Question

1.) M2 declined by almost 30% over the period 1929 - 1933 (the first part of the Great Depression). Explain why this happened. What could the Federal Reserve have done, but did not do, to prevent this from occurring.

2.) The U.S. government and Federal Reserve engaged in very unconventional fiscal and monetary policies in response to the financial crisis. With the knowledge you have so far, do you think intervention was a good idea or not? Explain.

Answer 1

1. The ‘M2’ measure of money supply is defined as the money supply which includes all cash deposits, cheque deposits and also other time deposits and money market securities. It is defined as:

M2=M1+ ‘Near Money’ which includes short term deposits and 1-day maturity money market funds.

It is clear from the formula that M2 depends on M1 directly where a fall in M1 with a constant ‘near money’ value will lead to a fall in M2. During the nascent stages of “The Great Depression”, in fact a little before it, there was a speculative bubble in the US stock market. This meant that the price of assets were much higher than their built-in values. In an attempt to blow this speculative bubble, the Federal Reserve started pursuing a very tight monetary policy. As a result, the amount of money in circulation faced a steep drop and M1 which is the most liquid form of money, started falling. Additionally, many rational citizens started withdrawing their deposits from banks and the “near money” component also started falling and the banks in turn started holding excess reserves. This act reduced the money multiplier so much that the money supply started falling. This is why M2 had fallen.

The Federal Reserve realized much later that its tight monetary policy through the sale of government securities was backfiring at some point. However, they couldn’t retreat and get this corrected. The Federal Reserve, instead of bursting the speculative bubble through tightening the monetary policy could’ve prevented the money supply from falling. The Fed went on tightening monetary policy so much so that both citizens and banks started holding cash on their own and neither did deposit them nor did loan them out. It was the Fed’s duty to make them ‘create funds’ or stimulate ‘credit creation’. Since the Fed didn’t do this, the Great Depression took a worse turn. Increasing the money supply later on couldn’t undo the damage.

2. In the real world, government intervention in an economy is required to a certain extent. However, whether that intervention is through the correct steps or on the correct track or not actually judges whether at all the intervention was a boon or a bane. In this particular case, government intervention was probably not a good idea because of how the government intervened. Had the government taken steps to counter the speculative bubble in a way so as to not plummet the economy into depression, the response would’ve been very different.

The Fed was already controlling the money supply and started making a mess of the money supply without having a clue of the consequences. A lot of the policies undertaken by the government had gone completely wrong. In addition to banks reducing loans and raising reserves, policies like ‘check tax’ which increased taxes to ensure a balanced budget, added fuel to the fire. Also, in a situation where stimulation of production and employment was an absolute necessity, a high-wage policy backfired by making labour unaffordable and further cutting down on production.

Technically, some markets should be allowed to be guided by the market forces of demand and supply. Had there been less intervention, demand for money would’ve matched the supply of money and the situation wouldn’t have been this bad. It is in fact the inefficiency of the government and its unnecessary intervention that led to an aggravation of the crisis into “The Great Depression”. Thus, intervention was not a good idea.