UNIT SEVEN: THE EMERGENCE
MODERN AMERICA
OF
LESSON 28
MONEY PANICS AND THE
ESTABLISHMENT OF THE
FEDERAL RESERVE SYSTEM
FOCUS: UNDERSTANDING ECONOMICS
IN
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
327
LESSON 28
MONEY PANICS AND THE ESTABLISHMENT
FEDERAL RESERVE SYSTEM
LESSON DESCRIPTION
Several students perform a play that illustrates how an unregulated banking system contributed to a number of severe money panics in
the late nineteenth century. The students then
read a passage about the establishment of the
Federal Reserve System and identify features of
the new system that improved banking stability
and the availability of credit. The Federal
Reserve System was the United States’ first central bank. It provided protection against bank
failures by creating new reserves.
MYSTERY
Most people today have no recent memory of
banks failing. Yet, for people in the nineteenth
century, bank failures were common events. Why
did so many banks fail in the nineteenth century? Why is it very rare for a bank to fail today?
ECONOMIC HISTORY
When a bank lends money to its customers, it
normally records the amounts loaned in the customers’ accounts. The customers are then free to
write checks on those accounts; thus, the
deposits are really a form of money. In the banking system as a whole, there is not enough
money in the form of coins and currency to back
the total amount of deposits. A system of this
sort is called a fractional reserve banking system. Today, banks keep reserve accounts at their
regional Federal Reserve Bank, and if customers
demand a lot of their money in the form of coins
and currency, banks can borrow from the Federal
Reserve Bank to give the customers what they
want. But in the nineteenth century, the Federal
Reserve System did not exist.
Before the Federal Reserve System was established, small-town banks kept reserve accounts
with large city banks, which in turn kept
accounts with banks in New York City, the financial capital of the nation. If many banks experienced bank runs simultaneously, with many
328
FOCUS: UNDERSTANDING ECONOMICS
IN
OF THE
customers demanding their deposited money
back in the form of gold and national bank notes
(the accepted reserve money at the time), some
banks would be likely to fail, leaving customers
with worthless deposits and actually reducing
the total amount of money in circulation.
Bank runs of this sort often resulted from bad
news in financial markets. Large banks held
loans or other investments in many business
firms. When a major firm, such as the Northern
Pacific Railroad, failed, many banks were endangered. In order to keep enough reserves on hand,
they sold stocks and bonds, which drove the
prices of these assets down. They also “called”
loans — required borrowers to pay loans back
immediately. And they were legally allowed to
suspend payments to smaller banks that held
reserves with them, even if that caused the
small banks to fail. Thus the failure of one large
bank, such as Jay Cooke and Company, in 1873,
put many banks in danger. Therefore, depositors
in banks around the country were not behaving
unreasonably when they tried to remove their
money from their local banks upon hearing of
bad financial news.
Another problem was that the amount of
money in circulation was “inelastic” — it didn’t
change with the needs of the economic system.
In a time when most Americans still made a living by farming, money was always least available when farmers needed it most — when they
had to pay workers to harvest their crops and
pay the railroads to take their goods to market.
The Federal Reserve System was established
to be a “lender of last resort,” to prevent banks
from failing by supplying them extra reserves
when needed, and to provide a money supply
that would increase and decrease according to
the credit needs of the economy.
However, some banks continued to fail even
after the Federal Reserve System began operations in 1914, and during the Great Depression
there were great waves of bank failures. Fear
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
MONEY PANICS AND THE ESTABLISHMENT
OF THE
FEDERAL RESERVE SYSTEM LESSON 28
mental concerns, define and protect property rights and attempt to make markets
more competitive. Most government policies also redistribute income. (NCEE
Content Standard 16)
inspired by one major bank failure led to bank
runs all over the country. Reasons for this will
be addressed in Lesson 30.
CONCEPTS
• Bank
History
•
Bank reserves
•
•
Central banking system
•
Federal Reserve
•
Fractional Reserve Banking System
•
Money
•
Money panic
The student understands how Americans
grappled with social, economic and political issues. (Era 6, Standard 3, National
Standards for History)
TIME REQUIRED
45 Minutes
OBJECTIVES
Students will:
MATERIALS
• A transparency of Visual 28.1
1. Explain major problems of United States
banks in the nineteenth century by reference to the lack of adequate bank reserves
in times of crisis and the inelasticity of the
money supply.
•
A copy of Activity 28.1 (a play script) for
every “actor.” You may want to provide a
copy of Activity 28.1 for every student
after the play has been performed.
•
Nine $100 dollar bills (three bills each for
Tom, Dick and Harry, and [optional] a
black construction paper mustache for
each girl who is playing a male character
— made from the pattern provided in
Activity 28.2.
CONTENT STANDARDS
Economics
•
A copy of Activity 28.3 for each student
•
Three pieces of large, white poster board
•
•
Tape and markers
•
Three tables and chairs
2. Identify provisions in the Federal Reserve
Act that addressed these problems.
3. Identify the role of the Fed in a modern
market economy.
Institutions evolve in market economies to
help individuals and groups accomplish
their goals. Banks, labor unions, corporations, legal systems and not-for-profit
organizations are examples of important
institutions. A different kind of institution,
clearly defined and well-enforced property
rights, is essential in a market economy.
(NCEE Content Standard 10)
•
Money makes it easier to trade, borrow,
save, invest and compare the value of
goods and services. (NCEE Content
Standard 11)
•
There is an economic role for the government to play in a market economy whenever the benefits of a government policy
outweigh its costs. Governments often provide for national defense, address environFOCUS: UNDERSTANDING ECONOMICS
IN
PROCEDURE
1. Before class begins, set up the classroom
as described in Activity 28.1.
2. Display Visual 28.1. Tell the students that
during the nineteenth century and into
the first part of the twentieth century,
money panics were a frequent occurrence.
In money panics, people became afraid
that their banks might fail, so they rushed
to their banks, in large numbers, to withdraw all their money from their accounts
— which indeed caused the banks to fail.
Ask the students if they have ever heard
of a bank failure in recent times. (Very few
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
329
LESSON 28 MONEY PANICS AND THE ESTABLISHMENT
banks have failed since the banking
reforms of the 1930s.)
3. Tell the students that they are about to
see a play. This play will explain how
banking worked in the 1870s, and it will
dramatize the Panic of 1873.
4. Select actors to fill the roles in the play,
and give each actor a script. (You may
want to pick actors the day before so that
they can read their scripts in advance.) Be
sure to choose an articulate student to
play the narrator. The other roles are for
male characters, but you may want to
choose some females for these roles; they
can become honorary males by wearing
black construction-paper mustaches made
from the pattern provided in Activity 28.2.
5. Have selected students perform the play.
At the narrator’s cue, hand out Activity
28.3; then give the students 15 minutes to
read the passage and answer the questions individually on a separate sheet of
paper. Collect their answers.
CLOSURE:
1. Discuss the questions with the students.
(Possible answer: A. Banks that needed
reserves, either to protect their reserves
from too many withdrawals or to use new
reserves as a basis for making more loans,
could pledge some of their current loans to
their district Federal Reserve Bank and
receive new reserves in return. B. Possibly,
if the New York Federal Reserve Bank had
acted aggressively to make reserve loans to
the big New York Banks. Federal Reserve
Board Chairman Alan Greenspan did
exactly that in 1987, averting a major
stock-market collapse. However, it took
many years for the Federal Reserve System
to develop the necessary structure and
knowledge to head off panics. The system
was a tremendous failure during the Stock
Market Crash of 1929 and the years of
depression that followed. C. Probably Sam
could have been saved as long as the
Cornfield Bank took Sam’s loan and a few
others into the Omaha Branch of the 10th
Federal Reserve Bank and pledged the
330
FOCUS: UNDERSTANDING ECONOMICS
IN
OF THE
FEDERAL RESERVE SYSTEM
loans in exchange for new reserves. Sam
could have gotten his additional loan, too,
since he was basically a good farmer who
just needed time to recover from a bad year
for grain prices. It certainly was not in the
interest of Augustus Murphy or the town of
Cornfield for Sam to go broke — prosperous citizens make a prosperous community
and a prosperous bank.)
2. End the lesson by referring to the final
paragraph of the reading. Tell the students
to keep this mystery in mind until they
study the Great Depression.
ASSESSMENT
Multiple-Choice Questions
1. Money panics and bank runs occurred in the
nineteenth century because
A. paper money in the United States was
not backed by gold.
B. the Federal Reserve System was too
stingy about lending reserves.
C. bankers made better profits by keeping
their bank notes and gold in the vault
than by making loans.
D. banks whose customers made too
many withdrawals had no reliable
source from which to borrow new
reserves.
2. The discount rate is the interest paid by member banks on the reserves that they have borrowed. If the Federal Reserve district bank
wanted to encourage business activity within
its district, it could
A. apply to the federal government for a
loan.
B. lower the discount rate, which
would tend to increase the amount
of money in circulation.
C. raise the discount rate, which would
tend to decrease the amount of money in
circulation.
D. lower the discount rate, which would
tend to decrease the amount of money in
circulation.
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
MONEY PANICS AND THE ESTABLISHMENT
OF THE
FEDERAL RESERVE SYSTEM LESSON 28
ESSAY QUESTIONS
1. How did nineteenth-century American
banks try to protect themselves against
bank runs and bankruptcy? How successful were they?
(Possible answer: Small banks kept reserve
accounts at banks in nearby big cities. In
theory, if a small bank experienced a bank
run, it could withdraw its funds from the
large city bank and, if necessary, borrow
additional funds from that bank. The city
banks kept reserve accounts at one of the
large banks in New York City, the financial
center of the nation. The system worked
pretty well most of the time, but the fact
that banks were linked by holding each
other’s reserves provided a path for failure
to travel from one bank to another. Also, the
linkage between the New York City banks
and the stock and bond markets allowed
problems in those markets to stimulate
withdrawals from banks at all levels.
Basically, no individual bank had a source
of reliable reserves to offset unusually high
withdrawals.)
2. How did the establishment of the Federal
Reserve System make it easier for banks
to make loans, and why is it usually desirable for banks to make more loans?
(Possible answer: With the Federal Reserve
System in place, banks could borrow new
reserves from their district Federal Reserve
Bank whenever they saw a profitable loan
opportunity. Now the banker could afford
to make more loans, too, since he could go
to Federal Reserve for more funds, instead
of trying to call loans in, if he faced
demands for an unusual amount of withdrawals from his bank. It is usually good
for the economy when banks make new
loans because this tends to increase the
amount of business activity and stimulate
economic growth.)
FOCUS: UNDERSTANDING ECONOMICS
IN
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
331
LESSON 28 MONEY PANICS AND THE ESTABLISHMENT
OF THE
FEDERAL RESERVE SYSTEM
VISUAL 28.1
THE GREAT BANK FAILURE MYSTERY
Most people today have no recent memory of banks failing. Yet, for people
in the nineteenth century, bank failures were common events. Why did so
many banks fail in the nineteenth century? Why is it very rare for a
bank to fail today?
332
FOCUS: UNDERSTANDING ECONOMICS
IN
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
MONEY PANICS AND THE ESTABLISHMENT
OF THE
FEDERAL RESERVE SYSTEM LESSON 28
ACTIVITY 28.1
DISASTER
AT THE
TELLER’S WINDOW: A BANKING TRAGEDY
Cast of Characters:
Narrator
Augustus Murphy
Tom
Dick
Harry
Sam the Farmer
Last National Bank Banker (LNB
Banker)
New York City Banker (NYC Banker)
Nathaniel the Stock Market Genius
In the United States after the Civil War, gold
and national bank notes, issued by the United
States Treasury, were considered to be money.
Silver coins were legally money, also, but few of
them were in circulation. Increasingly, people
used checks to pay for items. People felt safer
keeping most of their coins and currency in
banks and writing checks against their accounts
when they wanted to buy something or pay bills.
(Gesturing toward Augustus . . .) Allow me now
to introduce you to Augustus Murphy, owner of
the Cornfield Bank of Cornfield, Nebraska.
Augustus: (Bows deeply)
Stage Setting:
Narrator: The year is 1870. It is early fall
Three tables with chairs for bankers, marked
Cornfield Bank, Last National Bank and
New York City Bank, separated as much as
possible in the front of the room. A large white
cardboard poster behind each bank. Cornfield
Bank’s poster has four columns, labeled Tom,
Dick, Harry and Sam. Last National Bank has
one column, labeled Cornfield Bank. New York
City Bank has two columns, labeled Last
National Bank and Nathaniel, the Stock
Market Genius.
The Cornfield Bank is usually referred to as a
country bank, even though in 1870 Cornfield is a
sizable town of almost 1,000 people. And here
come Tom, Dick and Harry, citizens of Cornfield,
each with $300 to deposit.
Props:
Three $100 bills each for Tom, Dick and Harry.
Optional: Mustaches for female actors.
Narrator: The purpose of this thrilling — and
heartbreaking — drama is to show you why so
many money panics occurred in American history and how the Federal Reserve System was
established to stop these panics. Major money
panics occurred in 1873, 1893 and 1907. In each
case, they happened when a lot of people rushed
to their banks, all at about the same time, and
tried to withdraw all their money. The first few
people at each bank got the money they had
deposited, but then the bank would tell the rest
of the depositors, “Sorry! We ran out of money —
we can’t pay you!”
Where did the money go?
FOCUS: UNDERSTANDING ECONOMICS
IN
Tom, Dick and Harry: (Each walks up to
Augustus in turn, hands him three $100 bills,
and returns to his seat.)
Augustus: I keep a record of how much money
each customer deposits with me. (He marks the
accounts of Tom, Dick and Harry with $300
each.) Tom, Dick and Harry can come to me at
any time and get their money back in coins or
national bank notes. They can also write checks
on their accounts without even bothering to stop
in at the bank.
Narrator: Now, you would think that Augustus
would charge for the valuable service that he
gives Tom, Dick and Harry — keeping their
money safe in his big iron vault. But he doesn’t.
He provides this service free, and he even pays
his customers interest when they keep their
money in savings accounts. Why is Augustus
such a nice guy?
Augustus: Because, like all bankers, I earn
most of my profits by lending out money at
interest. For example, here comes Sam the
farmer. He’s probably here to borrow money he
needs before he gets paid for his harvest.
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
333
LESSON 28 MONEY PANICS AND THE ESTABLISHMENT
OF THE
FEDERAL RESERVE SYSTEM
ACTIVITY 28.1, CONTINUED
DISASTER
AT THE
TELLER’S WINDOW: A BANKING TRAGEDY
Sam: Howdy, Mr. Murphy. I need to borrow $300
to pay my harvest crew and to ship my crops to
the markets back east. How much interest are
you going to want?
Augustus: I’m afraid I’ll have to charge you
seven percent this year, Sam. A lot of folks want
loans during harvest season, and all that competition for loans runs up the interest rate.
Sam: Seven percent! That’s high! But I guess I
can’t get a loan cheaper anywhere else.
(Suspiciously) It’s funny that interest rates are
always lower in the spring and summer, when I
don’t need to borrow any money!
Augustus: No, I’m afraid it makes sense. Not
very many people in farm country like this want
to borrow money earlier in the year before the
crops are ready to harvest, so interest rates go
lower then. How do you want to take the money?
Sam: You might as well just put it in my checking account.
Augustus: (Writes $300 on Sam’s account to
indicate a deposit of the amount loaned.)
Sam : Thanks, Mr. Murphy. I’ll be back in when
I get paid for my crops. (Goes back to his seat.)
Narrator (Alarmed): But, wait a second! Sam
can write checks on that account, but there’s no
money backing it up! What if he writes a check
to someone and that person comes in and
demands gold or paper notes in exchange for the
check?
Augustus (Easily): That’s no problem. I would
just give that person some of the money that
Tom, Dick or Harry deposited. The notes are all
in my vault.
Narrator (Still upset): But what if Tom, Dick
and Harry all come in at once and demand their
notes back?
Augustus: Well, they usually don’t. My customers have confidence in my bank, and they
like the convenience of not having to keep a lot
of coins or notes in their pockets or their homes.
But, just to be on the safe side, I have an
334
FOCUS: UNDERSTANDING ECONOMICS
IN
account with a big bank in Omaha. I keep some
funds in an account there, and I can also call on
the bankers in Omaha to lend me gold or notes
if people here demand a lot of their money at
once. And the Omaha bankers pay me a good
interest rate to keep my excess money with
them. As a matter of fact, I have a lot more
deposits on my accounts than I have coins and
notes to back them up.
Narrator: That’s terrible!
Augustus: No, it’s pretty safe, and it’s really a
good thing. People need credit to conduct their
businesses — not only farmers, but other kinds
of businessmen as well. With credit, they can
expand their operations, produce more and make
more profit.
Narrator (Dubiously): Well, if you say so — I
guess bankers are pretty smart. (Walks over to
Last National Bank.) Is this where the Cornfield
Bank account is kept?
LNB Banker: Yes, it is. We call it a reserve
account, because Mr. Murphy keeps funds in it
that he can use to pay his customers if they all
demand their money at once. As a matter of fact,
we make loans, too, a lot more than Mr. Murphy
does, and we keep a reserve account at a big
bank in New York City. The New York bank pays
us an excellent rate of interest.
NYC Banker (Waving from his table): We’ve got
Last National Bank’s account and other reserve
accounts from all over the country. We’re so rich
and powerful we can’t believe it ourselves!
Narrator (Walking over to NYC Baker): Wow,
you must have a ton of money in your vaults!
What do you do with it all?
NYC Banker: We invest a lot of it in the call
loan market. A “call loan” has to be repaid in 24
hours if we demand our money back. We’re
allowed by law to lend 75 percent of the money
we hold in reserve accounts.
(Nathaniel the Stock Market Genius enters
and walks up to the NYC Banker.)
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
MONEY PANICS AND THE ESTABLISHMENT
OF THE
FEDERAL RESERVE SYSTEM LESSON 28
ACTIVITY 28.1, CONTINUED
DISASTER
AT THE
TELLER’S WINDOW: A BANKING TRAGEDY
Nathaniel: How do you do. I’m a New York City
stock and bond broker and a stock market
genius, and I have an account at your bank. I
have a hot tip on Northern Pacific Railroad. Jay
Cooke is raising money for it. He’s the banker
who made a fortune selling war bonds for the
Union government during the Civil War. I’d like
to borrow some money to buy Northern Pacific
stocks and bonds.
The Entire Cast (except for the Narrator;
loudly): Lord Help Us! Northern Pacific’s going
to fail!
NYC Banker: Yes, we’ve made a lot of loans to
brokers to buy Northern Pacific stocks and
bonds. In fact, we have a large investment in
Northern Pacific ourselves. That Jay Cooke is a
smart man! How much would you like to borrow?
NYC Banker: I can’t help it. I need the money
to protect my reserves. We’ll have to sell a lot of
our own Northern Pacific stocks and bonds, no
matter how low the price goes! We’ll probably
have to sell a lot of other stocks and bonds, too,
to get enough money for reserves.
Nathaniel: Perhaps I’ll start with $100,000. My
credit is good. I can back it up with the stocks I
own.
Nathaniel: But if everybody sells, the prices of
all stocks and bonds will crash!
NYC Banker (Writes $100,000 on the account of
Nathaniel the Stock Market Genius): Thank
you, Mr. Genius. It’s a pleasure doing business
with you.
Nathaniel: (Bows and leaves)
Narrator (To NYC Banker): Do you have
enough cash to back up that loan? What will
happen if a lot of the banks that have accounts
with you want their money back?
NYC Banker: No problem. I’ll just call the loans
I made to Mr. Genius and to others.
Narrator (To audience): It sounded like a simple system — and it did make funds available to
borrowers like Sam the Farmer, to the many
business firms who wanted to expand, and even
to stock market geniuses like Nathaniel. But
every once in a while something awful would
happen — like this!
Nathaniel (Running frantically up to the NYC
Banker): Did you hear the news? Jay Cooke’s
bank has failed! What’s going to happen to
Northern Pacific?
FOCUS: UNDERSTANDING ECONOMICS
IN
NYC Banker (To Nathaniel): Pay back that
loan now.
Nathaniel: But if I sell my Northern Pacific
stocks now, the price will be really low! I’ll be
ruined!
NYC Banker (loudly): I tell you, I can’t help it!
I’ve got to save myself!
Tom (running up to Augustus, followed by Dick
and Harry): We hear that Jay Cooke’s bank has
failed and the Northern Pacific is going to go
bankrupt! The country’s going into a panic! Give
us back our money — and none of those fancy
checks either! We want cash!
Augustus: But I don’t have enough cash on
hand. Wait till I contact my banker in Omaha.
LNB Banker: Hey, don’t look at me. I’m still
trying to get my money back from that city slicker who runs my bank in New York.
NYC Banker: I can’t help any of you out — I’m
in danger of failing myself!
Sam (walking up to Augustus; speaks calmly
and casually): Say, Mr. Murphy, I’m afraid I have
to ask to borrow a little more money. My crops
sold for a lot less than I thought they would, and
now I’ve got a mortgage payment coming up on
my farm.
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
335
LESSON 28 MONEY PANICS AND THE ESTABLISHMENT
OF THE
FEDERAL RESERVE SYSTEM
ACTIVITY 28.1, CONTINUED
DISASTER
AT THE
TELLER’S WINDOW: A BANKING TRAGEDY
Augustus (frantically): Are you crazy? All my
depositors want their money, and I don’t have
enough reserves to pay them all. As a matter of
fact, I want you to pay me back what you borrowed a few weeks ago.
Sam (alarmed): I can’t do that! I already spent
the money! And if you don’t lend me some extra
money now, I’m going to lose my farm!
Narrator: What a mess! And something happened like this every few years. Some panics
were worse than others, but the Panic of 1873
sparked a depression that lasted for several
years. The Panic of 1893 was even worse, and
the Panic of 1907 looked for a while like it might
be the worst of all. Only the intervention of the
fabulously wealthy investment banker J. P.
Morgan saved the economy from another horrible depression. So Congress decided to act. In
1913 Congress established the Federal Reserve
System. __________________ (name of the
teacher) will now pass out a reading and some
questions to help you find out how the new institution solved some of the problems of banks and
their customers.
336
FOCUS: UNDERSTANDING ECONOMICS
IN
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
MONEY PANICS AND THE ESTABLISHMENT
OF THE
FEDERAL RESERVE SYSTEM LESSON 28
ACTIVITY 28.2
PROPS FOR DISASTER AT THE TELLER’S WINDOW:
A BANKING TRAGEDY (ACTIVITY 28.1)
$100
(ONE MUSTACHE
FOR EACH GIRL
WHO IS PLAYING A MALE CHARACTER)
FOCUS: UNDERSTANDING ECONOMICS
IN
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY
337
LESSON 28 MONEY PANICS AND THE ESTABLISHMENT
OF THE
FEDERAL RESERVE SYSTEM
ACTIVITY 28.3
THE FEDERAL RESERVE ACT
OF
1913
The Federal Reserve Act divided the nation into 12 districts, with a regional Federal Reserve Bank for each
district. Most districts had one or more Federal Reserve branch banks as well. These banks were all
“bankers’ banks” — their only customers were the commercial banks in their districts. It is important to
note that the Federal Reserve System was not — and is not — controlled by the federal government,
although the government does appoint some of the top officials.
The Federal Reserve Act also provided a new currency: Federal Reserve Notes. Federal Reserve Notes
were backed by gold but also by commercial paper (loans to businesses). When a bank needed reserves
either to compensate for withdrawals or to allow it to make new loans, it could pledge some of its loans to
the district Federal Reserve Bank. The Federal Reserve Bank would then pay out Federal Reserve Notes
to the borrowing bank, which could use those Notes as reserves against its deposits. Banks could also
borrow reserves to make new loans. This actually increased the money in circulation, since new deposits
added into checking accounts circulate in the way that gold and bank notes do.
Banks paid an interest rate to borrow from the Federal Reserve Banks. This interest rate was called
the discount rate. The discount rate could be decreased when the district banks felt that more money was
needed for the economy to grow, and it could be increased when the Fed feared that inflation might occur
because too many new deposits were being created. Although there was a Federal Reserve Board in
Washington that coordinated the actions of the 12 district banks, the discount rate for each district was
set independently by the Federal Reserve Bank of that district.
The Federal Reserve System was the United States’ first central bank. It provided protection against
bank failures by creating new reserves. When banks borrowed from the Federal Reserve for the purpose of
making new loans, the total amount of money in circulation increased, and that increase encouraged new
business activity and economic growth. On the other hand, if Federal Reserve officials felt that inflation
caused by too much money in circulation was getting to be a problem, it could make it harder for banks to
borrow reserves and make new loans. So there was a happy ending, and no banks ever failed again, right?
Not exactly. Banks continued to fail, although at a reduced rate. Most of the banks that closed their
doors were small, and these failures did not spread through the system to cause panic and depression.
However, after the Stock Market Crash of 1929, there were three disastrous waves of bank failures: in
late 1930 and early 1931, in late 1931, and in late 1932. From 1930 through 1933, more than 9,000 banks
failed in the United States, and the U.S. money supply dropped by one third.
Why did the Federal Reserve System fail to do the job it had been set up to do, preventing bank failures and supplying an adequate amount of money to the economic system? You’ll learn more about this
when you study the Great Depression.
Questions for Discussion
A. How did the establishment of the Federal Reserve System make it possible for a bank to get additional
reserves without withdrawing them from another bank?
B. If the Federal Reserve System had been in place in 1873, would it have kept the stock and bond markets
from crashing? How?
C. If the Federal Reserve System had been in place in 1873, would it have kept Sam from losing his farm? How?
338
FOCUS: UNDERSTANDING ECONOMICS
IN
UNITED STATES HISTORY ©NATIONAL COUNCIL
ON
ECONOMIC EDUCATION, NEW YORK, NY