108
C H A PT E R 5 Policy Makers and the Money Supply
goals by formulating monetary policy. It uses its powers to regulate the growth of the money
supply and, thus, infl uence interest rates and the availability of loans.
The principal responsibilities of these policy makers have not always been the same.
When the Fed was established in 1913, most of the power to regulate money and credit was
placed in its hands. However, as the public debt grew during World War I, the Great Depres-
sion of the 1930s, and World War II, the Treasury became vitally
interested in credit condi-
tions. Policies that aff ect interest rates and the size of the money supply aff ect the Treasury
directly, since it is the largest borrower in the nation. Therefore, the U.S. Treasury took over
primary responsibility for managing the federal debt. In managing the large public debt and
various trust funds placed under its jurisdiction, the Treasury has the power to infl uence the
money market materially. The Fed came back into its own in the 1950s and is now the chief
architect of monetary policy.
It should not be surprising that the policy instruments of the various policy makers
at times put them at cross purposes. A long-standing debate
continues over the balance
between full employment and price stability. A particular policy that leads toward one may
make the other more diffi
cult to achieve, yet each objective has its supporters. As with
all governmental policy, economic objectives are necessarily subject to compromise and
trade-off s.
Government Reaction to the Perfect Financial Storm
CRISIS
As we briefl y discussed in earlier chapters, a “perfect fi nancial storm”
developed in
the midst of the 2007–08 fi nancial crisis and 2008–09 Great Recession. In 2008, the U.S.
economy was on the verge of fi nancial collapse. The housing price “bubble” burst in 2006 and
home prices began a sharp and prolonged decline. Stock market prices peaked in 2007 and
fell sharply until mid-2009. The economy began slowing in 2007, with economic contraction
beginning in early 2008. The resulting 2008–09 recession turned out to be the steepest U.S.
recession since the Great Depression of the 1930s. Individuals were defaulting on their home
mortgages in increasing numbers due to falling home prices and increasing unemployment.
Business fi rms and fi nancial institutions, who had borrowed heavily during years of easy
money and low interest rates, were faced with their own fi nancial diffi
culties as economic
activity slowed markedly. Many of the debt securities issued and backed by home mortgage
loans, called mortgage-backed securities, became diffi
cult to value
and quickly became known
as “troubled” or “toxic” assets.
Many major fi nancial institutions and business corporations were on the verge of col-
lapse or failure. Some of the very largest fi nancial institutions were deemed as being “too big
to fail” because their failure would cause cascading negative repercussions throughout the
United States and many foreign economies. As discussed in Chapter 4, the Federal Reserve
moved to increase liquidity in the monetary system and reduced its target federal funds rate
to below the .25 percent level. The Fed also worked with the U.S. Treasury to help facilitate
the merging of fi nancially weak institutions with those that were fi nancially stronger. For
example, in March 2008, the Fed and Treasury assisted in the acquisition of Bear Sterns by
JPMorgan Chase & Co.
The Federal National Mortgage Association (Fannie Mae) and the Federal Home
Mortgage Association (Freddie Mac), briefl y discussed in Chapter 4
as being major par-
ticipants in the secondary mortgage markets, were on the verge of fi nancial insolvency
and possible collapse in mid-2008. Fannie Mae was actively creating and packaging
mortgage-backed securities, many of which became troubled assets as home owners
began defaulting on the underlying mortgages. Freddie Mac purchased home mortgages,
including lower-quality subprime mortgages, attempting to support the mortgage markets
and home ownership. In
an attempt to avoid a meltdown, the Fed provided rescue funds
in July 2008 and the U.S. government assumed control of both Fannie Mae and Freddie
Mac in September 2008.
In addition to the eff orts of the Fed and the Treasury, the U.S. Congress and the president
responded with the passage of the
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