The Federal Reserve System: Its Purposes And Functions 1939

This book was printed and published under and by the authority of the Board of Governors of the Reserve System a board of seven members appointed by the President and confirmed by the Senate, for terms of 14 years.

I am doing this because when Mr. Eccles, the then chairman of the Board, retired, the Board had discovered that the book had made banking so simple that the masses could understand it and that was intolerable money must be kept a mystery. The few who got hold of the book began to ask why Congress should surrender a delegated Constitutional power to private corporations who used it for private gain.

They began to ask: "Why should the people give to bankers U.S. Bonds, and pay an annual interest on these bonds, that they might use their own credit? Why should the Government have to borrow its own money (use its own credit) when forced to use more revenues than current taxes afforded?

Our bonded indebtedness in 1913, at the time the first Reserve Act was passed was less than $10 billion dollars! In 1939 it had jumped to over $45 billion.

So in 1939, 1940 and 1941 there was such a demand for this revealing book, that the Board made five printings. The Board had come to realize the great danger to their money power gained and exercised through the Reserve Act of 1913, promptly stopped the distribution of this book, and had it rewritten, completely omitting or obscuring the damaging statements.

Finding that additional copies could not be had, I decided, after 15 years of waiting and trying to get additional copies, to reprint the book myself.

In this introductory statement I want to make a few quotes from it, then piece them together, to show you that the whole mechanics of money, shorn of the mystery bankers weave about it, are so simple that a high school student can understand it; at the same time I want to reveal the tremendous theft bankers have gotten away with since 1913. Not only have they consistently and coldly robbed our Government and its people, year in and year out, but during the Reserve System's control of our national economy, the last 44 years, bankers planned and staged one of the most destructive panics the Nation has ever suffered, and provoked a World War that cost the people around $300 billion, and thousands of lives of our young men.

This being admitted, I am sure that you would like to understand how private banking corporations can exercise such destructive powers and they like wars because their profits pile up in mountainous volumes.

The first crime committed by Congress and it is wholly and solely responsible for this tragic thing was when it passed the first Reserve Act, December 23, 1913. This Act not only gave the private banking corporations the absolute ownership and control of our Nation's credit, but it gave them the power to CREATE money, bank deposits.

The Act gave the Board of Governors the power to write a check against no funds: "Federal Reserve Bank credit . . . under the law has a limited and special use as a source of member bank reserve funds. It is itself a form of money authorized for special purposes, convertible into other forms of money, convertible therefrom, readily controllable as to amount . . . Federal Reserve Bank credit does not consist of funds that the Reserve authorities GET somewhere to lend but constitute funds that they are empowered to CREATE. The process of creation is one of giving the promises of the Federal Reserve Bank in the form of reserve deposits."

The Federal Reserve Banks have the power to increase or decrease the supply of reserve funds, therefore they are in a position to exercise considerable influence (power) over the amount of credit, in the aggregate, that banks may be in a position to extend (to Customers).

Th Fed states "The aggregate deposits in the banking system as a whole (and you must always think of them as a whole) represent funds lent by banks or paid by banks for securities, notes, mortgages, and other forms of investment obligations;" and "Loans and purchases of securities by the Federal Reserve authorities are one of the important sources of member bank reserves; member bank reserves in turn are the basis of member bank credit that is, of the loans and investments of member banks. And member bank credit is a source of bank deposits transferable by check wherewith business men and other persons make the bulk of their monetary payments."

"Federal Reserve Bank credit and member bank credit are not the equivalent of each other, dollar for dollar accordingly the $100,000,000 of Reserve Bank credit obtained by the sale of securities to the Reserve Bank would increase their reserves sufficiently to enable them to expand their credit (make loans and buy securities) by $500, 000,000!"

That covers the whole of the essential steps in providing the people with money, the keeping of their deposits, cashing and clearing their checks. That's not the whole of the business of the Federal Reserve Banks they dabble in stock market gambling, in fact they are the croupiers who spin the wheels and call the turns, but it covers the machinery the Constitution delegated to Congress "The Congress shall have the power to . . . coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures."

Let's take each step of this creative power the Reserve Banks have over the volume of money:

The Reserve authorities buy corporation stock in the open (stock) market. It gives a check against no funds for the securities.

The seller of the securities deposits the check the Reserve authorities gave him with his home bank. He gets deposit credits.

The commercial bank sends the check to its Reserve Bank; the Reserve Bank gives the commercial bank credit dollar for dollar in its reserve fund.

The commercial bank multiplies its new reserves by five, and arrives at its new bank credit.

The bank lends these bank credits to eager customers, and the banker gives them deposit slips showing that the bank has added to their deposit account the face of the loan.

That's all, gentle reader or are you bristling with anger by this time?

Suppose the Reserve authorities write a check for $20,000,000 General Motors stock. General Motors deposits the check in the Morgan City National Bank, and gets $20,000,000 in deposits to its credit. The City National bank sends the check across the street to its Reserve Bank, and the Reserve Bank gives the City National bank credit in its reserve fund for $20,000,000. Then the City National bank multiplies its new $20,000,000 deposits by 7 and finds that the Reserve Bank has graciously complimented it with $140,000,000 bank credits which were actual money to the bank, for it could go out and buy anything under the sun with them; or make loans to their customers to the amount of $140 million.

Suppose City National Bank loaned all of that $140 millions; adding that to the $20 million General Motors got, would increase our volume of money $160 million and that is why you are being paid for your goods and services with a 20 cent dollar.

Did you get the sleightofhand, mysterious trick? The Reserve authorities wrote a check for $20 million, this increased the money supply $20 million; then the bank loaned $140 million, which added $140 million more, or a total of $160 million, growing out of this sale of $20 million corporation stock?

We have with our publisher, The Meador Publishing Company, 324 Newbury St., Boston 15, Massachusetts, our manuscript on the "The Legalized Crime of Banking," which you doubtless will want to read. It will be off the press soon. It not only makes plain the crime of banking, but it suggests a way out, a solution that would forever take our Nation out of the borrowing class, and make it truly the master of its money and credit. It would eliminate all U.S. Bonds, and good times and bad times could not be planned at the will of the money changers.

Now let me recite the biggest crime of all. Banks promote wars because they are astoundingly profitable to bankers. World War II cost us over $280 billion. The Reserve Banks bought every bond, and paid for them by giving the Government deposit credits on their books. This increased our money $560 billion $280 billion in U.S. Bonds, a gift to the bankers, and $280 billion deposits to the credit of the Government.

As the Government checked these deposits out to the people in payment for their goods and services, these checks cleared through the Reserve Banks, adding $280 billion to their reserve funds. The commercial banks multiplied these funds by five, and found that they had the staggering sum of $1 trillion 400 billion bank credit to use just as you use your own bank deposits. Adding this we find that the World War II increased our National debt $280 billion, added $280 billion new deposits in the one act. Then the $280 billion reserve fund increased bank credits to $1,400 billion and all of that became the property of bankers, except the $280 billion deposits the Government got when it surrender the bonds to the banks.

Let's not forget that the total amount of bank credit the member banks may lend or pay for securities is an arbitrary amount, which the Reserve authorities may any time increase or decrease at their own will. They may buy corporation stock at any time, without consulting any bank, and when they, do bank credits increase seven to thirteen times amount of stock bought.

In other words, that the Government might use $280 billion of its own credit, it made a present of $1,680 billion in bonds and bank credit to the bankers.

And remember these $280 billion in U.S. Bonds, and the $1 trillion 400 billion bank credits cost the bankers not one thin dime.

And who is to blame? Congress and only Congress, because the Constitution no where gave it the authority to re-delegate its power to "coin money, regulate the value thereof, and of foreign coin."

Had the Congress kept control of the Nation's money and credit, when World War II faced us, Congress would have ordered the Treasury to give the Government deposit credits on the books of the Treasury, and checked from there.

Then there would have been no U.S. Bonds, and the bankers would not have come out of the war $1 trillion 680 billion richer!

Think of our paying private banking corporations $1 trillion 680 billion just for the privilege of using a checking account of only $280 billion!

But, you say of course they never used that bank credit it's too much. That may be true, but if a man has $100,000 deposit credits on the books of the bank, and never spends more than $25,000, we say he had $100,000 to spend. Whether they use the total bank credits or not has nothing to do with the fact that they had that total amount of bank credits to use if they wanted to. To them it was the same as the deposits are to you.

Now, let's quote Sir Josiah Stamp at the time he was president of the Bank of England, president of the English Railway System, his directorates filled several pages of Whose Who. He said in Austin, in the late 20s,

"Banking was conceived in iniquity and born in sin . . . . The bankers own the world. Take it away from them, but leave them the power to create money and control credit, with a flick of the pen they will create enough money to buy it back again . . . . Take this power away from bankers and all great fortunes like mine (he was the second richest man in Great Britain) will disappear, and they ought to disappear, for this would then be a happier and a better world to live in. My sons should not object. They are well educated, and should be willing to take their places in the business world and forge their own fortunes."

Get absurdity of this: The Nation, with its wealth and manpower their know-how valued at $500 billion, gives to the Federal Reserve authorities, with a capital and surplus of $350 million, to borrow $280 billion! The rich man borrowing from the pauper? Sure; and how absurd.

Sir Josiah was speaking for every person in America. He was speaking to you.

Note, we are using a different format. which enables us to compress two pages of the original book on one page of this reprint. We have at bottom of each column the page number that appeared on same page of the book. We have done this that we might use same index, so you may find subject you are looking for by turning to column with the indicated number under it.

We have left the pictures of the eleven Reserve Banks out, [including -ed.] reproducing only the Washington Reserve Bank that we might utilize the space for comments, which you will find [instead of "enclosed in parentheses," formatted as footnotes -ed.], in 9 point type. We have used a skinny 11 point type for space reasons, and such portions of the book as we think you should study carefully we have set in italics. We have separated our comments from the main text with rules, and placed each comment at the bottom of its own page. We have reproduced the map and charts; so we hope you may get the full picture of the "Legalized Crime of Banking" Congress has made possible through the passage of the 1913 Reserve! Act. The Reserve System has cheated the people out of the $272 billion outstanding in bonds, and an annual interest of $10 billion the interest is more than the total national debt before the Reserve Act was passed in 1913.

The Federal Reserve System is 25 years old this year. Its operations have become a factor of greatest importance in American economic life. While they chiefly concern banks and the Government, their effects extend into all forms of economic activity and are felt indirectly by everyone.

It is desirable, therefore, that the Federal Reserve System be as fully understood as possible by the public in whose interest it was established and in whose interest it is administered. [2]

The text of the book has been prepared by Bray Hammond and the staff of the Board of Governors of the Federal Reserve System.

1. The Board of Governors is composed of seven members. Their appointments are made by the President of the United States and confirmed by the Senate. Members are appointed for terms of fourteen years, so arranged that one term expires every two years. The Board's responsibilities lie in the field of money and banking. Their object in a broad sense is to maintain sound banking conditions and an adequate supply of credit at reasonable cost for use in commerce, industry, and agriculture. The Board supervises the operations of the twelve Federal Reserve Banks. Its offices are in Washington, D.C.

District No. 1.

Federal Reserve Bank of Boston.

District No. 2.

Federal Reserve Bank of N. Y.
Branch at Buffalo, N. Y.

District No. 3.

Federal Reserve Bank of Phila.

District No. 4.

Federal Reserve Bank of Cleveland
Branches: Cincinnati, Ohio.

Pittsburgh, Penna.

District No. 5.

Federal Reserve Bank of Richmond
Branches: Baltimore, Maryland.

Charlotte, N. C.

District No. 6.

Federal Reserve Bank of Atlanta
Branches: Birmingham, Ala.

Jacksonville, Florida
Nashville, Tennessee
New Orleans, Louisiana

Agency at Savannah, Georgia

District No. 7.

Federal Reserve Bank of Chicago
Branch: Detroit, Michigan

District No. 8.

Federal Reserve Bank of St. Louis
Branches: Little Rock, Arkansas

Louisville, Kentucky
Memphis, Tennessee

District No. 9

Federal Reserve Bank, Minneapolis
Branch at Helena, Montana

District No. 10.

Federal Reserve Bank, Kansas City
Branches: Denver, Colorado

Oklahoma City, Okla.
Omaha, Nebraska

District No. 11.

Federal Reserve Bank of Dallas
Branches: El Paso, Texas

Houston, Texas
San Antonio, Texas

District No. 12.

Federal Reserve Bank, San Francisco
Branches: Los Angeles, Calif.

Portland, Oregon
Salt Lake City, Utah
Seattle, Washington

Each of the twelve Federal Reserve Banks is a corporation, organized and operated in the public service. The Federal Reserve Banks differ essentially from privately managed banks in that they are not operated for profit, and their stockholders, which are the member banks, do, not have the powers and privileges that customarily belong to stockholders of privately managed corporations.

Each Federal Reserve Bank has nine directors, three of whom are known as class A directors, three as Class B directors, and three as Class C directors. These nine directors are not chosen the way directors of business corporations are usually chosen. Class A and Class B directors are elected by member banks, one director of each class being elected by small banks, one each by banks of medium size, and one of each class by large banks. The three Class A directors may be bankers. The three Class B directors must be actively engaged in the district in commerce, agriculture, or some other industrial pursuit, and must not be officers, directors, or employees of any bank. The three Class C directors are designated by the Board of Governors of the Federal Reserve System. They must not be officers, directors, employees, or stockholders of any bank. One of them is designated by the Board of Governors as chairman of the Reserve Bank's board of directors.

Under this arrangement, business men other than bankers constitute a majority of the directors of each Reserve Bank. The directors are responsible for the conduct of the affairs of the Reserve Bank, subject to the supervision of the Board of Governors. They choose the Reserve Bank officers, but the law requires that their choice of president and of the first vicepresident be approved by the Board of Governors. The salaries of all officers and employees are also subject to the approval of the Board of Governors. Each branch of a Federal Reserve Bank has its own board of directors, a majority of whom are selected by the Reserve Bank the remainder by the Board of Governors. These conditions with which the law circumscribes the selection of Reserve Bank directors and the management of the Reserve Banks, indicate the public nature of the Reserve Banks.

Decentralization is an important characteristic of the Federal Reserve System. Each Reserve Bank and each branch office is a regional and local institution as well as a part of a nationwide system. Its officers and employees are residents of the district, and its transactions are with regional and local banks. It gives effective representation to the views and interests of the particular region to which it belongs and at the same time helps to administer nationwide policies.

The Federal Reserve Banks derive an income from their operations which has been sufficient to cover expenses, to pay dividends limited to 6 percent per annum, cumulative, to pay a substantial amount to the United States Treasury, and to make additions to our surplus. This surplus, if the Federal Reserve Banks were to be liquidated, would belong to the United States Government.

3. The Federal Open Market Committee comprises the seven members of the Board of Governors and five representatives of the Federal Reserve Banks. The committee directs the open market operations of the Federal Reserve Banks, that is, the purchases and sales of United States Government securities and other obligations in the open market. The purpose of these operations is to maintain a basis for bank credit ample to meet the business needs of the country.

4. The Federal Advisory Council consists of twelve members, one selected annually by each Federal Reserve Bank through its board of directors. The Council meets in Washington at least four times a year. It confers with the Board of Governors on general business conditions and makes recommendations regarding the affairs of the Federal Reserve System. Its recommendations are purely advisory.

5. Member banks include all national banks in the continental United States, and such State banks and trust companies as apply for membership, meet the requirements, and are admitted. On December 31, 1938, the membership comprised 5,224 National banks and 1,114 State banks. There were over 8,000 other State banks and trust companies (exclusive of mutual savings banks) that did not belong to the System; these were mostly small banks, their aggregate deposits being about 17 percent of the total deposits of all commercial banks.

Each member bank, as required by law, holds stock, equal to 3 percent of its own capital and surplus, acquired directly from the Federal Reserve Bank; it can not be sold, transferred, or hypothecated, and can be disposed of only by being surrendered to the Federal Reserve Bank.

Each member bank also is required to maintain its legal reserves on deposit with the Federal Reserve Bank of its district. These legal reserves are proportionate to the member bank's own deposit, the proportion varying according to the location of the member bank and the character of its deposits. Higher reserves are required against demand deposits than against time deposits, and banks in large cities, generally speaking, are subject to higher reserve requirements than banks in smaller cities and rural regions. No interest is paid on these reserves.

Member banks may and do maintain reserves in excess of requirements, On December 31, 1939, their reserve balances amounted in the aggregate to about nine billion dollars, of which about three million were excess reserves.

The Monetary and Credit Functions of the Federal Reserve System

The monetary and credit functions of the Federal Reserve System mean much more than merely the issuance of paper currency and coin. Currency is actually used for only a small part of the country's total volume of payments, the greater part being effected by the use of bank checks. Whenever business is so active that additional means of payment are required, the additional amounts may, to some extent, be called for in the form of currency, in which event the Federal Reserve Banks have facilities for finishing promptly all that is required. Or the addition may be wanted in the form of bank deposits transferable by check, in which event member banks lend the required amounts. In case member banks have any difficulty making the loans that are asked for, because their own funds are made inadequate, it is possible for them to borrow additional funds from their Federal Reserve Bank and possible for the Federal Reserve authorities on their own initiative to supply additional funds through open market purchases of securities.

Before the establishment of the Federal Reserve System, the banks maintained the reserves required to be held against their deposits partly in the form of cash in their vaults and partly in the form of deposits in other banks. In general, banks in smaller cities and rural regions maintained the bulk of their reserve balances with banks in larger cities. A very large volume of these reserve balances was maintained in New York City and Chicago. These two cities and St. Louis were designated as central reserve cities, and National banks therein had to maintain all their legal reserves in the form of cash in their own vaults.

Under these circumstances, when banks throughout the country needed to draw down their reserve balances, the demand necessarily converged on a few banks situated in the financial centers. In ordinary times the demand was not excessive, for while some country banks would be drawing-down their balances, others would be building theirs up. Now and then, however, the demand became widespread and intense. Banks all over the country would call on the Chicago and New York banks for currency, which the city banks were to supply and charge to the reserve balances of the country banks. In such circumstances, it might be difficult for the city banks to meet this demand, because the currency constituted their own reserves and there was no source on which they could rely for additional reserve funds. The efforts of these banks to protect their reserves frequently involved the sale of securities and the refusal to make loans and renewals, with the result that securities prices would fall, interest rates would rise, borrowing would become difficult, and loans would have to be liquidated.

Panics and crises like this were apt to occur every few years, and in 1907 there was one of unusual severity. Congress appointed a National Monetary Commission shortly thereafter for the purpose of determining what should be done. There was active and thorough consideration of the question for several years, and though Congress greatly modified the plan recommended by the Commission, it eventually adopted legislation embodying the results of the study both by the Commission and other authorities inside and outside of Congress. This legislation is the Federal Reserve Act. It became law December 23, 1913. [4]

The Federal Reserve Act directed that the Federal Reserve Banks be established, required that reserves of member banks be deposited with the Federal Reserve Banks; it empowered Federal Reserve authorities to discount paper for the member banks, to engage in open market operations, and to issue Federal Reserve rates.

The member banks use the reserve accounts that they maintain with the Federal Reserve Banks in very much the same way that a bank depositor uses his checking account. On the one hand they may deposit in the reserve accounts the checks on the other banks from their customers: and on the other hand, they may draw on the reserve accounts for various purposes, especially to procure currency and to pay the checks drawn against them by their customers and deposited in other banks.

The volume of reserves required by law is much greater, ordinarily, than these uses would make necessary. The reason for this is that the required reserves have an additional purpose: they are the means through which the Federal Reserve authorities influence the lending and investing activities of banks. As long as a bank has reserves in excess of requirements, it is in a position to enlarge its extensions of credit, assuming a demand. As long as it is without reserves in excess of requirements, it is not in a position to enlarge its extensions of credit and may be impelled to borrow additional funds. Since the Federal Reserve authorities have the power to increase of decrease the supply of reserve funds and within limits to increase or decrease reserve requirements, they are able to exercise considerable influence over the amount of credit, in the aggregate, that banks may be in a position to extend.

These functions of the Federal Reserve authorities are sometimes called "central banking" functions. Practically every modern country has an institution for the performance of such functions. In Canada, it is the Bank of Canada; in England, it is the Bank of England; in France, it is the Bank of France. In the United States, however, there are twelve Federal Reserve Banks embraced in a regional system, and the coordination of their activities is effected through the Board of Governors in Washington.

The duties of the reserve authorities fall into two main groups. One group includes duties which relate primarily to the maintenance of monetary and credit conditions favorable to sound business activities in all fields agriculture, industrial, commercial. They call for policy decisions from time to time rather than routine activity. They involve lending to member banks, open market operations, fixing reserve requirements, establishing discount rates and issuance of regulations relating to these other functions.

The other group includes duties which relate primarily to the maintenance of regular services for the member banks of the Federal Reserve System, the United States Government, and the public. These services are principally the following: holding member bank reserve balances; furnishing currency for circulation; facil itating the clearance and collection of checks; supervising member banks, and obtaining reports of condition from them; acting as financial agents, custodians, and depositories for the United States Government.

These regular services engage by far the greater part of the time and attention of the officers and employees of the twelve Federal Reserve Banks. They will be described with more detail in the chapter immediately following. In later chapters the monetary and credit functions of the Federal Reserve authorities will be discussed. [6]

The Service Functions of the Federal Reserve Banks

The twelve Federal Reserve Banks hold the legal reserves of member banks, furnish currency for circulation, facilitate the collection and clearance of checks, exercise supervisory duties with respect to member banks, and are fiscal agents of the United States Government.

One of the primary functions of the Federal Reserve Banks is to hold the legal reserves of member banks. The member banks do not normally let these reserves lie idle awaiting an emergency but keep them in active use. This usually entails a heavy amount of continuous work for the Federal Reserve Banks: furnishing the member banks coin and paper money of all denominations; receiving and sorting deposits of currency; and receiving, sorting, collecting and clearing checks.

Treasury currency comprising silver certificates, silver dollars, subsidiary silver, minor coin and United States notes, is issued by the Treasury itself, but it is placed in circulation for the most part through the Federal Reserve Banks.

The kinds of currency in process of retirement, comprising national bank notes, gold certificates (old form), Federal Reserve Bank notes, and Treasury notes of 1890 are being replaced by other types of currency mainly Federal Reserve notes and silver certificates. Their retirement does not mean that the amount of money in circulation is being reduced but that fewer kinds of money are now being issued.

All of the kinds of currency listed above are legal tender for all debts, public and private, public charges, taxes, duties and dues.

All United States paper currency is printed at the Bureau of Engraving and Printing at Washington, D.C., and all United States coins are made at the Philadelphia, Denver, and San Francisco mints. The Bureau of Engraving and printing and the mints are operated by the United States Treasury. Federal Reserve notes are printed by the Bureau at the expense of the Federal Reserve Banks.

The total amount of paper money and coin in circulation which as indicated above, is about $6,856,000,000 fluctuates relatively little. The new currency being constantly produced by the Bureau of Engraving and Printing and by the mints for the most part merely takes the place of old currency that has been soiled, mutilated, or worn so that it is no longer fit to use.

Practically all money, therefore, passes into and out of banks at one time or another. There are times when banks are called on to pay out more cash than they receive and there are times when they receive more than they pay out. The demand varies from season to season, from place to place, and from bank to bank. A heavy demand for currency at Christmas time is practically universal. In agricultural regions there is a heavy demand for cash when crops are being harvested; in cities there is a heavy demand for cash at certain times in the summer, particularly around the Fourth of July and Labor Day, when people withdraw money for their vacations. Moreover, the demand varies for different kinds of cash. Some communities use more coin than others and less paper money, and some use more of certain denominations than others do.

In accordance with this demand, banks provide themselves with the amount and kinds of cash that the people of their communities want. Member banks depend upon he Federal Reserve Banks for replenishment of their supply ordering what they require and having it charged to their reserve accounts. Non-member banks generally get their supplies from member banks.

The twelve Federal Reserve Banks in turn keep a large stock of paper currency and coin on hand to meet this demand. This includes both Federal Reserve notes, which are their own liabilities, and coin, silver certificates, and United States notes, which they obtain from the Treasury, giving the Treasury credit in its checking account for the amount obtained.

Until the Federal Reserve Banks were established in 1914, the means of furnishing currency for circulation were unsatisfactory. A gap existed between the Treasury and the banking system, and demand for increased circulation could not always be met promptly. This was the case in the panic of 1907, and as already indicated, the experience of that year was one of the things that led to formation of the Federal Reserve system.

The currency mechanism provided under the Federal Reserve Act has worked satisfactorily money moves into and out of circulation automatically, in response to increase or decrease in the public demand. The Treasury, the twelve Federal Reserve Banks, and the thousands of local banks throughout the country form a system of distribution that reaches the community, that enables cash bills and coins to be furnished promptly where it is needed, and that also enables surplus cash to be retired from circulation at times when the public demand subsides. [9]

The use of checks is facilitated by the service of the Federal Reserve Banks in clearing and collecting them through the reserve accounts of member banks. For example, suppose that a manufacturer in Hartford, Connecticut, sells $1,000 worth of electrical equipment to a dealer in Sacramento, California, and receives in payment a check on a bank in Sacramento. The check is an order on the Sacramento bank to pay the Hartford manufacturer $1,000. Obviously, the Hartford manufacturer does not want to make a trip to California to collect $1,000 in cash, nor does he want to pay postage and insurance on a shipment of currency. He does not ordinarily want cash at all. What he wants is to have $1,000 placed to his credit in his checking account. Accordingly he deposits the check in his Hartford bank. The Hartford bank does not require cash for the check: it wants credit in its reserve account at the Federal Reserve Bank of Boston. Accordingly, it sends the check to the Federal Reserve Bank of Boston. The Federal Reserve Bank of Boston sends it to the Federal Reserve Bank of San Francisco. The Federal Reserve Bank of San Francisco sends it to the bank in Sacramento. The bank in Sacramento charges the check to the account of the depositor who wrote it, and either remits the amount to the Federal Reserve Bank of San Francisco or authorizes the San Francisco Reserve Bank to charge the amount to its reserve account. The Federal Reserve bank of Boston in turn credits the account of the Hartford bank. Thus the check effects the transfer through the Federal Reserve Banks of $1,000 of deposit credit from the checking account of the dealer in Sacramento to the checking account of the manufacturer in Hartford.[10]

Even though a bank is not a member of the Federal Reserve System, it may nevertheless arrange to maintain with the Federal Reserve Bank what is called a "clearing balance." Checks drawn on other banks which are received by the nonmember bank and forwarded by it to the Reserve Bank may be credited to this clearing balance, and checks drawn against the nonmember bank and deposited in other banks may be paid with funds from the balance.

Checks which are collected and cleared through the Federal Reserve banks must be paid in full by the banks on which they are drawn, without deduction of a fee charge. That is, they must be paid "at par." The Federal Reserve Banks have greatly shortened and simplified the process of clearing and collecting checks. By doing so, they have improved the means by which goods and services are paid for and by which monetary obligations are settled: they have also reduced the cost to the public of making payments and transferring funds. The Federal Reserve Banks also handle other items for collection besides checks, such as drafts, promissory notes, and bond coupons.

In order to make transfers and payments as promptly and efficiently as possible, the twelve Federal Reserve Banks maintain a fund in Washington called the Interdistrict Settlement Fund, in which each Reserve Bank has a share. Through this fund money is constantly being transferred by telegraphic order from the account of one Reserve Bank to that of another. Many millions of dollars of transfers and payments are made every day, including large transfers for member banks and for the United States Treasury.

The relative importance of currency and of checks is indicated roughly by the following figures: in the year 1938 the twelve Federal Reserve Banks handled about five billion separate pieces of coin and paper money, the total value of which was $9,000,000,000. In the same period they handled a billion checks, the value of which was $232, 000,000,000. In other words, the number of pieces of coin and paper money was five times as great as the number of checks, but the monetary value of the checks was over twentyfive times as great as the amount of currency and coin.

Supervisory Functions

According to the preamble to the Federal Reserve Act, one of the purposes of the Act was "to establish a more effective supervision of banking in the United States." However, specific duties of supervision are entrusted by law to other agencies as well as to the Federal Reserve authorities. The examination and supervision of all national banks, which comprise the majority of banks belonging to the Federal Reserve System, are conducted by the Comptroller of the Currency. Examination reports made by his examiners as the condition of banks are available to the proper Reserve authorities. The other banks which belong to the system all of them State banks are supervised by State authorities and examined by them with the cooperation of the Federal Reserve Banks. Information is available to Reserve authorities not only from the reports of examiners but also from periodic reports of conditions submitted by the member banks themselves. Banks that are not members of the Federal Reserve System, but have deposit insurance in he Federal Insurance Corporation, are examined by the Corporation and by State authorities. Each of the Federal Reserve Banks has an examining staff for the examination of banks in its district. The Federal Reserve Banks themselves are examined by the examining staff which the Board of Governors in Washington maintains.

Among other supervisory powers exercised by the Federal Reserve authorities, the most important are:

The power to fix the maximum rate of interest which member banks may pay upon time and savings deposit. The main purpose of this power is to prevent banks from paying such high rates, in competition for deposits, as to weaken their condition.The power to take disciplinary action, including the following: to remove officers and directors of member banks after citation in the case of national banks by the Comptroller of the Currency, and in the case of State member banks by the Federal Reserve Agent for continued violation of banking law or for continued unsafe or unsound banking practices; and to suspend member banks from recourse to the credit facilities of the Federal Reserve System if it is found that they are making undue use of bank credit for speculation in securities, real estate, or commodities.The power to grant permits to national banks to exercise trust powers.The power to grant permission to holding companies so that they may vote stock of member banks controlled by them. Such companies are usually corporations which own all or a majority of the stock of one or more member banks.The power to grant permits to member banks to establish branches in foreign countries. Under this authority seven large banks situated in New York, Boston, and San Francisco maintain foreign branches, about a hundred in all, situated in twentythree different countries.

Fiscal Agency Functions

The twelve Federal Reserve Banks carry the principal checking accounts of the United States Treasury, handle much of the work entailed in issuing and redeeming Government obligations, and performing numerous other important fiscal ditties of the United States Government.

The Government has an enormous amount of banking business to do. It is continuously receiving funds in all parts of the United States and spending them in all parts. Its receipts come normally from taxpayers and purchasers of Government securities and are deposited in the Federal Reserve Banks to the credit of the Treasury. Its funds are disbursed by check, and these checks are paid by the Federal Reserve Banks and charged to the Treasury's account.

The Federal Reserve Banks also perform important services for the Treasury in connection with the public debt. When a new issue of Government securities is sold by the Treasury, the Reserve Banks receive the applications of banks, dealers, and others who wish to buy, make allotments of securities in accordance with instructions from the Treasury, deliver the securities to the purchasers, receive payment for them, and credit the amount received to the Treasury's checking account. The Reserve Banks also redeem securities as they mature, making exchanges of denominations or kinds, handle transfers and conversions, pay interest coupons, and do a number of other things involved in servicing the Government debt. They issue and redeem United States savings bonds and upon request hold them in safekeeping for the owners. For the Convenience of the Treasury and also for the convenience of investors in Government securities, it is necessary that there be facilities in various parts of the country to handle such transactions, and the Federal Reserve Banks furnish these facilities. Since the Federal Reserve authorities are constantly in touch with the money and investment markets, the Treasury follows the practice of consulting them for their advice as to terms and conditions that will affect the sale and the refunding of Government obligations.

In connection with the lending and other financial activities of such Governmental agencies as the Reconstruction Finance Corporation, and the Commodity Credit Corporation, and the Home Owner's Loan Corporation, the Federal Reserve Banks act as custodians of collateral and securities. This not only involves safekeeping but disbursement of funds upon receipt of proper documents and maintenance of accurate records of large quantities of securities, warehouse receipts for commodities, and other valuable papers which are constantly in process of being received, transferred and returned, as loans are granted, as partial payments are made and as maturing obligations are paid off or renewed.

The Federal Reserve Banks are reimbursed by the United States Treasury and other Government agencies for much of the expense incurred in the performance of fiscal agency functions.

Because of its situation in one of the principal financial centers of the world, the Federal Reserve Bank of New York acts as the agent of the United States Treasury in the foreign exchange operations of the Treasury's Stabilizing Fund. The Federal Reserve Bank of New York also has occasion to receive deposits of foreign central banks and to perform certain incidental services as corespondent of such banks. The Board of Governors exercises special supervision over all relations and transactions of Federal Reserve Banks with foreign banks. Such relationships are confined almost wholly to the Federal Reserve Bank of New York, which in these matters generally acts as agent for the other Federal Reserve Banks.[11]

The service functions that have been described absorb the attention and time of the greater part of the Federal Reserve personnel. The fiscal agency and related activities alone occupy the full time of about 2,500 employees out of a total of about 11,000. These functions differ greatly in this respect from the task of determining and administering monetary and credit policy. Decisions as to discount rates, reserve requirements, and open market operations may need to be made by the Reserve authorities only occasionally. Yet, though they may take, on the whole, less time than functions that must be performed daily through the year, they may have more far reaching effects upon the country's economic life. [12]

The amount of reserves held in relation to legal requirements is a controlling factor in the lending policy of banks.

The aggregate deposits in the banking system represent mainly funds lent by banks or paid by banks for securities, mortgages, and other forms of investment obligations. It may seem that it ought to be the other way around that bank loans and investments would be derived from bank deposits instead of bank deposits being derived from loans and investments: and it Is true that deposits would not grow out of loans if currency were used by the public for monetary payments to the exclusion of bank deposits transferable by check. But as it is, the public in general prefers to have its monetary funds including what it borrows on deposit in banks rather than in the form of currency in its own possession. The result of this preference is that the proceeds of loans go on deposit to be disbursed by check, and aggregate deposits are increased.

Suppose, for example, that a man borrows $1,000 from a bank and took his loan in currency. The bank would have $1,000 less currency than before and in its place a promissory note for $1,000. Its deposits would remain untouched and unchanged. But suppose that the borrower, preferring not to take currency, asked for $1,000 deposit credit instead. In that case the bank's currency would remain unchanged it would have the promissory note and it would have $1,000 more deposits on its books. The loan instead of decreasing the bank's cash holdings would have increased its deposits.

Or suppose that the bank purchases a $1,000 Government bond from one of its customers. The customer does not want payment in currency. He wants payment in deposit credit. Accordingly, the bank acquires a $I,000 bond and its deposits increase by $1,000. The bank's currency is not involved in the transaction and remains what it was. [14]

It does not follow that bank deposits can be enlarged without limit by increased bank loans and investments. When banks give deposit credit to their customers, they assume an obligation to pay the customers' checks. Consequently, they must have funds on hand for the purpose; though ordinarily the amount need not be more than a fraction of the total deposit liability.

How much it must be depends largely on circumstances. But its amount relative to deposit liabilities limits the ability of banks to lend and to invest.

The fact that banks can not increase their loans and investments unless adequate funds are available to them makes bank reserves of key importance. Upon the adequacy of reserves hinges the power of banks to expand loans and investments and therewith to expand deposits. Upon reserves also hinges the power of the Federal Reserve authorities to influence the credit policy of the member banks.

Bank reserves need to be understood from both the operating and the legal point of view. From the operating point of view, they may be described as that portion of a bank's assets which the bank has not lent or invested but holds in cash or other forms readily available for use. In the early years of banking, reserves consisted of gold and other coin kept by each bank in its own chests; later on, reserves included also the funds which a bank might keep on deposit with another bank usually with a larger one situated in an important financial center. The more conservative a banker was the larger and more liquid the reserves he was inclined to maintain. Such reserves usually meant a sacrifice of income, but they also meant protection in time of emergency.

Although sound banking practice called for the maintenance of adequate reserves, there were banks that failed to observe sound banking practices. Consequently, about a hundred years ago, legislatures began to adopt legal standards, which might require, for example, that a bank's reserves be not less than 10 percent of its note and deposit liabilities. But, while a legal requirement made certain that reserves be maintained, it also might interfere with their availability, since occasions would arise when a bank could not make the necessary use of its reserves without reducing them below the legal minimum. Just at a time when it was especially desirable, in the public interest, for banks to lend, they might be impelled to stop lending in order to avoid depleting the reserves which the law required them to maintain. Accordingly, it became clear after long and painful experience that to require reserves to be maintained in certain volume was not enough there should also be means whereby banks could obtain additional reserve funds when needed.

This need was met by the establishment of the Federal Reserve Banks and the organization of the Federal Reserve System; member banks were required to maintain reserves of a certain volume with the Federal Reserve Banks, and at the same time the Federal Reserve Banks were given power to advance additional reserve funds to them either by lending to them directly or by purchasing securities and other forms of obligations in the open market.

Since it became possible under its power for the earning assets of banks to be converted readily into cash and reserve funds, the maintenance of large liquid reserves by individual banks became less necessary. Banks were put in a more secure position than they'd been in when no means existed for enlarging their reserves. In addition, the Federal Reserve authorities were directed to use their power not merely so as to assure ample credit for the legitimate monetary needs of commerce, industry and agriculture, but so as to curb the use of credit in speculation. Under these circumstances, reserve requirements took on a new significance. They became important as a means of giving effectiveness to the regulatory powers to be exercised directly with respect to volume of bank reserves and indirectly with respect to the extension of credit by banks.

For member banks in central reserve cities (New York City and Chicago), not less than 13 percent of demand deposits (checking account) and 3 percent of their time deposits (including savings).

For member banks in reserve cities (sixty other cities of lesser size), not less than 10 percent of their demand deposits and 3 percent of their time deposits.

For member banks in reserve cities called "country banks", not less than 7 percent of their demand deposits and 3 percent of their time deposit. The greatest number of banks fall in this third classification, but the total volume of their deposits is smaller than that of either of the other classes.

The law permits the foregoing requirements to be changed by the Board of Governors of the Federal Reserve System, "In order to prevent injurious credit expansion and contraction." It limits the possible range however; requirements may not be made lower than those stated in the law nor more than twice as high.

Classes of deposits and banks	June 21, 1917 - Aug. 15, 1936	Aug. 16, 1936 - Feb. 28, 1937	Mar. 1. 1937 - Apr. 30, 1937	May 1, 1937 - Apr. 15, 1938	Apr. 16, 1938 and after
*On net demand deposits:*	(Percent of deposits)
Central reserve city banks . .	13	19 ½	22 ¾	26	22 ¾
Reserve city banks . . . . . . . .	10	15	17 ½	20	17 ½
Country banks . .	7	10 ½	12 ¼	14	12
*On time deposits:*	(Percent of deposits)
All member banks . . . . . . . . .	3	4 ½	5 ¼	6	5

In practice, these requirements relate to balances maintained on the average over a period (semi-weekly, weekly, or seimmonthly depending on the bank's location) and do not imply that the funds are to be left untouched. While maintaining his average above the reserve balance at or above the required minimum. A banker may make constant and active use of his reserve account. From day to day he may have credits to the account for checks on other banks received from his depositors: and from day to day he may have charges to the account for checks that have been drawn on him and deposited in other banks. He may also from time to time withdraw currency and have it charged to the account, and when he has more currency than he needs, he may deposit it at the Reserve Bank to be credited to his account. These current uses of his reserve account will not necessarily reduce his average balance below the requirement.

Since reserve requirements govern the ratio between reserves and deposits, it is apparent that they may be regarded as limiting either the extent to which reserves may be allowed to shrink in relation to a given volume of deposits or the extent to which deposits may be allowed to expand on the basis of a given volume of reserves. Sometimes an increase or decrease in deposits results in a simultaneous increase or decrease in reserves, but this is not necessarily so. Suppose, for example, that a given bank has $2,000,000 of deposits, is required to have reserves of 10 percent, and has exactly that amount, namely $200,000. If a customer deposits an additional $100,000, either in cash or in the form of a check on another bank, the first bank not only has its deposits increased by that amount, but also is put in position to increase its reserves equally by depositing the currency or check in the Federal Reserve bank.

But suppose that instead of depositing $100,000 in cash, the customer borrowed that amount from the bank and deposited it in his account; in that case the bank's deposits would be increased, but the deposit would bring no currency or check with which the bank's reserves might be increased. Furthermore, the $100,000 which the customer borrowed might be checked out, in which case the bank's reserves would be reduced by half, while its original deposits would remain unchanged.[15]

In brief, when borrowed funds are checked out, the result is a decrease in reserves, and when they remain on deposit, the result is an increase in deposits without an increase in reserves. In either event, lending has an immediate reaction upon the ratio of reserves to deposits. And, as a corollary, the amount of reserves held in relation to legal requirements is a controlling factor in the lending policy of a bank.[16]

There are three prominent factors that, in the absence of operations by the Federal Reserve authorities, may render bank reserves inadequate in amount. One is an increased demand for borrowed funds, which, as banks increase their loans and investments in response to it, result in an expansion of bank deposits without a corresponding expansion of reserves. The second is an increased demand by the public for circulation currency: as the currency is withdrawn, it reduces both the reserves and the deposits of banks by the same amount, but the reduction in reserves is relatively greater than the reduction in deposits, since reserves are smaller than deposits. The third is a drain of gold out of the country, a condition which, like withdrawals of currency, effects a reduction of reserves relatively greater than the reduction it effects in deposits. Payment of federal taxes by the public and purchases by the public of new issues of Government securities also tend temporarily to reduce bank reserves, but these reductions are soon offset when the Government disburses the funds it has received.

When any of the factors renders member bank reserves insufficient, an occasion arises for Federal Reserve Bank credit that is, for funds which the Federal Reserve authorities are empowered to supply for the specific purpose of replenishing or increasing member bank reserves. This need may be confined to relatively few banks or it may affect banks in general. It may be met through loans to individual banks or through open market purchases, depending on prevailing credit conditions and policies.

Discounts and Advances for Member Banks

The loans which individual member banks may obtain from the Federal Reserve Banks are of two main classes:

(1) the discount of socalled eligible paper; and

(2) advances.

Eligible paper consists principally of notes, drafts, and bills of exchange used to finance payments for agricultural and industrial products. Such obligations are eligible for discount if their maturates at the time of discount are not more than ninety days in the case of commercial or industrial paper and not more than nine months in the case of agricultural paper. A member bank owning such obligations may transfer them by endorsement to the Federal Reserve Bank, which will credit the proceeds thereof to the member bank's reserves after deducting a discount or interest charge at the established rate.

Advances may be made by a Federal Reserve Bank to a member bank on the latter's promissory note secured by collateral. An advance secured of not more than ninety days and in subject to the same discounts or interest charges as eligible paper itself. An advance secured by other collateral satisfactory to the Federal Reserve Bank may have a maturity of not more than four months and is subject to a rate of interest not less than onehalf of one percent per annum above the current discount rate on eligible paper.

Under the two foregoing provisions a Federal Reserve Bank may supply a member bank with any amount of additional reserves the member bank needs, the only limitation being the amount of good assets the member bank may offer the Federal Reserve Bank as security.

Discount Rates

Although the discount or interest rate which the Federal Reserve Banks charge their member banks is generally lower than the rate which commercial banks charge their customers, banks do not make it a practice to borrow from the Federal Reserve Banks for the purpose of gaining a profit by lending at a higher rate, nor has it been the policy of the Federal Reserve authorities to encourage borrowing for such purpose. When member banks borrow, it is for the immediate reason that they need to in order to avoid a deficiency in their reserves. The Federal Reserve authorities may raise or lower the discount rate from time to time, accordingly as it seems advisable to impose restraint upon the lending activities of banks or to encourage such activities.

During the earlier period of the System's operation that is, until very recent years member banks had no excess reserves and in the aggregate were substantially in debt to the Reserve Banks. Under such circumstances, changes in the discount rates, which made this indebtedness either more or less expensive, were the principal instrument by which the Federal Reserve authorities gave effect to credit policy. In recent years, however, banks have had a large volume of excess reserves, there has been little occasion for them to borrow from the Federal Reserve Banks, and the discount rates have not had the importance they formerly had. Since 1934 they have been maintained at a low level. Throughout the entire year, 1938 discount rates on eligible paper were 1 percent at the Federal Reserve Bank of New York, and 1 ½ percent at the other eleven Federal Reserve Banks, whereas in the 1920's they varied from 3 percent to 7 percent at different Federal Reserve Banks at different times.

The Federal Reserve Bank discount rates are more closely related to the socalled open market rates than to rates on the loans that banks make to their customers. Open market rates include the rates on commercial paper, bankers' acceptances, Treasury bills, stock market call loans, and other forms of obligations that may be bought and sold in the open market or called without regard to the borrowers' convenience. Open market rates are more sensitive to Federal Reserve credit policy or to market developments than are the rates banks charge their customers, because it is open market paper that banks usually purchase first when they have an excess of funds and dispose of first when they need funds.

The relationship between open market rates and Federal Reserve Bank discount rates tends to be close when banks are borrowing and less close when they are not borrowing.

Securities purchased by the Federal Reserve authorities in the open market come out of the portfolios either of banks themselves or of investors and corporations that are the customers of banks. If they come out of the portfolios of investors and corporations, the checks given in payment by the Federal Reserve authorities are deposited by the investors and corporations in their respective banks, and as a result bank deposits are increased. The banks in turn deposit the checks in their accounts at the Federal Reserve Bank, so that bank reserves also are increased. If the securities come out of the portfolios of banks, however, there is no resulting increase in bank deposits, because the funds paid for the securities are received directly by the banks themselves not through their customers. There is a resulting increase in bank reserves however, for funds received by banks are deposited by them in their reserve accounts at the Federal Reserve Bank.[17]

Open market purchases of securities always increase the reserves of banks, therefore, but whether they increase deposits as well depends on whether the securities purchased come out of the portfolios of banks themselves or of bank depositors.

To the extent that open market purchases increase bank reserves relative to bank deposits, they tend to furnish member banks a larger basis for credit expansion, because expansion is limited by the excess of reserves over the ratio required by law to be held against deposits. Thus if $100,000,000 of securities purchased by the Federal Reserve authorities came from the portfolios of investors, with the result that bank deposits as well as reserves were increased by that amount, a portion of the reserves say $20,000,000 would be required as reserves against the $100,000,000 of new deposits, and only the portion remaining in this case, $80,000,000 would be available for credit expansion. If, however, the $100,000,000 of securities came from the portfolios of the banks themselves, the whole amount, when received by the banks and added to their reserves would be available as a basis for credit expansion.

The funds paid for securities by the Federal Reserve authorities do not necessarily remain with the banks that happen to receive them first. Demand will determine to what particular banks the funds will go, in what volume, or how long they'll stay with certain banks before being transferred to others. No matter what bank happens at any time to have possession of the funds, however, they continue to be a part of the aggregate reserves of the banking system as a whole.

The reverse of the process described in preceding paragraphs occur when the Federal Reserve authorities sell, rather than buy securities. If the securities are purchased by investors and corporations that is by the customers of banks there will be a reduction not only in bank reserves but also in bank deposits. If they are purchased by banks, the reduction will be in bank reserves only. In either event the reduction in reserves tends to diminish the amount of credit that banks can extend, but a reduction in reserves without a reduction of deposits tends to diminish it more rapidly, because there is no accompanying reduction in the amount or reserves required.

Open market operations have different objectives at different times. At times their purpose may be to expand reserves, in which case securities are purchased. At other times their purpose may he to reduce reserves, in which case securities are sold. This (of course) does not mean that open market operations are a mechanical process by which any desired result may be obtained at will. On the contrary their efficacy is dependent upon a variety of conditions. In recent years, with reserves at a high and rising level chiefly because of the gold inflow, but with business recovery still incomplete, the policy of the Federal Reserve authorities has been to maintain the existing portfolio in substantially unchanged volume. This policy has effected the purpose of the Federal Reserve authorities to contribute to the maintenance of monetary conditions that would encourage recovery of commerce, industry, and agriculture.

The accompanying chart (Federal Reserve Bank Credit) shows the amount of Federal Reserve Bank credit year by year for the period the Federal Reserve Banks have been in operation. It reflects the fact that in the 1920's Federal Reserve Bank credit was principally in the form of discounts for member banks, whereas in recent years it has been in the form of United States Government securities purchased in the open market.

Thus, for example, when there is an active demand for goods, there is a corresponding need for means of payment wherewith the purchasers may settle their obligations to the sellers. This need is reflected in part in a demand for member Bank credit that is, they lend the funds only if they have adequate reserves. But additional reserve funds are always available to them in the form of Federal Reserve Bank credit, which they may get either as the proceeds of loans made to them by the Federal Reserve Banks or as proceeds of purchases of securities by the Federal Reserve Banks.

In other words, member bank credit is used chiefly in the form of member bank deposits subject to check: Federal Reserve Bank credit is used chiefly in the form of member bank reserves held on deposit with the Reserve Banks, and the volume of member bank reserves deriving in greater or less degree from Federal Reserve Bank credit determines the ability of member banks to meet the demands of their borrowers for member Bank credit.

It is important to note, however, that Federal Reserve Bank credit and member bank credit are not the equivalent to each other, dollar for dollar. Member bank reserves do not have to be increased by $500,000,000 of Federal Reserve Bank credit in order to make possible an increase of $500,000,000 in member bank credit. The additional Federal Reserve Bank credit needed will be only a fraction of the additional member bank credit to be extended. The explanation of this goes back to the fact that an increase in member bank credit brings about an increase in bank deposits, because the funds that banks customers borrow commonly go on deposit; and the fact that reserves which member banks are required to maintain are only a fraction of their deposits.

Suppose that banks were required to maintain reserves of 20 percent and that they had just 20 percent and no more. Then if their deposits were to be increased by $500,000,000 they would have to increase their reserves by but $100,000,000. Accordingly, $100,000,000 of Federal Reserve Bank credit obtained by borrowing or by the sale of securities to the Federal Reserve Bank would increase their reserves sufficiently to enable them to expand their own credit by $500,000,000. Under varying circumstances, depending on what the reserve requirements are at the time and on the character of the deposits, the expansion of deposits may be as much as ten times the expansion of required reserves. In recent Years the possible expansion of deposits would be considerably less than ten times the expansion of reserves. But, however the ratio may vary, the fact remains that when the Federal Reserve authorities have occasion to provide the amount of reserves necessary to facilitate a given expansion of member bank credit and member bank deposits, the amount of Federal Reserve Bank credit that they may need to supply is only a fraction of such expansion.

This situation is different when a deficiency of member bank reserves arise from withdrawals of currency by the public for circulation or from shipments of gold abroad Whatever the deficiency, it must be made up in full, and the Federal Reserve authorities may in such circumstances have to supply their member banks with Federal Reserve Bank credit to the whole amount of currency or gold withdrawn.

Since the ability of member banks to lend is largely dependent upon the volume of their reserves, since they are required to keep their reserves on deposit with the Federal Reserve Banks, and since the Federal Reserve authorities are empowered to extend Federal Reserve Bank credit for the expansion of those reserves, it follows that the Federal Reserve authorities by the extension of Federal Reserve Bank credit, may influence very considerably the extension of Member bank credit. By enlarging the volume of member bank reserve funds they can make it possible for the latter to direct almost any conceivable volume of demand by borrowers; and by reducing the volume of reserve funds they can apply restraints to an overextension of member bank credit.

Yet, while Federal Reserve authorities have very great powers, they are also very much limited in the exercise of these powers. They can expand member bank reserves and to the extent that they do so, they can subsequently contract reserves. But they have no power to compel an extension of member bank credit. The initiative must be taken by business men and others who wish to borrow. The member banks may extend credit as long as they may have adequate reserves; when their reserves become inadequate, Federal Reserve Bank Credit is available with which to replenish these reserves; to the extent that their enlarged reserves permit, the member banks can expand their loans as long as there is sufficient demand. Thus, the Federal Reserve Bank credit can not insure a demand for member Bank credit; it can and does insure the availability of ample member bank credit when and if a demand exists.[18]

Federal Reserve Bank credit and gold are the two main sources of bank reserves; checks are the principal means by which reserves are transferred from bank to bank.

From the point of view of member banks taken collectively, reserves are derived chiefly from the following sources:

Federal Reserve Bank Credit, in the form of loans by the Federal Reserve Banks and purchases by them of bills and securities.

Gold, either produced from domestic sources or received from other countries.

From the point of view of the individual banker, the funds with which he currently maintains his reserves are :

Checks and other bank currency

Although the principal sources of bank reserves are Federal Reserve bank credit and gold, this does not mean that every individual bank, in order to have reserves, must have borrowed from its Federal Reserve Bank or have come into possession of gold. On the contrary, gold may be and actually is the basis of reserves of banks that have not possessed it, and Reserve Bank credit may be and actually is the basis of reserves of banks that have not borrowed.

How Reserve Funds Move from Bank to Bank

When the Federal Reserve Bank receives a deposit of gold or when it makes a loan or a purchase of securities, and the resulting credits are entered on the reserve accounts of the member banks concerned, the additional reserve funds resulting from the transaction immediately lose their connection with the transaction. They become simply reserve funds, indistinguishable from other reserve funds and transferable to other banks, regardless of how they originated. Like water circulating through connecting chambers, what is introduced at one point mingles with the rest and flows freely throughout the system.

Suppose, for example, a gold mining company has produced $100,000 worth of gold, has sold it to the United States Treasury, and has received a check in payment for it from the Treasury. The company deposits the check with the X National Bank, and receives credit for $100,000 in its checking account. The bank then deposits the check with the Federal Reserve Bank and receives credit for $100,000 in its reserve account. The mining company buys equipment, pays salaries, and distributes profits; in the process it issues checks aggregating $100,000 which are deposited by their recipients in other banks.

These banks having given their depositors credit for their checks, send them to the Reserve Bank and receive credit for them in their reserve accounts. At the same time the checks are paid out of the reserve balances of the X National Bank. Thereby the reserve funds derived from the original sale of gold become the reserve funds of banks which never heard of the gold. The other banks know then that checks drawn on the X National Bank were deposited by them in the Reserve Bank and that their reserve accounts have been credited accordingly. It is gold imports rather than domestic mining that has produced the great increase in our gold stock since 1933; but gold from whatever source gives rise to bank deposits and bank reserves substantially as just described.20

The same is true of Reserve Bank credit. If the X National Bank borrows $100,000 at the Reserve Bank or receives funds paid for securities purchased by the Federal Reserve Bank, its reserve account is increased by a corresponding amount.

It uses these additional funds incorporated in its reserves to pay checks drawn against it by its customers, and in the process, the funds leave its account and become credited to the reserve accounts of other banks. The funds are part of the total reserves, dispersed in hundreds of thousands of reserve accounts and constantly circulating in and out of each. No connection remains between them and the particular transaction which called them into being.

Although comparatively few banks receive gold and Federal Reserve Bank credit directly, yet all banks are daily receiving checks on one another. About a billion such checks were handled by the Federal Reserve Banks in 1938; no doubt many times that number cleared locally, and through banks in financial centers, never reached a Federal Reserve Bank. But, by whatever means they are cleared, checks deposited in banks other than those on which they are drawn maintain a constant flow of reserve funds from bank to bank.

But the gold is deposited and the reserve balance of a given bank is increased thereby, there is no corresponding charge to the reserve balance of any other bank, for the gold came either from abroad or out of an American mine. In this case, consequently, not merely the reserve balance of one bank but the total volume of reserves held by all banks taken together is increased. The same is true if the Reserve Bank makes a loan or buys securities; resulting increase in reserves of banks directly affected is not offset by a charge to the reserves of other banks. Instead, total reserves are increased. In both cases, the total remains at the higher level regardless of stream of checks by which funds are transferred from one reserve account to another. It remains at a higher level until any one of these things happens:

Federal Reserve sells securities;

loans by Federal Reserve are paid; or,

currency or gold is withdrawn.

When any one of these things occurs, and is not offset by a factor of opposite effect, there occurs a decrease in the aggregate amount of reserves. It comes about because the securities sold by the Reserve Bank are paid for by a charge against the reserves of the bankers by whom or by whose customers the securities were purchased; or because the loans are repaid by a charge against the reserves of the bankers that borrowed; or because the currency account or gold when withdrawn is charged to the reserve account of the bankers by whom it was withdrawn; and because the charges to these reserve balances are not offset by any corresponding credits to other reserve balances.[21]

From the individual bank's point of view, therefore, reserves are principally maintained by the deposit of checks on other banks; and from the point of view of all banks as a whole, reserves consist fundamentally of Federal Reserve Bank credit and gold. In other words, Federal Reserve Bank credit and gold are the two important basic factors in which bank reserves originate, and checks are the principal means by which reserves come to be transferred and distributed among all banks. Every banker has daily experience of the transfer of reserve funds resulting from check transactions and of his own consequent gain or loss of reserves; but experience of the origination and extinction of reserve funds resulting from gold transactions, open market operations, and Reserve Bank loans, is far less common. Very few banks outside those cities where gold shipments are received or Government obligations are bought and sold in large amounts ever have any direct experience of gold transactions and open market operations; and borrowings from the Reserve Bank, while not common, are never a matter of daily routine as checking transactions are.

Other Factors

Other factors affect the aggregate volume of bank reserves, but mostly in a minor or transitory way as compared with gold or Federal Reserve Bank credit. Acquisition of silver by the Treasury has the same effect on member bank reserves as the acquisition of gold, but the dollar amount of silver is less than gold. Chief among the transitory factors affecting the aggregate volume of reserves are receipts and expenditures by the United States Treasury. When Federal taxes are paid, the effect is to reduce the reserve balances of banks and to enlarge the cash balances of the Treasury. The same is true when banks use current funds to pay for new Government obligations issued by the Treasury. When the funds are disbursed by the Treasury, the effect is to reduce the Treasury's cash balance, and restore the reserve balances of the banks. The Treasury's transactions are in this way constantly producing large fluctuations which in the long run cancel each other. Similarly, fluctuations in the volume of currency in circulation affect the volume of reserves, but mostly in a temporary way. Currency on going into circulation is charged to member bank reserves and reduces them, and on retirement from circulation it is credited to reserves again and increases them. While these factors are of importance in explaining current fluctuations in the volume of reserves, they do not alter the fact that the basic constituents of reserves are gold and Federal Reserve Bank credit.

The Relation Between Federal Reserve Bank Credit and Gold

Before the Federal Reserve Banks were established, the basic reserves of the banking system consisted almost exclusively of gold, silver, and currency. There was no Federal Receive Bank credit, nor any institution whose purpose it was to supply additional reserve funds. Banks could borrow from one another, but that meant merely the use of existing reserve funds, not the creation of new ones. Moreover, with banks holding one another's reserves and advancing reserves to one another, the aggregate bank reserves shown on the books of banks always included duplication and exceeded the amount of gold and other currency that could be counted as reserves. Reserves shown in excess of this amount, however, were fictitious. In times of stringency it always developed that reserves were actually less than they appeared to be. With the establishment of the Federal Reserve Banks these faults were corrected. Existing reserves were transferred to the Federal Reserve Banks and the Reserve Banks were empowered to create additional reserve funds. The result is that the aggregate volume of reserves became a definitely known figure, without duplication; and the Reserve authorities can create the necessary additional funds, either by lending to individual banks or by purchasing securities in the open market.

Since the establishment of the twelve Federal Reserve Banks, therefore, bank reserves have consisted basically of gold, the amount of which is not readily subject to control, and the Reserve Bank credit, the amount of which is wholly subject to control. Neither is fixed either in amount or in relation to the other. At times Reserve Bank credit has been a more decisive factor and at times gold. The two tend to displace each other; that is, the more gold there is coming into the country the less need there tends to be for Reserve Bank credit, and the less gold there is coming in or the more gold there is going out the more need there tends to be for Reserve Bank credit. The movement of gold is largely independent of control; although under certain conditions an increase in the volume of Reserve Bank credit may tend to drive gold out of the country by bringing about lower money rates, and a decrease in its volume may tend to draw gold into the country by bringing about higher money rates.

If, for example, there were a reversal of the gold movement of recent years, and gold, because of altered international conditions, began to be exported in large volume, the Reserve authorities, by lending or by the purchase of Government securities and other obligations, could furnish funds which would add to member bank reserves as fast as the gold withdrawals subtracted from them. The Reserve authorities could by this action prevent the banks of the country from suffering such a depletion of reserves as would force them to make drastic reductions in their loans and investments.[22]

CHAPTER VI

Reserves of the Individual Bank and of the Banking System as a Whole

Additional reserve funds that enable the individual bank to enlarge its own loans by an almost equal amount, enable the banking system as a whole to enlarge the aggregate of loans by several times as much.

Bank deposits result chiefly from loans and other extensions of credit by banks. This does not mean though, that an individual banker can increase his deposits to any desired extent simply by lending. He can not do that, because when his customers borrow they use the money they borrow: they pay it to others by whom most or all of it will be deposited in other banks. The banker has to part with most of what he lends and must be prepared for reduction of his reserves accordingly. When he makes a loan and the funds are credited to the deposit account of the borrower and then checked out, the funds sooner or later leave the bank and go on deposit in another bank. Under the circumstances, his loan increases another bank's deposits. If the other banker is also lending, then the deposits of both will increase still further. Each gets a part of most of what the other lends. So, in fact, the individual banker normally has more money to lend when other bankers are lending than he has when they are not lending. It is only when this process of lending is general and simultaneous on the part of many bankers that it may cause a rapid growth of bank deposits. No one banker has control of such a process. He has no means of making other bankers lend no means of making customers start borrowing. He has to feel his way, constantly watching the volume of his reserves. Unless his reserves are adequate, he will not wish to lend and run the risk of having them depleted. Accordingly, the requirement that he maintain a certain ratio between his reserves and his deposits is in effect a limitation on his power to lend.

Assuming There Were Only One Bank

Suppose there were on/v one bank instead of several thousand, and that this one bank did all the commercial banking business in the country. Suppose further that this bank were required by law to have reserves equal to at least 20 percent of its deposits. Thus if it had deposits of $5,000,000,000, its reserve balance with the Reserve Bank would have to be at least $1,000,000,000.

Suppose that it had just exactly that $5,000,000,000 of deposits and $1,000,000,000 of reserves, with $4,000,000,000 of loans and investments. In such case, if it were to lend a simple additional dollar it would reduce its reserves below the legal requirement, because if it did make a loan, the borrower would be given credit for it in his checking account. The bank's deposits would go up, its reserve balance would not go up, and in consequence the reserve balance would be less than 20 percent of the bank's deposits.

The borrower, of course, would write a check for the amount he wanted to use, and so his deposit balance would be reduced; but the money would not necessarily leave the bank, or if it did, it would come right back. For if the check were deposited by its recipient it would merely transfer a certain amount of deposit credit from the borrower's account to the recipient's account. Or if it were cashed by the bank, the currency would sooner or later be deposited, and the funds which went out of the bank through one account would come back in through another. The bank's deposits would be increased by the loan in any event, except only if the money were kept in circulation, sent out of the country, or permanently lost, destroyed or hidden. There would be no other bank for it to go to.

Realizing that any additional loans it made would increase its deposits out of proportion to its reserves, the commercial bank might stop making the loans. Suppose, however, that the Reserve authorities were of the opinion that more loans might advantageously be made and that the bank should be provided with additional reserves so that it could make them. Suppose they therefore purchased $20,000,000 of securities in the open market. The sellers of the securiti

Reserve Notes . . . . . . . . . . . . . . . . . . . .	$4,405,000,000
Treasury Currency:
Silver certificates . . . . . . . . . . . . . . . . .	$1,339,000,000
Silver dollars . . . . . . . . . . . . . . . . . . . . .	$42,000,000
Subsidiary silver . . . . . . . . . . . . . . . . . .	$357,000,000
Minor or coin . . . . . . . . . . . . . . . . . . . . .	$151,000,000
U.S. Notes . . . . . . . . . . . . . . . . . . . . . . .	$257,000,000
Currency in Process of Retirement:
National bank notes . . . . . . . . . . . . . . .	$201,000,000
Gold certificates [7] . . . . . . . . . . . . . . .	$75,000,000
Reserve Bank Notes [8] . . . . . . . . . .	$28,000,000
Treasury notes of 1890. . . . . . . . . . . . .	$1,000,000

	$6,856,000,000

TABLE OF CONTENTS

THE CONSTITUTION'S MOST IMPORTANT POWER

Publisher's Forward

Foreword

CHAPTER I

A General Outline of the Federal Reserve System

The Monetary and Credit Functions of the Federal Reserve System

CHAPTER II

The Service Functions of the Federal Reserve Banks

Furnishing Currency for Circulation

Federal Reserve notes are liabilities of the Federal Reserve Banks.

How Currency Is Distributed

Collections, Clearances, and Transfers of Funds

Supervisory Functions

Fiscal Agency Functions

CHAPTER III

The Function of Bank Reserves [13]

Reserve Requirements

CHAPTER IV

The Expansion and Contraction of Bank Reserves

Discounts and Advances for Member Banks

Discount Rates

Open Market Operations

Federal Reserve Bank Credit and Member Bank Credit

CHAPTER V