Policy makers did not stand idly by as the financial markets and the economy unraveled. There are questions, though, about the appropriateness and magnitude of their responses. Monetary policy, determined and conducted then, as now, by the Federal Reserve, became restrictive early in 1928, as Federal Reserve officials grew increasingly concerned about the rapid pace of credit expansion, some of which was fueling stock market speculation. This policy stance essentially was maintained until the stock market Crash.
While there has been much criticism of Federal Reserve policy in the Depression, its initial reaction to the October 1929 drop in stock values appears fully appropriate. Between October 1929 and February 1930, the discount rate was reduced from 6 to 4 percent. The money supply jumped in the immediate aftermath of the Crash, as commercial banks in New York made loans to securities brokers and dealers in volume. Such funding satisfied the heightened liquidity demands of nonfinancial corporations and others that had been financing broker-dealers prior to the Crash and, of course, it helped securities firms maintain normal activities and positions.
The increase in required reserves, which necessarily accompanied the bulge in the money supply resulting from the surge in bank lending to securities firms, was met in part by sizable open market purchases of U.S. government securities by the New York Federal Reserve Bank and by discount window borrowing by New York commercial banks. According to a senior official of the New York Fed at the time, that bank kept its "discount window wide open and let it be known that member banks might borrow freely to establish the reserves required against the large increase in deposits resulting from the taking over of loans called by others." As a consequence, the sharp run-up in short-term interest rates that had characterized previous financial crises was avoided in this case. Money market rates generally declined in the first few months following October 1929.
By the spring of 1930, however, the distinctly easier monetary policy that had characterized the Federal Reserve's response to the stock market decline ended. Subsequent policy is more difficult to describe concisely. Open market purchases of government securities became very modest until large purchases were made in 1932. Further, although the discount rate was reduced between March 1930 and September 1931, it then was raised on two occasions late that year before falling back once again in 1932.
While the direction of monetary policy was somewhat ambiguous over this period, what happened in financial markets was not. Three severe banking panics...