Question

5. Refer to the Bernanke lectures. Why are central banks important in the contemporary global economy? Briefly discuss the Fed’s monetary policies during the Great Depression and the Great Recession. What role did shadow banks play in generating a financial bubble?

Answer 1

Central banks, such as the Federal Reserve, are responsible for the creation and execution of monetary policy, which tends to control the volume of capital circulating in the economy and interest rate rates, by processes such as free market operations. They also influence exchange rates between the domestic and international currencies.

Interest rates affect investment levels that, in turn, determine GDP figures and the levels of economic growth. Monetary policy's key goals are to ensure sustainable rates of economic growth, sustainable jobs and market stability

Conduct by the Federal Reserve in the run-up to the Great Depression has been significant in driving the economic downturn. The speculative effects of the stock market boom in 1928-29 caused the Fed to curtail the bullish trend by raising interest rates. While this policy action dampened excessive borrowing to finance stock purchases, it also had unintended consequences. In other sectors of the economy, capital investment (e.g. for machinery and infrastructure) decreased drastically, leading to a decline in factory production and export expansion. The notorious crash of the stock exchange in October 1929 eventually put the economy to a halt and shortly thereafter, the Crisis struck in full force.

Through 1933, government policy decisions (e.g., deposit insurance provision) helped strengthen the financial system and greatly strengthened the economy in the mid-1930's. As investor trust increased, gold and other assets again started pouring into the U.S., widening the money supply. Nevertheless, Fed officials became increasingly concerned at the possibility of high inflation and rising bank reserve standards (the amount of deposits banks have to keep in reserve). Some economists say that this rise caused loans to decrease, which in turn led the money supply to decline again

By comparison, Fed policies introduced during the Great Recession of 2007-09 varied significantly from those of the Great Depression era. As the Crisis erupted, the Fed took immediate steps to stem the financial sector's failure. Similar measures included reducing the federal funds rate to virtually zero percent, and creating short-term services that lent capital to banks. The latter was particularly significant in providing the American International Group (AIG) with stopgap funding, whose failure could have plunged the financial sector into further chaos.

The Fed has also encouraged the selling of troubled investment firm Bear Stearns to a commercial bank (JPMorgan Chase) in an extension of its balance sheet. In addition, the Fed made large-scale purchases of Treasury Bonds in two rounds of quantitative easing to reduce the risk of deflation that devastated the economy during the Depression.

Shadow banks first caught the attention of many experts in turning home mortgages into securities due to their increasing role. The "securitization chain" began with the creation of a mortgage, which was then purchased and sold by one or more financial entities until it ended up part of a mortgage loan package used to back up a security sold to investors. The security premium was related to the premium of the mortgage loans in the bundle, and interest on a mortgage-backed fund was charged out of the interest and principal homeowners paying out of their mortgage loans. Nearly every step from building the mortgage to selling the security took place outside of regulators direct view