The Federal Reserve System

In the nineteenth century, America didn't have much of a monetary system at all.

During the 19th century, as we have seen, Britain was "on the gold standard." America was not. America was never on any very consistent monetary standard at all. (A course in American economic history would be necessary to go into the details of the various banking "reforms" and changes the country tried out during the nineteenth century). Remarkably, we did fairly well despite this, but there were some problems, and early in the twentieth century the Congress attempted to remedy them.

In 1913, Congress established the Federal Reserve System (the "fed") to be the American central banking system -- the "bankers' bank" and main control on the monetary system.

The Federal Reserve system consists of 12 Banks for 12 districts in different parts of the country. According to law, each is a cooperative of the "member" banks. But for most practical purposes, "the fed" is a government agency. Its chairman and board of governors are appointed by the president with the consent of the Congress, as with many other government appointments. Its excess profits go to the treasury.

The federal reserve banks are also bankers' banks. In our system, "member" banks have deposits in the Federal Reserve, and these deposits are part of the member bank's reserves. The bank's reserves include the deposits in the Federal Reserve as well as cash in the bank's vaults, and these reserves take the place of the gold coins the Bank of Fred held in its vaults to assure that it would be able to redeem its banknotes. By controlling the amount of reserves, and regulating the reserve ratio, the Federal Reserve System controls the American Money Supply.

On an earlier page, We saw that there are three basic kinds of money: commodity, fiat, and fiduciary money. Which kind is modern American money? The answer is that it is a mixture of fiat and fiduciary money. Bank reserves, federal reserve notes and deposits in the Federal Reserve system, are fiat money. Checking accounts are fiduciary money, based on the faith that the checks will be accepted. Since we have many banks, a key problem is to assure that a check written on one bank will be accepted as a deposit in another bank. The Federal Reserve system assures this by controlling the reserves and "clearing" checks and deposits among the different banks. (We will see in the next few pages how this happens). Since he can deposit my check in his own bank, and write checks to make his own payments, the merchant who sells me goods or services is willing to accept my check. Federal reserve notes are fiat money, and are acceptable to banks because they are legal reserves. Since it is acceptable to banks, the dollar bill is acceptable to people in general.

Something similar could be said about most developed economies. In the modern world, money is not a commodity but a service provided by banks.

What is Money -- America Y2000?