ECON120 Study Guide

Unit 4: Federal Reserve System (1913–1944)

4a. Summarize the American monetary system up until the creation of the Federal Reserve System 

  • What were some forms of money used during the colonial era?
  • How was the dollar picked as a unit of account for the United States?
  • How was the American monetary system linked to precious metals?
  • What were some of the credit instruments on the second and third layers of money used in the United States from the late 18th century until the formation of the Federal Reserve system in 1913?
  • How did the Panic of 1907 contribute to the formation of the Federal Reserve system?

In New York in the American colonies, sea-shell beads called wampum circulated as legal tender during the seventeenth century. In Virginia, tobacco became a first-layer monetary asset and the pound-of-tobacco unit became an accounting standard. Virginia issued notes promising the delivery of pounds of tobacco as second-layer money circulated among the public as cash. Shells and tobacco sufficed as regional money because they each demonstrated some, but not all, of the monetary characteristics of coinage.
As time elapsed, gold and silver coins circulated as currency throughout the colonies. The most popular coin amongst the people was the Spanish silver dollar. In 1784, Thomas Jefferson argued for the dollar as the new American currency unit.
Two central banks were created in 1791 and 1812, but each ended after its twenty-year charter. Many early Americans didn't trust central banks to administer their currency. Notes issued by private sector banks functioned as cash throughout the nineteenth century. These notes were secured by United States Treasuries, the name for US government bonds. US government-issued gold certificates also circulated as cash. During the Civil War, paper money called the greenback, which couldn't be redeemed for precious metal, circulated as cash.
The gold standard that began in England influenced gold usage in the United States. The Gold Standard Act of 1900 eliminated silver from its monetary role and fixed one dollar at 1.5 grams of gold. This gave the United States the chance to create a central bank.
In the Panic of 1907, depositors withdrew bank deposits for gold coins or US Treasuries. These withdrawals caused regional banks to run on New York banks. The next year, United States Senator Nelson Aldrich set up the National Monetary Commission to study Europe's monetary system and recommend overhauling and modernizing the dollar system without a central bank. Congress created the Federal Reserve System on December 23, 1913.
To review, see Early American Money.

4b. Differentiate between the Federal Reserve's wholesale money and retail money 

  • What are the two types of money issued by the Federal Reserve?
  • Why does the Federal Reserve need retail-facing money and wholesale-facing money to conduct central banking?
  • How are Fed notes used in the financial system?
  • How are Fed reserves used in the financial system?

The word reserve implies a safety mechanism to help in a crisis. The Federal Reserve System (the Fed) was founded to combat financial crises. Fed reserves are deposits issued by the Federal Reserve to private sector banks. Fed notes (or "dollars") are available to people. Fed notes are issued as a reliable paper currency that can be easily used as a medium of exchange.
Wholesale money (Fed reserves) is money banks use, and retail money (Fed notes) is money that people use. The Federal Reserve's mandate was to provide wholesale money, or money for the banking system when credit instability stoked financial unrest. The Federal Reserve System is a wholesale rescue mechanism of reserves.
To review, see The Federal Reserve System.

4c. Describe some purposes of the Federal Reserve and how they affect the monetary hierarchy in the United States 

  • According to the Federal Reserve Act, what are the purposes of the Federal Reserve Act?
  • How does the Federal Reserve Act allow for a fractional reserve monetary system?
  • How did the Federal Reserve Act link the US monetary system to gold?

The Federal Reserve Act's first purpose is "to provide for the establishment of Federal reserve banks", and immediately establishes a federally unified and accepted second-layer money, "reserves", underlying all banking activity in the United States.
The second stated purpose of the Act is "to furnish an elastic currency", which confirmed that the Federal Reserve would have the ability to issue money in a fractionally reserved way and allow banks within its system to do the same.
The third purpose of the Act was the Walter Bagehot provision, giving the Federal Reserve the "means of rediscounting commercial paper". Commercial paper refers to short-term debt issued by banks and corporations. This allowed the Federal Reserve to act as a lender of last resort for the financial system by creating second-layer reserve balances to purchase distressed financial assets.
The last major purpose of the Act was "to establish a more effective supervision of banking in the United States", which allows the Federal Reserve to issue bank charters.
Finally, the Act decreed that 35% of the Federal Reserve's assets must be held in gold. Gold was 84% of the Federal Reserve's assets upon its founding, which decreased over time. Today, gold represents less than 1% of assets.
To review, see The Federal Reserve System.

4d. Describe the relationship between gold, US Treasuries, Fed reserves and notes, and commercial bank deposits by 1918

  • How do private sector banks contribute to the elasticity of the US dollar system?
  • Why was the Federal Reserve Act amended to allow for the ownership of US Treasuries?
  • On which layer of money did gold, US Treasuries, Fed reserves, and private sector bank deposits exist by 1918?
  • How did the Federal Reserve's gold-coverage ratio evolve?
  • How has war finance contributed to the layered-money system?

During World War I in 1916, the Federal Reserve Act was amended to effectively help the United States government finance its war effort. The Federal Reserve created reserves to purchase US Treasuries. US Treasuries joined gold on the first layer of money because by the end of World War I in 1918, the Federal Reserve's gold-coverage ratio went from 84% to less than 40% since the Federal Reserve held most assets in US government bonds. US Treasuries eventually replaced gold as the dollar pyramid's first-layer asset.
To review, see The Federal Reserve System.

4e. Explain why and how the United States government reduced its reliance on gold during the Great Depression 

  • How did the Federal Reserve respond to the financial crisis of 1929?
  • How did the Federal Reserve's gold-coverage ratio affect the crisis in 1929?
  • What did Executive Order 6102 mandate?
  • How was gold's role in the layered-money system affected by Executive Order 6102?
  • How did the Gold Reserve Act of 1934 affect gold's role in the monetary system?
  • How did the formation of the FDIC change the banking system and bank deposits?
  • How did the FDIC affect the three-layered monetary system in the US?

In October 1929, the Federal Reserve responded to a major financial crisis. With a fixed amount of gold reserves and a legally binding 35% gold-coverage ratio, the Federal Reserve could not create the necessary second-layer money to stave off economic depression. The Federal Reserve attempted to be a lender of last resort to the best of its ability, but it wasn't enough to overcome the effects of third-layer money contraction. These events led to gold being removed from the monetary landscape.
President Franklin Roosevelt issued Executive Order 6102 on April 5, 1933, which instructed all "gold coin, gold bullion, and certificates to be delivered to the government". The order eliminated access to first-layer money. The following year, the United States passed the Gold Reserve Act of 1934, which devalued the dollar against gold by increasing the gold price from $20.67 to $35 per ounce. The Act also legally transferred the ownership of all Federal Reserve gold to the United States Treasury and preceded the physical movement of gold bullion from New York to the United States Army's installation at Fort Knox in Kentucky.
The Banking Act of 1935 established the Federal Deposit Insurance Corporation (FDIC), which provided bank deposit insurance for the average American family. In the context of layered money, FDIC insurance is a federally guaranteed insurance policy on all third-layer bank deposits. The FDIC guarantee alleviated the public's fear of third-layer money. At this point, the monetary system existed between the second and third layers of money. The US dollar became independent of gold.
To review, see The Evolution of the Federal Reserve.

Unit 4 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • commercial paper
  • Fed notes
  • Fed reserves
  • reserves
  • retail money
  • wholesale money