Federal Reserve System

views updated May 08 2018


FEDERAL RESERVE SYSTEM. On 23 December 1913, the Owen-Glass Act founded the Federal Reserve System—the central bank of the United States. "The Fed," as most call it, is unique in that it is not one bank but, rather, twelve regional banks coordinated by a central board in Washington, D.C. A central bank is a bank for banks. It does for banks what banks do for individuals and business firms. It holds their deposits—or legal reserves—for safekeeping; it makes loans; and it creates its own credit in the form of created deposits, or additional legal reserves, or bank notes, called Federal Reserve notes. It lends to banks only if they appear strong enough to repay the loan. It also has the responsibility of promoting economic stability, insofar as that is possible, by controlling credit.

Founded in 1781, the nation's first bank, the Bank of North America, was possibly the first central bank. Certainly, the first Bank of the United States (1791–1811), serving as fiscal agent and regulator of the currency as well as doing a commercial banking business, was a central bank in its day. So too was the second Bank of the United States (1816–1836). It performed that function badly between 1817 and 1820, but improved between 1825 and 1826. The Independent Treasury System, which existed between 1840 and 1841 and between 1846 and 1921, was in no sense a central bank. A great fault of the National Banking System (1863–1913) was its lack of a central bank. The idea, and even the name, was politically taboo, which helps explain the form and name taken by the Federal Reserve System.

The faults of the National Banking System, especially perversely elastic bank notes—the paradox of dispersed legal reserves that were unhappily drawn as if by a magnet to finance stock speculation in New York—and the lack of a central bank to deal with the panics of 1873, 1884, 1893, and 1907, pointed out the need for reform. After the 1907 panic, a foreign central banker called the United States "a great financial nuisance." J. P. Morgan was the hero of the panic, saving the nation as if he were a one-man central bank. However, in doing this, he showed that he had more financial power than it seemed safe for one man to possess in a democracy. The 1912 Pujo Money Trust investigation further underlined his control over all kinds of banks. (Congressman Arsene Pujo, who became chairman of the House Banking and Currency Committee in 1911, obtained authorization from Congress to investigate the money trust, an investigation highlighted by the sensational interrogation of Morgan.) Meanwhile, the Aldrich-Vreeland Currency Act of 30 May 1908 provided machinery to handle any near-term crisis and created the National Monetary Commission to investigate foreign banking systems and suggest reforms. In 1911, Republican Sen. Nelson Aldrich proposed a National Reserve Association that consisted of a central bank, fifteen branches, and a top board controlled by the nation's leading bankers, which critics said J. P. Morgan, in turn, dominated. The proposal never passed, and the Democrats won the 1912 election. They accepted the groundwork done by Aldrich and others, but President Woodrow Wilson insisted that the nation's president choose the top board of this quasi-public institution. Democratic Rep. Carter Glass pushed the bill through Congress.

All national banks had to immediately suscribe 3 percent of their capital and surplus for stock in the Federal Reserve System so that it had the capital to begin operations. State banks could also become "members," that is, share in the ownership and privileges of the system. The new plan superimposed the Federal Reserve System on the National Banking System, with the new law correcting the major and minor shortcomings of the old one. In addition to providing a central bank, it supplied an elastic note issue of Federal Reserve notes based on commercial paper whose supply rose and fell with the needs of business; it required member banks to keep half their legal reserves (after mid-1917 all of them) in their district Federal Reserve banks; and it improved the check-clearing system. On 10 August 1914, the seven-man board took office, and on 16 November the banks opened for business. World War I having just begun, the new system was already much needed, but some of the controversial parts of the law were so vague that only practice could provide an interpretation of them. For that to be achieved, the system needed wise and able leadership. This did not come from the board in Washington, chaired by the secretary of the treasury and often in disagreement about how much to cooperate with the Treasury, but instead from Benjamin Strong, head of the system's biggest bank—that of New York. He was largely responsible for persuading bankers to accept the Federal Reserve System and for enlarging its influence.

At first, the Federal Reserve's chief responsibilities were to create enough credit to carry on the nation's part of World War I and to process Liberty Bond sales. The system's lower reserve requirements for deposits in member banks contributed also to a sharp credit expansion by 1920, accompanied by a doubling of the price level. In 1919, out of deference to the Treasury's needs, the Federal Reserve delayed too long in raising discount rates, a step needed to discourage commodity speculation. That was a major mistake. In 1922, the system's leaders became aware of the value of open-market buying operations to promote recovery, and open-market selling operations to choke off speculative booms. Strong worked in the 1920s with Montagu Norman, head of the Bank of England, to help bring other nations back to the gold standard. To assist them, he employed open-market buying operations and lowered discount rates so that Americans would not draw off their precious funds at the crucial moment of resumption. Nonetheless, plentiful U.S. funds and other reasons promoted stock market speculation in the United States. Strong's admirers felt he might have controlled the situation had he lived, but in February 1928 he fell sick and, on 16 October, died. As in 1919, the Federal Reserve did too little too late to stop the speculative boom that culminated in the October 1929 crash. In the years 1930–1932, more than 5,000 banks failed; in 1933, 4,000 more failed. Whether the Federal Reserve should have made credit easier than it did is still debatable. Businessmen were not in a borrowing mood, and banks gave loans close scrutiny. The bank disaster, with a $1 billion loss to depositors between 1931 and 1933, brought on congressional investigations and revelations, as well as demands for reforms and measures to promote recovery. Congress subsequently overhauled the Federal Reserve System.

By the act of 27 February 1932, Congress temporarily permitted the Federal Reserve to use federal government obligations as well as gold and commercial paper to back Federal Reserve notes and deposits. A dearth of commercial paper during the depression, along with bank failures that stimulated hoarding, created a currency shortage. A new backing for the bank notes was essential. However justified at the moment, the law soon became permanent and made inflation in the future easier.

Four other measures around this time were very important. These were the Banking Act of 16 June 1933; parts of the Securities Act of 27 May 1933 and of the Securities Exchange Act of 19 June 1934; and the Banking Act of 23 August 1935. Taken together, the acts had four basic goals: (1) to restore confidence in the banks, (2) to strengthen the banks, (3) to remove temptations to speculate, and (4) to increase the powers of the Federal Reserve System, notably of the board. To restore confidence, the 1933 and 1935 banking acts set up the Federal Deposit Insurance Corporation, which first sharply reduced, and, after 1945, virtually eliminated, bank failures. To strengthen banks, the acts softened restrictions on branch banking and real estate loans, and admitted mutual savings banks and some others. It was felt that the Federal Reserve could do more to control banks if they were brought into the system. To remove temptations to speculate, the banks were forbidden to pay interest on demand deposits, forbidden to use Federal Reserve credit for speculative purposes, and obliged to dispose of their investment affiliates. To increase the system's powers, the board was reorganized, without the secretary of treasury, and given more control over member banks; the Federal Reserve bank boards were assigned a more subordinate role; and the board gained more control over open-market operations and got important new credit-regulating powers. These last included the authority to raise or lower margin requirements and also to raise member bank legal reserve requirements to as much as double the previous figures.

The board, in 1936–1937, doubled reserve requirements because reduced borrowing during the depression, huge gold inflows caused by the dollar devaluation in January 1934, and the growing threat of war in Europe, were causing member banks to have large excess reserves. Banks with excess reserves are not dependent on the Federal Reserve and so cannot be controlled by it. This action probably helped to bring on the 1937 recession.

During the Great Depression, World War II, and even afterward, the Federal Reserve, with Marriner Eccles as board chairman (1936–1948), kept interest rates low and encouraged member banks to buy government obligations. The new Keynesian economic philosophy (the theory by John Maynard Keynes, perhaps the most important figure in the history of economics, that active government intervention is the best way to assure economic growth and stability) stressed the importance of low interest rates to promote investment, employment, and recovery, with the result that—for about a decade—it became almost the duty of the Federal Reserve to keep the nation on what was sometimes called a "low interest rate standard." In World War II, as in World War I, the Federal Reserve assisted with bond drives and saw to it that the federal government and member banks had ample funds for the war effort. Demand deposits tripled between 1940 and 1945, and the price level doubled during the 1940s; there was somewhat less inflation with somewhat more provocation than during World War I. The Federal Reserve's regulation limiting consumer credit, price controls, and the depression before the war, were mainly responsible. Regulation W (selective controls on consumer credit) was in effect from 1 September 1941 to 1 November 1947, and twice briefly again before 1952. The board also kept margin requirements high, but it was unable to use its open market or discount tools to limit credit expansion. On the contrary, it had to maintain a "pattern of rates" on federal government obligations, ranging from three-eighths of 1 percent for Treasury bills to 2.5 percent for long-term bonds. That often amounted to open-market buying operations, which promoted inflation. Admittedly, it also encouraged war-bond buying by keeping bond prices at par or better.

Securities support purchases (1941–1945), executed for the system by the New York Federal Reserve Bank, raised the system's holdings of Treasury obligations from about $2 billion to about $24 billion. The rationale for the Federal Reserve continuing these purchases after the war was the Treasury's wish to hold down interest charges on the $250 billion public debt and the fear of a postwar depression, based on Keynesian economics and memory of the 1921 depression. The Federal Reserve was not fully relieved of the duty to support federal government security prices until it concluded its "accord" with the Treasury, reported on 4 March 1951. Thereafter, interest rates moved more freely, and the Federal Reserve could again use open-market selling operations and have more freedom to raise discount rates. At times, bond prices fell sharply and there were complaints of "tight money." Board chairman William McChesney Martin, who succeeded Thomas McCabe (1948–1951) on 2 April 1951, pursued a middle-of-the-road policy during the 1950s, letting interest rates find their natural level whenever possible but using credit controls to curb speculative booms in 1953, 1956–1957, and 1959–1960 and to reduce recession and unemployment in 1954, 1958, and late 1960. After the Full Employment Act of 1946, the Federal Reserve, along with many other federal agencies, was expected to play its part in promoting full employment.

For many years, the thirty member banks in New York and Chicago complained of the unfairness of legal reserve requirements that were higher for them than for other banks, and bankers generally felt they should be permitted to consider cash held in the banks as part of their legal reserves. A law of 28 July 1959 reduced member banks to two classifications: 295 reserve city banks in fifty-one cities, and about 6,000 "country" banks, starting not later than 28 July 1962. According to this law, member banks might consider their vault cash as legal reserves. Thereafter, the requirement for legal reserves against demand deposits ranged between 10 and 22 percent for member city banks and between 7 and 14 percent for member country banks.

During the period 1961–1972, stimulating economic growth, enacting social welfare reforms, and waging war in Vietnam were among the major activities of the federal government that: (1) raised annual expenditures from $97 billion in fiscal 1960 to $268 billion in fiscal 1974; (2) saw a budget deficit in all but three years of that period; (3) raised the public debt by almost 70 percent; and (4) increased the money supply (currency and demand deposits) from $144 billion on 31 December 1960 to $281 billion on 30 October 1974. As early as 1958, the nation's international balance of payments situation was draining off its gold reserves (reflected in the Federal Reserve's gold certificate holdings). These fell from $23 billion on 31 December 1957 to $15.5 billion on 31 December 1964. With only $1.4 billion free (without penalties to the Federal Reserve) for payments to foreign creditors, Congress, on 18 February 1965, repealed the 25 percent gold certificate requirement against deposits in Federal Reserve banks on the theory that this action would increase confidence in the dollar by making $3.5 billion in additional gold available to foreign central banks or for credit expansion at home. Unfortunately, the situation worsened. On 18 March 1968, Congress removed a similar 25 percent reserve requirement against Federal Reserve notes, thereby freeing up all of the nation's gold. Nevertheless, the gold drain became so alarming that, on 15 August 1971, President Richard M. Nixon announced that the United States would no longer redeem its dollars in gold.

All these developments affected, and were affected by, Federal Reserve policies. During much of the 1960s, government economists thought they had the fiscal and monetary tools to "fine tune" the economy (that is, to dampen booms and to soften depressions), but the recession of 1966 damaged that belief. During the late 1960s, the monetarist school of economists, led by Milton Friedman of the University of Chicago, which sought to increase the money supply at a modest but steady rate, had considerable influence. In general, Reserve board chairman Martin advocated a moderate rate of credit expansion, and, in late May 1965, commented on the "disquieting similarities between our present prosperity and the fabulous'20s." Regardless, Congress and President Lyndon B. Johnson continued their heavy spending policies, but the president reappointed Martin as chairman in March 1967 because his departure might have alarmed European central bankers and precipitated a monetary crisis. With Martin's retirement early in 1970 and Arthur F. Burns's appointment as board chairman, credit became somewhat easier again.

Throughout this era, restraining inflation—a vital concern of the Federal Reserve—was increasingly difficult. What did the money supply consist of? If demand deposits are money, why not readily convertible time deposits? Furthermore, if time deposits are money, as monetarists contended, then why not savings and loan association "deposits," or U.S. government E and H bonds? What of the quite unregulated Eurodollar supply? As a result of such uncontrolled increases in the money supply, consumer prices rose 66 percent in the period 1960–1974, most of it occurring after 1965.

As of 27 November 1974, members of the Federal Reserve System included 5,767 of the 14,384 banks in the United States, and they held 77 percent of all bank deposits in the nation. Nevertheless, the Federal Reserve has changed markedly in structure, scope, and procedures since the 1970s. In the middle of that decade, it confronted what came to be known as "the attrition problem," a drop off in the number of banks participating in the Federal Reserve System. The decrease resulted from the prevalence of unusually high interest rates that, because of the central bank's so-called reserve requirement, made membership in the system unattractive to banks. In the United States, the federal government issues bank charters to national banks while the states issue them to state banks. A federal statute required all national banks to join the Federal Reserve; membership was optional for state banks. The Fed provided many privileges to its members but required them to hold reserves in non-interest-earning accounts at one of the twelve district Federal Reserve banks or as vault cash. While many states assessed reserve requirements for nonmember banks, the amounts were usually lower than the federal reserves, and the funds could be held in an interest-earning form. As interest rates rose to historical highs in the mid-1970s, the cost of membership in the Fed began to outweigh the benefits for many banks, because their profits were reduced by the reserve requirement. State banks began to withdraw from the Federal Reserve, and some national banks took up state charters in order to be able to drop their memberships. Federal Reserve officials feared they were losing control of the national banking system as a result of the attrition in membership.

The Depository Institutions Deregulation and Monetary Control Act of 1980 addressed the attrition problem by requiring reserves for all banks and thrift institutions offering accounts on which checks could be drawn. The act phased out most ceilings on deposit interest and allowed institutions subject to Federal Reserve requirements, whether members or not, to have access to the so-called discount window, that is, to borrow from the Federal Reserve, and to use other services such as check processing and electronic funds transfer on a fee-for-service basis.

In the same decade, a period of dramatic growth began in international banking, with foreign banks setting up branches and subsidiaries within the United States. Some U.S. banks claimed to be at a competitive disadvantage because foreign banks escaped the regulations and restrictions placed on domestic banks, such as those affecting branching of banks and nonbanking activities. In addition, foreign banks were free of the reserve requirement. The International Banking Act of 1978 gave regulatory and supervisory authority over foreign banks to the Federal Reserve. Together with the Depository Institutions Act of 1980, it helped level the playing field for domestic banks.

Unlike most other countries where the central bank is closely controlled by the government, the Federal Reserve System enjoys a fair amount of independence in pursuing its principal function, the control of the nation's money supply. Since passage of the Full Employment and Balanced Growth (Humphrey-Hawkins) Act of 1978, Congress has required the Federal Reserve to report to it twice each year, in February and July, on "objectives and plans…with respect to the ranges of growth or diminution of the monetary and credit aggregates." The Federal Reserve System must "include an explanation of the reason for any revisions to or deviations from such objectives and plans." These reports enable Congress to monitor monetary policy and performance and to improve coordination of monetary and government fiscal policies. The independence of the Federal Reserve System and its accountability continued to be controversial issues into the 1990s.


Broz, J. Lawrence. The International Origins of the Federal Reserve System. Ithaca, N.Y.: Cornell University Press, 1997.

Kettl, Donald F. Leadership at the Fed. New Haven, Conn.: Yale University Press, 1986.

Livingston, James. Origins of the Federal Reserve System: Money, Class, and Corporate Capitalism, 1890–1913. Ithaca, N.Y.: Cornell University Press, 1986.

Morris, Irwin L. Congress, the President, and the Federal Reserve: The Politics of American Monetary Policy-Making. Ann Arbor: University of Michigan Press, 2000.

Toma, Mark. Competition and Monopoly in the Federal Reserve System, 1914–1951: A Microeconomics Approach to Monetary History. Cambridge, U.K.; New York: Cambridge University Press, 1997.

Wells, Wyatt C. Economist in an Uncertain World: Arthur F. Burns and the Federal Reserve, 1970–1978. New York: Columbia University Press, 1994.

Wheelock, David C. The Strategy and Consistency of Federal Reserve Monetary Policy, 1924–1933. Cambridge, U.K.; New York: Cambridge University Press, 1991.

Earl W.Adams

Donald L.Kemmerer/a. e.

See alsoAldrich-Vreeland Act ; Banking ; Clearinghouses ; Federal Agencies ; Great Depression ; Keynesianism ; Open-Market Operations ; Pujo Committee ; andvol. 9:Fireside Chat on the Bank Crisis .

Federal Reserve System

views updated May 11 2018


The Federal Reserve System (Fed) came into existence in 1913. To overcome fears that a unified U.S. central bank would become too closely allied to the federal government and to big money interests, the Fed was made up of twelve regional reserve banks each with a high degree of local autonomy. A Federal Reserve Board, located in Washington D.C., operated as a supervisory body with a duty to ensure that the Federal Reserve banks complied with the law. All national banks, that is institutions that had received their charter from the federal government, were required to join the Fed. State banks were permitted to join if they could meet the relatively high reserve requirements laid down by the new system.


Few bankers wanted a strong central bank, and there was widespread support for regional division. In fact the dual system of national and state banks that the majority of bankers wished to retain had been preserved. After 1913 the commercial banking sector was made up of national banks, which were members of the Fed, and state banks, some of which joined the Fed while others remained nonmembers. In 1921, only 9,779 of the 29,018 commercial banks were members of the reserve system. Even in 1929 the structure was essentially the same. The Fed had 8,522 members while non-members numbered 15,173.

Among the objectives of the new system were the provision of ample credit for legitimate business, the stabilization of interest rates, and the maintenance of the gold standard. A key aspiration stressed by the supporters of central banking was the avoidance of financial panics and the attendant bank failures to which the American financial system was prone. Multiple bank failures during the depression of 1907 had proved to be a decisive turning point in the argument for the creation of a central bank.

Almost as soon as the Fed was established, the economy was affected by the demands of World War I. The Fed successfully lubricated the wheels of credit and after April 1917, when the United Statesentered the conflict, it directed credit to essential users and also supported the Treasury in its aim of keeping interest rates low so that the costs of war borrowing would be minimized. Unfortunately this action helped to fan the flames of inflation. When, in 1920, the Fed raised interest rates in order to bring rising prices under control, the severe postwar Depression of 1920 and 1921 quickly followed. Only after 1921 did the Fed begin to operate under normal peacetime conditions.


During this period the New York Reserve Bank, under its influential governor, Benjamin Strong, emerged as the leading institution. It had become apparent that if the reserve banks insisted on behaving independently, each raising or lowering discount rates or purchasing or selling securities, monetary policy would lack cohesion. Strong advocated the coordination of open market operations, and in 1922 a committee was formed to supervise the sale and purchase of government securities. With this tool, Monetary policy could be used to counter the impact of both booms and slumps and seasonal fluctuations in credit, so that the monetary authorities could influence events rather than simply react to them.

Some scholars believe that the Fed intervened directly to ensure that the minor recessions of 1924 and 1927 did not develop into full-blown Depressions. During each, the Fed adopted liberal credit policies by purchasing government securities and lowering discount rates. As the economy recovered rapidly in both cases, it would seem that the policies were very effective. However, compelling evidence suggests that the motives for the Fed's actions were linked to international rather than domestic issues. The Reserve wanted to keep U.S. interest rates low in order to assist European countries in either returning to the gold standard or staying on it. Credit was extended to European central banks, and low U.S. interest rates encouraged capital to flow to the old world. In other words, the domestic benefits of expansionary monetary policy were entirely secondary.

While the Fed encouraged the adoption of the gold standard overseas, it efficiently managed the massive influx of gold into the United States during the war and post-war years. The gold was effectively sterilized and not allowed to exert inflationary pressure. Indeed, this period is one of remarkable price stability given the economy's vigorous growth. However, the actions of the Fed in accumulating a large gold reserve, a strategy also pursued by the French, put pressure on other gold standard countries that were attempting to operate the system with inadequate reserves.

By 1928 the domestic advantages of reserve bank monetary co-operation had become apparent. For example, collective action had reduced seasonal fluctuations in interest rates, and bankers were becoming more confident in their ability to use monetary policy effectively. Bank failures, however, continued to be a problem. Between 1921 and 1929, some 776 national banks, 229 state banks, and 4,416 non-member banks closed their doors. The vast majority of the failed institutions were small banks adversely affected by farm misfortune. The figures reflect the fact that big banks joined the Fed, and the small, usually under-capitalized unit banks, remained outside and were unable to call on central bank help when in need.


In 1928 danger signals from the New York Stock Exchange (NYSE) were becoming a concern. The Fed reacted to growing stock market speculation by introducing a tight money policy. Intended to make borrowing for speculation less attractive, the higher interest rates were expected to reduce frenetic speculative activity. Unfortunately, this policy was totally ineffective as speculative activity actually increased. However, the policy did have an adverse effect on economic performance, and in the middle of 1929 it was clear that the economic boom had come to an end. Wall Street quickly absorbed these signs, the stock market collapsed in October 1929, and then the Fed, seeing speculation quashed, reduced interest rates.

The economic recovery that followed the crash did not last long. From the middle of 1930 the economy began a long slide, which took it to a trough in the winter of 1932 and 1933. A sustained recovery did not begin until the spring of 1933. A central feature of the Great Depression was extensive bank failure. Indeed, in mid-March 1933 there were approximately 12,600 fewer commercial banks than had been open for business in June 1929. Yet one of the duties of the reserve system was to act as a bulwark against bank failure. Why did the Fed fail in this task?

Scholars usually identify three banking crises in which the failures were concentrated: the first took place in 1930, the second in the fall of 1931, and finally the banking system reached an almost total state of collapse in the winter of 1932 and 1933. There is now widespread agreement that the 1930 wave of bank failures was part of a regional problem and had little national impact. However, the 1931 crisis was far more serious and occurred after Great Britain left the gold standard and devalued sterling. Speculators who had previously worried about the ability of the Bank of England to support the pound now turned their attention to the dollar. To give speculators a clear message that protecting the currency was a priority, the Federal Reserve raised interest rates and pursued a tight money policy. This was a logical move to protect the dollar, but it was disastrous for a banking system under great pressure. The beleaguered banks needed low interest rates and an easy money policy that would give them ready access to central bank support, quite the reverse of what was provided. As some institutions failed, panic spread and even soundly run banks could not keep their doors open when faced with so many customers who wished to withdraw deposits. Exactly the same thing happened during the "lame duck" period between Roosevelt's election in November 1932 and his inauguration in March 1933. Uncertainty led to further speculation against the dollar and the Fed responded by raising interest rates. By this time the financial sector had been exposed to such shocks that most state governors were forced to close their banks in order to save them from failing. The creation of the Reconstruction Finance Corporation in January 1932, with powers to assist troubled banks, is a clear indication that the Fed was failing to do its job. In February, the Glass-Steagall Act liberalized the Fed's discount provisions but, unfortunately, this move came too late to have a major impact.

Milton Friedman and Anna Schwartz are highly critical of the Federal Reserve and believe that its perverse decisions, which led to the failure of so many banks and a severe contraction in the money supply, transformed a recession into a major depression. However, the actions of the Fed in defending the dollar were consistent with the policies that seemed so effective in 1924 and in 1927, when external factors determined action. Elmus Wicker, the most authoritative of banking historians for this period, is cautious in his assessment of Federal Reserve policy. Unlike most commentators he does not believe that the Fed initiated the 1931 banking crisis, but he is critical of the failure to implement vigorous open market operations in 1930 and in 1931 that could have prevented the dramatic fall in depositor confidence. Even though most of the failed banks were not reserve members, the Fed wins few friends for its policy choices in the worst years of the Depression. Most scholars debate whether the failures were just bad or disastrous.


There was unanimous agreement that the banking sector needed assistance to achieve stability, and the first response of the Roosevelt administration was to create a breathing space by declaring a national bank holiday. On March 9, 1933, the Emergency Banking Act gave the executive branch of the government power to reopen banks once they had been examined and declared sound. The Banking Act (June 16, 1933), gave the Fed increased control over bank credit, called for greater coordination of open market operations and the legal recognition of an Open Market Committee. The act forbade the payment of interest on demand deposits by member banks and also regulated the interest payments on time deposits. The decision to separate commercial and investment banks so that the former could no longer underwrite securities gained widespread support. In spite of a lack of enthusiasm on the part of both the president and bankers, the Federal Deposit Insurance Corporation (FDIC) was established to ensure that depositors would be so confident in the security of their deposits that bank runs would become a thing of the past. All members of the Federal Reserve System were obliged to join FDIC.

A further refinement of the banking system came with the Banking Act (1935), which brought about fundamental changes in the Federal Reserve System. Marriner Eccles had assumed the chairmanship of the Board of Governors. An experienced banker with a forceful personality and known by Congress to be no friend of Wall Street, Eccles insisted on greater centralization and more power for the board. The 1935 Act was one of the most significant pieces of legislation in U.S. financial history establishing with its predecessor a structure for banking that was to last half a century. It created a Federal Reserve Board consisting of seven members to be appointed by the president and confirmed by Senate. The Federal Open Market Committee, which had consisted of the twelve governors of the Federal Reserve banks, was replaced by one consisting of the board and just five representatives from the Reserve Banks. The new Committee, which had far more authority than the one it replaced, came to play a leading role in shaping policy. It exercised a firm control over interest rates, the provision of credit, and the money supply. The board also gained the power to approve the appointments of the presidents, as they came to be called, of reserve banks and the authority to alter the reserve requirements of member banks.

The 1935 act transferred power from the reserve banks to the Reserve Board. This shift was possible because of Eccles's determination and authority combined with a congressional distrust of the reserve bankers that was shared by many members of the public. The U.S. president also acquired new powers of appointment to the board.

It is ironic that the Fed, having relentlessly pursued policies that most scholars believe made the impact of the Depression more acute, was given so much additional power by New Dealers. Moreover, an early action of the newly constituted board was to tighten the reserve requirements of member banks, which were viewed as excessive and a potential inflationary threat. This action, together with the imposition of a restrictive fiscal policy as Roosevelt strove to balance the federal budget, contributed to the onset of the deep recession of 1937 and 1938.



Calomiris, Charles W. and Eugene N. White, "The Origins of Federal Deposit Insurance." In The Regulated Economy. A Historical Approach to Political Economy, edited by Claudia Goldin and Gary D. Libecap. 1994.

Chandler, Lester V. American Monetary Policy 1928–1941. 1971.

Eccles, Marriner, S. Beckoning Frontiers. Public and Personal Recollections. 1951.

Friedman, Milton, and Anna J. Schwartz, A Monetary History of the United States 1867–1960. 1963.

Kennedy, Susan Estabrook. The Banking Crisis of 1933. 1973.

Smiley, Gene. The American Economy in the Twentieth Century. 1994.

Wheelock David C. The Strategy and Consisitency of Federal Reserve Monetary Policy, 1924–1933. 1991.

White, Eugene N. "Banking and Finance in the Twentieth Century." In The Cambridge Economic History of the United States, Vol. 111: The Twentieth Century, edited by Stanley L. Engerman and Robert E. Gallman. 2000.

Wicker, Elmus. Federal Reserve Monetary Policy 1917–1933. 1966.

Wicker, Elmus. The Banking Panics of the Great Depression. 1996.

Peter Fearon

Federal Reserve System

views updated May 23 2018


To promote the development of a sound economy and a reliable banking system, Congress passed, and President Woodrow Wilson signed, the Federal Reserve Act on December 23, 1913. The act was a response to the recurring bank failures and financial panics that had plagued the nation.

After much disagreement and eventual compromise, all parties to the discussionsthe government, banks, other financial institutions, and a few business and labor leadersagreed that a central U.S. bank was essential for the economic health of the country. Starting with the goal of stabilizing the nation's monetary and financial system, the Federal Reserve System (commonly called the Fed) has undertaken a number of responsibilities.


Designed by Congress and subject to congressional authority, the Fed is a politically independent and financially self-sufficient federal agency. It consists of the following components:

  1. A central bank, sometimes called the government's bank, located in Washington, D.C.
  2. Twelve regional Reserve Banks, located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco, and St. Louis. Each Reserve Bank relies on advisory groups for information and suggestions. Some of the more important ones concern operations, small business and agriculture, and thrift institutions (savings banks, savings and loan associations, and credit unions). Reserve Bank officials also meet periodically to discuss mutual problems. These groups include the Conference of Presidents, the Conference of First Vice Presidents, the Conference of Chairmen, and the Financial Services Policy Committee.
  3. Twenty-five branch banks, located within defined areas of the Reserve Banks. For example, branch banks within the San Francisco Reserve Bank area are located in Los Angeles, Portland (Oregon), Salt Lake City, and Seattle.
  4. Member banks, located throughout the country. Some are national banks (all of which are commercial banks) chartered by the federal government and, by law, are members of the Fed. Others are state commercial banks that have chosen to be members. Of the more than 9,000 commercial banks in the country, more than 3,700 are members of the Fed. Other depository institutions, including nonmember commercial banks and thrift institutions, are subject to many of the Fed's rules and regulations. A member bank is required to purchase stock from its Reserve Bank in an amount equal to 3 percent of its combined capital and surplus. However, this investment does not represent control of or a financial interest in the Reserve Bank. In return for its investment, however, a member bank receives a 6 percent annual dividend and the right to vote in elections of directors of its Reserve Bank.


These are three basic components in the governance structure of the Fed:

  1. The Fed's primary policy-making group is the seven-member Board of Governors. Appointed by the president and confirmed by the Senate, members serve for one fourteen-year term only. A member who is appointed to fill an unexpired term may be appointed for an additional full term. From among the seven members, the Board's chairman and vice chairman are also appointed and confirmed by the president and the Senate for four-year terms.
  2. There are three advisory groups that aid the Board of Governors:
    1. Federal Advisory Council, consisting of one member from each Reserve Bank. Its major concerns involve banking and economic issues.
    2. Consumer Advisory Council, consisting of thirty specialists in consumer and financial matters.
    3. Thrift Institutions Advisory Council, consisting of people representing thrift institutions. This Council is concerned with issues affecting those institutions.
  3. The Federal Open Market Committee (FOMC) consists of the seven-member Board of Governors, the New York Federal Reserve Bank president, and an additional four Reserve Bank presidents who serve on a one-year rotating basis. By tradition, the Committee elects the Board of Governors chairperson as its chairperson and the New York Reserve Bank president as its vice chairperson. Although all twelve Reserve Bank presidents attend the FOMC's eight-times-a-year formal meetings, only the Board, the New York Reserve Bank president, and the four rotating presidents are voting members.


In conjunction with the FOMC and the twelve Reserve Banks, the Board of Governors' main concern is the development of monetary policy, which it carries out through three means:

  1. The establishment of reserve-level rates (amounts that member banks must set aside to be reserved against deposits). These amounts depend on the nation's economic activity status, with emphasis placed on price levels and the volume of business and consumer expenditures. By the lowering of the required reserve-level rate, banks can increase the proportion of funds they are able to lend to customers. By raising the required reserve-level rate, the opposite effect takes place. Thus, the Fed can influence such factors as economic activities, the money supply, interest rates, credit availability, and prices. However, a change in a reserve-level rate usually causes banks to change their strategic plans. In addition, a reserve-level rate increase is costly to banks. Consequently, changes in reserve-level rates are uncommon.
  2. The approval of discount rates (interest rates at which member banks may borrow short-term funds from their Reserve Bank). When inflation threatens, a discount-rate increase tends to dampen economic activity because then banks charge higher interest rates to borrowers. On the other hand, a discount-rate decrease is designed to stimulate business activity. The term discount window is often used when describing a Reserve Bank facility that extends credit to a member bank.
  3. Another rate, the federal funds rate, is an important factor affecting day-to-day bank operations. This is the rate charged by one depository institution to another for the overnight loan of funds. This happens when one bank is short of funds while another has a surplus. The rate is not fixed; it may change from day to day and from bank to bank.
  4. Open-market operations (the purchase and sale of U.S. government securities in the open market). These activities are conducted by the FOMC, of which the Board of Governors comprises the majority. The Fed buys and sells U.S. government securities such as Treasury bills from banks and others several times a week. As a result, the amounts banks have available to lend to borrowers are affected. For example, when the Fed buys securities, banks have more funds, so interest rates tend to drop. The opposite occurs when the Fed sells its securities. By and large, open-market operations comprise the most powerful tool the Fed has to influence monetary policy.

Other activities and responsibilities of the Federal Reserve System include the following:

  1. Supervision of the twelve Reserve Banks and their branches. With regard to the latter, the Board of Governors, through the Reserve Banks, uses both on- and off-site examinations to maintain awareness of each member bank's activities. These activities include the quality of loans, capital levels, and the availability of cash.
  2. Cooperative efforts of the U.S. Treasury and the Fed. For example, the Fed acts as the Treasury's fiscal agent by putting paper money and coins into circulation, handling Treasury securities, and maintaining a checking account for the Treasury's receipts and payments.
  3. Oversight of banking organizations, such as bank holding companies (companies that own or control one or more banks).
  4. Provision of an efficient payments system such as check collections and electronic transactions. With billions of checks in circulation each year, the Fed plays a major role in assuring their efficient processing. By arrangements among the Reserve Banks, member banks and nonmember banks, checks are credited or debited (added to or subtracted from) to depositors' accounts speedily and accurately. Electronic methods are being used increasingly to transfer funds (and securities, too). One such method, involving very large sums, is called Fedwire. Another is the Automated Clearinghouse (ACH), which is used by the government, businesses, and individuals for the receipt or payment of recurring items, such as Social Security.
  5. Enforcement of consumer credit protection laws. These laws include the Community Reinvestment Act, which promotes community credit needs; the Equal Credit Opportunity Act, which prohibits discrimination in credit transactions on the basis of marital status, race, sex, and so forth; the Fair Credit Reporting Act, which allows consumers access to their credit records for the purpose of correcting errors; and the Truth in Lending Act, which enables consumers to determine the true amount they are paying for credit.
  6. Establishment of banking rules and regulations.
  7. Determination of margin requirements (the amount of credit granted investors for the purchase of securities, such as shares of stock). The borrowed funds are usually secured from a bank or a brokerage firm (a company that sells stocks and/or bonds). Margin requirements that are too liberal can damage the stock market and the economy.
  8. Approval or disapproval of applications for bank mergers (two or more banks joining together to form one new bank). The Fed also acts if the new bank is to become a state member bank of the Federal Reserve System.
  9. Approval and supervision of the Edge Act (named for Senator Walter Edge of New Jersey) and agreement corporations. Both cases involve corporations that are chartered to engage in international banking. Edge Act corporations are chartered by the Fed, while agreement corporations secure their charters from the states. The latter are so named because they must agree to conform to activities permitted to Edge Act corporations. The Fed is also responsible for approving and regulating foreign branches of member banks and for developing policies regarding foreign lending by member banks.
  10. Issuance and redemption of U.S. savings bonds. Regardless of how the bonds are purchasedfor example, through an employer savings plan or a bankit is the Fed that processes the applications and sends the bonds.


Since it holds substantial U.S. government securities, the Federal Reserve System earns sufficient interest to operate without government appropriations. Consequently, it is both a financially self-sufficient and politically independent agency that exerts great influence on the nation's economy. It bolsters domestic consumer confidence and is a major player in global economic activities.

see also Financial Institutions


Board of Governors of the Federal Reserve System. (2002) The Federal Reserve System: Purposes and Functions. Washington, DC: Books for Business.

Federal Reserve System (2003). "The Structure of the Federal Reserve System". Retrieved October 18, 2005, from http://www.federalreserve.gov.

Feinman, Joshua N. (1993, June). "Reserve Requirements: History, Current Practice, and Potential Reform." Federal Reserve Bulletin, 569-589.

Melvin Morgenstein

Federal Reserve System

views updated May 11 2018

Federal Reserve System

What It Means

All modern capitalist nations have central banks. In the United States the central bank is called the Federal Reserve System, or the Fed; it is an independent agency of the U.S. government. Most large banks in the United States belong to the Federal Reserve System. That is, they have accounts with the Fed that are almost exactly like the accounts individual people have with their banks. Member banks deposit checks and maintain a balance (an amount of money) with the Fed. But even those banks that are not Fed members must obey the banking rules set by the Fed, which regulates the entire industry. The Fed also serves as a bank for the U.S. government itself and oversees the circulation of hard currency (paper bills and coins). The Fed’s most important and complicated duty, however, is the setting of U.S. monetary policy: the Fed decides whether, when, and how to change the money supply (the amount of money circulating in the U.S. economy).

The size of the money supply affects all facets of the economy, and it has a direct link to inflation (the general rising of prices), which can cause a nation’s money to lose its value. The Fed monitors the economy and makes decisions about whether the U.S. money supply should be increased, decreased, or left alone. When it decides to change the size of the money supply, it does so by influencing banks and their ability to make loans.

When Did It Begin

The Federal Reserve System was created by the Federal Reserve Act of 1913, which was introduced in order to strengthen the U.S. banking system. Prior to 1913 individual banks made their own decisions about how much hard currency to keep on hand (in reserve) in case depositors (bank account holders) wanted to withdraw some or all of their account balances in cash. The banks made the rest of the money people deposited with them available for loan, charging interest (fees imposed for the use of borrowed money) in order to make profits. But the amounts of money that banks reserve and loan out directly determine how much money is circulating in the economy; thus uncertainty about reserve levels and other banking issues leaves the economy vulnerable to economic catastrophe of all kinds, including bank failures, or bank runs, when people lose faith in the system, and everyone demands their money at once (money that the banks do not have on hand). Numerous bank failures led to what became known as the panic of 1907, an economic crisis during which the stock market slumped, millions of bank account holders lost their savings, and many other banks and business firms closed down. By centralizing and stabilizing the banking system with the Federal Reserve Act, the U.S. government was able to take direct control over the money supply, one of the most important factors in the overall health of the economy.

More Detailed Information

The Fed’s most important function is the regulation of the country’s money supply. The Fed does not, however, simply order new dollar bills printed or pull old dollar bills out of the flow when it wants to change the amount of money in circulation. Instead, the Fed controls the money supply by setting rules for and influencing the practices of banks. To understand how this happens, it is first necessary to understand the way the banking system works.

All modern economies are driven by a fractional-reserve banking system, which means that at any given time banks possess hard currency amounting to only a fraction of the money that has been deposited by account holders. Fractional banking makes a great deal of economic activity possible that would be impossible if everyone needed cash for all purchases. In fact, fractional banking creates money that would not otherwise exist.

For instance, assume that Jane Doe deposits $10,000 in Bank X. Bank X will want to loan most of that money out so that it can collect interest and make a profit. Say that Bank X puts $1,000 of Jane’s total $10,000 in reserve and loans the remaining $9,000 to John Smith, who wants to open a coffee shop. Bank X will give John Smith a checkbook tied to a checking account with his $9,000 in it, and he will use his Bank X checks to pay Big Time Coffee Distributing, Inc. for $9,000 worth of tables, chairs, coffee makers, and coffee. Big Time will deposit John Smith’s $9,000 worth of checks at its own bank, Bank Y; then Bank Y will set aside $900 while making the remainder ($8,100) available for loans. Say that Mary Brown shows up at Bank Y asking for $8,100 to open a sandwich shop. The process described above will continue as Mary Brown writes checks that are deposited in yet another bank, and so on, through other individuals and banks, until the original $10,000 is used up. At that point there will be far more than $10,000 in circulation.

Though it would be more complicated in reality, the above scenario describes the process by which banks literally create money. The Fed can, therefore, expand or restrict the money supply by influencing this process. It has three basic methods for doing so.

First, the Fed can simply change the percentage of deposits banks are required to keep in reserve. The above example assumes banks are required to reserve 10 percent of all deposits. If Bank X had been required to keep 15 percent of Jane Doe’s deposit in reserve ($1,500), it would have been able to lend only $8,500 to John Smith, and this would have reduced the amount of money ultimately created by the chain of borrowers, businesses, and lenders involved. Likewise, if Bank X had to set aside only 5 percent of Jane’s deposit ($500), the amount of money created would be increased. Although the Fed has the ability to modify the reserve requirement to affect lending behavior, in practice it rarely, if ever, makes use of this policy tool.

The Fed’s second means of influencing the money supply is to change the interest rate it charges member banks to borrow money (this interest rate is called the discount rate). For instance, if Jane Doe had not made a $10,000 deposit, Bank X could still make a $9,000 loan to John Smith by borrowing enough money from the Fed to cover its reserve requirements (which would be $1,000 if the required reserve rate were 10 percent). If the Fed was currently charging a low price for this borrowed money (a low discount rate), Bank X would be likely to borrow from the Fed and, in turn, loan money to John Smith. If, however, the Fed was charging a high discount rate, Bank X might simply turn John Smith’s loan application down. By raising its discount rate, the Fed would have reduced the amount of money created by Bank X.

Finally, the Fed influences the money supply by engaging in what are called open-market operations: the buying or selling of government securities, such as treasury bills, treasury notes, and treasury bonds (different investment opportunities offered by the government, on which the government pays interest, and whose value the government guarantees). When the Fed buys government securities, it essentially injects money into the banking system, because it is buying the securities from individual dealers who deposit the Fed’s checks in banks like Bank X. When the Fed sells government securities, it essentially takes money out of the banking system, because then individual dealers write checks that are payable to the Fed, and the money is withdrawn from the individuals’ accounts at their own banks. This decreases the deposit totals of banks like Bank X.

Recent Trends

Today the media commonly reports on Fed announcements regarding interest rates, but few people correctly understand these reports. To decipher them, it would be necessary to understand the different types of interest rates (the discount rate, the federal funds rate, and the prime interest rate) that most crucially affect the economy and to understand the Fed’s relationship to each.

The Fed is responsible for setting the discount rate, or the rate it charges on loans that it makes to banks who want to borrow money. While this rate can affect the money supply, it is not usually the most influential interest rate in the bigger economic picture. When banks want to increase their reserves, they usually borrow from one another rather than from the Fed.

The rate that banks charge one another for loans is called the federal funds rate. While the Fed does not directly set the federal funds rate, it makes announcements publicizing what it thinks that rate should be; then it can enforce that target rate by using open-market operations to change the money supply. If the Fed decreases the money supply by selling government securities, interest rates tend to rise. If the Fed increases the money supply by buying government securities, interest rates tend to fall. Because banks commonly borrow money from one another to cover shortfalls in their reserves, the federal funds rate has a direct effect on the rates that banks charge consumers and businesses who take out loans.

The rate that individual banks charge consumers and businesses is based on what is called the prime interest rate. The prime rate is the standard interest rate set by major banks. It serves as a baseline to which individual banks add percentage points (raising the interest rate slightly), depending on the circumstances surrounding individual loans. Adding percentage points ensures that the bank covers its costs and makes a profit. In principle the prime rate depends on market forces such as supply and demand; in practice, however, it is closely tied to the federal funds rate. Today the prime interest rate is generally about 3 percentage points higher than the federal funds rate.

Therefore, while TV newscasters are not technically accurate when they say, for example, “The Fed lowered interest rates today,” practically speaking the Fed does have the power to change all of the economy’s key interest rates.

Federal Reserve System

views updated May 09 2018


The Federal Reserve System, also known simply as "the Fed," is a U.S. central bank. Its primary role is to influence the amount of money and credit circulating in the economy in order to promote full employment, stable prices, and economic growth. It also regulates and supervises the U.S. banking industry, distributes currency and coins, clears checks, and handles some electronic funds transfers. Unlike traditional banks, the Fed's purpose is not to make a profit but to serve the national interest. Moreover, its customers are not individual citizens but the roughly 4,300 banks that make up its members. The Fed is governed by a sevenmember Board of Governors appointed by the President of the United States and it is led by the Board's chairperson, who since 1987 has been Alan Greenspan(1926). Although the Board determines the Fed's policies, the twelve district Federal Reserve banks, located in major cities across the United States, perform its day-to-day operations.

The Federal Reserve System came into being after four financial panics destabilized the U.S. economy between 1873 and 1907. Congress established the National Monetary Commission to determine what made the U.S. banking system so susceptible to these periodic crashes. The commission's report led directly to the Federal Reserve Act of 1913, which created the Federal Reserve System. Initially, the Fed performed only the narrow functions of lending money to banks when they could not get loans elsewhere, supervising the banking industry, and increasing or decreasing the money and credit supply in response to changing economic conditions. However, many believed that the Great Depression of the 1930s occurred in part because the Fed did not provide banks with enough reserves to make loans that would have increased the money supply and kept the economy from contracting. In response, Congress passed the Banking Act of 1935 to give the Fed greater controls over the minimum amount of reserves each member bank needed to make loans. The Full Employment Act of 1946 empowered the Fed to make full employment and stable prices explicit goals of its policy, and the Full Employment and Balanced Growth Act of 1978 required that the Fed publicly state what the objectives of its monetary and credit policies are. In the 1980s, under President Ronald Reagan (19811989), the Fed adopted a monetary policy of maintaining specific rates of growth in the money supply.

See also: Central Bank, Federal Reserve Act of 1913, Financial Panic, Alan Greenspan

Federal Reserve System

views updated Jun 11 2018

Federal Reserve System US central bank, established in 1913 to maintain sound monetary and credit conditions. Twelve regional banks are supervised by a Federal Reserve Board of Governors. All national banks are members, as are many state and commercial banks. The Federal Reserve System regulates money flow and credit by varying its discount rate on loans to member banks and by varying the percentage of total deposits member banks must keep in reserve.


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