Optimal Use of Scale Economies in the Federal Reserve’s Currency Infrastructure

The Federal Reserve has been providing paper currency since its founding in 1913. In fact, the major purpose for creating the Federal Reserve System was to furnish an “elastic currency” that would make financial crises, such as the panic of 1907, less severe. While much has changed in the financial landscape over the last 87 years, currency remains an integral part of the U.S. payments system, accounting for over 80 percent of all transactions.1 (For a brief history of the Federal Reserve’s role in currency processing, see Good and Mitchell [1999].) For many types of transactions, currency has withstood the onslaught of checking accounts and credit cards, and will likely prevail over debit and smart cards for some types of transactions in the foreseeable future. The reasons for this are simple: Currency offers finality, anonymity, and familiarity at a reasonably low cost for small-value transactions. This sets a high hurdle for competing payment instruments. This is good news for the Treasury because the 20 billion Federal Reserve notes in circulation (with a value of $460 billion) are backed by Treasury debt. The $20 billion in annual interest payments generated by the backing of these notes is indirectly remitted to the Treasury.2 Ultimately, the interaction of paymentinstrument providers, payors, payees, and regulators will determine various instruments’ market shares, but currency will probably continue to retain a significant share of transactions. The Federal Reserve is responsible for operating its service efficiently. Even if the market were not evolving as a result of new payment instruments, the advent of nationwide branching of private depository institutions would