4 - Interest on reserves and reserve smoothing in a correspondent banking system

Summary

Introduction

Economists have recently renewed their interest in the effects of the founding of the Federal Reserve on the frequency of financial panics. Much of this interest stems from work by Miron (1986) which attributes financial panics before 1914 to strains on the banking system caused by seasonal spikes in market interest rates. Miron argues that the founders created a system that directed Federal Reserve officials to use their discretion to supply reserves to the banking system during periods of seasonal strain. A properly timed discretionary policy reduces seasonal movements in interest rates and reduces the probability of bank failures. Miron's work has given rise to what I refer to as the new consensus, or new traditional, view of the founding of the Fed.

This chapter emphasizes that the new consensus view differs fundamentally from the original conception of the Fed. For one thing, the founders tended to take seriously the gold standard constraints within which the newly created Fed would operate (Timberlake, 1978, pp. 221–2). These constraints would limit the ability of the Fed to control the interest rate. The founders' challenge, therefore, was to formulate a solution to the financial crisis problem that did not rely on interest rate control.

The key to their solution, I argue, was section 16 of the Federal Reserve Act which created the Fed as a national clearinghouse and granted it a right not possessed by private clearinghouses – the right to create reserves in the form of currency. As pointed out in the previous chapter, however, currency issue was restricted in the early years of the System.