One of the most important aspects of the Great Depression that stands out in economists’ minds is the surge of bank panics and failures during the depression’s onset (1930-1933). However, an institution created with the intention of preventing such a string of disasters failed to fulfill its obligation as a “lender of last resort.” This is the Fed, and its failure to prevent the early bank panics of the Great Depression is a very interesting economic issue. So why did the Fed fail to fulfill its duty? The reason for the Fed’s actions (or lack thereof) was a combination of the strict elitist leadership in the Fed and the results of adaptive expectations on immature monetary policy.
The Fed had only been created in 1913, and while there were previous experiences with bank panics (1907), the consequences were much less drastic, and so the elitists were unable to foresee the heavy blow to the money supply that would result from the failure of so many small banks. In 1907 the money stock fell by 5% due to bank panics; the Fed had no idea that bank panics would strongly contribute to the 31% decrease in the money supply by 1933(Friedman 156). While it may seem obvious that this might occur when 10,000 banks close, most of the banks that closed were non-members, and since these banks felt the opportunity cost of keeping reserves with the Fed was too great, the Fed returned the sentiment by denying them aid when they closed. Also, many of these banks were very small, and the Fed did not expect these small banks to have such a large effect on the money supply (Friedman).
All this is supported by the writings of Milton Friedman, Charles W. Calomaris and Richard H. Timberlak...
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...ey were its responsibility. According to Friedman, they saw panics as a result, and not a cause of the depression. The Fed did not know what its responsibilities were, and as a result failed to see the connection between the public’s confidence, banks and the money supply. While the Fed’s monetary policies blew up in their face, it did present them with the undeniable need for deposit insurance. Ultimately the Great Depression shocked the Fed into reality, and because of this future depressions will be averted.
Calomiris, Charles W. “Runs on Banks and the Lessons of the Great Depression” Regulation 22.1: 4-7
Friedman, Milton, and Schwartz, Anna. A Monetary History of the United States 1867-1960. Princeton , N.J.: Princeton University Press. 1963
Timberlake, Richard H. “The Roots of the Great Depression.” (Interview) Navigator. (2001).
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