One of the purposes of the Federal Reserve Act, as stated in the preamble, is "to furnish an elastic currency." The new system leaves all forms of currency issued by the Government practically unchanged, but provides for the gradual replacement of national bank notes by notes issued by the Federal reserve banks, and the issue to them at the discretion of the Federal Reserve Board, of emergency currency, to be known as Federal reserve notes. These latter notes are to be obligations of the Government, though issued through the reserve banks upon commercial paper assets, and are expected to supply the element of elasticity in the currency. Two new kinds of notes will thus be introduced into the currency system.
To guard against the possibility of a sudden contraction of the currency caused by the retirement of national bank notes the Federal reserve banks are authorized to purchase bonds and issue circulating notes under the same conditions and regulations as apply to national banks, "except that the issue of such notes shall not be limited to the capital stock of such Federal reserve bank." These notes are to be the obligations of the Federal reserve bank issuing them. As they are secured by bonds in the same way as national bank notes they, obviously, will be just as inelastic. National banks are not required to retire their circulating notes, but after two years from the passage of the Act they have the privilege, for a period of twenty years, of retiring any part or all of such notes. The method of retirement is briefly as follows: A member bank desiring to retire any or all of its circulation will file with the Treasurer of the United States an application to sell its government bonds now held in trust in the Treasury. The Treasurer furnishes a list of such applications to the Federal Reserve Board, which may require the Federal reserve banks to purchase these bonds at par and accrued interest. The Federal reserve banks buying the bonds are permitted to take out circulating notes up to their par value
This arrangement is advantageous both to the national banks and to the Government. It gives the banks an opportunity to sell at par their 2 per cent bonds, which without the circulation privilege would be worth in the investment market about 70, and still it provides a new group of bond purchasers, thus sustaining the market for government bonds. The plan for retiring the national bank notes, however, is open to several objections. In the first place it is not obligatory, and so may result only in adding to our inelastic currency another type of note equally inelastic, for the Federal reserve banks may buy bonds and issue notes on exactly the same terms as national banks. The plan for retirement does not go into effect until December 23, 1915, and even then retirement must be very slow. The Federal reserve banks are not permitted to purchase in any one year more than $25,000,000 of the bonds held by the banks against their circulation. Furthermore, since the Act specifically limits the retirement process to twenty years and since the national banks hold over $700,000,000 of these bonds, it is apparent that all the outstanding notes cannot be retired in the time prescribed. At the end of twenty years each bank would be left with approximately one-third of its bonds still on hand. It is generally understood, however, that the currency provisions of the Act are temporary and that considerable modifications will be made by subsequent legislation.