Discussion Activity

Eco2 1

Discuss in some detail what the proximate cause of the severity of the Great Depression was
according to Milton Friedman.

In the point of view of Milton Friedman, the great depression was caused by the
failure of the Federal Reserve System to perform its intended duties and the implementation of
its bad monetary policies at the time of crisis. Milton Friedman emphasizes that the depression
was not triggered by the failure of the capitalists and that this was the misconception majority
of the people believed in. Instead, the great depression was intensified by a series of
recession, when the Federal Reserve system allowed the volume of money to fall slowly that
eventually dropped by 3%, which might not sound like much, but to escape depression and
difficulties, a rising economy needs extra money. This decline affected the money structure
that was followed by a bank crisis. Several banks were rapidly failing, particularly the Bank of
the United States that had experienced severe runs as their depositors suddenly wanted to
withdraw all their deposits. However, the bank were not liquid enough to provide all the cash
needed, that mere instance precipitated a panic as it lose depositor’s confidence that their
money will not be secured because of the situation. For every withdrawn cash from the banks
there was a direct effect of a decline in money of the money supply. Thus, Friedman
recognized that there was clearly a shortage of money supply during that time and the Federal
Reserve System, who was the responsible organization to exercise such power of providing
cash to the banks, have failed to do such duty. If the FED had acted otherwise, the depositors
would have stopped withdrawing their money and the depression would have not worsen. FED
failed preventing the closure of several banks that by 1933, only 2 were left opened and that
the decline of money eventually gown down by a third. As Friedman mentioned, “For every
$100 in paper money, in deposits, in cash, in currency, in existence in 1929, by the time you
got to 1933 there was only about $65, $66 left.” Furthermore, the severity of the great
depression has become worldwide because of the Federal Reserve’s noncompliance of the
gold standard. Since the international monetary system was on a gold standard, the monetary
structure of the country was supposedly tied to the amount of gold available in the vaults of the
United States. However, the Federal Reserve did not play in accordance with the rules which
affected other countries especially Britain. Hence, from Milton Friedman's point of view, the
great depression was caused or at least made even worse by perverse monetary practices
pursued by the U.S. authorities and that the proximate cause was far from being a failure of
free capitalism but rather a result of the Federal Reserve system’s decisions and by not
functioning the way they were supposed to.
Explain how this cause confirms or contradicts the cause Keynesian
Macroeconomic Model.

Clearly, Milton Friedman’s opinion regarding the cause of the great depression was a
contradiction to the popular theory of the Keynesian Macroeconomic model. According to this
theory, aggregate demand which composed of household spending, private/businesses
investment spending and especially government spending, is what makes the economy stable
and not the quantity of money. It is for the reason that if aggregate demand is high then the
economy will be strong but if it’s low then the economy will slow down as private sectors will
have unsold inventories and that would result to unemployment. If unemployment rises,
household spending would be less which would eventually slow down the economy. The
proponent of the model claimed that this what happened to the great depression and that
capitalists/private investors, that are inherently unstable, let this happened. Basically, this
theory claims that during the great depression there was a need of government intervention
through engaging in fiscal policy or the massive deficit spending because it would neutralize
the decreased expenditures in private and household sectors. However, Milton Friedman was
opposed to this, in his opinion, the depression was due to a failure of government and not of
the capitalists. Specifically, the failure of the Federal Reserve System to aid actions during
bank failures and the bad monetary policies they followed. In the first place, FED was created
to be the last resort of banks at times of crisis, but they just watched the banks closed and let
supply of money to decline. Therefore, the perspective of Milton Friedman on the cause of the
depression contradicts the Keynesian Macroeconomic model because he believed that the
“quantity of money” played a significant role in stabilizing the economy and if only the FED was
able to expand the supply of money it could have stopped the worst economic history from
occurring.

Discuss how a banking panic can create problems for a nation that has a fractional reserve
banking system.

When a banking panic happens, people who are the depositors would demand to
withdraw their money abruptly in a way that banks cannot fully sustain their collective demands
because in reality the money that they deposit were not totally locked in vaults but undergoes
the same process as to how every bank does to earn interests, pays its expenses and other
banking related activities which is to lend it. If a bank follows a fractional reserve banking
system which is to hold only a fraction of bank deposits to be converted to cash and a bank
panic happens, chances are the bank’s option is to seek assistance on the nation’s central
bank. Given with the fact that the central bank plays as the provider of the legal means of
payment and of immediate liquidity with regards to bank’s financial crisis, the central bank
would then give aid by providing cash through lending to a bank that suffers from a financial
crisis. In turn, since it will make up to a huge amount, the central bank may have the possibility
that it may lose its monetary weapons and capabilities that could affect the nation as a whole.
In the long run, it will then have major effects towards the economic activity of a nation.