11.4 Banking and monetary policy reforms
2 min read•july 25, 2024
The U.S. banking system faced major issues before the Progressive era. Decentralization, lack of a central bank, and inelastic currency led to frequent and instability. These weaknesses eroded public trust and hindered economic growth.
The of 1913 aimed to fix these problems. It created a centralized system with 12 regional banks, standardized practices, and new monetary tools. This reform improved stability, crisis management, and economic flexibility, setting the stage for future growth.
Banking System Weaknesses and Reform
Weaknesses of pre-Progressive banking
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- Decentralized banking system lacked coordination between banks led to inconsistent practices across states
- Absence of central bank meant no limited ability to respond to financial crises
- Inelastic currency supply struggled to adjust money supply to economic needs caused seasonal fluctuations in demand
- Frequent and panics eroded in banks exacerbated by lack of deposit insurance
- Inadequate left banks undercapitalized increased vulnerability during economic downturns
- Wildcat banking allowed unregulated banks to issue own currency led to fraudulent practices and failures (Michigan, Illinois)
Provisions of Federal Reserve Act
- Established System created 12 regional Federal Reserve Banks overseen by Federal Reserve Board
- Centralized control of monetary policy enabled setting and conducting
- supply introduced Federal Reserve Notes as new national currency expanded or contracted money supply as needed
- Standardized reserve requirements imposed uniform reserve ratios for member banks improved stability and liquidity
- positioned Federal Reserve as lender of last resort provided emergency liquidity to banks
- Check clearing system streamlined processing of interbank transactions reduced costs and improved payment efficiency
Role of Federal Reserve System
- Monetary policy tools:
- Open market operations: buying/selling government securities
- Discount rate adjustments: influencing bank borrowing costs
- Reserve requirement changes: affecting banks' lending capacity
- Money supply regulation controlled monetary base influenced broader money aggregates (, )
- Lender of last resort function provided emergency loans to solvent but illiquid banks prevented systemic crises
- efforts implemented balanced inflation and employment objectives
- Financial system oversight conducted bank examinations and regulations promoted stability
- Payment system operation facilitated interbank settlements ensured smooth financial system functioning
Effectiveness of Progressive-era reforms
- Reduced frequency and severity of banking panics increased public confidence improved crisis management
- Enhanced monetary policy flexibility responded better to economic fluctuations controlled inflation/deflation
- Standardized banking practices lowered risk of failures due to mismanagement increased transparency
- Bolstered financial system resilience absorbed economic shocks improved institutional coordination
- Limitations of early reforms unable to prevent Great Depression necessitated additional measures (, )
- Long-term impact on growth created stable environment for business expansion attracted foreign investment due to credibility
Key Terms to Review (17)
Bank runs: Bank runs occur when a large number of customers withdraw their deposits simultaneously due to fears that the bank may become insolvent. This situation can lead to the bank's collapse, as banks typically keep only a fraction of deposits in reserve while lending out the rest. When confidence in the banking system erodes, these withdrawals can escalate quickly, triggering financial instability and forcing reforms in banking and monetary policies.
Countercyclical monetary policy: Countercyclical monetary policy refers to the approach taken by central banks to adjust the money supply and interest rates in order to counteract economic fluctuations. This policy aims to stimulate the economy during periods of recession by lowering interest rates and increasing money supply, while raising rates and reducing supply during periods of economic expansion to prevent overheating. This balancing act helps maintain economic stability and avoid severe booms and busts.
Discount window lending: Discount window lending refers to the financial mechanism through which central banks provide loans to commercial banks, allowing them to meet short-term liquidity needs. This tool is essential in maintaining stability within the banking system, especially during periods of financial stress, as it enables banks to borrow funds at a specified interest rate, known as the discount rate, from the central bank. By facilitating access to liquidity, discount window lending helps prevent bank runs and supports overall monetary policy objectives.
Economic stabilization: Economic stabilization refers to the efforts and policies implemented by governments and central banks to minimize fluctuations in the economy, particularly those related to inflation and unemployment. These measures aim to create a stable economic environment that encourages growth and development by smoothing out the business cycle, reducing volatility, and ensuring that economic indicators remain within desirable limits.
Elastic Currency: Elastic currency refers to a monetary system that can expand or contract in response to changes in the economy's needs. This flexibility allows for the adjustment of money supply based on factors such as economic growth, inflation, and demand for cash. The concept is crucial in ensuring stability in banking and monetary policy reforms, as it helps to prevent issues like deflation or excessive inflation.
FDIC: The Federal Deposit Insurance Corporation (FDIC) is a U.S. government agency created in 1933 to provide insurance for bank deposits, protecting depositors against bank failures. The establishment of the FDIC aimed to restore public confidence in the banking system during the Great Depression, ensuring that even if a bank failed, customers would not lose their savings.
Federal Reserve: The Federal Reserve, often referred to as the Fed, is the central banking system of the United States, established in 1913 to provide the country with a safe, flexible, and stable monetary and financial system. It plays a crucial role in regulating the economy by controlling monetary policy, supervising and regulating banks, maintaining financial stability, and providing banking services to the federal government and financial institutions. The Fed’s actions influence interest rates, inflation, and overall economic growth.
Federal Reserve Act: The Federal Reserve Act, enacted in 1913, established the Federal Reserve System as the central banking authority of the United States. This act aimed to create a safer and more flexible financial system by providing a means for banks to maintain reserve balances and regulating monetary policy through the control of interest rates and money supply.
Glass-Steagall Act: The Glass-Steagall Act was a landmark piece of legislation passed in 1933 that aimed to separate commercial banking from investment banking in the United States. Its primary purpose was to restore public confidence in the banking system after the Great Depression by preventing banks from engaging in high-risk investment activities that could jeopardize depositors' funds.
Interest rates: Interest rates represent the cost of borrowing money or the return on savings, expressed as a percentage of the principal amount. They are crucial in influencing economic activities, such as consumer spending, business investment, and inflation, and play a significant role in monetary policy and financial markets.
Lender of last resort: A lender of last resort is a financial institution, usually a central bank, that provides loans to banks or other financial institutions facing short-term liquidity problems. This function is crucial during times of financial crisis when institutions may face insolvency due to sudden withdrawals or lack of access to other funding sources. The role of a lender of last resort helps to stabilize the financial system and prevent bank runs, ensuring that banks can meet their obligations and continue operations.
M1: M1 is a measure of the money supply that includes the most liquid forms of money, such as physical currency, demand deposits, and other liquid assets that can quickly be converted into cash. This measure is crucial for understanding the availability of money in an economy and plays a significant role in monetary policy and banking reforms.
M2: M2 is a measure of the money supply that includes cash, checking deposits, and easily convertible near money. It expands on M1 by adding savings accounts, time deposits, and other liquid assets, reflecting a broader view of available money in an economy. This measure is crucial in understanding banking reforms and monetary policies, as it helps to gauge the potential inflationary pressures and the effectiveness of monetary policy strategies.
Open Market Operations: Open market operations refer to the buying and selling of government securities by a central bank to regulate the money supply and influence interest rates. This monetary policy tool helps central banks achieve their macroeconomic objectives, such as controlling inflation, managing employment levels, and stabilizing the economy during various financial conditions.
Panics: Panics are sudden, widespread financial crises characterized by a loss of confidence among investors and the public, often leading to bank runs, stock market crashes, and significant economic downturns. These events typically occur when there is uncertainty regarding the stability of financial institutions or the overall economy, prompting individuals and businesses to withdraw their funds or sell off assets en masse. The impact of panics can be severe, influencing banking practices and monetary policy reforms aimed at preventing future crises.
Public confidence: Public confidence refers to the trust and assurance that individuals and businesses have in the stability and reliability of financial institutions, government policies, and the economy as a whole. High levels of public confidence are crucial for economic growth, as they encourage spending, investment, and participation in financial systems. When public confidence is shaken, it can lead to reduced economic activity and crises.
Reserve Requirements: Reserve requirements are the minimum amounts of reserves that banks must hold against customer deposits, set by the central bank. This policy tool is critical for regulating the money supply and ensuring the stability of the banking system, as it helps prevent banks from lending out too much money, which could lead to financial instability.