To finance the American Revolution, the Continental Congress printed the new nation's first paper money. Known as "continentals," the fiat currency notes were issued in such quantity they led to inflation, which, though mild at first, rapidly accelerated as the war progressed. Eventually, people lost faith in the notes, and the phrase "Not worth a continental" came to mean "utterly worthless."

At the urging of Treasury Secretary Alexander Hamilton, Congress established the First Bank of the United States, headquartered in Philadelphia, in 1791. It was the largest corporation in the country and was dominated by big banking and money interests. Many agrarian minded Americans, uncomfortable with the idea of a large and powerful central bank, opposed it. By 1811 when the bank's 20-year charter expired, Congress refused, by one vote, to renew it.

By 1816 the political climate was once again inclined toward the idea of a central bank; by a narrow margin, Congress agreed to charter the Second Bank of the United States. But when Andrew Jackson, a central bank foe, was elected president in 1828, he vowed to kill it. His attack on its banker-controlled power touched a popular nerve with Americans, and when the Second Bank's charter expired in 1836, it was not renewed.

State-chartered banks and unchartered "free banks" took hold during this period, issuing their own notes, redeemable in gold or specie. Banks also began offering demand deposits to enhance commerce. In response to a rising volume of check transactions, the New York Clearinghouse Association was established in 1853 to provide a way for the city's banks to exchange checks and settle accounts.

During the Civil War the National Banking Act of 1863 was passed, providing for nationally chartered banks, whose circulating notes had to be backed by U.S. government securities. An amendment to the act required taxation on state bank notes but not national bank notes, effectively creating a uniform currency for the nation. Despite taxation on their notes, state banks continued to flourish due to the growing popularity of demand deposits, which had taken hold during the Free Banking Era.

Although the National Banking Act of 1863 established some measure of currency stability for the growing nation, bank runs and financial panics continued to plague the economy. In 1893 a banking panic triggered the worst depression the United States had ever seen, and the economy stabilized only after the intervention of financial mogul J.P. Morgan. It was clear that the nation's banking and financial system needed serious attention.

In 1907 a bout of speculation on Wall Street ended in failure, triggering a particularly severe banking panic. J.P. Morgan was again called upon to avert disaster. By this time most Americans were calling for reform of the banking system, but the structure of that reform was cause for deep division among the country's citizens. Conservatives and powerful "money trusts" in the big Eastern cities were vehemently opposed by "progressives." But there was a growing consensus among all Americans that a central banking authority was needed to ensure a healthy banking system and provide for an elastic currency.

The Aldrich-Vreeland Act of 1908, passed as an immediate response to the panic of 1907, provided for emergency currency issues during crises. It also established the National Monetary Commission to search for a long-term solution to the nation's banking and financial problems. Under the leadership of Sen. Nelson Aldrich, the commission developed a banker-controlled plan. William Jennings Bryan and other progressives fiercely attacked the plan; they wanted a central bank under public, not banker, control. The 1912 election of Democrat Woodrow Wilson killed the Republican Aldrich plan, but the stage was set for the emergence of a decentralized central bank.

Though not personally knowledgeable about banking and financial issues, Woodrow Wilson solicited expert advice from Virginia Rep. Carter Glass, soon to become the chairman of the House Committee on Banking and Finance, and from the Committee's expert adviser, H. Parker Willis, formerly a professor of economics at Washington and Lee University. Throughout most of 1912 Glass and Willis labored over a central bank proposal, and by December 1912 they presented Wilson with what would become, with some modifications, the Federal Reserve Act.

From December 1912 to December 1913 the Glass-Willis proposal was hotly debated, molded and reshaped. By December 23, 1913, when President Woodrow Wilson signed the Federal Reserve Act into law, it stood as a classic example of compromise -- a decentralized central bank that balanced the competing interests of private banks and populist sentiment.

Before the new central bank could begin operations, the Reserve Bank Organizing Committee, comprised of Treasury Secretary William McAdoo, Secretary of Agriculture David Houston, and Comptroller of the Currency John Skelton Williams, had the arduous task of building a working institution around the bare bones of the new law. But by November 16, 1914, the 12 cities chosen as sites for regional Reserve Banks were open for business, just as hostilities in Europe erupted into World War I.

When World War I broke out in mid-1914, U.S. banks continued to operate normally, thanks to emergency currency issued under the Aldrich-Vreeland Act of 1908. But the greater impact in the United States came from the Reserve Banks' ability to discount banker's acceptances. Through this mechanism, the United States aided the flow of trade goods to Europe, indirectly helping to finance the war until 1917, when the United States officially declared war on Germany and financing our own war effort became paramount.

Following World War I, Benjamin Strong, head of the New York Fed from 1914 to his death in 1928, recognized that gold no longer served as the central factor in controlling credit. Strong's aggressive action to stem a recession in 1923 through a large purchase of government securities gave strong evidence of the power of open market operations to influence the availability of credit in the banking system. During the 1920s the Fed began using open market operations as a monetary policy tool. During his tenure, Strong also elevated the stature of the Fed by promoting relations with other central banks, especially the Bank of England.

During the 1920s, Virginia Rep. Carter Glass warned that stock market speculation would lead to dire consequences. In October 1929 his predictions seemed to be realized when the stock market crashed, and the nation fell into the worst depression in its history. From 1930 to 1933 nearly 10,000 banks failed, and by March 1933 newly inaugurated President Franklin Delano Roosevelt declared a bank holiday, while government officials grappled with ways to remedy the nation's economic woes. Many people blamed the Fed for failing to stem speculative lending that led to the crash, and some also argued that inadequate understanding of monetary economics kept the Fed from pursuing policies that could have lessened the depth of the Depression.

In reaction to the Great Depression, Congress passed the Banking Act of 1933, better known as the Glass-Steagall Act, calling for the separation of commercial and investment banking and requiring use of government securities as collateral for Federal Reserve notes. The Act also established the Federal Deposit Insurance Corp. (FDIC), placed open market operations under the Fed and required bank holding companies to be examined by the Fed, a practice that was to have profound future implications, as holding companies became a prevalent structure for banks over time. Also, as part of the massive reforms taking place, Roosevelt recalled all gold and silver certificates, effectively ending the gold and any other metallic standard.

The Banking Act of 1935 called for further changes in the Fed's structure, including the creation of the Federal Open Market Committee (FOMC) as a separate legal entity, removal of the Treasury Secretary and the Comptroller of the Currency from the Fed's governing board and establishment of members' terms at 14 years. Following World War II, the Employment Act added the goal of promoting maximum employment to the list of the Fed's responsibilities. In 1956 the Bank Holding Company Act named the Fed as the regulator for bank holding companies owning more than one bank, and in 1978 the Humphrey-Hawkins Act required the Fed chairman to report to Congress twice annually on monetary policy goals and objectives.

The Fed largely supported the Treasury's fiscal policy goals from its founding in 1913 to the years up to and following World War II. When the Korean Conflict broke out in 1951, Fed chairman William McChesney Martin again faced pressure from the Treasury to maintain low interest rates to help provide funds for the new conflict. Martin, however, worked closely with the Treasury to break the long-standing practice of supporting government bond interest rates. Since then the Fed has remained staunchly independent in its use of open market operations to support its monetary policy goals.

The 1970s saw inflation skyrocket as producer and consumer prices rose, oil prices soared and the federal deficit more than doubled. By August 1979, when Paul Volcker was sworn in as Fed chairman, drastic action was needed to break inflation's stranglehold on the U.S. economy. Volker's leadership as Fed chairman during the 1980s, though painful in the short term, was successful overall in bringing double-digit inflation under control.

The Monetary Control Act of 1980 required the Fed to price its financial services competitively against private sector providers and to establish reserve requirements for all eligible financial institutions. The act marks the beginning of a period of modern banking industry reforms. Following its passage, interstate banking proliferated, and banks began offering interest-paying accounts and instruments to attract customers from brokerage firms. Barriers to insurance activities, however, proved more difficult to circumvent. Nonetheless, momentum for change was steady, and by 1999 the Gramm-Leach-Bliley Act was passed, in essence overturning the Glass-Steagall Act of 1933 and allowing banks to offer a menu of financial services, including investment banking and insurance sales.

Two months after Alan Greenspan took office as Fed chairman, the stock market crashed on October 19, 1987. In response, he ordered the Fed to issue a one-sentence statement before the start of trading on October 20: "The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system." The 10-year economic expansion of the 1990s came to a close in March 2001 and was followed by a short, shallow recession ending in November 2001. In response to the bursting of the 1990s stock market bubble in the early years of the decade, the Fed lowered interest rates rapidly. Throughout the 1990s, the Fed used monetary policy on a number of occassions-including the credit crunch of the early 1990s and the Russian default on government bonds-to keep potential financial problems from adversely affecting the real economy. The decade was marked by generally declining inflation and the longest peacetime economic expansion in our country's history.

The effectiveness of the Federal Reserve as a central bank was put to the test on September 11, 2001 as the terrorist attacks in New York, Washington, and Pennsylvania disrupted U.S. financial markets. The Fed issued a one-sentence statement reminiscent of its announcement in 1987. "The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs." In the days that followed, the Fed lowered interest rates and loaned more than $45 billion to financial institutions in order to provide stability to the U.S. economy. By the end of September, Fed lending had returned to pre-September 11 levels and a potential liquidity crunch had been averted. The Fed played the pivotal role in dampening the effects of the September 11 attacks on U.S. financial markets.

In 2003 the Federal Reserve changed its discount window operations so as to have rates at the window above the prevailing Fed Funds rate and provide rationing of loans to banks through interest rates.

The Federal Reserve faces many new challenges in the financial services industry: deregulation, technological advances in the payments system, the move to a more global economy, and continuing mergers and acquisitions in the banking industry. In late 2003, the Check Clearing for the 21st Century Act, known as Check 21 in the industry, was enacted. The coming years will see the use of “substitute checks,” paper reproductions of original checks that can be processed just like the originals.