The general belief that markets did not work carried over to an assumption that if the Fed did not peg government bond rates, then wild, erratic swings in bond prices would destabilize the government bond market. The velocity of money would vary according to the psychology of investors. According to this view, the economy was in a liquidity trap at a low rate of interest in which the public simply accommodated changes in the quantity of money. The assumed practical irrelevance of monetary policy constituted an important component of the Keynesian consensus. Keynesians believed that any increase in private consumption would fail to counter the inevitable decline in military expenditures after the war and that the Depression would return as a result. The juxtaposition of high unemployment in the Depression and low unemployment in World War II created an intellectual consensus in favor of Keynesian ideas. Based on the experience after the Civil War and World War I, the widespread expectation existed that deflation would follow the war. Resolution replaced indecision in fall 1950 with the entry of the Chinese into the Korean War and the belief in the imminence of World War III.īoth expectations created by historical experience and the intellectual environment worked against a challenge to the Treasury.

The Fed struggled internally about whether to challenge the Treasury over its subservience. As was the case after World War I, the Treasury enforced that rate peg well after the end of the war. Just as it had in World War I, in World War II, the Fed pegged interest rates at a low level in order to facilitate the financing of government debt.

The Federal Reserve by Robert L. Hetzel