the Fed today-- with applications to the Great Depression

I sure don't plan to blog on Fed policy very often! From social gatherings, I might infer that people are fascinated by the topic, since I'm often asked about interest rates when they find out I'm an economist. But I think that's less about their fascination than their ignorance about the (fascinating) range of what economists look at.

All that said: recent events, along with my recent post on the causes of the (length and depth of the) Great Depression, make a blog entry relevant.

An AP story this morning described the Fed "injecting billions of dollars into the banking system to calm markets" worried about the housing credit market. This activity is in stark contrast to the Fed of the 1930s which did little or nothing to deal with the fears/panic induced by the events early in that decade.

The "money supply" is a function of the monetary base and the money multiplier. The money multiplier is determined by the amount of activity in the market for credit-- as money is moved from an inactive state (e.g., reserves in a bank) to an active state (as reserves are loaned out). Greater activity in the credit market "multiplies" the effectiveness of that money. "Active" money generates economic activity as the money goes from passively sitting somewhere to being used to purchase goods/services by consumers or capital expenditures by businesses.

When the money multiplier falls (typically, because of a significant drop in confidence), the impact can be offset in the short-term by a publicly-advertised infusion to the monetary base. At least on paper, once the confidence has been restored, the money multiplier would return to normal and the Fed could return the monetary base to normal as well.

This is the same thing that happened with the stock market crash in 1987-- a fall as precipitous as the more famous 1929 crash. The 1987 crash did not lead to a Great Depression or even a recession. This points to the potential effectiveness of the Fed (at least in a crisis) and again, the fact that the causes of the Great Depression must extend far beyond a stock market crash.