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THE

FEDERAL RESERVE SYSTEM

TH E

FEDERAL RESERVE SYSTEM

Its Purposes and Functions

P rinted In U. S. A.
B y T h e N ational C apital P ress

W a sh in gton , D. C.

TABLE OF CONTENTS
CHAPTER

PAGE

A G eneral O utline of th e F ederal R eserve
System ......................................................................

The Federal Reserve System comprises the Board
of Governors, the twelve Federal Reserve Banks,
the Federal Open Market Committee, the Fed
eral Advisory Council, and the Member Banks;
the System’s functions lie in the field of money,
credit, and banking.

T he Service F unctions of th e F ederal R e
serve B an ks ...........................................................

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.

III

T he F unction

B ank R eserves.....................

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

T he E xpansion and C ontraction of B a n k
R eserves ..................................................................
The ability of member banks to lend is largely
dependent upon the volume of their reserves;
they are required to keep their reserves on deposit
with the Federal Reserve Banks; and the Fed
eral Reserve authorities are empowered to extend
Federal Reserve Bank credit for the expansion of
those reserves. Therefore, the Federal Rasorve
authorities, through the medium of bank reserves,
are able to influence the extension of member
bank credit.

CONTENTS

CHAPTER

PAGE

T he C omposition

B ank R eserves...................

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

R eserves of the I ndividual B a n k and of the
B a n kin g S ystem as a W h o l e ...........................

Additional reserve funds that enable the indi
vidual 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.
V II

F ederal R eserve P owers and L im it a tio n s . . .

Although Federal Reserve powers are important
and extensive, they are nevertheless constantly
subject to limitations inherent in the conditions
under which they are exercised.

V III

M ember B a n k R eserves and R elated I tems .

The principal factors involved in Federal Reserve
policy are member bank reserve balances, gold
stock, Federal Reserve Bank credit, money in
circulation, and Treasury cash and balances.

W hat th e T welve F ederal R eserve B anks
Ow n and W hat T h e y Ow e ................................

The central banking functions of the Federal Re
serve System are reflected in the balance sheet of
the Federal Reserve Banks.

F ederal R eserve B a n k E a r n in g s ......................
The operations of the Federal Reserve Banks,
although not conducted for profit, yield an in
come which is ordinarily sufficient to cover
expenses.

104

CONTENTS
CHAPTER

PAGE

M argin R equirements........................................

109

The Federal Reserve authorities have special
power to curb the use of credit for speculation
in securities.

X II

Su m m a r y ...............................................................

113

The Federal Reserve System has successfully
overcome certain difficulties that formerly beset
American economic life and imposed upon it great
losses; the System still has constantly to meet
new problems and difficulties.

Federal Reserve Publications............................

119

............................................................... ...

121

Index

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W O O D R O W W IL S O N
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W E S H A L L D E A L W IT H
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FIRST INAUGURAL ADDRESS
WOODROW WILSON

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FOREWORD

This book is intended primarily for students,
bankers, business men, and others who desire an
authoritative statement of the purposes and functions
of the Federal Reserve System. It is neither a primer,
nor is it an exhaustive treatise. The aim has been to
have it cover the middle ground between those ex
tremes and to make it clear and readable without
neglect of essentials.
The Federal Reserve System is twenty-five years
old this year. Its operations have become a factor of
great 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 inter
est it is administered.
The text of the book has been prepared by Bray
Hammond and the staff of the Board of Governors of
the Federal Reserve System.
T

Washington, D. C.
May 1 , 1939.

B oard of G overnors of t OS
F ederal R eserve SYsfem .

F ederal R eserve B uilding , C onstitution A venue

at 20t h Street, W ashington , D . C.

CHAPTER I
A GENERAL OUTLINE OF THE FEDERAL RESBBKVE
SYSTEM
The

Federal

Reserve

S ystem

comprises

the

Board oj Governors, the twelve Federal Reserve
Banks, the Federal Open M arket Com m ittee,
the Federal Advisory Council, and the M em ber
B anks; the S ystem ’s functions lie in the field of
m oney, credit, and banking.

HE Federal Reserve System was organized in
1914. As now constituted, the System comprises
the following:

1. The B oard

G overnors .

2. The twelve F ederal R eserve B a n k s .
3. T h e F ederal O p e n M a r k e t C o m m i t t e e .
4.
5.

The
The

F ederal A d viso ry C o u n c i l .
M em ber B a n k s .

Responsibility for Federal Reserve policy and deci
sions rests on the first three of the above. In some
matters the law puts primary responsibility on the
Board, in some on the Reserve Banks, and in some on
the Committee, though in practice there is close
coordination of action. Accordingly, for the sake of
simplicity, the term “Federal Reserve authorities” is
frequently used when it is unnecessary to indicate
which of the three is responsible for action or to what
extent the responsibility is shared.
- 1. The B oard of G overnors is composed of seven
members. Their appointments are made by the Presi
dent 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

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B oard R o o m , F ederal R eserve B uilding , W ash in gto n , D . C.

THE FEDERAL RESERVE SYSTEM

Board’s responsibilities lie in the field of money and
banking. Their objective in a broad sense is to main
tain sound banking conditions and an adequate supply
of credit at reasonable cost for use in commerce, in
dustry, and agriculture. The Board supervises the
operations of the twelve Federal Reserve Banks. Its
offices are in Washington, D. C.
2. Each F ederal R eserve B a n k serves a district
comprising several States or parts of States. The Fed
eral Reserve districts, and the location of the Federal
Reserve Banks and their branches are shown on the
preceding map. They are as follows:
Federal Reserve Bank of Boston

District Number 1

Federal Reserve Bank of New York

District Number 2

Branch at Buffalo, New York
Federal Reserve Bank of Philadelphia

District Number 3

Federal Reserve Bank of Cleveland

District Number 4

Branches: Cincinnati, Ohio
Pittsburgh, Pennsylvania
Federal Reserve Bank of Richmond

District Number 5

Branches: Baltimore, Maryland
Charlotte, North Carolina
Federal Reserve Bank of Atlanta

District Number 6

Branches: Birmingham, Alabama
Jacksonville, Florida
Nashville, Tennessee
New Orleans, Louisiana
Agency at Savannah, Georgia
Federal Reserve Bank of Chicago

District Number 7

Branch at Detroit, Michigan
Federal Reserve Bank of St. Louis
Branches: Little Rock, Arkansas
Louisville, Kentucky
Memphis,

Tennessee

District

Number 8

THE FEDERAL RESERVE SYSTEM

Federal Reserve Bank of Minneapolis

District Number 9

Branch at Helena, Montana
Federal Reserve Bank of Kansas City-

District Number 10

Branches: Denver, Colorado
Oklahoma City, Oklahoma
Omaha, Nebraska
Federal Reserve Bank of Dallas

District Number 11

Branches: E l Paso, Texas
Houston, Texas
San Antonio, Texas
Federal Reserve Bank of San Francisco

District Number 12

Branches: Los Angeles, California
Portland, Oregon
Salt Lake City, Utah
Seattle, Washington

Each of the twelve Federal Reserve Banks is a cor
poration organized and operated in the public service.
The Federal Reserve Banks differ essentially from pri
vately managed banks in that they are not operated
for profit, and their stockholders, which are the mem
ber banks, do not have the powers and privileges that
customarily belong to stockholders of privately man
aged 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 the directors of busi
ness 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 of each class 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, agricul
ture, or some other industrial pursuit, and must not be

OUTLINE OF THE SYSTEM

officers, directors, or employees of any bank. The three
Class C directors are designated by the Board of Gov
ernors 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 first vice-president
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
and the remainder by the Board of Governors. These
conditions with which the law circumscribes the selec
tion 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 part of a nation-wide system. Its officers and
employees are residents of the district, and its trans
actions 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 nation-wide policies.
The Federal Reserve Banks derive an income from

THE FEDERAL RESERVE SYSTEM

their operations which has been sufficient to cover
expenses, to pay dividends limited to 6 per cent per
annum, cumulative, to pay a substantial amount to the
United States Treasury, and to make additions to sur
plus. This surplus, if the Federal Reserve Banks were
to be liquidated, would belong to the United States
Government.
3. The F ederal O p e n M arket C o m m it t e e com
prises 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 F ederal A dvisory C o u n c il consists of twelve

members, one selected annually by each Federal Re
serve 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 busi
ness conditions and makes recommendations regarding
the affairs of the Federal Reserve System. Its recom
mendations are purely advisory.
5. M ember B a n k s 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

OUTLINE OF THE SYSTEM

being about 17 per cent of the total deposits of all
commercial banks.
Each member bank, as required by law, holds stock
in the Federal Reserve Bank of its district. This stock,
equal to 3 per cent of its own capital and surplus, is
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 is also required to maintain its
legal reserves on deposit with the Federal Reserve
Bank of its district. These legal reserves are propor
tionate to the member bank’s own deposits, the pro
portion varying according to the location of the mem
ber bank and the character of its deposits. Higher
reserves are required against demand deposits than
against time deposits, and banks in large cities, gener
ally speaking, are subject to higher reserve require
ments 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, 1938, thenreserve balances amounted in the aggregate to about
nine billion dollars, of which about three billion 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 acta*
ally used for only a small part of the country’s total
volume of payments, the greater part being effected

THE FEDERAL RESERVE SYSTEM

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 furnishing 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 the member banks have any difficulty in mak
ing the loans that are asked for, because their own
funds are 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, banks maintained the reserves required to be
held against their deposits partly in the form of cash
in their own 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 bal
ances 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 bal
ances, 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 theu,

OUTLINE OF THE SYSTEM

F ederal R eserve B a n k

B oston

30 Pearl Street, Boston, Massachusetts

however, the demand became wide-spread 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 bal
ances 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 sharply, borrowing

TH E FED ERAL RESERVE SYSTEM

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 de
termining 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 study
both by the Commission and by other authorities
inside and outside Congress. This legislation is the
Federal Reserve Act. It became law December 23,
1913.
The Federal Reserve Act directed that the Federal
Reserve Banks be established, required that reserves
of member banks be deposited with the Federal Re
serve Banks, and empowered the Reserve authorities
to discount paper for member banks, to engage in
open market operations, and to issue Federal Reserve
notes.
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 other banks and
the surplus currency received 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 on them by their
customers and deposited in other banks.
The volume of reserves required by law is much
greater, ordinarily, than these uses alone would make

OUTLINE OF THE SYSTEM

necessary. The reason for this is that required re
serves have an additional purpose: they are the means
through which the Federal Reserve authorities influ
ence the lending and investing activity 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 en
large its extensions of credit and may be impelled to
borrow additional funds. Since the Federal Reserve
authorities have the power to increase or decrease the
supply of reserve funds and within limits to increase
or decrease reserve requirements, they are able to exer
cise 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 Re
serve 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 activity in all
fields— agricultural, industrial, commercial. They call
for policy decisions from time to time rather than rou
tine activity. They involve lending to member banks,

THE FEDERAL RESERVE SYSTEM

open market operations, fixing reserve requirements,
establishing discount rates, and issuance of regulations
relating to these and other functions.
The other group includes duties which relate pri
marily 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 mem
ber bank reserve balances; furnishing currency for
circulation; facilitating the clearance and collection
of checks; supervising member banks and obtaining
reports of condition from them; and acting as fiscal
agents, custodians, and depositaries for the United
States Government.
These regular services engage by far the greater
part of the time and attention of the officers and em
ployees of the twelve Federal Reserve Banks. They
will be described with more detail in the chapter im
mediately following. In later chapters the monetary
and credit functions of the Federal Reserve authorities
will be discussed.

CHAPTER II
THE SERVICE FUNCTIONS OF THE FEDERAL
RESERVE BANKS
The twelve Federal Reserve Banks hold the
legal reserves of m ember banks, furnish cur
rency for circulation, facilitate the collection and
clearance of checks, exercise supervisory duties
with respect to m ember banks, and are fiscal
agents of the United States Government.

NE of the primary functions of the Federal Re
serve Banks is to hold the legal reserves of mem
ber banks. The member banks do not normally let
these reserves lie in idleness awaiting an emergency
but keep them in active use. This use 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 de
posits of currency; and receiving, sorting, collecting,
and clearing checks.

Furnishing Currency for Circulation
On December 31, 1938, the amount of United States
money in circulation— that is, the amount of currency
outside the vaults of the Treasury and the Federal
Reserve Banks— was $6,856,000,000. It was made up
of the following classes:
Federal Reserve Notes ................................... $4,405,000,000
Treasury Currency:
Silver certificates ......................................
1,339,000,000
Silver d o lla r s ...............................................
42,000,000
Subsidiary silver coin...............................
357,000,000
Minor c o i n ....................................................
151,000,000
United States n o t e s ....... ..........................
257,000,000

THE FEDERAL RESERVE SYSTEM
Currency in Process of Retirement:
National bank notes.................................
Gold certificates (old fo r m )* ................
Federal Reserve Bank n o te sf..............
Treasury notes of 1 8 9 0 ............................

201,000,000
75,000,000
28,000,000
1,000,000
$6,856,000,000

Federal Reserve notes are liabilities of the Federal
Reserve Banks that issue them. They are a prior lien
on the assets of the Federal Reserve Banks and are
specifically secured by the pledge of collateral of at
least equal amount. They are also obligations of the
United States Government. As of December 31, 1938,
the collateral pledged by the Federal Reserve Banks
against the Federal Reserve notes in circulation com
prised $4,888,000,000 of gold certificates (new form)
and $3,000,000 of promissory notes and other obliga
tions discounted by the Federal Reserve Banks, or
$4,891,000,000 in all.
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, com
prising national bank notes, gold certificates (old
form), Federal Reserve Bank notes, and Treasury
♦There are two forms of gold certificates. The old form, com
monly in circulation before 1934, is no longer in use, except for certi
ficates still outstanding. These are being retired as rapidly as they
come into the Treasury. The new form of gold certificate is issuable
by the Treasury only to the Federal Reserve Banks and is not in
circulation.
t Federal Reserve notes and Federal Reserve Bank notes are two
distinct types of currency authorized by the Federal Reserve Act.
The distinction between them is technical and for all practical, pur
poses Federal Reserve notes are sufficient. Federal Reserve Bank
notes are, therefore, no longer issued.

SERVICE FUNCTIONS

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 different 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 in 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 Re
serve 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.
How Currency Is Distributed
There are two principal ways by which any indi
vidual gets paper money and coin. Either he draws it
out of his bank and has it charged to his account; or
he is paid for his labor, his services, or his merchandise
with money that has been drawn out of a bank by
some one else.
Practically all money, therefore, passes into and out

THE FEDERAL RESERVE SYSTEM

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 at times 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 with
draw 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 amounts and kinds of cash that
the people in their communities want. Member banks
depend upon the Federal Reserve Banks for replenish
ment of their supply, ordering what they require and
having it charged to their reserve accounts. Non
member banks generally get their supplies from mem
ber banks.
The twelve Federal Reserve Banks in turn keep a
large stock of all kinds of paper money 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 amounts obtained.
Until the Federal Reserve Banks were established
in 1914, the means of furnishing currency for circula
tion were unsatisfactory. A gap existed between the

SERVICE FUNCTIONS

A Sh ip m e n t

N ew C urrency , C ash D epartment

of a

F ederal

R eserve B ank

Treasury and the banking system, and demand for in
creased 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 re
sponse 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 currency distribution that reaches
every community, that enables cash to be furnished

THE FEDERAL RESERVE SYSTEM

promptly where it is needed, and that also enables sur
plus cash to be retired from circulation at times when
the public demand subsides.
Collections, Clearances, and Transfers of Funds
Currency and coin are indispensable, yet they are
used only for the smaller transactions of present-day
economic life. A hundred years ago they were used
much more generally. The use of bank checks has
increased to such an extent that payments made by
check are now many times greater than payments
made with currency and coin.
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 Hart
ford manufacturer $1,000. Obviously, the Hartford
manufacturer does not want to make a trip to Cali
fornia to collect the $1,000 in cash, nor does he want
to pay postage and insurance on a shipment of cur
rency. 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 re
serve 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

SERVICE FUNCTIONS

C heck Sorting, C heck C ollection D epartment
R eserve B an k

of a

F ederal

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 San
Francisco thereupon credits the Federal Reserve Bank
of Boston. The Federal Reserve Bank of Boston in
turn credits the account of the Hartford bank. Thus
the check effects the transfer through the Federal Re
serve Banks of $1,000 of deposit credit from the check
ing account of the dealer in Sacramento to the check
ing account of the manufacturer in Hartford.

THE FEDERAL RESERVE SYSTEM

Even though a bank is not a member of the Federal
Reserve System, it may nevertheless arrange to main
tain with the Federal Reserve Bank what is called a
“ clearing balance.” Checks drawn on other banks
which are received by the nonmember bank and for
warded 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 or 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 re
duced 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 Inter
district 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
in Federal Reserve operations is indicated roughly by

SERVICE FUNCTIONS

the following figures: in the year 1938 the twelve
Federal Reserve Banks handled about five billion sep
arate 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 twenty-five times as great as the amount of
currency and coin.
Su p ervisory F u n ction s

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 Cur
rency. Examination reports made by his examiners as
to 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. Informa
tion is available to the Reserve authorities not only
from the reports of examiners but also from periodic
reports of condition submitted by the member banks
themselves. Banks that are not members of the Fed
eral Reserve System, but have deposit insurance in the
Federal Deposit Insurance Corporation, are examined
by the Corporation and by State authorities.

THE FEDERAL RESERVE SYSTEM

Each of the Federal Reserve Banks has an examin
ing 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:
1. The power to fix the maximum rates of interest
which member banks may pay upon time and savings
deposits. The main purpose of this power is to prevent
banks from paying such high rates, in competition for
deposits, as to weaken their condition.
2. The power to take disciplinary action, including
the following specific powers: 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 practice;
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.
3. The power to grant permits to national banks to
exercise trust powers.
4. The power to grant permission to holding com
panies so that they may vote the 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.
5. 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,

SERVICE FUNCTIONS

about a hundred in all, situated in twenty-three dif
ferent countries.
Fiscal A g e n c y F u n ction s

The twelve Federal Reserve Banks carry the princi
pal checking accounts of the United States Treasury,
handle much of the work entailed in issuing and re
deeming Government obligations, and perform numer
ous other important fiscal duties for the United States
Government.
The Government has an enormous amount of bank
ing business to do. It is continuously receiving funds
in all parts of the United States and spending them in
all parts. Its receipts come mainly 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 mostly by check,
and the 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 amounts received to the Treasury’s checking
account. The Reserve Banks also redeem securities
as they mature, make exchanges of denominations or
kinds, handle transfers and conversions, pay interest
coupons, and do a number of other things involved
servicing the Government debt. They issue and
United States savings bonds and upon request

in
redeem
hold

THE FEDERAL RESERVE SYSTEM

them in safekeeping for the owners. For the conven
ience 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 Re
serve authorities are constantly in touch with the
money and investment markets, the Treasury follows
the practice of consulting them for their advice as
to the 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 Government agencies as the Recon
struction Finance Corporation, the Commodity Credit
Corporation, and the Home Owners’ Loan Corporation,
the Federal Reserve Banks act as custodians of collat
eral and securities. This involves not only safekeeping
but disbursement of funds upon receipt of proper docu
ments and maintenance of accurate records of large
quantities of securities, warehouse receipts for com
modities, and other valuable papers which are con
stantly 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 agen
cies for much of the expense incurred in the perform
ance of fiscal agency functions.
Because of its situation in one of the principal finan
cial centers of the world, the Federal Reserve Baj»k
of New York acts as the agent of the United States
Treasury in the foreign exchange operations of the

SERVICE FUNCTIONS

F ederal R e s e r v e
B a n k of N ew Y o r k
33 Liberty Street,
New Y ork City,
New Y ork

Treasury’s Stabilization Fund. The Federal Reserve
Bank of New York also has occasion to receive deposits
of foreign central banks and to perform certain inci
dental services as correspondent of such banks. The
Board of Governors exercises special supervision over
all relationships and transactions of Federal Reserve
Banks with foreign banks. Such relationships are con
fined almost wholly to the Federal Reserve Bank of

THE FEDERAL RESERVE SYSTEM

New York, which in these matters generally acts as
agent for the other Federal Reserve Banks.
The service functions that have been described ab
sorb the attention and time of the greater part of the
Federal Reserve personnel. The fiscal agency and re
lated 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 require
ments, 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.

CHAPTER III
THE FUNCTION OF BANK RESERVES*
The amount of reserves held in relation to legal
requirements is a controlling factor in the lend
ing policy of banks.

HE aggregate deposits in the banking system as
a whole represent mainly funds lent by banks or
paid by banks for securities, mortgages, and other
forms of investment obligations. It may seem that it
should be the other way round— that bank loans and
investments would be derived from bank deposits in
stead of bank deposits being derived from loans and
investments; and it is true that deposits would not
grow out of loans if currency were to be 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— includ
ing 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 borrowed $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

* The term “ reserves” as used in this book denotes asset reserves
exclusively— that is, the reserves that count virtually as cash. It
does not denote tee reserves against contingencies that m ay be set
up on the liability side of a balance sheet.

THE FEDERAL RESERVE SYSTEM

have the promissory note, and it would have $1,000
more deposits on its books. The loan, instead of de
creasing the bank’s cash holdings, would have increased
its deposits.
Or suppose that the bank purchases a $1,000 Gov
ernment bond from one of its customers. The customer
does not want payment in currency— he wants pay
ment in deposit credit. Accordingly, the bank acquires
a $1,000 bond and its deposits increase by $1,000. The
bank’s currency is not involved in the transaction and
remains what it was.*
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 should 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 ex
pand deposits. Upon reserves also hinges the power
of the Federal Reserve authorities to influence the
credit policy of the member banks.
* A s this and the preceding paragraph indicate, a bank’s purchase
of investments, i.e., bonds, mortgages, etc., is an extension of credit
just as a loan i s ; and bank investments increase bank deposit* just
as bank loans do. For the sake of simplicity, the terms “ lending”
and “ extension of credit” are often used where the purchase of in
vestments b y banks as well as lending b y banks is meant.

FUNCTION OF RESERVES

Bank reserves need to be understood from both the
operating and the legal point of view. From the oper
ating 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, re
serves 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 practice. Conse
quently, about a hundred years ago, legislatures began
to adopt legal standards, which might require, for ex
ample, that a bank’s reserves be not less than 10 per
cent of its note and deposit liabilities. But, while a
legal requirement made certain that reserves be main
tained, 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

THE FEDERAL RESERVE SYSTEM

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 the power to ad
vance additional reserve funds to them either by lend
ing to them directly or by purchasing securities and
other forms of obligations in the open market.
Since it became possible under this 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
had 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 as
sure 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 circum
stances, reserve requirements took on a new signifi
cance. They became important as a means of giving
effectiveness to the regulatory powers to be exercised
directly with respect to the volume of bank reserves
and indirectly with respect to the extension of credit
by banks.
R e se rv e R eq u irem en ts

As stated in the Federal Reserve Act, the reserve
balances that must be maintained by member banks
with their Federal Reserve Banks are as follows: T
For member banks in central reserve cities (New

FUNCTION OF RESERVES

York City and Chicago), not less than 13 per cent of
their demand deposits (checking accounts) and 3 per
cent of their time deposits (including savings).
For member banks in reserve cities (sixty other cities
of lesser size), not less than 10 per cent of their de
mand deposits and 3 per cent of their time deposits.
For member banks elsewhere (so-called “ country
banks” ), not less than 7 per cent of their demand de
posits and 3 per cent of their time deposits. The great
est number of banks falls 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 or contraction.”
It limits the possible
change, however; requirements may not be made lower
than those stated in the law nor more than twice as
high.
The following table shows the reserve requirements
that have been in effect at different periods since 1917:

June 21,
Classes of deposits
1917and banks
A ug. 15,
1936

A ug. 16,
1936Feb. 28,
1937

M ar. 1,
1937A pr. 30,
1937

M a y 1,
1937Apr. 15,
1938

Apr. 16,
1938
and
after

(P e r cent o f denosits')

On net demand dep osits:
Central reserve
city banks . . .
R eserve
c ity
banks ...............
Country b a n k s ..
On time deposits:
A ll
member
banks ...............

13
10
7

19 %

22%

ioy2

17 %
12%

20
14

17%
12

THE FEDERAL RESERVE SYSTEM

In practice, these requirements relate to balances
maintained on the average over a period (semi-weekly,
weekly, or semi-monthly depending on the bank’s
location) and do not imply that the funds are to be
left untouched. While maintaining his average reserve
balance at or above the required minimum, a banker
may make constant and active use of his reserve ac
count. 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 ac
count 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 al
lowed to expand on the basis of a given volume of re
serves. Sometimes an increase or decrease in deposits
results in a simultaneous increase or decrease in re
serves, but this is not necessarily so. Suppose, for ex
ample, that a given bank has $2,000,000 of deposits, is
required to have reserves of 10 per cent, and has ex
actly 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

FUNCTION OF RESERVES

Federal R eserve B a n k

P hiladelphia

925 Chestnut Street, Philadelphia, Pennsylvania

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.
In brief, when borrowed funds are checked out, the

THE FEDERAL RESERVE SYSTEM

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 de
posits. 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.

CHAPTER IV
THE EXPANSION AND CONTRACTION OF BANK
RESERVES
The ability of m ember banks to lend is largely dependent
upon the volume of their reserves; they are required to
keep their reserves on deposit with the Federal Reserve
B a n ks; and the Federal Reserve authorities are em
powered to extend Federal Reserve Bank credit for the
expansion of those reserves.

Therefore, the Federal R e

serve authorities, through the medium of bank reserves,
are able to influence the extension of m ember bank credit.

HERE are three prominent factors that, in the
absence of operations by the Federal Reserve au
thorities, may render bank reserves inadequate in
amount. One is an increased demand for borrowed
funds, which, as banks increase their loans and invest
ments in response to it, results in an expansion of bank
deposits without a corresponding expansion of reserves.
The second is an increased demand by the public for
circulating 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 with
drawals of currency, effects a reduction of reserves rela
tively greater than the reduction it effects in de
posits. Payments of Federal taxes by the public and
purchases by the public of new issues of Government
securities also tend temporarily to reduce bank re^
serves, but these reductions are soon offset when
Government disburses
funds it has received.

the

THE FEDERAL RESERVE SYSTEM

When any of these factors renders member bank re
serves insufficient, an occasion arises for Federal Re
serve 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 rela
tively few banks, or it may affect banks in general. It
may be met through loans to individual member banks
or through open market purchases, depending on pre
vailing credit conditions and policies.
D iscou n ts and A d va n ces for M e m b e r B an ks

The loans which individual member banks may ob
tain from the Federal Reserve Banks are of two main
classes: (1) the discount of so-called 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 maturities 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 mem
ber 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
reserve account 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 by eligible
paper may have a maturity of not more than ninety
days and is subject to the same discount or interest
charge as eligible paper itself. An advance secured by

EXPANSION AND CONTRACTION

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
one-half of one per cent per annum above the current
discount rate on eligible paper.
Under the two foregoing provisions a Federal Re
serve 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 can offer the Federal Reserve Blink
as security.
D iscou n t R a tes

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 prac
tice 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 au
thorities to encourage borrowing for such a 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 substan
tially in debt to the Reserve Banks. Under such cir
cumstances, changes in the discount rates, which made
this indebtedness either more or less expensive, were

THE FEDERAL RESERVE SYSTEM

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 dis
count rates on eligible paper were 1 per cent at the
Federal Reserve Bank of New York and 1^/2 per cent
at the other eleven Federal Reserve Banks, whereas
in the 1920,s they varied from 3 per cent to 7 per cent
at different Federal Reserve Banks at different times.
The Federal Reserve Bank discount rates are more
closely related to the so-called open market rates than
to rates on the loans that banks make to their cus
tomers. Open market rates include the rates on com
mercial 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 Re
serve 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.
O p en M a rk et O perations

addi

The second method of supplying banks with
tional reserve funds is through open market purchases

EXPANSION AND CONTRACTION

F ederal R eserve B a n k

C leveland

East 6th Street and Superior Avenue, Cleveland, Ohio

of Government securities and other obligations. These
purchases are undertaken at the initiative of the Fed
eral Reserve authorities and not of individual member
banks. They do not have particular banks in view, but
the aggregate reserves of the banking system as a
whole.
Securities purchased by the Federal Reserve authori
ties in the open market come out of the portfolios
either of banks themselves or of investors and corpora
tions that are the customers of banks. If they come out
of the portfolios o f in vestors and corporations, the
checks given in payment by the Federal Reserve au

THE FEDERAL RESERVE SYSTEM

thorities are deposited by the investors and corpora
tions in their respective banks, and as a result bank
deposits are increased. The banks in turn deposit the
checks in their reserve accounts at the Federal Reserve
Bank, so that bank reserves also are increased. If the
securities come out of the p ortfolios o f 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 the funds received by the banks are deposited by
them in their reserve accounts at the Federal Reserve
Bank. Open market purchases of securities by the
Federal Reserve authorities always increase the re
serves of banks, therefore, but whether they increase
deposits as well depends on whether the securities pur
chased 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 expan
sion, because expansion is limited by the excess of re
serves 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 port
folios 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
the
of the banks themselves, the whole

portfolios

from

EXPANSION AND CONTRACTION

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 deter
mine to what particular banks the funds will go, in
what volume, and how long they will 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 part of the
aggregate reserves of the banking system as a whole.
The reverse of the process described in the preced
ing paragraphs occurs when the Federal Reserve au
thorities 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 reduc
tion will be in bank reserves on ly. In either event the
reduction in reserves tends to diminish the amount of
credit that banks can extend, but a reduction in re
serves without a reduction in deposits tends to dimin
ish it more rapidly, because there is no accompanying
reduction in the amount of 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 be to reduce reserves,
in which case securities are sold. This does not mean
that open market operations are a mechanical process
by which any desired result may be obtained at
On the contrary their efficacy is dependent upon a

will.

THE FEDERAL RESERVE SYSTEM

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 un
changed volume. This policy has reflected the purpose
of the Federal Reserve authorities to contribute to
the maintenance of monetary conditions that would
encourage recovery in commerce, industry, and agri
culture.
FEDERAL RESERVE BANK CREDIT

1914

1916

1918

1920

1922

1924

1926

1928

1930

1932

1934

1936

1938

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.

EXPANSION AND CONTRACTION

Federal R e se rv e B an k C redit and M e m b e r
B an k Credit

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 the bank deposits
transferable by check wherewith business men and
other persons make the bulk of their monetary pay
ments. Member bank reserves function, therefore, as
the link between Federal Reserve policy and member
bank policy.
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, for
funds to be lent by banks to the purchasers. The
member banks can furnish the credit— that is, they
can lend the funds— only if they have adequate re
serves. But additional reserve funds are always avail
able 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 the proceeds of purchases of securities by the Fed
eral 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 re
serves— deriving in greater or less degree from Federal
Reserve Bank credit— determines the ability of mem

THE FEDERAL RESERVE SYSTEM

ber banks to meet the demands of their borrowers for
member bank credit.
It is important to note, however, that Federal Re
serve Bank credit and member bank credit are not the
equivalent of 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 mem
ber bank credit brings about an increase in bank de
posits, because the funds that bank customers borrow
commonly go on deposit; and to the fact that the re
serves which member banks are required to maintain
are only a fraction of their deposits. Suppose that
banks were required to maintain reserves of 20 per cent
and that they had just 20 per cent 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 vary
ing circumstances, depending on what the reserve re
quirements 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 con
siderably 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

EXPANSION AND CONTRACTION

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 need to supply is only a fraction of
such expansion.
The situation is different when a deficiency of mem
ber bank reserves arises 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 Re
serve authorities are empowered to extend Federal
Reserve Bank credit for the expansion of those re
serves, it follows that the Federal Reserve authorities,
by the extension of Federal R e se r v e B an k credit, may
influence very considerably the extension of m em b er
bank credit. By enlarging the volume of member bank
reserve funds they can make it possible for the latter
to meet almost any conceivable volume of demand by
borrowers; and by reducing the volume of reserve
funds they can apply restraint to an over-extension 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 FEDERAL RESERVE SYSTEM

The initiative must be taken by business men and
others who wish to borrow. The member banks may
extend credit as long as they have adequate reserves;
when their reserves become inadequate, Federal Re
serve Bank credit is available with which to replenish
these reserves; to the extent that their enlarged re
serves permit, the member banks can expand their
loans as long as there is sufficient demand. Thus, Fed
eral Reserve Bank credit can not insure a dem and for
member bank credit; it can and does insure the avail
a bility of ample member bank credit when and if a
demand exists.

CHAPTER V
THE COMPOSITION OF BANK RESERVES
Federal Reserve Bank credit and gold are the
two main sources of bank reserves; checks are
the principal means by which reserves are trans
ferred from bank to bank.

ROM the point of view of member banks taken col
lectively, reserves are derived chiefly from the fol
lowing sources:

F ederal R eserve B a n k C redit , in the form of

loans by the Federal Reserve Banks and pur
chases by them of bills and securities.
G old, 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:
C h e c k s on other banks and C u r r e n c y .

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 re
serves, 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 re
serves of banks that have not possessed it, and Re
serve Bank credit may be and actually is the basis of
reserves of banks that have not borrowed.

THE FEDERAL RESERVE SYSTEM

H o w R e se r v e F u n d s M o v e fro m B an k to B an k

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 to the
reserve accounts of the member banks concerned, the
additional reserve funds resulting from the transaction
immediately lose their connection with the transac
tion. They become simply reserve funds, indistin
guishable 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 de
posits the check with the X National Bank, and re
ceives 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 ac
count. 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 other banks,
* A t present, gold purchased by the United States Treasury is not
in fact deposited at a Federal Reserve Bank but is delivered to one
of the United States Assay Offices, and the check received from the
Treasury in paym ent is deposited in the Federal Reserve Bank.
The technical steps involved in the transaction have no significance
for present purposes, the effect being the same as if the gold were
actually deposited in the Federal Reserve Bank and b y it turned
over to the Treasury. T h e gold, though held in the vaults of the
Treasury, is nevertheless a part of the m oney supply of the country;
on its way into the Treasury it gives rise to bank deposits and bank
reserves, and if withdrawn from the banking system , through export
or otherwise, it would reduce them .

COMPOSITION OF RESERVES

F ederal R eserve B a n k

R ich m on d

9th and Franklin Streets, Richm ond, Virginia

having given their depositors credit for the 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 balance 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. These other
banks know only that checks drawn on the X National
Bank were deposited by them in the Reserve Bank and
that their reserve accounts have been credited accord
ingly. 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

THE FEDERAL RESERVE SYSTEM

to bank deposits and bank reserves substantially as
just described.
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 and thou
sands 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 bil
lion 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 what
ever 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.
T h e F low o f F u n d s and the V o lu m e o f F u n d s

Sometimes a banker receives larger check payments
from other banks than they receive from him. When
that is the case, he gains reserves. Sometimes other
banks receive more from him than he receives from
them. In that case he loses reserves. It is obvious,

COMPOSITION OF RESERVES

however, that when a check is deposited in the reserve
account of one bank and charged to the reserve ac
count of another, the total volume of reserves, taking
all banks together, is not increased or decreased at all.
One bank loses what another bank gains.
But when gold is deposited and the reserve balance
of a given bank is increased thereby, there is no cor
responding 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: the resulting increase
in the reserves of the banks directly affected is not
offset by a charge to the reserves of other banks. In
stead, total reserves are increased. In both cases the
total remains at the higher level regardless of the
stream of checks by which funds are transferred from
one reserve account to another. It remains at the
higher level until any one of these things happens:
(1) the Federal Reserve sells securities; (2) loans by
the Federal Reserve are repaid; or (3) currency or
gold is withdrawn. When any 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 Re
serve Bank are paid for by a charge against the re
serves 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 or gold when
withdrawn is charged to the reserve account of the
banker by whom it was withdrawn; and because the

THE FEDERAL RESERVE SYSTEM

charges to these reserve balances are not offset by any
corresponding credits to other reserve balances.*
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 transac
tions and of his own consequent gain or loss of re
serves; but experience of the origination and extinc
tion 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 obli
gations are bought and sold in large amounts ever
have any direct experience of gold transactions and
open market operations; and borrowings from the Re
serve Bank, while more common, are never a matter
of daily routine as check transactions are.
O ther Factors

Other factors affect the aggregate volume of bank
reserves, but mostly in a minor or transitory way as
compared with gold and Federal Reserve Bank credit.
The 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 acquired is far
* Gold may be withdrawn from the United States Treasury, under
present law and regulations, at the discretion of the Secretary at
Treasury, for export or for use in the arts but not for domestic
circulation.

the

COMPOSITION OF RESERVES

less than that of gold. Chief among the transitoryfactors affecting the aggregate volume of reserves are
receipts and expenditures by the United States Treas
ury. When Federal taxes are paid, the effect is to re
duce 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 balances 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 tem
porary 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 fac
tors are of importance in explaining current fluctua
tions in the volume of reserves, they do not alter the
fact that the basic constituents of reserves are gold
and Federal Reserve Bank credit.
T h e R ela tion B e tw e e n Federal R e se r v e
B an k Credit and G old

Before the Federal Reserve Banks were established,
the basic reserves of the banking system consisted al
most exclusively of gold, silver, and currency. There
was no Federal Reserve Bank credit, nor any institu
tion 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 reserve

THE FEDERAL RESERVE SYSTEM

funds to one another, the aggregate bank reserves
shown on the books of banks always included duplica
tions and exceeded the amount of gold and other cur
rency that could be counted as reserves. Reserves
shown in excess of this amount, however, were ficti
tious. 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 Re
serve Banks were empowered to create additional re
serve 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 Re
serve Banks, therefore, bank reserves have consisted
basically of gold, the amount of which is not readily
subject to control, and of 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 dis
place each other; that is, the more gold there is com
ing 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 move
ment of gold is largely independent of control; al
though 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

COMPOSITION OF RESERVES

F ederal R eserve B a n k

A tlanta

104 Marietta Street, Atlanta, Georgia

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.

CHAPTER VI
RESERVES OF THE INDIVIDUAL BANK AND OF
THE BANKING SYSTEM AS A WHOLE
Additional reserve funds that enable the indi
vidual 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.

ANK 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 re
serves accordingly. When he makes a loan and the
funds are credited to the deposit account of the bor
rower and then checked out, the funds sooner or later
leave his bank and go on deposit in another bank.
Under these 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 or 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 can cause a rapid growth
of bank deposits. No one banker has control of such
a process. He has no means of making other bankers

THE SINGLE BANK AND ALL BANKS

lend— no means of making customers start borrowing.
He has to feel his way, constantly watching the vol
ume 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.
A ssu m in g T here W e r e O n ly O ne B an k

Suppose there were only one bank instead of sev
eral thousand, and that this one bank did all the com
mercial banking business in the country. Suppose
further that this bank were required by law to have
reserves equal to at least 20 per cent 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 single additional dollar it would
reduce its reserves below the legal requirement, be
cause 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 n ot
go up, and in consequence the reserve balance would
be less than 20 per cent 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 neces
sarily 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

THE FEDERAL RESERVE SYSTEM

account. Or if it were cashed by the bank, the cur
rency 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 de
posits 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 in
crease its deposits out of proportion to its reserves, the
commercial bank might stop making new loans. Sup
pose, however, that the Reserve authorities were of the
opinion that more loans might advantageously be
made and that the bank should be provided with addi
tional reserves so that it could make them. Suppose
they therefore purchased $20,000,000 of securities in
the open market. The sellers of the securities would
deposit in the commercial bank the money they re
ceived in payment. The commercial bank in turn
would deposit it in its reserve account at the Reserve
Bank. Having these additional reserves of $20,000,000,
the commercial bank, by making loans, could increase
its deposits to five times as much, or $100,000,000— the
$20,000,000 being the 20 per cent reserves required
against deposits of $100,000,000.
Another possibility is that the commercial bank
might borrow the $20,000,000 from the Reserve Bank.
But whether the commercial bank took the initiative
in borrowing or the Federal Reserve authorities took
the initiative in purchasing securities, in either event
the sum total of reserve funds would be increased, and
lending on an increased scale would be possible. In
either event also, the Reserve authorities would not
need to advance the full amount that the commercial

THE SINGLE BANK AND ALL BANKS

bank would lend, but only enough to supply the 20
per cent reserve required against the increased deposits
resulting from its lending.
Taking A ll B an ks T ogeth er

The same principle that would operate if there were
only one bank holds true of all banks taken together—
the great difference being that effects which are im
mediately and directly discernible when there is as
sumed to be only one bank are much more difficult to
follow when the explanation is applied individually to
the thousands of banks actually in operation. What is
true of banks as a whole is not true of every individual
bank; there are always exceptions. When bank re
serves in the aggregate are in excess of requirements,
there nevertheless will be individual banks with no ex
cess reserves; and when, therefore, banks in general
are in a position to extend abundant credit, there
nevertheless will be individual banks in no such easy
condition. In particular, when the sum total of re
serve funds is augmented by Federal Reserve or other
action the increase will manifest itself first at certain
individual banks which happen to be recipients of the
additional funds. But no bank can expect to keep per
manently what it receives. Its customers are always
checking its funds elsewhere. By the normal and ac
tive process of clearing the enormous number of checks
that are constantly being drawn on one bank and de
posited in another— thereby entailing the transfer of
funds from the reserve balance of one bank to the
reserve balance of another— a rapid movement or cir
culation of reserve funds is maintained. The result is
that any increase in the total volume of reserve funds
tends sooner or later to spread itself from the few

THE FEDERAL RESERVE SYSTEM

banks where it originates to many other banks, if not
all.
Let us assume that the Reserve authorities realize
that banks as a whole have insufficient reserves for the
expansion of credit that is needed and proceed to buy
Government securities in order to supply the money
market with additional funds. Suppose as before that
they buy $20,000,000 worth and that the entire sum
happens to be deposited in some one bank. That par
ticular bank’s deposits and reserves will both be in
creased by $20,000,000. But the bank is not required
to have reserves of more than 20 per cent, and 20 per
cent of the increase is $4,000,000. Therefore, $16,000,000 of what the bank receives is excess reserves. It
lends the $16,000,000— assuming it can find borrowers
— and the whole amount, let us suppose, is checked out
and deposited in a second bank. This second bank
with increased deposits of $16,000,000 against which
it is required to keep reserves of only 20 per cent, or
$3,200,000, gets in consequence excess reserves of
$12,800,000. It lends these funds, and they are checked
out by the borrowers and deposited in a third bank.
The third bank, having to keep reserves of only 20
per cent against the increase of $12,800,000 in its de
posits, gets excess reserves of $10,240,000 to lend. It
lends, and the amount is checked out by the borrowers
and deposited in a fourth bank. It is evident that this
process could go on till the amounts involved for suc
cessive banks were negligibly small. Including six
more banks in the illustration, or ten in all, the addi
tional deposits, loans, and reserves made possible by
the Federal Reserve Bank’s disbursement of $20,000,000 would be as follows:

THE SINGLE BANK AND ALL BANKS
Additional
Deposits
Received

Additional
Loans
M ade

Additional
Reserves
Retained

(1 0 0 % )

(8 0 % )

(2 0 % )

1st bank .......................... ..
2nd b a n k .......................... . . .
3rd bank .......................... . . .
4th bank .......................... . . .
5th bank ..........................
6th bank ..........................
7th bank ..........................
8th bank ..........................
9th bank ..........................
10th bank ..........................

$20,000,000
16,000,000
12,800,000
10,240,000
8,192,000
6,553,600
5,242,880
4,194,304
3,355,443
2,684,355

$16,000,000
12,800,000
10,240,000
8,192,000
6,553,600
5,242,880
4,194,304
3,355,443
2,684,355
2,147,484

$ 4,000,000
3,200,000
2,560,000
2,048,000
1,638,400
1,310,720
1,048,576
838,861
671,088
536,871

.
T otal first 10 banks ..
Other banks in t ur n. . . . . . .

$89,262,582
10,737,418

$71,410,066
8,589,934

$17,852,516
2,147,484

$100,000,000

$80,000,000

$20,000,000

These figures assume, for the sake of simplicity, that
every bank is able to find borrowers for the full amount
that it can lend and that the full amount of every loan
is checked out to some one other bank; that there are
no left-overs and that the different banks come into
the picture one at a time. They make no allowance
for the fact that an individual bank in making loans is
not limited to its excess reserves, because it can bring
them up to the required level by borrowing from its
Reserve Bank.
On this basis, the figures show that the first ten
banks had additional reserves of $17,852,516, addi
tional loans of $71,410,066, and additional deposits of
$89,262,582. Other banks sharing in the remaining
portion of the $20,000,000 of additional reserves would
increase their loans by $8,589,934 and would have ad
ditional deposits of $10,737,418. In the end, accord
ingly, an expansion of deposits amounting to $100,000,000 would be made possible by the $20,000,000 of addi
tional reserves created by Federal Reserve

action.

THE FEDERAL RESERVE SYSTEM

F ederal R eserve
B a n k of C hicago
230 South LaSalle
Street, Chicago,
Illinois

The result would be the same if the banks were to
purchase securities instead of making loans.
Of course, there would never be such an absolutely
uniform division as we have been supposing, but the
principle nevertheless holds true. Each bank could lend
whatever reserves it had in excess of what it was re
quired to have, and in the end the total additional loans
and the total additional deposits would be several times
as great as the total additional reserve funds created

THE SINGLE BANK AND ALL BANKS

by the Reserve authorities’ purchase of securities.*
The fact that what can be done by the banking sys
tem as a whole differs so much from what can be done
by any individual bank is one of the most difficult
things to understand clearly in the whole field of bank
ing. It seems paradoxical. Yet it is a fundamental
fact of utmost importance. The difficulty is to see that
the limited power of the individual bank, which can
lend somewhat less than the amount of additional re
serves it receives, can, when exercised by many indi
vidual banks, enable them all together to lend several
times the amount of the additional reserves. But what
each bank receives is in each case the greater part of
what has already been received by another bank, so
that the same amount keeps working over and over
again, a little diminished each time.
The practical consequence of this is that the Federal
Reserve authorities, by supplying a rela tively small
volume of additional reserve funds, make it possible
for the banking system as a whole to supply the public
with a jar greater additional volume of credit. Con
trariwise, by withdrawing a relatively small amount of
funds, when member banks have no excess reserves,
the Federal Reserve authorities can make it necessary
for the banking system to borrow the amount with
drawn or to reduce loans and investments— and con
sequently deposits— by several times that amount.
* T he reserves required are not in fact 20 per cent at present, but
about 15 per cent on the average. T h e figure of 20 per cent has been
used for greater simplicity in illustration. T h e actual figure is always
the result of several factors and varies from tim e to tim e, partly
because of changes in the various required percentages and partly
because of changes in the amount of deposits subject to the various
required percentages. Between 1918 and 1929 the ratio of required
reserves to deposits declined from about 9 per cent to about 7 per
cent and thereafter rose again to about 8 per cent b y the middle of
1936. In 1937 it rose to about 16 per cent, as a result o f changed
reserve requirements, and in 1938 it fell to about 15 per cent.

CHAPTER VII
FEDERAL RESERVE POWERS AND LIMITATIONS
Although Federal Reserve powers are important
and extensive, they are nevertheless constantly
subject

limitations inherent in the

condi

tions under which they are exercised.

HE limitations upon the powers of the Federal
Reserve authorities are partly statutory and partly
practical. Those that are statutory relate primarily
to the reserves that the Federal Reserve Banks are re
quired to maintain against their note and deposit lia
bilities.
The circulating notes issued by the Federal Reserve
Banks and the reserve deposits maintained with them
by member banks are alternative forms of Federal Re
serve Bank liability. As of December 31, 1938, Fed
eral Reserve notes in circulation amounted to about
$4,500,000,000, and member bank reserve balances on
deposit with the Reserve Banks amounted to about
$8,700,000,000. When a member bank needs addi
tional Federal Reserve notes, they are obtained from
its Federal Reserve Bank, which charges their amount
to the member bank’s reserve balance. Correspond
ingly, when a member bank finds that it has more
Federal Reserve notes on hand than it needs, it may
send the notes to the Federal Reserve Bank and have
their amount credited to its reserve balance.
The Federal Reserve authorities expand the volume
either of notes or of reserve balances in response to the
demands of the public and of the member banks. Al
though they may at times take action to reduce the
volume of bank reserves, they never need take

action

POWERS AND LIMITATIONS

to reduce the amount of notes in circulation. Cur
rency in excess of the public’s needs is promptly de
posited in banks and by them is deposited in the Fed
eral Reserve Banks. The process is spontaneous. In
effect, therefore, the amount of money in circulation is
governed by the public’s action, not by action
issuing authorities, and no more currency will
in use than is required.

of the
remain

Legal L im itation s

The Federal Reserve Act stipulates that the Federal
Reserve Banks shall have reserves of gold certificates
equal to at least 40 per cent of the Federal Reserve
notes in circulation and reserves comprising gold cer
tificates or lawful money equal to at least 35 per cent
of their deposits. Taking the figures as of December
31, 1938, this means that the Federal Reserve Banks
must have at least $1,800,000,000 in gold certificates as
the 40 per cent reserve against their Federal Reserve
notes of $4,500,000,000, and $3,535,000,000 of gold cer
tificates— assuming they have no other lawful money
— as the 35 per cent reserve against their $10,100,000,000 of total deposits. That is $5,335,000,000 of gold
certificates, taking the two requirements together. Ac
tually, however, the Federal Reserve Banks had $12,000,000,000 in gold certificates, or more than twice the
maximum amount required. Notes in circulation
and reserve deposits could therefore be more than
doubled on the basis of present gold reserves, so far as
the law is concerned. And since the Reserve authori
ties are empowered to suspend for limited periods the
requirements stated in the law, the volume of
and reserve deposits could be much more than
bled if an emergency should make it

necessary.

notes
dou

THE FEDERAL RESERVE SYSTEM
FEDERAL RESERVE BANKS - RESERVE POSITION

1914

1916

1918

1920

1922

1924

1926

1928

1930

1932

1934

1936

1938

The accompanying chart (Federal Reserve Banks—
Reserve Position) shows the volume of Federal Re
serve Bank liabilities in the form of deposits and cir
culating notes during twenty-four years of Reserve
System operations. It also shows the ratio of the Re
serve Banks’ reserves, which at their lowest, during
1920, were about 40 per cent of note and deposit lia
bilities, but in recent years have been about 80 per
cent.
Practical L im itation s

The practical limitation on Federal Reserve powers
to expand note circulation and reserve deposits can
best be understood when Federal Reserve notes and
member bank reserves (which are deposits on the
books of the Federal Reserve Banks) are considered
together with Federal Reserve Bank credit and gold.

POWERS AND LIMITATIONS

These four factors are closely interrelated, and no one
of them can change without a corresponding change
in one or more of the other three. They are the four
principal items on the Federal Reserve Banks’ state
ment of condition. Rounding them off and disregard
ing other items, they may be shown in balance as fol
lows:
(a) Gold certificates ................................................. $12,000,000,000
(b ) Discounts and securities ...............................
2,500,000,000
$14,500,000,000
(c) Deposits ................................................................ $10,000,000,000
(d) N otes in circulation ........................................
4,500,000,000
$14,500,000,000

In the latter part of the year 1938 the deposits on
the books of the the Federal Reserve Banks as shown
above (c) were $10,000,000,000, and the Federal Re
serve notes outstanding (d) were $4,500,000,000. At
the same time the Banks held (a) $12,000,000,000 in
gold certificates and (b) $2,500,000,000 of obligations
in bonds, promissory notes, etc. The two groups of
figures, taken together, show that $14,500,000,000 of
gold and Federal Reserve Bank credit made possible
$14,500,000,000 of Federal Reserve Bank deposits and
notes. In other words, the gold certificates (a) and
the Federal Reserve Bank credit (b) were the sources
of funds amounting to $14,500,000,000, and the re
serve deposits (c) and the notes (d) represented the
uses of those funds in like amount.
The Federal Reserve authorities have no control
over the volume of gold. Its shipment into the United
States is due to various causes, chief among them the
excess of exports over imports and the flight of capital
induced by the economic and political conditions in
other countries. As the gold is received, the Federal

THE FEDERAL RESERVE SYSTEM

Reserve Banks’ holdings of gold certificates (a) and
their deposits (c) are both equally increased. By the
same token, the reserve balances of member banks—
which constitute the bulk of Federal Reserve Bank de
posits—are increased, and member banks accordingly
find it easier to, meet reserve requirements. The de
mand for Federal Reserve Bank credit (b) is conse
quently lessened; the member banks will have little
occasion to borrow and the Federal Reserve authori
ties will have little occasion to purchase securities. If,
however, the Federal Reserve authorities were to pur
chase additional securities, the result would be to ex
pand member bank reserves (c). If they sold securi
ties or if some of the discounts (b) were paid, deposits
(c) would correspondingly decrease; unless there were
simultaneously an increase in gold certificate holdings,
or a decrease in the amount of notes in circulation.
The amount of notes in circulation (d) represents
what the public requires; if an increase in the amount
occurred— more notes being drawn into use— there
would be a corresponding decrease in deposits, and if a
decrease occurred— a smaller volume of notes being
used— there would be a corresponding increase in de
posits.
Although the power of the Federal Reserve authori
ties to create reserve funds by the extension of Federal
Reserve Bank credit is subject to the statutory require
ment as to the reserves in gold certificates and lawful
money that they shall maintain against their notes and
deposits, it is evident that the practical limitations
upon that power lie in conditions reflected in the other
three factors, namely, gold, member bank reserves,
and circulating notes. These conditions will of course
be diverse. The amount of gold in the country de

POWERS AND LIMITATIONS

pends upon world-wide political and economic condi
tions. The amount of bank reserves depends upon
the amount of gold and upon the demand for cur
rency, as well as upon the amount of Federal Reserve
Bank credit. The demand for currency depends upon
business conditions. The demand for Federal Re
serve Bank credit is affected by '$1 these factors and
by the demand for member bank credit.
In brief, monetary factors are not only dependent
on one another, they are dependent on other factors.
A given economic situation is the resultant of a wide
variety of forces— such as invention, labor, agriculture,
foreign trade, Government expenditures, taxation, war,
weather—besides money and credit. Federal Reserve
policy must always be related to other factors, and its
effectiveness is not independent of their influence.
R eq u ired R eserves

The power to change member bank reserve require
ments is closely related to the power to create and ex
tinguish reserve funds. If member banks are under a
requirement to have reserves of $6,000,000,000 and
actually have reserves of $10,000,000,000, it is apparent
that they have $4,000,000,000 of reserves in excess of
requirements. This excess would enable them to in
crease by an enormous amount the volume of bank
credit extended by them, assuming a strong enough
demand arose. If the Federal Reserve authorities
were to lower the reserve requirements, the amount
of excess reserves and therewith the volume of mem
ber bank credit that it might be possible to extend,
assuming sufficient demand, would be still further in
creased. If the Federal Reserve authorities were to
raise the reserve requirements, the amount of excess

THE FEDERAL RESERVE SYSTEM

reserves and therewith the volume of member bank
credit that it might be possible to extend would be
diminished, so long as the higher reserve requirements
remained effective. While an increase in reserve re
requirements of itself tends to restrict the volume of
member bank credit that might be extended, its effect
can be offset, if advisable, by increasing the volume of
Reserve Bank credit outstanding; with the possible
advantage that in principle excess reserves which arise
from Federal Reserve Bank credit are more flexible
and better subject to current adjustment than excess
reserves arising from gold. Consequently, a situation
in which the aggregate volume of reserve funds is to
a great extent dependent upon Federal Reserve policy
is apt to be more in the public interest than one in
which the aggregate volume is dependent upon gold,
the movements of which are largely beyond control.
At the present time reserve requirements, as shown
in Chapter III, are a little less than double what they
formerly were. The reason for increasing them was
that bank reserves had become expanded to an in
ordinate degree by the immense increase in the coun
try’s gold stock. As a result member bank reserves
were so much in excess of requirements that the lend
ing power of member banks, instead of being subject,
as contemplated in the Federal Reserve Act, to the
corrective influence of the Federal Reserve authori
ties, depended too largely upon the abnormal stocks
of gold received from abroad and too little upon
domestic factors subject to control. In an endeavor
to return more nearly to conditions under which the
normal regulatory powers established by Congress are
effective, the volume of reserves in excess of require
ments was reduced by raising the requirements. This

POWERS AND LIMITATIONS

F ederal R eserve B a n k

St . L ouis

411 Locust Street, St. Louis, Missouri

action had the effect of offsetting, to a partial extent,
the increase in the gold stock.
An increase in reserve requirements does not in
crease the power of the Federal Reserve Banks to lend
or to hold securities. The lending and investing power
of the Federal Reserve Banks is not derived from
member bank reserve deposits, and larger required
reserve balances do not increase that power. The
lending power of the Federal Reserve Banks is a stat
utory power whereby the Federal Reserve Banks may
acquire promissory notes, acceptances, bonds, and
other obligations and give in exchange therefor Fed
eral Reserve notes or credit to the reserve accounts of

THE FEDERAL RESERVE SYSTEM

member banks. Having such power, their ability to
lend and to purchase securities is not limited
volume of funds deposited with them by their mem
ber banks.

by the

T h e N a tu re o f Federal R e se r v e B an k C redit

Credit in general is a matter of monetary agree
ments, the essence of it being an acceptable promise
to pay. Bank credit is a special form of credit, pecul
iar in that it involves a promise or assumption of lia
bility b y a bank, given in exchange for a promise made
to the bank. Thus, a bank accepts the promissory
note of a customer and in exchange promises to pay
the customer a corresponding amount, which, pending
his order, is carried on its books as a deposit in his
favor. Bank credit plays a vitally important part
in modern economic life. As a source of bank
deposits transferable by check, it provides the funds
with which the bulk of monetary payments is effected.
It is always interchangeable with legal tender money,
but for the most part it is not derived from legal
tender money, nor does the volume of bank credit bear
any rigid relationship to the volume of legal tender
money. If the volume of loans that banks could make
and of deposits that they could accept were limited to
the volume of currency in existence, bank credit would
not have the utility it now has in our economic sys
tem. Bank credit is a means by which wealth in
other than monetary forms can be transmuted tem
porarily into monetary forms; as when, for example, a
man borrows a thousand dollars on mortgage
lateral security and thereby obtains monetary funds
without selling his property.

or col

POWERS AND LIMITATIONS

Federal Reserve Bank credit resembles bank credit
in general, but under the law it has a limited and spe
cial use— as a source of member bank reserve funds.
It is itself a form of money authorized for special pur
poses, convertible into other forms of money, con
vertible therefrom, and readily controllable as to
amount.
Federal Reserve Bank credit, therefore, as already
stated, does not consist of funds that the Reserve au
thorities “ get” somewhere in order to lend, but consti
tutes 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 Federal Reserve
notes and reserve deposits—in exchange for the prom
ises made by others to the Federal Reserve Banks, the
reason for the exchange being that the Federal Re
serve Banks’ promises are recognized by law as having
a particular monetary utility not possessed by the
promises of individuals or of private institutions. That
is, Federal Reserve Bank promises— or “ liabilities,” as
they are commonly called— serve in the form of F e d
eral R e se rve n o tes as the principal element of the
circulating medium, and they serve in the form of
reserve d eposits as a basis for the extension of credit
by member banks. These are the specific uses of the
funds that have their source in Federal Reserve Bank
credit.
Although the powers possessed by the Federal Re
serve authorities are important and extensive, never
theless they are constantly subject to limitations in
herent in the conditions under which they are to be
exercised. They are most effective when there is an
active demand for credit. When the demand is slack,

THE FEDERAL RESERVE SYSTEM

or member bank reserves are greatly in excess of re
quirements, the powers are much less effective. The
Federal Reserve authorities can create credit when it is
in demand, they can encourage the demand for it by
making funds abundant and cheap, they can create
deposits by open market purchases of securities from
others than member banks; but they can not create a
demand for credit or cause the created deposits to be
actively used.

CHAPTER VIII
MEMBER BANK RESERVES AND RELATED ITEMS
The principal jactors involved in Federal R e
serve policy are member bank reserve balances,
gold stock, Federal Reserve Bank credit, m oney
in circulation, and Treasury cash and balances.

N THE four preceding chapters the factors of Fed
eral Reserve policy have been discussed at length.
The accompanying chart (Member Bank Reserves and
Related Items) shows the movement of the more im
portant of these factors from the early years of the
MEMBER BANK RESERVES AND RELATED ITEMS

1918

1920

1922

1924

1926

IMS

1980 "1 9 3 2

1934

1988

088

THE FEDERAL RESERVE SYSTEM

Federal Reserve System to the present. This chart,
slightly modified for present purposes, and the chart
(Member Bank Reserve Balances) which appears
later in this chapter, are regularly published in the
F ederal R eserve B u l l e t in to portray current mone
tary developments.
The chart shows five fines, which may be considered
in the following order:
Member Bank Reserve Balances
Gold Stock
Reserve Bank Credit
Money in Circulation
Treasury Cash and Deposits
From 1918 through 1932 member bank reserve bal
ances in the aggregate never exceeded $2,500,000,000
for more than a few days at a time, and until 1932 and
1933 their total fluctuated relatively little. Since 1933
the amount of these balances has greatly increased,
until by the end of 1938— that is, in a period of five
years— they were $9,000,000,000, or three times as
much as they ever were before the increase began.
These reserve balances are a potential base for a credit
expansion far in excess of anything this country has
ever experienced.
G old and Federal R e se r v e B a n k Credit

As explained in preceding chapters, the principal
sources of reserve balances are gold and Federal Re
serve Bank credit. Which of these is responsible for
the remarkable increase in reserve balances since 1933?
It is obvious from the chart that it is gold, the total
amount of which has doubled since 1934, while the

RESERVES AND RELATED ITEMS

amount of Reserve Bank credit has remained practi
cally stationary; gold has risen to about $15,000,000,000, while Reserve Bank credit is only $2,500,000,000.
Before 1934, however, and prior to the recent large
increase in the gold stock, the volume of Federal Re
serve Bank credit showed wide fluctuations. It was
then a more active factor in the volume of reserves.
Before 1932 banks generally had no reserves at the
Federal Reserve Banks in excess of what was required,
and they frequently found occasion to borrow. At the
same time and for the same reason, the Federal Re
serve authorities had more occasion to buy and sell
securities currently in the open market as a means of
increasing and decreasing the volume of reserve funds.
When the Reserve Banks increased their holdings,
banks gained reserves and were enabled to pay off
their borrowings and extend additional credit; when
the Reserve Banks decreased their holdings, banks lost
reserves and were forced to borrow or else curtail their
extensions of credit. In 1932 and 1933 the Reserve
Banks increased their holdings of United States Gov
ernment securities, and the funds given in payment for
their purchases first enabled the member banks to re
duce their borrowings and then increased their excess
reserves.
Since 1933 the rapid inflow of gold shown by the
chart has increased member bank reserves much more
rapidly than bank credit has been expanded. Con
sequently, banks have held large amounts of reserves
in excess of requirements, and there has been little
occasion for them to seek Federal Reserve Bank credit,
or for Federal Reserve Bank credit to be expanded by
open market operations.

THE FEDERAL RESERVE SYSTEM

M o n e y in Circulation, T reasury Cash, and
T reasury Balances

It will be noted from the chart that at all times the
volume of bank reserves has been less than the total
of gold and Federal Reserve Bank credit combined.
This reflects the fact that gold and Federal Reserve
Bank credit are the principal sources not only of bank
reserves, but also of money in circulation, which consists
principally of Federal Reserve notes. They are also
a source of the cash held by the Treasury or deposited
by it in its checking account with the Federal Reserve
Banks. The amount of these Treasury balances was
relatively small until 1934, when it was substantially
enlarged by the increased value of the gold stock result
ing from revaluation of the dollar. As explained in a
preceding chapter, fluctuations in Treasury balances
generally represent a temporary rather than a perma
nent or basic use of funds. When the Treasury collects
taxes, it receives the bulk of the payments by check.
These checks in effect transfer money from the com
mercial banks to the Treasury; that is, they enlarge
the Treasury’s balances at the Federal Reserve Banks
and reduce the reserve balances of member banks.
The same thing occurs, in effect, when the Treasury
borrows. On the other hand, when the Treasury ex
pends the funds it has received, its own balances at the
Federal Reserve Banks are reduced and the reserve
balances of member banks are increased. Because
Treasury receipts and disbursements alternately de
crease and increase the reserves of banks, they tend to
cancel out; though at any given time they may account
for current changes of considerable magnitude in the
volume of bank reserves and of Reserve Bank credit.

RESERVES AND RELATED ITEMS

F ederal R eserve B a n k

M inneapolis

73 South 5th Street, Minneapolis, Minnesota

Another factor of potential importance, not shown
on the chart, is Treasury currency. This includes coin,
silver certificates, and United States notes. When
these forms of money go into circulation, they are
ordinarily deposited by the Treasury in the Federal
Reserve Banks and are paid out by them to member
banks as currency is required by the public. Like
gold and Federal Reserve Bank credit, they are a
source of bank reserves. They are not funds obtained
by the Treasury from existing reserves through bor
rowing or taxation. Accordingly, an increase in the is
sue of coin, silver certificates, or United States notes
will tend to increase bank reserves.

THE FEDERAL RESERVE SYSTEM

Interrelations B e tw e e n Factors

All of the factors shown on the chart are closely and
necessarily interrelated. Some of them are not directly
subject to control by the Federal Reserve authorities,
while others are subject to control in part. Increases
and decreases in the volume of gold are relatively un
controllable. The same is true of money in circula
tion; whatever the public requires is supplied without
delay or interference. Changes in Treasury cash and
deposits and in Treasury currency generally reflect
fiscal requirements and occasionally monetary policies
(e.g., revaluation of gold, gold sterilization, and issu
ance of silver certificates); at any rate they are not
among the factors directly subject to control by the
Federal Reserve authorities. This leaves Federal Re
serve Bank credit as the one factor that is largely
controllable. As explained in the preceding chapter,
the fact that it is controllable is the reason for its exist
ence; it can be increased or decreased as a counter
weight to changes in the less controllable factors.
At the present time, the interplay of the foregoing
controllable and uncontrollable factors determines the
volume of member bank reserve balances. At any given
moment this volume may be affected by the un con
trolled movement of gold, or changes in the amount of
money in circulation, or Treasury receipts and dis
bursements, and by the controlled increase and de
crease in the volume of Federal Reserve Bank credit.
Bank reserves are not always or necessarily, how
ever, so passive a resultant of other factors as they are
under present conditions. At times when member
banks have almost no reserves in excess of what they
are required to have, as tihey did before the gold

RESERVES AND RELATED ITEMS

influx of recent years, there will be a greater need for
Federal Reserve Bank credit, and member banks will
borrow from the Reserve Banks. Under those circum
stances changes in the volume of reserves will be a
governing cause of changes in the volume of Federal
Reserve Bank credit.
It will be noted that prior to 1934 there was a very
close relation between money in circulation and Re
serve Bank credit, seasonal fluctuations in the two
lines almost duplicating each other. This reflects the
fact that increases in the volume of money in circula
tion mean withdrawals of currency from the Federal
Reserve Banks, with a consequent decline in the
volume of member bank reserves. Similarly, when
currency is retired from circulation, and deposited in
the Federal Reserve Banks, it is credited to the reserve
balances of member banks and increases them. When
the reserve balances represent merely what banks are
required to have and there is no excess, the with
drawals of currency for circulation purposes have to
be offset by extensions of Federal Reserve Bank credit.
A given member bank, for example, that needs $100,000 in currency, but has no excess reserves, will borrow
$100,000 from the Federal Reserve Bank and have the
amount credited to its reserve account so that the with
drawal will not reduce its reserves below the required
amount. And, correspondingly, as soon as the member
bank accumulates sufficient currency, it will deposit
what it can spare in the Federal Reserve Bank and
pay off its borrowing. Therefore, when banks have
only such amount of reserves as they are required to
have— as was generally true before 1934— increases
and decreases in the amount of money in circulation

THE FEDERAL RESERVE SYSTEM

bring about corresponding increases and decreases in
the volume of Federal Reserve Bank credit. But
when banks have large excess reserves— as they have
had since 1934— increases and decreases in the amount
of money in circulation do not appreciably affect the
volume of Federal Reserve Bank credit but only the
volume of the excess reserves.
A striking feature of the chart is the abrupt increase
in the gold stock in 1934. This reflects revaluation
of the dollar, by which the price of gold was raised
from $20.67 to $35 an ounce. Before this action was
taken, all gold already in the country, which for the
most part was held by the Federal Reserve Banks,
was turned over to the Treasury. The whole increase
in the monetary value of the gold went to the United
States Government, therefore, and was added to the
Treasury’s cash balance. Except to the extent that a
part of this increment was later expended by the
Treasury, the increase in the value of the gold stock
had no effect on member bank reserves.
MEMBER BANK RESERVE BALANCES
WEDNESDAY FIGURES
BILLIONS OF DOLLARS

BILLIONS OF DOLLARS

0
1930

1931

1 93 2

1933

1934

1935

1936

1937

1938

1939

RESERVES AND RELATED ITEMS

R eq u ired and E x c ess R e se r v e s

The accompanying chart (Member Bank Reserve
Balances) shows reserve balances divided into required
reserves and excess reserves. Required reserves are
the part of total reserves which banks must keep in
proportion to their own deposits, and excess reserves
are the part in excess of what is required.
Before 1932, banks had almost no excess reserves.
They maintained just what they were required to
maintain and little more. When they needed larger,
reserves they used Federal Reserve Bank credit, which
was therefore a much more active factor, as already
explained, than it is now.

CHAPTER I X
W H A T T H E T W E L V E F E D E R A L R E SERVE
BANKS OW N AND W H A T T H E Y OW E
The central hanking junctions of the Fed
eral Reserve System are reflected in the
balance sheet of the Federal Reserve Banks.

HE functions described in the preceding chapters
are all reflected in the balance sheet of the twelve
Federal Reserve Banks, which is made public every
Friday and shows the condition of the Reserve Banks
as of the Wednesday immediately preceding. It ap
pears in the Friday issue of the principal daily news
papers of the country and is usually accompanied by
explanatory comment, particularly as to changes in
member bank reserves and related factors.
The statement as of December 31, 1938, in con
densed form is as follows, only the most important
items being shown separately.

A SS E T S

1. G old C ertificates on hand and due from U . S.

2.
3.
4.
5.
6.
7.

Treasury .............................................................................
Other cash . . .........................................................................
U . S. G overnm ent S ecurities ......................................
D iscounts for M ember B a n k s ...................................
Other earning assets .......................................................
Uncollected items ..............................................................
Miscellaneous assets .......................................................

T otal A ssets

............................................................

$11,798,000,000
368,000,000
2,564,000,000
4,000,000
16,000,000
711,000,000
120,000,000
$15,581,000,000

L IA B IL IT IE S

F ederal R eserve N otes

.................................................

$ 4,452,000,000

of M ember B a n k s ....................................
U . S. Treasurer’s account ......................................
Other deposits ................................................................
10. Deferred availability items ......................................
11. Miscellaneous liabilities ..............................................

8,724,000,000
923,000,000
441,000,000
694,000,000
3,000,000

9. D eposits:

R eserves

T otal L iabilities

$15,237,000,000

FEDERAL RESERVE BANK STATEMENT
C A P IT A L
12.
13.
14.
15.

ACCOUNTS

Capital ....................................................................................
Surplus (section 7) ............................................................
Surplus (section 13b) ...................................................
Other capital accounts ...................................................

T otal L iabilities

and

C apital A ccounts . . . .

135,000,000
149,000,000
27,000,000
33,000,000

$15,581,000,000

E xplanation o f A sse t A ccou n ts
1. G old C e r t if ic a t e s on hand and due from the
United States Treasury. This amount comprises cer
tificates due the Federal Reserve Banks for gold
acquired by the Treasury, including both gold trans
ferred by the Federal Reserve Banks to the Treasury
upon adoption of the Gold Reserve Act of 1934 and
gold subsequently acquired. It includes $ 1 0 ,0 0 0 ,0 0 0
constituting a redemption fund for Federal Reserve
notes.
2. Other cash is coin and paper money (not includ
ing gold certificates or Federal Reserve notes) in the
Reserve Bank vaults.
3. U n it e d S ta te s G o v e r n m e n t S e c u r it ie s are
bonds, Treasury notes, and Treasury bills purchased
from dealers and others in the open market. This
account shows the amount of Federal Reserve Bank
credit created by such purchases in order to increase
or replenish member bank reserves. Like the account
which follows, Discounts for Member Banks, it re
flects one of the most important Reserve Banking func
tions. Under the present law, Government obligations
are never purchased from the Treasury by the Federal
Reserve Banks but are purchased only in the open
market.
4. D i s c o u n t s f o r M e m b e r B a n k s . This account
shows the amount of Federal Reserve Bank credit
created by lending and is represented in part by prom

THE FEDERAL RESERVE SYSTEM

issory notes of member banks, secured by collateral,
and in part by promissory notes or other obligations
endorsed over to the Federal Reserve Bank by member
banks. These are usually called discounts, or redis
counts, because when the Reserve Bank acquires them
it gives credit for the amount thereof less a discount,
i.e., an interest charge deducted in advance at the
established rate. Like the account which precedes,
United States Government Securities, it reflects one
of the most important central banking functions.
Until recent years, before gold imports expanded the
reserves of member banks and made it unnecessary
for them to borrow except infrequently and on a small
scale, discounts were very large. In 1920, for example,
discounts for member banks were $2,500,000,000,
United States Government securities owned were only
$300,000,000, and other earning assets (mostly accept
ances bought in the open market, now less than
$1,000,000) were $400,000,000. This is in marked con
trast to the more recent figures.
5. Other earning assets are now mainly loans made
to industrial and commercial enterprises in accordance
with section 13b of the Federal Reserve Act. This
item also includes bills purchased, which, as referred to
in the preceding paragraph, now amount to less than
$1,000,000. At times when the supply of bank reserves
has been low, however, the Federal Reserve Banks have
bought substantial amounts of bills and thus have sup
plied funds for seasonal credit and currency demands,
especially in the autumn months. These bills are ac
ceptances, that is, two-party obligations arising from
transactions in commodities, especially in the import
and export trade. The Federal Reserve Banks pur-

FEDERAL RESERVE BANK STATEMENT

F ederal R eserve
B a n k of K ansas
C it y
10th Street and
Grand Avenue,
Kansas City,
Missouri

chase them at established rates in such volume as they
are offered for sale.
6. Uncollected items include checks and other cash
items deposited with the Federal Reserve Banks and
still in process of collection at the time the statement
is made up.
7. Miscellaneous assets consist of several items, of
which the largest is the bank premises owned by the

100

THE FEDERAL RESERVE SYSTEM

Federal Reserve Banks and carried at $43,000,000.
They also include premium on securities owned and
accrued interest receivable.
E xplan ation o f L ia bility and Capital A ccou n ts

8. F ederal R eserve N otes are the obligations of

the Federal Reserve Banks that circulate as money.
They are described in Chapters II and VII.
9. Deposits consist mainly of the R eserves of M e m
ber B a n k s . They also include checking accounts of
the United States Treasury and other Governmental
agencies, deposits of foreign banks, and deposits main
tained by certain nonmember banks for use in clear
ing and collecting checks.
10. Deferred availability items are of technical
rather than general significance. The account arises
from the fact that Federal Reserve Banks do not give
immediate credit for checks deposited for collection.
Broadly speaking, deposit credit is deferred until the
checks have had time to reach the banks upon which
they are drawn and to be paid by them. Pending this,
the Federal Reserve Banks give what is known as
“ deferred credit.” These items are generally in ap
proximate balance with “ Uncollected items,” shown
among the assets (Number 6).
11. Miscellaneous liabilities consist of several items,
the principal ones being discount on bills and secu
rities and miscellaneous accounts payable.
12. All of the capital stock of the Federal Reserve
Banks is owned by banks which are members of the
Federal Reserve System. See Chapter I.
13. Surplus (section 7) is governed by section 7 of
the Federal Reserve Act. It can be drawn on to meet
deficits or losses, if any. It can not be distributed to

FEDERAL RESERVE BANK STATEMENT

F ederal R eserve B an k

101

D allas

W ood and Akard Streets, Dallas, Texas

the stockholding member banks, except as may be
necessary to pay the regular 6 per cent dividend.
The law provides that, if the Reserve Banks are dis
solved, any surplus be paid to the United States.
14. Surplus (section 13b) represents the funds re
ceived from the Secretary of the Treasury for the
purpose of making loans in accordance with section
13b of the Federal Reserve Act, plus or minus the net
earnings or net loss arising from the use of such funds.
15. Other capital accounts consist primarily of re
serves for contingencies, amounting to $33,000,000,
and undistributed earnings, if any.

102

THE FEDERAL RESERVE SYSTEM

It is plain from a glance at the statement that four
items are by far the largest, namely, G o l d C e r t i f i
c a t e s and G o v e r n m e n t S e c u r i t i e s among the assets,
and N o t e s and R e s e r v e D e p o s i t s o f M e m b e r B a n k s
among the liabilities. These items, with D i s c o u n t s
f o r M e m b e r B a n k s , reflect the essential operations of
the Federal Reserve Banks as central banking institu
tions. The amount of gold certificates is increased
from time to time as the Treasury makes use of the
gold it acquires. The Government securities, dis
counts, and other earning assets are acquired when the
Federal Reserve authorities create additional reserve
funds for member banks. They represent the Re
serve Bank credit advanced by the Reserve Banks and
discussed in previous chapters.
Federal Reserve notes, on the liability side, consti
tute the largest and most flexible portion of the
country’s circulating medium. As already explained,
their amount can increase or decrease in immediate
response to the public’s requirement of increased or
decreased amounts of cash.
The reserve deposits standing to the credit of mem
ber banks on the books of the Reserve Banks serve at
the same time (a) as clearing balances through which
bank checks are collected and through which currency
is drawn into circulation and returned therefrom, and
(b) as the means through which regulation of the
lending power of commercial banks is effected. See
Chapters II, III, and IV.
It will be observed that the Federal Reserve Bank
statement shows a very small proportion of assets that
yield income— only about 15 per cent of the total.
That 85 per cent of the assets are in such form that
they yield no income is abnormal from the viewpoint

FEDERAL RESERVE BANK STATEMENT

103

of privately managed enterprise operated for profit.
It is not usual even for a central bank, but since such
an institution is conducted for public purposes and is
not guided by the motive of earnings, circumstances
may be such as to result in a large proportion of its
lending power remaining unused. Such circumstances
exist today.

CHAPTER X
FEDERAL RESERVE BANK EARNINGS
The operations of the Federal Reserve Banks,
although not conducted for profit, yield an in
come

which

is ordinarily

sufficient

cover

expenses.

HE creation of Federal Reserve Bank credit
through lending and through purchases of secu
rities incidentally yields an income to the Federal Re
serve Banks in the form of interest.
Ordinarily this income is adequate to cover the
necessary expenses of the Federal Reserve Banks and
the Board of Governors and to leave a balance.
Around the year 1920, the net earnings of the Federal
Reserve Banks were large, to a great extent because of
operations in connection with war financing, but since
that period they have been relatively small. Some
of the Federal Reserve Banks in certain years have
operated at a loss. In twenty-four years (1914-1938)
the total earnings of the twelve Federal Reserve Banks
have amounted to $1,277,000,000.
The distribution of these earnings is shown in the
accompanying chart (Distribution of Earnings of Fed
eral Reserve Banks, 1914-1938).
In round numbers, earnings have been used as
follows:

Expenses and reserves for contingencies .........................
Dividends .......................................................................................
Paid to United States Treasury ...................... .................
Paid to Federal Deposit Insurance Corporation.............
Surplus remaining .......................................................................

$669,000,000
170,000,000
150,000,000
139,000,000
149,000,000

$1,277,000,000

104

FEDERAL RESERVE BANK EARNINGS

105

DISTRIBUTION OF EARNINGS
OF FEDERAL RESERVE BANKS,

1914 - 1 9 3 8

TOTAL EARNINGS - $ 1 ,2 7 7 ,0 0 0 ,0 0 0

RESERVES FOR CONTINGENCIES
4 3 3 , 0 0 0 ,0 0 0

The twelve Federal Reserve Banks operate with a
force of about 11,000 officers and employees, and the
total payroll in the course of twenty-four years, after
deducting salary reimbursements, has been about
$345,000,000. Other important items of expense in
the same period have been $51,000,000 for depreciation
and charge-offs on bank premises; $50,000,000 for the
expense of issuing and redeeming Federal Reserve cur
rency; $56,000,000 for postage, expressage, and insur
ance on currency and securities shipments; $22,000,-

106

THE FEDERAL RESERVE SYSTEM

000 for local taxes; and $20,000,000 for maintenance
of the Board of Governors, in Washington, which regu
lates and supervises the Federal Reserve System. The
Board is not supported by Government funds or ap
propriated moneys but by assessment upon the twelve
Reserve Banks.
Congress provided in the Federal Reserve Act that
dividends of 6 per cent per annum, cumulative, be
paid by the Reserve Banks on their capital stock. The
Act requires that this stock be purchased and held by
member banks. Dividends are paid after all necessary
expenses have been met.
Until 1933, the Federal Reserve Act required each
Federal Reserve Bank to pay to the United States
Treasury an annual franchise tax consisting of all net
earnings after payment of dividends and certain addi
tions to surplus. The sum paid in the course of eight
een years amounted to about $150,000,000. In 1933,
Congress required the Reserve Banks to pay about
$139,000,000 to the Federal Deposit Insurance Corpo
ration, which had just been organized. This payment
reduced the surplus by about half. At the same time
Congress removed the requirement that the Reserve
Banks pay the Government a franchise tax. This
enabled the Banks to apply unused earnings to a more
rapid restoration of their depleted surplus.
As indicated, the surplus of the Federal Reserve
Banks is now about $149,000,000. This, with their
capital of about $135,000,000, gives them capital and
surplus combined of about $284,000,000.
The surplus is available to the Federal Reserve
Banks for meeting losses, deficits, and unearned divi
dends, but it can not be otherwise distributed to
stockholding member banks. As
stated,

already

the
the

107

FEDERAL RESERVE BANK EARNINGS

law provides that if the Reserve Banks should be
liquidated, any surplus would be paid to the United
States, after payment of debts and the par value of
the stock with dividends due thereon.
DISPOSITION

OF NET EARNINGS

OF FEDERAL RESERVE BANKS
MILLIONS OF DOLLARS

MILLIONS OF DOLLARS

100
50

0
-5 0

100
50

0
50
0
150
100

50
0
1915

192 0

1925

1 930

1935

1940

CONTRIBUTION TO CAPITAL OF F.D.LC., * 1 3 3,000.000

The accompanying chart (Disposition of Net Earn
ings of Federal Reserve Banks) covers the whole
period of Federal Reserve Bank operations and shows,
year by year, the amount of net earnings transferred to
surplus, the franchise tax paid to the Government, and
dividends paid to member banks. It reflects the fact
that there were large additions to surplus in the years

108

THE FEDERAL RESERVE SYSTEM

about 1920 when earnings were highest, and in some
subsequent years either there have been no additions
or surplus has been drawn down. It reflects the fact
that in 1933, as stated, Congress directed the Federal
Reserve Banks to pay an amount equal to half their
surplus to the Federal Deposit Insurance Corporation
and also discontinued the franchise tax.
It also re
flects the fact that dividends have remained about the
same.
As the chart shows, the net earnings of the twelve
Federal Reserve Banks have varied considerably in
the course of years. They were highest in 1919, 1920,
and 1921, when the total was $310,000,000. In these
three years there was a strong demand for credit, and
the Reserve Banks made a large volume of loans.
Their net earnings in those three years amounted to
approximately one-half their total net earnings in
twenty-four years. In 1936, 1937, and 1938 the total
net earnings were $29,000,000. The reduced earnings
in recent years reflect the fact that there has been little
demand for credit. In 1920 when the Federal Reserve
Banks had the highest earnings, they had loans and
investments of more than $3,000,000,000, most of
which were loans yielding from around 4 y 2 per cent to
6 per cent or 7 per cent. In 1938, when their net earn
ings were only a small fraction of what they were in
1920, they had loans and investments of about $2,500,000,000, most of which were Government securities
yielding less than 1y 2 per cent.

CHAPTER X I
MARGIN REQUIREMENTS
The Federal Reserve authorities have special power
to curb the use of credit for speculation in securities.

HE regulatory powers of the Federal Reserve
authorities so far described relate to the volume
and cost of bank credit in general, without regard to
the particular field of enterprise or economic activity
in which the credit is used. In one respect, however,
the Federal Reserve authorities are enjoined by law to
give particular attention to the use to which credit is
put. That is its use in speculation.
Speculation may occur in almost any field. It may
occur in land, in commodities, or in securities; and
wherever it occurs it is apt to have marked effect upon
credit conditions in general. The Reserve authorities
are instructed by the statute to keep themselves in
formed as to “ whether undue use is being made of
bank credit for the speculative carrying of or trading
in securities, real estate, or commodities” and are
authorized to take certain actions to prevent undue use
of credit in these fields. In addition, they have special
power to curb the use of credit for speculation in
securities.
This power is exercised by limiting the amount
which holders of securities may borrow upon them,
either from banks or from brokers and securities
dealers, for the purpose of purchasing or carrying
securities. The amount is a percentage.^ the current
market value of the securities. It is determined by the
Board of Governors of the Federal fteserve System.

109

110

THE FEDERAL RESERVE SYSTEM

Since 1934, when Congress gave the Board this
authority, the figure has been as low as 45 per cent
and as high as 60 per cent. A figure of 60 per cent
means, for example, that a person owning listed stocks
currently worth $1,000 may borrow on them for specu
lative purposes no more than $600. The limitation
does not apply, however, to any loan for commercial
purposes, even though the loan be secured by stocks.
When it appears that there is borrowing on a large
and growing scale to finance purchases of stock, and
that it is in the public interest to exercise further re
straint on speculation in securities, the Board may
reduce the percentage which can be borrowed. As
indicated, the limit has been as low as 45 per cent.
In this field, as in the general field of credit regula
tion, therefore, the Reserve authorities undertake to
exercise a stabilizing and corrective influence.
This power to establish loan values for securities is
commonly spoken of as a power to establish “ margin
requirements,,, that is, the amount of collateral which
must be put up by the borrower in excess of the
amount of his loan. If one is buying $1,000 worth of
securities, and the loan value is 60 per cent, he may
borrow $600 against the securities and must furnish
the other $400 himself. The banker or broker who
makes him the loan then holds collateral worth $400
in excess of the amount of the loan. This is his
margin. The Board’s regulation may be thought of,
therefore, either as prescribing minimum margin re
quirements or as limiting maximum loan values.
The Board’s regulation applies t o . the margin, re
quired at the time the loan is made. If the collateral
security subsequently declines in value, the regulation

MARGIN REQUIREMENTS

F ederal R eserve B a n k

111

San F rancisco

Sansome and Sacramento Streets, San Francisco, California

does not make it necessary either to put up additional
collateral or to reduce the loan.
Aside from having to do with a specific use of credit,
the authority with respect to security loans differs from
other Federal Reserve powers in reaching outside the
Federal Reserve System to banks which are not mem
bers of the System and to brokers and dealers in secu
rities. It is closely related, however, to other regu
latory powers of the Federal Reserve authorities, be
cause the use of credit for purchasing or carrying
securities has a very important bearing upon its use
for business purposes in general. The greater part

112

THE FEDERAL RESERVE SYSTEM

of credit used in carrying securities is extended by
brokers, whose customers pay only partly in cash for
the securities they purchase and go into debt to the
broker for the balance. The broker himself must pay
in full for the securities he buys, however, and ordi
narily he borrows from his bank. Since brokers could
not carry customers on any substantial scale unless
they were themselves carried by the bank, most of the
credit used by the customers in buying the securities
is in reality furnished by the banks, and fluctuations
in bank loans to brokers, as in any other bank loans,
directly affect the banks’ reserve position. A strong
demand on brokers for credit, reflected in a strong
demand by brokers for bank loans, may occasion sub
stantial changes in money rates. By limiting the
amount that can be borrowed on securities, therefore,
and so restraining such demand for credit, the Federal
Reserve authorities are able to impose restrictions on
the use of bank funds for stock market speculation
without restricting the volume of credit available for
commercial and industrial needs or raising its cost.

CHAPTER X II
SUM MARY
The Federal Reserve System has successfully
overcome certain difficulties that formerly beset
American economic life and imposed upon it
great losses; the System still has constantly to
meet new problems and difficulties.

HE basic powers of the Federal Reserve author
ities relate to money and banking. They are
monetary in that they deal with the means of pay
ment, which consists in part of currency, in part of
deposit credit originating from gold, and in part of
deposit credit originating in loans and in purchases
of securities by banks.
Before the Federal Reserve System was organized,
the outstanding defects of American banking were
diagnosed as “ inelastic currency” and “ scattered bank
reserves.” Establishment of the System promptly
cleared the way for the anticipated improvements.
Elasticity of the currency was achieved. The machin
ery for note issue proved adequate for the purpose
and in time was found to work almost automatically.
For many years now the volume of money in circula
tion has expanded and contracted smoothly and effi
ciently in accordance with the varying requirements
of the public, and the currency function of the Federal
Reserve Banks has become virtually a matter of rou
tine, entailing no uncertainties and no difficult admin
istrative problems.
The reserve function, on the other hand, has assumed
far greater importance. It has come to be recognized

113

114

THE FEDERAL RESERVE SYSTEM

as much more than a matter of “ pooling” or “ mobiliz
ing” scattered reserves and making available to banks
in need of funds the surplus reserves of banks that
have more than they need. It involves a power to create
reserve funds and to extinguish them. If the funds lent
by a Federal Reserve Bank, or paid by it for securities,
were merely the funds deposited with it by its member
banks, the loans and the purchases would not enlarge
the total volume of reserve funds. In fact, however,
they do enlarge the total volume of reserve funds. By
acquiring the obligation of a member bank or other
obligor and in exchange crediting an equivalent amount
to the reserve balance of the member bank, a Federal
Reserve Bank expands both its assets and its liabilities,
and the expansion continues in effect so long as the
obligation is held. The action is creative.
This does not mean that the power of the Federal
Reserve authorities is unlimited and that they can
create something out of nothing. The law itself limits
their power to expand their deposits— that is, the re
serve balances of member banks— and to expand their
note issue by requiring that their liabilities not exceed
a certain ratio to their holdings of gold certificates. Al
though this limitation has lost effectiveness, because of
the present large gold stock, a fully effective limitation
of more practical nature remains. This is that Federal
Reserve action will not result in an increased use of
bank credit unless there is a demand from the public
for additional funds. The Federal Reserve authorities
have considerable control over the v olu m e of bank
reserves, but they have no corresponding control over
the use of bank reserves, and in particular they do not
have power to create a demand for credit. They
are able to expand bank reserves to meet almost any

SUMMARY

115

conceivable demand for credit once that demand comes
into existence and also to curb or discourage a demand
for credit when it shows signs of developing specula
tive excesses. They possess no means, however, of im
pelling bank customers to borrow or of impelling
bankers to lend.
The purpose of Federal Reserve functions, like that
of Governmental functions in general, is the public
good. Federal Reserve policy can not be adequately
understood, therefore, merely in terms of how much
the Federal Reserve authorities have the power to do
and how much they have not the power to do. It must
be understood in the light of its objective— which is to
maintain monetary conditions favorable for an active
and sound use of the country’s productive facilities,
full employment, and a rate of consumption reflecting
widely diffused well-being.
In formulating their
policy, the Federal Reserve authorities take into ac
count the factors making up the prevailing situation
and use their powers in the way that seems to them
best calculated to contribute, with other agencies, to
economic stability.
In recent years the most important problems affect
ing Federal Reserve policy have arisen from the en
largement of bank reserves as the result of the in
creasing amount of gold in this country. This increase
has been contributed to by increased production of
gold from domestic mines, but to a much larger extent
it has been the result of movements of gold into this
country from abroad. The stock of gold in the United
States has become about four times as great as it ever
was before 1934 and amounts to about 60 per cent of
all the monetary gold in the world. Various causes have
brought about this unprecedented accumulation, but

116

THE FEDERAL RESERVE SYSTEM

the principal cause has been the disturbed economic
and political situation in Europe. The result of the
accumulation has been the expansion of the reserves
of American banks to an amount and degree never
before approximated. Member bank reserve balances,
which scarcely ever exceeded $2,500,000,000 before
1933, have mounted to $9,000,000,000 and more— prin
cipally as a result of gold shipments from other
countries.
The potential lending power derived by banks from
receipt of this gold creates an unprecedented problem
of control; because the unused reserves of banks are
much greater than can be absorbed by the Federal Re
serve authorities under present powers. If changed
conditions should result, however, in a return of gold
to Europe, the powers of the Federal Reserve author
ities would be found highly effective in protecting
American interests from being hurt by the withdrawal.
The principal means through which the Federal Re
serve authorities may exercise their powers over bank
reserves are, in review, the following:
O pen M arket O perations . These operations di
rectly affect the volume of reserves: purchases of secu
rities by the Federal Reserve authorities supply banks
with additional reserve funds, and sales of securities di
minish the volume of such funds. As a means of credit
expansion, these operations are limited only by the
supply of bills and securities available for purchase
and by the reserve position of the Federal Reserve
Banks themselves, assuming a demand for bank credit.
As a means of credit contraction, they are limited by
the amount of bills and securities held by the Reserve
Banks. This amount at the end of 1938 amounted to
about $2,500,000,000, which of course is considerably

SUMMARY

117

less than the amount of member banks’ excess reserves.
D isc o u n ts . Through the power to discount and
make advances, the Federal Reserve authorities are
able to supply individual banks with additional reserve
funds and may make these reserve funds more or less
expensive for member banks by raising or lowering the
discount rate. Discounts can expand only when mem
ber banks need to borrow.
R eserve R e q u ir e m e n t s . Raising or lowering re
quirements as to the reserves which member banks
maintain on deposit with the Federal Reserve Banks
has the effect of diminishing or enlarging the volume of
funds that member banks have available for lending.
Under existing law, the requirements may be raised
from the present level by only about one-seventh and
lowered by about three-sevenths.
As already stated, the foregoing powers directly af
fecting the volume of member bank funds have no
immediate effectiveness with respect to the utilization
of those funds. In the field of stock market specula
tion, however, the Reserve authorities have a direct
means of control over the use of funds— namely,
through margin requirements. The Reserve authorities
may also exercise limited influence over the credit prac
tice of banks through bank examinations.
In addition to the credit functions which have just
been described, the Federal Reserve Banks perform
certain services of which the most important are: hold
ing member bank reserve balances; furnishing cur
rency for circulation; facilitating the clearance and
collection of checks and the transfer of funds; and act
ing as fiscal agents, custodians, and depositaries of
United States Government.
Establishment of the Federal Reserve System

the

has

118

THE FEDERAL RESERVE SYSTEM

made it possible to meet and overcome many difficul
ties that formerly beset American economic life and
imposed upon it great losses. The System has accom
plished improvements in the monetary and banking
field that are now taken for granted. Yet new prob
lems and needs are always arising. Those that result
from recent changes in monetary conditions here and
abroad are especially complex and difficult. Federal
Reserve policies must be constantly adapted to condi
tions in an ever-changing world.

FEDERAL RESERVE PUBLICATIONS
The F ederal R eserve B u l l e t in , published monthly by the
Board of Governors, contains reviews of current economic develop
ments, special articles on banking and credit matters, regulations
and rulings of the Board, and statistics on domestic and foreign
financial and business developments.

It is sent to all member

banks without charge; to others in the United States the sub
scription price is $2.00 a year; and single copies are 20 cents.
A n A n n u a l R eport , reviewing operations and policies o f the
System, is submitted by the Board of Governors to Congress and
is available to the public.
The Board releases special statements from time to time as to
actions taken and regular weekly statements on the C o n d it io n
of t h e
of

T w e l v e F ederal R eserve B a n k s and on the C o n d it io n

R eporting M

em ber

B anks

101 L e a d in g C it i e s .

Com

prehensive statistics compiled from the C a l l R eports of all mem
ber banks are issued either three or four times a year.
Each Federal Reserve bank publishes a M

onthly

R e v ie w o f

banking and business conditions in its district.
A set of F ederal R eserve C h a r t s
R ates,

and

B a n k C r e d it , M

oney

B u s in e s s has been published by the Board and is

for sale to the public at 50 cents a copy.
The F ederal R eserve A ct

A m e n d e d has been printed by

the Board and will be supplied without charge.
A D ig est

R u l in g s

of t h e

B oard from 1914 to October 1,

1937 has been compiled and is available at $1.25 a copy.
Reprints have been made from time to time of statements
made by the Board, of special articles, and of statistical com
pilations published in the Bulletin or the Annual Report.

The

more important of these reprints, which will be supplied upon
request without charge, are as follows:
P roblem s

B a n k in g

B a n k S u p e r v is io n .

and

Excerpts

from the 1938 Annual Report of the Board of Governors
of the Federal Reserve System.
M

onetary

e asu res

and

O b j e c t iv e s .

Containing three

statements by the Board on objectives of monetary policy,
on proposals to maintain prices at fixed levels

through

monetary action, and on legislative proposals relating to
monetary measures and objectives.

119

TH E FEDERAL RESERVE SYSTEM

120
T

H ist o r y

R eserve R e q u ir e m e n t s

for

Banks

in th e

U n it e d S t a t e s .
Su p p ly

and

use

B a n k R eserve F u n d s .

em ber

explanation of the method of analyzing the sources of
member bank reserve funds and the uses to which such
funds are put.
M

em ber

Bank

S t a t is t ic s .

discussion of the statistics

compiled and published by the Board covering the opera
tions and condition of member banks.

Copies of this book, T
po ses a n d

F ederal R eserve S y s t e m — I t s P u r

F u n c t i o n s , are obtainable in cloth binding at 50 cents

a copy and in paper cover without charge.

They can be furnished

individually or in quantities for classroom and other use.

Orders

should be addressed to the Board of Governors of the Federal
Reserve System, Washington, D . C .

I N D E X

Acceptances:
Page
Asset item in statement of condition of Federal Reserve
Banks ........................................................................................................
98
Affiliates, Holding C o m p a n y :
Permits granted by Federal Reserve authorities........................
34
Assets of Federal Reserve Banks:
Definition of items in statement of condition......................
96-100
Balance sheet of Federal Reserve Banks:
D ec. 31, 1938 .................................................................................................
96
Description of ite m s..................................................................
79, 96-103
Bank credit. (See Credit, Bank.)
Bank examinations:
Federal Reserve Bank examination of banks ind istr ict.. . .
34
Federal Reserve Banks examined by
Board of Governors
34
National banks examined b y Comptroller of Currency...........
33
Nonm em ber insured banks examined by Federal Deposit
Insurance C o rp o r a tio n .......................................................................
33
State member banks examined by State authorities................
33
Bank premises of Federal Reserve Banks:
99
Asset item in statement of condition............................................
Charge-offs on ........................................................................................... 105
Bank supervision:
Federal Reserve A ct provision o n .........................................
33
Federal Reserve a u th o r itie s....................................................
33-35
“ Problems of Banking and Bank Supervision” ......................... 119
Responsibility diffused .........................................................................
33
Bills bought by Federal Reserve Banks:
Asset item in statement of condition...............................................
98
Board of Governors of Federal Reserve S ystem :
Annual report .............................................................................................
119
Exam ination of Federal Reserve B an ks........................................
34
Expenses assessed on Federal Reserve B an ks.............................
106
Foreign bank relations with Federal Reserve Banks, super
vised b y ...................................................................................................
37
Functions ......................................................................................................
15
Margin requ irem en ts.......................................................................
109-112
M em b ers:
Appointm ent of ...............................................................................
13
Term s of office....................................................................................
13
Photograph of building...........................................................................
12
Publications ......................................................................................
119-120
Rulings, Digest o f. . . .........................................................................
119
Statements to the public.......................................................................
119
Brokers and dealers in securities:
Margin requirements ............................................................ 109-112, 117
Capital accounts of Federal Reserve B a n ks..........................................
1Q1
Capital stock of Federal Reserve Banks:
Dividends on .................................................................................... 106, 107
Liability item in statement of condition........................................
100
Ownership of ..........................
16, 106

121

122

IN D E X

C ash :
Paee
Definition of “ other cash” in condition statement of Fed
eral Reserve B a n k s...........................................................
97
Central banking functions of Federal Reserve authorities . . . .
23
C harts:
Disposition of net earnings of Federal Reserve B an ks...........
107
Distribution of earnings of Federal Reserve Banks,
1914-1938 ..............................................
105
Federal Reserve bank c r e d i t ..............................................................
54
Federal Reserve Banks— Reserve position ...................................
78
Federal Reserve chart b o o k ..............................................................
119
94
M em ber bank reserve balances .......................................................
M em ber bank reserves and related ite m s...................................
87
Check clearing and collection:
Check sorting at Federal Reserve B a n k ..........................................
31
Discussion of ................................................................................ 30-33, 117
Check payments .................. ...............................................
19, 30-33, 62, 64
C o in s:
Circulation of ......................................................................................
25, 26
M inting o f ...................................................................................................
27
Reserves of member banks affected by circulation o f .............
91
Comptroller of Currency:
Examination of National ban ks.......................................................
33
Condition statem ents:
Federal Reserve Banks:
Dec. 31, 1938 ........................................................................................
96
Description of ite m s.........................................................
79, 96-103
W eek ly statement issued..............................................................
119
M em ber banks:
Call report ......................................................................................
119
W eek ly statement issued..............................................................
119
Credit, B ank:
Description o f .............................................................................................
84
footnote 40
“ Extension of credit,” Definition o f ...............................
Federal R eserve:
Chart ......................................................................................................
54
Dem and for ....................................................................................
80-81
Gold in relation t o ....................................................................... 65-67
M em ber bank credit in relation t o ...................................... 55-58
M on ey in circulation in relation t o ..........................................
93
Nature of ........................................................................................
84-86
Reserves of member banks in relation t o ...........
88-89, 92-94
Source of member bank reserves.......................................
59-67
M em ber ban k:
Federal Reserve Bank credit in relation t o ....................
55-58
Reserve requirement changes effect o n ...........
22, 81-84, 117
Reserves a factor i n ................................................... 39-46, 53, 114
Currency:
Circulation:
A m ount of ....................................................................
25-27
Reserves of member banks affected by ...........
4 7 ,6 5 ,9 2 -9 3
Dem and for ............................................................................................. 27-30
Distribution of ......................................................................................
27-30
Inelastic currency prior to establishment of Federal Reserve
System ...............................................................................................
28, 113
Issuance b y Federal Reserve B an ks.................................
20, 25, 117
K inds in process of retirement............................................................
26

IN D E X

123

Currency— Continued.
Page
Legal tender ...............................................................................................
27
Shipment received at Federal Reserve B a n k ..............................
29
Deferred availability item s:
Definition of term in statement of condition.............................
100
D ep osits:
Federal Reserve Banks:
Liability item in statement of condition......................
79, 100
Insurance o f :
Federal Reserve Bank contribution t o ....................
106, 108
Interest on, Regulation o f .....................................................................
34
Loans and investments create deposits........................................ 39-40
R atio of reserves to deposits a factor in bank credit...........
39-46
Reserves required against. (See Reserve requirements.)
Directors:
Federal Reserve B an ks...........................................................................
16
Discount rates of Federal Reserve B a n k s..........................................
49-50
Discounts and advances:
Federal Reserve Banks for member banks:
Asset item in statement of condition of Federal Reserve
Banks ...............................................................................................
97
Direct advances ................................................................................
48
Eligible p a p e r ....................................................................................
48
Reserves of member banks affected b y .................................
117
D ivid en d s:
Federal Reserve B an ks.........................................................
17, 106, 107
Earnings and expenses:
Federal Reserve Banks:
C h a r t s ...........................................................................................
105, 107
Discussion of ....................................................................
17, 104-108
Undistributed earnings as liability item in statement of
condition .....................................................................................
101
Econom ic stability as objective of FederalReserve p olicy......................... 115
Eligible paper ...................................................................................................
48
Examinations. (See Bank examinations.)
Expenses. (See Earnings and expenses.)
Federal Advisory Council:
Organization and du ties.........................................................................
18
Federal Deposit Insurance Corporation:
Bank examinations ...............................................................................
33
Federal Reserve Bank contribution t o ................................
106, 108
Federal Open M arket C o m m ittee:
Organization and duties .......................................................................
18
Federal Reserve A c t:
Enactment of .............................................................................................
22
Publication of Federal Reserve A ct, asam ended......................
119
Federal Reserve authorities:
Definition of term ..................................................................................
13
F unctions:
Central banking ....................................................................... 23, 102
M onetary and credit........................................................
19-24, 113
Security speculation control...................................
109-112, 117
Service .................................................................................................
24
Supervisory .................................................................................... 33-35
Foreign branches of member banks.................................
34
Holding company affiliates.................................................
34

124

IN D E X

Federal Reserve authorities— Continued.
Pase
Functions— Continued.
Supervisory— Continued.
Interest on deposits, Regulation o f .................................
34
R em oval of officers and directors of member banks
34
Suspension of member ban ks............................................
34
34
Trust powers for National B a n k s...................................
Objectives .........................................................................
15, 54, 115, 119
Powers limited .......................................................................
5 7 ,7 6 -8 6,1 1 4
Federal Reserve Bank notes:
Retirement o f .............................................................................................
26
Federal Reserve Bank of N ew Y o r k :
Agent of Treasury in operation of Stabilization F u n d -----36
Federal Reserve Banks:
Bank premises:
Asset item in statement of condition .................................
99
Charge-offs on ..................................................................................
105
Branches:
Directors .............................................................................................
17
Location of .........................................................................................
15
Directors ........................................................................................................
16
Dividends ....................................................................................
1 7 ,1 0 6,1 0 7
Earnings and expenses:
Charts ............................................................................................. 105, 107
Discussion of ..................................................................... 17,104-108
Examination of ban ks.............................................................................
34
34
Examined by Board of Governors...................................................
Franchise tax p aid ............................................................................... 106, 107
Functions:
Central banking ................................................................................
102
Fiscal agen cy.........................................................................
35-38, 117
25, 117
Reserves of member banks h eld .......................................
Service ....................................................................... 25-33, 35-38, 117
Loans and investm ents...........................................................................
108
Location of ..................................................................................................
15
M onthly reviews ....................................................................... , ...........
119
Officers and em ployees......................................................................
17, 105
P a y r o ll............................................................................................................
105
Photographs of buildings:
Atlanta .................................................................................................
67
B o s t o n ....................................................................................................
21
Chicago .................................................................................................
74
Cleveland .............................................................................................
51
Dallas ....................................................................................................
101
Kansas C ity ......................................................................................
99
M in n e a p o lis ........................................................................................
91
New Y ork ...........................................................................................
37
Philadelphia ......................................................................................
45
Richm ond ...........................................................................................
61
St. Louis ................................................................................................
83
San Francisco ....................................................................................
112
Stock owned b y member ban ks.....................................................
16,19
Surplus ............. .................................................................
18, 100-101, 106
Federal Reserve building, Photograph o f ............................................
12
Federal Reserve Bulletin .....................................
119
Federal Reserve chart b o o k .......................................................................
119

IN D E X

125

Federal Reserve districts:
Page
List o f ............................................................................................................
15
M ap of ..........................................................................................................
14
Federal Reserve notes:
Circulation o f ....................................................................
25, 26, 76, 78-81
Collateral security.........................................................................
26, 77-79
Description o f .............................................................................................
26
Issuance o f ...................................................................................................
76
Liability item in statement of condition of Federal Reserve
B anks................................................................................................... 100, 102
Printing o f ...................................................................................................
27
Federal Reserve policy:
Objectives of ..................................................................... 15, 54, 115, 119
Federal Reserve S ystem :
Organization of ........................................................................................
13
35-38
Fiscal agency functions of Federal Reserve authorities...............
Foreign banks:
Federal Reserve Bank relations with foreign banks super
vised by Board of G overnors.........................................................
37
Foreign branches of member banks:
Permits granted b y Federal Reserve authorities.........................
34
Franchise ta x :
Paid to Treasury by Federal Reserve B an ks...................... 106, 107
Glass, Carter, Bas-relief o f ...........................................................................
8
G o ld :
Deposits and withdrawals.............................................. footnotes 60, 64
Federal Reserve Bank credit in relation t o ..............................
65-67
Reserves of member banks affected b y ..........................................
47, 7 9 -8 3 ,8 8 -8 9 ,9 2 ,9 4 ,1 1 5
R e v a lu a tio n .................................................................................................
94
Source of member bank reserves...................................................
59-67
G old certificates:
Asset item in statement of condition of Federal Reserve
Banks .................................................................................................
97, 102
Federal Reserve holdings of gold certificates as reserves. . 77-81
Forms and uses............................................................................. footnote 26
Retirement of ..........................................................................................
26
Holding company affiliates:
Permits granted by FederalReserve authorities.....................
34
Industrial loans of Federal Reserve Banks:
Asset item in statement of condition............................................
98
Insurance of deposits:
Federal Reserve Bank contribution t o ................................. 106, 108
Interdistrict Settlement F u n d .......................................................................
32
Interest on deposits:
Regulation of .............................................................................................
34
Legal tender ........................................................................................................
27
“ Lending” :
Definition of the term as u sed.............................................. footnote 40
Liabilities of Federal Reserve Banks:
Definition of items in statement of condition...................... 100-101
Loans and investments:
Deposits created b y .............................................................................
39-40
Federal Reserve B an ks...........................................................................
108
M argin requirements......................................................................... 109-113, 117

126

INDEX

M em ber banks:
Page
Call report .................................................................................................
119
Condition statements ...........................................................................
119
National bank m em bers.........................................................................
18
State bank m em bers................................................................................
18
Statistics ......................................................................................................
120
Stock of Federal Reserve Banks owned b y ...........................
16, 19
Trust company m em bers...............................................................
18
M onetary policy:
Objectives of ..................................................................
15, 54, 115, 119
M on ey in circulation:
Dec. 31, 1938 ..........................................................................................
25-27
Federal Reserve Bank credit affected b y ......................................
93
Reserves of member banks affected b y ......................
47, 65, 92-93
M on ey rates:
Open m a r k e t ...............................................................................................
50
National Bank notes:
Retirement o f .............................................................................................
26
National banks:
Examined by Comptroller of Currency........................................
33
M embers of Federal Reserve S yste m ............................................
18
National M onetary Com m ission................................................................
22
Nonm em ber banks:
Insured:
Examined by Federal Deposit Insurance Corporation. .
33
Objectives:
15, 54, 115, 119
Federal Reserve p olicy..............................................
Open M arket C o m m ittee, F ederal:
Organization and duties.........................................................................
18
Open market operations:
50-54
Description o f ........................................................................................
Federal Open M arket Com m ittee, organization and duties. .
18
Objectives ....................................................................................................
53
Reserves of member banks affected b y ....................
50-53, 89, 116
Open market rates.............................................................................................
50
Paper currency:
Printing o f ...................................................................................................
27
Par clearance of checks..................................................................................
32
Price control; Board of Governors statement o n .............................
119
Public d ebt:
Fiscal agency functions of Federal Reserve Banks in con
nection w i t h .............................................................................................
35
Reserve bank credit. (See Credit, Bank.)
Reserve requirements:
Federal Reserve B an ks.............................t .......................................
76-78
“ History of Reserve Requirements for Banks in U . S.” . . . .
120
M em ber banks:
Credit control functions ..............................................................
22
Effect of changing requirements on member bank
credit .................................................................................... 81-84, 117
Legal requirements.......................................................
19, 22, 42-46
Open market operations effect o n ........................................
52-63
Table of requirements since 1917............................................
43
Prior to establishment of Federal Reserve S y ste m .............
20-22

IN D E X

127

R eserves:
Pase
Definition of te rm ........................................................................ footnote 39
Federal Reserve Banks:
Dec. 31, 1938 ......................................................................................
77
Chart ......................................................................................................
78
101
Liability item in statement of condition..........................
Function of ....................................................................
39-46
Individual bank reserves in relation to banking system as
a whole .................................................................................................
68-75
M em ber banks:
Dec. 31, 1938 ..................................................................................
19, 76
Balances held by Federal Reserve B a n k s .. .
19, 22, 25, 117
Bank credit in relation t o .......................... 39-46, 53, 55-58, 114
C h a r t s ............................................................................................... 87, 94
Composition of .............................................................................
59-67
Discounts of Federal Reserve Banks effect o n ..................
117
19, 49, 81, 89, 92, 93, 95
Excess .......................................................
Expansion and contraction o f ................................................. 47-58
Federal Reserve Bank credit in relation t o ........................
59-67 88-89 92-94
Gold in relation t o ...........4 7 ,5 4 ,5 9 -6 7 ,7 9 -8 3 ,8 8 -8 9 ,9 2 ,9 4 ,1 1 5
Gold stock revaluation had no effect o n ...............................
94
90, 92
Government deposits effect o n ............................................
Liability item in statement of condition of Federal
Reserve B a n k s......................................................................... 100, 102
M on ey in circulation in relation t o .................... 47, 65, 92-93
Open market operations effect o n ......................
50-53, 89, 116
R atio to deposits a factor in lending p olicy................ 39-46
Related items ...............................................................................
87-95
Required ........................................................................................
19, 95
Silver as a source o f .........................................................................
64
Sources o f ........................................................................................
59-67
“ Supply and Use of M em ber Bank Reserve Funds” . . .
120
Treasury currency a source o f .....................................................
91
Treasury receipts and expenditures effect o n ..
47, 65, 90, 92
Prior to establishment of Federal Reserve System 20-22 ,6 5,1 1 3
Security speculation:
Controlled through margin requirements...................... 109-112, 117
S ilver:
Source of member bank reserves.......................................
64
Silver certificates:
Circulation of ......................................................................................
25, 26
Reserves of member banks affected by circulation o f .............
91
Speculation in securities:
Controlled through margin requirements...................... 109-112, 117
Stability, E conom ic:
Objective of Federal Reserve p olicy..............................................
115
Stabilization F u n d :
Federal Reserve Bank of N ew Y ork as agent fo r ....................
36
State banks:
M em bers of Federal Reserve S yste m ............................................
18
State member banks:
Examined by State authorities.........................................................
33
Stock market speculation:
Controlled through margin requirements...................... 109-112, 117

128

INDEX
Page

Supervision of banks. {See Bank supervision.)
Surplus:
Federal Reserve B an ks.................................................
18, 100-101, 106
Surplus accounts of Federal Reserve B a n k s:
Liability items in statement of condition............................. 100-101
Treasury currency:
Kinds in circulation...........................................................................
25, 26
91
Source of member bank reserves.......................................................
Treasury notes of 1890:
Retirement o f .............................................................................................
26
Trust companies:
M em bers of Federal Reserve S ystem ............................................
18
Trust powers of National banks:
Permits granted by Federal Reserve authorities......................
34

Uncollected items:
Definition of term in statement of condition of Federal R e
serve B a n k s .............................................................................................
99
United States Governm ent deposits:
Fiscal agency functions of Federal Reserve B a n k s.............
35-36
Reserves of member banks affected b y ...................................... 90, 92
United States Governm ent securities:
Asset item in statement of condition of Federal Reserve
Banks .................................................................................................
97, 102
89
Federal Reserve Bank holdings o f ...............................................
Fiscal agency functions of Federal Reserve B an ks.............
35-36
United States notes:
Circulation o f ........................................................................................
25, 26
Reserves of member banks affected b y ........................................
91
United States Treasury:
Receipts and expenditures effect on member bank reserves..
47, 65, 90, 92
W ilson, W oodrow , Bas-relief o f ..................................................................
9