#Reserves against Federal reserve notes.# The rule applying in normal times to reserves against note issues is that each bank must provide a reserve in gold equal to 40 per cent "against the Federal reserve notes in actual circulation, and not offset by gold or lawful money deposited with the Federal reserve agent." At least 5 per cent is to be on deposit in the Treasury of the United States.

The proportion of reserves to the liability for note issues by any bank, however, may be allowed to fall below 40 per cent, on condition that the Federal Reserve Board shall establish a graduated tax of not more than 1 per cent per annum (it evidently might be made less if the board chose) upon such deficiency, until the reserves fall to 32-1/2 per cent and thereafter a graduated tax of not less than 1-1/2 per cent on each additional 2-1/2 per cent deficiency or fraction thereof.[8] This tax must be paid by the reserve bank, but it must add an amount equal to the tax to the rates of interest and discount charged to member banks.

The effect of these rules is to give a power of note issue in time of emergency without compelling the reserve banks to lock up their reserves held against notes.

Suppose for example that the circulating notes were in normal times $1,000,000,000 and the reserves, therefore, were $400,000,000 and the rate of discount 5 per cent.

Then the circulation might be doubled with the same reserves, the proportion thus falling to 20 per cent of outstanding notes, and the rate of discount to customers rising to 13.5 per cent (5 plus 8.5).