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. 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.

In 1907 a bout of speculation on Wall Street ended in failure, triggering a particularly severe banking panic. 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. 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.

Originally, the mandate of the Federal Reserve was not envisioned as an entity which would utilize an active monetary policy to stabilize the economy. The idea of using an economic stabilization policy only dates from the work of John Maynard Keynes in 1936. Instead, the founders viewed the Fed as a means of preventing the supplies of money and credit from drying up during economic contractions, as often happened prior to World War I.

The central bank’s function has changed since the days of the Great Depression, and the Fed now primarily manages the growth of bank reserves and money supply to help stabilize growth during expansions. In order to control the money supply, the Fed uses three main tools to change bank reserves. These tools are a change in reserve requirements, a change in the either the Discount rate or the federal funds rate, and the use of Open-market operations. Changing the reserve ratio is a seldom used, but quite powerful tool at the Fed’s disposal. The reserve ratio is the percentage of reserves a bank is required to hold against deposits. A decrease in the ratio will allow the bank to lend more, which will increase the supply of money. An increase in the ratio will have the opposite effect.