AP Macroeconomics – The Money Market and the Loanable Funds Market
Because of its thematic importance, this lesson is not framed as an
inquiry-driven dilemma, but instead, as a collection of resources that
can be used as part of an informational lesson directed by the teacher or
made available to students for independent study.
Do financial markets know best? Left alone by the federal government, would the markets benefit the nation’s economy and, through self-regulation, the American people as a whole, or would they benefit a narrower group of people? Do the markets care about how well the economy is serving the American people and, if they don’t, does the government have an important role to play in achieving outcomes that benefit all Americans? One way to look at U.S. history is that it reflects the efforts of a politically open society to manage concentrations of political and economic power in ways that advance the common good with a minimum of government intervention. The story of the Federal Reserve System (also known as the Federal Reserve Bank, the Federal Reserve, or the Fed) can be told in these terms because the very need for a central bank has always been identified with the needs of private bankers—a group that has represented a concentration of economic power. The debate about Hamilton’s First Bank of the United States illustrates this struggle, and this same struggle has continued throughout U.S. history. The controversy surrounding the Second Bank of the United States (the 1819 McCulloch v. Maryland U.S. Supreme Court case and President Andrew Jackson’s veto of the bank’s charter renewal), the various financial panics of the 19th century and accompanying debates about the gold standard versus “free silver,” and, right up to the present, the debate about the role of the Federal Reserve during and after the 2008 financial crisis, all illustrate this issue’s enduring nature. Recurring debates about national priorities, the proper role and scope of government, and the virtues and limitations of the free market are faces of the struggle to manage concentrations of power, though in detail and tone they reflect the historical peculiarities of the time period.
The role of the Federal Reserve is based on the assumption that a smoothly running economy benefits everyone and that, in order to run smoothly, the economy needs a stable currency, no more than a 4–5% level of unemployment, and the right amount of available credit—not too little and not too much. Keeping things running smoothly is the job of the Federal Reserve, a mostly autonomous, public/private system overseen by Congress. The Federal Reserve sets the nation’s monetary policy in part by either increasing or reducing the amount of money in circulation.
. . . The Fed can influence the money supply by modifying reserve requirements, which is the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able loan more money, which increases the overall supply of money in the economy. . . .
. . . If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply. Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking in cash and removing money from the economic system. (Gallant, 2007)
In theory this encourages banks to loan money at lower interest rates. Making more money available stimulates the economy and encourages economic growth, including employment. When the Federal Reserve pulls back the amount of money in circulation (by increasing the amount of money banks are required to keep in reserve), the opposite occurs. The Federal Reserve also influences the interest rates at which money is loaned by setting the rate for emergency, short-term loans to banks. Lower interest rates put more money in circulation.
The independence of the Federal Reserve is a matter of great importance and, inevitably, a source of controversy because of its power to dial the economy up or down in a way that fundamentally affects everyone’s well-being. Is the Federal Reserve a truly independent institution of experts, trying to maintain economic stability through unpredictable business cycles, being careful to maintain a balance between inflation and unemployment and regulating the financial system and money supply to the benefit of all? Or is it subject to the influence and power of the government or private interest groups? Is it, as some (usually conservative) critics have charged, an institution the government can use to inflate away the value of the currency and allow limitless deficit spending (“monetizing” the deficit) in order to expand the scope of the government’s power? Or is it, as other critics (usually liberal) have charged, an institution that bankers and corporate interests can use to maintain their own wealth and power at the expense of others?
This lesson is presented as a collection of resources that can be used in multiple places in a U.S. History curriculum. The Federal Reserve Bank that we know today was created in 1913 and has its own foundation story, but this lesson is designed to be used wherever an understanding of how central banking, the money supply, and regulation of the financial system relate to the business cycle and to the differing and often conflicting interests of large bankers (“Wall Street”), small business owners, farmers, salaried employees, and the poor.
Structure and Function of the Federal Reserve
The Federal Reserve is a public/private institution that regulates the nation’s economy by regulating the money supply. Its goal is to manage the money supply by balancing two competing forces—keeping inflation from getting too high if there is too much money in circulation, while ensuring there is enough money and liquidity to keep unemployment at around 4–5%. In September 2010, however, unemployment was 10%. In July 2012 it was 8.2%, and the number was even higher for blacks (14.4%) and teenagers (23.7%). As of November 2015, the unemployment rate had fallen to 5.0%, with higher rates for blacks (9.4%) and teenagers (15.7%) (Bureau of Labor Statistics, 2015).
Although we speak of “the” Federal Reserve, it is actually a somewhat decentralized system of interrelated parts configured as regional banks. They work together, but they also serve as a system of checks and balances (Suiter & Schug, 2012). At the top of the system is the Board of Governors, located in Washington, D.C., which is made up of seven political appointees who serve staggered 14-year terms. Underneath the Board of Governors is the network of 12 regional Reserve Banks. In addition to their checks and balances role, regional banks are intended to ensure that monetary policy supports the wellbeing of the people. The final component of the Fed is the Federal Open Market Committee (FOMC), which is composed of the governors and the presidents of five of the regional banks (always including the New York Bank). The FOMC is where the nation’s monetary policy is actually made—where interest rates are set and the money supply is regulated. (Note: taxing and spending are part of fiscal policy, which is set by Congress and the President.) (Board of Governors of the Federal Reserve System, 2012)
History of the Federal Reserve
The creation of the Federal Reserve System in 1913 followed a long series of events related to central banking and the monetary policy (Federal Reserve, 2012; ushistory.org, 2012):
1791–1811: The First Bank of the United States was established by Congress in Philadelphia to standardize the currency and help pay Revolutionary War debts. The bank became politically unpopular, especially among farmers, because it was associated with wealthy interests.
1816–1836: The Second Bank of the United States was established, in part to pay debts from the War of 1812 and to combat inflation, or a general increase in prices for goods and services. President Andrew Jackson did not like the idea of a central bank, and succeeded in blocking the renewal of its charter.
1836–1865: During this era, when there was no central bank, state banks and local, unchartered banks issued their own bank notes, or currency
1873–1907: The late-nineteenth and early-twentieth centuries saw a number of economic and financial “panics,” including the disastrous Panic of 1893 that led to the worst depression up to that point in U.S. history.
1907: Another particularly severe banking panic, caused in part by speculation on Wall Street, led to renewed calls for reform to the nation’s banking system. Although fierce debates between conservatives and progressives ensued over the exact nature of the reform, a national consensus emerged that the nation needed a central bank that could provide flexibility to the currency and regulation and stability to the banking system.
1908–1912: Debates persisted between corporate and banking interests, who supported a central bank led by bankers, and progressives such as William Jennings Bryan, who supported a central bank led by the public. A commission led by Senator Nelson Aldrich recommended a banker-controlled bank, but the 1912 election of progressive President Woodrow Wilson effectively killed that plan. Still, the somewhat paradoxical idea of a “decentralized central bank” had significant impact.
December 23, 1913: Based on ideas from Representative Carter Glass and economist H. Parker Willis, and after significant debate, compromise, and revision, Congress ultimately passed and President Wilson signed into law the Federal Reserve Act. Although it has evolved over time and been modified by later laws, the structure of the Federal Reserve System created by the act reflected the basic compromise of a decentralized central bank under a mixture of private and public control.
1914–1919: The Federal Reserve System proved to be useful during World War I, initially by aiding in the trade of goods with Europe and helping to finance the war, and from 1917 onward helping to finance the United States’ entry into the war.
1920s: Under the leadership of Benjamin Strong, the Federal Reserve began engaging in “open market operations,” or the buying and selling of government securities to influence interest rates and the availability of credit in the financial system.
1929–1933: In October 1929, the stock market crashed, meaning that a tremendous amount of wealth that people thought they held in the value of companies was lost. This event did not directly cause, but was correlated with, the start of the Great Depression, the worst economic depression in U.S. history. Nearly 10,000 banks failed in the first few years of the 1930s, and many debated about the best way to respond to stabilize the financial system, as well as whether the Fed had failed to prevent the crash and depression by allowing too much speculation.
1933–1935: President Franklin Delano Roosevelt and Congress enacted several changes in response to the Great Depression. One of the best known was the Banking Act of 1933, or the Glass-Steagall Act, which required commercial and investment banks to separate, increased the regulatory power of the Fed, and created the Federal Deposit Insurance Corporation (FDIC) to insure savings accounts. President Roosevelt also effectively ended the gold standard by recalling all gold and silver certificates. Over time, other changes were made to help ensure the Fed’s independence and ability to achieve its mission, including the creation of the Federal Open Market Committee to set monetary policy and the establishment of 14-year terms for the Board of Governors. Through the 20th century, the Fed’s role continued to evolve, including adding promoting full employment to its goals.
1951: When the government faced increased revenue and borrowing needs during the Korean War, the Fed resisted pressure to maintain low interest rates to help fund the conflict, leading to increased independence of monetary and fiscal policies.
1970s–1980s: After a period of rapid inflation through the 1970s, Fed Chairman Paul Volcker took drastic action through the 1980s to reduce inflation. The 1980s also saw significant changes to the banking industry, such as increased interstate banking and interest-bearing accounts, which led to the rise of the modern financial services industry.
1990s: Following a stock market crash on October 19, 1987, the Fed provided liquidity to support the economy and financial system. Under the leadership of Chairman Alan Greenspan, the Fed used monetary policy throughout the 1990s to prevent problems in the financial system from affecting the entire economy. During this period (but not necessarily as a direct result), the economy saw its largest peacetime expansion in history.
1999: The Gramm-Leach-Bliley Act overturned Glass-Steagall and allowed banks to offer a menu of services, including investment banking.
2007–2008: After a housing boom through the 2000s, in which low mortgage rates and the availability of subprime mortgages to borrowers with risky credit records increased homeownership as well as the demand for and price of housing, house prices began to fall, leading some people to owe more on their mortgages than their homes were worth. This led to a downward spiral in the financial system, in which the risks of selling bundled mortgages as securities or investments were revealed. Fears about the true value of assets and the financial health of many institutions spread, culminating in the failure of Lehman Brothers and Washington Mutual, two major financial institutions. Ripple effects, including tightened credit markets, significantly weakened business and consumer confidence, and loss of wealth led to a recession, or period of shrinking economic activity, from 2007 to 2008, with a slow and weak economic recovery following.
The Fed took several actions, some uncustomary (and controversial), to stabilize the financial system and prevent cascading effects. These included large loans to major financial institutions like insurance company American International Group (AIG) to prevent major financial losses from leading to devastating effects throughout the system. The Fed maintained extremely low interest rates to help lower the cost of borrowing and to stimulate the economy, in addition to using uncommon monetary policy tools, such as the purchase of mortgage-backed securities to help keep homes affordable in the wake of the housing market crisis.
2015: For the first time since 2006, the Federal Reserve, citing persistent improvements in the labor market after a slow recovery, engaged in monetary policy activities to raise interest rates. Although inflation remains well below the target rate, Fed leaders expressed concerns that rising prices often lag economic recoveries, as well as that keeping rates at or near zero for an extended period of time encouraged excessive risk and instability in the financial system and left the Fed with limited monetary policy tools to make future adjustments.
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