I am reading "Capitalism and Freedom" by Milton Friedman. In Chapter 3, "The control of Money", Dr. Friedman explains how the Fed exacerbated the Great Depression of the 1930s. In particular:

In September 1931, Britain went off the gold standard. This act was preceded and followed by gold withdrawals from the United States. Although gold had been flowing into the United States in the prior two years, and the U.S. gold stock and the Federal Reserve gold reserve ratio were at an all time high, the Reserve System reacted vigorously and promptly to the external drain as it had not to the previous internal drain. It did so in a manner that was certain to intensify the internal financial difficulties. After more than two years of severe economic contraction, the System raised the discount rate—the rate of interest at which it stood ready to lend to member banks—more sharply than it has within so brief a period in its whole history before or since. The measure arrested the gold drain. It was also accompanied by a spectacular increase in bank failures and runs on banks. In the six months from August 1931 through January 1932, roughly one out of ten banks in existence suspended operations and total deposits in commercial banks fell by 15 per cent.

My questions are:

  1. Why would an increase in the discount rate arrest gold withdrawal by foreign individuals?
  2. Why would an increase in the discount rate decrease the amount of bank deposits made by commercial banks?
  3. Why would an increase in the discount rate make commercial banks fail?

1 Answer 1

  1. An increase in the discount rate increases the cost of borrowing for commercial banks. Their normal response would be to

    (a) Offer higher interest rates to depositors to replace loans from the Reserve System, and

    (b) Increase commercial interest rates on the loans they offer to pass on their higher costs to customers.

This makes it more attractive for individuals (including foreign ones) to deposit gold or pay back loans, together "arrest[ing] withdrawal".

  1. I'm not sure it would and couldn't find this implied in the text.

  2. Because their cost of borrowing has gone up sharply. If they can't get rid of this cost by calling in loans or attracting savings, or offset it with profits, then they'll go under. And if they quickly pass on higher interest rates to borrowing customers, this is likely to lead to bankruptcies and foreclosures, so they have to write off loans, and go under.


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