The federal reserve notes are direct obligations of the United States, and are not, therefore, in the strict sense bank notes. They are receivable by all member banks and federal reserve banks, and for all taxes, customs, and other public dues, but they are not a legal tender in settlement of private debts. They are redeemable in gold at the United States Treasury, and in gold or lawful money at any federal reserve bank, and for this purpose each bank is required to carry with the Treasury a redemption fund of 5 per cent or more and to reimburse the Treasury in gold, gold certificates, or lawful money as the fund is depleted by redemptions. The expenses of redemption are charged to the federal reserve bank. The notes of each federal reserve bank bear a distinctive letter and serial number assigned to it by the board. Whenever federal reserve notes of one federal reserve bank are received by another federal reserve bank they must be promptly returned for credit or redemption to the issuing bank. No federal reserve bank may pay out notes issued through another, under penalty of a tax of 10 per cent per annum on the face of the notes so paid out. The federal reserve notes together with the federal reserve bank notes constitute a first and paramount lien on all the assets of the issuing bank.

The federal reserve notes may not be counted as reserve by either the federal reserve banks or the member banks, although the non-member state institutions may and do so use them, laws to this effect having been passed by certain states. The Federal Reserve Act contemplated the use of the notes for circulation purposes only, the reserves of the members being intended to consist of credit (deposit) balances with the federal reserve banks. It was argued that the elasticity of the federal reserve notes would be very materially impaired by their use as reserves, since once pocketed in bank vaults they would remain outstanding indefinitely; and to the degree that the notes are so held now by state institutions that is the case. It was also argued that to allow member banks to regard federal reserve notes as reserve on which to build a deposits superstructure would result in a plain case of pyramiding credit. In reply it may be argued that, though the federal reserve notes do stay out, nevertheless the volume of the currency may contract, for the recovery of the pledged paper may be made by paying gold or gold certificates. Again, federal reserve notes and deposits with the federal reserve banks are both demand liabilities of those banks and either may be procured by the process of rediscounting, so that it is illogical to allow deposits with the federal reserve banks to count as reserves for a member bank, while inhibiting federal reserve notes in the possession of the member bank from such privilege. Finally, in the case of federal reserve notes used as reserves there is no less pyramiding of credit than in the case of deposits with the federal reserve bank used as reserves, for they are both demand liabilities of the reserve bank against which it needs to keep but 40 per cent and 35 per cent gold reserve, respectively, and the potential capacity for inflation is as great in the one case as in the other.