Activity: The Great Depression and the Financial Crisis of 2008 (10 Points)
Please review “Lessons from the Great Depression” and “The Financial Crisis of 2008” and look back over
Part II of the Common Sense Economics textbook (2010). Using Parts II and III of CSE, identify the direct
and secondary effects of the following fiscal or monetary policy moves by the federal government
during the Great Depression (1929-41) or the Great Financial Crisis (2007-2010). Explain how these
types of interventionist policies hamper efforts to grow and prosper in households and businesses. Your
grade on this assignment will be influenced by your ability to actively use course resources in providing
The Great Depression (5 Points)
The Great Depression was the worst economic time in the United States’ history. It was characterized
by large reductions in Gross Domestic Product (both real and nominal GDP), soaring unemployment,
high levels of farm and home foreclosures, extensive bank failures, and a significant level of human
suffering. Prior to the depression or prolonged recession, the economy was booming with high levels of
technological advancements, innovation, and economic growth. The stock market reflected this
remarkable growth and development, but in October 29th, 1929, known as Black Tuesday, the market
crashed considerably. This crash in the stock market was thought by many individuals to be what fueled
the Great Depression. However, the stock market rebounded back to nearly its pre-cash levels in the
months following the “Great Crash.” However, it swiftly plunged again and the economy then struggled
considerably over the next fifteen years. What happened to cause the Crash and plunge the U.S. and
other countries into the Great Depression? Was it just a result of the inevitable swings of the stock and
other markets? Or, was this prolonged economic downturn intensified and lengthened by poor policy
fiscal and monetary policy decisions? Please answer the following questions to gain insight into the
nature and causes of the Great Depression.
1. The U.S. economy experienced price stability as a result of a slow and steady expansion of the
money supply during the 1920’s. However, in spite of this price stability, the Federal Reserve (the
central bank in the United States) decided to use restrictive monetary policy between January 1928
and August 1929. The Fed increased the discount rate, providing member banks with incentive to
raise interest rates charged to businesses and households. The Fed also used contractionary open
market operations and aggressively sold U.S. Treasury bonds to banks. This central bank move
decreased the amount of excess funds available to banks for the purpose of lending to households
and businesses. This drain of reserves for lending purposes from the U.S. banking system, reduced
the supply of money, decreased the demand for goods and services and, consequently, placed
downward pressure on prices.
A. What effect did the restrictive monetary actions of the Federal Reserve Bank have on overall
growth opportunities at the onset of the Great Depression Era?
2. President Hoover signed the Smoot-Hawley Trade Bill into law on June 17th, 1930. This bill passed
promising to generate tariff revenue for the government and increase the production of U.S. goods
and boost overall U.S. employment by saving U.S. jobs. This trade bill did increase tariffs on goods
imported by more than 50 percent on at least 3,200 imported goods.
A. Which of the seven sources of economic progress was violated by the passage of the Smoot-
3. In an effort to balance the budget and avoid running budget deficits, the government passed a large
tax increase during this severe recession. In 1932, the lowest marginal tax rate on personal income
was raised from 1.5 percent to 4 percent and the top marginal tax rate was raised from 25 percent
to 63 percent (meaning that of every dollar the people in the top marginal tax bracket earn, 63 cents
goes to the government and they only keep 37 cents). In 1936, the Roosevelt Administration
increased taxes again, making the top marginal tax rate 79% (of every dollar they earn, they keep 21
cents while 79 cents goes to the government).
How did this huge tax increase impact the incentives of people to earn income and invest in new
4. During the Great Depression, the Roosevelt Administration passed a number of regulations designed
to improve the current economic conditions. These policies were numerous with some working
better than others, but two of the most infamous policies were that Agricultural Adjustment Act
(AAA) and the National Industrial Recovery Act (NIRA). The AAA paid farmers to destroy crops and
livestock by making them unfit for human consumption in an effort to raise the price on these
agricultural goods. The NIRA organized over 500 companies into cartels and government officials
set production quotas, prices, wages, working hours, distribution methods, and other mandates
specific to each industry, thus, removing competitive practices from the market place. Both were
eventually found to be unconstitutional and later repealed.
A. What is a potential problem of consistently changing the rules under which an economy
operates by instituting numerous new laws, regulations, and programs?
B. Which of the seven sources of economic progress were violated with the passage of the AAA
and NIRA? There may be more than one.
The Crisis of 2008 (5 Points)
The Economic downturn of 2008 was characterized by the sharp rise and fall of housing prices, rising
default and foreclosure rates, and a subsequent sharp downturn in the stock market. This resulted in
many people losing their homes and the majority of the value on their investments, creating a
pessimistic view of the economy and its future. Further, many banks, whose investments were highly
leveraged in the housing market, started to experience losses that would have led to their closing if not
for the government bailout of these financial institutions. Many have called this recent recession the
worst economic time this country has experienced since the Great Depression. How did things get this
bad? What were the events that led to the boom and bust of the housing market and the economic
collapse that followed? Please answer the following questions to gain insight into the nature and causes
of this recent recession.
1. Fannie Mae and Freddie Mac are two government sponsored enterprises (GSE’s) created by
congress to provide liquidity in the secondary mortgage markets. These institutions were highly
political and often provided campaign funds in exchange for the protection of their privileged status
as GSE’s. The perception of them being backed by the government allowed them to dominate the
secondary mortgage market. With the good intention of helping the poor more easily afford
housing, the Department of Housing and Urban Development (HUD) imposed regulations designed
to make housing more affordable. For example, by 2008, 56% of all housing loans had to go to
borrowers with incomes below the national median. This means that Fannie Mae and Freddie Mac
had to accept smaller down payments and extend larger loans relative to the income of the
borrowers to meet these requirements. The Community Reinvestment Act (CRA) further loosened
mortgage lending standards by requiring banks to meet numeric goals with regards to extending
loans to low-income and minority populations. This significantly increased the amount and size of
loans to people with poor or incomplete credit histories.
A. What might you expect to be true of the ability of poor individuals with bad credit histories to
pay back mortgage loans made with very low down payments?
B. What were the government’s intentions with regard to the policies set forth by the Department
of Housing and Urban Development (HUD) and the Community Reinvestment ACT (CRA)? Do
you think the intentions of the policy-makers behind the CRA were good or bad? What were the
economic and financial outcomes of these regulations? In light of the secondary effects, were
the loose lending standards a boost or a bust for the economy?
2. In an effort to stimulate the economy and further encourage people to buy homes, the Fed
maintained a very low interest rate policy from 2002-2004. This made Adjustable Rate Mortgages,
which involve smaller housing payments when interest rates are down and larger housing payments
when interest rates are up, more attractive relative to fixed rate mortgages (in which housing
payments stay the same regardless of what happens to the interest rate). These low interest rates
on adjustable rate mortgages made it possible for families to afford the monthly payments for larger
more expensive homes. In 2005, the Fed raised interest rates to combat the inflation prompted by
the previous expansionary monetary policy.
a. What incentive do people have to finance a mortgage through an ARM when interest-rates
are relatively low? What type of homes do you expect them to buy?
b. What do you expect to happen to these people with adjustable rate mortgages when the
Fed pushed interest rates back up?
3. In April 2004, The Securities and Exchange Commission (SEC) relaxed regulations on investment
banks making it possible for these financial institutions to leverage themselves more highly by
extending more loans relative to the amount of capital they have to keep on hand. In particular, the
SEC made it possible for banks to leverage themselves most highly when it came to residential
mortgage loans and low risk securities (which housing market loans were still perceived to be
despite the recent relaxation of lending standards).
A. Mortgage loans were traditionally perceived to be fairly safe by banks since people usually made
sure to make their housing payments. However, given the recent events described in questions
1 and 2, do you think that mortgage loans during this time period were as safe as they used to
B. Banks make money by extending loans and getting repaid with the principle amount of the loan
plus interest. Therefore, the more successful loans the bank extends then the more money the
bank makes. If a manager of a bank is told that they can extend more loans than usual as long
as those loans are extended as residential mortgage loans which can be bundled into low-risk
securities then what do you expect the bank manager to do?
4. During the past two decades, housing debt has grown to unprecedented levels. By 2007, household
debt had grown to 135% of household income, meaning that an average household’s accumulated
debt is significantly greater than its annual income.
A. Interest payments on home mortgages and home equity loans are tax deductible, but interest
on other forms of debt are not. Given that this is true, where do you expect most households to
concentrate their debt? If households are unable to repay their loans which sector will be hit
B. How would you describe the strength of an economy where most people carry around high
levels of debt relative to their incomes?
5. Think back to Part II of the Common Sense Economics textbook on the seven sources of economic
growth. Which sources of economic growth were violated by the Federal Reserve’s and Federal
Government’s policies over the years leading up to the recent recession?
The Past and Present: Comparing the Great Depression and the Recent Financial Crisis
“Those who fail to learn from History are doomed to repeat it” – Winston Churchill
Compare the events and policies surrounding the Great Depression with those surrounding the recent
financial crisis. What similarities do you notice about these two periods in history?