America's Money Machine

148 PART II / THE GREAT REVERSAL
Theoretically designed to enable the central banks to regulate the volume
of bank credit, and hence to check, as well as encourage, expansion, it
proved more effective as a spur than as a restraint to expansion. Under
the Federal Reserve Act, a Federal Reserve bank was authorized to invest
not only in rediscounts and advances to member banks, but in a defined
category of commercial obligations.* These items could be purchased
and sold "in the open market, at home or abroad, either from or to
domestic or foreign banks, firms, corporations, or individuals."3 Such
dealings in the money market directly with the public were called "open
market operations."
A purchase of investments on the open market is paid for by the
Federal Reserve bank either in Federal Reserve notes or by check drawn
on itself, depending on whether the bank wishes to increase the actual
quantity of money in circulation, or the banking power of the System. If
paid in notes, the money passes directly into circulation; ifpaid by check,
the recipient ofthe check deposits it with his commercial bank, which in
turn presents it to the Federal Reserve bank for credit. This credit thus
becomes a deposit to the account of the member bank, and as such
deposits constitute banking reserves for the member bank, the lending
power of the member bank is thereby multiplied. Conversely, of course,
the effect of selling portfolio holdings by the Federal Reserve banks is to
reduce reserve credit outstanding, and to restrict the lending operations
of member banks.
In 1924, with the object of creating money conditions in the international
markets favorable to the efforts of Great Britain and a number of
lesser European countries to return to the gold standard, the Federal
Reserve System embarked on its famous "easy credit" policy, by reducing
the rate at which it lent to member banks (the rediscount rate) and by
forcing Reserve bank credit into the banking system by heavy open market
operations. As a result, between the end of 1923 and the end of 1927,
$548 million of Federal Reserve credit had been forced into the banking
system by purchases of bills and securities. This amount must be multiplied
many times to appreciate its effect on the credit power of the
banking system.
During the early years of this policy, the effect of this leverage was
nullified to some extent by the more cautious policy of the commercial
*United States government securities, and certain types ofagricultural credit obligations,
municipal warrants, trade acceptances and bankers' bills.