lecture21_312_Banks&Finance_SP11_overheads

lecture21_312_Banks&Finance_SP11_overheads -...

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Lecture #21 April 13, 2011 Financial Capital and the push for a central bank. There is no class on Monday, April 18. I have fallen behind on the reading list again. I am not going to lecture on WWI. But I would like you to look at that material, Hughes ch. 22 and 23. Next week we will start in on the Great Contraction, Hughes ch. 24 and Atack, ch. 21.
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The motivation underlying the creation of the Federal Reserve System in December 1913, was to create a “lender of last resort.” That is, in times of financial crisis, the Federal Reserve Board was supposed to lend liquid assets to the banking system by buying up the bank’s loans (assets) at the par value of the loans, rather than the depreciated market value. By doing so, the Fed would both inject liquidity into the banking system at a time when liquidity was needed, and stem the collapse in bond prices (rise in interest rates) caused by banks dumping their loans in the financial markets in an attempt to raise liquidity. We will see later that designing a central bank that would perform this function wasn’t easy given the dynamics of American politics. But the pressure to address the problem of financial panics was increasing because of the increasing integration of the financial system.
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The financial system had been growing in complexity throughout the 19 th century. In the 1850s and with increasing rapidity after the Civil War, the needs of railroads for large amounts of capital produced changes in financial markets, particularly in the “stock markets.” Before the 1850s, the primary financial instruments traded in financial markets were: Government bonds: - National government bonds, bills, and notes - State and local government bonds Stock of public utilities: - water companies - later power companies Stocks of Financial companies: - Banks - Insurance companies Very few stocks of manufacturing companies traded on the stock exchanges, well into the 19 th century.
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The railroad, as we have seen, required lots of capital. At first, railroads raised capital by issuing bonds, but railroads increasingly began to issue stock to raise money. Because, as we have seen, railroads were plagued by competitive price instability, there was a strong incentives to increase the size of railroads through mergers. These mergers were increasingly financed through the stock market, either by issuing bonds or stocks. “Investment bankers,” the most famous of whom was J.P. Morgan, arose who were capable of putting together these very large financial deals (for a share of the deal, usually a commission on the stocks and bonds issued).
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Commercial banks dealt in short term commercial paper, bills of exchange. The banking system was the market for bills of exchange, and in
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lecture21_312_Banks&Finance_SP11_overheads -...

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