Much of the experience of the U.S. Federal Reserve System, during the institution’s first hundred years, has revolved around controversies that fit squarely within the classical debate over rules versus discretion in economic policymaking. This paper looks back at the major episodes in this history since World War II, including the initial freeing of monetary policy from war-related interest-pegging, the Federal Reserve’s delayed but ultimately successful response to the inflation of the 1970s and early 1980s, the brief experiment with monetary aggregate targets, the extraordinary actions prompted by the 2007-9 financial crisis, and the current tentative exploration of inflation targeting. The paper concludes that the tension between the desire for rule-based policymaking and the practicalities that lead central bankers to preserve discretion in actual policy decisions does not admit of any easy, straightforward solution, and therefore that this tension is likely to persist into the Federal Reserve’s next century too.

In 1772, at the height of Scotland's worst banking crisis in two generations, David Hume wrote to his close friend Adam Smith. After recounting the bank closures, industrial bankruptcies, spreading unemployment, and even growing "Suspicion" of the soundness of the Bank of England, Hume asked Smith, "Do these Events any-wise affect your Theory?". They certainly did. Smith's analysis of the role of banking in The Wealth of Nations, published just four years later, clearly reflected the lessons he took away from the 1772 crisis. In contrast to the doctrinaire antiregulatory ideology with which he is usually associated by today's economists, Smith favored such measures as usury laws-- specifically, no lending at interest rates above 5 percent - and restrictions on the obligations that banks could issue.

The lessons learned from the recent financial crisis should significantly reshape the economics profession's thinking, including, importantly, what we teach our students. Five such lessons are that we live in a monetary economy and therefore aggregate demand and policies that affect aggregate demand are determinants of real economic outcomes; that what actually matters for this purpose is not money but the volume, availability, and price of credit; that the fact that most lending is done by financial institutions matters as well; that the prices set in our financial markets do not always exhibit the “rationality” economists normally claim for them; and that both frictions and the uneven impact of economic events prevent us from adapting to disturbances in the way textbook economics suggests.