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					                                           US Economic History
                Lecture Outline Four: The Federal Reserve, The Great Depression and Beyond
                                              October 9, 2009
Overview of the Federal Reserve
1.      When was the Federal Reserve established?
2.      When were the central banks in Sweden, England, France, and Canada established?
3.       What is the FOMC? What is the primary purpose of the FOMC? Who sits on the FOMC?
4.      Briefly…how does the Federal Reserve implement monetary policy?
5.      How many Federal Reserve Banks exist and where are these located? The state of Utah is in which
        district?

Readings:         Atack, Jeremy and Peter Passell: Chapter 18, 21, and 22
6.      How does the Gold Standard maintain the value of a nation’s currency?
7.      What are the advantages and disadvantages of the Gold Standard.
8.      Compare the following three events.
        a.        The economic downturn following the Bank Panic of 1837.
        b.        The recession of 1920-21.
        c.        The first two years of the Great Depression: 1929-1930.
        Review changes in national output and prices.
9.      Utilize the standard AD-AS framework to explain the Great Depression.
        Be sure to define each element of the model.

Discuss and evaluate the following explanations for the cause and duration of the Great Depression.
10.      The consumption arguments of Joseph Schumpeter.
11.      The consumption arguments of Peter Temin.
12.      The investment argument of John Maynard Keynes.
13.      The arguments focused on changes in international trade policy and government spending.
14.      The monetary arguments advanced by Milton Friedman and Anna Schwartz.
15.      The arguments offered by the Austrians and Liquidationists.

Discuss the following five monetary shocks (these are explained in the book from page 607-612).
16.      The stock market crash of October, 1929.
17.      First banking crisis (October 1930 - February 1931)
18.      Second banking crisis (March, 1931 - August, 1931)
19.      Britain’s abandonment of the gold standard (September, 1931).
         Hint: Be sure to understand the economics of the Gold Standard.
20.      Final banking crisis (October 1932 - March 1933)

21.     What are the various reasons offered in lecture for the general inaction of the Federal Reserve to adequately address
        the problems in the banking industry observed from October, 1930 till March, 1933.

22.     What is the pattern of unemployment, across time, age groups, and geographic regions, during the years
        1929 to 1940?
23.     List the arguments offered in the text and lecture for the recovery of 1933-1937.
24.     List the arguments offered in the text and lecture for the recession of 1937-1938.
25.     Between Roosevelt and Hoover, who was the better Keynesian? Explain the basics of Keynesian analysis
        and explain why macroeconomic policies in the 1930s were not generally consistent with this model.
26.     What were the objectives of New Deal spending? Answer this question from the perspective of Don
        Reading and Gavin Wright.
27.     Briefly explain the Glass-Steagall Act of 1933. Review the details of the legislation, the justification for
        the legislation, and the duration of its existence.
28.     Briefly explain the establishment of the FDIC. Define and review the issue of Moral Hazard.

Money and Banks Today
29.    The United States employs a dual banking system. Trace the origins of this system and review the
       multiple agencies charged with regulating this industry today.
30.    For much of American history prices rose and fell. In our lifetimes, prices have only risen. Why?
                                           US Economic History
                              Lecture Outline Four: PAGE TWO (REVISED)
                                             October 14, 2009


UNDERSTANDING MONETARY AND FISCAL POLICY DURING THE GREAT DEPRESSION

Taylor Rule (from Paul Krugman):
http://krugman.blogs.nytimes.com/2009/10/11/when-should-the-fed-raise-rates-even-more-wonkish/
Fed funds rate = 2 + 1.5 * inflation - 2 * excess unemployment
Okun’s Law:     A 1% increase in unemployment causes a 2% decline in output (GDP)

Given           In 1932 we see approximately the following:
                Unemployment Rate = 25%
                Natural Rate of Unemployment = 6%
                Inflation = -5% (this is a negative number so we have deflation)

Given this data,
31.      What is the deviation in GDP (in percentage terms)?
32.      Nominal GDP was approximately $800 billion before the Great Depression began.
         Given the answer to #31, what’s the new level of GDP?

MONETARY POLICY
33.  Given the answer to #31, what does the Taylor Rule suggest the Fed Fund’s Rate should be?
34.  Is your answer to #33 possible? a. Yes                b.        No
35.  What does this tell us about the effectiveness of monetary policy?
     a.       Won’t be effective.                  b.      Will be effective.

FISCAL POLICY
36.    Given the answer to #32, if the multiplier is 1.5, how much would government spending have to increase to
       offset the decline in GDP (assuming no crowding out)?
37.    Prior to World War II government spending was typically less than 10% of GDP. What percentage of GDP is the
       government stimulus calculated in #37?
38.    Given your answer to #37, is the size of stimulus calculated in #36 politically feasible in 1932?
                                                 US ECONOMIC HISTORY
                                                In Class Assignment EXAMPLE
                                                        October 21, 2009

Taylor Rule: Fed funds rate = 2 + 1.5 * inflation - 2 * excess unemployment
     Okun’s Law: A 1% increase in unemployment causes a 2% decline in output (GDP)
                 GDP = Gross Domestic Product (or national output)

Given               In 1930 we see approximately the following:
Unemployment Rate = 8%
Natural Rate of Unemployment = 6%
Excess Unemployment = Unemployment Rate – Natural Rate of Unemployment = 8% - 6% = 2%
Inflation = 2%


1.   What is the deviation in GDP (in percentage terms)?
     Okun’s Law says a 1% increase in unemployment leads to a 2% change in GDP. The above numbers
     tell us that unemployment is 2% above the natural rate (or the rate of unemployment we would expect
     if the economy was producing at capacity). Given Okun’s Law, a 2% increase in unemployment leads to a
     4% change or deviation in GDP.

2.   Real GDP was approximately $800 billion. Given the answer to #1, what is the new level of GDP?
     4% of $800 billion is $32 billion. So the new level of GDP is $768 billion.

MONETARY POLICY
3. Given the answer to #1, what does the Taylor Rule suggest the Fed Fund’s Rate should be?
   The Taylor rule (see above) tell us what the Fed Funds Rate (or the interest rate the Federal Reserve
   attempts to influence) should be; given the level of inflation and unemployment in the economy.
   The above numbers say Inflation = 2 and Excess Unemployment = 2
   Therefore…        Fed Funds Rate = 2 + 1.5*2 – 2*2 = 2 +3 -4 = 1
   Therefore…        The Fed Funds Rate should be 1% (or very low).

4.   Given the answer to #3, if the Fed Fund’s rate was initially 5%, the money supply would be
     a.      expanding.                  b.       contracting                c.      not changed
     Lowering the Fed Funds Rate will cause banks to lend more money and the money supply to increase.

5.   Given the answer to #4, interest rates would be
     a.      declining.                   b.      increasing.          c.            not changing.
     Lowering the Fed Funds Rate would cause other interest rates to decline.


6.   Given the answer to #5, investment would be
     a.       declining.                b.      increasing.              c.     not changing.
     When firms spend money on machinery, buildings, etc… we call that investment. If interest rates are lower, firms
     can borrow more money from banks. This means the firms can spend more money on machinery, buildings, etc….

7.   Given the answer to #6, aggregate demand would be
     a.      declining.                 b.     increasing.                  c.       not changing.

     Aggregate Demand = Consumption + Investment + Government Spending + Net Exports
     OR        AD = C + I + G + NX
     If there is more investment, aggregate demand will be higher.
8.   Given the answer to #7, in the short-run
     a.      the price level would increase.
     b.      the price level would decrease.
     c.      the price level and national output would increase.
     d.      the price level and national output would decrease.

     There is a link between money and prices. If the money supply expands, prices will increase. In the
     short-run, and increase in demand can also lead to an increase in National Output (or GDP).

     Another way to look at this… if there is more demand for goods (increase in aggregate demand) then
     the price level will rise. Again, in the short-run, that can lead to an increase in GDP.

9.   Given the answer to #7, in the long-run
     a.      the price level would increase.
     b.      the price level would decrease.
     c.      the price level and national output would increase.
     d.      the price level and national output would decrease.

     One cannot increase national output indefinitely by changing aggregate demand. Once the economy returns to
     capacity, then further increases in aggregate demand will only increase prices. So in the long-run, the monetary
     policy above – if continued – would just cause prices to rise.

FISCAL POLICY
10. Given the answer to #2, if the multiplier is 2, how much would government spending have to increase to offset
    the decline in GDP (assuming no crowding out)?

     The above numbers say there is a $32 billion gap in the economy. This gap can be filled in with
     government spending . Each dollar the government spends can have a larger impact on the economy.
     If we say the multiplier is 2, then each dollar the government spends will have a $2 impact on the economy.

     With a $32 billion gap and a multiplier of 2, government spending only has to increase by $16 billion
     to close the gap.

11. The increase in government spending will cause aggregate demand to
    a.       decline.        b.       increase.                 c.     not change.

     Aggregate Demand = Consumption + Investment + Government Spending + Net Exports
     OR        AD = C + I + G + NX
     If there is more government spending, aggregate demand will be higher.

12. Given the answer to #11, in the short-run
    a.      the price level would increase.
    b.      the price level would decrease.
    c.      the price level and national output would increase.
    d.      the price level and national output would decrease.

     If there is more demand for goods (increase in aggregate demand) then the price level will rise. Again, in the
     short-run, that can lead to an increase in GDP.
                                                   US ECONOMIC HISTORY
                                                 In Class Assignment PRACTICE
                                                         October 21, 2009

Taylor Rule: Fed funds rate = 2 + 1.5 * inflation - 2 * excess unemployment
     Okun’s Law: A 1% increase in unemployment causes a 2% decline in output (GDP)
                 GDP = Gross Domestic Product (or national output)

Given              In 1932 we see approximately the following:
Unemployment Rate = 21%             Natural Rate of Unemployment = 6%
Excess Unemployment = Unemployment Rate – Natural Rate of Unemployment = 21% - 6% = 15%
Inflation = -10%   NOTE: Inflation is a negative number (so we have deflation)


Given this data,
1. What is the deviation in GDP (in percentage terms)?              30%

2.   Real GDP was approximately $800 billion before the Great Depression began.
     Given the answer to #1, what’s the new level of GDP?       $560 billion


MONETARY POLICY
3. Given the answer to #1, what does the Taylor Rule suggest the Fed Funds Rate should be?
     Fed funds rate = 2 + 1.5 * (-10) - 2 * (15) = - 43


4.   Is your answer to #3 possible?      a.       Yes               b.          No
     Remember, interest rates cannot be negative.


5.   What does this tell us about the effectiveness of monetary policy?
     a.     Won’t be effective.                    b.      Will be effective.



FISCAL POLICY
6. Given the answer to #2, if the multiplier is 2, how much would government spending have to increase to offset the decline in
    GDP (assuming no crowding out)?

     GDP has declined from $800 billion to $560 billion. To fill in this $240 billion gap, the government would have to
     spend $120 billion.

7.   Prior to World War II government spending was typically less than 10% of GDP. What percentage of GDP (what GDP is
     after the downturn, not what it was before the downturn) is the government stimulus calculated in #6?

     Stimulus is 21.4% of GDP ($120 billion / $560 billion)

8.   Given your answer to #7, is the size of stimulus calculated in #6 politically feasible in 1932? NO
NOVEMBER 10, 2008, 4:38 PM
Stimulus math
By Paul Krugman
I wrote this morning’s column partly because I had a hunch that the Obama
people might be thinking too small on stimulus. Now I have more than a hunch –
I’ve heard an unreliable rumor! So let’s talk about stimulus math, as I see it.
Actually, before I get to the math, some concepts. Nearly every forecast now says
that, in the absence of strong policy action, real GDP will fall far below potential
output in the near future. In normal times, that would be a reason to cut interest
rates. But interest rates can’t be cut in any meaningful sense. Fiscal policy is the
only game in town.
Wait, there’s more. Ben Bernanke can’t push on a string – but he can pull, if
necessary. Suppose fiscal policy ends up being too expansionary, so that real GDP
―wants‖ to come in 2 percent above potential. In that case the Fed can tighten a
bit, and no harm is done. But if fiscal policy is too contractionary, and real GDP
comes in below potential, there’s no potential monetary offset. That means that
fiscal policy should take risks in the direction of boldness.
So what kinds of numbers are we talking about? GDP next year will be about $15
trillion, so 1% of GDP is $150 billion. The natural rate of unemployment is, say,
5% — maybe lower. Given Okun’s law, every excess point of unemployment above
5 means a 2% output gap.
Right now, we’re at 6.5% unemployment and a 3% output gap – but those
numbers are heading higher fast. Goldman predicts 8.5% unemployment,
meaning a 7% output gap. That sounds reasonable to me.
So we need a fiscal stimulus big enough to close a 7% output gap. Remember, if
the stimulus is too big, it does much less harm than if it’s too small. What’s the
multiplier? Better, we hope, than on the early-2008 package. But you’d be hard
pressed to argue for an overall multiplier as high as 2.
When I put all this together, I conclude that the stimulus package should be at
least 4% of GDP, or $600 billion.
That’s twice what the unreliable rumor says. So if there’s any truth to the rumor,
my advice to the powers that be (or more accurately will be in a couple of
months) is to think hard – you really, really don’t want to lowball this.
October 11, 2009, 3:01 pm

When should the Fed raise rates?
By Paul Krugman

Some back-of-the-envelope scribblings:

Let me start with a rounded version of the Rudebusch version of the Taylor rule:

Fed funds target = 2 + 1.5 x inflation - 2 x excess unemployment

where inflation is measured by the change in the core PCE deflator over the past
four quarters (currently 1.6), and excess unemployment is the different between
the CBO estimate of the NAIRU (currently 4.8) and the actual unemployment
rate (currently 9.8).

Right now, this rule says that the Fed funds rate should be -5.6%. So we’re hard
up against the zero bound.

Suppose that core inflation stays at 1.6% (although in fact it’s almost sure to go
lower.) Then we can back out the unemployment rate at which the target would
cross zero, suggesting that tightening should begin: it’s an excess unemployment
rate of 2.2, implying an actual rate of 7 percent. That’s a long way from here. If
inflation drops to, say, 1 percent, the Fed shouldn’t tighten until unemployment
drops to 6.25%.

What would it take to get to that range of unemployment? Okun’s Law suggests
that it takes 2 points of GDP growth in excess of potential to reduce
unemployment by 1 point. Potential growth is probably around 2.5. So say we
have 5 percent growth for the next 2 years — which would be hailed as a stunning
boom. Even so, unemployment should fall only 2.5 points, to 7.3. In other words,
even with a really strong recovery (which almost nobody expects), the Fed should
keep rates on hold for at least two years.

Bear in mind that I’m using entirely standard, conventional analysis here. It’s the
people saying that the Fed should start tightening in the near future who are
inventing some kind of new, unspecified framework to justify their views.