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 re serves 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 4o 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.
Provisions for Controlling Excessive Issues The original provisions against excessive issues of notes seemed ample to prevent inflation. A 4o per cent gold reserve was required, and this requirement could only be obviated by the payment of a progressive tax, which soon became prohibitive. The discount rate also increased as fast as this tax on the defi ciency of the reserve. How these three limitations are being evaded under present practice has been explained above.
When a federal reserve bank applies to its federal reserve agent for a certain amount of notes, the Federal Reserve Board has the right, acting through the federal reserve agent, either to grant the application in whole or in part, or to reject it entirely.
The board may at its discretion fix a rate of interest which shall be charged for the use of the federal reserve notes issued to the reserve bank and in this way force the retirement of the notes when redundant. To date (1921) the board has not deemed it necessary to impose any such interest rate.
In addition the board may impede inflation in any federal reserve district by directly raising the discount rate of the federal reserve bank, either at the instance of the reserve bank or on its own initiative.
As the denominations of the federal reserve notes range from $5 to $1oo and many are too large, therefore, to stay in general circulation, the notes, particularly of the larger denominations, drift to tills of business concerns and into the vaults of banks, and ultimately to places of redemption.
The board has another means of control in that it may more strictly define the paper eligible for rediscount if it is found desk able to restrict the pledging of paper for the purpose of securing notes. A stricter definition would reduce the volume of eligible paper and thereby restrict the possibility of note issues except against gold. By requiring that the paper be strictly commercial paper, not only is the volume limited by the amount of business transactions, but the paper, being self-liquidating, provides a means for its payment before maturity. Paper that covers fixed investments and speculations is specifically excluded from redis counts. Moreover, only short-term paper may be rediscounted, and therefore it is impossible to rediscount to an unlimited amount since some paper is coming due every day and must be paid through the member bank that discounted it. But this limitation on inflation is defeated by the permission granted to member banks to procure advances from the federal reserve banks on their promissory notes secured by the deposit or pledge of United States securities. Under this permission the federal reserve banks have been surfeited with "war paper" and their liabilities for notes and deposits have expanded altogether too easily. To the degree that the assets of the reserve banks consist of such promis sory notes secured by pledge of government securities, to that degree does the character of the federal reserve notes approach that of the national bank notes so far as the non-commercial quality of their security is concerned.
Responsibility for Stemming Inflation It is obvious that the ultimate control of note issue rests with the Federal Reserve Board, and, therefore, upon the personnel and policies of the board the possibility of inflation depends. If its members are conservative and conscious of their high public responsibility, the board will try to stifle anything in the nature of inflation. But for this it is necessary that the board have the support of the federal reserve banks and the member banks. Each of three parties concerned has a duty to perform in con trolling expansion, and though the problems of the three are inter related, they are nevertheless distinct.
The board has little direct contact with the member banks; it deals with general conditions and principles rather than with individual cases and details, whereas the reserve banks are in daily contact with the member banks and also with the board. The primary duty of the board is to see that the reserve banks function according to law, and its own regulations must, of course, also conform to the law.