on financial stability – seems obvious, but this connection was not always well understood. after the stock market crash of 1929, many thought a financial and economic crisis was necessary – even desirable – to wring out speculative excesses that had built up in the 1920s. remarkably, despite the fact that the federal reserve had been founded to mitigate financial panics, the central bank made essentially no effort to prevent the wave of bank failures that paralyzed the financial system at the start of 1930s. indeed, the treasury secretary at the time, andrew mellon, believed in the tonic effects of weeding out weak banks and famously advised president herbert hoover, “ liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … it will purge the rottenness out of the system. ” 1 economists themselves have not always fully appreciated the importance of a healthy financial system for economic growth or the role of financial conditions in short - term economic dynamics. even after the depression, some economists found it useful to think of see herbert hoover ( 1952 ), the memoirs of herbert hoover, vol. 3 : the great depression, 1929 – 1941 ( new york : macmillan ), p. 30. the financial system as a “ veil, ” which helped allocate the returns to physical assets but did little to affect so - called real economic outcomes. in contrast, more recent work on the subject, to which i contributed, showed that the health of the financial system and the performance of the broader economy are closely interrelated, both in the short run and in the long run. indeed, in a historical context, some of my own research on the great depression showed that countries such as the united states that, for institutional or other reasons, suffered severe banking problems, had significantly worse depressions than countries in which the banking system was more stable, such as great britain. 2 the lesson has been learned. in the current episode, in contrast to the 1930s, policymakers around the world worked assiduously to stabilize the financial system. as a result, although the economic consequences of the financial crisis have been painfully severe, the world was spared an even worse cataclysm that could have rivaled or surpassed the great depression. that lesson brings me to the second one – policymakers must respond forcefully, creatively, and decisively to severe financial crises. early in the depression, policymakers ’ responses ran the gamut from passivity to timidity. they were insufficiently willing to challenge the orthodox

##lity of the federal funds rate in recent months reflects the extent to which daily changes in demand for reserve balances have been unusually difficult to predict. 4 specifically, depository institutions hold balances at federal reserve banks, and the federal funds rate is the overnight interest rate at which these balances are traded. see mishkin ( 2007b ) for further discussion of open market operations and other policy tools for keeping the federal funds rate close to its target. the daily effective federal funds rate is a volume - weighted average of rates on trades arranged by major brokers. tool # 2 : overnight lending through the discount window the federal reserve's second tool for supplying liquidity during a financial disruption is to provide fully collateralized overnight loans directly to commercial banks and other depository institutions, which i will refer to collectively as banks. the federal reserve extends this credit through the discount window – that is, the lending facility at each of the regional federal reserve banks. ( the phrase " discount window " harks back to the good old days when loans were provided by a human being sitting behind a bank window. ) the primary credit facility is the main program under which the federal reserve extends loans to depository institutions. 5 under this program, each loan is extended for very short terms ( usually overnight ) to a depository institution in sound financial condition, and the interest rate on such loans is referred to as the " discount rate. " since 2003, the discount rate has been set above the usual level of short - term market interest rates, and during normal times this rate has been maintained at 100 basis points ( 1 percentage point ) above the federal funds rate target. as a tool for providing liquidity to the financial system, the discount window is distinct from open market operations in two important respects. first, open market operations influence the supply of short - term funds to the market as a whole, whereas loans through the discount window are made directly to individual institutions with particular needs for liquidity. second, open market operations are conducted using u. s. treasury and agency securities, whereas loans through the discount window can be made against a much wider range of collateral. in its august 10 announcement, the federal reserve reaffirmed that it stood ready to provide liquidity not only through open market operations but also via discount lending by stating : " as always, the discount window is available as a source of funding " ( board of governors, 2007a ). by august 17, the federal reserve had determined that the significant