Reference no: EM13183103

We explained how a central bank has an important role in maintaining confidence: "High confidence" keeps velocity growth and the money multiplier from falling. But as we've seen, sometimes one has to be cruel to be kind.

President Franklin Roosevelt followed this "tough love" approach during the Great Depression. Soon after taking office, he closed all banks for a four-day "bank holiday." During this holiday, he gave his first Fireside Chat, a radio address where he explained his policies to the American people in plain language. After the four-day holiday, he still kept one-third of all U.S. banks closed (mostly small farmer banks with one or two branches). Over the next few years, only have of this one-third eventually reopened.

Thus, FDR's bank holiday pushed the broad U.S. money supply (M1 or M2) down. Nevertheless, the economy grew quickly during FDR's first year, 1933. Why? Because FDR promised that the banks that reopened were the safest banks, and he promised that the banks that reopened were the safest banks, and he promised that the federal government would keep these safer banks open through generous discount window lending. This boosted confidence and encouraged people to borrow from and lend to the remaining banks.

As Milton Friedman and Anna Schwartz put it in their classic book A Monetary History of the United States: "The emergency revival of the banking system contributed to recovery by restoring confidence in the monetary and economic system and thereby inducing the public...to raise velocity...rather than by producing a growth in the stock of money" (p. 433).

Let's see how an emotional concept like "confidence" shows up mathematically. To keep things simple, we'll look at AD in terms of growth in nominal GDP (growth in dollar sales) rather than growth in real GDP (growth in actual output). We'll compare the "before" and "after," so we'll skip over 1933, the year of the biggest banking crisis and of FDR's solution to the crisis:

Year  M2 V

1932 $35.3billion 2.16

1934 $33.1billion 2.36

a. What was the level of nominal GDP in 1932 and 1934?

b. What was the growth of M2 between these two years?

c. What was the growth of velocity between these two years?

d. What was the growth of nominal GDP between these two years?

e. If velocity growth had been zero during this period (perhaps due to low confidence), but money growth stayed the same, what would have happened to nominal GDP growth?