Bernanke Lecture 2 Study Guide: The Federal Reserve after World War II

1. What are the two basic missions of a central bank?

1. Macroeconomic stability- use monetary policy to strive and aim for low and stable
inflation
2. Financial stability- central banks try to ensure that the nations financial system
functions properly; tries to prevent or mitigate financial panics or crises

2. How did the US finance WWII and what was the Feds role?
- Fed was pressed by the treasury to keep longer-term interest rates low to allow the government
debt accrued during the war to be financed more cheaply

3. How are low interest rates detrimental to an already strongly growing economy?
-Keeping interest rates low even as the economy was growing strongly risked economic
overheating and inflation

4. What is the Fed Treasury Accord of 1951?
-The Treasury agreed to end the arrangement and let the Fed set interest rates independently as
needed to achieve economic stability
-Fed has remained independent since 1951, conduction monetary policy to foster economic
stability without responding to short-term political pressures

5. Who said inflation is a thief in the night and if we dont act promptly and decisively we will
always be behind?
-William McC. Martin- Chairman of the Fed from 1951-1970

6. What is a Lean Against the Wind Monetary Policy?
-During most of the 1950s and earl 1960s, the Federal Reserve followed this policy that sought
to keep both inflation and economic growth reasonably stable

7. What was a big problem for the US in the 1960s and 70s?
-Starting in the mid-1960s, monetary policy was too easy
-This stance led to a surge in inflation and inflation expectations
-Inflation peaked at about 13%
-Exacerbating factors included: oil and food price shocks, fiscal policies that stretched economic
capacity

8. Who said inflation is always and everywhere a monetary phenomenon?
-Milton Friedman

9. What did Chairman Paul Volcker do in 1979 to subdue double-digit inflation on the US?
-He announced a dramatic break in the way that monetary policy would operate
-The new approach to monetary policy involved high interest rates (tight money_)to slow the
economy and fight inflation.


10. What is tight money or a tight monetary policy?
-The economic condition in which credit is difficult to secure and interest rates are high

11. Why was Mr. Volckers tight money policy considered costly?
-The high interest rates , which were necessary to bring down inflation, were having very
negative side effects on the economy and also caused a very sharp recession
12. Who was Chairman of the Fed during the period of The Great Moderation?
-Alan Greenspan (1987-2006)

13. What is a housing bubble?
-From the late 1990s until early 2006, house prices soared 130%
-Meanwhile, mortgage-lending standards deteriorated
-Rising house prices and weakening mortgage standards fed off each other: rising house prices
created an expectation that housing was a cant lost investment
-Lax underwriting and the availability of exotic mortgages drove up demand for housing, raising
prices further.

14. What is nonprime mortgage?
-As house prices rose, many lenders began to offer mortgages to less qualified borrowers, so-
called nonprime mortgages
-These mortgages required little or no down payment, and little or no documentation

15. What is sub-prime mortgage?
-Subprime mortgages were the lowest quality mortgages in terms of the credit of the borrows

16. What does it mean that a borrower has a negative equity in the home?
-Borrowers find themselves underwater, meaning that their mortgage, the amount of money
they owed, was greater than the value of their home
-Situation where the borrower in fact has negative wealth or negative equity in the home

17. What triggered the recent financial crisis?
-The decline in house prices and the mortgage losses were a trigger
-Weaknesses in the financial system that transformed what might otherwise have been a modest
recession into a much more severe crisis
-There were vulnerabilities in both the private sector of our financial system and also in the
public sector

18. What private sector and public sector vulnerabilities in the system turned the housing bust
into a financial crisis?
-Private sector:
-many borrowers and lenders took on too much debt, too much leverage because of 20
years of relatively calm economic and financial conditions, people became more
confident and willing to take on debt
-Financial contracts and transactions became more and more complex but the ability of
banks and other financial institutions to monitor and measure and manage those risks
was not keeping up
-Financial firms in a variety of contexts relied very heavily on short term funding like
commercial paper which can have a duration as short as one day or most of it is less than
90 days. They had very short-term liquid form of liability which was subject to runs in
the same way that deposits were subject to runs in the 19
th
century
-The use of exotic financial instruments, complex derivatives and so on
-Public sector:
-The financial regulatory structure had been changed a number of times and basically, It
was the same structure that had been created in the 1930s after the depression didnt
keep up with all kinds of changed in the structure of the financial system
- Many important financial firms that didnt really have any serious comprehensive
supervision by any financial regulator
-Fed made mistakes in supervision and regulation
-Didnt press hard enough on measuring risks

19. What were the four economic consequences of the crisis?
1. The stock market plunged
2. Very large decline in tech stocks
3. Home construction fell
4. Unemployment rose very sharply