The money supply is an important determinant of aggregate demand and business conditions in general. Until 1935, a significant proportion of U.S. paper money was issued by commercial banks. The opportunity to issue banknotes was an important source of lending power for banks.

Before the United States gained its independence, paper money was issued by the various British colonial governments. Massachusetts made the first issue in 1690 to finance military expenditures: The bills could simply be paid out to soldiers and suppliers. Most colonies issued currency in the wartime period of 1713-1718, causing significant price inflation. Issuing paper money was a means of financing government deficits before the development of well-ordered interest-bearing government bonds. The notes were not formally convertible into gold and silver (specie) but could be used to pay taxes. Several colonial governments established loan offices, mostly for mortgage loans secured by land. The borrowers received paper money. The new issues of paper were withdrawn as the loans were repaid. Some colonies managed their money creation with restraint, and the money supply grew enough to facilitate the spread of a market economy, specialization, and exchange. Real inflationary abuses occurred in Rhode Island, the Carolinas, and Massachusetts. The British government tried to stamp out the practice and issued a general prohibition in 1764. This enraged many colonists and was one of the many grievances precipitating the move for independence. During the 1770’s, the total money supply was about $12 million, of which half was British and foreign coins and half was paper money.CurrencyMoney supply

During the Revolutionary WarRevolutionary War, both the Continental Congress and individual states issued paper money to pay troops and purchase supplies. About $11 million was issued in 1775 and $44 million in the next two years, about 70 percent of it by the national government. Congress persuaded northern states to halt their own issues in 1778-1779, but Congress poured out $60 million in 1778 and $140 million in 1779. Severe inflation resulted: By 1780, wholesale prices in Philadelphia were about one hundred times their level in 1776. Efforts to curb depreciation of paper issues involved making them legal tender and imposing price controls. However, many farmers and merchants simply refused to accept the government’s paper.

In 1780, Congress shifted to borrowing by issuing interest-bearing securities and stopped issuing paper money. The last phase of the war was concentrated in the South, and Virginia issued more than $150 million of currency in 1780-1781. With the end of the war in 1781, most of the currency was withdrawn through taxation and through the issue of bonds. The Federal Funding Act of 1790 provided for acceptance of continental currency toward purchase of federal bonds, at a rate of one cent on the dollar.

Congress decreed that the dollar should be the national monetary unit. In 1780, it chartered the first modern commercial bank, the Bank of North America, in Philadelphia. Two more Bankingbanks were created in 1784, one in Boston and one in New York. Each began issuing banknote currency, typically paying out the notes to borrowers. The notes were convertible on demand into specie. Coins issued in Great Britain, in Europe, and in Latin America circulated extensively.

A serious economic depression swept the country during the mid-1780’s. Seven states resumed issuing paper money, partly to make loans to distressed citizens and partly to cover government deficits created when tax revenues declined. Nearly $3 million of government paper was issued in 1785-1786, creating alarm that the wartime financial disorder would be repeated. In response, the U.S. Constitution of 1787 gave Congress the power to coin money and regulate its value and forbade state governments from coining money, issuing bills of credit, or making anything except gold or silver legal tender.

Alexander Hamilton, AlexanderHamilton, the first secretary of the Treasury, initiated major policies regarding currency. At his urging, in 1791, Congress chartered the First Bank of the United States, FirstBank of the United States, which opened offices in major port cities, where its banknotes became an important payment medium. Hamilton also shaped the Coinage Act of 1792, which created the United States Mint, U.S.Mint. The law provided for a variety of gold, silver, and copper coins. Private individuals could bring gold or silver to the mint and it would be coined for them. However, the government did not initiate the process. Coinage output was not large, and foreign coins continued to circulate extensively.

The number of banks and the volume of banknote currency grew steadily. By 1811, there were eighty-eight state-chartered banks. By then, circulating currency comprised about $15 million in gold and silver coins and $28 million in banknotes. The War of 1812 generated inflationary pressure from large federal military spending financed by borrowing heavily from the banks. More than one hundred new banks were created. In 1814, most of the banks ceased redeeming their notes in specie, which freed them to expand their loans and note issues still more.

To restore order to the monetary situation, Congress chartered the Second Bank of the United States, SecondBank of the United States in 1816 (the charter of the first had expired in 1811). The new bank was larger than its predecessor and had as many as twenty-five branches. Its banknote issues were redeemed in specie, and it pressured the other banks to do the same. However, the Second Bank of the United States contributed to a severe boom-and-bust cycle of credit expansion and contraction in 1817-1818. President Andrew Jackson strongly opposed the bank and prevented its recharter. It ceased operation in 1841.

The number of state-chartered or unchartered banks increased greatly during the 1830’s, and the quality of banknote currency deteriorated. “Wildcat” banks were established in remote areas, making note redemption difficult. Many banks failed during a severe business contraction beginning in 1837. Bank expansion resumed during the 1840’s, to be interrupted by another bank panic in 1857. By 1860, there were more than 1,500 banks, almost all issuing their own notes. Coinage legislation during the 1850’s created the hierarchy of copper-nickel penny and silver dime, quarter, and half-dollar. (The nickel was added in 1866.) Circulation of foreign coins was prohibited in 1857.

No formal government paper money was issued after 1787, although the Treasury notes issued during some business recessions temporarily performed that function. The outbreak of the Civil War, U.S.;currencyCivil War in 1861 generated a huge increase in federal spending, and part of the resulting deficit was financed by issuing paper money. There were several different types, but the most nearly permanent were United States notes. In February, 1862, Congress authorized the issue of $150 million in legal-tender notes, soon named Greenbacksgreenbacks for their distinctive design. More issues followed.

Monetary expansion generated inflation, and by 1864 consumer prices in the North were 75 percent higher than they had been in 1860. The Confederacy relied even more heavily on paper money issues, which totaled more than a billion dollars and generated far worse inflation–prices in early 1865 were nearly a hundred times those of 1861.

The war provided a basis for government efforts to reform banknote currency. In 1863, Congress authorized the creation of the National Banking system. A bank could obtain a federal charter that permitted it to issue national bank notes that were standardized in design (except for the name of the issuing bank) and secured by U.S. government bonds. In 1865, a punitive tax was imposed on note issues by nonnational banks, and notes from these banks soon disappeared. Between federal paper money and national banknotes, the nation’s paper currency achieved very high quality–especially since the Secret Service effectively combated counterfeiting.

Women examining currency at the Bureau of Engraving and Printing in 1929.

(Library of Congress)

At the end of the war, neither greenbacks nor national banknotes were convertible into specie at par. Political pressure to restore par convertibility was strong, but even greater was the pressure to avoid a deflationary monetary contraction. Market forces gradually brought down the price of gold, and par convertibility was achieved in 1879. Congress authorized new forms of paper money: silver certificates (1878–redeemable in silver coin) and gold certificates (1863, but important only after 1882–redeemable in gold coin).

The economy continued to experience strong business cycles and periodic depressions, and there was pressure for monetary expansion to relieve depressions. During the 1890’s this pressure underlay the Free silver movementcampaign for “free silver”–a proposal to allow unlimited coinage of silver into dollars at a ratio of sixteen to one with gold–a ratio that significantly overvalued silver and would have led to extensive coinage. The proposal was a major part of William Jennings Bryan, William JenningsBryan’s presidential campaign in 1896. Bryan’s defeat and restoration of prosperity and rising prices put an end to the silver agitation. The Gold standardGold Standard Act of 1900 declared gold to be the country’s monetary standard and ordered that all other forms of money be maintained at parity with gold.

The United States continued to be plagued by bank panics. The panic of 1907 led to renewed effort for currency and banking reform, culminating in the Federal Reserve Act of 1913Federal Reserve Act of 1913. The act created a new type of paper money–Federal Reserve notes. These were supposed to be an “elastic” currency, capable of expansion during a panic when the banks were being pressed to redeem deposits in currency. Banks that chose to become members of the Federal Reserve system would maintain reserve deposits with their regional Federal Reserve bank. They could always draw currency from their reserve deposits, borrowing from the Federal Reserve if they needed more.

The new system seemed to work well. When the economy entered a brief but severe depression in 1920 following the end of the inflationary pressures arising from World War I, there was no banking panic. By 1920, Federal Reserve notes constituted about three-fifths of outstanding coin and currency.

As the United States slid into Great Depression;bankingdepression in 1929, the most severe bank panic in American history occurred. Numerous Bank failuresbank failures had taken place during the 1920’s but they were generally of small banks in rural areas. In 1930 failure struck numerous urban banks as well. The Federal Reserve was well designed to aid banks that were solvent but lacked cash. However, the bank failures that spread after 1930 generally involved insolvent banks–those whose assets were less than their liabilities, often because they had made speculative investments in stocks and real estate. Spreading bank failures led to massive withdrawals of currency from the banks, forcing them to sell investments and refuse to renew loans. Deflationary pressure was worsened by U.S. adherence to the international gold standard. Britain’s departure from the gold standard in 1931 set off a large effort to buy U.S. Treasury gold, a process that reduced bank reserves and the money supply. To protect the nation’s gold reserve, the Federal Reserve imposed credit restraints that worsened the economic downswing and accelerated bank failures.

Franklin D. Roosevelt was inaugurated president in March, 1933, in the midst of the bank collapses. One of his first actions was to take the country off the gold standard. New Deal;currencyPeople were ordered to turn in their gold coins; contracts calling for payment in gold were declared invalid. Other forms of money were no longer convertible into gold. The official price of gold was raised from $20.67 an ounce, where it had stood since the 1830’s, to $35 an ounce. American citizens could no longer buy Treasury gold, and even private gold transactions were severely regulated. Gold coins, gold certificates, and national banknotes were withdrawn from circulation.

After the Depression, U.S. currency became more routine and less interesting. The public can “buy” as much currency as it wants, supplied by the Federal Reserve through the banks. Links to precious metals were disconnected, except for gold and silver coins produced for collectors or investors and not intended to circulate as money. Beginning in 1965, silver was removed from U.S. coins, and silver certificates were discontinued. In 1971, the Treasury ceased to maintain a fixed price for gold or to sell it on demand to international buyers. After United States notes were discontinued in 1969, all paper currency consisted of Federal Reserve notes.

• Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton, N.J.: Princeton University Press, 1963. The definitive monetary history, with lots of attention to the economic causes and effects of policy decisions.
• Goodwin, Jason. Greenback: The Almighty Dollar and the Invention of America. New York: Henry Holt, 2003. Colorful, anecdotal history of American money; mostly pre-1900.
• Hessler, Gene. The Comprehensive Catalog of U.S. Paper Money. 6th ed. Port Chester, Ohio: BNR Press, 1997. This catalog has many color illustrations of the various historical paper money issues.
• Nussbaum, Arthur. A History of the Dollar. New York: Columbia University Press, 1957. A nice mix of scholarship and readability, this contains lots of detail on all the complexities of U.S. currency history.
• Trescott, Paul B. Money, Banking and Economic Welfare. New York: McGraw-Hill, 1960. Chapters 14-17 of this college textbook put currency evolution in a full context of economic and political history.

Bank failures

First Bank of the United States

Second Bank of the United States

Confederate currency

Federal Reserve

Gold standard

Inflation

U.S. Mint

Federal monetary policy

Panic of 1907

U.S. Department of the Treasury