Elasticity of deposit credit is also provided for in the "rediscounting device." A bank discounts commercial paper when it loans an individual, say, $980, on the security of a $1000 promissory note. The $20 represents an amount which the bank counts out, or discounts, as payment for the service. A further operation, long known in Europe as rediscounting, was authorized by the Act of 1913. When the reserves of a member bank are too low to justify further extensions of deposit credit, the bank can send certain types of discounted paper to the Federal Reserve bank of its district, and receive in return either a deposit credit or a special form of paper currency called Federal Reserve notes.
392. ELASTICITY OF CURRENCY (BANK NOTES).—When, in return for discounted commercial paper, the Federal Reserve bank extends a deposit credit to the member bank, the deposit credit of the member bank is rendered more elastic. When, on the other hand, the Federal Reserve bank sends the member bank Federal Reserve notes in exchange for discounted paper, the result is a certain elasticity in the currency.
The Federal Reserve notes are a new type of currency. They are secured by the maintenance, in the vaults of the Federal Reserve banks, of a forty per cent gold reserve for their redemption. Since these notes are issued to member banks in return for rediscounted paper, the expansion of business and the resultant tendency of member banks to send discounted paper to the Federal Reserve bank for rediscount causes the volume of Federal Reserve notes to expand. When the need for additional currency has subsided, there is an arrangement whereby a certain amount of the Federal Reserve notes may be withdrawn from circulation. This is important, for if the amount of money in circulation continues to be enormous after business has declined, inflation and high prices result. A truly elastic banking system necessitates contraction as well as expansion.
393. THE OUTLOOK.—On the whole, it would seem that the Federal Reserve System is a happy compromise between the centralized banking systems of Europe and the highly decentralized system existing in this country prior to 1913. The Federal Reserve system allows us to secure the main benefits of a great central bank without the political difficulties attendant upon the existence of such a bank. It does a great deal to make elastic our supply of money and credit. The Federal Reserve Board can mobilize the entire banking strength of the country in time of stress, so that the strength of one member bank is the strength of the whole system. Since it controls not only a substantial proportion of the bank reserves of the country, but also the privilege of note issue on the security of rediscounted paper, the Federal Reserve Board can administer the member banks as a unit. The system may not eliminate panics, but it is fair to expect that it will reduce their number and lessen their violence.
QUESTIONS ON THE TEXT
1. Distinguish between money and credit.
2. Name and distinguish between the four types of banks.
3. What is the primary function of a commercial bank?
4. Explain clearly the nature of bank credit.
5. If the cash reserve of a bank is low, and the bank is confronted with demands for loans, in what two ways may it dispose of these demands?