nonmonetary effects of the financial crisis in propagation of the great depression this paper examines the effects of the financial crisis of the 1930s onthe path of aggregate output during that period our approach is complementary to that of friedman and schwartz who emphasized the monetary impact of the bank failures we focus on non monetary primarily credit related aspects of the financial sector output link and consider the problems of debtors as well as those of the banking system we argue that the financial disruptions of 1930 33 reduced the efficiency of the credit allocation process and that the resulting higher cost and reduced availability of credit acted to depress aggregate demand evidence suggests that effects of this type can help explain the unusual length and depth of the great depression this abstract was borrowed from another version of this item

consequences of bank distress during the great depression the consequences of bank distress for the economy during the depression remain an area of unresolved controversy since john m keynes 1931 and irving fisher 1933 macroeconomists have argued that bank distress magnified the extent of the economic decline during the depression as the intermediaries controlling money and credit banks were in a special position to transmit their distress to other sectors but the mechanism through which banking distress mattered for the economy has been hotly contested milton friedman and anna j schwartz 1963 saw the contraction in the money multiplier driven in their view by panicked depositors withdrawals of deposits as the primary mechanism through which banking distress affected the real economy they described the mechanism transmitting banking distress to the real sector as operating at the national level through changes in the aggregate supply of money and interest rates bank distress reduced the money supply available to the public either through the closure of banks and the consequent freezing of bank deposits or the withdrawals of deposits by depositors that feared bank failure ben s bernanke 1983 building on fisher 1933 emphasized the transmission of monetary shocks via their effects on the balance sheets of borrowers and on the supply of credit by banks borrowers balance sheets were worsened by debt deflation as the result of fixed dollar debt obligations borrowers net worth and cash flow declined with the rising value of debt service costs relative to income borrowers with positive net present value projects but weak balance sheets had less internally generated retained earnings to invest and could not qualify for credit furthermore bernanke argued that the contraction of the money supply produced contraction of nominal income and prices relative to fixed debt service which weakened borrowers balance sheets and in turn weakened banks not only did firms financial distress reduce the number of qualified borrowers the contraction in banks net worth forced a reduction in the supply of bank loans to qualified borrowers many firms and individuals relied on banks for credit and as those banks suffered losses of capital due to asset value declines and contractions in deposits as depositors reacted to bank weakness by withdrawing their funds even borrowers with viable projects and strong balance sheets experienced a decrease in the effective supply of loanable funds bernanke termed the combined weakening of borrowers balance sheets and the contraction in bank credit supply a rise in the cost of credit intermediation the scarcity of perfect substitutes for the positive net present value investments of firms with weak balance sheets and for the credit supplied by existing banks implies that the weakening of firms and banks balance sheets the disappearance of banks and the contraction in surviving banks lending made it more difficult for the economy to channel funds to their best use thus what began as a contraction in aggregate demand became a contraction in aggregate supply which magnified adverse economic shocks and prolonged and deepened the depression the financial distress of firms and banks and the decline in bank lending were not only symptoms of the depression but means for magnifying the shocks that caused the depression bernanke s statistical evidence in support of this story is derived from time series analysis at the national level in calomiris graduate school of business 601 uris hall columbia university 3022 broadway new york ny 10027 and national bureau of economic research e mail cc374 columbia edu mason department of finance drexel university 3141 chestnut street philadelphia pa 19104 e mail joe mason drexel edu we thank valerie ramey david wheelock charles himmelberg steve zeldes gary gorton two referees and seminar participants at columbia university wharton northwestern university and the 2001 economic history association meetings for helpful comments on an earlier draft we gratefully acknowledge support from the national science foundation the university of illinois and the federal reserve bank of st louis

risk the financial market and macroeconomic equilibrium growing recognition of the importance of stock market phenomena to the real economy underscores the need for models linking exogenous uncertainty asset market performance and the rest of the economy in an optimizing framework without certainty equivalence this paper constructs a three agent model with continuous time stochastic variables uncertain private production and government expenditure and forward looking rational agents the growth rate of output physical capital accumulation financial asset returns and uncertain inflation are determined as functions of the exogenous uncertainty in the economy analysis of the model finds that increased risk associated with government policy often reverses in an explainable way the conventional comparative static predictions of nonstochastic macro models

forward rate target zones and exchange rate dynamics abstract a target zone for the forward exchange rate is developed using a log linear monetary model exchange rates are driven by a wiener process a central bank purchases or sells foreign exchange forward to keep the target forward rate in a specified band defending such a target zone does not require regulated wiener process for the central bank s forward exchange intervention can avoid disturbing the money supply a forward rate target zone can stabilize the spot rate against a free float and its stabilizing effects become more significant if the delivery term applying to the target forward rate is shorter

bond covenants and delegated monitoring this paper examines alternative contracting arrangements available to a firm seeking to finance an investment project the authors consider the choice between loan contracts with covenants based on noisy indicators of the firm s financial health and loan contracts enforced by a monitoring specialist in one interpretation the specialist is a financial intermediary the firm s choice is shown to depend upon the firm s credit rating the accuracy of financial indicators of the firm s condition the loss from premature liquidation of the firm s project and the cost of monitoring

exchange risk political risk and macroeconomic equilibrium with the advent of increased exchange rate flexibility the role of policy and the transmission of economic disturbances under flexible rates have become topics of considerable interest j marcus fleming 1962 and robert mundell 1963 in their early analysis of the theory of policy in open economies emphasized the importance of the degree of capital mobility subsequently a number of authors have analyzed the implication of the degree of capital mobility for exchange rate and income determination in open economies see for example pentti kouri and michael porter 1974 william branson 1975 1979 lance girton and dale henderson 1976 and turnovsky 1976 the polar case of perfect capital mobility has received most attention capital is perfectly mobile when investors consider domestic bonds denominated in domestic currency and foreign bonds denominated in foreign currency to be perfect substitutes two factors may cause perfect substitutability to break down one is exchange risk the values of the two bonds are defined in terms of different currencies and the exchange rate at the date of maturation is uncertain the second is default risk investors may perceive that foreign bonds are more subject to the risk of default than are domestic bonds for one thing in the event of default the investor must pursue his claim through a foreign legal system which is likely to be costly robert aliber 1973 terms differences in default risk arising from the foreignness of assets as political risk where domestic and foreign securities are assumed to be only imperfect substitutes it is important to distinguish the degree of imperfection due to each of these sources of risk while this distinction has been noted in optimal portfolio models developed by authors such as kouri 1976 and michael alder and bernard dumas 1977 it has not been brought out in the current macro literature the objective of the present paper is to investigate the macroeconomic consequences of this distinction and to show how it may be crucial in assessing the effects of various macroeconomic disturbances under varying degrees of capital mobility we find that well known results about the effects of increased capital mobility on the efficacy of monetary policy are correct when the increased mobility is due to a reduction in exchange risk but not necessarily so when it is due to a reduction in default risk section i formulates a general equilibrium macroeconomic model which embodies the distinction between these two sources of risk we assume that the economy is small so that it treats certain characteristics of the foreign economy as parametric section ii carries out certain comparative static exercises with this model specifically it considers some important relationships between the available policy instruments and endogenous variables and shows how these are affected by the degree of capital mobility in the two senses in which this term is defined in particular we show that as long as there is a possibility of default there exists an independent role for forward market intervention in the limiting case of no default risk yale university and university of illinois respectively see peter kenen 1965 for an early analysis of the forward market incorporating potential default political risk may derive from the threat of exchange controls as well as from the threat of outright debt repudiation in either case the risk may not be the loss of the total net worth of the investment when the threat derives from exchange controls the expected value of net worth may even be preserved but if payment is delayed forward cover obtained for the investment will no longer be appropriate for our purposes it is the risk that repayment not occur on the date for which the forward cover is arranged thereby exposing the investor to exchange risk that is relevant our analysis could easily be modified to incorporate a preservation of some or all net worth in the event of default see eaton and mark gersovitz 1981 for a model in which the probability of default is endogenous

deposit insurance regulation and moral hazard in the thrift industry evidence from the 1930 s this paper compares risk taking of insured and uninsured thrifts operating under strict and less strict regulatory regimes during the 1930 s analysis of balance sheet data indicates that while newly insured thrifts undertook less risk than their uninsured counterparts possibly because of screening by deposit insurance authorities moral hazard emerged gradually insured institutions operating under relatively permissive regulatory regimes were more prone to undertake risky lending activities than their more tightly regulated counterparts possibly because of screening by deposit insurance authorities moral hazard emerged gradually insured institutions operating under relatively premissive regulatory regimes were more prone to undertake risky lending activities than their more tightly regulated counterparts given the current system of deposit insurance the results suggest that effective regulation and supervision will play a key role in maintaining thrift stability in the 1990s copyright 1992 by american economic association

on the theory of effective demand under stochastic rationing abstract the concept of effective demand under stochastic manipulable quantity rationing is shown to be compatible with the existence of nontrivial equilibrium it is argued that stochastic rationing is unavoidable for any satisfactory definition of effective demand moreover manipulability of the rationing mechanism is necessary for reasons of logical consistency at least if the distribution over realisations for each agent depends on his own action and on the aggregate values of demand and supply only in that case anonymous stochastic rationing schemes reduce to those random functions the mean value function of which is the uniform proportional rationing mechanism

evidence of bank market discipline in subordinated debenture yields 1983 1991 we examine debenture yields over the period 1983 1991 to evaluate the market s sensitivity to bank specific risks and conclude that investors have rationally reflected changes in the government s policy toward absorbing private losses in the event of a bank failure although this evidence does not establish that market discipline can effectively control banking firms it soundly rejects the hypothesis that investors cannot rationally differentiate among the risks undertaken by the major u s banking firms an increasingly important issue in the regulation of financial institutions concerns the extent to which market investors can will recognize and control the risks of banking firms although the banking act of 1933 replaced some private risk bearing with federal deposit insurance legislators were reluctant to displace market discipline very extensively flood 1992 by the early 1980s however u s regulators had come to protect virtually all bank liability holders from credit losses most visibly at large banks which were deemed too big to fail sprague 1986 o hara and shaw 1990 this extension of the government safety net largely reflects a skepticism on the part of regulators that normal market forces could adequately identify and control bank risks while u s regulators have recently shown an increased willingness to let some bank investors bear default losses an official suspicion of the efficacy of market discipline remains widespread by contrast some prominent academic economists argue that market investors in bank debentures could provide timely and effective control over banking firms risk exposures and that the social cost of supervising banks would be lower if regulators ceded greater

international trade and exchange rate volatility for currencies with well developed forward markets several papers have investigated the conjectured negative relationship between trade and short term exchange rate volatility without being very successful a theoretical explanation for the empirical anomalies is provided by solving explicitly for the forward rate because importers and exporters are on opposite sides of the forward market so is their exposure towards exchange rate volatility moreover which trade flow benefits and which one loses from increased volatility is determined by the signs of the aggregate net foreign currency exposure and the aggregate measure of risk aversion

the currency denomination of long term debt in the canadian corporate sector an empirical analysis abstract a portfolio model explaining the allocation of long term debt between canadian dollar and us dollar denominated bonds is proposed and implemented the role of anticipated exchange rate changes and the specification of the adjustment process is emphasized the empirical results are consistent with the hypothesis that corporations alter their pattern of debt outstanding to issue more liabilities with the lower expected service cost these results are consistent with imperfect substitutability between canadian and us dollar denominated long term bonds the results also indicate significant difficulties inherent in estimating portfolio models of the issue of corporate bonds

using market information in prudential bank supervision a review of the u s empirical evidence in principle market and government supervision provide alternative devices for controlling governing any type of corporation most national governments have instituted nonmarket regulatory mechanisms for banking firms on the grounds that market based mechanisms do not adequately discipline banks but what evidence supports this assessment why must governments assure bank solvency but not the solvency of other firms government oversight naturally displaces private efforts to evaluate and control financial firms moreover if the banking business changes over time as it assuredly has in the past decade or two the best combination of government and private supervision may change concurrently this paper reviews and evaluates the growing empirical literature on private investors abilities to assess the financial condition of banking firms the evidence supports the proposition that market investors and analysts could reasonably provide a greater proportion of corporate governance services for large traded u s financial firms

spot and forward rates in a stochastic model of the foreign exchange market abstract in this paper we develop a simultaneous stochastic model of spot and forward exchange rate determination under rational expectations for spot rates we find that increases in speculative responsiveness dampen the effects of trade balance shocks but exacerbate effects of interest rate shocks for forward rates though increases in speculative responsiveness dampen the effects of both trade balance and interest rate shocks the bias of the forward forecast error decreases as specualtive responsiveness increases but the expected squared error may increase

which banks choose deposit insurance evidence of adverse selection and moral hazard in a voluntary insurance system this article investigates adverse selection and moral hazard in the voluntary deposit insurance system of kansas which operated from 1909 to 1929 regulations were imposed to limit risk taking and membership was made voluntary to assuage objections that insurance forces conservative banks to protect depositors of high risk institutions the authors find however that risk prone banks were the most likely to join the system at its inception using a simultaneous equations model they also detect both adverse selection and moral hazard behavior throughout the system s first ten years copyright 1995 by ohio state university press

real estate prices and bank stability abstract real estate prices can deviate from their fundamental value due to rigid supply heterogeneity in quality and various market imperfections which have two contrasting effects on bank stability higher prices increase the value of collateral and net wealth of borrowers and thus reduce the likelihood of credit defaults in contrast persistent deviations from fundamentals may foster the adverse selection of increasingly risky creditors by banks seeking to expand their loan portfolios which increases bank distress probabilities we test these hypotheses using unique data on real estate markets and banks in germany house price deviations contribute to bank instability but nominal house price developments do not this finding corroborates the importance of deviations from the fundamental value of real estate rather than just price levels or changes alone when assessing bank stability

the effect of forward exchange on spot rate volatility under risk and rational expectations abstract this paper presents a multiperiod rational expectations model of a foreign exchange market in order to analyze the effect of introducing currency forward trading on measures of exchange rate volatility based on an optimizing approach to risk average agents it highlights how commercial traders and interest arbitrageurs behave facing exchange risk and forward contracting opportunities it is found that forward trading tends to stabilize spot exchange rates if the trade disturbance is the predominant random factor in the market while it exacerbates spot rate variability if the disturbance in the interest rate differential is the chief stochastic element

does bank opacity affect lending abstract examining a sample of bank holding companies in the united states we find that opacity has a negative effect on bank loan growth this effect is more pronounced for banks that are more reliant on wholesale funds a further analysis of the relationship between opacity and wholesale funds confirms our hypothesis that opacity negatively affects lending via a wholesale funding channel moreover our results suggest that the negative effect of opacity on lending is less pronounced for banks with stronger capitalization we also show that this effect was stronger during the 2007 2009 financial crisis and is mitigated by a high gdp growth rate indicating that a strong weak macroeconomic condition tends to mitigate aggravate such an effect

valuation and systemic risk consequences of bank opacity abstract we examine the effects of opacity on bank valuation and synchronicity in bank equity returns over the years 2000 2006 prior to the 2007 financial crisis as expected investments in opaque assets are more profitable than investments in transparent assets and taking profitability into account have larger valuation discounts relative to transparent assets the valuation discounts on opaque asset investments decline over the 2000 2006 period only to be followed by a sharp reversal in 2007 the decline is coincident with a rise in bank equity share prices decrease in transparent asset holdings by banks and greater return synchronicity evidence consistent with a feedback effect

the paradox of liquidity the more liquid a firm s assets the greater their value in a short notice liquidation it is generally thought that a firm should find it easier to raise external finance against more liquid assets this paper focuses on the dark side of liquidity greater asset liquidity reduces the firm s ability to commit to a specific course of action as a result greater asset liquidity can in some circumstances reduce the firm s capacity to raise external finance firms with excessively liquid assets are in the best position to finance illiquid projects this leads us to a theory of financial intermediation and disintermediation based on the liquidity of assets

the behavior of an open economy firm under flexible exchange rates most proponents and opponents of floating believe that greater variability of foreign exchange rates will increase uncertainty in international transactions and hence that the volume of international trade and financial flows will be curtailed without well developed facilities for hedging against exchange uncertainty the effects of exchange risk on merchant exporters and importers have been studied by some authors under the assumption of fixed production ethier 1973 clark 1973 hodder 1977 etc others have investigated the production behaviour of an export firm in a static context see for example baron 1976a b however the impact of the greater volatility of exchange rates upon domestic employment and capital accumulation on the one hand and upon international financial transactions on the other has received scant attention in the literature this paper establishes a dynamic model of a small competitive firm which is engaged in domestic production foreign trade through exports of its products and or imports of its inputs and financial transactions in domestic and foreign currencies since the firm faces uncertainty about future exchange rates and future prices of outputs and inputs it attempts to hedge against the risk if it is risk averse a forward foreign exchange market is assumed to exist the firm s decisions on production investment forward contracting and financing which are closely related in the model are based on exogenously given probability distributions of exchange rates and prices the paper is planned as follows section i presents a model of the firm and formulates its objective function and constraints section ii solves its maximization problem and interprets the first order conditions for short run equilibrium in particular three different roles of the firm in the forward exchange or financial market are emphasized pure hedging speculative hedging and pure speculation section iii analyses the dynamic behaviour of a typical open economy firm section iv conducts comparative dynamic exercises of the firm in a long run steady state equilibrium and discusses how exchange rate uncertainty affects the firm s optimal decisions the implications of the purchasing power parity condition are also developed section v summarizes our conclusions