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combination of lower economic activity and deflation. This is the classic account by
Friedman and Schwartz (1963) of how the widespread bank failures in the United
States deepened the Great Depression.
However, such a model, at least as conventionally elaborated, cannot explain
why the recent problems of the financial sector should have caused a sharp recession,
sion, for the Friedman–Schwartz story depends on the monetary base remaining
fixed despite a collapse of the money multiplier. But under contemporary instixed
tutional arrangements, the Fed automatically adjusts the supply of base money as
necessary to maintain its target for the federal funds interest rate; thus, any change
in the money multiplier due to a banking crisis should automatically be offset by a
corresponding increase in the monetary base, neutralizing any effect on interest
rates, inflation, or output.1
Moreover, many of the institutions whose failure or near-failure appeared to
do the most damage in the recent crisis, such as Lehman Brothers, did not issue
liabilities that would c...
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