How the Fed Works

Sometimes, in order to understand why you need something, it helps to find out what it was like before that "something" was created. Before the Federal Reserve was created in 1913, there were over 30,000 different currencies floating around in the United States. Currency could be issued by almost anyone -- even drug stores issued their own notes. There were many problems that stemmed from this, including the fact that some currencies were worth more than others. Some currencies were backed by silver or gold, and others by government bonds. There were even times when banks didn't have enough money to honor withdrawals by customers. Imagine going to the bank to withdraw money from your savings account and being told you couldn't because they didn't have your money! Before the Fed was created, banks were collapsing and the economy swung wildly from one extreme to the next. The faith Americans had in the banking system was not very strong. This is why the Fed was created.

The Fed's original job was to organize, standardize and stabilize the monetary system in the United States. It had to set up a method that could create "liquidity" in the money supply -- in other words, make sure banks could honor withdrawals for customers. It also needed to come up with a way to create an "elastic currency," meaning it had to control inflation by making sure prices didn't climb too quickly, and it needed a way of increasing or decreasing the country's supply of currency in order to prevent inflation and recession. In the next two sections, we'll discuss these inflation and recession.