Question

How did Federal Reserve policy during the Great Depression cause the failure of banks?

Group of answer choices

a) The Fed followed an expansionary policy during the Great Depression, which caused inflation and higher nominal interest rates. Banks were not able to afford the higher rates that needed to be paid on deposits.

b) The Fed imposed stringent reserve requirements on banks, causing them to become illiquid.

c) The Fed followed a contractionary policy, causing real interest rates to become high. Consequently, banks that were still holding Treasury bonds issued at an earlier time and with lower rates were not able to keep up with their competitors.

d) The Fed followed a contractionary policy which increased the value of the dollar in international currency markets. Consequently, export-oriented manufacturers were unable to repay their bank loans.

e) The Fed followed a contractionary policy which caused deflation. Consequently, farmers were unable to repay their agricultural loans, and banks were not able to recover the loan amount through a farm foreclosure.

Answer 1

The Federal Reserve's contractionary policies during the Great Depression resulted in deflation and increased the real burden of debt, leading to widespread bank failures, particularly due to defaults on agricultural loans. High reserve requirements further exacerbated banks' liquidity issues, contributing to an era of significant financial instability.

Step-by-step explanation:

The Federal Reserve's policies during the Great Depression contributed to the failure of banks primarily due to a contractionary policy that led to deflation and high real interest rates. While the answer to the student's question is (e), we can explore the impacts of these policies further. By increasing reserve requirements and following contractionary policies, which consisted of raising interest rates and reducing the money supply, the Fed inadvertently made the economic situation worse. This resulted in a decrease in the amount of money available for banks to lend, which subsequently reduced their profits.

Furthermore, as the value of the dollar increased, deflation set in, meaning the price level of goods and services fell. Farmers, who were already suffering from dropping crop prices, found their debts harder to repay because the value of their debts effectively increased. Consequently, banks experienced a wave of defaults, particularly agricultural loans, which hurt their balance sheets. This, coupled with widespread bank runs due to a lack of confidence in the banking system, led to widespread bank failures. It wasn't until later reforms, such as the establishment of the Federal Deposit Insurance Corporation (FDIC), that more robust safeguards against such bank failures were put in place.