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3H -1464 1M 8-61
The Federal Reserve System
THE
Federal Reserve System
PURPOSES AND FUNCTIONS
B O A R D OF G O V E R N O R S
of the Federal Reserve System
Washington, D. C., 1954
F ir s t E d i t i o n - M a y 1939
S e c o n d E d it io n - N o v em b er 1947
T h ir d E d it io n - A p r il
1954
Library o f C ongress C atalog C ard N um ber 39-26719
FOREW ORD
HIS book is dedicated to a better public understand
ing o f the Federal Reserve System—its trusteeship for
the nation’s credit and monetary machinery, the range of
its operations and its organization, and how it helps to
further stable economic progress. On the cover of the book
there is reproduced a facsimile of a bronze relief which is
set into the marble fireplace of the Board room o f the
Federal Reserve Building in Washington. This bronze
relief well symbolizes the public aims o f Federal Reserve
functions—stability and productivity.
The present edition was prepared by the staff o f the
Board o f Governors under the supervision o f Ralph A.
Young, Director of its Division of Research and Statistics.
The revision has had the benefit of many suggestions from
the staffs of the Federal Reserve Banks. The preceding
edition was prepared by the late E. A. Goldenweiser, for
many years Director of the Board’s Division of Research
and Statistics.
T
B oard
of the
Washington, D. C.
April 1954
of
G o v er n o r s
F e d e r a l R eserve S ystem
CONTENTS
CHAPTER
I
F unc tio n
of the
F ederal R eserve S ystem . . .
The basic function of the Federal Reserve System is
to make possible a flow of credit and money that
will foster orderly economic growth and a stable
dollar. An efficient monetary mechanism is indis
pensable to the steady development of the nation’s
resources and a rising standard of living.
II
F unc tio n
of
B a n k R eserves ......................................
In performing its basic function, the Federal Reserve
depends chiefly on its ability to increase or decrease
the availability, cost, and volume of bank reserves,
which constitute the legally required basis of bank
deposits. Changes in the reserve position of banks
affect directly the flow of bank credit and money.
III
G eneral M ethods
of
R eg u la tio n ........................
The principal reserve banking methods of regulating
bank reserves are discounts for member banks,
purchases and sales of Government securities in the
open market, and changes in reserve requirements.
The source of Federal Reserve lending power is the
gold certificate reserves of the Reserve Banks.
IV
S elective C redit R eg u la tio n ...................................
In addition to its general methods of regulating the
flow of credit and money, the Federal Reserve has
special powers to regulate the credit terms on which
transactions in stock market securities are financed.
At times it has been authorized to prescribe terms
on which consumer credit and certain real estate
credit could be extended, and also to encourage
lenders to restrict other types of credit voluntarily.
CHAPTER
PAGE
V S tructure
of the
F ederal R eserve S ystem ___
68
All national banks and many State banks are mem
bers of the Federal Reserve System. There are
twelve Federal Reserve Banks, each serving one of
the districts into which the country is divided. The
policy responsibilities of the Federal Reserve are
entrusted to the Board of Governors of the Federal
Reserve System, the Federal Reserve Banks, and
the Federal Open Market Committee.
VI R elation
of
R eserve B a n k in g
to
C u r r en c y . . .
89
The Federal Reserve pays out currency in response
to the public’s demand and absorbs redundant cur
rency. Its operations make the entire currency
supply elastic.
VII R elation
of
R eserve B a n k in g
to
G o l d ...........
97
Gold and Federal Reserve credit are the principal
sources of member bank reserves. Gold inflows
reduce reliance of banks on Federal Reserve credit
and gold outflows increase it. Changes in the
country’s monetary gold stock are reflected in
Federal Reserve holdings of gold certificates.
VIII T he B a n k R eserve E q u a t io n ....................................
107
Gold, currency movements, and changes in Federal
Reserve credit are the principal factors that influ
ence the volume of member bank reserves—the basis
of the bank credit and money supply. The inter
relationship among these and other less important
factors is sometimes called the bank reserve equa
tion.
EX I nfluence
of R eserve B a n k in g o n E conomic
S t a b i l i t y ...........................................................................
Federal Reserve influence on the flow of credit and
money affects the volume of lending, spending, and
saving in the economy generally. Reserve banking
policy thus contributes to stable economic progress.
x
120
CHAPTER
X
page
I nterest R ate C hanges
142
In a flexible credit market, tightness or ease is re
flected in changes in interest rates which are essential
to the mechanism of the market.
XI
F e d e r a l R ese rv e S e r v ic e F u n c t io n s
152
The Federal Reserve Banks handle the legal reserve
accounts of member banks, furnish currency for
circulation, facilitate the collection and clearance
of checks, and act as fiscal agents of the United
States Government. To guide System policy and to
inform the public, the Board of Governors and the
Reserve Banks analyze national and regional eco
nomic changes.
X II
S u p erv isio n o f B a n k s b y t h e F e d e r a l R e se r v e
165
By keeping individual banks strong, bank super
vision helps to maintain an adequate and responsive
banking system and thus contributes to the smooth
functioning of economic processes.
X III
B a la n c e S h e e t o f t h e F e d e r a l R ese rv e B a n k s
173
Federal Reserve functions are reflected in the bal
ance sheet of the Reserve Banks. Changes in credit
and monetary conditions may also be traced in
this record.
XIV
S um m ary .......................................................................
191
Experience over four decades shows that reserve
banking is of vital importance to the national
economy. Provision of bank reserves has come to
be the major Federal Reserve function.
F e d e r a l R ese rv e B o a r d P u b lic a t io n s .................
199
I ndex
201
xi
ILLU STRATIO NS
PAGE
M oney and Bank Credit, Mid-1953.....................................
5
Deposits and Bank Lending.................................................
25
Member Bank Reserves. .......................................................
29
System Holdings o f Discounts and Government
Securities........................................................................... 42
U nited States Government D e b t.........................................
45
M ap o f Federal Reserve System ..........................................
74
Disposition o f Reserve Bank Earnings...............................
76
Organization o f the Federal Reserve System.................... 82-83
Kinds o f Currency......................................................................
91
Currency in C irculation.........................................................
93
Changes in United States Gold S tock................................
105
Bank Reserve Equation..........................................................
108
Interest R ates...........................................................................
147
Checks Handled by Reserve B anks.....................................
157
Reserves o f Federal Reserve B anks....................................
184
xiii
CHAPTER I
F U N C T IO N O F T H E FED ER A L RESERVE SYSTEM. The
basic Junction o f the Federal Reserve System is to make possible a
Jlow o f credit and money that will foster orderly economic growth
and a stable dollar. An efficient monetary mechanism is indis
pensable to the steady development o f the nation’s resources and a
rising standard o f living.
N December 23, 1913, President Woodrow Wilson
signed the Federal Reserve Act establishing the
Federal Reserve System. Its original purposes, as expressed
by its founders, were to give the country an elastic currency,
to provide facilities for discounting commercial paper, and
to improve the supervision of banking. From the outset,
there was recognition that these original purposes were in
fact integral parts o f a broader objective, namely, to help
counteract inflationary and deflationary movements, and
to share in creating conditions favorable to sustained high
employment, stable values, growth of the country, and a
rising level of consumption. Acceptance of this broader
objective widened over the years and today it is generally
O
1
T H E FED ER A L RESERVE SYSTEM
understood to be the primary purpose of the System.
How is the Federal Reserve System related to produc
tion, employment, and the standard o f living? The answer
is that the Federal Reserve, through its influence on credit
and money, affects indirectly every phase of American
enterprise and every person in the United States. The
purpose of this book is to describe the ways in which the
Federal Reserve System exerts this influence.
Background o f the Federal Reserve System
Before establishment of the Federal Reserve System,
the credit and money supply was inelastic and did not
respond to the needs o f a growing economy. This resulted
in an irregular flow of credit and money and contributed
to unstable economic development.
Banks in smaller cities and rural regions maintained
balances with banks in larger cities, which they were
permitted to count as reserves. A large volume o f these
reserve balances was maintained in New York and
Chicago. Many banks, furthermore, as a matter of con
venience and custom and as a means of utilizing idle funds,
kept in the financial centers balances over and above their
required reserves. In New York, Chicago, and St. Louis,
designated as central reserve cities, national banks were
required to maintain all their legal reserves in the form of
cash in their own vaults.
Under these circumstances, when banks throughout the
country were pressed for funds by their depositors and
borrowers, the demand for credit converged on a few
banks situated in the financial centers. In ordinary times
the demand was not excessive, for while some out-of-town
banks would be drawing down their balances, others
2
F U N C T IO N O F T H E FE D E R A L RESERVE
would be building theirs up. But at times when business
was unusually active and the public was in need o f larger
amounts o f currency for hand-to-hand circulation, the
demand on city banks for funds became widespread and
intense. Each year credit demand was particularly strong
during the crop-moving season. At such times banks all
over the country would call on banks in the financial
centers to supply funds.
Because no facilities were available for providing ad
ditional funds, including currency, the credit situation
would become very tight. To meet the out-of-town de
mand for funds, the banks in the financial centers would
sell securities and call loans or would refuse to renew
existing loans or make new ones. As a result, security
prices would fall, loans would have to be liquidated,
borrowing from banks as well as other lenders would
become difficult, and interest rates would rise sharply.
Every few years, difficulties o f this kind would lead to a
monetary crisis.
The problem had been under public discussion and
study for a long time when, following a crisis o f unusual
severity in 1907, Congress appointed a National Monetary
Commission to determine what should be done. After
several years of thorough consideration, Congress eventu
ally adopted legislation embodying the results of study by
the Commission and by other authorities. This legislation
was the Federal Reserve Act. It became law on December
23, 1913 and provided machinery by which varying de
mands for credit and money by the public could be met.
All o f the principal nations have reserve banks, some
times called central banks, to perform functions corre
sponding to those of the Federal Reserve System. In Eng
3
T H E FE D E R A L RESERVE SYSTEM
land it is the Bank of England, which has been in existence
since the end of the seventeenth century; in France it is
the Bank o f France, established by Napoleon I; in Canada
it is the Bank of Canada, which began operations in 1935.
In the United States there is a regional system of twelve
Federal Reserve Banks. Their activities are coordinated
through the Board of Governors in Washington.
The principal function of the Federal Reserve is to
regulate the flow o f credit and money. Other important
functions include the performance of essential services for
the member banks of the Federal Reserve System, the
United States Government, and the public. These services
are chiefly the following: handling member bank reserve
accounts; furnishing currency for circulation and making
currency shipments; facilitating the clearance and collec
tion of checks; effecting telegraphic transfers of funds;
acting as fiscal agents, custodians, and depositaries for the
Treasury and other Governmental agencies; and collecting
and interpreting information bearing on the economic and
credit situation. In addition, the Federal Reserve examines
and supervises State member banks, obtains reports of
condition from them, and cooperates with other super
visory authorities in the development of policies conducive
to a system of strong individual banks.
Since the main concern of the Federal Reserve is the
flow of credit and money, this expression must be given
meaning at the outset. This can best be done by considering
the following four questions: (1) What is money and how
is it related to credit? (2) How do changes in credit and
monetary conditions affect the lives of the people? (3) By
what means does the Federal Reserve regulate credit and
money? (4) What is the credit market?
4
F U N C T IO N O F T H E FE D E R A L RESERVE
Money is most meaningfully defined in terms o f the
functions it performs. Its three main functions are: (1)
a means o f payment; (2 ) a store o f purchasing power; and
(3) a standard o f value. In the United States, circulating
MONEY AND BANK CREDIT* MID-1953
M O N EY - M EAN S O F PAYM ENT
TIME D E P O S IT S
I______________ I_______________ I
0
50
.,1_______________ I
100
Billions of Dollar*
paper money and coins o f all kinds and the demand de
posits held by banks perform all o f these functions.
That paper money and coins (currency) are money needs
no elaboration or explanation. The reason that demand
deposits are money is not far to seek. When a person has
$ 1 0 in his pocket and $ 1 0 0 in his checking account in the
5
T H E FE D E R A L RESERVE SYSTEM
bank he is in a position to spend $110 at any time. These
two forms of money represent his active cash balance;
they serve the same general purpose and they can be
converted into each other at any time; that is, currency
can be converted into a demand deposit by taking it to a
bank, and a demand deposit can be converted into cur
rency by taking it out o f a bank.
The amount o f currency and o f demand deposits at
mid-1953 is shown in the chart on page 5. It will be
seen that the amount o f demand deposits is far greater
than the amount of currency. Banks also hold savings and
other time deposits on which an interest return is paid.
The amount of such deposits held at commercial and
mutual savings banks at mid-1953 is also shown in the
chart.
All bank deposits are a form o f credit. Basically, they
represent amounts owed by banks to depositors. They
come into existence by an exchange of bank promises to
pay customers for the various assets which banks ac
quire—currency, promissory notes of business, consumer,
and other customers, mortgages on real estate, and Gov
ernment and other securities.
Demand deposits, however, differ importantly from
savings and other time deposits. Time deposits are not
transferable by check. While convertible into demand
deposits or currency, savings deposits are subject to prior
notice of conversion and other time deposits are not pay
able prior to maturity except in emergencies. Thus time
deposits, while serving a store-of-value function, are not
in themselves means of payment; only demand deposits
and currency serve in this active monetary role.
It has long been customary for people to keep most of
6
FU N C T IO N O F T H E FE D E R A L RESERVE
their money in banks and to make most o f their pay
ments by drawing checks on their demand deposits with
banks. Habits in this respect, however, change from
time to time. Sometimes people keep more of their money
in pocketbooks and sometimes less. Sometimes they hold
more o f their money in demand deposits and sometimes
less. Such changes in money habits can have important
consequences.
For a general idea o f money, the two kinds—pocket
money and demand deposit money—should be considered
together. For the most part, both kinds originate in bank
loans and bank investments. The Federal Reserve’s chief
task is to influence the flow of such credit by affecting its
general availability and cost to borrowers. Changes in the
loans and investments of banks are the major factor in
bringing about changes in the volume of demand deposits,
which are the bulk of the money supply.
How Credit and Monetary Changes Affect People
Superficially, it might seem that the more credit and
money people have the better off they are. In fact, however,
it is not the number of dollars available but what they will
buy that is important.
People have different tests of whether they have enough
money. To the manufacturer, the test is whether he has
or can borrow at a reasonable cost enough dollars to buy
his raw materials, pay the wages o f his employees, and
make other payments necessary to a profitable level of
operation and to a sustained strong credit position. The
farmer, the merchant, and the banker have similar tests.
To the consumer, the test is whether he has or can borrow
enough money on credit charges and repayment terms
7
T H E FE D E R A L RESERVE SYSTEM
that he can meet to buy what he needs. Essentially, how
ever, people are primarily concerned with what the dollars
they earn, are indebted for, or need to borrow, do for
them. The ultimate test, in other words, is the purchasing
power of the dollar.
In a dynamic and growing economy, enough credit and
money is that amount which will help to maintain high
and steadily rising levels o f production, employment, and
consumption, and to foster a stable value for the dollar.
When credit becomes unduly scarce or excessively hard
to get and costs too much, factories and stores may curtail
operations and lay off employees. Smaller payrolls mean
hardship for workers, who curtail their purchases; mer
chants feel the decline in trade and reduce their orders for
goods. Manufacturers in turn find it necessary to lay off
more workers. A serious depression, unemployment, and
distress may follow.
When credit is excessively abundant and cheap, the
reverse o f these developments—an inflationary boom—
may develop. An increase in the volume and flow of money
resulting from an increase in the supply and availability of
credit, coupled with a lowering of its cost, cannot in itself
add to the country’s output. If consumers have or can
borrow so much money that they try to buy more goods
than can be produced by plants running at capacity, this
spending only bids up prices and makes the same amount
of goods cost more. If merchants and others try to increase
their stocks so as to profit by the rise in prices, they bid
up prices further. Manufacturers may try to expand their
plants in order to produce more. In doing so, they will
bid up interest rates, wages, and the prices of construction
materials. In the end they raise their own costs.
8
FU N C T IO N O F T H E FE D E R A L RESERVE
The nation as a whole does not profit from conditions
of price inflation because production costs will sooner or
later rise as much as prices of finished products, and the
cost of living as much as wages. At some point the upward
spiral will break, perhaps because prices get so high that
consumers, even though many of them receive higher
wages, can no longer buy the goods produced. Then a
downward spiral will develop. The higher values have
previously risen, the more abruptly and lower they are
likely to fall and the greater will be the accompanying
unemployment and distress.
These are the ways in which excessive changes in credit
and money can affect the lives o f the people. The story,
although oversimplified in that it does not include all the
factors that affect the level of economic activity, serves to
show what may happen if, on the one hand, credit is too
scarce or hard to get and too dear, or if, on the other
hand, it is too plentiful or easily obtainable and too cheap.
It is by influencing the flow o f credit, with resulting effects
on the flow o f money, that the Federal Reserve influences
the economic decisions that people make.
How the Federal Reserve Influences Credit and Money
This is the principal subject of this book and the main
points should be stated briefly at the outset. Practically all
of the money people use reaches them, directly or indirect
ly, through the banks. They may receive their pay in cash,
but the employer who pays them will have cashed a check
at the bank and may have borrowed from a bank before
making up his payroll. Therefore the flow o f money in the
country depends mainly on the ability of banks to meet
the credit and monetary requirements o f industry, trade,
9
T H E FE D E R A L RESERVE SYSTEM
agriculture, and all the other sectors of economic life.
The ability o f banks to meet the credit and monetary
needs of the people depends on the amount of reserves
the banks have. This in turn is affected by Federal Reserve
operations. Banks can extend credit to customers or invest
money in securities only in proportion to the reserves at
their disposal. The way the system o f reserves works, and
the fact that under it the banks can lend in the aggregate
several times as much as they have in reserves, will be
discussed later. What needs to be understood first is that
the Federal Reserve, through influencing the availability
and cost o f additional bank reserves, can influence the
amount o f credit the banks may extend to the public
through loans and investments, and thus influence the
total flow o f credit and money. The reserve position of
banks affects directly the willingness o f banks to extend
credit and the cost, or rate o f interest, which borrowers
will have to pay to obtain it. The Federal Reserve thus
has the power to influence the country’s credit situation
and, since bank loans and investments are the main assets
that serve as backing for deposits, its money supply.
A great variety of other forces also affect the credit and
money flow. These include, among others, governmental
policies in regard to expenditures, taxes, and debt; the
distribution o f income among different groups of the
population; the bargaining strength and policies of man
agement, labor, agriculture, and other sectors o f the
economy; the course o f foreign trade and foreign invest
ment; and the prospects for peace or war.
Thus the Federal Reserve alone cannot assure favorable
economic conditions nor can it direct whether credit shall
flow into particular channels. But it can affect the general
10
F U N C T IO N O F T H E FED ER A L RESERVE
flow o f credit and money as economic conditions change
and thus help to counteract instability resulting from
other forces. The supply of credit and money, and the
incentives to use credit and money, which the Federal
Reserve does influence, are indispensable factors in mod
em economic life.
What Is the Credit Market?
Federal Reserve influence is exerted primarily through
the credit market. Unlike the organized stock or commod
ity markets, the credit market has no formal organization
or specific place of business. As a matter of fact, modern
means of communication make the country practically one
national credit market in the financing of large trans
actions. Well-established borrowers with high credit
ratings can obtain bank or other loans on much the same
conditions in one city as in another; for if lendable funds
are scarce and costly in one center, the supply tends to be
replenished from other centers where it is more abundant.
Relatively small transactions originating from local needs
and represented by loans based on close contact with local
conditions are handled by the many regional credit mar
kets. The rates of interest charged and other conditions
in these local markets may vary somewhat from place to
place, but they are, nonetheless, related to one another.
Contacts of these local markets with the national mar
ket, and thus with one another, are maintained in part
through balances kept by local banks with city correspond
ents. They are also facilitated through direct credit
contacts between city banks and large out-of-town busi
nesses; through a network of brokerage and other local
contacts with the large regional and national savings
11
T H E FE D E R A L RESERVE SYSTEM
institutions; through the relationships between local
dealers in investment securities and the underwriting
houses and stock exchange members of the financial
* centers; and through the mechanism of the Federal
Reserve System. Funds from the local markets are likely
to flow in and out of the financial centers with changes
in local demand for credit.
Through this flow of funds, banks in all parts of the
country, as well as other financial institutions, are in
constant contact with the national market. The movement
of funds between the local markets and the national mar
ket is no longer disruptive, as it frequently was before the
organization o f the Federal Reserve System. The Reserve
Banks can supply additional funds to the market if nec
essary or can absorb redundant funds.
Loan and investment transactions, as indicated, take
place through banks and other financing institutions, but
the market comprises the customers of banks and these
related financing institutions as well as the lending insti
tutions themselves. For instance, when the United States
Treasury borrows by selling its obligations in the credit
market, the lenders—that is, the buyers of the obligations
—include insurance companies, investment trusts, other
institutional investors, and individuals, as well as banks.
The obligations in which the credit market deals vary
widely as to risk and maturity. Obligations that are low
in risk—for example, short-term Government securities
and prime short-term business paper—are highly liquid
financial instruments, being very close to cash in hand,
and typically bear the lowest interest yields. The sector of
the market which specializes in such paper is commonly
called the money market. The fact that prime short-term
12
FU N C T IO N O F T H E FE D E R A L RESERVE
paper is used as a principal medium for temporary invest
ment by banks, other financial institutions, and business
corporations, and is handled by a special group of dealers,
gives the money market proper a distinctive character.
New York City, being the principal financial center in the
United States, is the heart of the American credit and
money market.
As in any other kind of market, demand sometimes
exceeds supply in the credit market, and supply sometimes
exceeds demand. As a result, interest rates rise and fall in
response to changes in demand and supply. It is the re
sponsibility of the reserve banking authorities to watch
the market, to help correct disorderly market conditions
should they develop, and generally to foster an orderly
flow of credit and money. Of the measures described in
later chapters as available to the reserve banking author
ities, those with the most pervasive influence on the credit
market are the ones that operate through the medium of
bank reserves.
Federal Reserve actions affecting the credit market are
directed for the most part to the functioning of banks.
Such actions influence the market as a whole, however,
since they affect the availability of funds to other lending
institutions, their attitude toward prospective borrowers,
and their appraisal of investments. The attitude of lenders
toward loan and investment opportunities is sometimes
referred to as the tone of the market. When bank reserve
funds are more readily available, banks lend and invest
more freely, as do also other financial institutions; and the
tone o f the market is easy. When bank reserve funds are
less readily available, the opposite situation prevails and
the tone of the market is tight.
13
CHAPTER II
F U N C T IO N O F BANK RESERVES. In performing its basic
function, the Federal Reserve depends chiefly on its ability to in
crease or decrease the availability, cost, and volume o f bank re
serves, which constitute the legally required basis o f bank deposits.
Changes in the reserve position o f banks affect directly the flo w o f
bank credit and money.
OMMERCIAL banks, like other business organiza
tions but unlike the Federal Reserve Banks, are in
business for the purpose of making a profit. The bulk
of a commercial bank’s earnings comes from returns it
receives from loans to customers and holdings of securities.
Consequently, it is usually a bank’s policy to put into loans
and investments as much as possible of the money it re
ceives as capital and deposits. Banks in practically all
States, however, are required by law to hold as reserves
an amount of uninvested funds equal to a designated
portion of their deposits.
Historically, reserve requirements were imposed by law
for the purpose of protecting depositors—to assure that
C
14
FU N C T IO N O F B A N K RESERVES
banks maintained a cash fund adequate to meet their
depositors’ withdrawals. This was before establishment of
the Federal Reserve System, when there was no reserve
bank from which a commercial bank could obtain addi
tional reserves in time of temporary need. Reserve require
ments, although they restrained credit expansion, did not
effectively protect depositors during periods of stress, for
the banks could not pay out to their depositors the cash
they were required to keep as reserves without drawing
down such reserves below legal requirements and threat
ening the ability of the banks to continue active operations.
Since other ways of protecting depositors have been
developed, bank reserves have come to be considered
primarily a medium through which the flow of credit and
money is influenced. It is because the Federal Reserve can
regulate the volume of reserves available to banks that it
can influence the availability, cost, and supply of credit.
Member Bank Reserve Requirements
If a bank is a member of the Federal Reserve System, it
is required at the present time (December 1953) to keep
as reserves, on deposit with a Federal Reserve Bank, the
following percentages of its demand deposits:
Central reserve city b anks......................................
Reserve city banks...................................................
Other member banks...............................................
22
19
13
Banks that are not members of the Federal Reserve
System are subject to reserve requirements that vary from
State to State.
The operation of bank reserves, which are the basis of
the money system, is described below in general and
15
T H E FED ER A L RESERVE SYSTEM
simplified form assuming a 2 0 per cent reserve required
against demand deposits. The 20 per cent reserve require
ment assumed is higher than the average of the three
percentages given above and is also somewhat above the
present ratio of total required reserves to total demand
deposits. The 20 per cent figure is used, however, for the
sake of simplicity in explaining the operation of reserves.
On this basis, when a member bank receives a demand
deposit of $ 100 , in currency or in the form of a check on
another bank, it must deposit $20 with a Federal Reserve
Bank as required reserves against the deposit and is free
to lend or invest the remaining $80. If there is an adequate
demand for loans from customers or a supply of suitable
securities in the market, the bank will lend or invest prac
tically all of the $80. It will retain a little of the $80
inasmuch as it needs some cash in its till to meet day-to-day
needs of customers for cash. The amount retained can be
relatively small because currency can always be obtained
promptly from its Reserve Bank. For purposes of simpli
fied exposition, therefore, it may be assumed that all of
the money above the required 20 per cent is lent or
invested by the bank.
How the Banking System Works
It is on the relationship between bank reserves and bank
lending and investing that the Federal Reserve depends
chiefly in exercising its credit and monetary functions.
Ways in which the Federal Reserve influences the amount
of bank reserves will be described in the next chapter. The
present chapter explains how changes in bank reserves
against demand deposits affect the flow of credit and
money.
16
FU N C T IO N O F BAN K RESERVES
For the purpose of simplifying the operation of the
banking system, let us imagine that there is only one
commercial bank in the United States, that it is the sole
member bank in the Federal Reserve System, and that all
the people keep their demand deposits with this bank and
go there to obtain all their bank loans. Let us give the
member bank enough resources to represent all the banks
in the country. Let us assume that the relevant items in
its balance sheet are as follows (in billions of dollars):
Loans and investments............................................ 80
Reserves with the Federal Reserve........................ 20
Demand deposits..................................................... 100
Ratio o f reserves to demand deposits.......... 20 per cent
Let us further assume that this 20 per cent ratio of
reserves to demand deposits is the legal minimum. Under
the circumstances, the bank would not be in a position to
make any additional loans or investments. Its funds would
be in use up to the limit permitted by law.
Now let us assume that the Federal Reserve believes
that additional loans are desirable to meet the credit needs
of the country and that its actions add 10 billion dollars
to the member bank’s reserves in a manner that also in
creases the bank’s demand deposits by the same amount.
Then the simplified balance sheet of the bank would be
(in billions of dollars):
Loans and investments............................................ 80
Reserves.................................................................... 30
Demand deposits..................................................... 110
Ratio o f reserves to demand deposits . . . .27.3 per cent
The member bank would have a higher ratio of reserves
to deposits (27.3 per cent) than is required by law (20 per
17
T H E FE D E R A L RESERVE SYSTEM
cent). Therefore, it could make additional loans and in
vestments. A little figuring will show that the bank has
the 22 billion dollars of reserves required for its deposits
of 110 billion and also has 8 billion of reserves above
requirements, or excess reserves.
Let us assume that the public is eager to get additional
money and wants to borrow as much as the member bank
will lend. Let us assume also that the proceeds of the loans
will be kept on deposit with the bank. This is not a far
fetched assumption, because borrowers most likely want
the money in order to pay other depositors in the bank.
While there will be transfers from one deposit account to
another, no deposits will be withdrawn from the bank,
and the total of deposits will remain at the higher level
made possible by the increase in reserves.
Another calculation will show that on the basis of the
8 billion dollars of excess reserves the member bank can
add 40 billion to its loans and investments. The bank’s
balance sheet would then be (in billions of dollars):
Loans and investments.......................................... 120
Reserves.................................................................. 30
Demand deposits................................................... 150
Ratio o f reserves to demand deposits.......... 20 per cent
This overly simplified picture of bank transactions indi
cates that a deposit of 10 billion dollars of reserve money
with the member bank gave rise to a growth of 40 billion
in loans and investments and of 50 billion in demand
deposits. The calculation, which leaves out of account
many complications, shows what a powerful instrument
reserve banking action can be. It can provide the basis for
an increase in the money supply not merely by the amount
18
FU N C T IO N O F B A N K RESERVES
that it adds to the bank’s reserves, but by about five times
that amount. This is true because there can be a multiple
expansion of demand deposits on the basis of the addi
tional reserves.
Consider the course o f events in case there is too much
money and it is decided that the amount should be
diminished. Suppose that Federal Reserve action reduces
the 20 billion dollars of reserves the member bank had in
the first place by 5 billion, at the same time lowering
deposits by an equal amount. The balance sheet would
then read (in billions of dollars):
Loans and investments..........................................
Reserves..................................................................
Demand deposits...................................................
80
15
95
Ratio o f reserves to demand deposits.. . .15.8 per cent
On the basis of a 20 per cent legal reserve requirement,
the member bank would be deficient in reserves to the
extent of 4 billion dollars. The bank would have to call
loans or sell investments, and thus absorb deposits to the
extent o f five times its deficiency in reserves, that is, by
20 billion dollars. If its depositors repaid loans or re
purchased 20 billion dollars of investments by drawing on
their deposits, the result would be (in billions of dollars):
Loans and investments..........................................
Reserves..................................................................
Demand deposits...................................................
60
15
75
Ratio o f reserves to demand deposits.......... 20 per cent
Once more we see the powerful impact of reserve
banking action, this time in the direction of contraction.
A reduction o f 5 billion dollars in the member bank’s
reserves can bring about a liquidation of 20 billion in
19
T H E FED ER A L RESERVE SYSTEM
loans and investments and a reduction of 25 billion in
demand deposits, or money.
The all-important fact brought out by this discussion
is that the Federal Reserve, by adding to or extinguishing
the member bank’s reserves, can influence it to increase
or decrease its loans and its demand deposits by several
times the amount added or extinguished. It is because of
this fact that Federal Reserve dollars are often called
“high-powered” dollars as compared with ordinary de
posit dollars.
In the exposition so far we have considered one member
bank, large enough to represent all the banks in the
country, as doing all the banking business. We have
assumed that the bank will lend or invest as much money
as the law will permit, and that this action results in the
creation of an equal amount o f demand deposits. We have
also assumed a uniform reserve requirement of 20 per
cent, and we have assumed that all the money lent by the
bank will be kept on demand deposit.
To the extent that the public chooses to withdraw some
of the money in currency or to transfer some of the money
to savings or other time deposits, this will not be the case.
The changes that occur from time to time in the public’s
demand for currency will be described in a later chapter.
For this chapter, the main point is that the people’s de
mand for currency is related to the total money supply
(demand deposits and currency) held by the public, and
that it represents merely the share of the money supply
that the public desires to hold in the form of currency.
Currency and demand deposits are interchangeable at the
option of the public; the major factor increasing or de
creasing the money supply is the loans and investments of
20
FU N C T IO N O F B AN K RESERVES
commercial banks. It should be noted, however, that
currency withdrawals from banks reduce bank reserves
dollar for dollar and that such withdrawals affect the
expansion potential of a given volume of new reserves.
The transfer of funds from a demand to a savings or
other time deposit reflects the preference of the depositor
for an asset which earns interest rather than an asset which
earns no return but has immediate usefulness as a means
of payment. A time deposit cannot have checks drawn
against it and its conversion into cash is subject to limi
tations.
Commercial banks in this country have both demand
and time deposits and their loans, investments, and
reserves form a common pool of assets backing the
two kinds o f deposits. Whereas member banks must
at present keep average reserves of about 18 per cent
of their demand deposits, they are required to keep only
6 per cent against savings and other time deposits. If
holders of demand deposits transfer them to time deposits
as temporary or semipermanent saving, there is a release
of reserves—the difference between 18 per cent and 6 per
cent—on the basis o f which the bank can expand its loans
and investments and its demand deposits. Conversely, if
holders of time deposits shift them into demand deposits,
the bank finds it necessary to reduce its holdings of loans
and investments or otherwise obtain additional reserves
in order to meet the higher reserve requirements against
demand deposits.
Multiplying Power o f Bank Reserves
The process of reserve operation in the imaginary sit
uation in which one member bank does all the banking
21
T H E FED ER A L RESERVE SYSTEM
business may now be transferred to the actual and more
complex situation in which thousands o f member banks
make loans and investments and hold deposits.
It has been seen that our consolidated bank can expand
its loans and investments by as much as 40 billion dollars
if Federal Reserve action adds 10 billion to its reserves.
No individual bank can do that because borrowers may
wish to take the money out of the lending bank. In fact,
a borrower is likely to use the demand deposit created by
his loan to write checks to pay various people. His banker
cannot assume that the funds thus paid out will return in
the form of deposits in his bank. Consequently, he does
not lend more than he has in reserve funds in excess of
requirements; if he did, he might not be able to honor the
checks of his other depositors. How, then, can the banking
system—that is, all the banks together—lend about four
times as much as is obtained from the Federal Reserve?
What appears to be paradoxical is really simple and
understandable. When a member bank receives a deposit
of $100, in currency or in the form of a check on another
bank, it must, holding to our earlier assumption of a 20
per cent reserve requirement, deposit $20 with a Reserve
Bank as required reserves. It is free to lend or invest the
remaining $80. In practice, as explained earlier, the bank
will keep a little more than the $20 because it will need
ready till cash to meet demands of depositors.
The fact that individual member banks are required to
hold only a fraction of their deposits as reserves makes it
possible for additional reserve funds, as they are deposited
and invested through the banking system as a whole, to
generate deposits on a multiple basis. The table illustrates
how deposit balances are built up as reserve funds are
22
FU N C TIO N O F BANK RESERVES
diffused throughout the banking system. The process may
be sketched as follows: A member bank at which $100 is
deposited needs to hold $20 in reserves at the Reserve
Bank. The remaining $80 can be lent. This money may be
paid out at once by the borrower to someone who deposits
T he M ultiplying C apacity of R eserve M oney
I n B a n k T ransactions 1
Transactions
Bank
Amount
deposited
in checking
accounts
Amount
lent
Amount set aside
as reserves on
deposit at
Reserve Banks
1........................
2 ........................
3 ........................
4 ........................
5 ........................
$100.00
80.00
64.00
51.20
40.96
$ 80.00
64.00
51.20
40.96
32.77
$ 20.00
16.00
12.80
10.24
8.19
6 ........................
7 ........................
8 ........................
9 ........................
10........................
32.77
26.22
20.98
16.78
13.42
26.22
20.98
16.78
13.42
10.74
6.55
5.24
4.20
3.36
2.68
11........................
12........................
13........................
14........................
15........................
10.74
8.59
6.87
5.50
4.40
8.59
6.87
5.50
4.40
3.52
2.15
1.72
1.37
1.10
.88
16........................
17........................
18........................
19........................
20........................
3.52
2.82
2.26
1.81
1.45
2.82
2.26
1.81
1.45
1.16
.70
.56
.45
.36
.29
Total for 20 banks..
$494.29
$395.45
$ 98.84
Additional banks.........
5.71
2 4.55
2 1.16
Grand total, all banks
$500.00
$400.00
$100.00
1 Assuming an average member bank reserve requirement of 20 per
cent of demand deposits.
2 Adjusted to offset rounding in preceding figures.
T H E FE D E R A L RESERVE SYSTEM
it at another bank. The second bank needs to hold $16
as reserve against the new deposit o f $80 and can lend
the remaining $64. Similarly, the borrower here may
draw down the newly created deposit at once, but the
funds will merely be shifted to a third bank, which in turn
can lend 80 per cent of $64 and add $51.20 to its deposits.
This sequence can be traced through many banks until
$500 of demand deposits have grown out of the original
$100 deposit. On the asset side of their books, the banks
hold $100 in reserves (20 per cent of $500) and $400 in
loan or investment paper.
A further point needs clarification. While in the prac
tical workings of the banking system the bulk of deposits
originates in the granting of loans or the purchase of
investments by banks, the day-to-day experience o f each
individual banker is that deposits are brought to him by
his customers, and his ability to make loans and invest
ments arises largely from the receipt of his depositors’
money. This is another apparent banking paradox which
causes much confusion.
The fact is that demand deposits originating in loans
and investments move from one bank to another in the
course o f business and seldom stay with the bank of
origin. The series of transactions is as follows: When a
bank makes a loan it credits the amount to the borrower’s
deposit account; the depositor writes checks against it in
favor of various people who deposit them at their banks.
Thus the lending bank is likely to retain or receive as
deposits only a small portion of the money it lends, while
a portion of the money lent by other banks is brought to
it by its customers. Therefore, taking the banking system
as a whole, deposits originate in bank loans and invest
24
FUNCTION OF BANK RESERVES
ments, but each individual bank’s ability to lend or invest
arises largely from deposits brought to it by its customers.
How the process has worked out over the years is depicted
by the chart.1
1 The curve “Deposits and Currency” relates to the public’s holdings
of demand deposits, time deposits, and currency. Time deposits are
included in this curve because commercial banks in this country generally
engage in both a time deposit and a demand deposit business and do not
segregate their loans and investments behind the two types of deposits.
Since mutual savings banks are also im portant time deposit institutions,
their time deposits and loans and investments are also included for
consistency in the two curves shown on the chart. Time deposits of
commercial banks are generally subject to some reserve requirements,
while those of mutual savings banks are not.
25
T H E FE D E R A L RESERVE SYSTEM
Some Important Observations
Sometimes it is said that, since the banking system can
lend several times as much as it obtains in reserves, indi
vidual banks create money by a stroke o f the pen, but as
the preceding description indicates, this is not correct. An
individual bank can lend or invest only on the basis of
money provided by its stockholders, its depositors, or its
borrowing, and the maximum it can lend or invest is the
excess over what it must hold as reserves. Only the Federal
Reserve has the power to create (or extinguish) the money
which serves as the reserves of banks. New reserve money,
after it leaves the hands of the first bank acquiring it,
continues to expand into deposit money as it passes from
bank to bank until deposits stand in some established
multiple relation to the additional reserve funds.
Three additional points about the functioning of the
banking system are worth noting at this stage. The first
is that bank credit and monetary expansion on the basis
of newly acquired reserves takes place only through a
series of transactions. This takes time and thus delays the
multiplying effect of new bank reserves.
The second point is that for expansion to take place at
all there must be a demand for bank credit by credit
worthy borrowers—those whose financial standing is such
as to entail a likelihood that the loan will be repaid at
maturity—and/or an available supply of low-risk invest
ment securities such as would be appropriate for banks to
purchase. Normally, these conditions prevail, but there
are times when demand is slack and eligible loans or
securities are in short supply. Also, market conditions for
bankable paper and attitudes of bankers with respect to
the market exert an important influence on whether, with
26
F U N C T IO N O F B AN K RESERVES
a given addition to the volume of bank reserves, expansion
o f bank credit is faster or slower.
Thirdly, it must be kept in mind that reserve banking
power to create or extinguish high-powered money is
exercised through a market mechanism. The Federal Re
serve may assume the initiative in creating or extinguishing
bank reserve money, or the initiative may be taken by the
member banks through borrowing or repayment of
borrowing at the Federal Reserve. With respect to mem
ber bank borrowing, reserve banking authority is expressed
principally through the cost of the borrowed reserve funds.
At times the forces of initiative may work against one
another, and the effect of this counteraction is mainly to
avoid an abrupt impact on the flow of credit and money
of pressures working to expand or contract the volume of
bank reserves. This interrelation between reserve banking
initiative and member bank initiative in changing the vol
ume of Federal Reserve credit will be discussed further in
the succeeding chapter.
Aside from these qualifications, what is significant from
the standpoint of reserve banking operations is that the
issuance of a given amount of high-powered money by
the Federal Reserve may generate a volume of ordinary
money which is several times as large as the amount issued,
and that, on the other hand, Federal Reserve extinguish
ment of a given amount of high-powered money may
result in a reduction of several times that amount in loans
and investments and in demand deposits, that is, in ordi
nary money. It is this leverage which enables Federal
Reserve action to bring about large changes in the flow
of credit and money by undertaking relatively small
operations.
27
T H E FE D E R A L RESERVE SYSTEM
Management o f Reserve Balances
The foregoing discussion sets forth the general principles
on which the banking system operates. In practice an indi
vidual bank does not match one transaction against
another. There is a continuous flow of funds into the
bank from its depositors, who bring checks on other banks
as well as currency to be added to their deposits. And
there is a continuous outflow of funds as borrowers and
other depositors write checks on their own accounts or
cash checks drawn on other banks. The bank must con
stantly watch its deposits and its reserve position, which
is the net result of all the transactions in the bank, to make
sure that its reserves are sufficient to comply with legal
requirements.
While a member bank must watch its reserve balance
with the Federal Reserve Bank to make sure that it is
large enough, this does not mean that the balance remains
unused. Under Federal Reserve rules, reserve requirements
are related to reserve balances maintained on the average
over a period (a week for central reserve and reserve city
banks and half a month for other member banks). While
maintaining its average reserve balance at or above the
required minimum, a bank may make constant use of its
reserve account. Through this account the bank can not
only settle adverse clearings balances with other banks but
can also transfer funds to other cities. A member bank
uses its reserve account with the Federal Reserve Bank in
much the same way that a depositor uses his checking
account. It must be careful, however, to see that over the
reserve period the account averages at or above the
amount required in relation to its deposits. The occasion
28
FUNCTION OF BANK RESERVES
to borrow from a Federal Reserve Bank usually arises
from the need to replenish reserves when they have fallen
below the required level.
A t the beginning of this chapter, it was stated that banks
as business organizations endeavor to use all their avail
able funds in profitable ways and keep as reserves only the
m inimum required by law. During the greater part of the
life of the Federal Reserve, member banks have put
practically all their funds to use and have had practically
no excess reserves. During the middle and late 1930’s and
29
T H E FE D E R A L RESERVE SYSTEM
the early part of World War II, however, this was not the
case, as is brought out in the chart on page 29.
After the early 1930’s there was a large movement of
gold into the country which greatly increased the reserves
of member banks. At the same time there was only a
limited demand for loans acceptable to banks at current
interest rates, and a limited supply of investment securities
that bankers desired to acquire at interest rates prevailing
in the market. Consequently, the banks had an excessive
volume of unused reserves. As credit expanded during and
after World War II, as currency demand increased, and as
reserve requirements were increased in a manner described
in the next chapter, the greater part of the excess reserves
was absorbed. In recent years excess reserves have once
again constituted a relatively small proportion of total
reserves, although a larger proportion than in the 1920’s.
30
CHAPTER III
G EN ERA L M E T H O D S O F R E G U L A T IO N . The principal
reserve banking methods o f regulating bank reserves are discounts
for member banks, purchases and sales o f Government securities in
the open market, and changes in reserve requirements. The source
o f Federal Reserve lending power is the gold certificate reserves o f
the Reserve Banks.
I
T has been shown how changes in bank reserves
influence the volume of bank credit and money. Since
banks as a group can expand the country’s money supply
by a multiple of any addition to their reserves, and must
cut back their participation in the credit market by a
multiple of any reduction in their reserves, Federal Reserve
operations to create or extinguish reserves exert a powerful
influence on the flow o f credit and money. This influence
is exercised by three methods, which this chapter will
describe.
These methods are discount operations, open market
operations, and changes in reserve requirements. The first
two are generally more flexible and more adaptable to
31
T H E FED ER A L RESERVE SYSTEM
*
day-to-day changes in credit and monetary conditions than
the third. The timing of the use of all three methods and
their coordination are of cardinal importance in Federal
Reserve policy.
D is c o u n t O p e r a t io n s
To a commercial bank, one o f the most important
advantages of Federal Reserve membership is the privilege
of obtaining additional reserves on occasion by borrowing
from a Federal Reserve Bank. In effecting such borrowing,
a member bank may rediscount one or more of its cus
tomers’ notes with a Reserve Bank, or it may give its own
note to a Reserve Bank, using paper from its own holdings
as collateral. The second procedure, known as an advance,
differs from the first in form but not in substance. In
either case the Reserve Bank gives the member bank credit
in its reserve account for the amount of the accommoda
tion and thereby increases the reserve deposit which the
member bank holds at the Federal Reserve Bank. For this
service the Reserve Bank charges interest at a rate known
as the discount rate.
Eligible Paper
For the first two decades of the System’s existence,
Federal Reserve Bank authority to extend credit was con
fined to advances collateraled by obligations of the United
States and to discounts of or advances on so-called
“eligible paper.” Eligible paper includes commercial paper
representing loans of limited maturities to meet the current
needs of commerce, industry, or agriculture but excludes
loans made for investment or speculative purposes. It was
thought by the System’s founders that this limitation of
32
G EN ER A L M ETHO DS O F R E G U LA T IO N
Federal Reserve lending authority would act as an auto
matic brake on overexpansion of bank credit and money.
Experience showed that such restrictions on the types
of paper eligible for discount did not in fact prevent an
overexpansion of bank credit and money in periods of
business boom when eligible paper was plentiful. Con
versely, the restrictions tended to hinder adequate assist
ance by the Federal Reserve to member banks in time of
business recession, particularly severe recession, when
eligible paper was scarce. Consequently, in 1932 the law
was broadened to authorize a Federal Reserve Bank to
make advances to member banks on notes secured by any
collateral satisfactory to the Reserve Bank. If the collateral
does not meet the requirements of eligible paper as pre
scribed by law, however, the Reserve Bank must charge
an extra one-half per cent or more of interest.
Because of the higher discount rate on other than
eligible paper, member banks usually borrow on eligible
paper. The paper pledged is typically of prime quality and
very short maturity; today it is usually short-term Govern
ment securities. Accordingly, member banks commonly
maintain, as a second line of reserves, a portfolio of prime
short-term paper, which is readily discountable or salable.
The secondary reserve is a means of replenishing transitory
reductions in a member bank’s reserve balance.
Reserve Bank Discount Standards
When a member bank applies for accommodation, a
Federal Reserve Bank is under no automatic obligation to
grant the credit; its decision is expected to rest on its
judgment concerning the applicant’s need and the use to
be made of the additional funds. In the language of the
33
T H E FE D E R A L RESERVE SYSTEM
law: “Each Federal Reserve Bank shall keep itself in
formed of the general character and amount of the loans
and investments of its member banks with a view to
ascertaining whether undue use is being made of bank
credit for the speculative carrying of or trading in secu
rities, real estate, or commodities, or for any other purpose
inconsistent with the maintenance of sound credit con
ditions; and, in determining whether to grant or refuse
advances, rediscounts or other credit accommodations,
the Federal Reserve Bank shall give consideration to such
information.”
To meet bona fide needs, a member bank with satis
factory collateral can obtain accommodation from a
Federal Reserve Bank. The Reserve Bank may stipulate,
however, that the borrowing be for a short time only. An
advance from the Federal Reserve has always been con
sidered a resource available to member banks to meet
temporary requirements or unusual banking situations
rather than a resource to meet continuous operating needs
or to substitute for new bank capital. Since the Federal
Reserve System has a responsibility for furthering the
maintenance of sound credit conditions in the nation and
for providing an ultimate source of liquidity for the entire
banking system, it is the duty of each Federal Reserve
Bank to examine carefully individual cases of member
bank borrowing.
Member Bank Reluctance to Borrow
In coping with emergency banking developments, mem
ber banks properly feel free to rely on full use of Federal
Reserve lending facilities to meet unusual cash drains
which they may experience. Under normal banking
34
G E N E R A L M ETHO DS O F R EG U LA T IO N
conditions, however, member banks generally are reluc
tant to borrow from a Federal Reserve Bank, or to stay
long in its debt. Special circumstances may at times
weaken this reluctance, but it nonetheless persists as a
force affecting member bank borrowing.
In part member banks’ reluctance to borrow results
from the disposition o f depositors, especially business and
financial depositors, to be critical o f borrowing on the
part of individual banks. Another consideration is a purely
operating one, namely, that borrowed funds are more
expensive than funds obtained through deposits, and
usually cost a bank as much as, or more than, it would
give up in earnings through the sale of some o f its holdings
of prime short-term paper.
In general, it is a well-established rule of prudence for
member bank operations that, under normal conditions,
borrowing from the Federal Reserve Banks should be to
replenish reserves when, in meeting temporary banking
needs, they have fallen below current legal requirements.
Accordingly, when member banks are obliged to borrow,
they feel under pressure to restrict their lending or to re
adjust their investment positions in order to pay off such
indebtedness as soon as possible.
Discount Rate Practice
The policy of the Federal Reserve with respect to mem
ber bank borrowing expresses itself not only in granting
or discouraging loans but also in the rate charged for
discounts and advances. This rate is ordinarily maintained
at a level that imposes some penalty cost on the borrowing
bank. As a general rule, when the Federal Reserve is of
the opinion that expansion in the flow of credit and money
35
T H E FE D E R A L RESERVE SYSTEM
should be encouraged in the public interest, it reduces its
discount rate in relation to prevailing market rates. When
it believes that expansion should be checked, it raises the
discount rate in relation to these rates.
To the business community, the discount rate in effect
at the Federal Reserve Banks, and particularly a change
in this rate, serves as an objective index of Federal Reserve
policy. An advance in the rate is commonly interpreted to
mean that in Federal Reserve opinion there is danger of
too rapid a pace of bank credit and monetary expansion,
and a reduction in the rate to indicate that encouragement
of expansion is in the public interest. The discount rate
thus not only represents the cost to member banks of
accommodation at the Federal Reserve Banks but also
conveys to the public Federal Reserve judgment as to
whether the current flow of credit and money is consistent
with the country’s transactions and liquidity needs.
Federal Funds Market
Member banks in temporary need of reserve funds may
borrow from other member banks. Such borrowing, when
it can be arranged, usually occurs at interest rates below
the Federal Reserve Bank discount rate. There is a fairly
well-organized market, known as the Federal funds mar
ket, in which member banks that hold reserve balances in
excess of legal requirements offer to lend them on a dayto-day basis. The supply of funds in this market varies
with general credit conditions. When funds are available
from other banks in the Federal funds market, the use of
the discount privilege by member banks is reduced.
Effect o f Discounts on Credit Conditions
Experience has demonstrated that the pace of bank
36
G EN E R A L M ETHO DS O F R EG U LA T IO N
credit expansion and in fact the tone of the whole credit
market reflects the extent to which member banks are
borrowing at Federal Reserve Banks. Changes in the
volume of borrowing normally represent the first response
of member banks as a group to losses or gains of reserve
funds or to changes in the pressure of bank credit expan
sion on the available supply of bank reserves. When such
borrowing is low, bank credit expansion tends to be
encouraged and the tone of the credit market is easy. An
easy market may be described as one in which funds tend
to be readily available at going interest rates to all borrow
ers who are acceptable credit risks. When member banks
are heavily in debt to the Federal Reserve Banks, bank
credit expansion tends to be discouraged and the tone of
the credit market is tight. In a tight market, the less credit
worthy loans are subject to deferment, and even better
credit risks may have to shop around for accommodation.
These responses tend to be independent to some extent
o f the level of the discount rate or of interest rates gen
erally. For example, the tone of the credit market might
be easy even though the discount rate were 4 per cent.
This would happen where member bank borrowing was
low. Conversely, the tone of the market might be tight
even when the discount rate was 1% per cent. This would
occur when member banks were heavily in debt.
Experience with Discount Operations
In important periods since establishment of the Federal
Reserve System, discount operations have been a principal
method of expressing Federal Reserve policy with respect
to expansion of bank credit and the money supply. In
some periods, however, as the result of an inflow of gold
37
T H E FE D E R A L RESERVE SYSTEM
from abroad that gave member banks additional reserves
without recourse to borrowing from the Reserve Banks,
and in other periods as the result o f wartime developments,
discounts for member banks have been small and discount
operations have been of minor importance in Federal
Reserve policy. During periods when discount operations
have been effective, their effectiveness has been closely
related to the complementary use of open market opera
tions. This relationship is dealt with in the following dis
cussion of open market operations.
O p e n M a r k e t O p e r a t io n s
As a method of influencing the flow o f credit and money,
open market operations differ significantly from discount
operations in that they are initiated by the Federal Reserve,
not by the member banks. In the case of discounts, the
Federal Reserve establishes a discount rate at which mem
ber banks may obtain Reserve Bank credit for appropriate
uses if they apply for it. Initiative, once the rate is set, is
with the member banks. In the case o f open market
operations, the Federal Reserve can proceed o f its own
accord to buy or sell securities in the open market if it
decides that the flow o f credit and money is too sluggish
or too active. Obligations of the United States Govern
ment are the principal kind of paper which the Federal
Reserve is authorized to buy or sell.
General Explanation o f Operations
The process through which open market operations by
the Federal Reserve are reflected in the volume o f member
bank reserves, loans and investments, and deposits merits
simplified description. If the Federal Reserve decides to
38
G EN E R A L M ETHODS O F R EG U LA T IO N
buy, say, 25 million dollars of Government securities, it
places an order with a dealer in such securities and he
buys the securities in the open market, or sells the secu
rities from his own portfolio. In payment the dealer re
ceives a Federal Reserve Bank check. The dealer deposits
the check with a member bank, which in turn deposits it
in its reserve account with a Federal Reserve Bank. The
dealer then draws checks on these funds to pay the seller
of the securities or to retire loans which he had contracted
in order to carry the securities in his portfolio. The result
is that the Reserve Bank has added 25 million dollars to
its holdings of United States Government securities, and
the same amount has been added to the reserve accounts
o f some member banks.
These banks are now in a position to expand their loans
and investments and deposits. In so doing the banks will
lose funds to other banks, which in turn may expand their
loans and investments and deposits in accordance with
the pattern of banking developments illustrated in Chapter
II. Thus, while the open market transaction of this example
has increased initially the reserve positions o f a limited
number of member banks, the ordinary course o f banking
operations will diffuse these funds throughout the banking
system. The reserves, the loans and investments, and the
deposits of the banking system as a whole will be increased
—the loans and investments and the deposits by several
times the amount of the added reserves.
If the Federal Reserve decides to reduce the amount of
member bank reserves and thus to restrain credit expan
sion and growth in the money supply, it sells Government
securities to a dealer, who may either sell them to custom
ers or hold them in his own portfolio. In payment the
39
T H E FED ER A L RESERVE SYSTEM
dealer draws a check on some member bank in favor of
a Federal Reserve Bank and the Reserve Bank deducts the
amount from the reserve deposit of this bank. The source
of these funds will depend on whether the dealer sold the
securities or borrowed the money to carry them in his
portfolio. If the amount is 25 million dollars, the result
is a corresponding decrease in Federal Reserve holdings
of Government securities and in the reserves of certain
member banks. These banks are then obliged to adjust
their loan and investment and reserve positions, and in
making the adjustment they shift the impact of the trans
action to other member banks. The reserves, loans and
investments, and deposits of the member banks as a group
will be decreased, the latter two by a multiple of the
decrease in the first.
Since the primary purpose of open market operations
(buying or selling) is to influence the flow of credit and
money, they necessarily reflect an active Federal Reserve
policy to this end. Although such operations may be con
ducted in securities of any maturity, traditional reserve
banking practice has been to limit transactions to short
term Government securities. These securities are the most
liquid paper in the market and, because o f their role as
operating and liquid assets of financial institutions and
business corporations, are subject to a large daily volume
of trading. Moreover, open market operations in these
securities are rapidly communicated throughout the credit
market by the mechanism of the market itself, as well as
through their effects on bank reserves.
A technical type of open market operation, which needs
brief explanation, has to do with the accommodation of
dealers in Government securities during temporary pe40
G EN E R A L M ETHODS O F R EG U LA T IO N
riods of credit tightness. These operations are conducted
by purchasing short-term securities, primarily Treasury
bills, under agreement with the selling dealer to repurchase
them within a specified period of fifteen days or less. Such
repurchase agreements may at times be renewed. Treasury
bills, which are today the major prime short-term paper
in the market, are issued weekly by the United States
Treasury, at rates determined by competitive bids. On
occasion, because of credit stringency, the supply of bills
in the hands of dealers may greatly exceed demand. Re
purchase agreement operations assist dealers to carry
their inventory of bills over these periods while providing
the market with reserve funds to relieve the temporary
stringency. Since the dealers will repurchase the securities
when the stringency has passed, the reserve funds created
will be extinguished automatically, thus avoiding redun
dancy of funds in the market at that time.
Relation to Member Bank Discounts
Under conditions favorable to flexible open market
operations, increases in Federal Reserve holdings of
Government obligations (that is, open market purchases)
tend to be accompanied by declines in holdings o f dis
counts. On the other hand, decreases in security holdings
(that is, open market sales) tend to be reflected in increased
holdings of paper discounted for member banks. This
relationship is illustrated in the chart on page 42 covering
the period 1922-32. Experience with discounting since
1951, when open market operations were again used
flexibly, confirms this tendency.
Federal Reserve practice over the years has been to
make complementary use of these two instruments of
41
THE FEDERAL RESERVE SYSTEM
credit policy. If member banks are substantially in debt
to the Federal Reserve when it purchases securities, they
probably will use at least part of the reserves acquired as
the result o f the purchases to reduce their debt. This use of
reserve funds will reflect their reluctance to rem ain long
in debt to the Federal Reserve. On the other hand, the
loss of member bank reserves resulting from sales by the
Federal Reserve in the open m arket will probably be made
up, at least tem porarily and in part, by additional borrow
ing from the Federal Reserve.
42
G EN ER A L M ETHODS O F R EG U LA T IO N
Thus Federal Reserve action in the open market is not
likely to result in a sudden or extreme expansion or
contraction in the flow of credit and money. Instead,
under ordinary conditions it is likely to result temporarily
in a marked decline or increase in member bank indebt
edness, with no immediate substantial change in member
bank reserves and deposits.
But this does not mean that the action can have no
effect on the flow of bank credit and money. When member
banks are out of debt to the Federal Reserve they are
much more willing to make loans and investments and
thus to increase their deposits; and the Federal Reserve
can reassure them as to the availability o f additional
reserve funds by reducing the discount rate. When mem
ber banks are heavily in debt, they are less willing to make
new loans or to renew old ones as they come due. The
Federal Reserve is in a position to encourage this attitude
by raising the discount rate.
Open market operations, therefore, work more gently
than would be the case if the member banks were not in
a position to borrow from or to repay borrowing at the
Federal Reserve and if such operations led to an immediate
and rapid multiple expansion or contraction o f bank
deposits. They nevertheless exert a definite influence on
the flow of credit and money because, by decreasing or
increasing member bank indebtedness, they tend to en
courage or discourage expansion of deposits at member
banks. They also have important effects, as explained
below, on the credit market directly, and these effects
contribute to their usefulness in fostering financial balance
and economic stability.
43
T H E FED ER A L RESERVE SYSTEM
Functioning o f the Market for Government Securities
Since the early 1930’s perhaps the most important
change in the nation’s financial structure has been the
great growth in the debt of the Federal Government
resulting from financing economic recovery and the Second
World War. This change has greatly affected open market
operations as an instrument of Federal Reserve policy
because United States Government securities have come
to play a dominant role in the flexibility and sensitiveness
of the American credit market. Relatively small reserve
banking purchases or sales in this market will, by adding
to or subtracting from bank reserves, affect the capacity
of banks to make loans and investments, including in
vestments in Government securities. The entire credit
market will feel the effects of this shift in the banking
situation and there will be an accompanying change in
the market’s tone, in the liquidity of all marketable secu
rities, and in the climate of financial and business expec
tations.
All commercial banks as well as other financial insti
tutions, such as savings banks, insurance companies, and
savings and loan associations, have the bulk of their
operating or secondary reserve funds invested in Govern
ment securities, particularly in short-term issues. Large
commercial and industrial corporations also invest cash
balances in excess of operating needs and funds accumu
lated for large payments, like taxes and dividends, in these
securities. This use of Government securities as a tem
porary haven for liquid funds reflects the effort of many
thousands of individuals and businesses to have such
funds earn a return until they are needed for regular
operating purposes. In these circumstances, financial and
44
GENERAL METHODS OF REGULATION
business institutions sell Governm ent securities when
payments to be made exceed cash receipts, and buy
Governm ent securities when receipts exceed payments.
Purchases and sales of Governm ent securities by finan-
UNITED STATES GOVERNMENT DEBT
HELD
G R O S S DEBT
BY:
INDIVIDUALS
and
OTHERS
CORPORATIONS
SAVINGS
INSTITUTIONS
CO MMERCIA L
BANKS
FEDERAL
RESERVE
BANKS
U. S. G O V T .
A G E N C IE S and
TRUST F U N D S
1930
1940
1 95 0
mid -1 9 53
cial institutions and business corporations to adjust their
operating positions play an im portant part in the function
ing of the Governm ent securities m arket. They help to
m ake for a continuous stream of trading activity in the
m arket. Since there is no risk of loss on any Governm ent
security if it is held to m aturity, the main considerations
45
T H E FE D E R A L RESERVE SYSTEM
for a portfolio manager are the current market yields and
prices of individual security issues and, for liquidity pur
poses, the length of time until maturity.
Another kind of transaction, commonly referred to as
“arbitrage,” also contributes to trading activity in the
Government securities market. Arbitrage, however, per
forms two additional basic functions in the market. First,
it keeps the prices of different issues of securities and of
different maturities in line with one another. Second, it
provides a mechanism for transmitting changes in demand
or supply conditions felt in one maturity sector o f the
market to its other sectors.
If a particular issue is selling out of line, say at a yield
lower (price higher) than that on other comparable issues,
portfolio managers and professional traders tend to sell
the lower yielding issues and buy the higher yielding
ones. Similarly, if securities maturing in, say, less than
six months fall in yield (rise in price), portfolio managers
and traders may find it profitable to sell these short-term
securities and buy somewhat longer term issues. The
arbitrage operations as between the short-term issues and
those of longer maturities will tend to moderate somewhat
the yield decline (price advance) in the short-term sector
and at the same time extend the scope of the yield decline
to other maturity sectors. In other words, these arbitrage
actions will transmit the force of the stronger market for
short-term issues on out to the longer term securities.
When the yields and prices of individual issues have re
aligned themselves, or when stable relationships between
short-term, intermediate-term, and long-term securities
have been re-established, the portfolio manager or trader
may reverse the arbitrage transactions. Those who are
46
G EN E R A L M ETHODS O F R EG U LA T IO N
alert to such arbitrage opportunities profit by them and
at the same time help to correct yield and price disparities
and to spread throughout the entire credit market the
effects o f changes in the demand for or supply of credit
in one sector of the market.
Operations in Bankers' Acceptances
Mention needs to be made o f a special element in
Federal Reserve open market operations that has not
been important in recent years but was of considerable
moment in the past, namely, dealings in bankers’ ac
ceptance bills. A banker’s acceptance is a draft, often
drawn by a seller of goods on a bank under a letter of
credit issued by the bank at the instance o f the buyer.
When the bank “accepts” the draft, it becomes primarily
liable on the instrument, in effect substituting its own
credit for that o f the buyer. In this country most accept
ances arise out o f exports or imports. A seller of cotton,
for example, may draw a draft payable in ninety days
covering a shipment to Liverpool. The buyer may have
an arrangement with a bank in New York whereby the
bank will accept the seller’s draft on presentation and the
buyer will provide funds to pay the acceptance at maturity.
These instruments are readily salable in the market by the
seller of the goods who originally draws the draft. They
are usually based on goods in process of shipment, repre
sented by the shipping documents. They are considered to
be market paper o f the highest quality.
Federal Reserve Bank practice has been to stand ready
to buy seasoned acceptances from the market (acceptances
o f short maturity and usually carrying one or more
endorsements) at a rate slightly higher than the rate on
47
T H E FE D E R A L RESERVE SYSTEM
bankers’ acceptances generally prevailing in the open
market. In addition to unconditional purchases, the Re
serve Banks may also buy acceptance bills in the market
under an agreement by which the seller agrees to re
purchase within fifteen days.
C h a n g e s in R ese r v e R e q u ir e m e n t s
Discounts and open market operations by the Federal
Reserve Banks, as has been seen, add to or subtract from
the volume o f funds available as member bank reserves.
Changes in reserve requirements do not directly alter the
total of reserves but do change the proportion of a mem
ber bank’s deposits that must be held as reserves with a
Federal Reserve Bank. Consequently, changes in reserve
requirements affect the liquidity position of member banks
and hence the amount available for lending or investing.
For example, if the reserve requirement against demand
deposits is 15 per cent, a member bank must keep in its
reserve account with a Federal Reserve Bank $15 of every
$100 of its own deposits, and has $85 left to lend or invest.
If the reserve requirement is 20 per cent, the member bank
has to keep $ 2 0 uninvested and has only $80 to lend, and
if requirements are 10 per cent, it needs to keep only $ 1 0
uninvested and has $90 to lend or invest. Thus a change
in reserve requirements changes the rules under which the
member banks must operate.
Besides affecting the liquidity of individual banks,
changes in reserve requirements affect the rate of multiple
expansion of deposits for the entire banking system. On a
15 per cent reserve requirement against demand deposits,
$ 1 0 0 of reserves will support a deposit volume of $6 6 6 .
On a 20 per cent basis $100 will support $500 of deposits,
48
G EN ER A L M ETHODS O F R EG U LA T IO N
as was shown in Chapter II, and on a 10 per cent basis it
will support $1,000 of deposits. It will be seen that changes
in reserve requirements are a powerful instrument for
influencing the volume of bank credit and money.
Authority to Change Reserve Requirements
The Federal Reserve Act prescribed certain reserve
requirements and originally made no provision for changes
by the Federal Reserve. The basic percentages prescribed
by statute since June 21, 1917 are:
Demand deposits:
Central reserve city banks..................................
Reserve city banks...............................................
Country banks......................................................
Time deposits, all member banks..........................
13
10
7
3
Central reserve cities now are New York and Chicago.
At mid-1953 there were 53 reserve cities, including most
of the larger cities of the country. For purposes of deter
mining reserve requirements, banks outside of these cities
are classified as country banks.
In 1933 banking legislation empowered the change of
member bank reserve requirements when an emergency
existed and in 1935 further legislation made this authority
a continuously available means of Federal Reserve action.
Except for a temporary broadening of powers in 1948, the
authority has not been significantly changed since it was
revised in 1935. As the law stands today, the Federal
Reserve has authority to increase reserve requirements to
twice the ratios stated in the law, and to reduce require
ments that are above the statutory ratios to any level
that is not below them. The range of discretion and the
49
T H E FED ER A L RESERVE SYSTEM
requirements in effect in late 1953 are as follows (in
percentages):
Range
Demand deposits:
Central reserve city banks..........
Reserve city banks.......................
Country banks.............................
Time deposits, all member banks.
, 13 to
, 10 to
, 7 to
. 3 to
26
20
14
6
In effect
22
19
13
6
Changes in reserve requirements may be made applicable
to any or all the groups of banks shown above but must
be uniform for all banks within a group.
Effects o f Changes in Requirements
Because changes in reserve requirements affect at the
same time and to the same extent all member banks subject
to the action, they are a potent instrument. Their immedi
ate incidence, as stated above, is upon the operating
reserves and liquidity positions of the affected banks.
Increasing or decreasing the available reserves and liquidity
o f banks tends to find prompt response in the rate of bank
lending and investing, in the tone of the whole credit
market, and in the rate of monetary expansion. The fact
that the multiplying power of bank reserves is affected
exerts either a dampening or an accelerating influence on
the expansion o f bank credit and money.
Changes in member bank reserve requirements neces
sarily affect the demand for Reserve Bank credit. If reserve
requirements are increased when member banks have no
excess reserves, the additional reserves needed, if not
supplied to member banks through open market opera
tions, will have to be borrowed from the Federal Reserve
50
G EN E R A L M ETHO DS O F R EG U LA TIO N
until banks can make the necessary contractive adjustment
in their loans or investments. If reserve requirements are
decreased while the member banks are substantially
indebted to the Reserve Banks, the member banks can
use the excess reserves so obtained to reduce or retire
such debt.
Even when reserve requirements are increased to absorb
excess reserves in the banking system as a whole and thus
to forestall the too rapid expansion of bank credit and
money, there is likely to be an effect on the demand for
Reserve Bank credit. This is because excess reserves will
probably be unevenly distributed among member banks.
Some banks may have more than they need, and others
may have less than they need. The increase in requirements
will make it necessary for some banks to acquire additional
reserves either by reducing their loans and investments or
by borrowing.
The authority to change reserve requirements has not
been used frequently. Generally speaking, action to in
crease requirements has been taken at times when the total
o f excess reserves was so large that the effect on the total
demand for Reserve Bank credit and on the number of
individual banks needing to acquire additional reserves
was small, or at times when bank holdings of Government
securities were very large and the Federal Reserve was
supporting their prices and yields. On the other hand,
action to reduce reserve requirements has been taken when
it was desired to avert bank credit and monetary con
traction and to add to banking liquidity in order to foster
bank credit and monetary growth.
Numerous administrative and technical problems handi
cap changes in reserve requirements. Experience has shown
51
T H E FE D E R A L RESERVE SYSTEM
that this instrument of credit policy is not adapted to dayto-day changes in banking and monetary conditions. Even
small changes in reserve requirements, say of one or
two percentage points, result in large changes in the
available reserves and liquidity positions of member banks.
Frequent changes in requirements even by very small
percentage amounts would be disturbing to member banks
and to the credit market. For these reasons this method
of influencing bank reserve positions and the flow of credit
and money is usually employed only when large-scale
changes in the country’s available bank reserves are de
sired. For day-to-day operations in influencing the flow of
credit and money, the Federal Reserve depends principally
on the more flexible instruments of discount and open
market operations.
S o u r c e o f F e d e r a l R eserv e L e n d in g P o w e r
It is clear that the reserve balances of member banks
as a group serve as the source o f their lending power and
that the reserve requirements of member banks set the
limits to the exercise of such power. In much the same
way the gold certificate reserves of the Federal Reserve
Banks are the source of their lending power and the gold
reserve requirements to which the Reserve Banks are
subject set limits to their deposit and note expansion.
The Reserve Banks can lend their credit in the form of
member bank reserve balances and other deposits or in
the form of Federal Reserve notes up to an amount four
times their holdings of gold certificates. This limiting ratio
of four to one is prescribed by the Federal Reserve Act.
Thus the source of Federal Reserve lending power is not
its holdings of member bank and other deposits, but its
52
G EN ER A L M ETHODS O F R E G U LA T IO N
authority provided by statute to create bank reserves and
issue notes in an amount exceeding the Federal Reserve
Banks’ holdings of gold certificates.
There is, however, an important difference in the mone
tary effects of the creation of bank reserves and the
expansion of Federal Reserve notes. When Federal Reserve
discounts and advances or purchases of Government
securities increase the reserve accounts of member banks,
the basis is laid for a further multiple increase in bank
credit and money through increased loans and investments
by the banking system. On the other hand, when Federal
Reserve notes are expanded in response to an increase in
currency in circulation, bank reserves are reduced, and the
increase in Federal Reserve credit that cushions or offsets
this impact does not support an additional multiple bank
credit and monetary expansion.
The role of the Federal Reserve System in this country’s
banking system can be summarized by outlining the major
differences between member bank operations and those
of the Federal Reserve:
1. Member banks cannot issue notes (currency); the
Federal Reserve can. Thereby the Federal Reserve pro
vides an elastic currency allowing the public to hold
money in currency or on deposit at banks, as it may elect.
2. Member banks compete with one another for the
deposits of their customers, while the Federal Reserve
Banks do not.
3. Depositors o f member banks are legally free to with
draw their deposits at any time while the member bank
depositors of Federal Reserve Banks are subject to certain
penalties if they fail to maintain required reserve balances
with the Reserve Banks.
53
T H E FE D E R A L RESERVE SYSTEM
4. Member banks are motivated by a profit incentive
and do not ordinarily keep a large volume of uninvested
funds. Federal Reserve Banks, as public institutions, are
responsible for adjusting the volume o f their credit in
accordance with the general needs of the economic situ
ation and not in accordance with the volume of excess
gold certificate reserves which they may carry.
5. Member banks are monetary instrumentalities in that
an increase or decrease in the volume of their credits
directly affects the nation’s money supply. Primary and
ultimate authority to create and extinguish money, how
ever, rests with the Federal Reserve System. Expressed
another way, changes in the volume of member bank loans
and investments and o f deposits are directly related to
changes in the supply o f reserve funds. The availability o f
member bank reserve funds is subject to regulation in the
public interest by the Federal Reserve System.
6 . The Federal Reserve Banks are the operational
trustees o f the nation’s gold reserves, the base of its
monetary system. The limits on Federal Reserve lending
power are set by the requirement that the Reserve Banks
must hold a 25 per cent reserve in gold certificates against
their combined liabilities for deposits and notes. The
Board of Governors can suspend this requirement, subject
to penalty, for short periods.
In summary, Federal Reserve lending power arises from
the authority given to the System by law to create money,
and the limits o f this power are set by the requirement
that aggregate liabilities on deposits and notes must not
be in excess o f four times Federal Reserve holdings of
gold certificates. Federal Reserve lending power is not
used for profit, but for the purpose of influencing the flow
54
G EN E R A L M ETHO DS O F R EG U LA T IO N
of credit and money in the interest of economic stability.
Therefore, there is no attempt to extend Federal Reserve
credit to the limit permitted by law, and historically the
ratio o f the System’s deposit and note liabilities to its
holdings of gold certificates (prior to 1934 holdings of
gold) has generally been well below the legal requirement.
At mid-1953, the actual amount o f Federal Reserve
deposits and notes outstanding was only 2 .2 times the
System’s reserve o f gold certificates.
55
CHAPTER IV
SELECTIVE CREDIT REGULATION. In addition Co its general methods o f regulating thejlow o f credit and money, the Federal
Reserve has special powers to regulate the credit terms on which
transactions in stock market securities are financed. A t times it has
been authorized to prescribe terms on which consumer credit and
certain real estate credit could be extended, and also to encourage
lenders to restrict other types o f credit voluntarily.
HE instruments of credit policy so far discussed—
discount operations, open market operations, and
changes in reserve requirements—affect the flow of credit
and money generally, without regard to the particular
field of enterprise or economic activity in which the
credit is used. Thus they are distinct from the three
instruments now to be discussed, which are particular or
selective. These three relate to stock market credit, con
sumer credit, and real estate credit, respectively. A further
method of influencing credit in particular areas is through
a program that encourages lenders to restrict voluntarily
certain types of credit.
T
56
SELECTIVE C R E D IT R EG U LA T IO N
Selective instruments of Federal Reserve action do not
approach the problem through influencing bank reserves.
Instead they prescribe the terms on which lenders may
make certain kinds of loans, regardless of the reserve
position of commercial banks.
As supplements to general methods of influencing credit
conditions, selective methods make it possible to reach
specific credit areas without imposing stronger general
credit measures than might otherwise be appropriate. For
example, if an unhealthy use of credit for stock market
speculation develops at a time when credit for production
and trade is expanding no more than would be considered
normal, and when the application of general instruments
of regulation might do harm to the country’s over-all
economic activity, the power of the Federal Reserve to
regulate stock market credit can be especially helpful.
Margin Requirements on Stock Market Credit
The Federal Reserve authorities are enjoined by law to
restrain the use of bank credit for speculation; they are
to keep themselves informed, in the language o f the law,
as to “whether undue use is being made of bank credit
for the speculative carrying of or trading in securities, real
estate, or commodities,” and they are authorized to take
restrictive action to prevent undue use of credit in these
fields. Since 1934 the Board of Governors of the Federal
Reserve System has also been specifically directed to curb
the excessive use of credit for the purpose of purchasing
or carrying securities. It is authorized to do this by limiting
the amount that brokers and dealers in securities, banks,
and others may lend on securities for that purpose. At
brokers, the limitations apply to credits extended for the
57
T H E FED ER A L RESERVE SYSTEM
purpose of purchasing or carrying any type o f security, and
at banks they apply only to loans for purchasing or
carrying securities registered on national security ex
changes. 1 In neither case do they apply to any loan for
commercial purposes, even though the loan is secured
by stocks.
Margin requirements are established by the Board of
Governors under Regulations T and U. The amount that
can be lent against securities as collateral is always less
than the current market value o f the securities, and the
difference between the two is called the margin. Thus, if
a loan of $7,500 is secured by stock worth $10,000, the
margin is $2,500 or 25 per cent o f the value of the stock.
The Board’s regulations may be thought of as prescribing
either minimum margin requirements or maximum loan
values; the greater the margin required, the less the loan
value, that is, the amount that can be lent.2
For several years before the war, the Board’s regulations
required margins of 40 per cent. During the war the re
quirements were raised first to 50 per cent, then to 75
per cent, and in 1946 to 100 per cent. The 100 per cent
requirement was in effect from early 1946 to early 1947,
when it was reduced to 75 per cent, making it possible for
1 The provisions of the law make some distinctions between brokers
or dealers and banks; brokers or dealers cannot extend credit on un
registered securities except in certain limited circumstances, such as
temporarily in connection with cash transactions; banks are not restricted
by margin requirements in making loans on securities other than stocks.
2 The Board’s regulations require the lender to obtain the specified
margin in connection with the purchase of the security. If the collateral
security for the indebtedness subsequently declines in value, the regu
lations do not make it necessary for the borrower either to put up ad
ditional collateral or to reduce the indebtedness. However, the banker or
broker making a loan may require additional collateral if he deems it
necessary.
58
SELECTIVE C R E D IT R EG U LA T IO N
banks and brokers to lend 25 per cent o f the value o f the
collateral. The margin requirement was reduced to 50 per
cent in the spring of 1949 at a time o f moderate business
recession and was restored to 75 per cent early in 1951
when inflationary pressures following the outbreak of
Korean hostilities were at their peak. In early 1953, when
these inflationary dangers had begun to abate, the margin
requirement was again reduced to 50 per cent.
The control effected by margin requirements, though
bearing directly on the lender, puts restraint upon the
borrower and dampens demand. It can be used accord
ingly to keep down the volume o f stock market credit
even though lenders are able and eager to lend.
Another effect o f high margin requirements is to restrict
the amount o f pyramiding that can take place in a rising
market. In other words, they limit the extent to which
traders may add to their holdings, when the market is
rising, by borrowing against the additional market value
of securities already held in their accounts without putting
up additional money or additional securities. Restriction of
pyramiding exerts restraint on rising stock prices as well
as on the growth o f credit employed in the stock market.
By the regulation of margin requirements the danger of
excessive use of credit in the stock market, which caused
serious disturbances to the economy in the past, has been
minimized. A speculative stock market boom financed by
credit, like the one that culminated in 1929, for example,
could hardly occur except on the basis o f very low stock
purchase margins. A boom and a collapse in the stock
market is always possible, but without the excessive use
o f credit it is not likely to assume the proportions or to
have the effects it has had on some occasions in the past.
59
T H E FE D E R A L RESERVE SYSTEM
Aside from having to do with a specific use of credit,
the authority with respect to security loans differs from
other Federal Reserve powers in that it reaches outside
the Federal Reserve System to banks that are not members
of the System and to brokers and dealers in securities. It
is closely related, however, to other regulatory powers of
the Federal Reserve authorities, because the use of credit
for purchasing or carrying securities has an important
bearing upon its use for business purposes in general.
Consumer Credit
Regulation of consumer credit by the Federal Reserve
has been a temporary credit restraint in times o f emer
gency to supplement general credit measures. It was first
established in 1941 by an Executive Order of the President
based on war emergency powers. Its purpose was to curb
the use of credit for the purchase of automobiles, electric
refrigerators, radios, washing machines, vacuum cleaners,
household furniture, and other consumer goods and
services. Consumer goods and services were becoming
scarce because the equipment, materials, and labor re
quired for their production were being transferred to the
defense effort. At the same time, the purchasing power of
consumers was increasing. In this situation, with decreased
civilian supply and increased demand, there was reason to
expect that expansion of consumer credit would accentuate
tendencies toward rising prices.
In accordance with the President’s Executive Order, the
Board of Governors issued Regulation W prescribing
terms upon which such credit might be granted. At the
outset it applied only to instalment credit, including both
instalment sales and instalment loans, in which form the
60
SELECTIVE C R E D IT R EG U LA T IO N
great bulk of consumer credit was being generated. All
grantors of credit of the types specified in the regulation—
whether financial institutions or retailers—were subject to
the regulation, were required to register under it, and
could be penalized for its violation.
The restraints imposed by Regulation W on instalment
credit were twofold: they limited the amount of credit that
might be granted for the purchase of any article listed in
the regulation, and they limited the time that might be
agreed upon for repaying the obligation. Instalment loans
not related to specifically listed articles were subject only
to limitation on the time of repayment.
Later in World War II the scope of the regulation was
broadened to include a larger number of articles whose
purchases involved down payments and to cover charge
accounts and single-payment loans. Requirements were
made more restrictive as to down payments and maturities
on instalment credits; charge accounts were closed against
further purchases (of listed articles) unless paid by the
tenth day of the second calendar month following the
purchase date; and single-payment loans of defined cate
gories were limited to ninety days with limited renewals.
In the two-year period immediately following the war,
regulation of consumer credit was continued, though some
of the terms were relaxed and the scope of the regulation
was contracted to about what it was at the outset, namely,
the area of instalment credit. The supply of durable goods
at the time was inadequate to meet the current and the
war-accumulated backlog demand, and inflationary ten
dencies in the economy generally were strong. Restraint
upon the use of credit in purchasing scarce durable articles
lessened the pressure for a rise in prices, both directly and
61
T H E FE D E R A L RESERVE SYSTEM
by helping to restrain expansion in the volume o f con
sumer credit. In addition, fixing minimum down payments
for important consumer durable goods and the maximum
length of contract for consumer instalment financing in
general tended to cause business forces to take the direction
of price competition instead of progressive easing of credit
terms with continuing price advances.
Regulation o f consumer credit by the Federal Reserve
was terminated late in 1947, after having been in effect a
little over six years. It was reinstated temporarily from
early fall in 1948 until mid-1949 as a special anti-inflation
measure. Inflationary forces, already strong in the United
States, grew stronger after the invasion o f South Korea
created an international crisis. Regulation o f consumer
credit was again reinstated in the early fall of 1950 under
the temporary authority o f the Defense Production Act.
The outlook was for increased consumer demand at a time
when more and more labor and materials would have to
be diverted from civilian to defense uses.
In the post-Korean period, Regulation W applied to
instalment sale credit and instalment loan credit used for
the purchase of specified major durable goods, and to
instalment loan credit for some other purposes. The mini
mum down payments and maximum maturities first
applied were only slightly more restrictive than those
prevailing in consumer markets. As the strength of infla
tionary pressures became apparent a short time later,
tighter terms were imposed and kept in effect until mid1951. They were then relaxed to conform to actions taken
by Congress in amending the Defense Production Act. In
early May 1952, when it became clear that easier supply
conditions for consumer durable goods were in prospect
62
SELECTIVE C R E D IT R EG U LA T IO N
and that less inflationary credit market conditions would
permit the Federal Reserve to place increased reliance on
the general instruments of credit regulation, the Board of
Governors suspended regulation of consumer instalment
credit. In the Defense Production Act amendments ap
proved June 30, 1952, Congress repealed the authority for
regulation of consumer credit.
Real Estate Credit
Credit extended on real estate, especially residential
properties, expanded rapidly after World War II, and was
exerting strong inflationary pressure in mid-1950, when it
became necessary for the United States to embark on a
major defense program. The economy was operating close
to capacity and there was little prospect that the program
could be carried out without diverting resources from other
uses. Excessive credit to finance construction would have
led to greater competition with defense requirements for
manpower and materials, bidding up costs and prices, and
increasing inflationary pressures throughout the economy.
In this setting, temporary authority to regulate certain
real estate credit was granted to the President by the De
fense Production Act o f September 1950. The President
was authorized to regulate the terms on which ( 1) real
estate loans could be made, insured, or guaranteed by
Federal agencies and (2) credit not so insured or guaranteed
could be extended in connection with the construction or
major improvement of real property.
The President delegated authority for regulating Government-aided lending to the Housing and Home Finance
Administrator, and authority for restricting other kinds
of real estate credit to the Board of Governors. The Board
63
T H E FE D E R A L RESERVE SYSTEM
was required to obtain the concurrence of the Adminis
trator with its regulatory terms, and the Administrator
was required to apply similar restrictions to the fullest
extent practicable to Government-aided loans, preserving
the preferences accorded to veterans under existing law.
In mid-fall 1950 the Board issued Regulation X for real
estate credit. The Housing and Home Finance Administra
tor concurred in the Board’s regulation and applied
similar restraints to Federally-aided loans. Regulation X,
like Regulation W for consumer credit, applied to the
terms on which individual loans could be made. It specified
the maximum amount that could be borrowed, the max
imum length of time the loan could run, and the minimum
periodic amounts that must be paid to amortize the
principal amount of the loan.
After a year the permissible maximum loans were in
creased and the permitted maturities for residences priced
at less than $ 1 2,0 0 0 were extended, thus easing mortgage
credit restraints in accordance with a change in statutory
directive. In mid-1952 the Board liberalized terms for
credit to finance one- to four-family housing and reduced
down-payment requirements for multi-unit residential
structures.
An amendment to the Defense Production Act in June
1952 continued authority for real estate credit regulation
until mid-1953, but required that the regulation be relaxed
earlier if the estimated number of dwelling units started
in each of three successive months was below an annual
rate (seasonally adjusted) of 1.2 million. Estimates for the
next three months were all below the specified rate and,
accordingly, the Board suspended regulation of credit
terms in mid-September 1952.
64
SELECTIVE C R E D IT R EG U LA T IO N
Action taken under Regulation X and parallel regulation
o f Government-aided loans were the first attempts in this
country, and probably anywhere in the world, to restrain
an inflationary rise in real estate credit through compre
hensive regulation of mortgage terms. The experiment
was too brief, however, to permit judgment concerning
the effectiveness of such regulation.
Voluntary Credit Restraint
Another type o f credit restraint, closely related to
selective regulation in special areas, was initiated as part
of the anti-inflation program of the post-Korean period.
The Defense Production Act authorized the President,
subject to certain conditions, to encourage financing insti
tutions to take voluntary action to restrain credit that
might interfere with the defense program, and provided
protection from the antitrust laws when such voluntary
action was taken. The President delegated this authority
to the Board of Governors.
The program that developed was in every sense a vol
untary undertaking by credit institutions. In the latter part
of 1950, representatives of commercial banks, life insurance
companies, and investment bankers met, at the invitation
of the Board of Governors, to formulate plans, and in
accordance with these plans the Board selected a National
Voluntary Credit Restraint Committee. Representatives of
mutual savings banks and savings and loan associations
were later added to the National Committee, and this
Committee appointed regional committees to be in contact
with the lending institutions that cooperated in the
program.
The program got under way early in March 1951 when
65
T H E FE D E R A L RESERVE SYSTEM
the conferring representatives o f financial institutions
issued a Statement of Principles and the Board of Gov
ernors wrote to all financial institutions in the United
States requesting their cooperation in the program. The
Statement o f Principles set forth broad standards to be
applied voluntarily by cooperating lenders in deciding
whether, in the face o f national defense requirements, a
loan application or a proposed security offering involved
an essential or a nonessential use of funds. In effect, lenders
were requested to screen loan applications on the basis of
this purpose in addition to their customary test of credit
worthiness.
From the beginning, it was recognized that precise rules
and regulations would be inconsistent with a voluntary
program, and so the standards set in the original State
ment of Principles and later bulletins and memoranda
were in fairly broad and general language. The basic test
for sound lending in an inflationary period was summa
rized as follows: “Does it commensurately increase or
maintain production, processing, and distribution of es
sential goods and services?” The National Committee
aided financing institutions by issuing bulletins on special
types of credit from time to time, and the regional com
mittees were always available upon request to help partici
pating financial institutions to decide whether particular
loans would be in accord with the principles noted by the
National Committee.
For more than a year the Voluntary Credit Restraint
Program was an essential part of the national effort to
restrain the inflationary pressures generated by the Korean
crisis. With cumulating evidence of the abatement of these
pressures, the Board of Governors in mid-May 1952, on
66
SELECTIVE C R E D IT R E G U LA T IO N
recommendation of the National Committee, suspended
the program. Statutory authority for the program expired
at midyear.
Prerequisites o f Effective Selective Regulation
Selective instruments of credit policy have been devel
oped far enough to show that in certain situations they
can be useful complements to the older and more general
instruments—discount operations, open market opera
tions, and reserve requirements. When appropriate to the
circumstances and applied flexibly, they can help to make
credit policy in general more effective. They apply to the
flow of credit in specific channels rather than to the over
all flow of credit and money.
Federal Reserve experience indicates that effective use
o f selective regulation in national credit policy depends on
several factors. The credit area regulated must be of
sufficient size and importance to the economy to make its
regulation a telling reinforcement of general credit meas
ures. At the same time, the credit area must be reasonably
definable in terms of the purpose o f the credit, the col
lateral for it, or the nature of the credit contract. Also,
the flow of credit in the area must be responsive to prac
tical adjustments in the terms of lending. Trade practices
should be sufficiently specialized and standardized for
regulation to permit continuation o f established proce
dures rather than cause a drastic disruption o f them.
Finally, the contribution of selective regulation to the
over-all credit and monetary situation should be substan
tial enough to outweigh the burdens of regulation, on
both those subject to it and those administering it.
67
CHAPTER V
S T R U C T U R E O F T H E FED ERA L RESERVE SYSTEM. A ll
national banks and many State banks are members o f the Federal
Reserve System. There are twelve Federal Reserve Banks, each serv
ing one o f the districts into which the country is divided. The policy
responsibilities o f the Federal Reserve are entrusted to the Board o f
Governors o f the Federal Reserve System, the Federal Reserve
Banks, and the Federal Open Market Committee.
O FAR the Federal Reserve has been treated as a unit,
without reference to its structure or to the distribu
tion of duties and responsibilities among its component
parts. This presentation has the advantage of emphasizing
that from the point of view of regulating the flow of credit
and money the responsibility rests on the System as a
whole, and that all of its parts perform their allotted
functions in accordance with policies directed toward
accomplishing a common objective.
Consideration of the System’s structure is now in order.
Attention will be given first to the national and State banks
that are members of the Federal Reserve System, and to
S
68
STRU C TU R E O F T H E SYSTEM
the obligations and privileges o f membership. Then the
responsibilities of the several parts of the System for the
formation and execution o f credit and monetary policy
will be described.
Membership
At mid-1953, the Federal Reserve System had 6,765
member banks. Of these, 4,874 were national banks and
1,891 were State-chartered banks. All banks with national
charters are required to belong to the System. Banks with
State charters may voluntarily join the System if qualified
for membership, and if accepted by the Federal Reserve.
While somewhat less than one-half of all banks in the
United States belonged to the System, in mid-1953 they
held about three-fourths of the country’s total bank de
posits. The different kinds of banks in this country at that
time and the amount of their deposits are shown in the
table on the following page.
It will be noted that member banks hold about 85 per
cent o f the demand deposits of all banks, which along
with currency serve as means of payment. Consequently,
Federal Reserve policies have a direct influence on institu
tions holding nearly nine-tenths of the bank deposits that
are the major component of the country’s active money
supply.
Obligations and Privileges of Member Banks
By becoming members of the Federal Reserve System,
banks become eligible to use all of the System’s facilities
and, in return, undertake to abide by certain rules pre
scribed by law, or developed by regulation in accordance
with the law, for the protection of the public interest.
69
T H E FE D E R A L RESERVE SYSTEM
A l l B a n k s in t h e U n ite d S ta te s , J u n e 30, 19531
Kind of bank
Number
Deposits2
(In millions of dollars)
Demand
Time
Member bank..............................
Nonmember b ank ......................
6,765
7,772
93,780
15,609
34,117
32,053
Total......................................
14,537
109,389
66,170
4,874
1,891
62,365
31,415
23,516
10,601
7,247
525
15,572
37
8,485
23,568
Classes of member banks:
National....................................
State.........................................
Classes of nonmember banks:
Commercial..............................
Mutual savings 3 ......................
1 Excepting national banks located in Alaska or in an insular possession
or in any part of the United States outside the Continental United States.
2 Excludes interbank deposits.
8 Excludes three mutual savings banks that are State member banks.
National banks are chartered by the Comptroller of the
Currency, a Federal Government official, and are subject
in their operations to the National Banking Act as well
as to the Federal Reserve Act. State-chartered banks that
become members of the Federal Reserve System retain
their charter privileges but agree to be subject to the re
quirements o f the Federal Reserve Act. Since these banks
join the System voluntarily they have the privilege of
withdrawing from membership on six months’ notice.
Every member bank is required to subscribe to the
capital of its Reserve Bank. Its maximum subscription is
an amount equal to 6 per cent of its capital and surplus,
but only half of this amount must be paid in, with the
other half subject to call. At the end of June 1953, all
member banks together owned about 260 million dollars
70
STR U C TU R E O F T H E SYSTEM
o f paid-in capital stock o f the twelve Federal Reserve
Banks.
Through Federal Reserve membership, a bank assumes
several important obligations: To comply with the reserve
requirements o f the Federal Reserve and to keep its re
quired reserves on deposit without interest at its Reserve
Bank; to be subject to various requirements o f the Federal
law with respect to branch banking, holding company
regulation, interlocking directorates, certain loan and in
vestment limitations, and other matters; and, if the mem
ber bank is chartered by a State, to be subject to general
supervision and examination by the Federal Reserve.
In return, member banks are entitled to the following
principal privileges, among others: ( 1) to borrow from the
Federal Reserve Banks, subject to tests for borrowing set
by statute and regulation, when temporarily in need of
additional funds; (2) to use Federal Reserve facilities for
collecting checks, settling clearing balances, and trans
ferring funds to other cities; (3) to obtain currency when
ever required; (4) to share in the informational facilities
provided by the System; (5) to participate in the election
o f six of the nine directors of a Federal Reserve Bank;
and (6 ) to receive a cumulative statutory dividend o f 6 per
cent on the paid-in capital stock o f the Federal Reserve
Banks.
Federal Reserve Banks
For purposes o f administering the Federal Reserve
System the country is divided into the twelve districts
shown in the map on page 74. The district boundaries do
not always follow State lines and in many instances parts
o f the same State are in different districts. There is a
71
T H E FED ER A L RESERVE SYSTEM
Federal Reserve Bank in each district and some of the
Reserve Banks have branches. A list of the districts and
branches is given below:
Federal Reserve Bank of Boston
District Number 1
Federal Reserve Bank of New York
Branch at Buffalo, New York
District Number 2
Federal Reserve Bank of Philadelphia
District Number 3
Federal Reserve Bank of Cleveland
Branches: Cincinnati, Ohio
Pittsburgh, Pennsylvania
District Number 4
Federal Reserve Bank of Richmond
Branches: Baltimore, Maryland
Charlotte, North Carolina
District Number 5
Federal Reserve Bank of Atlanta
Branches: Birmingham, Alabama
Jacksonville, Florida
Nashville, Tennessee
New Orleans, Louisiana
District Number 6
Federal Reserve Bank o f Chicago
Branch at Detroit, Michigan
District Number 7
Federal Reserve Bank o f St. Louis
Branches: Little Rock, Arkansas
Louisville, Kentucky
Memphis, Tennessee
District Number 8
Federal Reserve Bank of Minneapolis
Branch at Helena, Montana
District Number 9
Federal Reserve Bank o f Kansas City
Branches: Denver, Colorado
Oklahoma City, Oklahoma
Omaha, Nebraska
District Number 10
72
STR U C TU R E O F T H E SYSTEM
Federal Reserve Bank of Dallas
Branches: El Paso, Texas
Houston, Texas
San Antonio, Texas
District Number 11
Federal Reserve Bank o f San Francisco
Branches: Los Angeles, California
Portland, Oregon
Salt Lake City, Utah
Seattle, Washington
District Number 12
Each of the twelve Federal Reserve Banks is a corpora
tion organized and operated for public service. The
Federal Reserve Banks differ essentially from privately
managed banks in that profits are not the object of their
operations, and their stockholders, which are the member
banks of the Federal Reserve System, do not have the
powers and privileges that customarily belong to stock
holders of privately managed corporations.
Each Federal Reserve Bank has nine directors. Three of
them are known as Class A directors, three as Class B
directors, and three as Class C directors. Class A and
Class B directors are elected by member banks, one
director of each class being elected by small banks, one
of each class by banks of medium size, and one of each
class by large banks. The three Class A directors may be
bankers. The three Class B directors must be actively en
gaged in the district in business, agriculture, or some other
commercial pursuit, and must not be officers, directors, or
employees of any bank. The three Class C directors are
designated by the Board of Governors o f the Federal
Reserve System. They must not be officers, directors,
employees, or stockholders of any bank. One of them is
designated by the Board of Governors as Chairman of
73
ft (p
THE FEDERAL RESERVE SYSTEM
BOUNDARIES OF FEDERAL RESERVE DISTRICTS fir THEIR BRANCH TERRITORIES
q) a
the Reserve Bank’s board of directors and one as Deputy
Chairman. The Chairman, by statute, also serves as Fed
eral Reserve Agent. 1
Under this arrangement, businessmen and others who
are not bankers constitute a majority of the directors of
each Federal Reserve Bank. The directors are responsible
for the conduct of the affairs of the Reserve Bank in the
public interest, subject to the supervision of the Board of
Governors. They choose the Reserve Bank officers, but
the law requires that their choice of President and First
Vice President, whose terms are for five years, be approved
by the Board of Governors. The salaries of all officers and
employees are also subject to the approval o f the Board
of Governors. Each branch of a Federal Reserve Bank has
its own board o f directors, a majority of whom are selected
by the Reserve Bank and the remainder by the Board of
Governors. The provisions of law circumscribing the
selection of Reserve Bank directors and the management
of the Reserve Banks indicate the public nature of the
Reserve Banks.
Decentralization is an important characteristic o f the
Federal Reserve System. Each Reserve Bank and each
branch office is a regional and local institution as well as
part of a nationwide system. Its officers and employees
are residents of the Federal Reserve district, and its trans
actions are with regional and local banks and businesses.
It gives effective representation to the views and interests
of its particular region and at the same time helps to
administer nationwide banking and credit policies.
1 The Federal Reserve Agent, subject to approval by the Board of
Governors, appoints such assistant Federal Reserve Agents as he may
need in the performance of his duties.
75
THE FEDERAL RESERVE SYSTEM
While the Federal Reserve Banks earn an income, their
operations are not carried on for this purpose but are
determined by Federal Reserve credit policies, which are
discussed in other chapters. A part o f this income is used
DISPOSITION OF RESERVE BANK EARNINGS
1914-53
SURPLUS
U.S.
TO
TREASURY
to cover expenses, including the expenses of the Board of
Governors in Washington, to pay the 6 per cent statutory
dividend to members, and to make additions to surplus
as required by law.
For many years the System’s net earnings were turned
over in large part to the Government as a franchise tax.
76
STRU C TU R E O F T H E SYSTEM
At a time when these earnings were small and after the
Congress had directed the Reserve Banks to contribute
half o f their surplus to the capital of the Federal Deposit
Insurance Corporation, the provision for the franchise tax
was repealed. By 1947, reflecting the effects of war financ
ing, earnings o f the Reserve Banks were once more large.
The Federal Reserve therefore adopted a procedure by
which it pays to the Treasury nine-tenths of its earnings
above expenses and dividends, as interest on Federal
Reserve notes. The remaining one-tenth is added to the
surplus of the Banks. The Federal Reserve makes these
payments to the Treasury on the basis of authority con
tained in a section o f the law dealing with Federal Reserve
notes. In case o f liquidation of the Reserve Banks the
surplus would go to the United States Government. This
is another illustration o f the public character o f the
Federal Reserve.
From the point o f view o f credit policy the Federal
Reserve Banks make the decisions regarding what loans
and discounts to individual member banks will be in
harmony with the objectives of the Federal Reserve Sys
tem. The Reserve Banks also establish the discount rate,
subject to review and determination by the Board of
Governors. In connection with open market operations
the Federal Reserve Banks, in groups prescribed by law,
elect five of the twelve members o f the Federal Open
Market Committee—to be described later.
Board o f Governors
The Board o f Governors o f the Federal Reserve System
is a governmental institution with offices in Washington,
77
T H E FE D E R A L RESERVE SYSTEM
D. C. It consists of seven members appointed by the
President of the United States and confirmed by the
Senate. Members devote their full time to the business of
the Board and are appointed for terms o f fourteen years,
with the terms so arranged that one expires every two
years. No two members of the Board may come from the
same Federal Reserve district. The Board’s expenses are
paid out o f assessments upon the Reserve Banks, and the
Board’s accounts are audited twice each year by qualified
outside auditors.
One of the Board’s duties is to supervise the operations
of the Federal Reserve System. As already indicated, the
Board appoints three of the nine directors o f each Federal
Reserve Bank, including the Chairman, who is also the
Federal Reserve Agent, and the Deputy Chairman. Ap
pointments of the President and First Vice President of
each Federal Reserve Bank are subject to the Board’s
approval. The Board also issues regulations that interpret
the provisions of law relating to Reserve Bank operations.
It directs the System’s activities in bank examination and
supervision and coordinates its economic research and
publications.
Annual budgets for each o f the twelve Federal Reserve
Banks and their twenty-four branches are submitted to
the Board. As already stated, the salaries of all officers
and employees of the Reserve Banks and branches are
subject to the Board’s approval. Certain other expendi
tures such as those for purchase of real estate for banking
house purposes and for the construction or major altera
tion of bank buildings are subject to the Board’s specific
approval. Reports showing expenses of the Federal Re
serve Banks are analyzed by the Board’s staff, which also
78
ST R U C TU R E O F T H E SYSTEM
makes surveys at the Reserve Banks of operating pro
cedures and o f other matters relating to their expenses
and cost accounting systems.
Each Federal Reserve Bank and branch is examined at
least once a year by the Board’s field examiners, who are
directed to determine the financial condition of the Bank
and compliance by its management with applicable pro
visions of law and regulation. These examiners conduct an
examination o f the Bank’s expenditures, including a de
termination of compliance with restrictions placed thereon
by the Board of Governors and a review to determine
that expenditures are properly controlled. The Board’s
examiners also review the audit program and activities of
the resident Auditor and his staff to see that they are
adequate and effective. Throughout the year, the Auditor
and his staff make comprehensive audits of all phases of
the Bank’s operations. Copies of the Auditor’s reports are
furnished to the Board o f Governors, where they are
carefully reviewed.
The Board represents the Federal Reserve System in
most o f its relations with executive departments o f the
Government and with Congressional committees. It is
required to exercise special supervision over foreign con
tacts and international operations of the Reserve Banks.
The Chairman of the Board is a member of the National
Advisory Council on International Monetary and Finan
cial Problems. The Board submits an annual report to
Congress and publishes weekly a statement required by
law o f the assets and liabilities of the Federal Reserve
Banks.
Of the principal monetary actions of the Federal
Reserve, the Board has full authority over changes in
79
T H E FE D E R A L RESERVE SYSTEM
reserve requirements. It also “reviews and determines”
discount rates established by the directors of the Reserve
Banks. The members of the Board are members of the
Federal Open Market Committee, described below, and
constitute a majority of that important body. As already
described, the Board has responsibility for the determina
tion of selective regulation of stock market credit and, for
limited periods, has also had responsibility for regulating
consumer credit and real estate credit. It has authority to
establish the maximum rates o f interest that member banks
may pay on savings and other time deposits. In general,
the Board of Governors is largely responsible for formu
lating national credit policies and for supervising their
execution.
Federal Open Market Committee
This Committee comprises the seven members of the
Board of Governors and five representatives elected by
the Federal Reserve Banks. It has responsibility for de
ciding on changes to be made in the System’s portfolio of
Government securities—in other words, when and how
much to buy or sell in the open market and under what
conditions. The Reserve Banks, in their operations in the
open market, are required by law to carry out the decisions
of the Open Market Committee.
The Federal Open Market Committee meets in Wash
ington four times a year, or oftener if necessary, and
reviews the national business and credit situation with the
help of its staff, which is drawn from the staffs of the
Board of Governors and the Reserve Banks. In meetings
of the Committee, representatives of the Reserve Banks
bring to the council table their special knowledge of
80
STRU C TU R E O F T H E SYSTEM
regional conditions. Decisions about open market policy
are made in the light of a full discussion of national and
regional factors.
Purchases and sales of securities for the Federal Open
Market Committee are effected in the name of the System
Open Market Account, participations in which are al
located among the twelve Federal Reserve Banks in
accordance with the ratio of each Reserve Bank’s total
assets to the total assets for all Reserve Banks combined.
AU transactions are supervised by the Manager of the
Account, who is an officer of the Federal Reserve Bank
of New York. Such transactions are required to be in
accordance with instructions issued by the Committee.
Federal Advisory Council
The Federal Reserve Act provides for a Federal Ad
visory Council o f twelve members, one from each Federal
Reserve district, selected annually by the Federal Reserve
Bank through its board of directors. Council members are
usually selected from among representative bankers in
each district. The Council meets in Washington at least
four times a year. It confers with the Board of Governors
on business conditions and makes advisory recommenda
tions regarding the affairs of the Federal Reserve System.
It constitutes a link between the Board and representatives
of banking in the twelve districts.
Other Advisory Committees
In addition to the Federal Advisory Council the System
has a number o f conferences and committees that help in
reaching understanding on common problems. Of these
the most important is the Conference of Presidents of the
81
THE FEDERAL RESERVE SYSTEM
ORGANIZATION
BOARD
OF
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FEDERAL
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A P P O IN tS
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COMMITTEE
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A P P O IN T
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FIRST VICE PRESIDENT
A N D OTHER OFFICERS
A N D EMPLOYEES
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OF P A R T S TO I N S T R U M E N T S O F C R E D I T P O L I C Y
T H E FE D E R A L RESERVE SYSTEM
Federal Reserve Banks. This Conference meets by itself
and with the Board at least three times a year.
Distribution o f Federal Reserve Authority
The Federal Reserve System is a unique institution
designed by its founders to assist in meeting the credit and
monetary needs of a large, diversified, and complex econ
omy. A graphic view of System organization can be
helpful to an understanding of its structure in relation to
its primary functions. The charts on pages 82-83 show
in broad outline the statutory organization of the System
as it is at the present time, and also the relationship
o f the organizational parts o f the System to the several
instruments of credit policy. These are represented at the
bottom o f the second chart by four squares, and each of
these is joined by a line to the agency or agencies that
make policy decisions with reference to that instrument.
As preceding discussion has brought out, the power of
decision over two of the instruments—reserve require
ments for member banks and margin requirements on
stock market collateral—rests exclusively with the Board
of Governors. Authority over member bank borrowing
resides with the Federal Reserve Banks, subject to general
supervision of the Board of Governors. Authority over
the discount rate is shared between the directorates of the
Reserve Banks by which the rate must be “established”
and the Board of Governors by which it must be “reviewed
and determined.” Policy with respect to open market
operations is decided neither by the Board of Governors
nor by the directorates of the Reserve Banks but by the
Federal Open Market Committee.
84
STRU C TU R E O F T H E SYSTEM
Other Federal and International Credit Agencies
Since the Federal Reserve System is not the only official
agency in the banking and monetary field, its operations
cannot be fully understood without reference to certain
other agencies. The Office of the Comptroller of the
Currency, the Federal Deposit Insurance Corporation,
and the State bank supervisors are referred to in a later
chapter on bank supervision. There remain for consider
ation here the Treasury Department, certain Federal
agencies that make loans or guarantee loans made by
banks and other financing institutions, and certain inter
national credit organizations.
Treasury Department. The Government department with
which the Federal Reserve System is most closely related
is the United States Treasury. The reason for this is
manifest. Debt management policy, which is the responsi
bility of the Treasury, and credit and monetary policy,
which is the responsibility of the Federal Reserve, must
constantly be coordinated. The Treasury, in its refunding
or borrowing operations, goes repeatedly to the credit
market which, as has been related in previous chapters,
reflects the credit and monetary policy of the Federal
Reserve. It is important from the standpoint of the Treas
ury that there be a well functioning and resilient market
for Government securities, and it is important to the
Federal Reserve that these financing operations be con
sistent with Federal Reserve policy regarding the flow of
credit and money. The Federal Reserve therefore keeps
the Treasury fully informed as to its policy and counsels
with the Treasury on the credit and monetary implications
o f its debt management program.
85
T H E FE D E R A L RESERVE SYSTEM
The Treasury has other operations that affect the re
sponsibilities of the Federal Reserve System. For example,
the flow of cash into and out of Treasury deposits with
the banking system has an important influence on the
credit situation. If the Treasury builds up its balances with
the Federal Reserve Banks and draws down its accounts
in commercial banks, its operations tend to tighten bank
reserves and the credit market. Conversely, if it increases
its commercial bank balances and draws down balances
with the Federal Reserve, it tends to make bank reserves
more plentiful and to ease the credit market. A main
objective o f Treasury deposit policy, however, is to smooth
out the effects of seasonal or other fluctuations in Treasury
cash receipts and disbursements so as to avoid undesirable
effects on the reserves of the banking system or on Federal
Reserve operations. The close relationship o f Treasury
and Federal Reserve functions in this and related areas
gives rise to constant cooperation and interchange of
information between the two organizations.
Domestic credit agencies. Several Federal corporations
and agencies have independent responsibilities for making
credit available to private borrowers. Congress has author
ized some agencies to make loans and others to insure or
guarantee loans made by banks and other private financing
institutions. A few of these agencies can both lend and
guarantee loans. In some cases the lending or insuring
functions are related primarily to specific purposes, such
as aid to agriculture, home owners, and veterans, and in
other cases they are intended primarily to make credit
available on terms not ordinarily offered by private lenders.
The operations of these Federal agencies affect the flow
of credit to private borrowers.
86
STRU C TU R E O F T H E SYSTEM
The principal Federal lending agencies include a number
in the Farm Credit Administration, which make produc
tion, intermediate, and mortgage loans to agriculture; the
Rural Electrification Adminstration, which makes loans
to encourage the use of electricity and to extend telephone
service in rural areas; a group under the Housing and
Home Finance Agency, which make loans to finance
housing and home ownership; the Export-Import Bank,
which makes loans, mostly to foreign borrowers, to aid
financing of United States exports and imports; and the
newly established Small Business Administration, which
is authorized to make fixed and working capital loans to
small business concerns. The Reconstruction Finance
Corporation, now in liquidation, was formerly engaged in
lending to business enterprises, financial institutions, and
municipalities and other public organizations.
Important among the Federal agencies that insure or
guarantee loans are the Veterans Administration, which
is authorized to guarantee and insure loans (so-called
“G.I.” loans) obtained from banks and other institutions
by veterans of World War II, and the Federal Housing
Administration, which under certain conditions can insure
home mortgage and home modernization loans made by
banks and other financing institutions.
International credit institutions. The International Mone
tary Fund and the International Bank for Reconstruction
and Development, which have offices in Washington, D. C.,
have functions related to the Federal Reserve System.
These institutions are not part of the American banking
and monetary system, but they affect the domestic money
market through their operations in gold and through their
influence on the demand for credit in this country. The
87
T H E FE D E R A L RESERVE SYSTEM
United States shares with other nations the ownership and
control of these two institutions and has representatives
on their directing bodies appointed by the President with
the Senate’s approval.
In order to coordinate the policies and operations of
these representatives and of all agencies of the Government
that make foreign loans or engage in foreign financial
transactions, Congress has established the National Ad
visory Council on International Monetary and Financial
Problems, whose members are ex officio, the Secretary of
the Treasury, who is Chairman of the Council, the Sec
retary of State, the Secretary of Commerce, the Chairman
of the Board of Governors of the Federal Reserve System,
and the Director of the Foreign Operations Admin
istration.
88
CHAPTER VI
RELATION OF RESERVE BANKING T O CURRENCY.
The Federal Reserve pays out currency in response to the public*s
demand and absorbs redundant currency. Its operations make the
entire currency supply elastic.
A N important purpose of the Federal Reserve Act was
J t \ . to provide an elastic supply o f currency—one that
would expand and contract in accordance with the needs
of the public. Prior to 1914 the currency consisted prin
cipally of Treasury notes secured by gold or silver and
of national bank notes secured by specified kinds of
United States Government obligations. These main forms
of currency were so limited in amount that additional
paper money could not easily be supplied when the na
tion’s business needed it. As a result, currency would
become hard to get and at times command a premium.
Currency shortages, together with other related devel
opments, caused several financial crises or panics. One of
the tasks of the Federal Reserve is to prevent such crises
by providing a kind of currency that responds in volume
89
T H E FE D E R A L RESERVE SYSTEM
to the needs o f the country. The Federal Reserve note is
such a currency.
How Federal Reserve Notes Are Paid Out
Federal Reserve notes are paid out by a Federal Reserve
Bank to a member bank on request and the amount so
paid out is charged to the member bank’s reserve account.
Any Federal Reserve Bank, in turn, can obtain the needed
notes from its Federal Reserve Agent, the representative
of the Government. The Federal Reserve Agent is located
at the Federal Reserve Bank and has custody of all un
issued notes. The Reserve Bank obtaining notes must
pledge with the Federal Reserve Agent an amount of
collateral at least equal to the amount o f notes issued.
This collateral may consist of gold certificates, United
States Government securities, and eligible short-term paper
discounted or purchased by the Reserve Bank. The
amount o f notes which may be issued is subject to an
outside limit in that a Reserve Bank must have gold
certificate reserves of not less than 25 per cent of its
Federal Reserve notes in actual circulation. Gold certifi
cates pledged as collateral with the Federal Reserve Agent
and gold certificates deposited by the Reserve Bank with
the Treasury o f the United States as a redemption fund
against Federal Reserve notes both count as such reserves.
Under this system the volume of currency in circulation
increases when the public’s needs become larger, and de
clines when they become smaller. In the latter case member
banks, on receipt of currency from their depositors, re
deposit it with the Federal Reserve Banks, receiving credit
in their reserve accounts. The Reserve Banks can then
turn it over to the Federal Reserve Agents and redeem
90
RELATION TO CURRENCY
the assets previously pledged as collateral for the notes.
Federal Reserve notes constitute about seven-eighths of
all the currency in circulation, as shown in the chart. The
other kinds o f currency are Treasury currency. Treasury
KINDS OF CURRENCY
M i d - 1953
FORMS
D EN O M IN ATIO N S
currency includes United States notes (a rem nant o f Civil
W ar financing), various issues o f paper money in process
of retirement, silver certificates, silver coin, nickels, and
cents. Since Federal Reserve notes are not issued in de
nom inations smaller than $5, ali of the $1 and $2 bills, as
well as some bills of larger denominations, are in other
91
T H E FE D E R A L RESERVE SYSTEM
forms of paper money, chiefly silver certificates and United
States notes. At mid-1953 the total amount of currency in
circulation was 30 billion dollars, of which 25.6 billion
was Federal Reserve notes. Of the remainder, the largest
amount consisted of silver certificates.
All kinds of currency in circulation in the United States
are legal tender, and the public makes no distinction
among them. It may be said that the Federal Reserve has
endowed all forms of currency with elasticity since they
are all receivable at the Federal Reserve Banks whenever
the public has more currency than it needs and since they
may all be paid out by the Reserve Banks when demand
for currency increases. In the subsequent discussion ref
erence will be made to the total of currency in circulation
rather than to any particular kind.
Demand for Currency
It has already been stated that the amount o f currency
in circulation now changes in response to changes in the
public’s needs. These changes are substantial and frequent.
The demand varies for different days o f the week, for
different days o f the month, and for different seasons. It
increases before holidays such as Independence Day,
Labor Day, and Thanksgiving, when many people take
trips and need more pocket cash. There is an extraordinary
increase in the demand before Christmas, when cash is
used for Christmas shopping and as gifts. After the holi
days, excess currency is promptly deposited in the banks
by the merchants, hotel keepers, and others with whom
it has been spent, and the banks in turn send it to the
Federal Reserve Banks. The effect of holiday movements
of currency, when they occur at a week-end or month-end,
is sometimes offset by other influences.
92
RELATION TO CURRENCY
In addition to seasonal changes in the dem and for
currency, there are changes that reflect variations in busi
ness conditions. W hen business activity is rising, the de
m and for currency increases, and when business activity
CURRENCY IN CIRCULATION
1953
declines, the demand also declines. While m ost payments
in this country are made by check, some types of payment
are m ade principally in currency. The most im portant of
these are payrolls and retail trade transactions, and
statistical studies show that the am ount of currency in
circulation fluctuates in response to changes in the volume
93
T H E FE D E R A L RESERVE SYSTEM
o f these two kinds of payments. There have been occasions,
as in 1931-33, when the demand for currency increased
because numerous bank failures caused people to withdraw
their deposits from other banks.
During the war the amount of currency in circulation
increased greatly in response to a variety o f influences:
the growth of payrolls, retail trade, and travel; many and
widespread changes in places of residence; payments to
members of the armed forces; larger incomes of people
not in the habit of using banks; and no doubt hoarding of
currency for various reasons. The demand for additional
currency subsided after the war, but the volume in circu
lation remained extraordinarily large. Following the
Korean crisis and the undertaking o f a large rearmament
program, demand for currency again strengthened, as
shown in the chart on page 108. Over the ensuing three
years, the amount in circulation continued to expand
gradually.
Effect o f Note Circulation on Federal Reserve Position
From the point o f view o f the Federal Reserve and
member banks, changes in the demand for currency have
a special significance that arises out of the system of reserve
requirements. As has been explained, reserve requirements
o f member banks are expressed as percentages of their
deposits. If someone borrows, say $1,000, from a member
bank and leaves it on deposit to be transferred from bank
to bank by check, the amount of reserves that the banking
system must hold increases only $2 0 0 , assuming required
reserves to be 20 per cent. If, however, the borrower
wishes to withdraw the proceeds of the loan in currency
and the member bank has insufficient currency in its till,
94
R ELA TIO N TO C U R R EN C Y
it must obtain the currency from a Reserve Bank, which
will charge the full amount withdrawn to the member
bank’s reserve account. Consequently the reserves o f the
bank—and of the banking system as a whole—will di
minish by the full $ 1,0 0 0 .
If the banking system had no excess reserves, it would
have to obtain additional reserves. The Federal Reserve
could supply the reserves by lending to member banks or
it could buy an equivalent amount of Government securi
ties in the open market if this were considered desirable.
Whichever procedure was followed, the demand for Fed
eral Reserve credit and Reserve Bank holdings o f discounts
and securities would increase. The increase, however,
would be only $ 2 0 0 in the case of the demand for $ 1,0 0 0
o f checking deposits, while it would be $ 1 ,000 in the case
o f demand for an equal amount of currency. Because the
increase in the demand for Federal Reserve credit is so
much greater when the public withdraws its funds from
banks in currency than when it leaves them on deposit,
the volume of discounts and securities held by the Federal
Reserve Banks is greatly influenced by changes in the
demand for currency. As noted before, the changes in this
demand are both frequent and substantial.
Similarly, the reserve position of the Federal Reserve
Banks is affected when the public elects to hold money in
the form of currency rather than as demand deposits at
banks. The Reserve Banks are required to hold the same
ratio o f reserves in gold certificates against their Federal
Reserve notes in circulation as against their deposits (25
per cent), but when the public demand is for $ 1 ,0 0 0 in
currency, the Federal Reserve Banks pay out that amount
of Federal Reserve notes—and their reserve requirements
95
T H E FE D E R A L RESERVE SYSTEM
increase by $250. If, however, the public’s demand is for
$ 1,000 in checking deposits, member bank reserves, which
are the deposits against which the Reserve Banks must
hold reserves, increase by only $ 2 0 0 and the reserves
needed by the Reserve Banks by only $50 (25 per cent of
$200). Consequently, an increase in currency ties up five
times as much o f the Reserve Banks’ reserves as does an
identical increase in bank deposits.
Federal Reserve policy with respect to the expansion or
contraction o f Reserve Bank credit must always be alert
to the character of the demand for such credit and, in the
interests o f economic stability, must be adapted to it. It
is principally because o f the large growth in currency in
circulation during the war that the Federal Reserve Banks’
ratio of reserves to combined note and deposit liabilities
declined to a point where in 1945 it threatened to impinge
upon the Federal Reserve’s freedom of policy action. In
these circumstances, Congress deemed it wise to reduce
the reserve requirement of the Reserve Banks from 40 per
cent for Federal Reserve notes and 35 per cent for deposits
to 25 per cent for each kind of liability.
While the Federal Reserve pays out currency in response
to the demand of the public and absorbs currency that the
public does not need, it should not be concluded that
currency demand is free of influence by the Federal Re
serve. The policies pursued by the Federal Reserve affect
this demand, as they also do the community’s use of bank
deposits. The main task of the Federal Reserve in pro
viding an elastic currency, however, is to see that the total
of the two forms of money is appropriately related to the
volume of trade and production and does not itself tend
to make the total demand for goods excessive or deficient.
96
CHAPTER VII
RELATION OF RESERVE BANKING TO GOLD. Gold and
Federal Reserve credit are the principal sources of member bank
reserves. Gold inflows reduce reliance o f banks on Federal Reserve
credit and gold outflows increase it. Changes in the countrys
monetarj gold stock are reflected in Federal Reserve holdings of
gold certificates.
HERE is a dual relationship between the Federal
Reserve and gold. Gold is the ultimate basis of
Federal Reserve credit, and gold movements are an
important factor in member bank use of Federal Reserve
credit.
Gold is the basis of Reserve Bank credit because,
as explained in Chapter III, the power of the Reserve
Banks to create money through adding to their deposits
or issuing Federal Reserve notes is limited by the require
ment o f a 25 per cent reserve in gold certificates against
both kinds of liabilities. That is to say, the total of Federal
Reserve notes and deposits must not exceed four times the
amount of gold certificates held by the Reserve Banks.
T
97
T H E FE D E R A L RESERVE SYSTEM
Thus the ultimate limit on Federal Reserve credit expan
sion is set by gold.
Flows o f gold into and out o f the monetary mechanism,
besides increasing or decreasing the reserves of the Federal
Reserve Banks, also affect the need o f the banking system
for Federal Reserve credit. For example, when the United
States Government acquires more monetary gold, addi
tional reserves usually become available to the member
banks without their having to obtain credit from a Reserve
Bank. Except to the extent that there is a more than
temporary decline in the amount o f currency in circulation,
gold and Federal Reserve credit are the main sources of
member bank reserves. The more gold that comes to the
monetary system from abroad or from domestic mines,
the less demand there is for Federal Reserve credit. This
relationship between gold and member bank reserves re
quires more detailed explanation and description.
Gold as Reserve Money
In the American monetary system the standard dollar
is defined as a weight o f gold. Gold, however, is not coined
into money, and currency based dollar for dollar on gold,
represented by gold certificates, does not directly enter into
circulation with the public or into member bank reserves.
Gold nevertheless functions directly and without restric
tion as reserve money of the Federal Reserve Banks and
in this role affects the reserve position o f the banking
system. Except that imports or exports o f gold are subject
to license by the Treasury, gold also functions freely as a
means o f settling international balances.
All gold that enters the monetary mechanism becomes
reserve money o f the Federal Reserve Banks, not directly
98
REL A TIO N T O G O L D
as gold but in the form o f gold certificates. Under the Gold
Reserve Act o f 1934, private persons are not permitted to
hold in this country any gold in monetary form. Monetary
gold is bought by the Treasury, which pays $35 an ounce
for it by check drawn against its deposit account at the
Reserve Banks. Against the gold acquired, the Treasury
issues an equivalent amount o f gold certificates as a basis
for restoring the Treasury’s deposit account at the Reserve
Banks.
The Treasury must hold gold at the rate o f $35 an ounce
for all the gold certificates it issues.1 Consequently, while
the title to the gold is in the Government, the greater part
o f it is held as cover for gold certificates. The gold certifi
cates are held as reserves o f the Reserve Banks and may
not be used for any other purpose. The Reserve Banks are
the only institutions permitted by law to hold gold cer
tificates, which are not permitted to circulate outside the
Reserve Banks.2
In practice the Reserve Banks actually hold only a
relatively small amount o f gold certificates; most o f their
reserves are represented by a credit in a gold certificate
account on the books o f the Treasury. This serves the same
purpose and saves the unnecessary expense o f printing and
shipping the certificates.
At the end o f June 1953, the Treasury held monetary
gold in the amount o f 22,463 million dollars. O f this
1 The amount of gold that the Treasury must hold as cover for each
dollar of gold certificates can be changed only by an Act of Congress.
2 A total of 37 million dollars of gold certificates issued before the
Gold Reserve Act of 1934, and not turned into the Treasury in accordance
with the terms of that Act, are still regarded as outstanding in the official
report on currency in circulation. Some part of this amount may have
been lost or destroyed and some of it may be held in hoards abroad.
99
T H E FE D E R A L RESERVE SYSTEM
amount 21,323 million was cover for gold certificates, all
but 37 million o f which was held by the Reserve Banks as
required and excess reserves. Another 156 million was held
as the statutory reserve against United States notes. The
remainder, 984 million, was in the general fund o f the
Treasury. Only the gold in the general fund is at the free
disposal of the Treasury.3
In addition to the gold stock held in its general fund,
the Treasury keeps a relatively small amount in the work
ing balance o f the Exchange Stabilization Fund. The gold
so held amounted to 58 million dollars as o f June 30,1953.
Most of the gold transactions o f the Treasury are con
ducted through this Fund, which buys gold from and sells
gold to foreign monetary authorities for dollars.
How Gold Is Monetized
The process by which gold produced in the United
States or imported from abroad reaches the Treasury and
is reflected in additions to the reserves o f member banks
and Federal Reserve Banks is described below.
The gold is taken to a United States assay office or to
a United States mint. The United States Treasury, as
3 When gold was revalued from $20.67 to $35.00 an ounce in 1934,
there accrued to the Treasury a revaluation “profit” of 2.8 billion dollars.
A total of 2 billion of this “gold profit” was placed in an Exchange
Stabilization Fund, of which 1.8 billion was held inactive. Most of the
“profit” not placed in the Stabilization Fund was used indirectly to retire
national bank notes. In 1947, 688 million dollars of the 1.8 billion in the
inactive account of the Exchange Stabilization Fund was used to pay the
United States gold subscription to the International Monetary Fund, and
the balance was added to the general fund of the Treasury, or used to
cover issuance of gold certificates. In the latter part of 1953 the Treasury
issued 500 million dollars of gold certificates against gold in the general
fund and used the proceeds to purchase for redemption Government
securities held by the Federal Reserve System.
100
R ELA TIO N T O G OLD
explained, pays $35 an ounce for it by check. The seller of
the gold will deposit this check with his bank, usually a
member bank, which in turn deposits it with a Reserve
Bank, where it is added to the reserve balance o f the
member bank and charged to the account o f the United
States Treasury. The Treasury replenishes its account by
issuing an equivalent amount o f gold certificates to the
Reserve Bank. Assume that the gold is worth 10 million
dollars. Then the gold stock of the Treasury, the gold
certificate holdings o f the Reserve Bank, the reserve bal
ance o f the member bank, and the bank deposit o f the
seller o f the gold will each increase by 10 million dollars.
For many years movements o f gold into and out o f this
country’s monetary reserves have been handled almost
exclusively by foreign governments and reserve or central
banks, so that most gold transactions proceed through
official channels and under a general license issued by the
Treasury. When the seller o f gold is a foreign official
authority, the immediate purpose o f the sale is often to
build up dollar balances in this country. The dollar pro
ceeds o f the sale in these cases are usually deposited in a
foreign deposit account with a Federal Reserve Bank.
Thus, while this leads to an increase in the gold certificate
reserves o f the Reserve Banks, there is no immediate
increase in member bank reserve balances and deposits.
Such increases do occur, however, when the foreign official
authority draws on its Reserve Bank deposit account to
make payments in American markets.
On the other hand, when a foreign monetary authority
wants to acquire 10 million dollars in gold it may draw a
check on a correspondent member bank in the United
States in favor o f the Federal Reserve Bank. The Federal
101
T H E FE D E R A L RESERVE SYSTEM
Reserve Bank charges the check to the member bank’s
reserve account and turns over 10 million dollars o f gold
certificates to the Treasury which furnishes the gold to the
Federal Reserve Bank as agent for the foreign authority.
The result is that the deposits and the reserve balance of
the member bank, the gold certificate holdings o f the Re
serve Bank, and the gold holdings o f the Treasury are each
reduced by 10 million dollars.
When foreign official authorities are purchasers o f gold,
the impact o f gold transactions on member bank reserve
balances and deposits often precedes the actual gold pur
chase. Such purchases are made after the foreign deposit
account at the Reserve Bank has increased as a result o f
a balance o f dollar receipts from transactions in American
markets. Member bank deposits and reserve balances go
down at the time the foreign balances at the Reserve Banks
go up.
The deposits o f foreign reserve or central banks and
governments held at the Federal Reserve Banks are
generally used in balancing international transactions be
tween residents o f the United States and those o f the other
countries concerned. Since they are held for these purposes
and since they do not bear interest, their level is normally
determined by transaction needs. When they fall below
levels desired for working purposes and other means o f
replenishing them are unavailable, they are replenished by
sales of gold. When they rise above these levels and the
foreign holder does not desire to invest the excess in prime
marketable securities, they are drawn down through the
purchase o f gold.
Gold transactions with foreign countries are frequently
effected without a physical movement o f gold into or out
102
R ELA TIO N T O G O LD
o f this country. A foreign monetary authority may pur
chase gold in the United States and have it “earmarked,” or
segregated, for its account at the Federal Reserve Bank o f
New York; the gold is actually held by that Reserve Bank.
Conversely, a foreign authority may sell some o f its ear
marked gold to the United States Treasury. Earmarked
gold belongs to foreign authorities and is not a part o f
the monetary gold stock o f the United States. Foreign
purchases o f gold to go into, and sales o f gold to come out
of, earmarked accounts have the same effect on our bank
ing system as foreign purchases o f gold for export and
foreign sales o f gold after import.
The processes o f monetizing gold described above are
essentially the same as they were when gold itself was held
by the Federal Reserve Banks. The only difference is that
the title to the gold owned by the United States is in the
Treasury and that the Reserve Banks hold claims on it in
the form o f gold certificates or a credit in the gold certifi
cate account. The ultimate effects o f gold flows on the
reserves o f Federal Reserve Banks and member banks and
on bank credit and the total money supply are not changed
in any significant respect by the altered procedure.
Gold in International Payments
Movements o f gold from one country to another are the
ultimate means by which international balances are settled.
On one side o f the account are all the commodities,
services, and securities the United States, for example, has
sold to foreigners, and on the other side are all the com
modities, services, and securities the United States has
bought from foreigners. There are other items, such as the
Government’s aid to foreign countries and remittances by
103
T H E FE D E R A L RESERVE SYSTEM
immigrants to their mother countries, that enter into one
or both sides o f the balance-of-payments account. If, after
all o f these items have been taken into account, there is
still a balance due to the United States from abroad, it
can be met by foreigners in one o f three ways: by borrow
ing in the American market, by drawing down their dollar
deposit balances, or by selling gold to the United States.
Sale o f gold is usually the last resort employed to cover
the balance.
In recent years the balance o f international transactions
has sometimes been due to the United States and some
times to foreign countries. Gold has therefore moved in
both directions, and there have been corresponding
changes in the monetary gold stock o f the United States,
as the chart shows. Since 1948 the movement on the whole
has been outward. This development has reflected progress
abroad in restoring stable monetary conditions and, in turn,
has been a factor enabling foreign countries to relax controls
over normal trade and foreign exchange transactions.
Gold and Federal Reserve Operations
It has been shown that gold purchases or sales by the
United States increase or decrease the reserves o f Federal
Reserve Banks and, therefore, their ability to supply notes
and create deposits. It has also been shown that, disre
garding transitory lead-and-lag effects sometimes associ
ated with the gold transactions o f foreign official authori
ties, gold purchases or sales by the Government also affect
the reserve position o f member banks and hence their
ability to make loans and investments and expand their
demand deposits.
The ultimate effect on member bank reserves o f move
104
RELATION TO GOLD
ments into or out o f the nation’s m onetary gold stock is
thus the same as that o f Federal Reserve discount or open
m arket operations. W hen gold flows in, it increases mem
ber bank reserves in the same way as would an equivalent
am ount o f discounts or open m arket purchases by the
Reserve Banks; when gold flows out, it diminishes member
bank reserves in the same way as would the paying off of
a discount by a member bank or the sale o f a security by
a Reserve Bank. It is for this reason that the dem and for
Reserve Bank credit diminishes when gold comes in and
105
T H E FE D E R A L RESERVE SYSTEM
increases when gold goes out. Sometimes the Federal
Reserve makes loans on gold to foreign reserve banks and
this has the same effect on credit conditions in this country
as any other advance by a Reserve Bank.
Except for currency movements in and out o f the Federal
Reserve Banks, which follow the independent pattern ex
plained in the preceding chapter, gold and Federal Reserve
Bank credit are the two principal sources o f member bank
reserves, which in turn are the basis o f member bank
credit and o f the money supply. It is for this reason that
the Federal Reserve, in performing its functions, must
adapt its operations to the prevailing flow o f gold.
The Federal Reserve’s financial strength and authority
is such today that it is in a position to offset, when desir
able, the credit and monetary effects o f any likely move
ment o f gold. Offsetting operations can be accomplished
through open market transactions or changes in reserve
requirements. Nevertheless, unusually large and abrupt
flows o f gold in one direction or the other can present
delicate problems o f credit and monetary adjustment.
Under conditions o f international monetary stability,
gold movements are subject to frequent changes o f direc
tion, with annual changes in the country’s gold stock that
are relatively moderate. In such circumstances, gold flows
are merely one factor to which Federal Reserve operations,
in regulating the flow o f credit and money, are adapted.
In fact, international financial stability and convertibility
o f currencies can facilitate the execution o f Federal Reserve
functions by fostering the ready settlement o f trade ac
counts and by minimizing speculative and capital move
ments, and thereby reducing the need for gold movements
between countries.
106
CHAPTER VIII
THE BANK RESERVE EQUATION. Cold, currenc/ movemerits, and changes in Federal Reserve credit are the principalfa c
tors that influence the volume o f member bank reserves— the basis
o f the bank credit and money supply. The interrelationship among
these and other less importantJactors is sometimes called the bank
reserve equation.
EMBER bank reserves and all the principal factors
that affect their volume have been discussed
separately and will now be brought together. These
factors reflect the numerous forces in the country’s eco
nomic life which affect the credit and monetary activities
o f the commercial banks.
All the factors that affect member bank reserves—gold,
currency in circulation, and Federal Reserve credit, plus
certain other factors o f minor or transitory importance—
can be combined into a bank reserve equation. In this
equation the factors supplying member bank reserve funds
are set opposite the factors absorbing such funds.
Taking the situation at mid-1953, the accompanying
M
107
THE FEDERAL RESERVE SYSTEM
BANK RESERVE EQUATION
Annual Averages of Daily Figures
108
B A N K RESERVE E Q U A TIO N
table shows that three factors—gold, Federal Reserve
credit, and Treasury currency—accounted for the supply
o f member bank reserves. Treasury currency outstanding,
as explained in Chapter VI, consists o f United States notes,
silver certificates, silver dollars, and subsidiary coin plus
F a c t o r s i n t h e B a n k R e s e r v e E q u a t io n , M id -1953
[In billions of dollars]
Factors accounting for supply of reserves:
Monetary gold stock.............................................
Federal Reserve credit..........................................
Treasury currency..................................................
22.5
25.4
4.9
Total....................................................................
52.8
Factors accounting for use of reserves:
Currency in circulation.........................................
Treasury cash accounts.........................................
Nonmember bank, foreign, and other accounts
at the Federal Reserve......................................
30.1
1.4
1.7
Total....................................................................
33.2
Member bank reserve balances............................
19.6
Total...................................................................
52.8
remnants of obsolete issues not yet presented for retire
ment. While growth in Treasury currency over the years
operates to supply bank reserves, short-run fluctuations in
Treasury currency are usually small and therefore relatively
unimportant in bank reserve positions.
The table also brings out that the use o f reserve funds
is accounted for by member bank reserve balances and
three other factors—currency in circulation, Treasury cash
accounts, and nonmember bank, foreign, and other ac
109
T H E FE D E R A L RESERVE SYSTEM
counts at the Federal Reserve. As compared to currency
in circulation, the other two items are small and changes
in them are o f only temporary importance.
The course o f these factors over the period 1934-53 is
shown in the chart on page 108. It will be seen that the
relative importance of different factors changed from time
to time during the period. Through 1941 the dominant
factor was an increase in the gold stock. During the war
the predominant influences were increases in currency in
circulation and in Federal Reserve credit. Since the war
changes in major factors have been smaller and more var
ied than in the earlier periods.
It will be evident that over a period o f time any o f the
factors can increase or reduce reserves. Taking the prin
cipal factors for illustration, it is apparent that inflows o f
gold, decreases in currency in circulation, and increases
in Federal Reserve credit add to member bank reserves,
while outflows o f gold, increases in currency in circulation,
and contraction o f Federal Reserve credit diminish member
bank reserves.
Interplay o f Bank Reserve Factors
Gold flows are greatly affected by forces outside Federal
Reserve regulation. They necessarily depend on interna
tional as well as domestic financial conditions. For many
years they have been less responsive to relative levels of
interest rates than they had been in the past, but have
been determined more by official policies o f foreign
reserve or central banks and governments and by war and
political tension. Currency movements follow a course
primarily influenced by the level o f business activity and
the habits and preferences o f the public for currency.
110
B A N K RESERVE EQ U A TIO N
Federal Reserve credit is the balance wheel between
these two more or less independent factors and member
bank reserves. It is the chief means by which the Federal
Reserve, through influencing the volume o f member bank
reserves, can discharge its responsibility to regulate the
flow o f credit and money generally. The Federal Reserve
can use its credit powers either to initiate changes in the
volume of member bank reserves or to modify changes
caused by gold or currency movements. Action to offset
the effects of gold and currency movements will or will not
be taken, depending on whether these effects are in har
mony with current Federal Reserve credit and monetary
policy.
Member bank reserves, although affected by the opera
tions o f the three other principal factors in the bank
reserve equation, are not themselves an entirely passive
element. They respond to economic forces that are not
necessarily reflected in gold or currency movements, and
their independent impulses are subject to influence by the
Federal Reserve. For instance, at times of vigorous de
mand for borrowed funds and consequent growth in bank
loans and deposits, member banks need more reserves.
The need for additional reserves expresses itself in a
demand for additional Reserve Bank credit. The type o f
Federal Reserve action taken in response to these demands
depends in general upon the prevailing state of economic
conditions and the desirability at the time of enlarging the
flow o f credit and money. The Federal Reserve ordinarily
supplies its credit through some combination o f additional
discounts and open market purchases, but it may also
meet the demand by a reduction in the reserve require
ments o f member banks.
Ill
T H E FE D E R A L RESERVE SYSTEM
Prewar Changes in Member Bank Reserves
A brief account of the interplay o f the major factors in
the bank reserve equation over the past two decades can
illustrate the usefulness of the equation approach. How
these factors affected member bank reserves from mid1934, which was shortly after adjustment o f the monetary
system to gold revaluation, until the United States entered
World War II, is shown in the table.
M a j o r F a c t o r s i n B a n k R e s e r v e E q u a t io n
J u n e 30, 1934—D e c e m b e r 31, 1941
[In billions of dollars]
Factors supplying reserves:
Inflow of gold.........................................................
14.9
Factors absorbing reserves:
Increase in currency circulation...........................
Reduction in Federal Reserve credit...................
Other factors (net).................................................
5.8
0.1
0.4
Total.....................................................................
6.3
Increase in member bank reserves.......................
8.6
Total.....................................................................
14.9
It will be seen that the principal factor supplying re
serves was a huge inflow o f gold and that the principal
factor absorbing reserves was a steady increase in currency
in circulation. This was a period of world depression and of
unsettled political conditions abroad. With the nation’s
own manpower and other resources continuously under
employed, the Federal Reserve authorities pursued a
policy o f monetary ease to encourage their fuller utilization.
As the gold inflow continued, the effect on member bank
112
B A N K RESERVE E Q U A TIO N
reserves was substantial and excess reserves became large.
As economic recovery progressed, it seemed desirable to
temper this effect and also to restore the contact o f the
Federal Reserve Banks with the credit market. Accord
ingly, in 1936 and 1937 the Federal Reserve authorities
raised the reserve requirements o f member banks by steps
to their statutory maximum. Some downward adjustment
o f reserve requirements was made as business activity
receded in 1938, but with the threat o f excessive bank
credit and monetary expansion resulting from the national
defense emergency in the early 1940’s, the Federal Reserve,
just prior to this country’s entering the war, raised them
again to their statutory maximum. Over this entire period,
Federal Reserve credit remained fairly stable with prac
tically no use made o f Reserve Bank discount facilities.
The War and Postwar Adjustment Periods
After the United States entered the war and began to
provide exports under lend-lease, the gold inflow to this
country stopped. During the war period, gold flowed out
o f the United States, reflecting chiefly large-scale purchase
o f goods from South American countries. For a period
after the war the gold inflow was resumed, but beginning
in 1949 there was some outflow. Taking the war period
and the postwar adjustment period as a whole, as in the
table on page 114 which shows the major factors affecting
reserves in this period, gold was a factor operating on
balance to absorb member bank reserves.
By far the major factors affecting member bank reserves
over these abnormal years were the increases in Federal
Reserve credit and in currency in circulation, most o f
which occurred during war years. During these years, the
113
T H E FE D E R A L RESERVE SYSTEM
Federal Reserve System, in support o f war finance, under
took to supply through open market operations enough
Federal Reserve credit to enable the banking system to
purchase the Government security offerings not taken up
by nonbank investors and to meet the rapid wartime
increase in currency in circulation. Another objective o f
M a j o r F a c t o r s i n B a n k R e s e r v e E q u a t io n
D e c e m b e r 31,1941—J u n e 30, 1951
[In billions of dollars]
Factors supplying reserves:
Increase in Federal Reserve credit......................
Other factors (net).................................................
21.7
2.5
Total.....................................................................
24.2
Factors absorbing reserves:
Increase in currency circulation...........................
Outflow o f gold.....................................................
16.6
1.0
Total....................................................................
17.6
Increase in member bank reserves......................
6.6
Total.....................................................................
24.2
operations in war years was to maintain a stable credit
market so that the credit needs o f Government and essen
tial industry could be met promptly and cheaply. Federal
Reserve discount rates were maintained at low levels. In
support of this program, the authorities in 1942 reduced
reserve requirements o f central reserve city banks to make
them the same as those o f reserve city banks.
The financial needs o f the war effort expanded rapidly
up to the end o f hostilities, and the net effect o f Federal
114
B A N K RESERVE EQ U A TIO N
Reserve policies was to offset the drain on bank reserves
resulting from the increase in currency circulation and to
enlarge bank reserve positions enough, together with ex
cess reserves carried over from the prewar gold inflow, to
support a more than doubling o f commercial bank de
posits. Since Federal Reserve credit was supplied freely
during this period through open market operations, very
little use was made by member banks o f the discount
privilege despite the low level o f Reserve Bank discount
rates.
The Federal Reserve authorities carried over into the
postwar period a policy o f supporting the prices o f Gov
ernment securities at close to par, thus maintaining a high
degree o f yield stability in this and other sectors o f the
credit market and continuing a policy o f credit and mone
tary ease. In this situation banks, and indeed all holders
o f Government securities, were able to make adjustments
in their operating positions through transactions in Gov
ernment securities. Since Federal Reserve credit was freely
available at the call o f the market, the System was pre
cluded from absorbing substantial additions to reserve
balances from a return flow o f gold and currency. Because
o f their easy reserve positions, member banks had only
infrequent occasion to obtain reserve funds through re
discounting with the Reserve Banks.
In early postwar years, Federal Reserve credit, which
had expanded so rapidly during the war, tended to be
reduced by Treasury retirement o f Government debt held
by the Reserve Banks. But this factor was more than offset
by credit extended through open market operations to
maintain Government security prices and yields, by the
postwar gold inflow, and by some reduction in currency
115
T H E FE D E R A L RESERVE SYSTEM
in circulation. In order to curb inflationary credit expan
sion based on further growth in member bank reserves,
the Federal Reserve authorities in 1948 increased the
Reserve Bank discount rate modestly and raised reserve
requirements in several steps, in part under special tempo
rary authority granted by the Congress. As banks sold
Government securities to supply themselves with reserves
to meet the higher requirements and as nonbank investors
also liquidated some o f their holdings, the Federal Reserve
made purchases in support o f the market, thus expanding
the volume o f its credit.
Early in 1949, inflationary pressures abated and a mod
erate recession in business activity set in. In these circum
stances the Federal Reserve authorities lowered reserve
requirements by steps over the period from late spring to
early fall. Commercial bank demands for Government
securities resulting from the increased availability o f re
serve funds were met largely by Federal Reserve sales in
order to stabilize prices and yields in the Government
securities market. This action reduced the volume o f
Federal Reserve credit.
Economic recovery from mild recession was in full
swing by mid-1950 when the outbreak o f hostilities in
Korea touched off another surge o f inflationary pressures.
In the nine months following, Federal Reserve credit
expanded rapidly as a result o f System purchases o f Gov
ernment securities from bank and nonbank investors in
stabilizing market prices and yields. The increase more
than offset the drain o f a large gold outflow and some
increase in currency circulation. As a measure to reduce
the over-all liquidity o f the banking system and thus to
help curb inflationary bank credit trends, the Federal
116
B A N K RESERVE EQ U A TIO N
Reserve authorities early in 1951 raised reserve require
ments. One effect o f this action, under conditions o f Fed
eral Reserve support o f the Government securities market,
was to increase Federal Reserve credit through open
market purchases.
There was a growing recognition in this period that
Federal Reserve support o f Government securities prices
and yields at arbitrary levels was incompatible with
effective Federal Reserve regulation o f the volume of
bank reserves. In March 1951 the Treasury and the Federal
Reserve agreed to discontinue the policy. The major ob
jective o f the accord was to minimize the creation of
reserve funds at the initiative o f the banks and other
investors through sales o f Government securities to the
Federal Reserve at pegged prices and yields.
The Post-Accord Period
After a brief adjustment period during which the Federal
Reserve continued to buy some Government securities in
the open market, Federal Reserve operations were re
adapted to the flexible use o f its general methods of
influencing bank reserve positions in accordance with the
transitory and growth needs o f the economy. Over the
next two years, the principal factors affecting bank reserve
positions changed as shown in the table on page 118.
Further increase in member bank reserve balances was
limited. A sizable gold inflow occurred during the first
year and some outflow in the second, with a net gold inflow
supplying reserves. Currency circulation growth continued
and was a factor absorbing reserve funds. Federal Reserve
credit also expanded, the expansion reflecting a combina
tion o f discount and open market operations rather than
117
T H E FE D E R A L RESERVE SYSTEM
open market operations alone. To make these combined
operations effective in regulating the volume o f Federal
Reserve credit, Federal Reserve Bank discount rates were
raised moderately early in 1953.
M a j o r F a c t o r s i n B a n k R e s e r v e E q u a t io n
June
30, 1951—J u n e 30, 1953
[In billions of dollars]
Factors supplying reserves:
Increase in Federal Reserve credit......................
Inflow of gold........................................................
Other factors (net).................................................
1.4
0.7
0.7
Total.....................................................................
2.8
Factors absorbing reserves:
Increase in currency circulation...........................
2.3
Increase in member bank reserves.......................
0.5
Total.....................................................................
2.8
With other factors about in balance in the first part of
1953, a reduction in Federal Reserve credit from open
market operations early in the year and later from repay
ment of member bank borrowing resulted in a decline in
member bank reserve balances. To keep this decline from
exceeding seasonal proportions, and in view of the pros
pects ahead for Treasury financing and also for expansion
in bank credit consistent with normal economic growth,
the Federal Reserve authorities toward midyear increased
the supply o f reserve funds through open market opera
tions and later made reserves available through a reduction
in reserve requirements.
118
B A N K RESERVE E Q U A TIO N
Concluding Comment
The foregoing analysis indicates how the major factors
in the bank reserve equation are interrelated, and how ups
and downs in any one o f them may be offset by changes
in the others or may be reflected in changes in member
bank reserves. Changes in minor factors are usually either
small or temporary in importance. The discussion has also
brought out how Federal Reserve operations may be ad
justed to the various factors affecting member bank
reserves. Students o f monetary and banking developments
can gain considerable insight into the developments o f any
particular period by arranging and analyzing the monetary
factors in this way. The data are published each month
in the Federal Reserve Bulletin and weekly changes are
reported in the regular Federal Reserve Bank condition
statement described in Chapter XIII. Behind all the
changes in this equation, o f course, is the impetus of
innumerable economic forces.
119
CHAPTER IX
IN FLU EN C E O F RESERVE B A N K IN G O N E C O N O M IC
STABILITY. Federal Reserve influence on the flo w o f credit and
monej ajffects the volume o j lending, spending, and saving in the
economy generally. Reserve banking policy thus contributes to
stable economic progress.
E
ARLIER chapters have described the way the Federal
Reserve operates to affect member bank reserve
positions in order to curb the flow of credit and money
when it is excessive or to encourage the flow when neces
sary to foster economic expansion. N ot much has been
said about the various ways Federal Reserve actions
actually influence commercial bank lending and investment
decisions. Nor has consideration been given to how reserve
banking policy can operate to influence the economic de
cisions o f other lenders and o f individuals and businesses.
In this chapter the discussion is pursued along these lines.
The object is to describe the broader working o f reserve
banking operations in influencing the lending, spending,
and saving o f all sectors o f the economy.
120
IN F L U E N C E O N ECO N O M IC STABILITY
General Effects o f Credit Tightening or Easing
Credit and monetary policy has widespread effects in
discouraging or encouraging expenditures. A general
tightening or easing o f credit has its most direct effect in
restricting or increasing the amount o f spending with
borrowed funds. Credit restraint or ease also curbs or
promotes expansion o f the money supply and so affects
the amount o f cash balances which individuals, businesses,
and other groups have available for spending.
Credit restraint or ease, moreover, has important de
terrent or stimulative effects on spending out o f existing
cash balances and from funds obtained by the sale of
assets, where no credit granting and no money creation
are involved. These are indirect effects, which come about
in a number of ways.
Credit restraint, for example, will tend to dampen the
too optimistic expectations o f businesses and consumers.
A rise in interest rates produced by credit tightening will
tend to reduce the value o f capital assets, a development
that will discourage some new investment in construction
and in producers’ equipment. Consumers and businesses
may decide to save more, either because they are less sure
that credit will be available to meet possible emergencies
or to ensure fulfillment o f future plans, or because the
interest return on savings has become more attractive.
Easing of credit, on the other hand, tends to have
opposite effects. It encourages spending with borrowed
money. It also stimulates more spending out o f current
income and past savings. Credit easing does this by pro
moting the belief that prices o f goods and services will
rise, by reducing interest rates and thereby both lowering
the cost of borrowing and stimulating a rise in capital
121
T H E FE D E R A L RESERVE SYSTEM
values, and by making it less necessary and less profitable
for businesses and consumers to save.
Whether a tightening or an easing o f credit will find a
response in the demand for credit depends on the existence
o f a fringe o f borrowing or potential borrowing. That is,
greater difficulty in obtaining credit or increased cost o f
credit influences decisions o f borrowers by deterring them
from using credit for investments with marginal profit
ability or for consumption o f marginal usefulness. It may
also deter borrowers from using as much credit for other
purposes as might have seemed profitable or useful had
credit conditions remained unchanged. In a boom period
when credit is in great demand, there is always fringe
borrowing that can be cut out either by greater selectivity
in lending or by higher interest costs. If an easing o f credit
is to stimulate borrowing in a period o f business recession,
there must be a similar fringe o f potential borrowing that
will become effective when credit is more readily available
and cheaper. Under most conditions such a fringe exists,
and an easing o f credit will stimulate borrowing in
amounts or for purposes that were previously not regarded
as profitable or useful, and for purposes for which credit
could not previously be obtained.
This fringe o f potential borrowing, however, may be
very limited under special circumstances. In a period o f
inflationary boom, investment in plant and equipment
(productive capacity) and in housing and purchases o f
consumer durable goods may proceed so rapidly, unless
checked somewhat, that future needs will be too far antic
ipated. Then in case o f a serious business downturn,
many activities involving credit that would ordinarily have
been greatly stimulated by an easing o f credit may not
122
IN F L U E N C E O N ECO N O M IC STABILITY
respond. For the time being the demand for them will
already have been filled in the previous boom. Other
potential borrowers may feel so discouraged about profit
possibilities as a result o f the downturn that they too will
not borrow, however cheaply and readily credit may be
available. Once such conditions and attitudes have devel
oped the immediate effect of an easing o f credit will be
limited, although such an easing is still an essential
measure in setting the stage for ultimate recovery. The
ability to combat a recession with credit and monetary
action depends in large part, therefore, on the extent to
which restrictive credit action has been taken in the pre
ceding boom so as to leave an unsatisfied fringe demand
for credit, as well as on how early and aggressively the
easing action occurs after a downturn.
How a Tightening or Easing o f Credit Comes About
A general tightening of credit results from a reduction
in the availability o f credit relative to the demand for it.
Such tightening may develop because the supply o f credit
has contracted without a corresponding reduction in de
mand, because the demand for credit has increased without
a corresponding increase in supply, or from some combi
nation o f these factors. In a boom period demand for
credit typically increases and credit conditions tend to
tighten even though there is an actual increase in the
amount of credit granted. In order to keep credit from
tightening under such conditions, the total credit and
monetary base would need to expand at a pace set by the
progress of the boom, regardless o f the inflationary or
other unsound developments that might be occurring.
A general easing o f credit results from an increase in
123
T H E FE D E R A L RESERVE SYSTEM
the supply o f credit relative to the demand for it. Easier
credit conditions may generally be expected to develop in
a period o f economic recession, unless there are banking
difficulties or extreme pressures for liquidity on the part
o f consumers and businesses. Credit and monetary policy
in such a period should promote the development o f
easier credit conditions.
Effect on Lenders
A general tightening or easing o f credit affects lenders
in all sectors o f the credit market, from short- to long-term.
In the short- and intermediate-term sectors o f the market,
the major suppliers o f funds are the commercial banks.
Expansion or contraction o f their loans and investments
tends to expand or contract the volume o f money. There
are, however, many other lenders that supply a substantial
volume o f short- and. intermediate-term credit through
investment in prime-grade marketable paper o f secondary
reserve funds and o f cash balances not needed for current
expenditures. The volume o f such investment varies with
the attractiveness o f the interest return. The supply o f bank
credit is dependent on bank reserve positions, which in
turn may be tightened or eased by reserve banking actions,
as was explained in Chapters II and III. The total supply
o f short- and intermediate-term credit is thus highly
flexible.
In the market for long-term credit the supply o f funds
is closely related to the volume o f saving. Major lenders
in this market, in addition to individuals, are insurance
companies, savings banks, savings and loan associations,
public and private pension funds, and nonprofit institu
tions. Commercial banks, although primarily short- and
124
IN FL U E N C E O N ECO N O M IC STABILITY
intermediate-term lenders, invest their savings and other
time deposits in real estate loans and in long-term corpo
rate, Federal, and State and local government securities.
The supply o f investment funds is relatively fixed at any
time and does not adjust quickly to changes in demand.
In a period o f boom, however, increased demand for long
term credit tends to spill over into the short-term credit
market, and in a period o f recession lack o f long-term
credit demand may induce investment funds to seek short
term outlets. Conditions o f availabilty and cost o f short
term and long-term credit thus are constantly interacting.
Moreover, the lending and investing activities o f commercial
banks bridge the credit markets and help to link them
together.
Commercial banks. Individual commercial banks obtain
funds primarily from the deposit o f working balances and
savings o f individuals and businesses. For the banking
system as a whole, however, most o f the deposits result
from credits extended by banks, as has been explained in
preceding chapters. Commercial banks as a group can
expand their credits only to the extent that they have or
can obtain the reserves needed to support the resulting
growth in deposits, and the availability o f bank reserves
is directly subject to Federal Reserve influence.
Commercial banks, as was noted earlier, consider that
they should borrow only as a temporary expedient. They
do not like to be long in debt. Any individual bank can
get additional funds to lend by selling Government or
other securities or by permitting maturing issues to run
off. The action o f this bank affects other banks, however,
for the buyer o f securities sold by the bank will draw down
a bank account to make payment. Consequently, banks
125
T H E FE D E R A L RESERVE SYSTEM
as a group cannot expand their total supply o f lendable
funds in this way except when such paper is being bought
by the Federal Reserve System. Unless the Federal Re
serve is supplying reserves, a reduction in security holdings
by one or more banks will normally draw reserves from
other banks and no net addition to reserves will occur.
An attempt by banks as a group to obtain additional
reserves by selling securities, or by allowing maturing
issues to run off, will increase the supply o f short-term
paper for sale in the market, thus lowering prices and
raising yields on such paper. Similar market pressure may
result if banks, in order to build up their reserves, draw upon
balances with correspondents or call loans made in
central credit markets.
At the lower prices and higher yields, Government and
other short-term securities will be more attractive. Non
bank investors may be induced to buy more o f them,
using temporarily idle deposit balances. Sales o f short-term
paper by banks to other investors and the use by banks
o f the proceeds to make loans will shift the ownership o f
deposits and may increase the activity o f existing deposits,
but such sales will not increase total bank reserves so as
to permit an increase in total bank credit and deposits.
With prices lower and yields higher on short-term paper,
banks are less likely to reduce their holdings o f secondary
reserve assets, notably short-term Government issues.
Some banks may continue to do so, but others will stop
selling or may buy. In the aggregate, the secondary reserve
position o f banks will tend to stabilize.
This development is brought about in several ways.
Many banks and other potential lenders are reluctant to
sell securities at a loss. As the potential loss becomes
126
IN F L U E N C E O N ECO N O M IC STABILITY
greater, this reluctance deepens. Rising yields on short
term paper, moreover, make the credit outlook uncertain.
This uncertainty, together with the possibility o f losses on
the sale of paper held, makes the secondary reserve posi
tions o f banks less satisfactory to bank managements.
Hence the amount o f liquid assets held as secondary
reserves, which was previously viewed as adequate or even
more than adequate, comes to be viewed with concern.
The result is a greater unwillingness on the part o f bank
managers to reduce holdings o f secondary reserve securi
ties in order to make more loans.
The key fact is that, with a tightening in the credit
situation, banks cannot count with as much certainty on
the ready availability o f additional reserve funds and will
therefore tend to be more restrictive in their lending prac
tices and standards. This restraint both reflects and is a
part o f the process o f credit tightening. As the credit and
monetary climate changes, bankers modify their expecta
tions about the general outlook for business and commod
ity prices. Applications for loans, particularly inventory
loans, are more carefully screened. Businesses that obtain
credit to accumulate inventories are under pressure from
their bankers to keep inventories more closely in line with
actual requirements. Bankers may also bring pressure for
repayment o f outstanding obligations on some borrowers
whose financial positions have become less satisfactory.
In general, rather than being eager to extend credit, they
are more selective in their loan judgments, especially
where there are reasons for refusing credit requests or not
meeting them fully and for accelerating repayment o f out
standing loans.
When credit conditions ease, more and more banks free
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T H E FE D E R A L RESERVE SYSTEM
themselves from borrowing and, as reserves accumulate
in excess o f working requirements, they become more
aggressive in competing for loans and marketable paper.
Other lenders and investors are also under pressure to
keep their funds employed. This change in the credit situ
ation finds prompt response in declining yields in all
sectors o f the market. Uses o f credit that under conditions
o f credit tightness were postponed or not cultivated by
lenders are promoted by them under conditions o f credit
ease.
Lenders and investors in the long-term market. A tighten
ing in credit and the accompanying increase in interest
rates significantly affect lenders and investors who operate
primarily in the long-term credit market, including
life insurance companies, mutual savings banks, savings
and loan associations, and pension funds. They become
less willing to make any but the best grade loans and in
vestments, and they generally exercise greater caution in
accepting credit applications from marginal risks.
This change in attitude reflects in part the declining
value o f assets associated with rising interest rates. All
income-producing assets yielding a fixed rate o f return
tend to decline in price when market rates o f interest rise.
This is true because they are valued in the market on the
basis o f expected returns, capitalized at the appropriate
current rate o f interest including allowance for risk. It is
easy to see this relationship in the case o f prime-risk secu
rities, since their market value changes only with changes
in interest rates; when interest rates rise, the value o f such
securities correspondingly declines. Actually the decline
can be even more marked in the case o f securities or other
income-yielding assets o f lesser grade. As interest rates
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IN F L U E N C E O N ECO N O M IC STABILITY
increase, investors become less optimistic about the busi
ness outlook and therefore change their appraisals o f risk
positions. Such changes in appraisals o f risk, combined
with the general increase in interest rates, result in an even
greater decline in value for lesser grade securities than for
prime assets.
Thus in a period o f tightening credit, long-term lenders
and investors, while at first attracted by the higher yields
available on assets o f less than top grade, gradually become
more restrictive and selective. They become less willing to
sell prime securities to acquire higher yielding but more
risky assets, partly because they can sell the prime securi
ties only at a loss, which they hesitate to accept. They also
become more interested in retaining in or adding to their
portfolios the more liquid types o f assets, because o f
concern about the decline in the market value o f their
entire investment portfolio and the general uncertainty
about future developments. In addition, the higher interest
rates on these more liquid assets in a period o f tightening
credit come closer to providing the average interest rate
that institutional lenders must obtain on their earning
assets in order to meet contracts with their own creditors.
In recent decades the flow of savings to nonbank insti
tutional lenders, particularly insurance companies, has
increased rapidly and the size of the investment problem
o f these lenders has grown accordingly. In order to ensure
the ready placement o f funds regularly becoming available
for investment from new savings and from repayment o f
old loans, the major savings institutions have developed
methods o f committing their funds in advance to corpo
rate, mortgage, and other borrowers. Such commitments
make it possible for potential borrowers to proceed with
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T H E FE D E R A L RESERVE SYSTEM
projects that they might not undertake without assurance
o f financing on satisfactory terms. But nonbank institu
tional lenders will hesitate to commit themselves beyond
the funds they expect to have coming in, if they fear that
interest rates may rise in the near future and that they
may therefore have to sell securities at a loss to meet future
commitments. As a result, when credit is tightening, some
proposed projects requiring long-term credit may be de
ferred because financing commitments cannot be arranged.
When interest rates decline, investors in the long-term
market will find their positions more liquid. The yields
available on high-grade securities will fall and the prices
o f such securities will rise. This development in itself will
encourage long-term lenders to extend investment into
areas with more attractive rates o f return. Moreover, if
institutional lenders are quite certain that interest rates
will fall and that prices o f high-grade securities will rise,
they will be willing to commit themselves to future lending
that will require the sale o f high-grade securities in order
to make loans with a more attractive interest return.
Underwriters and security dealers play an important
role in the credit market, and their responses to credit
tightness in turn affect the availability o f credit. They are
particularly sensitive to changes in interest rates because
they customarily carry a large inventory o f securities in
the process o f distribution. They risk large losses if they
are holding large amounts o f securities in a period o f
rising interest rates, since they may not be able to sell
them except below cost or may have to carry the securities
for some time on borrowed money. Thus underwriters and
dealers may be expected to carry securities less readily and
hence to discourage security flotations while interest rates
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IN FL U E N C E O N ECO N OM IC STABILITY
are rising. When yields are stable or are expected to fall,
they will be more likely to encourage such flotations.
Effect on Borrowers
Restraint on borrowing exerted by tightening credit
results in part, as already explained, from the increased
difficulty of finding lenders and obtaining loans. It also
results in part from the influence on the borrower o f higher
interest costs and from his greater uncertainty about
future credit and business developments.
Borrowers for business investment. Business borrowing
is done on the basis o f being able to obtain capital at rates
o f interest lower than the return that is expected from the
use o f that capital. These margins will be affected by
changes in interest rates and by changes in the profitability
o f the business concerned. Each change, though small,
may influence borrowing for which the profit margin is
narrow, while not affecting the bulk o f economic enter
prise. Such small effects, however, help to maintain
economic balance.
The sensitivity o f business borrowers to changes in
interest rates varies widely. Business borrowers in the short
term market may be greatly influenced by changes in credit
conditions. Inventory accumulation is normally financed
in substantial part by short-term credit. When businesses
have been building up inventory positions, a tightening in
the credit and monetary situation removes some o f the
incentives for inventory accumulation. Uncertainty with
respect to renewing the credit, moreover, increases the
possibility that inventory holdings may have to be sold
under unfavorable market circumstances. This deters par
ticularly inventory accumulations o f a speculative variety.
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T H E FE D E R A L RESERVE SYSTEM
In certain fields o f long-term investments, such as
industrial and commercial construction, public utilities,
and railroads—each o f which is a large and important
field—interest costs are particularly significant. In such
fields comparatively small increases in interest rates can
have a substantial effect in postponing the demand for
capital. Even in other fields where interest costs are less
important, fringe borrowers may be deterred from borrow
ing when interest rates rise, while other borrowers may
decide to get along with less credit. The higher long-term
rates become, and the more likely this condition is tempo
rary, the greater will be the tendency for long-term
borrowers to postpone investment expenditures because
they expect to be able to borrow later at considerably lower
interest costs.
An increase in interest rates does more than affect the
cost o f credit to borrowers. It also reduces the market
value of existing assets unless the actual or expected
earnings on these assets rise, since earnings are capitalized
at a higher rate o f interest. The liquidity position o f all
asset holders is adversely affected by this development,
and their willingness to undertake new long-term commit
ments may be influenced.
A rise in interest rates also influences the utilization of
productive resources, directing some activity away from
production o f long-lived, slowly depreciating capital goods
and thereby freeing resources for an immediate increase
in output o f consumption goods and o f producers’ equip
ment to make consumption goods. A rise in interest rates
brings this about both by increasing the cost o f long-term
borrowing and by changing the relationship between prices
o f existing capital assets and the cost of producing new
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IN F L U E N C E O N ECO N O M IC STABILITY
assets. In the fixed capital area these changes, together
with changes in the outlook for profits and risks due to
the altered credit and monetary situation, shift the balance
o f business decisions toward holding or buying old assets,
and adapting old assets to new uses, rather than producing
new ones.
How the changed relationship between prices o f existing
capital assets and costs o f producing new ones occurs is
indicated below. The illustration pertains to an office
building with a net income from rent o f $ 1 0 0 ,0 0 0 a year.
Estimated cost o f constructing a new building
Capitalized market value of an existing build
ing with earnings from rent (net of all
current costs and depreciation) of $100,000:
$1,500,000
If the current interest rate, with allowance
for risk, is 6 per cent
1,666,667
If the current interest rate, with allowance
for risk, is 7 per cent
1,428,571
If the current interest rate for such investment, with
allowance for risk, were 6 per cent, the capitalized value
o f the existing property would be more than the cost o f
constructing a new building with the same earning pros
pects. An investor in this type o f real estate, instead o f
buying an existing building, would build a new structure,
other things being equal. On the other hand, if the relevant
interest rate were 7 per cent, it would not pay to build a
new structure and the decision would go the other way.
Lower interest rates, through their effects on costs,
capital values, and business anticipations, will encourage
borrowers to make additions to physical property and also
to accumulate inventory.
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T H E FE D E R A L RESERVE SYSTEM
Consumer borrowers. Use o f credit by consumers is not
readily subject to direct limitation by higher interest rates
in the credit market. Consumer credits are generally ex
tended on fairly standardized terms and at relatively high
and inflexible credit charges. The rate paid for money at
wholesale by the institutions that lend to consumers is only
one o f a number o f important cost elements in the credit
charge to consumers at retail. Thus changes in interest
rates in the credit market have a less than corresponding
effect on the charge for credit to consumers. Nevertheless,
the interest cost is one important element in lenders’ cost,
and general credit tightness or ease tends to be transmitted
to consumer credit through its influence on the strictness
or leniency of credit standards applied by institutions
granting such credits. Alteration of credit standards is a
method by which lenders in this area control other im
portant elements o f their costs, namely, collection costs
and losses by default. Because o f the nature o f the con
sumer credit market, selective credit regulation has been
used in this field during emergency periods.
Borrowers on residential mortgages. Mortgage borrowing
for house purchases is considerably affected by tightening
credit conditions and increases in interest rates. Borrowing
to buy houses is typically long-term and on an instalmentrepayment basis. An increase in the interest rate, which
adds to the monthly mortgage payment, raises the attrac
tiveness o f rental housing compared with ownership.
Total spending for houses may thus be reduced, as some
buyers are discouraged altogether and others are induced
to buy cheaper houses. This affects economic activity
most directly through the market for new houses.
Since the size o f the monthly payment on a mortgage
13 4
IN FL U E N C E O N ECO N OM IC STABILITY
reflects the length o f the borrowing term as well as the
interest rate, the restrictive effect in the housing sector of
an increase in interest rates may be largely offset by
lengthening the period o f mortgage repayment. It is,
consequently, highly important to avoid encouragement
o f longer mortgage maturities during a period o f boom
when credit tightness is being relied on to help hold down
spending pressures and maintain economic stability.
The tendencies here described, o f course, work in re
verse to stimulate house purchases during a period o f
recession.
Investors and traders in corporate stock. The direct effect
o f changes in credit conditions and interest rates on de
mand for credit to finance purchases o f corporate stocks
depends largely on what is happening in the stock market.
When stock prices are stable, credit tends to be used by
regular investors and professional traders who deal in lots
o f substantial size and expect only small unit profits.
Credit demand for such transactions may be sensitive to
interest rates, since the increased cost o f higher rates may
wipe out profits, while lower rates will tend to add to
profits. On the other hand, when stock prices are rising
or declining under the impact o f speculative pressures, the
expectation o f quick capital gains may be so strong as to
make borrowing costs a matter o f distinctly secondary
importance. In such circumstances, selective credit regu
lation o f margin requirements on loans to purchase or
carry stocks can aid in restraining credit expansion in this
area.
Tighter or easier credit conditions may indirectly affect
borrowing on stocks through their influence on the pace
o f economic activity. The willingness o f individuals to buy
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T H E FE D E R A L RESERVE SYSTEM
and hold stocks, both outright and on credit, is necessarily
related to their judgments o f business developments and
prospects.
Effect on Saving
Changes in credit conditions and concomitant changes
in interest rates will affect the volume o f saving. When,
for example, some groups in the economy increase their
saving, an increase can take place in investment expendi
tures, or in consumption expenditures financed by borrow
ing or by drawing down asset holdings, without resulting
in an increase in the total demand in the economy.
To trace the effects on saving o f a tightening or easing of
credit and the accompanying changes in interest rates
requires a many-sided approach. To begin with, one needs
to keep in mind some facts about the term “saving” as it
is generally used. First o f all, saving may be done not
only by individuals (including unincorporated businesses)
but also by corporations and certain other institutional
forms in the economy. Second, and more important, the
aggregate volume o f individual or other saving in any
period is the total accumulated by all who saved in the
period, minus the total o f all who consumed, or distributed
as dividends, more than their incomes—that is, dissaved—
by borrowing or by drawing on accumulated assets. Third,
there are many forms o f saving, or rather many uses o f
saving, and they vary in their response to credit tightening
or ease and in their economic effects. In a discussion o f
how saving is affected by changes in credit conditions,
each o f these points must be considered.
For saving by individuals, credit tightness and a rise in
interest rates, for example, may set up cross currents o f
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IN FL U E N C E O N ECO N O M IC STABILITY
response. Some individuals save for the purpose o f building
up assets that will provide a retirement income o f a certain
size. As long-term interest rates rise, the amount o f saving
required for such an income declines. Such savers can
reduce their saving and still meet their needs, if they choose
to do so. On the other hand, some individuals are con
cerned about the current return and will save more when
a more attractive return is available. It is not easy to estab
lish where the balance o f these motivations may be.
It is not necessary, however, that those who save increase
their total saving in order to have an increase in the
aggregate of personal saving. An increase in the aggregate
o f saving may be achieved by a reduction in the volume
o f dissaving—that is, a reduction in the extent to which
consumption is financed by using past savings or by
borrowing.
Here the effect o f a tightening credit policy is clearer.
First, since credit is less readily available, the amount o f
dissaving with borrowed funds will be reduced from what
it would otherwise have been. Second, dissaving through
the use o f previous savings will also be discouraged, de
pending on the form in which such savings are held. For
savings held in marketable bonds and many other noncash
assets, a decline in market values will accompany the
general rise in interest rates. The sacrifice o f principal
involved in liquidation o f these savings will deter dissaving
o f this kind. Dissaving through the use o f past savings
held in savings accounts or in other liquid forms will be
less penalized. For some types, however, the current in
terest return will rise with the general advance in interest
rates and thus will make it more attractive to continue to
hold the accumulated savings.
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T H E FE D E R A L RESERVE SYSTEM
Another important consideration when credit conditions
are being tightened is that dissaving o f any kind wiJl be
discouraged, and saving encouraged, by the fact that
action to restrict the availability o f credit is being taken
for the purpose o f restraining speculative and inflationary
trends. There will be less incentive to hedge against ad
vancing prices by buying in anticipation o f such advances.
The fact that measures are being taken to tighten credit
and to curb monetary expansion will in itself reduce the
likelihood o f rising prices and lessen the incentive of
individuals to buy goods ahead o f needs. Also, overly
optimistic expectations as to future income, other than
from interest, will be tempered, and saving will be en
couraged as a matter o f prudent management o f personal
finances.
A business corporation saves when it pays out less in
dividends in any period than it makes in profits. Dissaving
occurs when losses are sustained or when more is dis
tributed in dividends than is made in profits. Total
corporate saving over any period is equal to the sum ot
all such saving minus all such dissaving.
Again taking the situation o f credit tightening, corpora
tions that plan to expand plant and equipment are likely
to be more cautious in their dividend policies (save more)
in order to ensure that funds will be available for such
outlays. Because availability o f credit is uncertain, other
corporations will be inclined to hold larger cash balances
rather than to increase dividends—on the chance that an
emergency or a profit possibility requiring cash might
develop.
Savings may be held or used in many different ways.
Personal savings, for example, may be invested in capital
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IN FL U E N C E O N ECO N OM IC STABILITY
assets, either directly, such as in houses or individual
business enterprises, or indirectly, such as in corporate
stocks or bonds. Savings may be held as accumulated cash
balances in demand deposit accounts or as currency hold
ings. They may be channeled into savings institutions
through increased ownership of savings deposits or shares,
or through the building up o f claims in pension funds,
annuities, or life insurance. Savings may also be kept in
savings bonds or other Government securities.
The form in which people wish to hold savings, current
or past, is o f great importance for economic stability. A
policy o f credit and monetary restraint, for instance, can
influence the decisions o f many savers, both individuals
and corporations, to invest new savings in dollar claims,
such as savings deposits or Government securities, and to
keep old savings in that form. Yields on these investments
tend to become more attractive. At the same time the
desire to invest in goods in order to beat price increases
is reduced because the expectation o f price increases,
particularly o f capital goods, is lessened. Holders o f certain
liquid savings, such as bonds, are discouraged from liq
uidating them to invest elsewhere by the fact that the
selling prices o f the bonds decline with increasing interest
rates.
In a period o f recession, increased credit availability and
declining interest rates, together with the expectation o f
continuing monetary ease, will tend to make employed
individuals more willing to spend and to go in debt for
consumption and business purposes, and corporations
more willing to maintain dividend payments even though
borrowing is required to provide for plant and equipment
outlays. Both individuals and corporations will be en
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T H E FE D E R A L RESERVE SYSTEM
couraged, by the greater certainty o f credit availability and
capital gains on assets held, to rely on sales o f such assets
if necessary to meet future needs. Added to all this will
be a growing confidence that declines in incomes and
prices will be checked. Relatively low levels o f interest
rates on prime assets under such circumstances may en
courage savers to invest in lower grade, higher yielding
securities.
Secondary Effects
The effects o f changes in credit conditions on lending,
spending, and saving discussed in this chapter are their
initial and more direct results in combating excess or
deficient demand and resultant inflationary or deflationary
pressures. These initial effects are succeeded by secondary
effects which may be o f great importance.
At a time when productive resources are virtually fully
employed, for example, tighter credit conditions will mean
that initially less money is paid out to consumers when
additional money income would merely increase prices
without expanding the supply o f goods available. As a
result, there will subsequently be less to spend for goods
and services and accordingly an abatement in pressure of
demand against the supply o f goods. Curtailed spending
for consumer goods and other finished products in turn
will have a dampening effect on the demand for the ma
chines and other producers’ equipment required to make
them. Consumers and investors may anticipate these
secondary effects and, through their attitudes and actions,
may bring them about more promptly and in greater
degree. In an inflationary period these developments tend
to restore stability in the economy.
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IN FL U E N C E O N ECO N OM IC STABILITY
On the other hand, in a period when the total demand
for goods and services tends to be deficient, the initial
stimulation to spending arising from easier credit condi
tions will likewise be multiplied. Increased activity arising
from credit ease will add to the money income available
for subsequent spending, thereby expanding the demands
o f consumers for goods and services and strengthening
incentives to improve and add to production facilities.
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CHAPTER X
IN TER EST R A T E C H A N G E S. In a flexible credit market,
tightness or ease is reflected in changes in interest rates which are
essential to the mechanism o f the market.
I
NTEREST rates are the prices paid for credit. In a
free enterprise system, they are established by the
interplay o f market forces. Interest rates perform the
important function o f influencing the volume o f funds
flowing into various channels. They also serve as a basis
for establishing the present value o f any assets which are
expected to provide income to their owners over a suc
cession o f years. Changes in interest rates constitute
incentives and disincentives by means o f which demand
for funds is kept in balance with supply.
In the discussion in the preceding chapter no specific
reference was made to the magnitude of interest rate
changes. As was explained, a tightening o f credit involves
an increase in interest rates; an easing of credit, a decline
in interest rates. Higher interest rates tend to eliminate
some marginal demand for loans. At the same time the
increased interest rates, combined with capital losses on
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IN TER EST R A T E C H A N G ES
assets and a change in business expectations, make lenders
more selective in their lending activities and spenders in
general less willing to spend. Conversely, lower interest
rates tend to increase marginal borrowing, to encourage
lenders to expand into lower grade securities, and to make
spenders generally more willing to spend.
The magnitude o f interest rate changes necessary to
bring supply and demand for funds into equilibrium and
to retard the development o f inflation or deflation depends
on many factors. This chapter will give some examples of
these, with specific reference to their operation in periods
o f tightening credit conditions.
Kinds o f Interest Rates
There are many interest rates because there are many
kinds and grades o f loans and investments. They are all
related to one another in some degree and reflect in varying
measure the relationship in the market between the de
mand for credit and the supply o f funds available for
lending and investing.
Traditionally, Reserve banking operations are not di
rected toward establishing any particular level or pattern
o f interest rates. Rather, they are aimed at expanding or
contracting the flow o f Federal Reserve credit as needed
to maintain general economic and financial stability. This
activity necessarily affects the flow o f bank and other
credit and the level o f interest rates. Moreover, the Reserve
Bank discount rate has a relationship to the cost o f credit
generally. Since Reserve Bank advances are extended on
short-term paper o f prime quality, the relationship be
tween the discount rate and other market rates is closest
in the short-term prime credit area.
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T H E FE D E R A L RESERVE SYSTEM
As pointed out earlier, Government securities under
existing conditions play a dominant role in the credit
market. The market rate on Treasury bills is the most
sensitive index o f changes in credit market forces, including
particularly changes in commercial bank reserve positions.
Other short-term interest rates usually have similar move
ments. When credit and monetary demands expand and
member bank borrowing at the Reserve Banks increases,
rates on short-term Government securities tend to rise,
and this tendency toward higher rates is in turn transmitted
to other credit markets. Adjustment o f the discount rate
to these changes depends on the judgment o f the Federal
Reserve as to the general economic situation and the
strength and soundness o f credit developments. The rela
tion o f the discount rate to a representative short-term
interest rate during the 1920’s and since World War II is
shown in the upper section o f the chart on page 147.
Long-term rates generally rise when short-term rates
rise and decline when short-term rates decline. The tighter
or easier credit conditions that accompany changes in
business activity are generally felt directly in both longand short-term fields. One reason is that, for some lenders,
the long-term markets for credit are competitive with the
short-term markets.
While short- and long-term rates generally move to
gether, the change in long-term rates is ordinarily smaller
than that in short-term rates. Lenders generally expect
extreme levels o f short-term rates to prevail for only a
short period o f time. Since the current yield on long-term
securities will be received until the maturity o f the security,
a relatively small change in long-term rates will restore
the competitive relationship. As already noted, moreover,
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IN TER EST R A TE CHA NG ES
when such yields rise the capital loss incurred on long-term
securities may serve to check sales and thus moderate the
rise in long-term yields. On the other hand, investors
generally hold short-term paper for the express purpose
o f adjusting to changes in their requirements for funds.
Hence short-term paper tends to be sold or bought as
cash assets o f investors temporarily fall below or rise above
desired levels. In recent years, long-term rates have been
constantly above short-term rates, but this has not always
been the case, as the chart on page 147 shows.
Influence o f General Economic and Financial Factors
The extent o f interest rate increases under conditions o f
credit tightness will depend on the entire economic back
ground at the time. To understand that background calls
for careful consideration of many questions. For example,
how strong are the credit demand pressures? By what
forces are they being generated? How extended or over
extended is the underlying economy itself? How optimistic
is the climate o f business expectations? And always, in
appraising the possible response o f interest rates to a
general tightening o f credit, it is necessary to take into
account the established organization o f the credit market
and the investment and operating experience o f the insti
tutions which make up this market.
Under some circumstances, reserve banking measures
to restrain undue credit and monetary expansion might be
reflected in only minor increases in interest rates; with
another background, the increase in rates might be
pronounced.
The response o f the economy to reserve banking action
will depend in part on the habits and patterns o f financial
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T H E FE D E R A L RESERVE SYSTEM
management built up over the preceding months and
years. Restrictive action, for example, may be effective
with relatively small increases in interest rates if existing
interest levels have prevailed for some time. Under these
circumstances institutional investors will be doing business
on the assumption that interest rates will remain substan
tially stable and that consequently securities may be sold
without significant loss. To these investors and to a great
many others, a tightening o f credit will introduce new
problems o f liquidity and bring about a retrenchment in
their activities, including their commitments to grant
credit at some future time. In the light o f extensive past
experience, uncertainty regarding future increases in in
terest rates will promote caution among lenders as long
as demand for credit continues strong.
The absolute level o f interest rates prevailing at a given
time and the range o f variation in interest rates for various
kinds and grades o f credit are other factors influencing the
extent to which a given credit action may cause interest
rates to change. A given absolute increase in rates, for
example, has a more depressing effect on the capital values
o f prime long-term investments if they are capitalized on
the basis o f a 2 Vi per cent rate rather than at 4 per cent.
More significantly, if the spread between the rate on prime
paper and the rates on secondary grade credits has been
small, the impact on capital values o f a given increase in
prime rates will tend to be carried more quickly throughout
the entire credit market than if a wider spread in rates
had prevailed.
The effect o f a change in interest rates depends also on
the total volume o f those types o f assets having market
prices that will respond quickly to such a change. The
146
INTEREST RATE CHANGES
INTEREST
RATES
Per C e n t p e r A n n u m
S H O R T - T E R M AN D F. R . D I S C O U N T
S H O R T - AN D L O N G - T E R M
RATES
RATES
147
T H E FE D E R A L RESERVE SYSTEM
larger this volume is, the greater and more immediate will
be the impact on the entire economy of a given interest
rate movement. On balance, developments in the American
credit market in the past twenty-five years, including
particularly the large expansion in marketable public debt,
have increased the importance o f assets having prices that
move promptly with interest rate changes.
Influence o f Special Credit Conditions
Institutional and other factors that exist in the credit
market at a particular time can have a big influence on
the responsiveness o f the economy to credit tightness and
on the size o f interest rate increases that credit tightness
will bring about. In 1928 and 1929, for example, specu
lation in the stock market had raised stock prices so high
that equity capital was available to corporations on more
attractive terms than debt capital. The cost o f debt finan
cing (the long-term interest rate) was increasing, but a
corporation could sell stock on such favorable terms that
this became the favored method o f financing.
In this period corporations relied heavily on the equity
market for capital. Investors on their part were attracted
into equities by prospects for future gains, even though
yields on high-grade bonds were higher than those current
ly obtainable on stocks. The stock market boom in those
years was based largely on margin trading financed heavily
in the brokers’ loan market, mostly by nonbank credit
(loans to brokers and dealers for the account o f others).
Interest rates o f 9 per cent or more in this market did not
prevent a large volume o f borrowing for speculation in
stocks.
Under such circumstances, credit actions to restrict the
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IN TER EST R A T E C H A N G ES
general availability o f credit could not easily be made
effective in curbing an unsustainable speculative boom in
the stock market except by affecting economic activity in
general and in that way making investment in equities
unprofitable. After the downturn that followed the eventu
al stock market crash, long-term interest rates declined
sharply. Even after the decline, however, borrowing costs
were higher than the very low cost o f equity financing that
had been available to prime companies during the stock
market boom o f 1929. Legislation designed to prevent a
repetition of this situation authorized the Federal Reserve
to regulate the use o f credit in the stock market through
margin requirements, as discussed in Chapter IV.
Under other and quite different circumstances, restraint
on credit may have a sharply restrictive influence before
the interest rate rise has been large. For example, when a
large amount o f business financing is being done in the
bond market, investment underwriters and security dealers
need to carry a substantial inventory o f bonds. For these
institutions the ratio o f capital to this inventory is typically
small, and their operations are heavily dependent on the
use o f short-term bank credit. Moderate increases in
interest rates raise their cost o f operation, cause the value
o f their inventory o f bonds to decline, put their capital
positions in jeopardy, threaten their credit-worthiness, and
cause them to reduce the volume o f new flotations o f
securities that they are willing to underwrite.
To give another example, the mortgage market was
particularly sensitive in the spring o f 1951 to a moderate
increase in long-term rates. This was because major lenders
were overextended in their lending commitments. Up to
that time lending had been running substantially in excess
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T H E FE D E R A L RESERVE SYSTEM
o f the funds they had from repayments o f old loans and
new savings, with the difference made up by sales o f
Government securities, which in turn had been purchased
by the Federal Reserve at support prices. In response to
the change in the credit situation at that time, and the
uncertainty as to future interest rate and security price
levels, these lenders reduced sharply their commitment
activities in mortgage financing and to some extent in
other financing also. This brought about some limitation
on the volume o f their lending.
Purposes o f Chapters IX and X
This chapter and the preceding one have described the
way in which a general tightening or easing o f credit, with
accompanying changes in interest rates, may function to
help maintain economic stability. The many forces, other
than credit and monetary forces, that cause instability
have not been considered. The chapters have taken for
granted that credit and monetary measures are not the
only reliance o f public policy in sustaining economic
balance.
The discussion in these chapters has focused more
largely on the broader effects o f credit tightness and rising
interest rates on lending, spending, and saving in a free
enterprise system. The mechanism o f credit ease is in
general the opposite o f tightness. It has been noted that
the response to credit easing is greatly influenced by cyclical
or other prevailing circumstances, and that the effective
ness o f credit easing in checking monetary contraction and
in bringing about resumed growth in economic activity
depends greatly on earlier effective reliance on credit
tightness to limit excessive credit and monetary expansion.
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IN TER EST R A TE C H A N G ES
The mechanism o f credit tightness and o f related in
creases in interest rates counteracts unsound business
booms to a large extent by curbing the pace o f investment.
In appraising the operation and effects o f this mechanism,
it is important to bear in mind the alternatives. To avoid
credit tightness in such a boom situation, it would be
necessary to create enough additional funds so that all
credit demands could be met, even though they might be
excessive from the standpoint of the maintenance o f stable
values and sustainable economic progress. Actually, the
extent to which it is possible to devote resources to expan
sion o f productive capacity and the stock o f housing and
commercial construction without generating an excessive,
inflationary flow o f credit and money depends largely on
the current aggregate volume o f saving.
In a free enterprise economy the volume o f saving is
not dictated by Government but depends rather on the
composite o f decisions regarding the use o f purchasing
power made by all those who receive incomes, who have
cash balances on which they can draw, who can liquidate
other assets for spending, or who can borrow. When sav
ings are very large, as they ordinarily are in this country,
sustained expansion o f productive capital in substantial
volume is possible without an excessive and unstabilizing
growth o f credit and money.
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CHAPTER XI
FEDERAL RESERVE SERVICE FUNCTIONS. The Federal
Reserve Banks handle the legal reserve accounts o f member banks,
furnish currency Jo r circulation, fa cilita te the collection and clear
ance o f checks, and act asfiscal agents o f the United States Govern
ment. To guide System policy and to inform the public, the Board
o f Governors and the Reserve Banks analyze national and regional
economic changes.
HE Federal Reserve System, in addition to its re
sponsibility for regulating the flow o f credit and
money, performs a variety o f regular services for member
banks, the United States Government, and the public.
The principal service functions o f the Federal Reserve are
described in this chapter.
T
Handling Member Bank Reserve Accounts
A substantial part o f the daily work o f the Reserve
Banks relates to member bank reserve accounts. Member
banks use their reserve accounts much as individuals use
their bank accounts, drawing on and replenishing them in
day-to-day transactions. The Reserve Banks must record
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FE D E R A L RESERVE SERVICE FU N C T IO N S
all transactions and strike a daily balance for the reserve
account o f each member bank. As previously indicated,
the average balance that a member bank must maintain
with a Federal Reserve Bank as a required reserve is re
lated to the member bank’s deposits, which are constantly
changing. Reserve requirements are computed by averag
ing daily deposits over a weekly period for central reserve
and reserve city banks and over a semimonthly period for
country banks. When the reserve account o f a member
bank falls below its requirement, the bank, in preference
to other adjustments o f its position, may borrow tempo
rarily from its Federal Reserve Bank to restore its balance
to the required level. With some 7,000 member banks, the
number o f such borrowing transactions in any year may
run into the thousands, even when the great majority o f
member banks do not borrow.
The credit transactions o f member banks described in
earlier chapters are by no means the only entries in their
reserve accounts at the Reserve Banks. For example,
entries are made as member banks obtain currency (paper
money and coin) to pay out to their customers or redeposit
currency in excess o f the amount needed for circulation,
checks are collected and cleared, Treasury deposits are
transferred from member banks to the Federal Reserve
Banks, and funds are transferred by telegraph for various
purposes. These transactions are described in subsequent
paragraphs.
Distributing Currency
There are two principal ways by which any individual
gets paper money and coin. Either he draws it out o f his
bank and has it charged to his account, or he is paid for
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T H E FE D E R A L RESERVE SYSTEM
his services or his merchandise with currency that has been
drawn out o f a bank by someone else. Practically all
currency, therefore, passes into and out o f banks at one
time or another.
As was shown in Chapter VI, there are times when
banks are called on to pay out more currency than they
receive and there are times when they receive more than
they pay out. In agricultural regions there is a heavy de
mand for currency at times when crops are being harvested;
in cities there is a heavy demand for currency at certain
times in the summer and in the fall before the Christmas
holiday season. Moreover, the demand varies for different
kinds of currency. Some communities use more coin and
less paper money than others, and some use more o f
certain denominations than others do.
When the demand for currency increases, banks provide
themselves with the amounts and kinds o f currency that
the people in their communities want. Member banks
depend upon the Federal Reserve Banks for replenishment
o f their supply, ordering what they require and having it
charged to their reserve accounts. Nonmember banks
generally get their supplies from member banks.
The twelve Federal Reserve Banks in turn keep a large
stock of all kinds o f paper money and coin on hand to
meet this demand. This includes both Federal Reserve
notes, which are Reserve Bank liabilities, and Treasury
currency, which consists principally o f silver certificates,
United States notes, and coin. A Reserve Bank pays for
currency obtained from the Treasury by crediting the
Treasury’s checking account for the amount obtained.
When the demand for currency abates, currency flows
back from the public and the nonmember banks to the
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FE D E R A L RESER V E SERVICE FU N C T IO N S
member banks. The member banks return the currency to
the Federal Reserve Banks, where it is credited to member
bank reserve accounts. The Federal Reserve adjusts its
operations so that the outflow and return flow o f currency
may take place with minimum tightening or easing effect
on the general credit situation.
Before establishment o f the Federal Reserve Banks in
1914, the means o f furnishing currency for circulation were
unsatisfactory. A gap existed between the Treasury and
the banking system, and the demand for additional cur
rency could not always be met promptly. This was the
case in the panic o f 1907 and, as already related, the
experience o f that year highlighted the need for a reserve
banking system.
The currency mechanism provided under the Federal
Reserve Act has worked satisfactorily—currency moves
into and out o f circulation automatically in response to
an increase or decrease in the public demand. The Treas
ury, the twelve Federal Reserve Banks, and the thousands
o f local banks throughout the country form a system that
distributes currency promptly wherever it is needed and
also enables surplus currency to be retired from circulation
at times when the public demand subsides.
Collecting, Clearing, and Transferring Funds
Currency is indispensable, yet it is used only for the
smaller transactions o f present-day economic life. A
century ago it was used far more generally. Since then the
use o f bank deposits has increased to such an extent that
payments made by check are now many times greater
than payments made with paper money and coin. The use
o f checking deposits by business and the general public
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T H E FE D E R A L RESERVE SYSTEM
is facilitated by the service o f the Federal Reserve Banks
in clearing and collecting checks and in providing the
mechanism through which commercial banks settle for the
checks they clear and collect.
For example, suppose that a manufacturer in Hartford,
Connecticut sells $1,000 worth o f electrical equipment to
a dealer in Sacramento, California and receives in pay
ment a check on a bank in Sacramento. The Hartford
manufacturer deposits the check in his Hartford bank.
The Hartford bank does not want currency for the check;
it wants credit in its reserve account at the Federal
Reserve Bank o f Boston. Accordingly, it sends the check
(together with other checks) to the Federal Reserve Bank
o f Boston, which sends it to the Federal Reserve Bank of
San Francisco, which in turn sends it to the Sacramento
bank. The Sacramento bank charges the check to the
account o f the depositor who wrote it, and has the amount
charged to its reserve account at the San Francisco Reserve
Bank. The Federal Reserve Bank of San Francisco there
upon credits the Federal Reserve Bank o f Boston, which
in turn credits the account o f the Hartford bank.
Since promptness is important in collecting checks, the
Federal Reserve Banks extend to member banks having a
substantial volume o f checks payable in other Federal
Reserve districts the privilege o f sending such checks direct
to other Federal Reserve Banks for collection. The Hart
ford bank, therefore, might have forwarded the $1,000
check direct to the Federal Reserve Bank o f San Francisco
for collection, at the same time informing the Federal
Reserve Bank o f Boston o f its action. Credit would then
have been given to the Hartford bank’s reserve account
by the Federal Reserve Bank o f Boston on the basis of
156
FEDERAL RESERVE SERVICE FUNCTIONS
this inform ation ju st as if the check had been sent through
Boston.
The volume o f checks handled through the Federal
Reserve Banks has grown rapidly over the years, as the
CHECKS HANDLED BY RESERVE BANKS
3750
3000
2250
-
1500
NUMBER
M illio n s of C h e c
1920
193 0
1940
r 1 95 0
______
accompanying chart shows. During 1953 the num ber was
nearly 2.9 billion, amounting to 1,026 billion dollars. In
addition, many other checks are collected by the city
correspondent banks and local checks are collected by
banks through local clearing houses or by direct presenta
tion to one another. In such cases, however, the settlement
157
T H E FE D E R A L RESERVE SYSTEM
or payment for checks on member banks is largely made,
directly or indirectly, through the member banks’ reserve
balances with the Federal Reserve Banks. Thus, the
facilities o f the Reserve Banks aid in check clearing and
collection whether or not the checks originate locally or
move across the country.
All checks collected and cleared through the Federal
Reserve Banks must be paid in full by the banks on which
they are drawn, without deduction o f a fee or charge.
That is, they must be payable at par; otherwise the Reserve
Banks will not receive them for collection. Banks on the
par list include all member banks and those nonmember
banks that maintain clearing balances with a Reserve
Bank. At the end of 1953, nearly 90 per cent o f all com
mercial banks and branches, accounting for 98 per cent o f
all commercial bank deposits, were on the Federal Reserve
par list.
Over the years the process o f clearing and collecting
checks has been greatly shortened and simplified. In that
development both commercial banks and the Federal Re
serve Banks have taken a part. By doing so, they have
improved the means by which goods and services are paid
for and by which monetary obligations are settled; they
have also reduced the cost to the public o f making pay
ments and transferring funds.
Besides checks, the Federal Reserve Banks also handle
other items for collection. These include such items as
drafts, promissory notes, and bond coupons.
In order to make transfers and payments as promptly
and efficiently as possible, the twelve Federal Reserve
Banks maintain a gold certificate fund in Washington
called the Interdistrict Settlement Fund, in which each
158
FE D E R A L RESERVE SERVICE FU N C T IO N S
Reserve Bank has a share. This fund represents a substan
tial part of the gold certificate reserves o f the Federal
Reserve Banks. Through it money is constantly being
transferred by telegraphic order from the account o f one
Reserve Bank to that o f another. On an average business
day, over a billion dollars o f transfers and payments are
made, consisting for the most part o f settlements for
checks collected, transfers o f balances for account of
member banks and their customers, and transfers for the
United States Treasury. During the month o f December
1953 the total o f such transfers and payments was nearly
75 billion dollars.
The cost of clearing and collecting checks and o f supply
ing and shipping currency and coin is a major part o f
Federal Reserve Bank expenses. These and other services
are provided for member banks free o f charge. This
practice is consistent with the ideal o f a money that
circulates at par in all regions o f the country.
Fiscal Agency Functions
The twelve Federal Reserve Banks carry the principal
checking accounts o f the United States Treasury, handle
much o f the work entailed in issuing and redeeming Gov
ernment obligations, and perform numerous other im
portant fiscal duties for the United States Government.
The Government has an enormous amount of banking
business to do. It is continuously receiving and spending
funds in all parts o f the United States. Its receipts come
mainly from taxpayers and purchasers o f Government
securities and are deposited eventually in the Federal
Reserve Banks to the credit o f the Treasury. Its funds are
disbursed mostly by check, and the checks are charged to
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T H E FE D E R A L RESERVE SYSTEM
Treasury accounts by the Federal Reserve Banks.
The Federal Reserve Banks also perform important
services for the Treasury in connection with the public
debt. When a new issue o f Government securities is sold
by the Treasury, the Reserve Banks receive the applications
of banks, dealers, and others who wish to buy, make
allotments o f securities in accordance with instructions
from the Treasury, deliver the securities to the purchasers,
receive payment for them, and credit the amounts received
to Treasury accounts. As brought out below, these pay
ments for the most part are initially made to and kept on
deposit in tax and loan accounts at member and non
member banks.
Each Federal Reserve Bank administers for the Treasury
the tax and loan deposit accounts o f banks in its district.
Both member and nonmember banks, by complying with
the Treasury’s requirements, may become “special depos
itaries” o f the Treasury and carry tax and loan deposit
accounts. The principal requirement is the pledge with a
Federal Reserve Bank, as fiscal agent o f the Treasury, o f
Government securities or other acceptable collateral that
will fully secure the balance in the account.
A bank designated as a special depositary credits to the
tax and loan account the proceeds o f its customers’ and
its own subscriptions to Government securities issued by
the Treasury from time to time. Taxes withheld at the
source are also deposited in these accounts. As the Treas
ury calls for the funds, they are transferred to a Treasury
account at a Federal Reserve Bank and become available
for disbursement. Tax and loan deposit accounts are a
convenient and practically indispensable device for the
sale of Government securities in large volume and, coupled
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F E D E R A L RESERVE SERVICE F U N C T IO N S
with their use for tax receipts, they provide a means o f
moderating the effect on member bank reserves o f fluctu
ations in the Treasury’s cash receipts. The great bulk o f
Government deposits is carried by the Treasury in these
accounts, pending transfer to the Federal Reserve Banks.
The Reserve Banks redeem Government securities as
they mature, make exchanges o f denominations or kinds,
pay interest coupons, and do a number o f other things
involved in servicing the Government debt. They issue and
redeem United States savings bonds and upon request hold
them in safekeeping for the owners. For the convenience
o f the Treasury and also for the convenience o f investors
in Government securities, it is necessary that there be
facilities in various parts o f the country to handle public
debt transactions. The Federal Reserve Banks furnish
these facilities.
During World War II the Federal Reserve Banks, under
the general direction o f the Board o f Governors, acted as
fiscal agents for the Army, the Navy, and the Maritime
Commission in guaranteeing war production and contract
termination loans made by commercial banks and other
financing institutions. The guarantee arrangement was a
war measure to expedite production o f essential goods and
materials by competent contractors and subcontractors
who lacked sufficient working capital. Following the out
break o f hostilities in Korea in mid-1950, a program o f
guaranteed loans patterned after the wartime program was
inaugurated. The Federal Reserve Banks are again serving
as fiscal agents under the general direction o f the Board’s
Regulation V, issued after consulting with the guaranteeing
agencies. These are the Departments o f the Army, Navy,
Air Force, Commerce, Agriculture, and Interior, the Gen
161
T H E FE D E R A L RESERVE SYSTEM
eral Services Administration, and the Atomic Energy
Commission.
The Federal Reserve Banks may also perform fiscal
agency services in connection with the financial activities
o f various Government lending agencies. The Federal
Reserve Banks are reimbursed by the United States Treas
ury and other Government agencies for much o f the ex
pense incurred in the performance o f fiscal agency func
tions other than depositary functions.
Because o f its location in one o f the principal financial
centers o f the world, the Federal Reserve Bank o f New
York acts as the agent o f the United States Treasury in
gold and foreign exchange transactions. It acts as deposi
tary for the International Monetary Fund and the Inter
national Bank for Reconstruction and Development; it
receives deposits o f foreign monetary authorities and per
forms certain incidental services as their correspondent.
These services include handling their short-term invest
ments in this market and holding gold under earmark for
them in the United States. All the Federal Reserve Banks
participate in foreign accounts carried on the books o f
the Federal Reserve Bank o f New York, which, in these
matters, acts as agent for the other Federal Reserve Banks.
The Board o f Governors in Washington exercises special
supervision over all relationships and transactions o f
Federal Reserve Banks with foreign monetary authorities
and with the International Monetary Fund and the Inter
national Bank.
Volume o f Reserve Bank Service Operations
The annual volume o f Reserve Bank service operations
described thus far runs into huge number and dollar
162
F E D E R A L RESERVE SERVICE F U N C T IO N S
figures. Both the composition and the total volume o f these
operations vary considerably with short-term fluctuations
in the level o f production, trade, and prices. Over the forty
years o f the Federal Reserve System’s existence, they have
grown rapidly as the financial resources o f the nation have
grown. The accompanying table shows the volume figures
for the principal operations o f the Federal Reserve Banks
for the year 1953.
V o lu m e o f S e le c te d F e d e r a l R e se rv e O p e ra tio n s, 1953
Pieces handled
Type of operation
Number
Amount
(thousands)1 (thousands of dollars)
Member bank borrowing:
Discounts and advances.............
20
93,364,640
Currency received and counted:
Paper currency............................
Coin............................................
4,405,255
5,889,238
29,514,663
607,205
Checks handled:
U. S. Government checks.........
Other...........................................
Postal money orders...................
458,607
2,415,164
366,807
140,739,438
885,726,031
6,091,173
Transfers of funds..........................
1,718
876,838,475
Treasury debt transactions:
Issues, redemptions and
exchanges of U. S. Govern
ment securities........................
177,596
381,877,330
1 Two or more checks, coupons, etc., handled as a single item are
counted as one “piece.”
Informational Services
Since economic forces are interacting, accurate back
ground as well as current information about major
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T H E FE D E R A L RESER V E SYSTEM
economic conditions is essential in determining and carry
ing out credit and monetary policy. The staffs o f the Board
o f Governors and the Federal Reserve Banks are constant
ly engaged in assembling and analyzing economic and
financial information that serves as a guide to the System
in the formulation and administration o f policy. By making
the bulk o f this information available in its publications,
the System helps to keep the public informed about the
functioning o f the economy and the reasons for Federal
Reserve action.
The Federal Reserve System follows the practice o f
explaining its credit actions to the public and publishing
the factual information on which policy decisions rest
because it believes that public understanding helps to
make effective a credit and monetary policy designed to
foster stable economic development and a stable dollar.
The more fully the public understands the issues involved,
the simpler and easier credit and monetary administration
can be. Accordingly, System publications undertake to
present objective, authoritative, and comprehensive dis
cussions o f economic and financial trends, together with
related statistical series.
The major publications o f the Board o f Governors are
listed following the closing chapter o f this book. These
publications deal for the most part with national economic
problems and trends. Each Federal Reserve Bank has its
own publications, presenting for the most part regional
material. Board and Federal Reserve Bank publications
together reflect the national and regional considerations
that must be welded in forming Federal Reserve policy.
164
CHAPTER XII
SUPERVISION OF BANKS BY THE FEDERAL RESERVE.
By keeping individual banks strong, bank supervision helps to
maintain an adequate and responsive banking system and thus con
tributes to the smooth functioning o f economic processes.
E
FFECTIVE operation o f individual banking institu
tions is essential to the orderly functioning o f the
whole banking system. The current financial needs of
commerce, industry, and agriculture are met partly
through loans and investments made by individual banks,
and the bulk o f the nation’s payments is made through
the checking deposits resulting from these lending activi
ties. Failure o f banks to meet their liabilities can reach far
beyond depositors and borrowers and the immediate
territory that the banks serve. The business o f banking,
therefore, is vested with a public interest and is subject to
supervision by governmental authorities.
Bank supervision, which began in this country more
than a century ago, is rooted in two characteristics peculiar
to the American banking system: first, a great number o f
commercial banks o f wide variation in size and in type o f
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T H E FE D E R A L RESERVE SYSTEM
banking service offered; and second, a mass o f detailed
State and national banking legislation, and o f regulations
issued under general legislation, designed to safeguard the
public interest.
Purpose o f Bank Supervision
Briefly stated, the major purpose o f supervision is to
aid in maintaining a system o f sound individual banks—
banks that are in a position not only to meet their liabilities
but also to supply the legitimate and changing credit needs
o f their communities. Such a banking system is one com
posed of individual banks in strong financial position,
operated by competent management in accordance with
tested banking principles and applicable banking laws and
regulations. It is also a banking mechanism through which
the flow o f credit and money will be responsive to reserve
banking policy and consistent with the public’s financing
needs under conditions o f stable economic progress.
Four groups have a direct and vital interest in bank
supervision: the banks subject to supervision; the custom
ers who have entrusted banks with their deposits and who
look to banks for credit accommodation and other finan
cial services; the investors who have purchased bank stock;
and those whose task it is to administer the supervisory
function in the public welfare.
Bank Supervisory Functions
As a governmental activity, bank supervision encom
passes a wide variety o f technical functions relating to the
operations o f banks. These concern the issuance and
enforcement o f supervisory and other regulations; the
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B A N K SU PERV ISIO N
organization and chartering o f banks; the periodic exami
nation of banks and the requiring o f steps by bank
management to correct unsatisfactory or unsound condi
tions found through such examination; the review and
analysis of periodic reports o f condition and o f earnings
and expenses; the rendering o f counsel and advice on
bank operating problems when requested, particularly in
the case o f smaller banks; the approval o f proposed
changes in the scope o f corporate functions exercised by
individual banks and o f proposed changes in their capital
structures; the authorization of branches and of the
exercise of trust powers; in some instances, the approval
o f bank mergers and consolidations; the regulation o f bank
holding companies; and the liquidation o f banks, including
the appointment o f a conservator under certain conditions
or a receiver in other circumstances.
While the technical functions o f bank supervision are
many and varied and relate to the full life cycle o f a
banking institution, its chief preoccupation is with banks
as going concerns. Its objective is to protect the banking
structure against weakness o f the component banks and
whenever possible to assist them in becoming stronger
units. Consequently, a major responsibility o f the super
visory authorities is to keep informed o f the condition,
operations, and quality o f management o f the banks
subject to their review and to contribute to the correction
o f unsound situations when they develop. Compared with
this primary and continuing supervisory function, other
functions, however necessary, may be regarded as limited
and occasional.
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T H E FE D E R A L RESERVE SYSTEM
Bank Examination
Bank examination, the best-known form o f supervisory
activity, is the fact-finding function o f the supervisory
authorities. Its purpose is to develop information that will
disclose the current financial condition o f the individual
bank, ascertain whether it is complying with applicable
laws and regulations, and indicate its future operating
prospects.
The examination process involves a number o f detailed
steps: verification o f all the examined bank’s assets and
the proof o f its liabilities; analysis and appraisal o f its
assets; analysis o f its liabilities; review and appraisal o f
its management; determination o f its liquidity position
and operating trends; study o f the bank’s position in re
lation to community factors and general business condi
tions; and consideration o f the bank’s operating record
in the light o f various statutory and regulatory limitations
affecting the conduct o f its business.
Supervisory uses o f the information developed through
examination are threefold: first, it is used by the authorities
as the basis o f supervisory policy with respect to particular
institutions; second, it is used by the directors and officers
o f examined banks as the basis o f corrective action to
prevent future difficulties; third, the information accumu
lated from many examinations is used by the authorities
as a guide in framing or revising regulations and in shaping
or reshaping supervisory policies. Information derived
from examination processes has at times pointed the way
to necessary or desirable changes in banking laws. The
composite data thus obtained are an essential part o f the
nation’s economic intelligence.
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B AN K SU PERVISION
Governmental Agencies Concerned with Supervision
The complex nature o f this country’s banking system is
reflected in, and indeed is in part the product of, the
governmental structure o f bank supervision. State banks
are chartered by and operate under the laws o f any one of
the forty-eight States. National banks operate under
Federal banking law, with membership in the Federal
Reserve System mandatory. 1 System membership is also
available to State banks that meet membership qualifica
tions. A system o f Federal insurance o f deposits is appli
cable to all member banks and to others that voluntarily
desire and qualify for insurance. In such a structure o f bank
supervision, there are necessarily cases o f overlapping
responsibilities and functions. Inasmuch as the basic ob
jectives o f all supervisory authorities are similar, however,
much o f the seeming duplication o f supervisory activity is
averted in practice by common interests that result in
close working arrangements among the governmental
agencies concerned.
Federal Government legislation to deal with national
banking problems at different times has given rise to three
Federal agencies actively and directly engaged in bank
supervisory functions.
The Office o f the Comptroller o f the Currency, a bureau
o f the Treasury Department established in 1863, has
charter and supervisory authority with respect to the
national banks o f the country.
The Federal Deposit Insurance Corporation, established
in 1933, has supervisory authority in connection with its
1 Excepting national banks located in Alaska or in any insular posses
sion or in any part of the United States outside the Continental United
States.
169
T H E FE D E R A L RESERVE SYSTEM
responsibility to insure deposits o f Federal Reserve mem
ber banks and other banks that voluntarily become
members o f the Corporation. The Corporation makes a
practice o f applying its visitorial examination authority
only to those insured banks that are not subject to exami
nation by another Federal supervisory agency.
The Federal Reserve System, established in 1913 to
provide, among other purposes, a “more effective super
vision of banking in the United States,” has supervisory
authority with respect to all o f its members. In practice,
the System confines its visitorial examination powers to
State member banks and, whenever practicable, such
examinations are made jointly with State supervisory
authorities.
Supervisory Functions o f the Federal Reserve
The supervisory functions o f the Federal Reserve relate
primarily to the operations o f its State bank members.
Its responsibilities have to do particularly with the ad
mission o f State banks into System membership; the
examination o f such banks and review o f operations o f all
member banks; the correction o f unsatisfactory conditions
in, or violation o f banking law by, these banks, including,
if necessary, disciplinary action to remove officers and
directors for unsafe or unsound banking practices or for
continued violation o f banking law; the issuance and
enforcement o f regulations pertaining to member banks;
and the granting o f certain banking and trust powers.
Examples o f special Federal Reserve supervisory func
tions are: to authorize national banks to exercise fiduciary
responsibilities; to permit holding companies to vote stock
in member banks; to charter foreign banking corporations
170
B A N K SU PERV ISIO N
and permit member banks to engage in banking in foreign
countries; to regulate loans by banks, brokers, and dealers
in securities for the purpose o f purchasing or carrying
stocks registered on national securities exchanges.
Some phases o f the field work involved in Federal
Reserve supervisory activities, notably the bank examina
tion function, have been delegated by the Board o f
Governors to the Federal Reserve Banks under a policy
o f decentralization. The Board o f Governors directs and
coordinates the supervisory work o f the Reserve Banks,
reviews the results o f their examination activities, and
determines broad supervisory policies. Since national
banks are subject to examination by the Comptroller o f
the Currency, the Reserve Banks, to avoid duplication,
are furnished by the Comptroller’s Chief District Exam
iners with copies of reports of examination of all national
banks in their respective districts. Inasmuch as State
member banks are subject to examination by the State
supervisory authorities, the Reserve Banks and these
authorities cooperate, whenever feasible, in joint or
alternate examinations. The established policy is for a
Federal Reserve Bank to conduct one regular examination
o f each State member bank every calendar year.
Supervision in Relation to General Credit Policy
To the extent that bank supervision helps to maintain
strong individual banks under competent management and
thus an adequate and responsive banking system collec
tively, it contributes to the smooth functioning o f the
economy. Bank supervision, however, cannot and should
not be used for the purpose o f enforcing the System’s
general credit policy by compelling member banks to
171
T H E FE D E R A L RESERVE SYSTEM
restrict credit in times o f inflationary boom or to extend
credit in times o f general recession. In a free enterprise
economy, whether credit availability is tightened in booms
or eased in depressions will depend on national credit
conditions. The Federal Reserve’s responsibility in regu
larizing the flow o f credit and money with a view to stable
economic progress is to influence these conditions through
its established instruments o f credit policy rather than
through the mechanism o f bank supervision.
172
CHAPTER XIII
BALANCE SHEET OF THE FEDERAL RESERVE BANKS.
Federal Reserve Junctions are reflected in the balance sheet o f the
Reserve Banks. Changes in credit and monetary conditions m a j also
be traced in this record.
AJOR reserve banking functions, as described in
other chapters, are reflected in the combined
balance sheet o f the twelve Federal Reserve Banks. The
balance sheet, which is one o f the most complete state
ments o f its kind, is released every Thursday, showing the
condition of the Reserve Banks on the Wednesday im
mediately preceding. The statement, known generally as
the weekly condition statement, appears in the Friday
issue o f the principal daily newspapers of the country and
is usually accompanied by explanatory comment. The
first page shows the changes in the bank reserve equation,
discussed in Chapter VIII.
The Federal Reserve condition statement is necessarily
complex because its purpose is to provide a summary of
the many factors which enter into the nation’s reserve
M
173
T H E FE D E R A L RESERVE SYSTEM
banking position. The nation’s demand for money con
verges on the commercial banks, especially the member
banks, and through them on the Federal Reserve Banks.
Accordingly, much can be learned about current banking
and financial trends by following the week-to-week changes
in the principal items o f the statement.
The combined balance sheet o f the Federal Reserve
Banks for December 23, 1953 is shown in condensed form
on the following page. Explanation of its items provides a
review of many important points made in earlier chapters
and an opportunity to mention briefly some technical
aspects o f Federal Reserve operations not heretofore
dealt with.
Explanation o f Asset Accounts
1. G o l d C e r t ific a t e R eserves . Although the law does
not permit the Federal Reserve Banks to own gold and
forbids the use o f gold or gold certificates in circulation,
it does authorize the Treasury to issue gold certificates to
the Federal Reserve Banks for the gold it acquires. In
exchange for these certificates the Federal Reserve Banks
credit Treasury checking accounts. The Federal Reserve
Banks do not actually hold any large amount o f gold
certificates, however, their actual receipt and transfer being
unnecessary and cumbersome. Instead the Reserve Banks
and the Treasury keep a book record o f gold certificates
due the Federal Reserve Banks. This arrangement gives the
Reserve Banks an asset in the form o f a due from claim on
the United States Treasury.
2. Other cash is coin and paper money (other than gold
certificates and Federal Reserve notes) in the Reserve
Bank vaults.
174
BALANCE SH EET O F RESERVE BANKS
Com bined B a la n c e S h e e t o f t h e R eserv e B a n k s
December 23, 1953
Millions
of dollars
ASSETS
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
G old C ertificate R eserves............................................
21,339
298
420
15
2
Other cash..........................................................................
D iscounts for M ember B a nk s .......................................
Other discounts and advances...........................................
Industrial loans..................................................................
Acceptances purchased......................................................
U. S. G overnment S ecurities........................................
Federal Reserve notes of other Reserve Banks.................
Uncollected cash items.......................................................
Other assets........................................................................
25,886
167
4,503
197
T o t a l A s se ts ..........................................................................
52,827
LIABILITIES
11. F e d e r a l R eserve N o t e s ..............................................................
12. Deposits
26,808
(a) Member B an k —R eserve A c c o u n t s ............................
(b) U. S. Treasurer—general account............................
(c) Foreign.....................................................................
(d) Other........................................................................
13. Deferred availability cash items.........................................
14. Other liabilities...................................................................
20,064
799
461
427
3,134
26
T o t a l L ia b ilities ......................................................
51,719
CAPITAL ACCOUNTS
15. Capital paid in....................................................................
16. Surplus (Section 7 and Section 13b)...................................
17. Other capital accounts........................................................
265
612
231
T o t a l L iabilities a n d C a p ita l A c c o u n ts .................
52,827
18. T he R eserve R a tio (percen t) ..........................................
43.9
3. D iscounts for M ember B anks represent the amount
o f Federal Reserve credit created by Reserve Bank lending
to member banks, and for the repayment o f which member
banks have a direct responsibility. This is a very important
item in that the money and financial markets are highly
175
T H E FE D E R A L RESERVE SYSTEM
sensitive to its size. 1 Indebted banks, as a result o f the
tradition against borrowing, tend to retire their borrowing
before seeking other uses for the funds that become
available to them. The act o f repayment by one bank is
likely to reflect transfers o f reserve funds from other banks,
which in turn borrow to replenish their reserve balances
and are put under pressure to reduce their borrowing.
Accordingly, member bank indebtedness is usually owed
by a shifting group o f member banks and the restrictive
effects o f the borrowing tend to spread through the whole
commercial banking system. Experience over the forty
years o f Federal Reserve operations, as previously brought
out, shows that there is a close correlation between in
creases or decreases in the volume o f member bank
discounts and a condition o f tightness or ease in the credit
market.
Member banks borrow from the Federal Reserve Banks
either by discounting commercial, industrial, and agri
cultural paper o f appropriate quality and short maturity
or by offering their promissory notes secured by such
eligible paper, by Government securities, or by other satis
factory collateral. Reflecting in part the important role
played in bank assets by Government securities and in
part the greater convenience o f using collateral free of
credit risk, most member bank discounts represent ad
vances secured by short-term Government securities.
Borrowing against eligible paper or Government securities
is done at the established discount rate; borrowing secured
by other collateral satisfactory to Federal Reserve Banks
1 Inasmuch as the volume of discounts varies widely from day to day,
the weekly condition statement includes the average daily member bank
borrowings for the week covered by the statement. |
176
BALANCE SH EET O F RESERVE BAN KS
is charged a rate not less than one-half per cent higher.
4. Other discounts and advances include, first, loans
secured by gold made to foreign monetary authorities,
and, second, advances to individuals, partnerships, and
corporations on the security o f direct obligations o f the
United States. Under the authority for this second type
o f advance, the Federal Reserve Banks may lend to non
member banks as well as other financial institutions,
subject to such regulations as the Board o f Governors may
prescribe, against Government securities as collateral.
Rates charged for such borrowing are usually higher than
those charged member banks. As o f December 23, 1953
discounts and advances other than for member banks
represented entirely foreign loans secured by gold.
5. Industrial loans. These are working capital loans to
established commercial and industrial enterprises. Such
loans may have a maturity up to five years and be arranged
with the participation o f a bank or other financing insti
tution. Although loans of this kind may be made directly
by Reserve Banks when eligible enterprises are unable to
obtain financial assistance on a reasonable basis from
usual sources, the majority o f such loans are made by
member and nonmember banks with commitments on the
part o f the Reserve Banks to discount or purchase the
paper on demand without recourse. A financing institution
participating in such loans must obligate itself for at least
one-fifth o f any loss sustained. Commitments to make such
loans usually bear a charge known as the commitment rate
and funds actually advanced command a rate higher than
the established discount rate. The amount o f commitments
outstanding is shown regularly as a memorandum item on
the weekly condition statement.
177
T H E FE D E R A L RESERVE SYSTEM
6 . Acceptances purchased. These are prime bankers’
acceptances purchased by the Federal Reserve Banks at
the buying rate in effect when they are offered for sale by
bankers, dealers, and others on their initiative. Sometimes
such purchases are made under repurchase agreement
whereby the seller agrees to buy them back within fifteen
days or less. At the date o f the accompanying statement
the Federal Reserve Banks held no acceptances.
7. U nited States G overnment Securities comprise
Treasury bills, Treasury certificates o f indebtedness,
Treasury notes, and Treasury bonds. Since Reserve Bank
purchases o f securities are a principal means o f creating
Reserve Bank credit at the initiative of the Federal Reserve,
the amount o f securities held is one of the most significant
items o f the Reserve Bank balance sheet. A breakdown o f
holdings, by type o f security, is published each week in
the full condition statement.
Federal Reserve holdings o f Government securities
sometimes include purchases from dealers under dealer
agreement to repurchase them within a specified period of
fifteen days or less, and these are shown separately in the
complete weekly statement. Repurchase facilities are made
available to dealers in Government securities from time
to time in order to meet market needs during periods o f
temporary credit stringency and also to assist dealers in
carrying their inventory o f securities over such periods.
Use o f the facilities, when available, is at the initiative o f
the dealers.
On December 23, 1953, 568 million dollars o f United
States Government securities were held by the Reserve
Banks under repurchase agreements with dealers. All other
United States Government securities owned by the Reserve
178
BALANCE SH EET O F RESERVE BANKS
Banks on this date had been purchased outright in the
market from previous owners—banks, dealers in securities,
and others. The law authorizes the Reserve Banks to
hold at any one time as much as 5 billion dollars of
Government obligations acquired directly from the
Treasury. Such direct transactions are infrequent and of
very short duration. When these special obligations are
outstanding on the Wednesday statement date, they are
reported separately in the weekly statement. Use o f this
special authority enables the Treasury to permit its bal
ances with the Federal Reserve Banks to decline to a
minimum immediately prior to tax-collection peaks, and
at such times the Treasury may sell special certificates of
indebtedness to the Reserve Banks to cover what would
otherwise amount to a temporary overdraft in the Treas
ury’s checking accounts with the Reserve Banks.
8 . Federal Reserve notes o f other Reserve Banks. The
law requires that when notes o f one Reserve Bank are
received by another, they shall be promptly returned to
the Reserve Bank o f origin for credit or redemption, or,
if unfit for further circulation, forwarded to the United
States Treasury for retirement. This item, therefore, repre
sents notes held and in transit pending receipt o f credit
from other Reserve Banks.
9. Uncollected cash items are checks and other cash
items deposited with the Federal Reserve Banks and in
process o f collection at the time the statement is made up.
The item has a counterpart on the liability side o f the
statement in a technical account described as deferred
availability cash items. This account represents checks in
process o f collection that are to be credited to banks in
accordance with a specific time schedule. The difference
179
T H E FE D E R A L RESER V E SYSTEM
between the asset account (uncollected cash items) and the
liability account (deferred availability cash items), which
is sometimes a sizable amount, is generally referred to as
Federal Reserve Bank “float.”
10. Other assets for this condensed statement consist o f
balances due from foreign central banks, bank premises,
premium on securities owned, accrued interest and other
accounts receivable, and various other items o f small
magnitude.
Explanation o f Liabilities and Capital Accounts
11. F ederal Reserve N otes, which constitute the prin
cipal part o f currency in circulation, are liabilities o f the
Federal Reserve Banks and also obligations o f the United
States Government. They are a first lien on all the assets
o f the issuing Reserve Bank and, as explained in earlier
chapters, they are backed by not less than a 25 per cent
reserve o f gold certificates. The amount not covered by
the pledge o f gold certificates must be covered by eligible
paper or Government securities pledged as collateral.
Changes in the amount o f Federal Reserve notes in circu
lation occur in accordance with changing demands o f the
public for currency and reflect seasonal and other varia
tions in the volume o f business activity.
12. Deposits consist mainly o f the R eserve A ccounts
of M ember Banks.2 They also include checking accounts
of the United States Treasury, deposits o f foreign reserve
2 The weekly condition statement shows in a special item an estimated
breakdown of member bank deposits into required reserves and excess
reserves. Because these items are subject to wide daily fluctuation, the
statement also provides an estimate of the daily average of excess reserves
for the statement period.
180
BALANCE SH EET O F RESERVE BANKS
banks, foreign governments, international agencies, and
clearing accounts maintained by nonmember banks. Of
the nonmember deposit accounts, the largest week-to-week
changes usually occur in Treasury accounts, which are
used by the Treasury to make payments for Government
purchases o f goods and services. These changes, although
occasionally directly related to accompanying changes in
other balance sheet accounts, will most often be reflected
in opposite changes in member bank reserve deposits. The
Treasury also maintains deposit accounts with approved
commercial banks for the receipt o f certain taxes and of
payments for securities sold to the public. Its established
practice is to schedule the transfer o f its funds from the
accounts at commercial banks to its account at the Federal
Reserve Banks in such a way as to minimize the effects on
member bank reserves o f seasonal and other fluctuations
in Treasury receipts and expenditures.
Changes in the deposits o f foreign authorities, which
are maintained with the Reserve Banks for international
settlement and foreign monetary reserve purposes, are
sometimes an important factor affecting member bank
reserves. Changes in these accounts, however, may be
directly associated with changes in other accounts, par
ticularly in gold certificate reserves.
13. Deferred availability cash items, as discussed on page
179, are of technical significance. The account arises from
the fact that Federal Reserve Banks do not give immediate
credit for all checks deposited with them for collection.
The credit is deferred according to a schedule that allows
time for out-of-town checks to go through the mail to the
banks on which they are drawn. Maximum deferment o f
credit is now two days. Since the time actually taken to
181
T H E FE D E R A L RESERVE SYSTEM
collect checks is often longer than that allowed in the
schedules, the result is that some Federal Reserve credit is
extended in connection with the check collection process.
14. Other liabilities consist principally o f unearned dis
count on notes and securities, miscellaneous accounts
payable, and accrued dividends.
15. Capital stock o f the Federal Reserve Banks is owned
by the member banks o f the Federal Reserve System,
which are required to subscribe for such stock in a per
centage o f their own capital stock and surplus.
16. Surplus is governed by two sections o f the Federal
Reserve Act (Sections 7 and 13b). The first and main
category o f surplus (Section 7) represents earnings derived
by the Reserve Banks from their loans and investments.
Ordinarily, these earnings are adequate to cover the
expenses o f the Reserve Banks, the statutory 6 per cent
annual dividend payable to member banks, and additions
to surplus. In recent years, net earnings have been large
and, beginning in 1947, 90 per cent o f them, after divi
dends, has been paid to the United States Treasury as
interest on Federal Reserve notes, with the remainder
being added to surplus. In some past years, however, the
Reserve Banks operated at a loss. The surplus can be
drawn on to meet deficits and pay dividends in years when
operations result in loss, but it cannot be distributed
otherwise to the stockholding member banks. The law
provides that if the Reserve Banks are dissolved any sur
plus is to be paid to the United States Government.
The second category o f surplus (Section 13b), which is
a relatively small amount, represents funds received from
the Secretary o f the Treasury in accordance with the law
for the purpose o f making working capital loans to estab
182
BALANCE SH EET O F RESERVE BAN KS
lished businesses, that is, industrial loans, plus or minus
the net earnings or net loss arising from using such funds.
17. Other capital accounts at the date o f this statement
comprised reserves for contingencies and unallocated net
earnings for the year to the date o f the statement.
18. The Reserve R atio. By law, our standard unit o f
value, the dollar, is defined in terms o f gold. The Treasury
buys gold in monetary form at $35 an ounce. The Treasury
pays for such gold out o f its general fund; it can then
replenish this fund by issuing gold certificates to the Fed
eral Reserve Banks, which credit its account. When it sells
gold, on the other hand, the proceeds are added to the
general fund o f the Treasury, which may in turn use them
to redeem gold certificates. Reserve Bank holdings o f gold
certificates constitute their basic reserves and so set a limit
to expansion o f Reserve Bank credit.
The reserve ratio o f the Federal Reserve Banks, which
is published regularly as a memorandum item on their
financial statement, is a constant reminder o f these im
portant facts. The law prescribes that gold certificate
reserves must be maintained equal to at least 25 per cent
o f Federal Reserve deposit and note liabilities, unless the
requirement is suspended by the Board o f Governors
subject to a graduated tax upon any reserve deficiency.
At its recent high level—43.9 per cent on December 23,
1953—the reserve ratio has little operating significance. In
fact, during most o f the existence of the Federal Reserve
System, excess or unused monetary reserves have been
sufficient, as the chart on page 184 shows, to permit a fur
ther large expansion of Federal Reserve credit if that
had been desirable in the public interest.
That Federal Reserve Bank reserves exceed the minimum
183
THE FEDERAL RESERVE SYSTEM
legal requirement reflects the fact that these Banks are not
operated to make a profit and consequently do not extend
additional credit simply because they have enough reserves
to do so. The volume o f Federal Reserve credit is deter-
RESERVES OF FEDERAL RESERVE BANKS
..... ........................................... .........
mined, as has already been emphasized, by the dem and
of the public for currency and bank deposits and by the
policy pursued by the Federal Reserve to encourage or
discourage this demand. This policy is determined ex
clusively in the public interest and it is not m otivated
by any profits that could be obtained by putting to
184
BALANCE SH EET O F RESERVE BANKS
work the unused reserves o f the Federal Reserve Banks.
Historical Comparison
It is plain from preceding chapters, as well as from this
item-by-item discussion o f the condensed Federal Reserve
statement, that five accounts reflect the essential credit and
monetary operations o f the Federal Reserve Banks. These
accounts include, among the assets, gold certificates, dis
counts for member banks, and holdings o f Government
securities and, among the liabilities, Federal Reserve notes
and reserve balances o f member banks. In the course of
years these accounts have undergone important changes
in volume resulting from changed economic and monetary
conditions generally; to indicate these changes, condensed
balance sheet data for dates near the end o f 1920, 1930,
1940, and 1953 are shown on page 187.
G old Certificates. The increase in the amount o f
gold certificates from 1920 to 1953 reflects the enormous
increase in this country’s stock o f monetary gold that
occurred principally in the decade between 1930 and 1940.
By the terms o f the Gold Reserve Act o f 1934, the value o f
the stock o f gold held as monetary reserves and taken over
at that time by the Treasury was raised from 4 billion
dollars to about 7 billion, and subsequently the release of
some gold devaluation funds was a factor in the increase in
Federal Reserve gold certificate holdings. Another factor
in the increase over this decade was the Treasury purchase
o f domestic production o f gold. By far the greatest factor,
however, was the flow into this country o f foreign gold,
reflecting the pulling power in world depression o f this
country’s strong creditor position as well as unsettled
political conditions in Europe. Between January 1934 and
185
T H E FE D E R A L RESERVE SYSTEM
the end o f 1940, imports o f gold exceeded exports by
almost 16 billion dollars.
During World War II the country’s stock o f gold
declined somewhat but after the war it again increased.
In recent years, changes in the monetary gold stock and
the Federal Reserve’s gold certificate reserves have oc
curred in both directions.
D iscounts for M ember Banks and H oldings of
G overnment Securities. The change in relative impor
tance o f these two accounts reflects several important
developments. In 1920 Federal Reserve Bank credit was
being furnished mainly in the form o f discounts for
member banks, but a few years later member banks had
to a great extent ceased to borrow at the Reserve Banks.
At the same time, open market purchases o f Government
securities had become important as a means o f supplying
member banks with the reserves they had previously
obtained by rediscounting.
Between 1930 and 1940, member banks borrowed at the
Reserve Banks less than in the preceding decade, and the
Federal Reserve authorities purchased more Government
securities. The increased purchases occurred mainly in the
years 1931-33 when Reserve Bank holdings rose from 729
million dollars to 2,437 million. This was the period of
drastic recession and banking crisis that culminated in
the bank holiday o f March 1933, and the Federal Reserve
authorities bought securities for the purpose o f easing the
money market and offsetting contraction in the flow of
credit and money that resulted from bank failures and the
liquidation o f bank loans. The Reserve Bank portfolio o f
Government securities remained close to 2,500 million
dollars until the end o f the decade.
186
BALANCE SH EET O F RESERVE BANKS
Comparison of Balance Sheets of F ederal R eserve B anks 1
(In millions of dollars)
Account
1920
1930
1940
1953
ASSETS
Gold certificate reserves...................... 22,060
Other cash............................................
264
Discounts for member banks.............. 2,687
Other discounts and advances............ • • «
Industrial loans.................................... • •
Acceptances purchased........................
260
287
U. S. Government securities...............
Federal Reserve notes of other
Reserve Banks..................................
31
Uncollected cash items........................
637
Miscellaneous assets............................
28
Total assets...................................
6,254
22,941 19,692 21,339
220
229
298
251
3
420
1
15
• ••
2
• •«
8
364
♦*♦
«• •
729 2,184 25,886
22
585
89
27
914
88
167
4,503
197
5,201 23,146 52,827
LIABILITIES
Federal Reserve notes.......................... 33,553
Deposits:
Member bank—reserve accounts . . . 1,781
57
U. S. Treasurer—general account . .
Foreign and other deposits..............
23
Deferred availability cash items.........
519
Miscellaneous liabilities.......................
19
Total liabilities............................. 5,952
1,663
5,965 26,808
2,471 13,837 20,064
482
19
799
28 1,712
888
564
774 3,134
11
5
26
4,756 22,775 51,719
CAPITAL ACCOUNTS
Capital paid in.....................................
Surplus.................................................
Other capital accounts.........................
100
202
(4)
Total liabilities and
capital accounts........................
6,254
The reserve ratio (per cent).................
43.3
170
275
(4)
138
179
54
265
612
231
5,201 23,146 52,827
73.7
90.6
43.9
1 As of Dec. 31, 1920 and 1930; Dec. 24, 1940, and Dec. 23, 1953.
2 Prior to enactment of the Gold Reserve Act of 1934, the amount
reported under this item included gold owned by Federal Reserve Banks.
3 Includes 217 million dollars of Federal Reserve Bank notes, which
are no longer issued.
4 Included in “miscellaneous liabilities.”
187
T H E FE D E R A L R ESERVE SYSTEM
The low level o f member bank discounts that continued
throughout the 1930’s is only partly explained, however,
by the increase in the Federal Reserve Banks’ holdings o f
Government securities during recession years early in the
decade. It is also to be explained by the very large increase
in member bank reserves that arose out o f gold imports
during the latter half o f the decade. By the fall o f 1940
all member banks together held 7 billion dollars o f excess
reserves. This volume o f excess reserves was capable o f
supporting an expansion o f demand deposits about five
times as great. In the circumstances, few member banks
needed to obtain Federal Reserve credit through discounts
or advances, and Reserve Bank discount facilities had
only standby importance.
Between 1940 and 1953, the most noteworthy change
in the Federal Reserve condition statement was the
increase o f nearly 24 billion dollars in Government security
holdings. M ost o f this increase occurred in the years o f
United States participation in World War II when the
Federal Reserve pursued a policy o f supporting war
finance by stabilizing yields on Government securities at
low levels. With Federal Reserve credit freely available
through open market operations, member banks made
little use o f Reserve Bank discount facilities.
The Treasury-Federal Reserve accord in March 1951
provided a basis for returning to a program o f adjusting
Federal Reserve credit availability to the seasonal and
growth needs o f the economy through the flexible and
complementary use o f the System’s general instruments o f
policy. This change in the pattern o f Federal Reserve
operations resulted in an increase in member bank use o f
Reserve Bank discount facilities, and near the end o f 1952
188
BALANCE SH EET O F RESER V E BANKS
the discounts o f member banks amounted to more than
1,700 million dollars compared with only 3 million near
the end o f 1940. By December 23,1953, however, they had
been reduced to 420 million dollars, mainly reflecting a
shift in Federal Reserve policy from credit restriction in
the first half o f the year to credit ease in the second half.
F ederal Reserve N otes. Compared with earlier levels,
the volume o f Federal Reserve notes outstanding was
unusually large in 1920. In that year, which was one o f
high prices, the amount o f currency in circulation was
larger than ever before, and Federal Reserve notes made
up about three-fifths o f the total. For the remainder
o f the decade the volume o f notes was substantially less,
but in the years 1931-33 it increased greatly as a result o f
the banking weakness o f that period and the general
withdrawal o f deposits from banks.
Thereafter the amount o f Federal Reserve notes out
standing rose steadily until 1940. In that year, in response
to wartime demand for currency, the volume began to
increase far more rapidly than at any previous time. By
the end o f the first year after the war, currency in circula
tion amounted to nearly 29 billion dollars, o f which
Federal Reserve notes accounted for almost 25 billion.
From 1946 the level o f currency in circulation receded
gradually through 1950 and then, following Korean
hostilities, increased again during the defense program to
31 billion dollars by the end o f 1953.
R eserves of M ember Banks. Increases in the country’s
gold stock and in the amount o f Reserve Bank credit have
tended since 1920 to augment member bank reserves. On
the other hand, growth o f currency in circulation has
tended to reduce member bank reserves. All three o f these
189
T H E FE D E R A L RESERVE SYSTEM
elements, as well as member bank reserves, reflect in some
way basic economic and political conditions. For instance,
the tremendous growth in the monetary gold stock between
1930 and 1940 reflected the unsettled foreign conditions
that were driving gold to the United States; the great
expansion in Reserve Bank credit that resulted chiefly
from purchases o f United States Government securities
during World War II reflected the immense monetary
expansion associated with war finance, including the war
time demand for currency. The volume o f member bank
reserves, therefore, is not the product o f domestic policy
alone; indirectly it is also the product o f conditions arising
from developments all over the world.
Other Statement Items. The principal other changes
in the Federal Reserve Bank statement over a period o f
years have occurred in uncollected cash items and deferred
availability cash items. The recent great increase in these
accounts, which reflect the volume o f bank checks de
posited with the Federal Reserve Banks and in process o f
collection, is a consequence mainly o f the greatly increased
volume o f monetary payments in recent years and the
increase in the use o f bank checks in making out-of-town
payments.
190
CHAPTER XIV
SUM M ARY. Experience overJour decades shows that reserve hank
ing is o f vital importance to the national economj. Provision o f
bank reserves has come to be the major Federal Reserve function.
A S the foregoing chapters have explained, the basic
J x . powers o f the Federal Reserve relate to credit and
money. They are credit powers in that they directly
affect the ability o f commercial banks to supply funds to
the credit market and indirectly influence the willingness
o f other lenders and investors to supply funds. They are
monetary powers in that they affect the size o f the money
supply, which consists in part o f currency and in much
larger part o f demand deposits.
Before the Federal Reserve System was established, the
outstanding defects o f our bank credit and monetary
mechanism were diagnosed as “inelastic currency” and
“scattered bank reserves.” The System promptly cleared
the way for correcting these defects.
From its beginning, the System through its currency
function has provided elasticity. The machinery for supply-
191
T H E FE D E R A L RESERVE SYSTEM
ing currency for circulation when it is needed and with
drawing it when no longer needed has proved adequate
and has worked almost automatically. For many years,
including two major wars, the volume o f currency in
circulation has expanded and contracted in accordance
with the varying requirements o f the public. Today the
currency function o f the Federal Reserve System is a
matter o f routine, virtually free from uncertainties or
administrative difficulties.
Four decades o f reserve banking experience have made
clear, however, that the reserve function o f the System is
much more than a matter o f pooling or mobilizing
scattered reserves and making available to banks in need
o f funds the surplus reserves o f other banks. It is a function
o f providing a pool o f reserve funds which adjusts to the
changing pace o f business activity and increases over time
as the economy grows. Moreover, the continuing ability
o f individual banks in many growing communities to
adapt to the varying bank credit and monetary needs of
their localities depends on the effective performance o f the
reserve function. It requires the constant use o f the Federal
Reserve’s power to create reserve funds or to extinguish
them.
If the funds lent by a Federal Reserve Bank, or paid by
it in purchasing securities, were merely the funds deposited
with it by its member banks, its loans and security pur
chases would not enlarge the total volume o f reserve funds.
The significant fact to bear in mind, however, is that the
credit operations o f the Reserve Banks do affect the total
volume o f reserve funds available to commercial banks.
By acquiring the obligation o f a member bank or other
obligor and, in exchange, crediting an equivalent amount
192
SU M M A RY
to the reserve balance o f the member bank, a Federal
Reserve Bank expands its assets and its liabilities, and
these continue to be expanded as long as the obligation
is held. Such action creates reserve funds which may be
come the basis for a multiple increase in commercial bank
credit and demand deposits and thus an expanded flow o f
credit and money.
This does not mean that the permissive power o f the
Federal Reserve to create or extinguish bank reserves is
unlimited. The law sets an ultimate limit on the System’s
power to expand its deposits and its notes by restricting
its liabilities to a maximum o f four times the System’s
holdings of gold certificates. Moreover, operating limita
tions on both its power to expand and its power to con
tract these liabilities derive from the law through the
System’s responsibilities for fostering economic stability.
Federal Reserve action to affect the volume o f bank
reserves encourages an increased or decreased use o f bank
and other credit. It has this result for two reasons. First,
a change in the reserve position o f banks affects the
incentives o f bankers to lend or invest. Second, a tighter
or easier bank reserve position usually results in a change
in credit conditions generally and in interest rates, which
in turn influences the incentives o f other lenders to supply
funds and of borrowers to demand them. In other words,
a change in bank reserve position initiates a chain reaction
in the credit market with powerful secondary effects upon
decisions to buy or sell commodities and services, decisions
to save and invest, and total spending in this free enterprise
economy. The powers o f the Federal Reserve to regulate
the flow o f credit and money are thus among the im
portant factors that influence the current financial and
193
T H E FE D E R A L RESERVE SYSTEM
economic situation. It is because o f these far-reaching
effects that reserve banking policy is considered so im
portant a force in contributing to economic stability at
high and rising levels o f output and employment.
The objective o f Federal Reserve functions, like that o f
governmental functions in general, is the public welfare.
Federal Reserve policy must be viewed in the light of this
broad objective, which is approached through action
directed toward regularizing the flow of credit and money,
fostering a stable dollar, and providing an effective mone
tary mechanism that will be conducive to the country’s
growth and economic well-being. In carrying out policy
the Federal Reserve, after taking into account the factors
making up the prevailing economic situation, strives to
use its powers in the way that will contribute to economic
stability and progress.
Instruments o f Federal Reserve Policy
To recapitulate—The Federal Reserve has three general
means o f influencing over-all credit and monetary condi
tions by affecting the reserve position o f member banks—
discount operations, open market operations, and changes
in reserve requirements. Changes in member bank reserve
positions affect the total volume o f credit that can be
granted by member banks, and thereby the volume o f the
economy’s money, without directing the flow o f credit and
money into particular sectors of the economy. Decisions
regarding the use o f available funds are left to the banks,
their borrowers and other depositors, and the currencyholding public.
Discount operations. Through discounts for and advances
to member banks, the Federal Reserve is able to supply
194
SUM M ARY
individual banks with additional reserve funds. By this
means and by raising or lowering Reserve Bank discount
rates, the Federal Reserve can influence directly the avail
ability and cost o f bank credit and indirectly the avail
ability and cost o f nonbank credit. Discounts for proper
banking purposes are initiated by individual member
banks, subject to Reserve Bank approval, but changes in
the discount rate are made at the discretion o f the Federal
Reserve after consideration o f the need to tighten or ease
credit conditions. The volume o f member bank discounts
has come to be regarded as an important factor in the
tightness or ease o f the credit market, and changes in
Reserve Bank discount rates are viewed by the business
community as an objective index o f Federal Reserve policy.
Open market operations. Through purchases o f Gov
ernment securities in the open market, the Federal Reserve
can take the initiative and offset drains on or expand
member bank reserves. Similarly, through sales o f such
securities, it can extinguish reserves and reduce their total
volume. Because Government securities play a key role
in the credit market, and because all financial institutions
are affected by changes in the yields and prices o f such
securities as well as by changes in member bank reserve
positions, open market operations have direct effects upon
credit availability and the climate o f business expectations.
Traditionally, open market operations are used flexibly in
combination with discount operations to provide an
orderly and adequate flow o f credit and money.
Changes in reserve requirements. Raising or lowering
reserve requirements o f member banks has the effect o f
diminishing or enlarging the volume o f funds that member
banks have available for lending. Such action also im
195
T H E FE D E R A L RESERVE SYSTEM
pinges on the liquidity position o f banks and so affects
the deposit expansion potential o f bank reserves. The law
sets certain basic requirements for each o f three classes o f
member banks, but empowers the Federal Reserve to in
crease the requirements up to twice the prescribed basic
percentages. For many years the actual requirements set
by the Federal Reserve have been at or near the permissible
maximum percentages. The use o f this power encounters
numerous administrative and technical problems which
handicap its frequent and continuous application in
affecting the demand for Federal Reserve credit. For this
reason it is used mainly for influencing unusual and large
changes in bank reserve positions occasioned by special
circumstances. It is not so adaptable to meeting day-to-day
changes in credit conditions.
Selective credit regulation. The types o f credit to which
selective regulation has been applied by the Federal
Reserve authorities are stock market credit, consumer
credit, and real estate credit. Stock market credit has been
subject to margin requirements since 1934. The other two
types o f credit have been regulated only temporarily.
By limiting the terms on which a given type o f credit
may be granted, selective credit regulation affects decisions
regarding individual loans in the area to which it is
applied. It is thus a supplement to general credit regulation
in that it can be directed to specific problem areas without
involving action to influence credit conditions generally.
For selective credit regulation to be practicable, the area
to which it relates must be reasonably definable, and the
trade practices o f the area must be sufficiently specialized
and standardized for the regulation to be readily tailored
to them.
196
SU M M A R Y
Federal Reserve Service and Supervisory Functions
In addition to credit functions, the Federal Reserve
performs certain services o f which the most important are:
handling member bank reserve accounts; furnishing cur
rency for circulation; facilitating the clearance and
collection o f checks and the transfer o f funds; acting as
fiscal agents, custodians, and depositaries o f the United
States Government; and making available to the public the
economic and financial information that serves to guide
System policy administration. The System also performs
important supervisory functions that help to keep indi
vidual member banks in sound condition and to maintain
the strength o f the banking system as a whole.
Concluding Comment
The Federal Reserve System was established in an era
when the country’s financial problem was one o f scarcity
o f credit and money and rigid limitation on expansion.
To a considerable extent because o f a long period of
international political unsettlement, involvement o f the
United States in two major wars, and the inflow o f gold
following two world-wide economic depressions, the finan
cial problem with which the System has been concerned
during much o f its existence has been one o f abundance
and need for restraint.
The Federal Reserve System is a unique reserve banking
mechanism, essential to a dynamic, private enterprise
economy like ours. It is especially adapted to a banking
system with many independent unit banks, today number
ing some 15,000, o f which nearly 7,000 are System member
banks. Through its twelve Reserve Banks and their co
ordination through the Board o f Governors in Washing
197
T H E FE D E R A L RESERVE SYSTEM
ton, the System is designed to combine private and public
interests in an organization that serves efficiently the
public welfare. Experience during the System’s four
decades of operation has shown that reserve banking is a
potent and indispensable instrument o f public policy; that
under conditions o f peace it can facilitate economic
stability and progress; and that, in the event o f the threat
o f war or war itself, it can be an invaluable aid in facili
tating the financing o f essential programs and in ameliorat
ing resulting economic disturbances.
The Federal Reserve System is a service institution to
the nation. The more than 250 directors o f the twelve
Reserve Banks and their twenty-four branches, the 20,000
officers and others who work in them, as well as the Board
o f Governors and its staff in Washington, are all serving
as trustees o f the nation’s money.
198
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P u r po ses
200
INDEX
Acceptances, bankers’......................................................................47,178
Balance of international payments.................................................... 103
Balance sheet of Federal Reserve Banks:
Description of items....................................................................... 173
Historical comparison.................................................................... 18S
Bank credit {See Credit)
Bank reserve equation, factors influencing volume of member
bank reserves..............................................................................107,173
Bank supervision: {See also Examinations)
Federal Reserve supervisory functions.............................. 165, 170, 197
Governmental agencies concerned with......................................... 169
Purpose and functions.................................................................... 166
Relation to general credit policy.................................................... 171
Bankers’ acceptances....................................................................... 47,178
Banking system:
Operation of bank reserves in........................................................
15
Role of Federal Reserve System summarized................................
53
Board of Governors of the Federal Reserve System:
Annual report to Congress............................................................
79
Audit of accounts...........................................................................
78
Chairman....................................................................................... 79, 88
Duties.............................................................................................
78
Expenses, assessment on Federal Reserve Banks..........................
78
Informational services.................................................................... 164
Members.........................................................................................
78
Publications................................................................................164, 199
Regulations {See Regulations, Board of Governors)
Charts:
Bank reserve equation.................................................................... 108
Checks handled by Federal Reserve Banks................................... 157
Currency:
Kinds o f......................................................................................
91
Seasonal changes in currency in circulation..............................
93
Deposits and bank lending............................................................
25
Federal Reserve Bank earnings, disposition of..............................
76
Federal Reserve holdings of discounts and Government securities 42
Interest rates.................................................................................. 147
Member bank reserves...................................................................
29
Money and bank credit, mid-1953.................................................
5
Organization chart of Federal Reserve System.............................82, 83
Reserves of Federal Reserve Banks............................................... 184
United States gold stock, changes in............................................. 105
United States Government debt....................................................
45
Check clearing and collection........................................................... 155
Comptroller of the Currency:
Authority to charter and supervise national banks.....................70,169
Examination of national banks..................................................... 171
201
IN D EX
Credit:
Bank credit:
Bank reserves as basis................................................ 10, 14,106,107
Effects of changes in reserve requirements........................ 48, 50, 195
Federal Reserve influence on availability, cost, and supply. 10,15,195
Member bank borrowing and....................................................37, 43
Open market operations and..................................................... 38, 43
Regulation o f.............................................................................
31
Relation to gold..........................................................................
97
Reserve banking operations and.................................... 120, 124, 125
Tightness or ease reflected in interest rate changes.................... 142
Consumer credit, regulation by Board of Governors....................
60
Federal Reserve:
Factor in bank reserve equation................................................ 107
Source and limitation o f......................................................31, 52, 97
General methods of regulation....................................................31, 194
Policy:
Coordination with debt management policy....................85, 117, 188
Discount rate changes as index of Federal Reserve policy___36, 195
Influence of reserve banking policy on economic stability........ 120
Instruments of Federal Reserve credit policy.............31, 56, 194, 196
Relation of bank supervision to ................................................. 171
Responsibility of Board of Governors and other parts of
System for.............................................................................. 80, 84
Real estate credit, regulation by Board of Governors and Housing
and Home Finance Administrator.............................................
63
Selective credit regulation............................................................56, 196
Stock market credit, regulation by Board of Governors 57,149, 171,196
Voluntary credit restraint program................................................
65
Credit agencies, Federal and international............................... 86, 87, 162
Credit and money:
Changes in, effect on lives of people.............................................
7
Effect of changes in bank reserves on flow o f...............................14, 16
Function of Federal Reserve System to regulate flow of........1,4,9,191
Situation prior to establishment of Federal Reserve System........
2
Credit market:
Description of........................................................................11, 120-141
Tightness or ease of, reflected in interest rate changes.................. 142
Tone of, meaning of phrase...........................................................
13
Currency:
Amount in circulation....................................................................... 92
Demand for..................................................................................92,154
Distribution of........................................................................4,153,191
Elasticity o f.............................................................. 53, 89, 92, 155, 191
Factor in bank reserve equation.................................................... 107
Federal Reserve notes (See Federal Reserve notes)
Kinds and denominations............................................................91, 154
Relation of reserve banking to ......................................................
89
Situation prior to establishment of Federal Reserve System. .3, 89, 155
Treasury currency.................................................................91, 109,154
202
IN D E X
Deposits:
All banks in the United States, June 30, 1953 ..............................
70
Bank deposits, as form of credit....................................................
6
Demand deposits as form of money..............................................
5
Federal Reserve Banks, gold certificate reserves....... 52, 54, 95, 97, 183
Insurance o f............................................................................... 169, 170
Interest rates on time deposits, authority of Board of Governors
to establish maximum................................................................
80
Liability item in balance sheet of Federal Reserve Banks............ 180
Relation to loans and investments of banks........................... 14, 16, 25
Reserves against (See Reserve requirements; Reserves)
Reserves, as basis of bank deposits...............................................
14
Treasury tax and loan accounts..................................................... 160
Directors:
Federal Reserve Banks:
Classes o f....................................................................................
73
Responsibilities o f......................................................................
75
Federal Reserve branch banks.......................................................
75
Member banks, power of Federal Reserve to remove................... 170
Discount rate:
Authority of Board of Governors to review and determine___77, 80, 84
Changes in, as index of Federal Reserve policy..........................36, 195
Establishment by Federal Reserve Banks............................... 77, 80, 84
Relation to other market rates...................................................... 143
Discounts by Federal Reserve Banks:
Asset items in balance sheet of Federal Reserve Banks.. . . 175, 177, 186
Effect on credit conditions.............................................................
36
Eligible paper.................................................................................
32
Federal Reserve Bank standards....................................................
33
Federal Reserve experience with....................................................
37
Regulation of bank reserves through.......................................... 32, 194
Relation to open market operations......................................38, 41, 195
Review since 1920.......................................................................... 186
Economic stability:
Influence of interest rate changes on................................. 142, 150, 191
Influence of reserve banking operations on.......................120, 150, 191
Examinations:
Bank supervisory function............................................................. 168
Federal Reserve Banks...................................................................
79
National banks............................................................................... 171
Nonmember insured banks............................................................ 170
State member banks........................................................ 4, 71, 170,171
Exchange Stabilization Fund............................................................. 100
Federal Advisory Council, members and duties...............................
81
Federal Deposit Insurance Corporation......................................... 77, 169
Federal funds market........................................................................
36
Federal Open Market Committee, members and duties...................77, 80
203
IN D E X
Federal Reserve Act:
Currency mechanism provided under..........................................89,155
Passage........................................................................................... 1,3
Reserve requirements, provisions relating to changes in............. 49, 196
Federal Reserve Agents...............................................................75, 78, 90
Federal Reserve Banks:
Assessment for expenses of Board of Governors..........................
78
Balance sheet of, description of items........................................... 173
Bank supervisory functions............................................................ 171
Branches:
Directors.....................................................................................
75
List.............................................................................................
72
Capital stock................................................................................70, 182
Chairmen and Deputy Chairmen............................................ 73, 75, 78
Directors........................................................................................
73
Districts, list...................................................................................
72
Dividends paid by..................................................................71, 76, 182
Earnings.......................................................................................76, 182
Examination o f..............................................................................
79
Federal Reserve Agents........................................................... 75, 78, 90
Fiscal agency functions..........................................................4, 159, 197
Foreign and international accounts................................... 101,103, 162
Franchise tax paid by....................................................................
76
Informational services.................................................................... 164
Lending power, source and limitation.......................................... 31, 52
List.................................................................................................
72
Operations, comparison with those of member banks..................
53
Presidents:
Appointment of..........................................................................75, 78
Conference o f.............................................................................
81
Service functions.................................................................... 4, 152, 197
Stockholders...................................................................................
70
Surplus......................................................................................... 76, 182
Federal Reserve notes:
Distribution o f...............................................................................
90
Effect of circulation on reserve position of Federal Reserve Banks. 94
Gold certificate reserves required against............52, 54, 90, 95, 97, 183
Interest charge paid to Treasury................................................. 77, 182
Issuance o f.....................................................................................
90
Items in balance sheet of Federal Reserve Banks............. 179, 180, 189
Redemption fund............................................................................
90
Review of circulation since 1920.................................................... 189
Federal Reserve System:
Background o f...............................................................................
2
Decentralization...........................................................................75, 171
Distribution of authority...............................................................
84
Establishment o f............................................................................
1
Functions...................................................................................1, 4,191
Influence of reserve banking operations on economic stability.. . 120,
150,191
204
IN D E X
Federal Reserve System: (Continued)
Influence on credit and money......................................................
9
Informational services........................................................... 4, 163, 197
Instruments of credit policy...........................................31, 56, 194, 196
Map................................................................................................
74
Membership.................................................................................69, 169
Organization chart........................................................................ 82, 83
Relation to currency......................................................................
89
Relation to gold.............................................................................
97
Relation to other Federal agencies and international credit agencies 85
Role in banking system summarized.............................................
53
Service functions.................................................................... 4, 152, 197
Structure........................................................................................
68
Supervisory functions.........................................................165, 170, 197
Fiscal agency functions of Federal Reserve Banks................... 4,159, 197
Float, meaning of term...................................................................... 180
Foreign banking corporations, authority of Federal Reserve to
charter............................................................................................ 170
Gold:
99
Amount held by Treasury.............................................................
Earmarked................................................................................. 103, 162
Factor in bank reserve equation.................................................... 107
International payments.................................................................. 103
Monetization of............................................................................. 100
Movements, effect on member bank reserves................ 30, 98, 100, 105
Relation to reserve banking...........................................................
97
Reserve money of Federal Reserve Banks.....................................
98
Stock, review of changes since 1920.............................................. 185
Title to ......................................................................................... 99, 103
Transactions with foreign countries.............................................. 101
Gold certificate reserves:
Asset item in balance sheet of Federal Reserve Banks............. 174,185
Ratio to deposits and Federal Reserve notes-----52, 54, 90, 95, 97, 183
Source of Federal Reserve lending power.....................................31, 52
Government securities:
Asset item in balance sheet of Federal Reserve Banks............. 178, 186
Federal Reserve Bank issuance and redemption services.............. 159
Federal Reserve holdings o f................................................ 42, 178, 186
Investors in..................................................................................... 44
Kinds o f......................................................................................... 178
Open market operations in............................ 38, 80, 114, 117, 186, 195
Repurchase agreements............................................................... 41,178
Government securities market:
Arbitrage transactions in...............................................................
46
Functioning o f...............................................................................
44
Guarantees of defense production, war production, and contract
termination loans.......................................................................... 161
Holding company affiliates, authority of Federal Reserve to issue
voting permits................................................................................ 170
205
IN D E X
Interdistrict Settlement Fund............................................................ 158
Interest rates:
Changes in, influence o f................................................................. 142
Kinds of......................................................................................... 143
Time deposits, authority of Board of Governors to establish
maximum....................................................................................
80
International Bank for Reconstruction and Development............. 87, 162
International Monetary Fund................................................. 87, 100, 162
International payments...................................................................... 103
Legislation (See Federal Reserve Act)
Lending agencies, Federal and international............................ 86, 87, 162
Lending, spending, and saving, influence of reserve banking opera
tions on.......................................................................................... 120
Loans:
Defense production, war production, and contract termination
loans, fiscal agency services performed by Federal Reserve Banks 161
Federal Reserve lending power, source and limitation.................31, 52
Industrial loans, asset item in balance sheet of Federal Reserve
Banks.......................................................................................... 177
Paper eligible for discount at Federal Reserve Banks...................
32
Loans and investments:
Capital and deposits of banks as basis for....................................14, 16
Relation of bank deposits to ...................................................14, 16, 25
Margin requirements, regulation of stock market credit
through.................................................................................57, 149, 196
Member banks:
70
Deposits.........................................................................................
Number and classes.......................................................................
69
Obligations and privileges.............................................................. 69
Officers and directors, authority of Federal Reserve to remove... 170
Operations, comparison with those of Federal Reserve Banks___
53
Reserves (See Reserves)
Money: (See also Credit and money)
Definition....................................................................................... ...... 5
Forms................................................................................................... 5
Functions....................................................................................... ...... 5
Gold as reserve money................................................................... 98
Money market, description o f...........................................................
12
National Advisory Council on International Monetary and Finan
cial Problems................................................................................. 79, 88
National banks:
Chartered by Comptroller of the Currency.................................70,169
Deposits.........................................................................................
70
Examinations.................................................................................
171
Number.......................................................................................... 69 /
Supervision.................................................................................. 70, 169
Trust powers, authority of Federal Reserve to grant.................... 170
206
IN D E X
National Monetary Commission, appointment to devise new
banking system..............................................................................
3
Nonmember banks:
158
Clearing balances maintained with Federal Reserve Banks.........
Deposits.........................................................................................
70
Examinations................................................................................
170
Number..........................................................................................
70
Open market operations:
Explanation o f..............................................................................
38
Regulation of bank reserves through........................... 38, 117, 186, 195
Relation to discount operations............................................ 38, 41, 195
System Open Market Account......................................................
81
Par clearance of checks..................................................................... 158
Rediscounts (See Discounts by Federal Reserve Banks)
Regulations, Board of Governors:
Nature of........................................................................................
78
T and U, margin requirements established under.........................
58
V, defense production loans..........................................................
161
W, consumer credit........................................................................
60
X, real estate credit........................................................................
64
Repurchase agreements............................................................. 41, 48, 178
Reserve requirements:
Federal Reserve Bank:
Gold certificates, ratio to deposits and Federal Reserve
notes............................................................. 52,54,90,95,97, 183
Member bank:
Authority of Federal Reserve to change................................. 49, 196
Computation by Federal Reserve Banks................................... 153
Effects of changes in.......................................................... 48, 50, 195
Percentages in effect, December 1953..................................15, 21, 50
Percentages prescribed June 21, 1917.........................................
49
Reserves:
Federal Reserve Bank:
Excess..................................................................................... 100, 183
Gold certificate.................................................52, 54, 90, 95, 97, 174
Reserve ratio, item on balance sheet of Federal Reserve Banks 183
Function o f....................................................................................
14
Gold, as reserve money.................................................................
98
Maintenance of reserve balances prior to establishment of Federal
Reserve System...........................................................................
2
Member bank:
Balances with Federal Reserve Banks......................... 4, 28, 152, 197
Effect of gold movements on..................................... 30, 98, 100, 105
Excess................................................................... 30, 36, 50, 180, 188
Factors influencing volume of, bank reserve equation.............. 107
Review of changes..........................................................112, 117,189
Sources o f................................................................................ 97, 106
Multiplying power o f.....................................................................
21
207
IN D E X
Reserves: (Continued)
Operation of, in banking system....................................................
Regulation of............................................................................... 31,
Saving, effect of changes in credit conditions and interest rates o n ..
State member banks:
Deposits..........................................................................................
Examinations................................................................... 4, 71, 170,
Number..........................................................................................
Obligations and privileges..............................................................
System Open Market Account..........................................................
Transfer of funds...............................................................................
Treasury Department:
Fiscal agency services performed by Federal Reserve Banks___
Relation of Federal Reserve System to .........................................
Treasury-Federal Reserve accord with respect to monetary and
debt management policies..........................................................117,
Trust powers of national banks, authority of Federal Reserve to
grant...............................................................................................
Voluntary credit restraint program...................................................
Voting permits, power of Federal Reserve to grant..........................
208
15
194
136
70
171
69
69
81
158
159
85
188
170
65
170
@FedFRASER