The Federal Reserve: "Everyday Economics"

Read this article on the inception of the Federal Reserve system. Also learn about how this institution evolved over time to become one of the most important decision makers in our economy.

The Need for a Federal Reserve System

People who lived during the early 1900s used banks much as we do today. They deposited their money into savings accounts and borrowed money to build a home or start a business. When people borrowed money, banks issued them banknotes, which the borrowers spent the way we spend dollars today. The public valued these banknotes as money because banks promised to exchange them for gold or silver on demand.

Occasionally the public feared that banks would not or could not honor the promise to redeem these notes. Believing that a particular bank's ability to pay was questionable, a large number of people in a single day would demand to have their banknotes exchanged for gold or silver. This was called a bank run, and the fear that these runs created often spread, causing runs on other banks and general financial panic.

Runs and Financial Panic

During a run, even the healthiest and most conservative bank could not redeem all of its notes at once. Banks then, just as now, used most of the money deposited with them to make loans. As a result, the money was not sitting in the banks' vaults but was circulating in the community. In other words, the banks may have been solvent but not liquid. So when a bank run occurred, many times a bank had to close because it couldnot exchange the large number of notes presented in a single day.

Bankers tried to prepare for increasing depositor withdrawals by building up their reserves of gold or silver and by restricting credit. They stopped making loans, and panic ensued as everyone scrambled to redeem notes. Businesses had difficulty operating normally. The country's economic activity slowed, and many people lost their jobs and life savings.

Financial panics such as these occurred frequently during the 1800s and early 1900s. One of the most serious bank panics occurred in 1907. The large number of bank failures and the subsequent loss of savings prompted cries for reform. People wanted a central banking authority to ensure the operation of healthy banks that might otherwise fail because of a bank panic and to supervise bank activities so banks would not engage in unsound business practices that might lead to more bank failures. The public also wanted a more elastic currency and an improved payments system, which would contribute toeconomic stability.

Creating the Fed

In response, Congress set up the National Monetary Commission to study the nation's financial system and pinpoint its weaknesses. One of the primary weaknesses identified was that the United States lacked an elastic currency. This meant the banking system did not have a way to supply currency if demand for it increased significantly in a short time, so panics occurred. In 1912, the commission presented Congress with a monetary reform plan that recommended the establishment of the National Reserve Association, which would hold the reserves of commercial banks and could make short-term loans to banks to ensure credit availability. Congress responded by drafting the Federal Reserve Act, creating the Federal Reserve System. President Woodrow Wilson signed the act into law on Dec. 23, 1913.