Understanding the History of the US Federal Reserve

Presented by Jeffrey M. Lacker, President Federal Reserve Bank of Richmond

- The Federal Reserve was created to solve “the currency problem”: The supply of currency did not expand and contract appropriately with the needs of the economy, for example, during seasonal increases in the demand for money or during banking panics.
- Several features of the banking system at the time contributed to the currency problem. First, it was very cumbersome to issue bank notes. Second, the banking system was highly fragmented. Finally, in order to make commerce possible, banks were connected through an intricate system of clearinghouses and correspondent banks. When individual banks were unable to meet the demand for money, the strains spread throughout the system, and interest rates would spike.
- The Federal Reserve was created by the Federal Reserve Act in December 1913 with the intent to “furnish an elastic currency.” After considerable debate, policymakers eventually settled on a system modeled after the clearinghouses of the day, with 12 regional Reserve Banks overseen by a Board of Governors. This structure has generally provided independence from political pressures along with accountability to the American people.
- There also was debate about which assets the Fed would hold, aside from gold. Policymakers decided on commercial paper and loans to banks backed by commercial paper. During World War I the Fed began purchasing Treasury securities as well. These asset purchases all increase the money supply and are a form of monetary policy. In response to the 2008 financial crisis, the Fed instituted several emergency lending programs and began purchasing agency mortgage-backed securities. In the initial phase of the crisis, these programs changed the composition of the Fed’s portfolio but did not affect the money supply, and can be thought of as credit policy rather than monetary policy.
- There is a tension between those who would have the Fed use both monetary policy and credit policy to minimize financial disruptions, and those who believe that the Fed should focus more narrowly on monetary policy. The latter approach is supported by the view that government rescues may result in excessive financial market instability and that policymakers should be humble about their ability to identify constructive interventions in particular financial markets.

PDF document: http://www.richmondfed.org/press_room/speeches/president_jeff_lacker/2013/pdf/history_federal_reserve_20130829.pdf

Video: http://bcove.me/p42eogog

Learn More: http://www.richmondfed.org/press_room/speeches/president_jeff_lacker/2013/lacker_speech_20130829.cfm

SOURCE: Richmondfed.org