ÃÂÃÂ The Early Years: Discount as Primary Tool
Changing the discount rate was the primary tool of monetary policy when the Fed was created and the Fed had not yet discovered the power of open market influencing money supply. Before WWI, the Fed had taken a passive role the utilized policy following the "real bills doctrine". However, by the end of WWI, Fed's passive policy had led to a raging inflation. As a result, Fed decided to take an active role in influencing the economy and raised the discount rate significantly in 1920, which led to a sharp recession in 1920-1921. Although the Fed was blamed from its action, in one sense the Fed was still successful since it did make the price level declined.
ÃÂÃÂ Discovery of Open Market Operations
In the early 1920, Fed accidentally discovered the use of open market operation. When the Fed was created, its revenue came exclusively from the interest it received on the discount loans.
However, by the end of the 1920s, open market became the most important weapon to the Fed.
ÃÂÃÂ The Great Depression
The stock market boomed in 1928 and 1929. In the beginning, the Fed wanted to temper the boom by raising the discount rate. However, it was reluctant to do so due to its concerns about business and individual that may have credit needs. As a result, when the Fed decided to intervene, it was too late. The stock market crashed and thus led to a recession of the economy. Many banks failed during that time.
ÃÂÃÂ War Finance and the Pegging of Interest Rates: 1942-1951
During WWII, the spending of US government increased sharply therefore the Treasury issued huge amount of debt. The Fed agreed to help the Treasury pegging the low interest rate, which result...