likely to spend it on the capital they need, which means the money ends up in someone’s pocket. And that person is likely to deposit it in a bank, which will then keep a fraction of it and lend out the rest. That is, the loan becomes a deposit, which becomes another loan, which becomes another deposit and on and on the cycle goes. --Let’s walk through this with an example and some numbers. Let’s say that you deposit $10,000 into Bank A. That bank typically would have a policy about what percentage they would keep in reserve, which we will call the reserve ratio. If a bank keeps 10% of all deposits in reserves, then their reserve ratio is 10%. So, Bank A would split that $10,000 deposit up. They would keep $1,000 – 10% of $10,000 – in reserve, and they would use the remaining $9,000 to make loans. To make things easy, let’s assume they use all $9,000 for one loan. In the real world, that money is likely to end up all over the place, but let’s say that the $9,000 is used to pay a single contractor, and that contractor deposits the money into Bank B. Now, Bank B just got a $9,000 deposit. If they also have a reserve ratio of 10%, they will keep $900 in reserves, and lend out the other $8,100, which might end up in Bank C. Let’s take stock of our situation so far. Right now, we have three people with money. You deposited the original $10,000. Then there is this contractor who banks at Bank B who has another $9,000 in their account, and someone else who deposited $8,100 into Bank C. If we go around and ask people how much money they have, we will get a total of $27,100 (or $10,000 + $9,000 + $8,100). Through this process of lending, the banks have actually created money, and increased the money supply in the economy. And it won’t end here. Bank C will keep $810 in reserves and lend out the remaining $7,290. When that lands in Bank D, they will keep $729 and lend out $6,561, and now our money supply is up to $40,951. We could keep doing this to infinity, adding a little more to our money supply each time, but luckily there is a little math shortcut we can take to find out the grand total of how much money there will be. --The money multiplier is 1 over R, which is the reserve ratio. If banks keep 10% of deposits in reserve, then R would be 0.1, which is the decimal form of 10%. 1 divided by 0.1 is equal to 10, which is our money multiplier. For every new dollar deposited in a bank, the money supply will increase by $10. So, your initial deposit of $10,000 will result in an additional $90,000 created through the process of lending, for a total of $100,000 (or $10,000 times 10, our money multiplier). Since banks would generally keep 10-20% of deposits in reserve, you can see how the creation of a little bit of new money could result in a big increase in the money supply. And vice versa, if a bit of money disappears, the money supply could shrink significantly. In the days of the Gold Standard, this could happen often, with the discovery of new gold deposits or the movement of gold out of the U.S. And with the Federal Reserve now empowered to print money, they needed to have control over this ratio in order to properly regulate the supply of money. --And so, the first important tool that the Fed has to influence the money supply is the required reserve ratio. The Federal Reserve has the power to set a minimum reserve ratio that all banks must adhere to. This not only helps ensure that banks keep a large enough fraction to handle a potential run, where lots of depositors demand their money back, but also allows the Fed to keep control of the money multiplier. When the Federal Reserve raises the required reserve ratio, they shrink the money multiplier and therefore shrink the money supply. Likewise, when the Fed lowers the required reserve ratio, they magnify the money multiplier and increase the money supply. If you remember the video about recessions, one problem was that recessions kicked off a deflationary spiral where prices fell, making it difficult for businesses to earn sufficient revenues to keep their workers employed and pay back loans. Combined with their monopoly over the printing of money, these regulatory powers over banks gave the Fed control over the nation’s supply of money, allowing them to keep the quantity of money stable, which should then keep prices stable in line with their legal mandate.

Practice Questions

1. Liana deposits her $2,500 paycheck into her local credit union (a type of bank). The Federal Reserve has set a required reserve ratio of 6% for Liana's credit union.

How much of Liana's deposit does the credit union have to keep in reserves?
Where will the credit union keep those reserves?
How much of Liana's deposit can the credit union use to make loans?

Reveal the Answer

If the required reserve ratio is 6%, and Liana deposits $2,500, then the credit union has to keep:

0.06 x $2,500 = $150

The credit union will send that $150 of reserves to their account with the Federal Reserve Bank that oversee their district.

As for the remaining $2,350, the credit union can use some or all of it to make loans to other customers.

2. Calculate the money multiplier when the reserve ratio is 6%.

Reveal the Answer

The money multiplier is:

1 / (Reserve Ratio)

To compute the multiplier, we need to convert the reserve ratio of 6% into decimal form:

6/100 = 0.06

Now we can use that value to compute the multiplier.

1/0.06 = 16.67

3. What will be the change in the money supply due to Liana's deposit of $2,500, assuming all banks maintain a reserve ratio of 6%?

Reveal the Answer

The money multiplier is 16.67 (computed in the last question). So, the change in the money supply is:

$2,500 x 16.67 = $41,666.67*

*We rounded the money multiplier, which was really sixteen and two-thirds. While the math shows this rounded to 16.67, I did the calculation without rounding. As a rule of life: Don't round until the final answer.

The Lender of Last Resort

In the Panic of 1907, J.P. Morgan and other bankers pooled their money together and used it to provide the crucial liquidity banks needed to survive the ensuing bank run. But putting together enough money to make that feasible was tough even for folks like Morgan. The Federal Reserve, however, is not bound by the pecuniary limits of mere mortals. The Federal Open Market Committee has the power to just create money out of thin air, and use it to shore up the financial system. Temperance is virtue though, and the Fed only wants to use this extraordinary power if there is no other option available.

Open Video Transcript

Every bank has a Federal Funds Account with the Federal Reserve, which is where they keep their reserves. Through the normal course of operations, a bank will see its reserves fluctuate up and down depending on whether they see more deposits or more withdrawals on any given day. But every once in a while, their reserves will get depleted, or fall below the reserve requirement set by the Fed. This could happen for all kinds of reasons, such as one of their larger corporate clients sending out paychecks to many employees, effectively withdrawing a huge amount of money all at once. Even before the Federal Reserve, when a bank ran into trouble like this, and didn’t have enough cash on hand to meet customer demands, they would reach out to another bank which still had plenty of excess reserves, and they would borrow that money from them. Then, when things stabilized again for the borrowing bank, they would repay that loan, which would typically happen in a matter of days. The Federal Reserve centralized that system of interbank lending, and it facilitates this lending by allowing banks to lend to each other right from their accounts with the Federal Reserve. A bank could simply call up their local Fed bank and let them know to move some money from their account into another banks account, quickly providing them with the liquidity they needed to meet that day’s demands. The Federal Funds Rate is the interest rate banks charge each other for short-term loans made from their Federal Funds account. The problem was that when a panic would start to spread, many banks would see their reserves depleted as customers withdrew their money in fear of a collapse. Not wanting to expose themselves to the risk, banks would refuse to lend to other troubled banks. Just when the system of interbank lending was needed the most, it would freeze up and escalate the severity of the crisis. --When that happens, banks can borrow directly from the Federal Reserve’s Discount Window. It was once a literal window at the Federal Reserve Bank of New York where bankers could come and acquire the loan, but these days it is all done electronically. The Federal Reserve can snap their fingers and create some new money, and then lend it out to banks in crisis. It’s not free though. The Fed charges interest on the loans just like any other bank. The interest rate the Fed charges banks is called the Discount Rate. By providing emergency loans, the Fed is able to prevent a financial panic from bringing down bank after bank like dominos as a run spreads through the financial system. Remember, these banks have plenty of assets in the form of loans they have made which would allow them to stay healthy and profitable if not for the panic driving withdrawals. These critical loans allow the banks to keep their doors open and weather the crisis, which means their depositors money is a lot safer as a result. --In order to ensure that they are indeed the last resort for a bank in trouble, the Fed typically sets the discount rate above the federal funds rate. Once again, the Federal Funds Rate is the interest rate banks charge each other for short-term loans. It’s common practice for banks to lend to each other as a way of smoothing out fluctuations in withdrawals and deposits. Under the Federal Reserve System, interbank lending is facilitated by the Fed to maintain stability of the system. However, if a bank is unable to secure a loan from another bank, they can turn to the Federal Reserve’s Discount Window and borrow directly from the Fed. To make sure this option is unappealing to banks except in dire circumstances, the Fed sets their discount rate – the interest rate they charge on a loan – higher than the going Federal Funds Rate. In this way, the discount rate is a bit of a misnomer. The name is not a reference to its value, but rather just some old timey lingo for interest rates that has stuck around in this context. Back in 1913, this was the primary tool the Fed had in staving off a financial crisis. By setting the required reserve ratio, they were instilling confidence in the system that would hopefully make panics less likely to occur. But when a panic did happen, this is how the Fed would be able to save the financial system and keep the economy from collapsing. As the lender of last resort, the Fed could prevent credit markets from freezing up by fulfilling the role themselves. The financial system was no longer dependent on the discretion of banking giants like J.P. Morgan. Now it had this government-backed super-bank that could always rescue it in times of need.

Open Market Operations

The Federal Reserve has the power to increase the money supply by printing new money and circulating it. This can help in the midst of an economic crisis, but when the panic is over, all of that extra money could result in high inflation. In order to prevent an episode of inflation after they print some money to help during a crisis, the Fed needs a way to get that money back. One way they can do this is through Open Market Operations. It is a very serious sounding name, but its really just a nerdy way of saying, "they buy and sell some stuff".

Open Video Transcript

The Federal Reserve instilled confidence in the banking system by setting required reserve ratios that forced banks to keep enough money in reserve to weather high levels of withdrawals. They were also able to intervene when a panic threatened the entire system by lending directly to banks, preventing the panic from spreading when a bank fails due to a run. But the Fed has another power it can use to meet its mandate of maximum employment, price stability, and moderate long-term interest rates. The Fed has the power to print money and use it to achieve those goals. When the Federal Open Market Committee wants, they can simply create money out of thin air. And they do the same thing we would if we had this superpower. They go shopping. But the FOMC is full of very serious and boring people. And they only go shopping for one thing. --Government bonds. Large organizations, like big corporations or the U.S. government, usually don’t turn to banks when they need to borrow money. Instead, they leverage their reputations and sell bonds directly to investors. Every day the U.S. treasury auctions these bonds – like the treasury bill shown here – in order to raise money to cover a budget deficit. A bond is just an agreement to pay a certain amount of money on a certain date. The bond shown here was issued on October 9th, 1969. The buyer paid something like $96,575 for this bond at that time, and six months later the U.S. government paid them $100,000. But if that buyer wanted to, they could have sold it a month early to someone else for around $99,429, essentially forgoing the interest they would be earning for that last month. In fact, there is a massive market for reselling government bonds before the date they mature. And a very frequent participant in those markets are banks. --Because the market for reselling government bonds is so big, they are usually the only assets the Federal Reserve will think about buying through open market operations. Open market operations are when the Fed buys or sells securities, or financial assets like government bonds, on the open market. Here is the idea behind these open market operations. Banks use deposits to make loans, and a good chunk of the loans they make take the form of buying government bonds, essentially lending money to the government. But from time to time, something will happen that kicks off a financial panic and leads many people to withdraw their money from banks. Without enough cash in reserves to meet these demands, a bank could fail, even though they have all of the financial assets like government bonds. The bank needs to liquidate those assets by selling them for cash. In a financial panic, there aren’t a lot of buyers for these bonds, and so the Fed can step in and create a bunch of money and go shopping for them, buying them off the banks and infusing the banks with the cash they need to cover the demands of their depositors. Eventually the panic subsides, and the money people withdrew in fear makes its way back into the banks. But with so much money in circulation, there is bound to be inflation. But the Fed is sitting on all these valuable financial assets. Now, they can sell the bonds back to banks in exchange for the cash, and then just delete the cash, avoiding the financial panic and the inflation all together. --With its three tools, the Federal Reserve has the power to manage financial markets and promote economic stability. When a panic ensues and results in a rapid and sharp decrease in the supply of loanable funds, it can be devastating for an economy. Businesses lose access to critical loans, bank runs lead to bank failures which means depositors at those banks lose everything they have, and production stalls. And while these panics sometimes happen in just days, their negative effects on the economy can last for years. To prevent those negative effects, the Fed has the power to bring an end to the panic as quickly as it starts. To increase the supply of loanable funds, the Fed could lower the required reserve ratio, letting those reserves loose so that banks have access to the liquidity they need in a crisis. They can also lower their own discount rate, which is the interest rate the Fed charges when it makes loans directly to banks. As the lender of last resort, the Fed can help otherwise healthy banks stay afloat during the crisis by giving them direct access to the credit they need. And then there are open market operations, where the Fed can create new money and use it to purchase bonds in the open market, flooding banks with cash in exchange for these financial assets. Any and all of those options can be used to increase the supply of loanable funds, bringing down interest rates, and helping to restore the economy after a panic.

The Classical School

Financial panics and recessions presented a problem for advanced economies. The disruptions in economic growth proved devastating for regular people who would be randomly thrown out of work, sometimes for years on end. At the beginning of the 20th century, many believed that it was a problem that could be solved. But to understand a problem, we need a framework for understanding the root causes of recessions that can be used to identify potential solutions. In our first of nine schools of thought we will examine we have the Classical School.

Open Video Transcript

We can now build a model of the economy using the tools we have gained. This is our Solow model, which shows three functions plotted on a graph. The production function represents the economic process of taking inputs like capital and labor and turning them into output, which we measure with real GDP. Our standard of living depends on what we produce, meaning that our income will be based on real GDP. Some of that income we will use for consumption, but some of it we will save. Whatever fraction we save is used to finance investment, or the creation of new capital. So, the green function labeled investment is defined by the fraction of income we save. And of course, some of our capital will depreciate at some rate, represented by the depreciation function. Where depreciation and investment cross is the steady state. At that point, the amount of capital added each year through investment is equal to the amount lost to depreciation. Follow that point down to the horizontal axis at it tells you our steady state amount of capital. Follow it up to the production function, and then over to the vertical axis and it tells you our steady state amount of real GDP. The Solow Model is a very useful model of our economy. We can use it to see what would happen when we make changes to ideas, capital, education, depreciation, savings and the rest. But just as we endogenized some aspects of economic growth like ideas and human capital into this model, we can go a step further and add our models of how the savings rate and labor supply are determined by the economy. --The graph at the top right is the market for loanable funds, or the credit market. This market sets the interest rates on loans, which is paid to the lenders and attracts savings into banks. In other words, this market sets our savings rate for the economy. The graph at the bottom right is the labor market. The demand for labor is determined by the productivity of workers, and the supply shows how many will be willing to work at every wage. This market sets wages, but also sets the size of the labor force, an important input to our production function. With these models together, we can think about what will happen when something in the economy changes. For example, when the Industrial Revolution increased labor productivity by pairing it with new machines, the demand for labor increased.--When the demand for labor increases and shifts to the right, not only do wages increase, but the size of the labor force increases too. With more labor feeding into our production function, it shifts upwards, and pulls investment along with it. We can see that our new steady state results in a higher level of real GDP, meaning this economy has experienced growth. That prediction matches reality, which is important if we want to use our model to make other predictions. For example, what happens when a financial panic rapidly reduces the supply of loanable funds? When the supply of loanable funds shifts to the left, it reduces the total quantity of funds available, meaning that we are now saving a lower percentage of our income, despite the sharp rise in interest rates. Normally this would just reduce our investment, and we would see a small reduction in GDP. But after the Industrial Revolution, capital and investment were even more important. Pairing humans with capital is what makes us so productive, and so a reduction in capital would also mean a reduction in our labor productivity and a shift left of the labor demand. This would reduce the labor force feeding into our production function and shrink the economy even more. This model helps explain why recessions were so much worse after the industrial revolution. But it also shows us a way out of them. The newly formed Federal Reserve has the power and the tools to prevent the supply of loanable funds from collapsing during a financial panic. By regulating bank reserves, acting as the lender of last resort, and controlling the money supply through open market operations, the Fed could restore the supply of loanable funds immediately, making sure there was no break in our prosperity. The logic of the model is right, but the question is whether or not the model matches reality. This is our map, but does it fit the terrain? As with any model, that depends on the assumptions we are making when we build it. --A century ago, macroeconomics wasn’t really a subject of study. There was just economics, a discipline investigating how our economy makes decisions about scarce resources. And so, the “classical school”, as we call it, wasn’t really a cohesive school of thought on the matter. You wouldn’t have been able to pick up a book on the subject and read about the predictions of the model we just looked at. Instead, there was an understanding cobbled together from the main tenants of economics. The three most important ideas which we have made use of to form our anachronistic model of the economy are Say’s Law of Markets, Self-Correcting Markets, and the Quantity Theory of Money. Say’s Law of Markets was put forward by the French economist Jean-Baptiste Say. He noted that when someone produces and sells a product in the open market, they earn an amount of money equal to the value of what they produced. And further, if we add everyone together, than their total income should be equal to the value of what they all produced in total. This means that total income for our economy should be enough to afford everything it is that we produce. It all feels like a bit of circular logic, and in some ways it is. But the takeaway is this: In a recession, people aren’t earning enough money to afford everything the economy is producing. According to Say’s Law, that just cannot last very long. The lower incomes will bring down prices until we can afford everything that is produced. The reason we should expect those changes to happen is simply the market forces of supply and demand. When demand falls, prices fall. And markets make that adjustment happen automatically. Prices are a signal wrapped up in an incentive. When market conditions change, prices will adjust until the markets reach equilibrium again. And lastly, there is the Quantity Theory of Money. This is a theory we will dive into more down the road, but for now the key idea is that the price level – the average price of goods and services in the economy – should also adjust when there are changes in the money supply. So, the ups and downs in the credit market should, in the end, only result in inflation or deflation. They should not result in persistent recessions. These three assumptions underpin our model of the economy. We are using Say’s Law to assume that the steady state in the Solow model sets real GDP, which in turn sets our income. We are also assuming that credit markets and labor markets and all other markets will adjust when there are fluctuations, setting prices to incentivize the efficient use of our resources, where nothing is going wasted or unused. And the quantity theory of money lets us conclude that our intervention via the Federal Reserve will help to manage prices and prevent financial panics, but it cannot itself be a source of economic growth or decline. With the Federal Reserve in place after 1913, working to keep prices and financial markets stable, all that was left to do was wait and see if it was going to work. --After World War I came the first big test of the new system. When the war ended, there was a sharp downturn in the global economy as waring nations reverted to a peacetime economy, but also because the peace was uncertain for a while. Compared to the Panic of 1907, however, this recession was a breeze. It was much shorter, just like the classical school predicted, and not nearly as severe. It seemed as though the new system was working exactly as everyone hoped. Reducing the frequency of financial panics and recessions.--What followed was the Roaring Twenties, a decade of unprecedented economic growth and change. The Dow Jones Industrial Average rose from $63.90 in 1921 to $381.17 in 1929. This is an annual growth rate of 25%! Mass production made technology affordable to the middle class, and assembly lines increased productivity. New infrastructure was built, including roads, phone lines, and plumbing. More and more of the U.S. was introduced to electricity. The city, as opposed to rural areas, gained prominence. Economic growth pushed above 5% for most of the decade, and America established itself as the richest country on Earth. There was also a cultural renaissance, with women being given the vote, the spread of cinema, and a new wave of music, art, and dance. It was a period of unbridled optimism and progress. --Many believed that this prosperity was now permanent. The problem of panics and recessions had been solved. John Maynard Keynes, who will feature heavily in the rest of this course, said in 1927 that we will not have any more crashes in our time. President Calvin Coolidge, in his State of the Union address said of the U.S. economy, “In the domestic field there is tranquility and contentment... and the highest record of years of prosperity. In the foreign field there is peace, the goodwill which comes from mutual understanding.” But there was one quote which proved to be disastrous for the man who uttered it. --Irving Fisher was the most prominent economist in America, developing many of the theories of economics discussed in this video, including the entire framework for credit markets. His wisdom was also highly sought after by investors, and on October 17th, 1929, reacting to what seemed like a briefly stalling economy, Fisher said, “Stock prices have reached what looks like a permanently high plateau.” And no one would ever let him live the quote down. Because less than two weeks later, a record-breaking crash in the stock market would mark the beginning of the greatest economic crisis the world has ever faced.

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

Office Hours

Deeper Thoughts and Extra Practice

Dr. Goegan Explains...

Example Question
The Federal Reserve can expand the money supply by changing its required reserve ratio for banks. The Federal Open Market Committee seeks to increase the money supply by 7.2%. The required reserve ratio for banks is currently 17%.

What reserve ratio should the Federal Reserve require to produce the desired change in the money supply?

Do not round until your final answer, at which point you can round to two decimal places. The error margin allowed on this question is really small, so seriously, don't round until the final answer.

Video Solution

Page updated

Report abuse