The Act, "Provided for the establishment of Federal Reserve Banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes. The Act provided for a Reserve Bank Organization Committee that would designate no less than eight but no more than twelve cities to be Federal Reserve cities, and would then divide the nation into districts, each district to contain one Federal Reserve City.
The Dilemma of the New York Fed. In , the Bank opened an office in East Rutherford, New Jersey to accommodate currency and check processing operations and conduct electronic payments. In , the Bank opened a branch in the city of Buffalo to serve institutions located in the ten later increased to 14 westernmost counties of New York State.
Consequently, few state banks joined the Federal Reserve System in the early years. Federal Reserve Banks provided various financial services, such as check clearing and collection, for their members. However, these restrictions may have made the Fed less effective as lender of last resort for the banking system. For example, during the Great Depression, many member banks could not borrow from the Federal Reserve because they had little paper that was eligible for rediscounting.
The founders also sought to increase the amount of international trade financed by US banks and to expand the use of the dollar internationally. Further, the Act authorized the Reserve Banks to purchase acceptances in the open market to ensure a liquid market for them, thereby spurring growth of that market. The war had a profound impact on the US banking system and economy, as well as on the Federal Reserve.
The start of the war triggered a brief financial panic and a gold outflow from the United States. US exports began to rise within a few months, however, and gold began to pour into US banks. War disrupted European financial markets and reduced the supply of trade credit offered by European banks, providing US banks with an opening.
Low US interest rates, abundant reserves, and new authority to issue trade acceptances enabled American banks to finance a growing share of world trade.
By the second half of the s, over half of US imports and exports were financed by dollar-denominated acceptances, as was a large share of the international trade of other countries Eichengreen , p. The Fed assisted in selling government securities to banks and the public, with Reserve Bank governors serving as chairmen of committees in each Federal Reserve district to sell Liberty bonds to the public Meltzer , p. The Federal Reserve Banks held substantial gold reserves and discount loans to their member banks.
A modest gold outflow and rising inflation prompted the Fed to increase its discount rate sharply in The price level then began to fall and the US economy entered a recession. The recession was relatively short, however, and the US economy grew at a moderately high and stable rate, with low inflation, over the remainder of the decade. Schwartz attribute the good performance of the US economy in the s to enlightened Federal Reserve policy.
Under the leadership of Federal Reserve Bank of New York Governor Benjamin Strong , Friedman and Schwartz write, the Federal Reserve developed its first macroeconomic stabilization policy aimed at moderating the business cycle and maintaining price stability. Strong was also an ardent proponent of the international gold standard, which he viewed as fundamental to economic and financial stability.
Throughout the decade, Strong worked closely with governors of foreign central banks to promote and expand the international gold standard. Although each Reserve Bank set a discount rate, subject to Federal Reserve Board approval, Federal Reserve credit was supplied at the initiative of member banks when they came to the discount window to borrow reserves or obtain currency. Interest rates were already at low levels when the Fed agreed to prevent them from rising during the war.
As it did during World War I, the Fed actively supported the war effort by promoting war bond sales to the public. Wartime spending and armed forces mobilization brought full employment and rising household incomes which alongside highly expansionary fiscal and monetary policies put upward pressure on prices. To keep inflation in check, controls were put on wages and prices as well as on the growth of private credit.
Wage and price controls were removed in summer of , unleashing the suppressed inflation. As the essay describes, this triggered a debate between Fed and Treasury officials over whether to allow the yields on U. Treasury securities to rise. Although Treasury officials eventually acquiesced to a small increase in short-term rates, they insisted that the yield on long-term government bonds not be allowed to rise above 2.
Ultimately, however, the situation became untenable. The Fed and Treasury ultimately reached an agreement in March , known as the Accord, which ended interest rate controls and freed the Fed to use its monetary tools to control inflation. The Accord enabled the Fed to use monetary policy to achieve macroeconomic goals. However, the Fed continued to assist the Treasury by agreeing to limit interest rate moves when the Treasury was issuing new debt and to intervene if needed to prevent Treasury auctions from failing.
The Accord also brought a change in leadership to the Fed. After an extended period of low and relatively stable inflation from the early s through the mids, U. By accepting somewhat higher inflation, it seemed possible to drive the unemployment rate down significantly and, perhaps, permanently. To keep interest rates from rising the Fed pumped more and more money into the economy, and higher inflation was the result. By the early s, policymakers sought ways to contain inflation without tightening monetary policy and causing a recession.
Fed chair Arthur Burns, who replace Martin in , worked out an apparent solution with the Nixon Administration in the form of wage and price controls.
Temporary controls on prices, it was thought, could squash inflation without having to raise interest rates or slow the growth of the money supply. Burns supported the move and agreed to chair a committee charged with encouraging voluntary restraints on interest rates and dividends.
Unfortunately, wage and price controls proved ineffective at controlling inflation for very long. As the essay explains, at the time, Burns and others publicly blamed inflation on a variety of causes, including government budget deficits, pricing power of firms and labor unions, and sharply rising prices of oil and other commodities.
Burns was succeeded as Fed chair in by G. William Miller. Volcker had previously been employed as a Fed economist and an official in the Treasury Department, as well as in the private sector.
Soon after his appointment to the Board, Volcker convinced the FOMC to adopt new operating procedures to enhance control of the money supply and bring inflation under control. The poor performance of the U. Among them were:. This section describes key events leading to the establishment of the Federal Reserve System and how the Fed has evolved to meet the needs of the U. Prior to gaining independence from British rule, American colonists were limited to using European coins, commodity money, and barter as their primary means of exchange.
Troubled by shortages in foreign coins and the inefficiencies of barter and commodity money, many colonies decided to mint coins and issue paper currency for transactions. Unlike the banking system today, banks in the colonies did not take deposits or make loans. Instead, they issued paper currency commodity money backed by land or precious metals such as gold.
The primary sources of credit or loans came through wealthy merchants and other individuals. This was ineffective. People lacked faith in colonial currency and the right of a colony to issue money was often challenged by their British rulers. Central banking in the United States began with the ratification of our Constitution in This was controversial. The new federal bank would also establish a national currency, replacing the notes issued by the colonies.
In addition, the federal bank would carry out all financial matters for the U. He argued that the Constitution did not authorize the federal government to charter a national bank or issue paper currency.
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