A Brief History of the Federal Reserve

The authority to create and regulate money rests with Congress,

which is empowered, according to Article 1, Section 8, Clause 5, of the

U.S. Constitution, “to coin money [and to] regulate the value thereof.”

By enacting the Federal Reserve Act in 1913, Congress, in turn, cre-

ated the Federal Reserve System and authorized it to create money and

regulate its value. In designing the Federal Reserve System, Congress

benefited from the experience of other countries central banks.

By the time the Federal Reserve was founded in 1913, the phrase

‘regulate the value’ had acquired an interpretation broader than mere

regulation of the purchasing power of money. The Federal Reserve Act

came in the aftermath of several financial panics, which were accompa-

nied by the failure of many banks and nonfinancial businesses and by the

disruption of commerce and general economic activity. In response, the

act was specifically designed to provide the country with enough liquid-

ity, to provide facilities for discounting commercial credit, and to im-

prove the supervision of the banking system. Thus, from the beginning,

the Federal Reserve Act mandated the functions of the Fed: (1) to pro-

vide enough money and credit to facilitate economic activity and (2) to

supervise banks. In other words, safeguarding the health of the economy

and the health of the financial system itself were the dual ultimate goals

of the Federal Reserve.

By working toward these goals, the Fed hoped to prevent bankrupt-

cies of financial and nonfinancial businesses and disruptions in eco-

nomic activity. It failed, however, to avert the Great Depression of the

1930s, when thousands of banks and even more nonfinancial businesses

failed. The level of economic activity became so weak that it could sup-

port only a shockingly small proportion of the labor force. Unemploy-

ment soared.

In the aftermath of the Great Depression, the Banking Acts of 1933

and 1935 amended the form and functions of the Federal Reserve. In

addition to giving the Fed power to regulate rates on savings and time

deposits, the 1933 act established the Federal Open Market Commit-

tee (FOMC), the third component of the Federal Reserve System. The

1935 act restructured both the Board and the FOMC by removing the

secretary of the Treasury and the comptroller of the currency from these

two bodies, thereby making the Fed more independent. The next major

amendment came with the Depository Institutions Deregulation and

Monetary Control Act of 1980 (DID&MCA). As Chapter 5 points out,

this act deregulated deposit rates and subjected all depository institu-

tions to reserve requirements.

These three acts—the Banking Act of 1933, the Banking Act of 1935,

and DID&MCA of 1980 – were concerned with the Fed’s role as a

regulator both of the banking industry and of economic activity. Two

additional acts focused primarily on the Fed’s role as a regulator of eco-

nomic activity. The Full Employment Act of 1946 directed the govern-

ment to promote ‘maximum employment, production, and purchasing

power.’ The term government was interpreted to include the Federal

Reserve. The goals of monetary policy were further refined by the 1978

Full Employment and Balanced Growth Act, commonly called the

Humphrey-Hawkins Act in honor of its prime sponsors, the late senator

Hubert Humphrey and Congressman Augustus Hawkins. The preced-

ing years had been characterized by high and rising inflation rates. The

Humphrey-Hawkins Act instructs the Fed to pay attention to the rate of

unemployment and the rate of growth of real GDP but also to the rate

of inflation. It also requires the Fed to report semiannually to Congress

about its outlook on economic activity and inflation and to relate this

outlook for the economy to that set down by the administration in the

annual Economic Report of the President. Additionally, the Humphrey-

Hawkins Act requires the Fed to set and report on targets for money

growth. The requirements of the Humphrey–Hawkins Act reflected not

only the public’s awareness and concern about inflation but also the as-

cendancy of monetarism, a school of thought whose basic tenet is that

inflation is caused by excessive growth of monetary aggregates.

To date, none of the laws mandates a rigid set of practices to which

the Fed must adhere regardless of economic conditions. The practices

that the Fed has pursued in striving to achieve its twin goals of safeguard-

ing the health of the economy and the health of the financial system have

changed over time, as the Fed has adapted to the economic and political

realities of the day.

Unit 5

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