To understand and appreciate the importance and the various functions of the Federal Reserve banks, it is necessary to look back to the last century when the nation's sixteen hundred banks were issuing about ten thousand different kinds of bank notes, which then served as currency. Some notes were good, some worth but half the amount printed on them, and many were worthless. Counterfeit bills were easily printed and passed freely. After a wave of bank closings caused thousands of Americans to lose their savings in 1857, busi¬nessmen and even astute bankers were unable to determine which bank notes were good and which were worthless or counterfeit. The situation became so unwieldy that in 1863 Congress passed an act creating a national currency. Thereafter national banks chartered by the government were permitted to issue paper money only if their bank notes were backcd by federal bonds that had been deposited with the Treasurer of the United States. Three years later, a tax on all notes issued by state banks forced them to stop printing their own money and obtain national charters. At last the country had sound currency. But this step by itself was not enough.
Once the transcontinental railroad opened in 1869, wave after wave of immigrants headed West to settle the new frontiers. At the same time, industrialists were building new factories in the East and the Midwest, hoping to fill all the orders for goods that a growing country required. As the population and industrial activity expanded, a currency shortage gradually developed. Smaller banks in the areas distant from the big cities had difficulty obtaining enough money to satisfy the needs of their customers.
Creation of the Federal Reserve
The currency shortage had become so severe by 1907 that Congress appointed the National Monetary Commission to study the problem and recommend a solution. The Commission discovered that countries whose currency supply could expand or contract to meet the needs of business usually had some kind of central bank that could issue currency as needed. The Federal Reserve Act of 1913 was the result of Congress listening to the pleas of people living in the South and West, far removed from the nation's capital and from New York City, the nation's financial hub. Instead of depending on one central bank, like the Bank of England, a decentralized Federal Reserve System was created consisting of twelve Federal Reserve banks located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Each bank served a particular Federal Reserve district. More than 40 percent of the nation's banks, which hold 75 percent of the country's bank deposits, are now members of the Federal Reserve System. Under this arrangement America's economic and financial policies would be set by bankers who represented every part of the country, instead of only officials and bankers in New York and Washington.
The basic purpose of the Federal Reserve is to make possible a flow of credit and money that will ensure orderly economic growth and a stable dollar. The system is like the adrenal glands in our bodies. When we need extra energy to meet an emergency, the glands release hormones into the blood stream. When our economy is in trouble and more money and credit are needed, the Federal Reserve System releases them. Conversely, when it appears that the nation is on an inflationary course because there is too much money, the sys¬tem tightens the credit reins and thus retards economic activity.
Managing the Nation's Money Supply
There are three principal ways in which the Federal Reserve intends to manage the nation's money supply. The first is by raising or lowering the "discount rate," which is the amount of interest banks have to pay the Federal Reserve when they borrow money. The banks, in turn, then raise or lower the interest rates they charge their customers who need money. This has the effect of making it either harder or easier for business to borrow money.
The second way the Federal Reserve regulates our money supply is by raising or lowering the "reserve requirements" of member banks. As noted in the previous chapter, this is the method of increasing or decreasing the amount of your "checkbook money," because as banks are required to put more or less of their funds into their reserve accounts, the amount of money available to lend is affected.
The third way is through the Federal Reserve's "open market operations." Every three or four weeks the Federal Open Market Com¬mittee meets in the Federal Reserve building in Washington. It consists of the governors, the presidents of the twelve Federal Reserve Banks, and top staff members who determine the Federal Re¬serve system's policies for the weeks ahead. The decisions that the group reach will affect not only the economy of this country but also foreign trade and possibly international financial transactions. If it is decided that money and credit should be loosened, the New York Federal Reserve Bank's six securities traders will be instructed to buy huge blocks of United States Treasury notes. Millions of dollars then flow into the banks as they sell the securities they are holding. Thus the banks have more money to lend their customers.
