Monetary Policy Normalization: Why the Fed Was Founded

May 27, 2015

Stephen Williamson, a vice president and economist with the St. Louis Fed, discussed why the Federal Reserve was founded and the importance of establishing a national currency that was uniform, safe and elastic.

Presentation (PDF)



Stephen Williamson: Okay, so now we move on, okay, to the founding of the Fed. The Fed started up in 1914. The Federal Reserve Act passed in 1913, is what the initial framework for what the Fed does. That came out of serious science. So unlike the Bank of England just got—this is kind of; it's sort of like an accident. But this is not an accident. This comes out of studies of the National Monetary Commission. People thought about this hard. They studied banking systems in the world. Thought hard about what was going wrong in the U.S., in the—over the 19th century, and later. And the work of the National Monetary Commission is kind of what goes into the Federal Reserve Act. So then the idea was that the currency—you know, the Federal Reserve Notes, the stuff we carry around today, what it was going to be was uniform, safe, and elastic.

So this elastic idea, that's important. So we want to kind of understand what that's about. So basically, you know, the thing about that, you have to think about what happened earlier. So when—in the 19th century, sort of pre-Civil War, we had this system of private bank currency issued. The currency was issued by state-chartered banks. Each state with different rules about how that happened. And those notes were by no means—we weren't uniform, because there were thousands of banks. They were not safe. These banks were failing. There was a lot of counterfeiting, mistrust of the quality of these notes, et cetera. And they certainly weren't elastic in any sense. The national banking era, so this is after the Civil War, before the Federal Reserve Act, the system got created where the notes were in fact—the currency was safe and uniform, but you didn't have this elasticity. And lack of elasticity—the elasticity just has to do with kind of, one is just accommodating business activity. Which has to do with day of the week. People use more currency on the weekend. It could have to do with the time of the month. Things going on in the banking system. Historically, you had to do with harvest season, for instance. Big demand for currency at harvest season. So what would be—the way we understand it now, the way a central bank should work is that the money supply should fluctuate to accommodate economic activity. And that national banking system didn't do it. And the result was banking panics. The way we understand it now, this lack of elasticity was part of what gave you the panics. So a properly functioning monetary system is one where you've got something that's going to make the money supply move around in response to economic activity, so you don't get panics, effectively.

This popular lecture series addresses key issues and provides the opportunity to ask questions of Fed experts. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.

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