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8H-1464 1M 8-61




The Federal Reserve System







THE

Federal Reserve System
PURPOSES AND FU N CTIO N S

BO AR D OF GOJi fi RNORS




LIBRARY

F ir s t E d it io n - M a y

1939

S e c o n d E d it io n - N o v e m b e r
T h i r d E d it io n - A p r il

1947

1954

F o u r t h E d it io n

First printing, February 1961, 100,000 copies
Second printing, April 1961, 100,000 copies

Library of Congress Catalog Card Number 39-26719




FOREWORD
HIS edition o f The Federal Reserve System: Purposes
and Functions is dedicated to a better public under­
standing of the System’s trusteeship for the nation’s credit
and monetary machinery. It describes the System’s or­
ganization, the range o f its operations, and its contribu­
tion to stable economic progress. On the cover o f the book
is a facsimile o f the bronze relief that is set into the marble
fireplace o f the Board room o f the Federal Reserve Build­
ing in Washington. This relief symbolizes the aims of
Federal Reserve functions in furthering orderly growth,
stability, and productivity.
The coverage o f this edition is comparable with that o f
the one published in 1954. The revision, however, takes
into account the lessons taught by the flexible administra­
tion of monetary policy during the past decade as well as
the advances that have been made in monetary knowledge
through systematic research. Aside from the desire to im­
prove content and organization, the single objective o f the
revision has been to help the reader understand the subject
matter.
The present edition, like the former one, was prepared
as a collaborative effort o f the Board’s technical staff.
Ralph A. Young, Adviser to the Board, was responsible
for coordinating and supervising this task.

T

Bo a rd of G o vernors
of

Washington, D. C.
February 1961




the

F e d er a l R eserve S ystem




ACKNOW LEDGM ENTS

HE content and arrangement o f this edition has bene­
fited from suggestions by many members o f the
Board’s staff and by readers and critics o f the previous
edition. All o f these suggestions are acknowledged with
appreciation.
Special acknowledgment should be made to W oodlief
Thomas, Adviser to the Board, and Guy E. Noyes, Direc­
tor, Division o f Research and Statistics, for criticism on
matters o f substance. Susan S. Burr, former Associate
Adviser in the Division of Research and Statistics, helped
greatly in the original planning and development o f the
revision.
O f particular help in reviewing the book as a whole, or
in pointing out or formulating needed revisions, were:
Frederic Solomon, Director, and Robert C. Masters, Asso­
ciate Director, Division o f Examinations; M. B. Daniels,
Assistant Director, Division o f Bank Operations; Lewis N.
Dembitz, Associate Adviser, Division o f Research and
Statistics; J. Herbert Furth and A. B. Hersey, Advisers,
Division o f International Finance; and Robert Solomon,
Chief o f the Capital Markets Section, and Charles Yager,
Economist, Division o f Research and Statistics. Stephen
H. Axilrod, Economist, Division o f Research and Sta­
tistics, contributed a new chapter describing the credit
market, collaborated in revising chapters dealing with the
economic effects o f monetary policy, and assisted in
preparing the final text.

T




A CK NO W LED GEM EN TS

For editorial work in preparing the material for publi­
cation, special credit is due to Elizabeth B. Sette, Chief o f
the Economic Editing Unit, Division o f Research and
Statistics. Helen R. Grunwell supervised the preparation
o f the illustrations.




R a lph A . Y o u n g

x

CONTENTS
CHAPTER
I.

F u n c t io n o f t h e F e d e r a l R eserve S y s t e m ..........

An efficient monetary mechanism is indispensable to
the steady development of the nation’s resources and a
rising standard of living. The function of the Federal
Reserve System is to foster a flow of credit and
money that will facilitate orderly economic growth
and a stable dollar.

II.

F u n c t io n o f B a n k R e se r v e s .........................................

Bank reserves constitute both the legally required
basis and the functional basis of bank deposits.
Changes in the reserve position of banks, therefore,
will affect directly the flow of bank credit and money.
In carrying out its central responsibility, the Federal
Reserve System relies primarily on its ability to in­
crease or decrease the availability, volume, and cost
of bank reserves.
III. I n s t r u m e n t s o f M o n e t a r y R e g u l a t i o n ................
Principal reserve banking methods of regulating bank
reserves are purchases and sales of U. S. Government
securities in the open market, lending to member
banks, and changes in reserve requirements. Regula­
tion of stock market credit supplements these means
of influence. Use of all the instruments is closely
coordinated.

IV.

S t r u c t u r e o f t h e F e d e r a l R eserv e S y s t e m ____

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 dis­
tricts 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.




PAGE

CHAPTER

V.

T h e C r e d it M a r k e t ...........................................................

85

The national credit market is made up of many inter­
related markets, of which the market for commercial
bank credit is an important one. Developments in all
parts of the market interact on and influence other
parts. Neither the banking sector nor the nonbank­
ing sectors of the market can be understood by
themselves.

VI.

I n t e r e s t R a t e s ......................................................................

105

Interest rates are prices paid for borrowed money.
They are established in credit markets as supplies of
and demands for loanable funds seek balance. Move­
ments of interest rates are influenced by the nation’s
saving and investment, by market expectations, and
by the flow of bank credit and money.

VII.

I n f l u e n c e o f R eserve B a n k in g o n E c o n o m ic
S t a b il it y ................................................................................

123

Federal Reserve influence on the flow of bank credit
and money affects decisions to lend, spend, and save
throughout the economy. Reserve banking policy
thus contributes to stable economic progress.

VIII.

S u p e r v is o r y F u n c t io n s o f t h e F e d e r a l R eserve

145

By keeping individual banks strong, bank supervision
helps to maintain an adequate and responsive bank­
ing system and thus contributes to the smooth func­
tioning of economic processes.

IX .

R e l a t io n o f R e se rv e B a n k in g t o C u r r e n c y . . .

The Federal Reserve is responsible for providing an
elastic supply of currency. In this function it pays
out currency in response to the public’s demand and
absorbs redundant currency.




x ii

155

PAGE

CHAPTER
X.

R e l a t io n o f R e se r v e B a n k in g t o G o l d ...............

165

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 coun­
try’s monetary gold stock are reflected in Federal
Reserve holdings of gold certificates.
XI. B a l a n c e S h e e t o f t h e F e d e r a l R e s e r v e B a n k s .
Federal Reserve functions are reflected in the con­
solidated balance sheet of the Reserve Banks, known
as the weekly condition statement. This statement
shows how much Federal Reserve credit is being used
and the key items that account for its use.
X II.

T h e B a n k R e serv e E q u a t io n ........................................

177

189

Gold, currency in circulation, and Federal Reserve
credit are the principal factors that influence the
volume of member bank reserves — the basis of bank
credit and the money supply. The relationship among
these factors, together with other more technical
ones, is sometimes called the bank reserve equation.
X III. S h o r t - T e r m C h a n g e s i n B a n k R e s e r v e s ............... 203
Reserve banking policy responds to all of the ele­
ments affecting member bank reserve positions. A
full accounting of bank reserve factors is published
each week in a table accompanying the Reserve Bank
condition statement.
X IV .

S e r v ic e F u n c t i o n s .........................................................

213

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 U. S. Govern­
ment.
S e l e c t e d F e d e r a l R ese rv e P u b l ic a t io n s ............

225

I n d e x ...........................................................................................

231




xiii




ILLUSTRATIONS
PAGE

Money and Bank Deposits...............................................

5

Process of Deposit Expansion..........................................

22

Deposits and Bank Lending.............................................

25

Member Bank Reserves....................................................

29

U. S. Government Marketable Debt...............................

40

Discount and Bill Rates...................................................

49

Federal Reserve Credit.....................................................

59

Map of the Federal Reserve System................................

67

Disposition of Reserve Bank Earnings............................
72
Organization of the Federal Reserve System............... 80-81
Credit Expansion..............................................................
86
Gross National Saving.................................. ..................

90

Change in Financial Position...........................................
Long- and Short-term Interest Rates...............................

101
109

Selected Interest Rates......................................................

110

Yields and Prices on U. S. Government Securities.........

113

Flow of Federal Reserve Influence..................................

125

Gross National Product and Money Supply...................

143

Kinds of Currency............................................................

157

Currency in Circulation....................................................

159

Currency and Federal Reserve Credit..............................

161




xv

ILLUSTRATIONS
PAGE

Changes in U. S. Gold Stock...........................................

166

U. S. Balance of Payments..............................................

174

Reserves of Federal Reserve Banks.................................

187

Bank Reserve Equation....................................................

193

Production and Prices......................................................

200

Reserves and Borrowings.................................................

210

Checks Handled by Reserve Banks..................................

219




xvi

CHAPTER I

FUNCTION OF THE FEDERAL RESERVE SYSTEM.
An efficient monetary mechanism is indispensable to the steady
development o f the nations resources and a rising standard of
living. The Junction o j the Federal Reserve System is to Joster
a flow o f credit and money that will facilitate orderly economic
growth and a stable dollar.

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 parts o f a broader objective, namely, to help counter­
act inflationary and deflationary movements, and to share
in creating conditions favorable to sustained high employ­
ment, stable values, growth o f the country, and a rising
level o f consumption. Acceptance of this broader objective

O




1

T H E FE D E R A L RESERVE SYSTEM

has widened over the years and today it is generally under­
stood to be the primary purpose of the System.
How is the Federal Reserve System related to produc­
tion, employment, and the standard of 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 pur­
pose 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
supply of bank credit and money was inelastic. This
resulted in an irregular flow of credit and money and
contributed to unstable economic development.
Commercial banks in smaller cities and rural regions
maintained balances with commercial banks in larger
cities, which they were permitted to count as reserves
against the deposit accounts of their customers. Large
amounts of these reserve balances were maintained in
New York and Chicago. Many banks, furthermore, as
a matter of convenience and custom and as a means of
utilizing idle funds, kept in the financial centers deposit
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, these demands ultimately converged on a few
commercial banks situated in the financial centers. In
ordinary times the pressures were not excessive, for while

2




F U N C T IO N O F T H E FE D E R A L RESERVE

some out-of-town banks would be drawing down their
balances, others would be building theirs up. But in periods
when business was unusually active and the public needed
larger amounts of 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 addi­
tional funds, including currency, the credit situation would
become very tight. To meet the out-of-town demand for
funds, the banks in the financial centers would sell securi­
ties 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 of this
kind would lead to a sharp liquidation of bank credit.
These liquidations were called money crises.
The problem had been under public discussion and study
for a long time when, following a crisis of unusual severity
in 1907, Congress appointed a National Monetary Com­
mission to determine what should be done. After several
years of thorough consideration, Congress adopted legis­
lation 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 demands for credit
and money by the public could be met.
All of the principal nations have reserve banks, com­
monly called central banks, to perform functions corre­




3

T H E FED ER A L RESERVE SYSTEM

sponding to those of the Federal Reserve System. In
England it is the Bank o f England, which has been in
existence since the end of the seventeenth century; in
France it is the Bank of France, established by Napoleon I ;
in Canada it is the Bank of Canada, which began opera­
tions 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 Wash­
ington.
The principal function of the Federal Reserve is to
regulate the flow of bank credit and money. Essential to the
performance of this main function is the supplemental one
of collecting and interpreting information bearing on eco­
nomic and credit conditions. A further function is to ex­
amine and supervise State member banks, obtain reports
of condition from them, and cooperate with other super­
visory authorities in the development o f policies conducive
to a system of strong individual banks.
Other important functions include the provision o f cashbalance or payment services to the member banks o f the
Federal Reserve System, the U.S. 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 collection of checks; effecting telegraphic
transfers of funds; and acting as fiscal agents, custodians,
and depositaries for the Treasury and other Government
agencies.
Since the main concern of the Federal Reserve is the
flow of credit and money, these words must be given
meaning at the outset. This can best be done by considering
these four questions: (1) What is money and how is it
4




FUNCTION OF THE FEDERAL RESERVE

used? (2) How is money related to bank deposits and to
bank credit? (3) How do changes in credit and monetary
conditions affect the lives of the people? (4) By what means
does the Federal Reserve regulate credit and money?
M O N E Y Ai

DEPOSITS

MI0-1960

M

§ ||| • M U N 3 Gi ? A m £ N T

CURRENCY.

IQIAJ

--BitU o ni of d o !!ar»

Money and Its Uses

Money is most meaningfully defined in terms of how it
is used. Money serves as: (1) a means of payment; (2) a
standard of value; and (3) a store of purchasing power.
As a means of payment, money allows individuals to
concentrate their productive efforts on those activities
for which they are best equipped and in which they are




5

T H E FED ER A L RESERVE SYSTEM

trained to engage. Money is what people receive in return
for their services and what they use to buy the goods and
other things they need for themselves and their families.
As a standard o f value, money provides the means by
which a day’s work can be equated with a family’s food,
housing, and other bills, including what is set aside for
old age or for children’s education. It is thus the measuring
rod in terms o f which producer and consumer choices can
be assessed and decided.
As a store of purchasing power, money enables us to set
aside some of our present income for future spending or
investing. It is a way in which labor and work expended
in the present can be saved for education, old age, and for
the many contingencies that individuals and families are
likely to meet.
Because money has all these uses, it is vital and necessary
to the functioning o f our economic system. If money were
impaired as a means of payment, or a standard o f value,
or a store of purchasing power, the economy’s ability to
grow and to produce and distribute goods in accordance
with the needs and wishes of the people would be jeopard­
ized.
Currency, Bank Deposits, and Bank Credit
In the United States circulating paper money and coins
of all kinds (currency) and the demand deposits held by
banks perform all the functions of money. The reason that
currency and demand deposits are both money is not far
to seek. When a person has $10 of paper money and coin
in his pocket and $ 1 0 0 in his checking account in the bank,
he is in a position to spend $110 at any time. These two
sums represent his active cash balance; they serve the same
6




FU N C T IO N O F T H E FE D E R A L RESERVE

general purpose and each can be converted into the 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 currency by taking it out
o f a bank.
The amounts of currency and of demand deposits at
mid-1960 are 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-1960 is also shown in the chart.
All bank deposits basically represent amounts owed by
banks to depositors. They come into existence as banks
extend credit to customers by exchanging bank deposits
for the various assets that banks acquire — promissory
notes o f businesses and consumers, mortgages on real
estate, and Government and other securities.
Demand deposits differ importantly from savings and
other time deposits. Time deposits are not transferable by
check. While convertible into demand deposits or cur­
rency, savings deposits o f individuals are subject to prior
notice of conversion, and other time deposits are not pay­
able prior to maturity except in emergencies. Thus savings
and time deposits, while serving a store-of-value function,
are not in themselves means of payment; only currency and
demand deposits serve in this active monetary role.
It has long been customary for people to keep most of
their money in banks and to make most of their payments
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 pocket-




7

T H E FE D E R A L RESERVE SYSTEM

books and sometimes less. Sometimes they hold more of
their money in demand deposits and sometimes less. Such
changes in money habits can have important consequences.
For a general idea of money, the two kinds — pocket
money and deposits in checking accounts — should be
considered together. For the most part both kinds originate
in bank credit, that is, the loans and investments of com­
mercial banks. The Federal Reserve influences the flow of
bank 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
nation’s 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 that all the people have
available that is important, but what those dollars will
buy today as compared with earlier periods and as com­
pared with the future.
People have different tests of whether they as individuals
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 of his em­
ployees, 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, at a cost and on repayment terms
that he can meet, to buy what he needs. Essentially, how­
ever, people are concerned mainly with what they can do
with the dollars they earn, are indebted for, or need to




F U N C T IO N O F T H E FE D E R A L RESERVE

borrow. The ultimate test, in other words, is the stability
o f the purchasing power o f the dollar over time.
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, in­
comes, and consumption and to foster a stable value for the
dollar. When credit, including bank credit, becomes unduly
scarce or excessively hard to get and costs too much, fac­
tories and stores may curtail operations and lay off employ­
ees. Smaller payrolls mean hardship for workers, who cur­
tail their purchases; merchants 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 of 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 prices of mate­
rials. In the end they raise their own costs.
The nation as a whole does not profit from conditions
of price inflation because production costs, prices of fin­
ished products, wages, and the cost of living will rise




9

TH E FED ER A L RESERVE SYSTEM

together or in closely linked sequence. At some point
the upward spiral will break, perhaps because prices of
finished goods get so high that ultimate consumers, even
though many of them receive higher wages, can no longer
buy the goods produced. Then a downward spiral will
develop. The higher that values have risen, the more
abruptly and lower they are likely to fall and the greater
will be the associated unemployment and distress.
The above recital is oversimplified in that it does not
include all the factors that affect the level o f economic
activity. Nevertheless, it shows how the lives o f people
are affected 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 plenti­
ful or easily obtainable and too cheap. By influencing the
flow of bank credit, with resulting effects on the flow of
money and the flow o f credit generally, the Federal Re­
serve 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 that people use reaches them, directly or
indirectly, through banks. They may receive their pay in
cash, but the employer who pays them will have cashed a
check at a bank or may have borrowed from a bank before
making up his payroll. Therefore, the flow o f money in the
country depends greatly on the activities of commercial
banks in accommodating the credit and monetary require­
ments of industry, trade, agriculture, and all the other
sectors of economic life.
The ability o f commercial banks to extend credit and
provide cash-balance and payment services to the people
10




F U N C T IO N O F T H E FE D E R A L RESERVE

depends on the amount of reserve funds the banks have.
This amount is directly 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 of reserves works, and
the fact that under it the banks can lend in the aggregate
several times as much as they have in reserves, is discussed
in Chapter II.
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 of
credit the banks may extend to the public through loans
and investments. The reserve position o f banks affects
directly the willingness of banks to extend credit and the
cost, or rate o f interest, that borrowers from banks will
have to pay to obtain it. In this way the Federal Reserve
has the power to influence the country’s over-all credit
situation and its money supply.
While the Federal Reserve directly influences the avail­
ability and cost o f bank credit and thereby affects the total
flow o f credit, a great variety of other forces also affect
the total flow o f credit in the economy. These include,
among others, governmental policies in regard to expendi­
tures, taxes, and debt; the distribution o f income among
different groups of the population and the allocation of
income between current consumption and saving; the
bargaining strength and policies of management, labor,
agriculture, and other sectors of the economy; the course
o f foreign trade and foreign investment; the prospects for
peace or war; and the expectations of businesses and con­
sumers as to future changes in economic activity, espe­
cially in prices.




11

T H E FE D E R A L RESERVE SYSTEM

Thus the Federal Reserve alone cannot assure favorable
economic conditions nor can it direct whether bank or
any other credit shall flow into particular channels. But
it can affect the general flow of credit and money as eco­
nomic conditions change and thus help to counteract
instability resulting from other forces.
Economic Intelligence
For monetary regulation to be most effective and suc­
cessful, it must be supported by adequate current informa­
tion. This requires analysis of the developing economic
situation and of the forces shaping basic trends, and calls
for an efficient mechanism of economic intelligence. The
staffs o f the Board o f Governors and o f the twelve Reserve
Banks are constantly engaged in assembling and observing
economic and financial information to guide the System
in the formulation and administration o f policy.
From its formative years, the Federal Reserve System
has undertaken, through its publications, to help keep the
public informed about the functioning of the economy, as
well as to make relevant statistical material available for
public use. The System has also come to follow the practice
of publishing promptly the key factual information on
which policy decisions have been based and of explaining
in official reports why past actions have been taken.
These practices are based on the belief that public
understanding helps to make effective a credit and mone­
tary policy designed to foster stable economic development
and a stable dollar. It is the Federal Reserve view that the
more fully the public understands the issues involved, the
simpler and easier credit and monetary administration
can be.
12




CHAPTER II

FUNCTION OF BANK RESERVES. Bank reserves constitute
both the legally required basis and the functional basis o f bank
deposits. Changes in the reserve position <f banks, therefore, will
affect directly the flow o f bank credit and money. In carrying out
its central responsibility, the Federal Reserve System relies pri­
marily on its ability to increase or decrease the availability,
volume, and cost o f bank reserves.

OMMERCIAL banks, like other business organiza­
tions, are in business to make a profit. The bulk o f
a commercial bank’s earnings come from the returns it
receives on its loans and from its security holdings. Con­
sequently, it is usually a bank’s policy to put into loans
and investments as much as possible of the money it
receives as capital and deposits. Banks in practically all
States, however, are required by law to hold as reserve
assets 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




13

TH E FED ER A L RESERVE SYSTEM

banks maintained a cash fund adequate to meet temporary
drains of reserve funds caused by their depositors* with­
drawals as well as to elicit depositors’ confidence in the
banks’ ability to redeem their deposits when called upon
to do so. This was before establishment of the Federal
Reserve System, when there was no reserve bank from
which a commercial bank could obtain additional reserves
in time of temporary need. Reserve requirements, although
they restrained credit expansion, did not effectively protect
depositors during periods of stress, for the banks could
not continuously pay out for their depositors’ benefit the
cash they were required to keep as reserves without draw­
ing down such reserves below legal requirements and
threatening their ability to continue active operations.
Since other ways of protecting depositors have been devel­
oped (for example, Federal insurance of deposits), re­
quired bank reserves have become for the most part a
medium through which the flow of bank credit and money
is influenced.
Member Bank Reserve Requirements
If a bank is a member of the Federal Reserve System, it
is required to keep as reserves the following percentages
of its demand deposits:1
Central reserve city banks................................. ... 16Vi
Reserve city banks................................................. 16lA
Other member banks (often described as
“country banks”)............................................... 12
1 These are requirements in effect in December 1960. Under the Federal
Reserve Act as amended in 1959, the separate category of “central reserve
city banks” is to be abolished in 1962.
14




FU N C T IO N O F B A N K RESERVES

These reserves must be on deposit with a Federal Reserve
Bank, except for any amounts that the member bank may
choose to hold in actual cash. As explained in Chapter III,
the Federal Reserve may alter the required percentages
within limits specified by law when credit conditions make
a change appropriate and feasible. Banks that are not
members of the Federal Reserve System are subject to
reserve requirements that vary from State to State.
The function of bank reserves may be easily explained
in a general way. For instance, assume that banks are
required to hold a 2 0 per cent reserve against demand
deposits. This 20 per cent figure is higher than the actual
percentages given above, but it is a convenient round figure
for illustrative purposes.
In this example, when a member bank receives a demand
deposit o f $ 100 , in currency or in the form of a check on
another bank, it must hold $ 2 0 as required reserves against
the deposit. These reserves must be deposited with a
Federal Reserve Bank, unless held in currency in the bank’s
own vault. The bank is free to lend or invest the remaining
$80. If there is an adequate demand for loans from cus­
tomers or a supply of suitable securities in the market, the
bank will lend or invest practically all of the $80.
How the Banking System Works
To further clarify 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 of its liabilities to
customers are in the form of demand deposits. Further­
more, let us give this single member bank enough resources
to represent all the commercial banks in the country. Let




15

T H E FE D E R A L RESERVE SYSTEM

us assume that the relevant items in its balance sheet are
as follows (in billions):
Loans and investments.....................
Reserves with the Federal Reserve..
Demand deposits...............................

$ 80

Ratio o f reserves to demand deposits

20 per cent

20

100

Let us again assume that this 20 per cent ratio of reserves
to demand deposits is the legal minimum. Under the cir­
cumstances 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 finds that
additional loans are desirable to meet the credit needs of
the country, and let us also assume that its actions add
$ 1 0 billion to the member bank’s reserves in a manner
that also increases the bank’s demand deposits by the
same amount. Then the simplified balance sheet o f the
bank would be (in billions):
Loans and investments.......................................
Reserves..............................................................
Demand deposits................................................

$ 80
30
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
cent). Therefore, it could make additional loans and
investments. A little figuring will show that the bank has
the $ 2 2 billion of reserves required for its deposits of $ 1 1 0
billion and also has $8 billion of reserves above require­
ments, or excess reserves.
Let us next assume that the public is eager to get addi­
tional money and wants to borrow as much as the member
16




F U N C T IO N O F B A N K RESERVES

bank will lend; let us assume also that the proceeds of the
loans will remain 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 stay at the higher
level made possible by the increase in reserves.
Another calculation will show that on the basis of the
$8 billion o f excess reserves the member bank can add $40
billion to its loans and investments. The bank’s balance
sheet would then be (in billions):
Loans and investments......................................
Reserves..............................................................
Demand deposits................................................

$120
30
150

Ratio o f reserves to demand deposits...........20 per cent

This simplified picture of bank transactions indicates
that a deposit of $ 1 0 billion 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 o f account
many complications, shows what a powerful instrument of
monetary regulation reserve banking action can be. It can
provide the basis for an increase in the money supply not
merely by the amount that it adds to the bank’s reserves,
but by a multiple o f the additional reserves — five times
in this example.
Consider the course of events in case there is too much
money and it is decided that the amount should be dimin­
ished. Suppose that Federal Reserve action reduces the
$ 2 0 billion o f reserves the member bank had in the first




17

T H E FED ER A L RESERVE SYSTEM

place by $5 billion, at the same time lowering deposits by
an equal amount. The balance sheet would then read (in
billions):
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. The bank would have to call loans
or sell investments, and thus absorb deposits to the extent
of five times its deficiency in reserves, that is, by $ 2 0 billion.
If its depositors repaid loans or repurchased $20 billion of
investments by drawing on their deposits, the result would
be (in billions):
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 bank­
ing action, this time in the direction of contraction. A
reduction of $5 billion in the member bank’s reserves can
bring about a liquidation of $ 2 0 billion in loans and invest­
ments 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 the bank to
increase or decrease its loans and its demand deposits (the
major component o f the money supply) by several times
the amount added or extinguished. This is why the dollars
18




FU N C T IO N O F B AN K RESERVES

created by Federal Reserve action that become bank
reserves are often called “high-powered” dollars to dis­
tinguish them from ordinary deposit dollars.
Other Influences
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 as­
sumed 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 of demand deposits. We have
also assumed a reserve requirement of 2 0 per cent, and
we have assumed that all the money lent by the bank will
be kept on demand deposit. In practice, to the extent that
the public chooses to withdraw some of the money in cur­
rency 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
demand for currency is related to the total money supply
(currency and demand deposits) held by the public, and
that such demand reflects merely the share of the money
supply that the public desires to hold in the form of cur­
rency. Since currency and demand deposits are inter­
changeable at the option of the public, the major factor
increasing or decreasing the money supply is the loans and
investments of commercial banks. It should be noted, how­
ever, that currency withdrawals from banks reduce bank
reserves dollar for dollar. For this reason, currency with­
drawals affect the expansion potential of a given volume
of new reserve funds.




19

T H E FE D E R A L RESERVE SYSTEM

The transfer o f funds from a demand to a savings or
other time deposit reflects the preference o f the depositor
for an asset that earns interest rather than an asset that
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 limita­
tions.
Commercial banks in this country have both demand
and time deposits, and their loans, investments, and re­
serves form a common pool of assets backing the two
kinds of deposits. Whereas member banks must at present
keep average reserves of about 15 per cent against demand
deposits, they are required to keep only 5 per cent against
savings and other time deposits. If holders of demand
deposits transfer them to time deposits, there is a release
of reserve funds from the required reserve category — the
difference between 15 per cent and 5 per cent — on the
basis of which the bank can expand its loans and invest­
ments and its demand deposits. Conversely, if holders of
time deposits shift them into demand deposits, the bank
finds it necessary to reduce its loans and investments or to
obtain additional reserve funds in some other way 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 situa­
tion in which one member bank does all the banking
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 hypothetical bank can expand
20




FU N C T IO N O F BAN K RESERVES

its loans and investments by as much as $40 billion if
Federal Reserve action adds $10 billion to its reserves. In
practice, of course, there are a great many banks in this
country and no one bank can do that since 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 to
his bank in the form of deposits. 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 banks together—lend four times as
much as is obtained from the Federal Reserve?
The process by which this happens is simple and under­
standable. It is illustrated in the following chart and table,
which show how deposits are built up as reserve funds
are diffused throughout the banking system, and may be
sketched as follows: We can suppose that new reserve
funds of $ 1 0 0 are made available to member banks in a
manner that also increases deposits by that amount at
one bank. The member bank at which $100 is deposited
needs to hold $ 2 0 in required reserves, in keeping with our
earlier assumption, and the remaining $80 can be lent or
invested.
Suppose that ail the money is lent. The amount lent is
first credited to the borrower’s deposit account. This money
is then paid out at once by the borrower to someone who
deposits it at another bank. The cash holdings and newly
created deposits of the first bank are thus drawn down and
transferred to a second bank.
The second bank receives $80 in cash reserves and in new




21

THE FEDERAL RESERVE SYSTEM

deposits; it holds $16 as required reserve against the de­
posit received and can lend the remaining $64. Similarly,
the borrower here may draw down the additional 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,
thereby adding a further $51.20 to deposits.

PROCESS OF DEPOSIT EXPANSION
D o lla r s
m -—C U M U L A T IV E T O T A L
H

N EW DEPO SITS

400

I N C R E A S E IN:
REQ UIRE D RESERVE S
LO AN S

AN D IN VE S TM E N TS

300

200

100

N EW

1st

RESERVES

2nd

3 rd

b
4 th

5 th

IN D IV ID U A L B A N K S

6 th

A LL
BAN KS

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.
Thus, an individual bank does not lend out more than
it receives, but the banking system as a whole expands by
22




FU N C T IO N O F B A N K RESERVES

a multiple of new reserve funds made available to it. The
fact that individual member banks are required to hold
only a fraction of their deposits as reserves, and the fact
that payments made with the proceeds of bank loans are
eventually redeposited with banks, make it possible for
M ultiplying C apacity of R eserve M oney
I n B ank T ransactions 1
Amount
Amount
lent

Amount set aside
as reserves

Transactions

• deposited
| in checking
accounts

Bank 1.........................
2 ........................
3 ....................
4 ........................
5 ........................

$100.00
80.00
64.00
51.20
40.96

1 $ 80.00
I
64.00
!
51.20
40.96
32.77

S 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

Total for 10banks...

$446.33

! $357.07

$ 89.26

Additional banks.........

53.67

Grand total, all banks

,
|

|

$500.00

2 42.93

2 10.74

$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.

additional reserve funds, as they are deposited and invested
through the banking system as a whole, to generate deposits
on a multiple scale.
An Apparent Banking Paradox?
The foregoing discussion of the working of the banking
system explains an apparent paradox that is the source of




23

T H E FE D E R A L RESERVE SYSTEM

much confusion to banking students. On the one hand,
the practical experience of each individual banker is that
his ability to make the loans or acquire the investments
making up his portfolio of earning assets derives from his
receipt of depositors’ money. On the other hand, we have
seen that the bulk of the deposits now existing have origi­
nated through expansion of bank loans or investments by
a multiple of the reserve funds available to commercial
banks as a group. Expressed another way, increases in
bank reserve funds are to be thought o f as the ultimate
source of increases in bank lending and investing power
and thus of deposits.
The statements are not contradictory. In one case, the
day-to-day aspect of a process is described. In a bank’s
operating experience, the demand deposits originating in
loans and investments move actively from one bank to
another in response to money payments in business and
personal transactions. The deposits 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 his account in favor of various of his creditors who
deposit them at their banks. Thus the lending bank is likely
to retain or receive back as deposits only a small portion
of the money it lent, while a large portion of money lent
by other banks is likely to be brought to it by its customers.
From the point of view of the individual bank, therefore,
the statement that the ability of a single bank to lend or
invest rests largely on the volume of funds brought to it
by depositors is correct. Taking the banking system as a
whole, however, demand deposits originate in bank loans
and investments in accordance with an authorized multiple

24




FUNCTION OF BANK RESERVES

of bank reserves. The two inferences about the banking
process are not in conflict; the first one is drawn from the
perspective of one bank among many, while the second
has the perspective of banks as a group.
The commercial banks as a whole can create money only
if additional reserves are made available to them. The
Federal Reserve System is the only instrumentality enm p sm

AND

MM

LENDING
Billions o f tlo iio ri

B A N K LO A N S
A N D IN VESTM EN TS

1915

'20

dowed by law with discretionary power to create (or ex
tinguish) the money that serves as bank reserves or as the
public’s pocket cash. Thus, the ultimate capability for
expanding or reducing the economy’s supply of money
rests with the Federal Reserve.
New Federal Reserve money, when it is not wanted by
the public for hand-to-hand circulation, becomes the
reserves of member banks. After it leaves the hands of the




25

T H E FE D E R A L RESERVE SYSTEM

first bank acquiring it, as explained above, the new reserve
money continues to expand into deposit money as it passes
from bank to bank until deposits stand in some established
multiple of the additional reserve funds that Federal
Reserve action has supplied.
How the process of expansion in deposits and bank loans
and investments has worked out over the years is depicted
by the chart on page 25. The curve “deposits and currency’*
relates to the public’s holdings of demand deposits, time
deposits, and currency. Time deposits are included be­
cause 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.
Additional Aspects o f Bank Credit Expansion
At this stage of our discussion, three additional aspects
o f the functioning of the banking system are worth noting
briefly. The first is that bank credit and monetary expansion
on the basis o f newly acquired reserves takes place only
through a series of banking transactions. Each transaction
takes time on the part of bank managers and, therefore,
the deposit-multiplying effect of new bank reserves is
spread over a period. The banking process thus affords
some measure of built-in mechanical protection against
unduly rapid expansion of bank credit should a large
additional supply of reserve funds suddenly become avail­
able to banks.
The second point is that for expansion of bank credit to
take place at all there must be a demand for it by credit­
worthy borrowers — those whose financial standing is
such as to entail a likelihood that the loan will be repaid
26




FU N C TIO N O F B A N K RESERVES

at maturity — and/or an available supply o f low-risk
investment securities such as would be appropriate for
banks to purchase. Normally these conditions prevail, but
there are times when demand for bank credit is slack and
eligible loans or securities are in short supply. Also, market
conditions for bankable paper and attitudes o f bankers
with respect to the market exert an important influence on
whether, with a given addition to the volume of bank
reserves, expansion of bank credit will be 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
Reserve may assume the initiative in creating or extin­
guishing bank reserves, or the member banks may take the
initiative through borrowing or repayment of borrowing
at the Federal Reserve.
Sometimes the forces of initiative work against one
another. The effect of this counteraction is mainly to
avoid an abrupt impact on the flow of credit and money
o f pressures working to expand or contract the volume of
bank reserves. This relation between reserve banking
initiative and member bank initiative in changing the
volume of Federal Reserve credit will be discussed further
in the succeeding chapter.
Apart from these supplementary aspects of the banking
mechanism, the significant feature of reserve banking oper­
ations is that the issuance of a given amount of highpowered money by the Federal Reserve will generate a
volume of ordinary money that is several times as large
as the amount issued, and that, on the other hand, Federal
Reserve extinguishment of a given amount o f high-powered
money will result in a reduction of several times that




27

T H E FE D E R A L RESERVE SYSTEM

amount in loans and investments and in demand deposits,
that is, in ordinary money. As a result o f this leverage, it
is possible for relatively small Federal Reserve actions to
bring about relatively large changes in the flow o f credit
and money through the national economy.
Management o f Reserve Balances
In ordinary practice an individual commercial bank does
not match one or more loan or investment transactions
against the exact amount of reserve funds it has in excess
of its required reserves. There is a continuous flow o f
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
constantly watches these offsetting flows and estimates
their net impact on its deposits and its reserve position.
Its day-to-day management problem is to make sure that,
after all transactions, its reserves are sufficient to comply
with legal requirements.
While a member bank must watch its reserves to make
sure that they are large enough, this does not mean that
reserves remain unused. Actually, a member bank uses its
reserves, most of which are held with the Federal Reserve
Bank, in much the same way that a depositor uses his
checking account.
Under Federal Reserve rules, reserve requirements
apply to reserves maintained on the average over a period
(a week for central reserve and reserve city banks and two
weeks for other member banks). While maintaining these
reserves at or above the required minimum, a bank may
28




FUNCTION OF BANK RESERVES

make constant use of them. Through its reserve account at
its Reserve Bank the bank not only settles adverse clear­
ing balances with other banks but also transfers funds to
other cities. The bank must be careful, however, to see
that over the reserve period the average amount of its
MEMBER BANK RESERVES
B illio ns of d o lla rs

1930

'3 5

’4 0

’4 5

’5 0

’5 5

’6 0

reserves equals or exceeds the amount required in relation
to its deposits. The occasion for borrowing from a Fed­
eral Reserve Bank usually arises when reserves have fallen
below the required level and banks must replenish them.
At the beginning of this chapter, it was stated that banks




29

T H E FED ER A L RESERVE SYSTEM

as business organizations endeavor to use all their available
funds in profitable ways and keep as reserves only the
minimum required by law. During the greater part of the
life of the Federal Reserve System, member banks have
put practically all their funds to use and have had prac­
tically no excess reserves. During the middle and late
1930’s and the early part o f 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 wanted to acquire at interest rates prevailing
in the market. Consequently, the banks had an excessive
volume of unused reserves. During and after World War
II the greater part of these excess reserves were absorbed
into required reserves as credit expanded, demand for
currency increased, and increases were made in their
reserve requirements, as permitted by law. In recent years
excess reserves have once again constituted a relatively
small proportion of total reserves, although a larger pro­
portion than in the 1920’s.

30




CHAPTER III

INSTRUMENTS OF MONETARY REGULATION. Principal reserve banking methods o f regulating bank reserves are pur­
chases and sales o f U. S. Government securities in the open
market, lending to member banks, and changes in reserve require­
ments. Regulation o f stock market credit supplements these means
o f influence. Use o f all the instruments is closely coordinated.

I

T has been shown how changes in bank reserves result
in a multiple expansion or contraction of bank loans
and investments and of the money supply. Thus, Federal
Reserve actions to create or extinguish bank reserves exert
a powerful influence on the flow of bank credit and money.
This influence is exercised principally through three related
and complementary instruments.
These instruments of monetary policy, as they are com­
monly referred to, are open market operations, discount
operations, and changes in reserve requirements. The first
two are generally more flexible and more adaptable to
day-to-day changes in credit and monetary conditions than
the third. In addition, the System has authority to influence




31

T H E FE D E R A L RESERVE SYSTEM

directly stock market credit. This limited purpose instru­
ment is specially designed to prevent the excessive use o f
bank and other credit in stock market speculation. The
timing and degree o f the use o f these Federal Reserve
instruments and their coordination are o f major importance
in making credit and monetary policy effective.
O pen M arket O perations

The bulk o f Federal Reserve operations affecting the
reserve positions of banks relate to short-term variations
in the economy’s needs for bank credit and are effected by
the use o f open market operations. These operations
consist of Federal Reserve purchases or sales o f securities
in the open market. Regardless o f who may sell the
securities purchased or who may buy the securities sold
by the Federal Reserve, these transactions have a direct
impact on the volume o f member bank reserves. The dis­
tinctive aspect o f open market operations is that they are
undertaken solely on the basis o f Federal Reserve decision
or initiative.
How Operations Are Conducted
Open market purchases or sales o f securities are made
by the manager o f the System’s open market account
under instruction of the Federal Open Market Committee,
a special statutory body, described in Chapter IV, that
makes open market decisions for the entire System. Open
market transactions are in U.S. Government securities
primarily, but sometimes they include relatively small
amounts of bankers’ acceptances.
The System open market account buys from or sells to
dealers who specialize in buying and selling Government

32




IN STRU M ENTS O F R EG U LA T IO N

securities or bankers’ acceptances on their own account as
well as for others. These dealers carry their own inventory
o f securities and allow transactions for customers to affect
these holdings. A score of dealers engage in making such
markets. Purchases for the System open market account
are made at the lowest prices, and sales at the highest
prices, that are available in the market at the time of the
transaction.
When the Federal open market account places an order
with a dealer for a specified amount of Government se­
curities, the dealer either buys the securities in the open
market or sells them from his own portfolio. In payment
the dealer receives a check on a Reserve Bank, which he
deposits in his own account with a member bank. The
member bank then deposits the check in its reserve account
with a Reserve Bank. Federal Reserve purchases o f Gov­
ernment securities thus add to the reserve balances of
member banks. Conversely, sales of securities reduce the
reserve balances o f member banks. The resulting changes
in reserve positions affect the ability of member banks to
make loans and /or to acquire investments.
Federal Reserve open market sales are made outright,
while purchases may be outright or they may be made
under repurchase agreement. When such agreements are
made, the selling dealer agrees to repurchase the securities
within a specified period of 15 days or less. This kind of
arrangement provides Federal Reserve credit on a tempo­
rary basis—puts out the funds with a string tied to them,
as it were. It also provides temporary financing o f dealer
inventories of Government securities at a time when funds
for dealer loans are not readily available in the market and
the System is willing to supply bank reserves for a limited




33

T H E FE D E R A L RESERVE SYSTEM

period. Repurchase agreements may be terminated before
maturity at the option of either party.
Open Market Procedures
The effectuation o f credit and monetary policy has been
the principal objective of open market operations since
the early 1950’s. For several years prior to World War II
and for a number of years thereafter, however, mainte­
nance of orderly conditions in the money and securities
markets was officially declared to be a main purpose of
System open market operations. During the period of war
and early postwar finance, this purpose provided a rationale
for regularly conducting operations in all maturities of the
Government securities market, and orderliness became
extended to include or mean stability of market prices and
yields. Thus, the Federal Reserve bought and sold Govern­
ment securities with the general purpose of stabilizing
prices and yields. As a result all Government securities,
whether they were short-term or long-term, could be con­
verted into cash with equal ease. In other words, all
Government securities had full market liquidity.
This experience demonstrated that System use of open
market operations to stabilize market prices and yields of
Government securities prevents their use to regulate bank
reserves. When offerings of securities in the market
exceeded the private demand for them, the Federal Reserve
was obliged to buy them to keep the market stable. As a
result, commercial bank reserves were expanded auto­
matically at times when such expansion was adverse to the
public interest. By stabilizing the market, the System func­
tioned as residual buyer and created bank reserves at the
initiative of the market.

34




IN STRU M EN TS O F R EG U LA T IO N

This operating dilemma came into sharp focus when the
Korean crisis in 1950 caused a rapid increase in credit
demands and a surge of inflationary pressures. To resolve
the dilemma, an accord was reached with the Treasury
early in 1951 that the Federal Reserve System would dis­
continue stabilizing prices and yields on Government
securities.
Following this accord, it became desirable for the
Federal Open Market Committee to determine and make
known to participants in the Government securities market
the “ground rules” that it intended to follow in its open
market operations. After extensive study of this compli­
cated technical problem, the Committee agreed on a set
of rules in the spring of 1953. The key ones limited open
market operations to the effectuation of credit and mone­
tary policy, including the correction of disorderly market
situations should any occur; excluded from securities
eligible for System purchase those involved in or related
to imminent refinancings of the Treasury; and confined
System open market transactions as an ordinary matter to
short-term securities.
The Committee has followed a policy of reviewing and
reaffirming or changing its established operating proce­
dures each year or whenever necessary, and these rules were,
of course, subject to this policy. In early 1961, in view of
conditions that had developed in the domestic economy
and in the U.S. balance of payments with other countries,
the Open Market Committee authorized transactions in
longer term securities.
Effectuation o f policy. Open market operations are
administered so as to affect bank reserve positions, and
hence the flow of bank credit and money. As with other




35

T H E FED ER A L RESERVE SYSTEM

policy instruments, they are used primarily to help mini­
mize cyclical fluctuations in economic activity and to help
maintain relative stability in average prices o f goods and
services.
The efficient conduct of open market operations requires
a well performing Government securities market. In such
a market, prices and yields at which willing buyers and
willing sellers can arrange transfers of ownership are con­
tinuously being established. These prices and yields affect
the allocation of funds within the market and between it
and other markets and uses. It is important that operations
of monetary policy be designed so as to minimize the extent
to which the process o f providing bank reserves interferes
with basic market functions.
Credit markets, however, do not always function effec­
tively and well. They sometimes reflect unusual psycho­
logical tensions growing out of overly optimistic or overly
pessimistic expectations as to some prospective develop­
ment, economic or political and domestic or international.
Monetary policy must be responsive to and counteract
such destabilizing developments when they occur.
Market disturbances are usually limited in extent, and
the self-correcting tendencies characteristic o f a sensitive
market mechanism keep the flow of trading continuous
and orderly. There is always a possibility, however, that a
market disturbance will become self-feeding and the market
situation disorderly. Because of this risk, the Federal Open
Market Committee explicitly recognizes a responsibility to
undertake open market transactions to correct disorderly
conditions.
Periods o f Treasury financing. During the period when
the Federal Reserve System was stabilizing the market, it

36




IN STRU M ENTS O F R EG U LA T IO N

purposely used its open market instrument to support
Treasury borrowing operations. To this end the System
engaged in open market transactions in maturing issues,
in securities announced for issuance (“when issued” securi­
ties), and in outstanding issues of maturities comparable
to those being offered by the Treasury in a particular
refinancing. With its virtually unlimited resources, the
System competed with market traders in such transactions
and the latter, in consequence of the System’s dominant
role in the market, tended to limit the volume o f their own
trading.
The risk to System policy from this situation was not
only the undesired release to the banks during Treasury
financings of additional reserve funds but also the inter­
ference, when not necessarily warranted, with the process
by which the market allocates funds among competing
users. In order to avoid or limit this risk, the 1953 ground
rules discontinued this kind of operation. Discontinuance
of the practice o f facilitating Treasury borrowings also
had as a broad objective, of course, the fostering o f a
more self-reliant Government securities market.
This action, however, could not resolve all aspects of
the market relationship between debt management and
monetary administration. The marketable and convertible
part of the Federal debt held by the public amounted at
mid-1960 to more than $150 billion. The periodic refi­
nancing o f this debt and the need from time to time for
new cash borrowing require that the Treasury engage
frequently in financing operations, other than its weekly
auctions of Treasury bills. While the System has believed
that its powers to create money should not be used to
support these financings, it has recognized that concurrent




37

T H E FED ER A L RESERVE SYSTEM

monetary actions may affect their success. Consequently,
the Federal Reserve has come to pursue whenever feasible
what is known as an “even keel” monetary policy im­
mediately before, during, and immediately after Treasury
financing operations.
Maintenance of an “even keel” in monetary manage­
ment during Treasury financing periods helps to keep
abrupt changes in bank credit conditions from interfering
with Treasury financings. It has the disadvantage of shift­
ing to periods before or following such financings whatever
monetary action may be appropriate in the prevailing
economic situation, in light of the public interest viewpoint
of longer run stability. Ordinarily, monetary management
is flexible enough that these shifts in the timing of action
can be accomplished without destabilizing effects upon
the economy. There are occasions, however, when an
endeavor to keep bank credit conditions on “even keel”
for the benefit o f markets for debt obligations may conflict
with the need for adaptation in the economy’s monetary
position.
Operations in short-term securities. The general practice
of limiting System open market transactions to short-term
securities, preferably Treasury bills but also other short­
term securities, was the third important ground rule
adhered to. These securities are closer to cash than any
other money market instrument and they are traded in
most actively and continuously. Operations of the Federal
Reserve System in this sector of the market affect bank
reserve positions with a minimum of direct effect on the
supply of and the demand for the specific securities pur­
chased or sold, and so with a minimum direct effect on
their prices and yields.
38




IN STRU M EN TS O F R EG U LA T IO N

Effects of operations on security prices and yields derive
primarily from whatever change in bank reserve positions
is brought about. The changed availability of reserve funds
will affect both the lending and investing of banks, and
other participants in the credit market will be obliged to
adapt themselves to the altered market situation that has
developed.
Seasonal and erratic movements in the economy affect
bank reserves first in one direction and then in the other.
To offset these influences, the System continuously buys
and sells securities in the market. Even though the Sys­
tem’s portfolio may show little net change over time, the
daily or weekly volume of System transactions—that is, its
total purchases and sales—is often very large.
Such a large volume of open market operations can be
conducted with least direct impact on basic market proc­
esses in that part of the Government securities market
in which trading is most active and continuous. For several
reasons this is the short-term area.
Foremost is the fact that commercial banks as
well as other financial institutions, such as savings banks,
insurance companies, and savings and loan associations,
invest the bulk of their operating or secondary reserves
in short-term Government securities. Also, many commer­
cial and industrial corporations invest in such securities
excess cash or funds being accumulated for large payments,
such as taxes and dividends. Thus, the short-term end of
the Government securities market provides an interestearning lodgement for liquid funds until they are needed
for operating purposes. The daily sales and purchases by
thousands of financial institutions and businesses make for
a steady stream of trading in these securities.




39

THE FEDERAL RESERVE SYSTEM

Experience shows that changes in commercial bank
reserve positions brought about by System transactions in
short-term securities affect the entire Government securi­
ties market. Many institutional investors, especially com­
mercial banks and savings institutions, hold securities of
longer term along with some of shorter term. The maturity
distributions of their portfolios are adapted to their
special needs. The managers of these portfolios are neces­
sarily alert and sensitive to changes in demand and supply
in the market and are continuously adjusting their port­
folios as they assess and reassess prospects for the market.
Thus they adapt their portfolios to changing market condiU. S. GOVERNMENT MARKETABLE DEBT
H E LD B Y T H E P U B L IC / M ID - 1 9 6 0

BY TY P E O F H O LD ER:
COMMERCIAL BANKS
OTHER F IN A N C I A L
INSTIT U TIO N S
N ONFINA NCIAL
CORPORA TIONS
O TH ER S

B Y M A T U R IT Y :
W I T H I N 15 M O N T H S

15 M O N T H S - 5 Y E A R S
5 - 10 Y E A R S
•

O V E R 10 Y E A R S

0

20

40

60

B illio n s of d o lla rs

N o t e . — Based on data from Treasury Survey o f Ownership, and also
on Federal Reserve estimates.

40




IN STRU M ENTS O F R E G U LA T IO N

tions, and in this process transmit the effects o f Federal
Reserve operations throughout the range of maturities of
debt obligations outstanding in the market.
In the course o f 1960 the Federal Open Market Com­
mittee adapted its procedures to take account o f a worsen­
ing in the U.S. balance o f payments that occurred at a
time when the domestic economy was in recession. During
the last half of the year and in early 1961 an outflow o f
short-term credit and capital from the United States, partly
as a result o f higher short-term interest rates abroad, led to
large purchases o f gold from this country. In an endeavor
to check this movement, while at the same time continuing
to encourage domestic monetary expansion as an aid to
economic recovery, the Federal Reserve in February 1961
extended the area o f its open market operations to longer
term securities.
D is c o u n t O p e r a t io n s

An important advantage of Federal Reserve membership
to a commercial bank is the ability to obtain additional
reserves on occasion by borrowing from a Federal Reserve
Bank. As a matter of fact, provision of facilities for such
borrowing was a main objective of reserve banking as
established in this country.
Mechanics o f Discounting
Member banks may borrow from a Reserve Bank in
two ways. First, they may rediscount short-term commer­
cial, industrial, agricultural, or other business paper, with
recourse on the borrowing bank. Second, they may give
their own promissory notes secured by paper eligible for
discounting, by Government securities, or by other satis­




41

T H E FED ER A L RESERVE SYSTEM

factory collateral. Borrowings by the first method are
called discounts; by the latter, advances.
The custom has developed of referring to both types of
Reserve Bank lending as discounting, and the interest
charge applicable to such lending is known as the discount
rate.
Actually, the main form of member bank borrowing
has become advances against notes having Government
securities as collateral. Borrowing in this form is more
convenient and time-saving for the borrowing bank, since
the collateral is free of credit risk, is instantly appraisable
as to value, and can be more readily supplied in large
amounts conforming to the borrowing needs of individual
banks. Many member banks leave Government securities
at a Federal Reserve Bank for safekeeping; this arrange­
ment makes it easy to pledge such securities as collateral
when an advance is desired.
When a member bank borrows at a Reserve Bank, the
proceeds of the loan are added or credited to its reserve
balance on deposit at the Reserve Bank. Conversely, when
a member bank repays its indebtedness, the amount of
repayment is deducted from or charged against its reserve
balance. Federal Reserve advances to or discounts for
member banks are usually of short maturity — up to 15
days.
From the viewpoint o f the individual member bank, a
decision to discount is usually prompted by the need to
avoid a deficiency in its legal reserve. Such a deficiency is
likely to result from a loss of deposits and therefore of
reserves to another bank. In adjusting to such a reserve
drain, an individual bank has the alternatives of restricting
its lending, of selling securities in the market, o f borrowing
42




IN STRU M ENTS O F R EG U LA T IO N

from another member bank, or of borrowing from a
Reserve Bank. Since the member bank will seek to pre­
serve continuity of loan services to customers, it will be
likely to choose one of the last three methods. Of these,
the bank will choose borrowing from a Federal Reserve
Bank to obtain temporary reserve funds when this
method is cheaper or when for other reasons it seems
advantageous.
Described in this way, the discount facilities o f the
Reserve Banks appear mainly as a convenience to member
banks, enabling them to adjust their reserve positions to
unexpected shifts in deposits by temporary borrowing
rather than by an alternative type of adjustment. From the
standpoint o f the amount of reserve funds available to the
banking system, however, borrowing from Reserve Banks
is clearly more than a convenience.
Apart from offsetting influences, any increase in Reserve
Bank discounts for member banks will tend to add to the
total reserves o f member banks, and any reduction in the
volume of such discounts will tend to reduce them. In
contrast, when banks experiencing reserve drains make their
adjustments by selling assets in the market or by interbank
borrowing, there may be no effect on total bank reserves.
The reserve funds acquired by the banks that are adjusting
their reserves may then come from the excess reserve funds
of other banks.
Discount Administration
Federal Reserve Banks do not discount eligible paper or
make advances to member banks automatically; the dis­
count facilities are made available to member banks as a
privilege of membership in the System and not as a right.




43

T H E FE D E R A L RESERVE SYSTEM

Under Regulation A o f the Board o f Governors, applicable
to the discount process, each Federal Reserve Bank in
accommodating member bank applications for discount
credit adheres to the following guiding principles:
Federal reserve credit is generally extended on a short-term
basis to a member bank in order to enable it to adjust its asset
position when necessary because of developments such as a
sudden withdrawal of deposits or seasonal requirements for
credit beyond those which can reasonably be met by use of the
bank’s own resources. Federal Reserve credit is also available
for longer periods when necessary in order to assist member
banks in meeting unusual situations, such as may result from
national, regional, or local difficulties or from exceptional cir­
cumstances involving only particular member banks. Under
ordinary conditions, the continuous use of Federal Reserve
credit by a member bank over a considerable period of time is
not regarded as appropriate.
In considering a request for credit accommodation, each
Federal Reserve Bank gives due regard to the purpose of the
credit and to its probable effects upon the maintenance of sound
credit conditions, both as to the individual institution and the
economy generally. It keeps informed of and takes into account
the general character and amount of the loans and investments
of the member banks. It considers whether the bank is borrow­
ing principally for the purpose of obtaining a tax advantage or
profiting from rate differentials and whether the bank is extend­
ing an undue amount of credit for the speculative carrying of or
trading in securities, real estate, or commodities, or otherwise.

Member Bank Reluctance to Borrow
The Federal Reserve policy o f emphasizing to member
banks that the use o f its discount facilities should be tem­
porary is reinforced in practice by a well established tradi­
tion among this country’s banks against operating on the
basis o f borrowed reserves — at least, for any extended
44




IN STRU M EN TS O F R EG U LA T IO N

period. This tradition does not mean that member banks
feel reluctant to rely on Federal Reserve lending facilities
to meet temporary or unusual cash drains. But it does
mean that under normal conditions member banks manage
their affairs so that they do not need to resort to Reserve
Bank borrowing except for necessary contingencies and so
that, once in debt, they seek to repay such debt promptly.
Continuing pressures on their reserve positions and other
special developments may, at times, weaken this reluctance,
but it nonetheless persists as a factor affecting member
bank borrowing.
Member bank attitudes toward operating with borrowed
funds vary from bank to bank. Many banks never borrow
from a Reserve Bank, preferring to make reserve adjust­
ments in other ways, including, when necessary, restriction
of their lending to customers. Reluctance to borrow, as
well as incentive to repay promptly, results from the dis­
position of depositors, especially larger business and finan­
cial depositors, to be critical of bank borrowing since, in
case of insolvency, it takes precedence over the claims of
depositors. Another consideration is that for an individual
bank borrowed funds are generally more expensive than
funds obtained through deposit inflows.
Because o f the tradition against borrowing, banks
indebted to a Reserve Bank tend to retire this indebtedness
from the funds that become available to them before
adding to their loans and investments. The act of repay­
ment by one bank is likely to reflect net transfers o f reserve
funds to that bank from other banks, which may then bor­
row to replenish their reserve balances and so in turn need
to repay their borrowing. Thus, when member bank in­
debtedness is relatively large, it is usually owed by a shift­




45

T H E FE D E R A L RESERVE SYSTEM

ing group of banks. In this way its effects in restricting
member bank lending tend to spread through the whole
banking system. Experience generally shows that tightness
in the availability of credit to bank customers is related to
a large volume of member bank discounts outstanding, and
easy credit conditions to a small volume of borrowing
from Reserve Banks.
The Discount Rate
The discount rate is the cost to member banks o f reserve
funds obtained by borrowing from Reserve Banks. Each
Reserve Bank must establish its own discount rate, subject
to review and determination by the Board of Governors in
Washington, every 14 days. These rates are publicly
announced.
The financial community thinks o f Reserve Bank dis­
count rates as pivotal rates in the credit market. The key
role assigned to them derives largely from the fact that
they have been established by the administrative action o f
a public body having special information and competence
to judge whether expansion of bank credit and money
is consistent with the economy’s over-all cash needs for
transactions and liquidity. In the light of this fact, it is only
natural that the business and financial community should
commonly interpret a change in the level o f Reserve Bank
discount rates as an important indication of the trend in
Federal Reserve policy.
There are no simple rules for interpreting changes in
discount rates, however. In some circumstances a change
in discount rates may express a shift in direction of Federal
Reserve policy toward restraint or ease. In other instances
it may reflect a further step in the same direction. In still
46




INSTRUMENTS OF REGULATION

other cases, when market rates o f interest have moved
away from close relationship with the existing discount
rate, a change in the level of rates may represent merely
a technical adjustment of discount rates to market rates
so that the System’s discount mechanism will function
effectively in line with current policy.
Tendency Toward Uniform Discount Rates
The founders of the Federal Reserve System contem­
plated that Reserve Bank discount rates would be set in
accordance with regional financial conditions. They ex­
pected that variations in regional conditions would lead to
variations in discount rates among the Reserve Banks.
In recent decades, however, rates have tended to be uni­
form, although there have been temporary periods in which
different rates have obtained. Basically, this tendency
toward uniformity reflects improvements in the facilities
and speed o f communication and transport as well as
further geographical integration of industrial, commercial,
and financial enterprise.
Credit is a fluid resource that tends to flow to the market
o f highest yield. Growth in the number and assets o f re­
gional and national enterprises that are capable of meeting
their financing needs readily in the cheapest market has
increased the mobility of demand for funds. Furthermore,
the highly sensitive central money markets, that is, the
markets for Treasury bills and other short-term instru­
ments, have provided a mechanism through which the
forces o f fluid supply and mobile demand are promptly
registered. Thus, the regional credit and money markets
have really become only segments of a closely knit national
market, and this fact has found expression in a tendency




47

THE FEDERAL RESERVE SYSTEM

toward uniformity of discount rates among the Reserve
Banks. Increasingly, Federal Reserve discount rate policy
is referred to and considered in terms o f “the discount
rate” rather than in terms of twelve Reserve Bank rates.
Relation o f the Discount Rate to Market Rates
The position o f the discount rate in relation to market
interest rates will affect a member bank’s decision as to
the most desirable way for it to make an immediate ad­
justment in its reserve position. The cost of adjusting a
reserve position by borrowing is, of course, the interest
charge incurred. When a bank sells securities to acquire
funds, it measures the cost by the interest earnings sacri­
ficed. Thus, a bank’s preference as among Federal Reserve
discounting, other borrowing, or selling securities is in­
fluenced to a large extent by the relation o f the discount
rate to market yields on the types of securities it holds as
liquid assets or as a second line of reserves. Among these
are Treasury bills, other short-term Government obliga­
tions, and prime short-term private paper, such as bankers’
acceptances and commercial paper.
As the chart shows, the movement o f the Federal Re­
serve Bank discount rate is closely related to the move­
ment of short-term market interest rates. In a period when
credit demands are expanding strongly, short-term market
rates will tend to rise in response to demand for funds.
They will rise also as a result of sales of Treasury bills and
other paper o f ready marketability by banks experiencing
rapid expansion of their loans and investments and there­
fore needing to make reserve adjustments.
If short-term market rates rise above the discount rate,
member banks would have a greater tendency to borrow
48




INSTRUMENTS OF REGULATION

at Reserve Banks than to adjust their reserve positions by
shifting the ownership of their liquid paper through the
market. Under these circumstances, the Reserve Banks
would be likely to raise the discount rate in order to keep
the discount mechanism functioning as a deterrent to
unduly rapid bank credit expansion. Failure to raise the
discount rate, in other words, would encourage and enlarge
member bank use of the discount window.
DISCOUNT AND BILL RATES
Pe r c e nt

On the other hand, if the discount rate is raised above
market rates, member banks would be likely to prefer, as
a means of reserve adjustment, the lower cost involved
in sales of Government securities. But such sales, by
increasing the market supply of short-term securities rela­
tive to the demand, would tend to drive short-term interest




49

THE FEDERAL RESERVE SYSTEM

rates up toward or moderately above the discount rate.
Thus, in a period of strong credit demands, short-term
market rates and the discount rate are likely to rise in
fairly close sequence until the demand pressures have
spent their force.
Federal Funds Rate
In a banking system with as many independent units
and with as widely varying banking conditions as prevail
in this country, individual banks will at times be deficient
in reserves while other banks have excess reserves. Since
total reserve funds are limited in supply, a practice has
developed whereby banks with reserve balances in excess
o f needs offer to lend them on a day-to-day basis to banks
deficient in reserves. Thus, in addition to borrowing at Fed­
eral Reserve Banks or selling securities in the market, com­
mercial banks can adjust their reserve positions by borrow­
ing from other banks in a fairly well organized market
known as the Federal funds market. The interest rate
on Federal funds is generally below the discount rate;
the discount rate, in fact, acts as a kind of ceiling for the
Federal funds rate since, at a cost above the discount rate,
member banks would naturally prefer discounting.
Conditions o f supply and demand in the Federal funds
market, and also the proximity of the Federal funds rate
to the discount rate, necessarily vary directly with general
credit conditions and influence member bank borrowing
from the Reserve Banks. When general credit conditions
are easy, Federal funds are usually available in greater
volume than when conditions are tight, and the margin of
the Federal funds rate below the discount rate widens. In
these circumstances, use of the discount facility by mem­

50




INSTRUMENTS OF REGULATION

ber banks is reduced, partly because fewer banks are then
experiencing reserve deficiencies and partly because of the
greater availability and lowered cost of Federal funds as
a source of temporary reserves.
C h a n g e s i n R e se r v e R e q u ir e m e n t s

Federal Reserve authority to vary the required reserve
percentages for commercial banks is a relatively new tool
o f reserve banking. It was first made available on a tem­
porary basis in the emergency banking legislation o f 1933
and was made a permanent instrument of reserve banking
by the Banking Act of 1935. Under present amended law,
the Board o f Governors may set within specified limits the
required reserve percentages for each of the three classes
of banks — central reserve city banks, reserve city banks,
and other banks, which are usually referred to as country
banks. Changes in requirements may be applied to one or
more classes o f banks at the same time, but they must be
kept within the limits set for each class and must be uni­
form for all banks within a class.
The range of Federal Reserve discretion over reserve
percentages and the percentage requirements in effect in
December 1960 are shown in the table, together with data
on the distribution o f member banks by reserve classes.
According to legislation enacted in 1959, the central
reserve city classification is to be abolished in 1962, and
thereafter member banks will be divided into only two
classes, reserve city banks and other banks.
Operation o f the Instrument
Action to change the level of reserve requirements does
not itself affect the amount of total member bank reserve




51

THE FEDERAL RESERVE SYSTEM
M ember Bank R eserve R equirements, D ecember 1, 1960
Class of bank
Item

Central
reserve
city

Reserve
city

Other

Net demand deposits
Reserve requirements (per cent of
deposits):
Statutory range..............................
In effect..........................................
Deposits (percentage distribution)1..

10 to 22
161/2
25

10 to 22

16%
38

7 to 14
12
37

Time deposits
Reserve requirements (per cent of
deposits):
Statutory range..............................
In effect..........................................
Deposits (percentage distribution)1..

3 to 6
5
11

3 to 6
5
39

Number of member banks................

26

217

3 to 6
5
50
5,957

1As of Sept. 30, 1960.

balances, but it does affect the amount of deposits and of
loans and investments that member banks can legally
maintain on the basis of a given amount o f reserves. As
explained in Chapter II, a given amount o f member
bank reserves can support more or less bank credit and
money depending on the level of required reserve per­
centages.
Two things happen when required reserve percentages
are changed. First, there is an immediate change in the
liquid asset or secondary reserve position of member banks.

52




IN STRU M ENTS O F R EG U LA T IO N

If reserve percentages are raised, banks that do not have
enough excess reserves to cover the increase in require­
ments must find additional reserve funds by selling liquid
assets in the market or by borrowing from other banks or
from the Reserve Banks; the banking system as a whole,
however, can find the additional reserve funds required
only if they are provided by Federal Reserve open market
operations or by member bank borrowing at Reserve
Banks.
If reserve percentages are lowered, individual banks
find themselves with a margin o f excess reserves available
for investment in earning assets and for debt repayment.
Since banks sustain their earnings at the highest levels con­
sistent with solvency by keeping their own resources as
fully invested as possible and by avoiding debt, their usual
response to a lowering of reserve requirements, after retir­
ing any indebtedness, is to acquire earning assets. Initially,
they are likely to purchase short-term market paper of
high liquidity as assets for temporary holding.
A second effect of a change in the required reserve per­
centages is an immediate change in the deposit-expansionmultiplier for the entire banking system. If the required
reserve percentage is 20 per cent, $1 of reserves will sup­
port $5 of deposits. If the percentage requirement is
reduced to 15 per cent, $1 of reserves will support $6.67
o f deposits. The 15 per cent requirement, thus, will sup­
port one-third more deposits than the 20 per cent require­
ment. In practice, how much effect a change in required
reserve percentages will have on the deposit-expansionmultiplier will depend in part on the distribution o f de­
posits by type (demand, time, and savings) and on the
distribution of these deposits by class of bank.




53

T H E FE D E R A L RESERVE SYSTEM

Role o f Reserve Requirement Changes
As an instrument of monetary management, changes in
required reserve percentages are less flexible and continu­
ously adaptable than the open market and discount
instruments. For one thing, changes in reserve require­
ments affect at the same time and to the same extent all
member banks subject to the action, regardless o f their
individual reserve needs on the occasion. For another, a
change of even one-half of one percentage point in reserve
requirements would result in relatively large changes in
the total available reserves and in the liquidity positions
of member banks as a group. If, to avoid a large reserve
effect, a change is limited to a particular class o f bank, a
perplexing problem of equity as between classes o f banks
is presented.
Moreover, a change to a new level of reserve require­
ments cannot be made gradually over a period o f time, but
must become effective on a selected preannounced date.
The credit market is forewarned that on this date either
demand or supply pressures will be accentuated, with the
risk of disturbance and instability in the prices o f and yields
on securities at the time.
For the individual member bank the required reserve
percentage is the basis for current and forward decisions
by management concerning composition and maturity of
loans and investments. Accordingly, frequent or abrupt
changes in the required percentage may unduly complicate
the task of bank management. This is especially true for a
large number o f “country banks” that are inadequately
equipped to make adjustments to frequent, even though
small, changes in the reserve requirement percentages.
In the System’s experience, changes in reserve require­

54




IN STRU M ENTS O F R EG U LA TIO N

ments have been applied most advantageously in meeting
bank reserve situations that had more than temporary
significance. In the 1930’s reserve requirements were in­
creased in order to absorb an unnecessarily large volume
o f excess bank reserves. In early postwar years increases
were applied in an attempt to absorb reserves supplied by
Federal Reserve support o f Government security prices,
but their market effect was in fact such as to necessitate
additional purchases to maintain the support.
Since reestablishment of flexible monetary operations
in the early 1950’s, reserve requirement percentages have
been reduced in recession periods in order to supply
bank reserves simultaneously to all parts of the economy.
These counter-recession decreases in requirements were
facilitated by the fact that existing levels of reserve require­
ments were high in relation to past periods and also in
relation to the standards for nonmember banks adhered
to by many States.
In accordance with legislation enacted in 1959, there
were reserve requirement changes in 1960 having mainly a
structural objective. These adjustments, which at the time
released reserves on balance, were for the purpose o f uni­
fying reserve requirements for central reserve and reserve
city banks and of offsetting in part the effects on reserves
o f making vault cash eligible for meeting reserve require­
ments. Prior to this legislation, member banks could not
count vault cash in meeting their reserve requirements.
R e g u l a t io n o f S t o c k M a r k e t C r e d it

Since 1933 the Federal Reserve has been directed by law
to restrain the undue use of bank credit for speculation
in securities, real estate, or commodities. Since 1934 the




55

T H E FED ER A L RESERVE SYSTEM

System has been specifically authorized to curb the exces­
sive use of credit for purchasing or carrying securities by
setting limitations on the amount that brokers and dealers
in securities, banks, and others may lend on securities for
that purpose. At brokers and dealers the regulatory limita­
tion applies to any type of corporate security; at banks it
applies only to corporate stocks registered on national
securities exchanges. The regulatory limitation does not
apply to any loan for other purposes, even though stocks
may be pledged as collateral for the loan.
The mechanism of stock market credit regulation is
readily illustrated. The amount that lenders will advance
against securities will always be less than the current
market value of the securities to be pledged as collateral.
The lender calls the difference between the two the cus­
tomer’s margin. For example, if a loan of $6,000 is secured
by stock having a market worth of $10,000, the customer’s
margin is $4,000 or 40 per cent and the loan value o f the
stock is 60 per cent o f its market value. Thus, by prescrib­
ing the loan value of the securities, the customer’s margin
may be controlled; the less the amount that can be lent,
the greater the margin required. In recent years the margin
required by Federal Reserve regulation has varied from
90 per cent to 50 per cent.
Federal Reserve regulation requires the lender to obtain
the specified margin in connection with the purchase of
the security. If the collateral that is security for the indebt­
edness subsequently declines in market value, regulation
does not make it necessary for the borrower either to put
up additional collateral or to reduce the indebtedness.
However, the banker or broker making the loan may
require additional collateral if he deems it necessary. If

56




IN STRU M ENTS O F R EG U LA T IO N

the margin requirement is increased by the Federal Re­
serve, borrowers need not reduce existing loans (or in­
crease the amount of collateral deposited with the broker
or the bank), but borrowers who have under-margined
accounts have to apply half of the proceeds from any sales
of the securities they have pledged as collateral to reduction
o f their indebtedness.
Regulation of stock market credit by the margin require­
ment, though applied through the facilities of the lender,
puts restraint on the borrower and thus dampens demand
for credit. An important aspect of this restraint is that it
limits the amount of pyramiding of borrowing that can
take place in a rising market as higher prices create high­
er collateral values and permit more borrowing on the
same collateral.
The purposes of regulation through margin requirements
are to minimize the danger of excessive use of credit in
financing stock market speculation and to prevent the
recurrence of speculative stock market booms based on
credit financing, such as culminated in the price collapse
of 1929 and the subsequent severe credit liquidation. A
stock market boom followed by collapse is always possible,
but without excessive feeding by credit-financed specula­
tion it is not likely to assume the proportions or to have
the effects that it had in earlier periods.
How

M o n e t a r y I n s t r u m e n t s A r e C o o r d in a t e d

The bulk o f Federal Reserve operations to affect bank
reserve positions are for the purpose of adjusting the avail­
ability of reserve funds to short-run variations in the needs
that banks have for them. As already discussed, the System,




57

T H E FED ER A L RESERVE SYSTEM

on its own initiative, brings about such changes in bank
reserves largely by open market operations. Also, through
the discount mechanism, individual member banks, espe­
cially in communities subject to unusually wide seasonal
fluctuations in business payments, may cushion or spread
out somewhat the reserve adjustments they find it necessary
to make. In coping with short-term instabilities in bank
reserve positions, open market operations and discount
operations are complementary tools of monetary policy.
When dealing with the bank credit and monetary aspects
of cyclical instability in economic activity, Federal Re­
serve policy is also effectuated largely through interaction
of these two instruments. How balance is attained in use
of the two instruments is a complex process. An important
characteristic of the process is that member bank demands
for borrowing from Reserve Banks in general tend to vary
inversely with the volume of reserves being supplied
through open market operations.
When the Federal Reserve curtails provision of reserve
funds by open market sales o f securities in a period o f high
and rising economic activity, for example, banks can ac­
commodate expanding demands for credit only by in­
creased use of the discount window. Typically, some banks
respond to the rising demand pressures from customers in
this way. But such borrowing must be repaid after a short
period, and these banks must curtail their lending or sell
investments to effect such repayment. Obtaining funds to
repay discount debt draws reserve funds from other banks,
some of whom will meet their reserve deficiencies by bor­
rowing and then curtail their loans and investments to repay
their discount debts. An increasing number o f member
banks thus get involved in temporary borrowing from the

58




INSTRUMENTS OF REGULATION

Reserve Banks and in banking adjustments to repay such
borrowing.
To limit incentives for member bank discounting in
periods of economic upswing, the discount rate may need
to be raised in accordance with changes in the general
credit situation and with the increases that are likely to be

19 5 4

1956

1958

1960

occurring in market interest rates. The active use of the
open market and discount instruments jointly to slow down
the flow of bank credit and money will not be extended
indefinitely, but only long enough to contain unduly ex­
pansive tendencies in these flows. Experience since re­
establishment of flexible monetary operations in 1951 sug­
gests that when the indebtedness of member banks as a
group has reached about 5 per cent of their total required
reserves, the pace of bank credit and monetary expansion
has tended to slacken.




59

T H E FED ER A L RESERVE SYSTEM

Interaction of the open market and discount instruments
is also involved when countercyclical monetary policy is
directed toward accelerating the expansion of bank credit
and money. Reserve funds made available by increased
open market operations of the Federal Reserve tend first
to lead to the reduction of outstanding discounts of the
member banks. As conditions in credit markets show in­
creasing ease, reflected in part by declining interest rates—
particularly short-term—the discount rate may be lowered
in successive steps. In these circumstances strengthening
of bank reserve positions tends to result in observable
pickup in the pace of bank credit and monetary expansion.
In connection with the problem o f moderating cyclical
swings in the flow of bank credit and money, it should be
noted that, in a growing economy, developments seldom
call for a full halt in or an all-out stimulation o f bank
credit expansion. Adaptations in the joint use o f the mone­
tary instruments, therefore, are generally gradual, that is,
made in greater or lesser degree according to the needs
shown by the flow o f current economic information. Al­
though in this process day-by-day changes in the availa­
bility of reserve funds may vary considerably, monetary
policy typically is geared to restraint or stimulus over a
period of many months.
Provision o f bank reserves for meeting the economy’s
need for long-term growth in the supply of money is
accomplished in part by open market operations and in
part by changes in reserve requirements. Reserve require­
ment levels may also be changed in special situations where
large changes in the volume o f bank reserves, such as may
result from large and persistent international movements
o f gold, need to be offset or cushioned.
60




IN STRU M ENTS O F R EG U LA T IO N

Regulation o f stock market credit supplements the
instruments affecting the bank reserve base. It deals
directly and selectively with the possibility o f unstable
and undue absorption of bank and other credit in stock
market speculation. Since fluctuations in stock market
activity correlate generally with those in over-all economic
activity, changes in margin requirements tend to be
similarly correlated. The availability of the margin require­
ment instrument means that the more general bank reserve
instruments do not have to be specially directed to the
avoidance o f excessive stock speculation financed on
credit. Such use of the general instruments, to be effective,
would necessarily run the risk of undesirable, broader
effects.




61




CHAPTER IV

STRUCTURE OF THE FEDERAL RESERVE SYSTEM.
All national banks and many State banks are members o f the
Federal Reserve System. There are twelve Federal Reserve Banks,
each serving 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.
This has emphasized the responsibility o f the System
as a whole for regulating the flow o f bank credit and money.
It has also underscored the role o f all o f its parts in per­
forming their allotted functions in accordance with policies
directed toward a common objective. In this respect the
System is, so to speak, a trusteeship created by the Con­
gress to safeguard the integrity o f the nation’s money.
Consideration o f the System’s organizational structure
is now in order. Attention will be given first to the national
and State banks that are members o f the Federal Reserve
System and to the obligations and privileges o f member­

S




63

TH E FE D E R A L RESERVE SYSTEM

ship. Then the responsibilities o f the several parts o f the
System for the formation and execution o f reserve banking
or monetary policy will be described.
Membership
At mid-1960 the Federal Reserve System had 6,217
member banks. Of these, 4,542 were national banks and
1,675 were State-chartered banks. In all 50 States and the
District of Columbia, banks with national charters are
required to belong to the System. Banks with State charters
may 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-1960, this group held nearly threefourths of the country’s total bank deposits. The different
kinds o f banks in this country at that time and the amounts
o f their demand and time deposits are shown in the table
on the opposite page.
Member banks hold about 85 per cent o f the demand
deposits of all banks, which along with currency, serve as
means o f payment. Consequently, Federal Reserve policies
have a direct influence on institutions holding nearly ninetenths of the bank deposits that constitute the major com­
ponent of the country’s active money supply.
Obligations and Privileges o f Member Banks
By becoming members o f the Federal Reserve System,
banks become eligible to use all o f the System’s facilities.
In return, these banks undertake to abide by certain rules,
prescribed by law or developed by regulation in accordance
with the law, for the protection o f the public interest.
64




STRUCTURE OF THE SYSTEM
A ll Banks in the U nited States, June 30, 1 9 6 0 1

Kind of bank

Number

Deposits 2
(in millions of dollars)
Demand

Time

Member bank...................................
Nonmember bank.............................

6,217
7,789

111,311
20,018

53,536
48,931

Total..........................................

14,006

131,329

102,467

Classes of member banks:
National1......................................
State..............................................

4,542
1,675

70,864
40,447

36,905
16,631

Classes of nonmember banks:
Commercial...................................
Mutual savings 3............................

7,276
513

19,987
31

13,648
35,283

1 Includes one national (member) bank in the Virgin Islands.
2 Excludes interbank deposits.
3 Excludes two mutual savings banks that are State member banks.

National banks are chartered by the Comptroller o f 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 require­
ments of the Federal Reserve Act. Since these banks join
the System voluntarily, they have the privilege of withdraw­
ing from membership on six months’ notice.
Every member bank is required to subscribe to the
capital o f its Reserve Bank. Its paid-in subscription is an
amount equal to 3 per cent of its capital and surplus, and
another 3 per cent is subject to call. At the end of June
1960, all member banks together owned about $400 million
o f paid-in capital stock of the twelve Federal Reserve
Banks.




65

T H E FED ER A L RESERVE SYSTEM

Banks that become members o f the Federal Reserve
System must assume several important obligations. They
must maintain legal reserves on deposit without interest
at the Reserve Bank (except for reserves held as vault cash
by the member bank); remit at par for checks drawn against
them when presented by a Reserve Bank for payment; and
comply with various Federal laws, regulations, and condi­
tions o f membership regarding the adequacy o f capital,
mergers with other banking institutions, establishment o f
branches, relations with holding company affiliates and
bank holding companies, interlocking directorates, loan
and investment limitations, and other matters. If the mem­
ber bank is chartered by a State, it must be subject to gen­
eral 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 criteria for discount­
ing set by statute and regulation, when temporarily in need
o f 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 o f the nine directors of the Federal Reserve Bank
for their district; and (6 ) to receive a cumulative statutory
dividend o f 6 per cent on the paid-in capital stock o f the
Federal Reserve Bank.
Federal Reserve Banks
For purposes o f administering the Federal Reserve
System the country is divided into the twelve districts.
These are shown in the map on the opposite page.
66







TH E FE D E R A L RESERVE SYSTEM

The boundaries of the Federal Reserve districts do
not always follow State lines and in many instances parts
o f a State are in different districts. There is a Federal
Reserve Bank in each district and most o f the Reserve
Banks have branches. A list o f the districts and branches
is given below:
Federal Reserve Bank of Boston

District Number 1

Federal Reserve Bank o f 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 of Chicago
Branch at Detroit, Michigan

District Number 7

Federal Reserve Bank of 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

68




STRU C TU R E O F T H E SYSTEM

Federal Reserve Bank of Kansas City
Branches: Denver, Colorado
Oklahoma City, Oklahoma
Omaha, Nebraska

District Number 10

Federal Reserve Bank of Dallas
Branches: El Paso, Texas
Houston, Texas
San Antonio, Texas

District Number 11

Federal Reserve Bank of San Francisco 1
Branches: Los Angeles, California
Portland, Oregon
Salt Lake City, Utah
Seattle, Washington 1

District Number 12

Each of the twelve Federal Reserve Banks is a corporation organized and operated for public service. The Federal
Reserve Banks differ essentially from privately managed
banks in that profits are not the object o f their operations
and in that their shareholders, the member banks o f the
Federal Reserve System, do not have the proprietorship
rights, powers, and privileges that customarily belong to
stockholders o f privately managed corporations.
Each Federal Reserve Bank has nine directors. Three o f
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 o f
each class being elected by small banks, one o f each class
by banks o f medium size, and one o f each class by large
banks.
1 Alaska and Hawaii were added to District Number 12 as of January
3 and August 21, 1959, respectively. Alaska became part of the Seattle
Branch territory and Hawaii part of the Head Office territory of the
District.




69

T H E FE D E R A L RESERVE SYSTEM

The three Class A directors may be bankers. The three
Class B directors must be actively engaged in the district
in commerce, agriculture, or some other industrial pursuit,
and must not be officers, directors, or employees o f 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
o f any bank. One o f them is designated by the Board of
Governors as Chairman o f the Reserve Bank’s board of
directors and one as Deputy Chairman. The Chairman, by
statute, also serves as Federal Reserve Agent.2
Under this arrangement, businessmen and others who
are not bankers constitute a majority o f the directors of
each Federal Reserve Bank. The directors are responsible
for the conduct o f the affairs of the Reserve Bank in the
public interest, subject to the supervision o f the Board o f
Governors. They appoint the Reserve Bank officers, but
the law requires that their choice o f President and First
Vice President, whose terms are for five years, be approved
by the Board o f Governors. The salaries o f all officers and
employees are also subject to the approval o f the Board of
Governors. Each branch of a Federal Reserve Bank also
has its own board o f directors. A majority are selected by
the Reserve Bank; the remainder, by the Board o f Gov­
ernors. The provisions o f law circumscribing the selection
o f Reserve Bank directors and the management o f the
Reserve Banks indicate the public nature o f these Banks.
Decentralization is an important characteristic o f the
Federal Reserve System. Each Reserve Bank and each
2 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, which are noted in Chapter IX.

70




STRU CTU RE O F T H E SYSTEM

branch office is a regional and local institution as well as
part o f a nationwide system. Its officers and employees
are residents o f 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
o f its particular region and at the same time helps to
administer nationwide banking and credit policies.
While the Federal Reserve Banks earn an income, their
operations are not carried on for this purpose but are
determined by Federal Reserve credit and monetary poli­
cies, which are discussed in other chapters. Part o f this
income is used to cover expenses, including the expenses
o f the Board o f Governors in Washington; to pay the
6 per cent statutory dividend to members; and to make
any needed additions to surplus.
For many years the System’s net earnings were turned
over in large part to the Government as a franchise tax.
The provision for the franchise tax was repealed 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 o f the Federal Deposit Insurance
Corporation.
By 1947, earnings were large once more, and the Federal
Reserve adopted a procedure by which it turned the bulk o f
its earnings over to the Government and added any re­
mainder to surplus. In the years 1947-58 the Federal
Reserve paid to the Treasury nine-tenths o f its earnings
above expenses and dividends. In 1959, the Board o f Gov­
ernors, after consultation with the Reserve Banks, reached
a conclusion that the maintenance o f each Bank’s surplus
at a level of twice the paid-in capital would be appropriate
under current conditions. Inasmuch as the aggregate sur­




71

THE FEDERAL RESERVE SYSTEM

plus and contingency reserves of the twelve Reserve Banks
exceeded the surplus to be retained under the new formula,
the excess was paid to the Treasury. Since then, all earnings
above expenses and dividends have been paid to the
Treasury, except for retentions to accord with changes in
paid-in capital. In case of liquidation of the Reserve Banks,
DISPOSITION OF RESERVE BANK EARNINGS
1914 - 5 9

the law provides that the surplus would go to the U.S.
Government.
From the point of view of 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 and regulations of the Federal
Reserve System. The Reserve Banks establish their own
72




STRU CTU RE O F T H E SYSTEM

discount rates, subject to review and determination by the
Board o f Governors. In connection with open market
operations the Reserve Banks, in groups prescribed by
law, elect five o f the twelve members o f the Federal Open
Market Committee, whose function will 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,
D.C. It consists of seven members appointed by the Presi­
dent o f the United States and confirmed by the Senate.
Members devote their full time to the business o f 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 o f the Board may come from the same Fed­
eral Reserve district. The Board’s expenses are paid out o f
assessments upon the Reserve Banks, and the Board’s
accounts are audited each year by qualified public account­
ants.
One o f the Board’s duties is to supervise the operations
o f the Federal Reserve System. As already indicated, the
Board appoints three o f the nine directors o f each Federal
Reserve Bank, including the Chairman, who is also the
Federal Reserve Agent, and the Deputy Chairman.
Appointments o f the President and First Vice President
o f each Federal Reserve Bank are subject to the Board’s
approval. The Board also issues regulations that interpret
and apply the provisions o f law relating to Reserve Bank
operations. It directs Reserve Bank activities in bank
examination and supervision, a subject discussed in Chapter
VIII. As a further responsibility, the Board coordinates
the System’s economic research and publications.




73

T H E FE D E R A L RESERVE SYSTEM

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 o f all officers and em­
ployees o f the Reserve Banks and branches are subject to
the Board’s approval. Certain other expenditures such as
those for purchase o f real estate for banking house pur­
poses and for the construction or major alteration o f bank
buildings are subject to the Board’s specific approval.
Reports showing expenses o f the Federal Reserve Banks
are analyzed by the Board’s staff, which also makes surveys
at the Reserve Banks o f operating procedures 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 o f the Bank
and compliance by its management with applicable pro­
visions o f law and regulation. The scope o f examination
includes a comprehensive review o f the Bank’s expendi­
tures to determine if such expenditures are properly con­
trolled and are o f a nature appropriate for a Reserve Bank.
It is also the practice to have representatives o f a public
accounting firm observe the examination o f one Reserve
Bank each year, to provide an outside evaluation o f the
adequacy and effectiveness o f examination procedures.
In addition to the annual examination by the Board’s
examiners, the operations o f each Reserve Bank are
audited by the Bank’s internal auditing staff on a yearround basis under the direction o f a resident General
Auditor. He is responsible to the Bank’s board o f directors
through its chairman and its audit committee. Each year
the Board’s examiners review thoroughly the internal audit
74




STRU C TU R E O F T H E SYSTEM

programs at all o f the Banks to see that the coverage is
adequate and the procedures effective.
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 o f the Reserve Banks.
The Chairman o f the Board is a member o f the National
Advisory Council on International Monetary and Finan­
cial Problems, which coordinates the financial activities
and policies o f Government in the foreign field. The Board
submits an annual report to Congress and publishes a
weekly statement, as required by law, o f the assets and
liabilities of the Federal Reserve Banks.
Of the principal monetary actions o f the Federal
Reserve, the Board has full authority over changes in
reserve requirements. It also “reviews and determines”
discount rates established by the directors o f the Reserve
Banks. The members o f the Board constitute a majority
o f the Federal Open Market Committee, which sets policy
for open market operations. As already described, the
Board has responsibility for the determination o f selective
regulation o f stock market credit. It also 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 o f Governors is largely responsible
for formulating national monetary policy and for super­
vising its execution. A record of the policy actions taken by
the Board o f Governors and by the Federal Open Market
Committee, together with a brief summary o f the circum­
stances surrounding each action, is included in the annual
report o f the Board o f Governors.




75

T H E FED ER A L RESERVE SYSTEM

Federal Open Market Committee
The Federal Open Market Committee comprises the
seven members of the Board of Governors and five repre­
sentatives elected by the Federal Reserve Banks. It is
assisted by a staff o f economists drawn from the staffs of
the Board and the Banks. The Committee has responsi­
bility for deciding on changes to be made in the System’s
portfolio o f 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 opera­
tions in the open market, are required by law to carry out
the decisions o f the Open Market Committee.
The Federal Open Market Committee meets in Wash­
ington at three-week intervals, or oftener if necessary, and
it may in exceptional circumstances hold a meeting using
a national telephone hook-up. At each meeting the Com­
mittee reviews the national business and credit situation
with the help o f its staff.
Presidents o f all twelve Reserve Banks participate in the
Committee’s discussions and thus make available the
knowledge and information o f the directors and officers
o f the twelve Reserve Banks and the twenty-four branches.
Decisions about open market policy and the coordination
o f this instrument with other instruments o f monetary
policy are made in the light o f a full discussion o f national
and regional conditions. In this sense the Federal Open
Market Committee is the principal policy-shaping body
o f the System.
Purchases and sales o f securities for the Federal Open
Market Committee are effected through the facilities of
the Federal Reserve Bank o f New York in the name o f the

76




STRU C TU R E O F T H E SYSTEM

System Open Market Account. Each Federal Reserve
Bank participates in the Account in accordance with the
ratio of its total assets to the total assets for all o f the
Reserve Banks combined. All transactions on behalf o f
the Committee are supervised by the Manager o f the
Account, who is an officer o f the Federal Reserve Bank ot
New York. Transactions in the Committee’s name are
required to be in accordance with instructions issued by it
At the request of the Federal Open Market Committee,
the Board’s examining staff audits the Account annually.
Federal Advisory Council
The Federal Reserve Act provides for a Federal Advis­
ory Council consisting o f one member from each Federal
Reserve district. Each Federal Reserve Bank by its board
of directors annually selects one Council member, usually
a representative banker in its district. The Council meets
in Washington at least four times a year. It confers with
the Board o f Governors on business conditions and makes
advisory recommendations regarding the affairs o f 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. O f these
the most important are the Conference of Presidents and
the Conference o f Chairmen of the Federal Reserve Banks.
The former Conference meets by itself and with the Board
at least three times a year, while the latter usually meets
with the Board once a year.




77

THE FEDERAL RESERVE SYSTEM

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 o f a large, diversified, and complex
economy. A graphic view o f System organization can be
helpful to an understanding o f its structure in relation to
its primary functions. The charts on pages 80-81 show in
broad outline the statutory organization o f 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 instru­
ments of credit policy. The four squares at the bottom o f
the second chart represent these instruments; each 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 o f
decision over two o f the instruments — reserve require­
ments for member banks and margin requirements on
stock market collateral — rests exclusively with the Board
o f Governors. Authority over member bank borrowing
resides with the Federal Reserve Banks, subject to general
supervision o f the Board o f Governors. Authority over
the discount rate is shared between the directorates o f the
Reserve Banks by which the rate must be “established”
and the Board o f Governors by which it must be “re­
viewed and determined.” Policy with respect to open market
operations is decided neither by the Board o f Governors
nor by the directorates o f the Reserve Banks but by the
Federal Open Market Committee.
Other Credit Agencies
Since the Federal Reserve System is not the only official
agency in the banking and monetary field, its operations
78




STRU C TU R E O F T H E SYSTEM

cannot be fully understood without reference to certain
other agencies. The Office o f the Comptroller o f 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 consideration here
the Treasury Department, certain Federal agencies that
make loans or guarantee loans made by banks and other
financing institutions, and certain international credit
organizations.
Treasury Department. The Government department with
which the Federal Reserve System comes into closest
operating contact is the U.S. Treasury. The reason for this
is manifest. Debt management policy, which is the respon­
sibility o f the Treasury, and bank credit and monetary
policy, which is the responsibility o f the Federal Reserve,
present specific problems o f coordination.
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 mone­
tary policy o f the Federal Reserve. It is important from
the standpoint o f the Treasury that there be a well func­
tioning and resilient market for Government securities,
and it is important to the Federal Reserve that the Treas­
ury’s financing operations interfere as little as possible with
Federal Reserve policy regarding the flow o f credit and
money.
The Treasury has other operations that affect the
responsibilities o f the Federal Reserve System. For ex­
ample, the flow o f cash into and out o f Treasury deposits
with the banking system exerts an influence on the credit
situation. If the Treasury builds up its balances with the
Federal Reserve Banks and draws down its accounts in




79

O




TH FE E A R V SYSTEM
E D R L ESER E
ORGANI ZATI ON
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T H E FE D E R A L RESERVE SYSTEM

commercial banks, its operations tend to tighten bank
reserves and the credit market.
Conversely, if the Treasury increases its commercial
bank balances and draws down balances with the Federal
Reserve, these operations tend to make bank reserves more
plentiful and to ease the credit market. In administering
its deposit balances, the Treasury endeavors to avoid un­
desirable effects on the reserves o f the banking system or
on Federal Reserve operations.
These points o f contact between Treasury and Federal
Reserve responsibilities give rise to the frequent interchange
o f intelligence between the two organizations regarding
economic, credit, and fiscal developments. The Federal
Reserve, on its part, endeavors to keep the Treasury
informed as to underlying forces influencing action in the
credit and monetary area and counsels with the Treasury
on the implications for Federal Reserve policy o f alter­
native debt management courses. The Treasury, in turn,
strives to keep the Federal Reserve fully informed about
the Government’s fiscal trends and about plans for meeting
prospective financing problems.
Domestic credit agencies. Several Federal corporations
and agencies have independent responsibilities for making
credit available to private borrowers. Congress has
authorized some agencies to make loans and others to
insure or guarantee loans made by banks and other
private financing institutions. A few o f these agencies can
both lend and guarantee loans.
The lending or insuring functions of some agencies are
related primarily to specific purposes, such as aid to agri­
culture, home owners, and veterans, while those o f other
agencies are intended primarily to make credit available

82




STRU C TU R E O F T H E SYSTEM

on terms not ordinarily offered by private lenders. The
operations o f these Federal agencies affect the flow o f
credit to private borrowers.
The principal Federal lending agencies include a number
under the supervision o f the Farm Credit Administration
that make short- and long-term loans to agriculture; the
Rural Electrification Administration, which makes loans
to extend the use o f electricity and o f telephone service in
rural areas; a group under the Housing and Home Finance
Agency that make loans to finance housing and home
ownership; the Export-Import Bank, which makes loans,
mostly to foreign borrowers, to aid the financing o f U.S.
exports and imports; and the Small Business Administra­
tion, which makes loans to small business concerns, small
business investment companies, and State and local devel­
opment companies.
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 o f World War II and the Korean conflict, and the
Federal Housing Administration, which under certain
conditions can insure home mortgage and home moderni­
zation loans made by banks and other financing institu­
tions.
International credit institutions. The International Mone­
tary Fund and the International Bank for Reconstruction
and Development, which have offices in Washington,
D.C., are not part o f the American banking and monetary
system, but affect the domestic money market whenever
their operations draw upon or add to the supply o f credit
in this country. The United States shares with other nations




83

T H E FE D E R A L RESERVE SYSTEM

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 o f
these representatives and o f all agencies o f the Government
that make foreign loans or engage in foreign financial
transactions, Congress has established the National Advis­
ory Council on International Monetary and Financial
Problems. The members o f this Council are, ex officio,
the Secretary o f the Treasury, who is Chairman, the Secre­
tary of State, the Secretary of Commerce, the Chairman
o f the Board o f Governors of the Federal Reserve System,
and the President and Chairman o f the Export-Import
Bank of Washington.
Concluding Comment
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 14,000, o f which more than 6,000 are System
member banks. Through its twelve Reserve Banks and
their coordination through the Board o f Governors in
Washington, the System is designed to combine private
and public interests in an organization that serves the
public welfare efficiently.
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 19,500
officers and others who work for 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.

84




CHAPTER V

THE CREDIT MARKET. The national credit market is made
up o f many interrelated markets, of which the market fo r com­
mercial bank credit is an important one. Developments in all parts
o f the market interact on and influence other parts. Neither the
banking sector nor the nonbanking sectors o f the market can be
understood bjr themselves.

HE national credit market provides the medium
through which the current flow o f money saving and
other available funds in the economy is mobilized and
invested in loans and securities ultimately representing
real wealth. The commercial banking system is a part o f
this market, but in terms o f dollar volume it is by no means
the dominant part, as the chart on page 86 shows.

T

The credit market is made up o f a wide variety o f market
segments, distinguished one from another by such char­
acteristics as kind o f credit transaction or geographic
coverage. To a great extent, however, all segments o f the
market are interdependent. The national credit market is
composed o f these interconnected market sectors.




85

THE FEDERAL RESERVE SYSTEM

Developments within the commercial banking system
are usually transmitted soon to other market institutions
and participants. Similarly, market developments appear­
ing initially in other sectors are likely to react soon on
banks. The banking system is thus sometimes responding
CREDIT

EXPANSION

C U M U LA T IV E

FLO W S,

1947 = 0

Billions of dollars
500

4
!

400

TO TA L

C R E D IT

200

C O M M E R C IA L
BANK

1948

1952

1954

1956

C 8 EDIT

1958

1960

in part to a spill-over of demand or supply forces from
other market sectors, while at other times developments
within the banking system are giving rise to pressures on
other sectors.
Nonbank participants in the market react to monetary
policy in different ways and in varying degree, depending
on the sources of their funds and the ways in which they
customarily invest these funds. To clarify some of the pos­
86




T H E C R E D IT M A R K E T

sibilities, this chapter discusses the elements o f the credit
market and identifies in a general way the factors that
influence the volume and composition of funds flowing
through it.
Market Structure
A financial market brings together borrowers and lend­
ers or investors, and it establishes and communicates the
prices at which they can make transactions. Some financial
markets, such as the stock market, are highly organized
and have a specific place o f business, but credit markets
generally have no formal organization or designated place
o f business. Nevertheless they bring together a large num­
ber o f transactors willing to borrow or to lend funds at a
range of prices. The prices o f credit are interest rates.
These rates represent the cost to the borrower and the
return to the lender or investor.
Credit markets differ in several ways. For one, they deal
in different kinds o f instruments. There are markets for
U.S. Government obligations, State and local government
obligations, corporate bonds, stocks, bank loans, mort­
gages on real estate, and so on. Also, the instruments in
which they deal vary in maturity, risk, and liquidity; and
there are submarkets specializing in securities delineated
by these features.
For example, short-term U . S. Government securities
and prime short-term business paper are low in risk, highly
liquid, and typically offer the lowest interest yields. They
are close substitutes for cash and for each other and are a
principal medium for temporary investment by banks,
other financial institutions, and business corporations. The
money market specializes in such paper.




87

T H E FE D E R A L RESERVE SYSTEM

Credit markets, though differing in the ways descril
are nevertheless closely linked through the activities
borrowers, lenders, and investors. As these groups s
the most favorable opportunities for borrowing or for
vestment o f available funds, they may find it advantage
to move from one market to another.
From a geographical standpoint, the national cr
market is made up o f a large number o f regional and 1<
credit markets. The rates o f interest charged and of
conditions in these regional or local markets may v;
but these rates and markets are nonetheless related thro;
conditions affecting both the supply o f and demand
credit.
Geographically separated markets maintain contact v
one another in a variety o f ways: through the correspo
ent relations o f local banks with banks in other mark
through local contacts with large savings and financ
institutions, whose operations may be either regional
national; through arrangements between local dealerf
investment securities and either the underwriting hoi
or stock exchange members o f the financial centers; j
through the facilities o f the Federal Reserve System.
While local markets handle most o f the relatively sn
loans originating from local needs and based on local c
ditions, regionally or nationally known concerns, wh
borrowings involve large sums, obtain most o f their cr<
in a broader, even nationwide, market. The changing a
cation o f their borrowing demand, region by region,
response to changing financial conditions helps keep in
r rates in fairly close alignment.
In such ways geographically separated markets
linked in a broad national market. If lendable funds




THE C R E D IT M A R K ET

scarce and costly in one center, the local supply will tend
to be augmented by an inflow from centers where funds
are more abundant and less costly. As a result, well estab­
lished borrowers with a high credit rating can obtain loans
from banks or others, on much the same conditions in one
city as in another. There are many regional credit centers
—such as Chicago, Boston, San Francisco—but the largest
share o f the nation’s credit and money market business is
transacted in or through New York City.
Sources o f Funds
The funds available in credit markets find their sources
primarily in four supplier groups—consumers, nonfinan­
cial businesses, governments, and financial institutions.
Some members o f each group also borrow in credit mar­
kets. N o one group plays a single market role—that is,
as lender only, or as borrower only—but an individual
group may tend to be more one than the other as will
be brought out in more detail later.
At this point, however, it should be recognized that
savers, who make funds available to markets, are often
also borrowers; that borrowers become savers as they re­
turn funds to market institutions through debt repayment;
and that financial institutions obtain funds in credit mar­
kets as well as from the flow o f savings into savings de­
posits and shares, life insurance premiums, and the like.
Foreign transactors, too, lend and borrow in our credit
market, but their impact is generally small.
Consumers. Consumers save more than any other sector
o f the economy, as shown in the chart, and their saving is
the largest source o f funds to credit markets. The amount
that consumers save and the portion flowing to credit




89

THE FEDERAL RESERVE SYSTEM

markets are affected by many factors, such as incomes,
interest rates, capital values, and forw ard expectations.
During the past decade consumers have provided about
three-fifths of the economy’s gross saving. This share has
fluctuated little from year to year. Gross saving o f conGROSS NATIONAL SAVING
Billions of dollars
150

B Y SEC TO R :
1959

TOTAL

100

F IN A N C IA L
IN S T IT U T IO N S

N O N F IN A N C IA L
B U S IN E S S E S

50

CO N SU M ERS

sumers is the am ount o f current income not spent for cur­
rent consumption on such items as food and clothing.
Part o f saving goes directly for purchases o f consum er
capital goods—automobiles, other durable goods, and
homes; p art flows into the acquisition o f financial assets;
and part is used to repay debts incurred earlier. Con­
sumers, as well as other groups in the economy, also finance
purchases of capital goods and acquisitions o f financial

90




T H E C R E D IT M A R K E T

assets by incurring new debt and by drawing upon existing
holdings o f assets.
When consumers acquire financial assets, they make
funds available to credit markets. They lend directly when
they purchase bonds, stocks, and other credit instruments
in the market. These purchases may be either from the
ultimate borrower or from another individual or institu­
tion that wishes to sell the particular security from its
holdings; purchases are generally made through facilities
o f security brokers or dealers. Also, individuals or institu­
tions that wish to reduce their holdings o f securities may
do so by selling through brokers and dealers.
When consumers invest their saving in time deposits,
saving and loan shares, premiums on insurance policies,
and contributions toward pensions, their saving still flows
into credit markets—not directly but through savings in­
stitutions as intermediaries. Since the end o f the Second
World War there has been a comparatively rapid expan­
sion o f financial institutions engaging in this intermediary
function. Consumer saving that flows into these institu­
tions reaches ultimate borrowers when the financial insti­
tutions advance funds through market instruments such as
corporate or government bonds, real estate mortages, and
short- or intermediate-term paper o f varying negotiability.
Consumers may also use some of their saving to increase
their checking account balances at commercial banks.
During the second half o f the 1950’s the amount o f con­
sumer saving reaching the credit market indirectly through
financial institutions averaged $19 billion a year. In con­
trast, the amount flowing directly from consumers into
credit market instruments averaged about $9 billion, or
less than half as much, as shown in the table on page 94.




91

T H E FE D E R A L RESERVE SYSTEM

Business. Another important source o f funds to credit
markets is the gross saving o f nonfinancial businesses—
that is, the amount o f funds generated by retained earnings
and through allowances for the consumption or using up
o f capital. While businesses use much o f their saving di­
rectly to finance replacement o f capital goods or to expand
working and fixed capital, some business funds do become
available to credit markets. In relation to credit markets
though, businesses in the aggregate are primarily borrowers
rather than lenders.
Business investment in financial assets is often tempo­
rary. An increase in funds supplied by business may pre­
cede or foreshadow a rise in capital outlays or accompany a
rise in liabilities o f business. As outlays increase or as
liabilities coming due are paid, this source o f credit market
funds tends to contract. Thus, since businesses expect to
use a large proportion o f their funds in the near future, or
at least want the funds readily available in case o f need,
they tend to invest in highly marketable short-term paper.
As an alternative businesses sometimes place temporarily
idle funds in time deposit accounts. Ordinarily businesses
keep the amounts in their demand deposit accounts close
to the minimum needed for working purposes, but when
market rates o f interest on prime short-term paper are low,
they may add to these accounts.
Businesses also use funds to provide credit directly to
their customers as, for example, through charge accounts
for retail customers or book credit among businesses. Such
credits are made feasible, in turn, by the availability of
bank and other short-term credits to businesses.
Governments. Governmental units both borrow in and
supply funds to credit markets, but like businesses they

92




T H E C R E D IT M A R K ET

are usually net borrowers as a group. Some o f the funds
advanced by governments, particularly those out o f retire­
ment funds, represent the reinvestment of a net inflow o f
saving from consumers; such funds are usually invested in
long-term obligations.
Special governmental programs not only supply funds
directly but also affect the volume o f funds in specific
markets. This is illustrated by home mortgage programs
o f the Federal Government. The Government provides
funds directly when a Federal agency purchases mortgages
from lenders in the secondary market. Such operations
enable lenders to make additional mortgage credit avail­
able. The main aspect of Government participation in the
mortgage market, however, has been the guaranteeing or
insuring o f home mortgages. These programs affect the
willingness o f private lenders to supply funds to the mar­
ket, but they do not result in direct Government loans.
N et repayment of debt by governments, reflecting mainly
budgetary surpluses, supplies funds to credit markets at
times. As governments repay obligations held by market
institutions, funds become available to those institutions
for relending. Funds repaid to individuals and nonfinancial
business may also enter the credit market, or they may
result in reduced individual demands on credit markets if
they are used to finance expenditures that would otherwise
have been financed by borrowing.
Savings institutions. As already noted, savings institu­
tions advance funds to credit markets mainly by relending
or investing the current saving o f others that flows into
savings accounts, life insurance equity, pension funds, and
investment companies. They also make funds available
from their retained earnings, from capital stock issues, and




93

T H E FE D E R A L RESERVE SYSTEM

S upply of a n d D emand for F u nds , 1955-59
(Annual averages. In billions of dollars)
Instrument and sector

Amount

Supply quantities

Flows into financial assets, total1...........

73.0

Credit market instruments2.

43.8

Consumers.......................
Nonfinancial businesses..
Financial institutions.......
Governments...................

8.8
1.9
27.6
4.4

Fixed-value claims on financial institutions'*
.

Consumers.................................................
Others........................................................

20.7

18.8
1.9
8.5

Other assets4.
Demand quantities

Incurrence of debt and other liabilities total1.

71.7

Credit market instruments2.

43.9

Consumers.......................
Nonfinancial businesses..
Financial institutions.......
Governments....................

16.0
15.9
3.3
7.6

Fixed-value obligations of financial institutions3........................ 1 20.5
Other liabilities4........................................................................... ‘ 7.3
1 The flows in these categories are on a net basis. For example, purchases
of credit market instruments are net of sales, and increases in debt represent
extensions net of repayments.
2 Consists of marketable Federal, State, and local government securities,
corporate bonds and stocks, mortgages, consumer credit, security credit,
and bank and other loans. Rest-of-world included in total but not shown
separately.
3 Consists of currency and demand deposits, savings deposits and shares,
and saving through private life insurance and pension funds. Excludes
funds raised in credit markets by financial institutions.
4 Consists of consumer-held U.S. savings bonds, trade credit, pro­
prietors’ net investment in noncorporate business, saving through govern­
ment life insurance and pension funds, and miscellaneous items.
N ote.—Based on Federal Reserve flow-of-funds data. Differences
between supply and demand quantities (including paired subtotals) reflect
statistical discrepancies. Details may not add to totals because of
rounding.

94




T H E C R E D IT M A R K ET

from such borrowings in the credit market as may be
appropriate for them to make.
The availability o f new saving to particular types of
financial institutions reflects the aggregate flow o f income,
the level of interest rates, and other factors that affect the
amount o f saving in financial form in the economy and the
preferences o f individuals, businesses, and governments for
different types o f financial assets. Some funds flow into
financial institutions under contractual arrangements such
as insurance contracts and retirement funds. The flow o f
such funds is little affected by economic fluctuations or
interest rate variations.
Commercial banks. The amount o f lending that com­
mercial banks may do depends on the availability o f re­
serve funds to them. As earlier chapters have shown, the
amount o f reserves in turn is influenced by the credit and
monetary policy o f the Federal Reserve System. The own­
ers o f bank deposits, however, determine their form and
location, as well as their rate o f use. If banks, by extending
credit, are able to make more funds available than the
public wishes to hold as cash balances at existing price
levels, the flow o f spending will tend to accelerate. If, on
the other hand, the public wants to hold more in the form
o f cash balances than banks can make available, total
spending in the economy may be curtailed.
Market Institutions and Use o f Funds
Financial institutions, including commercial banks, ad­
vance directly through credit markets more funds than any
other sector in the economy. These advances take the form
o f net acquisitions o f bonds, stocks, and other securities,
o f real estate mortgages, and o f bank and other loans. The




95

T H E FE D E R A L RESERVE SYSTEM

different types o f market institutions, however, participate
in differing degrees in the various long- and short-term
credit markets. To an important extent, the kinds o f loans
and investments made by financial institutions are influ­
enced by the nature and source o f their funds—that is to
say, by the character o f their liabilities. Legal restrictions
and administrative regulations may also affect the kind o f
lending and investing activity.
Commercial banks have the shortest term liabilities o f
all financial institutions. Demand deposits make up about
two-thirds of their liabilities to depositors, and time and
savings deposits the remainder. Bank capital generally
amounts to less than 10 per cent o f their total resources.
Because demand deposits at banks show wide seasonal or
other temporary variations, banks must be prepared to
meet large drains on their deposits and consequently on
their reserves.
For this reason banks in general tend to lend on shortor intermediate-term maturities. The two exceptions are
instalment loans to business, which may be o f compara­
tively long maturity, and real estate mortgage loans. The
security portfolio o f commercial banks is also weighted in
the direction of shorter term instruments, which are rela­
tively liquid. These are for the most part issues o f the
Federal Government.
Liabilities o f mutual savings banks and savings and loan
associations are savings deposits and savings shares, held
mainly by individuals. These have much lower withdrawal
rates than the checking accounts of commercial banks.
Consequently these institutions hold longer term assets to a
greater extent than commercial banks. They invest princi­
pally in mortgages and hold a large proportion o f their

96




TH E C R E D IT M A R K ET

liquid funds in U. S. Government obligations. Mutual
savings banks also invest moderate amounts in other mar­
ketable securities.
The obligations o f life insurance companies to their
policy holders and o f pension plans to their participants are
largely long-term and relatively predictable in character.
These institutions, accordingly, invest most o f the funds
they receive in long-term capital market instruments. Nonlife-insurance companies invest heavily in both stocks and
bonds.
Among more specialized market institutions, sales
finance and consumer finance companies not only make
funds available in credit markets, but also obtain most o f
their funds in these markets by borrowing from commercial
banks or by selling their own negotiable obligations di­
rectly. Mortgage companies also finance themselves in
credit markets, for the most part by borrowing from banks.
They function primarily as middlemen in the mortgage
market; that is, they buy mortgages to resell rather than
to hold for current income. Investment companies acquire
their funds from consumers and channel these funds into
equity markets.
Dealers in securities borrow at banks to carry inventories
and their borrowings may vary widely over short periods
o f time. Security brokers also borrow at banks to finance
customers’ accounts. Such borrowings have been relatively
large at times in the past and have played a key role in
the behavior o f the money market. Since 1934, when regu­
lation o f margin requirements on such credits became effec­
tive, borrowing for this purpose has been restricted, as
described in Chapter III.
All o f these intermediary financial institutions add




97

T H E FED ER A L RESERVE SYSTEM

breadth and flexibility to credit markets. As a result o f
their development, individuals can hold relatively liquid
assets such as savings and loan shares or can safeguard
the future through life insurance policies and pension
plans, while at the same time ultimate borrowers can have
access to a wide range o f sources for short- and long-term
credit.
Shifts o f funds among these various uses and sources,
as well as changes in the total amount available, may have
important effects upon the course o f economic develop­
ments. The total amount o f credit available, though influ­
enced by Federal Reserve actions, is determined largely
by the amount that the public saves. How much o f its sav­
ing the public allocates among different markets reflects
its own preferences.
Composition o f Demand in the Credit Market
The same broad groups that supply funds to the market
—that is, consumers, businesses, governments, and finan­
cial institutions—also borrow funds in the market. These
groups differ in both the amount and type o f credit sought,
with consumers and businesses borrowing the largest
amounts. In the second half of the 1950’s these two groups
raised an average o f about $16 billion a year through the
medium of credit market instruments. Governments bor­
rowed an average o f $8 billion a year, and financial
institutions $3 billion.
Consumers obtain funds chiefly through long-term home
mortgages and short- and intermediate-term consumer
credit instruments. They use short- and intermediate-term
credit to finance outlays not only for such durable goods
as autos, household equipment, and household repair but

98




T H E C R E D IT M A R K ET

also for education and travel and for meeting personal
emergencies o f various kinds. Such credit is obtained from
banks, sales and other finance companies, and credit
unions, and also from retail stores.
Mortgage debt o f consumers originates primarily in
connection with their purchases o f homes. Like all forms
o f debt, however, it may also finance other expenditures.
Or it may enable the borrower to retain financial assets
that he might otherwise have had to dispose of, or even to
add to such assets.
Nonfinancial businesses raise funds in capital markets
through the issue o f bonds and o f preferred and common
stocks and also through mortgages. Those that need funds
to carry inventories or to meet other short-term require­
ments rely heavily on bank loans with short- and inter­
mediate-term maturities. Borrowing for these purposes is
often under a line o f credit. Such an arrangement enables
a regular business borrower to obtain funds up to a certain
amount for short periods of time without further negotia­
tion. Some businesses also raise short-term funds through
sales in the open market o f their own commercial paper or
of bankers’ acceptances, which bear the endorsement o f a
bank. Businesses sometimes borrow at banks for longer
term capital expenditure programs as well as for short-term
needs.
Governments raise funds mainly by issuing securities.
The Federal Government issues marketable debt with
varying terms and conditions. Such debt includes Treasury
bills, which are sold on a discount basis and have maturi­
ties up to a year (mostly three or six months), certificates
(having maturities o f around one year), notes (maturing
in one to five years), and bonds (maturing in more than




99

TH E FED ER A L RESERVE SYSTEM

five years). The Federal Government also issues nonmarketable securities, o f which the principal types are U.S.
savings bonds sold to the public and special issues to
Government trust funds.
State and local governments issue mainly long-term
bonds, but they also borrow on short-term securities or
loans and tax-anticipation notes. State and local govern­
ment obligations are distinguished by the fact that interest
received from them is exempt from Federal income taxes.
Financial institutions also raise funds in credit markets
in a variety o f ways. As mentioned earlier, finance com­
panies and mortgage companies are active users o f bank
funds, as are also securities dealers and brokers. Long­
term capital markets are a source o f funds to other financial
institutions, including banks, mainly for equity issues.
Savings and loan associations, at times o f heavy mortgage
demands, supplement their receipts from saving inflows by
borrowing from the Federal home loan banks; these Gov­
ernment sponsored banks obtain their funds by selling
their own obligations in the market.
Market Roles o f Economic Groups
Participants in credit markets are often both borrowers
and lenders. For example, groups that are primarily savers,
such as consumers, are also ultimate borrowers. Similarly,
groups that are primarily borrowers, such as businesses,
also advance funds to markets. The net position o f each
group in relation to credit markets reflects both supplier
and user roles. While the net position o f any one group
varies with the course and pattern o f economic activity,
some groups have consistent and typical roles.
Consumers as a group generally advance more funds to
100




THE CREDIT MARKET

credit markets than they borrow in such markets; most of
this investment is through financial institutions as inter­
mediaries. Businesses, on the other hand, generally raise
more than they advance. Thus, funds flow in large part
from consumers through financial institutions to busiCHANGI IN FINANCIAL POSITION
A N N U A L IN C R EA SE
Billions of do lla rs

_4 4 0

C O N SU M ER
Cl AIMS

M
ii

Mi

■

■

B

1 °“ts S lH
1

120

.

1
“

40

B U SIN E SS

1957

195 8

1959

nesses. Like businesses, State and local governments in the
aggregate generally borrow more funds than they advance.
The Federal Government’s role fluctuates with its budg­
etary position; it is a net source of funds, mainly through
repayment of debt, when tax and other receipts exceed
expenditures and a net borrower when expenditures are
running ahead of receipts.




101

T H E FE D E R A L RESERVE SYSTEM

Changes in the net supply o f and demand for funds are
usually accompanied by changes in national income, in
levels o f interest rates, and in the volume or pattern o f
capital outlays. Increased capital outlays by businesses,
for example, give rise to greater net borrowing when in­
ternal saving is not rising fast enough to finance the larger
outlays. Reductions in capital outlays by consumers, with
gross saving relatively well maintained, result in a larger
net flow o f funds to credit markets from this group. Such
shifts as these are immediately reflected in the particular
markets most closely related to the changing consumer or
business financial needs. Because o f the interrelationship
o f markets, however, they are soon felt to some degree
throughout the whole credit market structure.
Relations Among Markets
Credit markets are interrelated in that borrowers and
lenders may take advantage o f alternative means for satis­
fying financing needs or for making funds available. Thus,
as borrowers and lenders compete for the most favorable
borrowing or investment opportunities, conditions in one
market come to affect conditions in other markets.
All borrowers compete to some degree for available
funds, but competition is most apparent for similar kinds
o f credit. For example, Federal Government demands for
both short- and long-term funds in money and credit
markets compete directly with demands from private busi­
ness for credit with similar maturities.
Competition also arises from the fact that a borrower
can raise funds for a particular purpose in a variety o f ways.
For example, within limits a corporation has the option of
raising funds through a bank loan or a bond issue. A bank
102




TH E C R E D IT M A RKET

loan to business competes directly with bank funds avail­
able for financing short- and intermediate-term consumer
borrowing. Similarly, a corporate bond issue competes
with the financing needs of governments and with those o f
consumers for mortgage funds.
More broadly, any one group o f borrowers competes
to some degree with all other groups o f borrowers, regard­
less o f whether such groups actually are, or have the op­
tion of, engaging in similar types o f financing. This stems
from the fact that the composition o f funds flowing into
credit markets is noticeably responsive to the changing
composition o f demand.
Funds supplied to markets shift among alternative uses
in response to differential movements in interest rates or to
changes in other conditions, such as the economic outlook,
which in turn may affect interest rate movements. Never­
theless, flexibility o f supply is neither immediate nor
complete, in part because supplies respond to changing
conditions only after a lag and in part because o f legal,
institutional, and other restrictions.
Markets are also linked through the ability o f lenders
to obtain funds in one market and make them available in
another. This can be illustrated by the behavior o f banks.
As demand for credit expands, commercial banks may sell
securities out of their investment portfolio to obtain funds
to lend to, say, nonfinancial businesses. This increased
supply o f securities competes with other securities coming
onto the market and tends to drive up interest rates in the
market.
Interest rates in the securities market thus are affected
by the demand for bank loans and, in turn, have an effect
on the terms and conditions on which such loans are made.




103

T H E FE D E R A L RESERVE SYSTEM

As the effect of rising demand for bank loans spreads
through credit markets in this way, the terms on which the
Government can obtain new funds in the securities market
are also influenced.
Because market sectors are related in these and other
ways, the effect o f reserve banking policy on bank reserve
positions, whether for tightness or ease, is transmitted
throughout the national credit market and has an influence
generally on the willingness to borrow in markets and on
the willingness and ability o f nonbank financial institu­
tions to lend. Monetary policy, therefore, influences over­
all borrowing and lending in the economy. At the same
time the broadening o f the credit market and the growth of
financial intermediaries enlarge the sources o f credit avail­
able to borrowers, intensify competition on the side o f
supply, and increase the potentiality for accelerated credit
expansion.
Thus, the emerging patterns of supplies o f and demands
for funds in the credit market are important influences on
the direction and intensity o f credit and monetary actions.
To increase understanding o f these patterns and to pro­
vide a comprehensive framework for analyzing current and
past developments, the Board o f Governors publishes a
flow-of-funds system o f national accounts. These accounts
show transactions in particular financial assets by major
sectors of the economy. In addition, financial transactions
are dovetailed with nonfinancial transactions so that events
in financial markets can be directly related to income,
spending, and saving flows. Flow-of-funds data, including
saving and investment figures both for individual sectors
and for the entire economy, are available in the Federal
Reserve B u l l e t in .
104




CHAPTER VI

INTEREST RATES. Interest rates are prices paidfo r borrowed
money. They are established in credit markets as supplies o f and
demands fo r loanable funds seek balance. Movements o f interest
rates are influenced by the nation s saving and investment, by
market expectations, and by the flow o f bank credit and money.

I

NTEREST rates are prices paid for the use o f credit.
In a market economy they are established by the inter­
play o f supply and demand forces in credit markets. The
pricing function o f interest rates is to bring the supply o f
and demand for funds into balance. In this process interest
rates influence the volume and composition o f available
loan funds and their allocation among competing economic
activities.
Variations in the average level o f market interest rates
and in the relationship o f particular rates to one another
have an impact on both the demand for and supply o f
credit. This results from the incentive and disincentive
effects they exert on individual seekers and suppliers of
funds. These effects derive directly from the pricing role




105

T H E FE D E R A L RESERVE SYSTEM

o f interest rates and indirectly from their role as capitaliza­
tion rates by means o f which future streams o f income
may be translated into present-day capital values.
This chapter describes briefly the relationship o f con­
tract (coupon) rates to market interest rates, considers
cyclical fluctuations in the interest yields on different types
o f loans and investments, discusses the underlying eco­
nomic processes that affect interest rate formation, and
describes how actions o f the banking system influence
movements in interest rates.
Contract Interest Rates and Market Yields
Most obligations traded in the market bear a specified
contractual rate o f interest to maturity. This rate is stated
ordinarily in interest coupons attached to a bond and
hence is known as the coupon rate. The coupon rate is to
be distinguished, however, from the market rate o f interest
or yield to maturity, which is the rate as o f today that the
market is prepared to pay or accept in exchanging present
for future purchasing power.
The extent to which the market rate departs from the
coupon rate depends on the changing demand for an
obligation in relation to its supply. As demand rises rela­
tive to supply, the market price o f an obligation rises and
the market yield declines. The interest yield declines be­
cause market participants pay a higher price to obtain the
same fixed interest return. The opposite occurs when de­
mand falls relative to supply; market interest rates then
rise as a lower price is established in the market for the
same interest income.
The amount o f variation in market price that is asso­
ciated with a divergence between market yield and coupon
106




IN T ER E ST RATES

rate is affected by the length o f time an obligation has to
run until it matures. As an example, assume that an
obligation with a coupon rate o f 2l/ i per cent per annum
and a current market rate o f 2l/ i per cent per annum will
>
mature in only six months. A market price o f about 99lA
for the obligation would make the coupon rate, the market
rate, and the maturity consistent with each other.
If, as a contrast, we assume a 10-year maturity on an
obligation o f similar coupon rate and similar market rate,
then the market price would be 91
The current market
price for the longer term security has to be lower than
that o f the short-term obligation in order to provide the
investor with an equal percentage return, that is, for the
two maturities to be equally attractive from the standpoint
o f yield. That is to say, for the long-term issue to yield an
average o f 3 l/ i per cent over the 10-year period, the current
market price must be low enough so that the gain in capital
value over the period, together with annual payments, will
make the market yield one per cent higher than coupon rate.
Some short-term negotiable securities, notably Treasury
bills and bankers’ acceptances, do not have a contractual
rate of interest specified for the investor. The yield on a
new issue, given its maturity, is determined entirely by the
discount from par at which the obligation is sold. Its subse­
quent market price depends, as with coupon bonds, on the
yield at which market participants engage in transactions
and on the effect on this yield of changes in the length o f
time until maturity.
When we speak o f fluctuations in market rates o f inter­
est, we usually refer to changes in the yields at which
existing obligations are traded in the market. We assume
that new borrowers in the market will have to pay at least




107

THE FEDERAL RESERVE SYSTEM

this rate. In general, coupon rates and actual market yields
on new securities will be a little higher than this as a special
inducement to investors to make purchases.
In considering the effects o f changes in the rate o f inter­
est, it is important to bear in mind that these changes will
affect the cost o f borrowing only in the case o f new loans.
They will affect existing loans through changes in the
prices at which outstanding obligations are traded.
Differences Among Interest Rates
Reflecting the many purposes and situations that give
rise to borrowing and lending, there is a wide variety o f
loans and investments in credit markets, each bearing an
interest rate. Some interest rates are relatively high, and
some relatively low. The particular level for each security
will reflect distinctive characteristics o f the obligation, the
particular class o f borrowers using it, and the preferences
that lenders and investors may show for it.
Observable differences in market interest rates are
affected by a wide variety o f factors. Among the most
important are the term structure o f market instruments,
that is, whether short- or long-term; the market’s evalua­
tion o f differences in factors related to risk, including
the business experience o f borrowers and the kinds of
assets or guarantees that back up their obligations;
whether the loan is large and readily negotiable in form or
is relatively small and less negotiable; tax exemption fea­
tures; and the varying supplies that lenders make available
in given circumstances for different uses.
In general, securities with shorter maturity and greater
negotiability bear lower interest rates than other obliga­
tions. This is related in part to the fact that market pros­
108




INTEREST RATES

pects are always uncertain and that many types o f investors
prefer to commit their funds in prime paper o f shorter
term rather than in longer term, less readily marketable
securities. The extent to which market rates reflect these
features of term, risk, and negotiability changes over time.
Shifting needs of borrowers and evaluations o f investors
naturally exert an important influence in altering the
structure o f rates.
L O N G - A N D S H O R T - T E R M INTEREST RATES
Per cent per annum

1900

1910

1920

1930

1940

1950

1960

During the postwar period short-term interest rates
have generally been below long-term rates, but in earlier
periods this was not always the case. There have been
prolonged periods when short-term rates were above long­
term rates. In addition, the relationship between the two
has varied with short-term economic cycles.




109

THE FEDERAL RESERVE SYSTEM

How Interest Rates Move Over Time

Both borrowers and lenders have considerable flexibility
in substituting one type of instrument for another. As a
result, interest rates on various kinds of market instru­
ments tend to fluctuate together. Movements in these
rates differ, however, in both degree and timing. This has
been true in both recent and earlier times.

Market experience shows that whether the interest rate
of a particular instrument responds continuously to a
changing market situation—that is, rises or falls by small
increments from day to day, or even from hour to hour—
depends on the character of the instrument as well as on
the nature of market demand and supply. Interest rates
on obligations designed for and traded in central credit
110




IN TER EST RATES

and security markets respond quite sensitively to changes
in either demand or supply.
Some interest rates, however, respond only slowly to
shifting market conditions. Examples include rates on
smaller business loans, on consumer loans, and on mort­
gage loans.
For still another group, rates are adjusted in steps by
administrative decision o f lenders as conditions warrant.
Examples o f such rates are those charged by commercial
banks to prime customers, the rate charged member banks
by the Federal Reserve Banks, and rates paid bank cus­
tomers on their time deposits. The effects o f institutional,
administrative, or legal factors on the extent and timing
o f interest rate movements will depend on the character­
istics o f the particular market sector.
Changes in credit conditions accompanying changes in
business activity are felt in both short- and long-term mar­
kets as a rule. Rates in these markets generally rise and
fall together, but fluctuations are normally greater in
short-term rates than in long-term rates. There are a
number of reasons for this.
From a supply standpoint, movements in short-term
interest rates reflect to a considerable extent the shifting
ease or tightness of bank reserve positions. As described
earlier, banks often make their initial asset adjustments to
changing reserve availability by buying or selling short­
term securities o f prime quality.
From a demand standpoint, fluctuations in short-term
rates reflect the highly variable expectations o f investors
about their cash position and needs for liquidity and about
the near-term economic and credit situation. These move­
ments in rates are especially influenced by the shifting




111

T H E FE D E R A L RESERVE SYSTEM

liquidity attitudes o f institutional investors, such as large
business corporations and financial institutions. These
investors, in managing their changing requirements for
funds, tend to look upon short-term paper as an interestearning store o f value that is a close substitute for non­
interest-earning cash. Hence, they sell or buy short-term
paper when their cash funds temporarily fall below or
exceed levels desired for transactions needs.
Fluctuations in long-term interest rates are less extreme
than those in short-term rates. This is in part because the
owners of such obligations regard them primarily as invest­
ments and also because a small change in interest rates
affects earnings over a longer period.
Owners of long-term securities generally expect to retain
them for extended periods. Any decisions they make to
buy, sell, or hold such securities are based for the most
part on longer run economic prospects. Thus near-term
and temporary factors influence the market demand for
and supply o f long-term securities much less than they do
shorter term obligations.
Market yields on longer term securities reflect evalu­
ations of market conditions that may prevail in the more
distant future as well as current and near-term market con­
ditions. Estimates o f yields for the near term will neces­
sarily be more variable than for more distant years, in part
because possible instabilities in the more distant future
cannot be projected with any confidence, and in part be­
cause cyclical movements in credit conditions tend to even
out over a span o f years. The greater stability o f yield
estimates for the more distant future will counteract the
greater variability o f yield projections for the near future.
Accordingly, long-term interest yields, which are in some
112




INTEREST RATES

sense weighted averages of yields expected over both the
short and longer run future, will usually show smaller up­
swings and downswings than will short-term rates.
Over the past decade, as in most periods before the
two decades covered by the 1930’s and by the war and
YIELDS AND PRICES ON U.S. GOVERNMENT SECURITIES
Per cent per annum

1956

1958

1960

early postwar years, interest rate movements have been
correlated with cyclical movements of the economy, and
short-term rates have moved above long-term rates during
phases of cyclical expansion.
While short-term interest rates fluctuate more than long­




113

T H E FE D E R A L RESERVE SYSTEM

term rates, prices of long-term securities fluctuate more
than prices o f short-term securities for reasons indicated
earlier in this chapter. This is illustrated in the chart on
page 113, which shows yields and prices o f short- and
long-term Government securities in recent years.
Factors in Interest Rate Changes
Variations in the supply of and demand for loanable
funds o f enough strength to change the level and structure
o f market interest rates are usually the joint product o f a
number of underlying economic forces. Of these, three are
primary and closely interrelated. They are changes in the
nation’s saving and investment tendencies, changes in
market expectations as to the future course o f economic
activity and o f prices, and changes in the flow o f bank
credit and money.
Saving-investment process. From a saver’s point of view
the rate of interest can be viewed as a price that translates
present saving into future buying power. For example, at
a 5 per cent annual interest rate, $100 saved from present
income will exchange for $105 after one year. In the mean­
while, since the saver has not spent his $ 100 —that is, has
refrained from current consumption to this extent—his
saving permits resources to be used to an equivalent dollar
amount for the nation's investment in plant and equip­
ment, durable goods, and housing (or in net foreign in­
vestment).
A nation’s saving represents the restraint that its mem­
bers in the aggregate have exercised in using income to
buy goods and services to be consumed currently. The
investment o f this saving, which represents expenditures
for tangible wealth (plus or minus the net change in claims
114




IN TER EST RATES

on foreigners), increases the economy’s capacity to produce
goods and services in the future. This increase, when
realized, takes the form o f added output o f goods and serv­
ices from which borrowers are able to pay the interest
earned by the nation’s saving.
Interest is both an earning on saving and a cost of invest­
ment in buildings, equipment, or other capital goods.
Movements o f interest rates, therefore, can be said to
reflect the balancing o f saving and investment tendencies
at given levels o f output and prices. But the demand for
investment in relation to the economy’s willingness to save
also affects a nation’s real output as well as the market
prices o f the goods and services that have been produced.
The extent o f influence depends on the economic and finan­
cial organization of a country, the phase o f its economic
cycle, and on specific economic conditions at the time.
In recession periods the plant facilities o f a country turn
out a volume o f goods and services below their capacity.
In these circumstances an increase in investment demand
relative to the supply o f saving is likely to lead to the
financing o f a larger volume o f real investment, and thus
to increased output and rising real income. The rise in
real income from the expanded investment demand will be
accompanied by an increase in saving. Hence any tendency
for interest rates to rise may be checked, and saving and
investment may be brought into balance at little net ad­
vance in either interest rates or in the level of prices for
goods and services.
In times o f economic boom, however, when plant
capacity is fully or almost fully utilized, investment de­
mand in excess o f available saving works progressively
to intensify upward pressures on interest rates and price




115

T H E FE D E R A L RESERVE SYSTEM

levels. Under these conditions the extent to which saving
might be increased out o f a rise in output and real income
will necessarily be limited.
Role o f expectations. Shifts in expectations o f businesses
and consumers as to the future course o f prices, produc­
tion, and income affect saving, investment, and interest
rates. Two kinds o f effects can be distinguished. First,
there are very short-run effects, felt mainly in short-term
markets and not closely related to basic tendencies in
saving and investment. Second, there are longer term
effects on saving and investment having a more pervasive
and sustained impact on interest rates.
How shifts in business expectations may affect interest
rates in the short run is illustrated by what typically hap­
pens in credit markets in the early stages o f a cyclical
recovery. Under these conditions interest rates — par­
ticularly short-term rates — usually rise faster than basic
demand-supply developments warrant. This rise is influ­
enced by prospects o f rapid expansion in economic
activity, high and rising demands for credit, and a possible
shift in Federal Reserve operations from being appre­
ciably stimulative to being less stimulative or even restrain­
ing. Conversely, market expectations that the near-term
economic outlook is unfavorable may precipitate a sharp
decline in short-term rates. At such times prospects will
loom large for a significant reduction in borrowing de­
mands and for an increase in the supply o f funds as a result
o f more active bank credit expansion under the stimulus
of monetary policy. Interest rate movements o f this short­
term type may slow down markedly, or even be reversed,
if it becomes evident that the market’s expectations are
not to be realized.
116




IN TER EST RATES

Longer run effects o f expectations may include disloca­
tions in the saving-investment process, and may thereby
have more enduring effects on credit market conditions.
For example, upward pressures on interest rates and com­
modity prices become and remain intensified during
periods when high capacity utilization is accompanied by
widely prevalent expectations o f inflation. In such periods
potential borrowers are stimulated to obtain immediate
financing in order to beat the expected higher costs o f
business plant and equipment in the future. Investors also
take steps to protect themselves against the expected
inflation. For instance, they purchase inflation hedges such
as equities and land rather than debt obligations, and they
also borrow to finance these purchases.
When inflationary expectations are modified, the process
will be reversed. Investors’ preferences for debt obligations
relative to equities will become stronger; yields on equi­
ties will tend to rise; and upward pressures on interest
rates will be displaced by declining tendencies.
Money and bank credit. Fluctuations in market interest
rates are affected not only by changes in the saving-invest­
ment process and in the economy’s expectations but also
by changes in the supply o f money and bank credit. In­
creases in the supply o f money not matched by increases
in the public’s desire to hold cash have one o f two effects
or some combination o f them. As one alternative, the net
supply o f funds in credit markets may rise as the public
attempts to substitute other financial assets for cash, and
thus interest rate movements may be affected. As another,
they may be directly reflected in spending on goods and
services as consumers and businesses endeavor to reduce
the amount o f cash they hold.




117

THE FEDERAL RESERVE SYSTEM

Expansion o f the money supply can be accomplished
only by expansion o f bank credit. When bank credit ex­
pands, it adds directly to the supply o f funds available for
purchasing existing financial assets and for financing eco­
nomic activity. Thus, interest rates come under supply
pressure and may fall.
Interactions. The factors influencing the supply o f and
demand for loanable funds and the levels o f interest rates—
that is, the money supply, saving and investment, and ex­
pectations—are not independent o f each other. The be­
havior o f one is influenced by and impinges on the move­
ments of the others. Changes in interest rates, output, and
prices are a product o f their joint effects.
When economic activity declines, saving tends to out­
run investment demand and interest rates tend to fall. At
such times reserve banking actions to increase the avail­
ability o f credit and the supply o f money will make for
easier credit market conditions, declining interest rates,
and a financial environment and expectations favorable
to a revival in economic activity.
When the economy is at a high level o f capacity utiliza­
tion, when demands for goods and services tend to exceed
the capacity to produce them at current prices, and when
investment demand exceeds the propensity to save, prices
and interest rates tend to rise. Under these circumstances
reserve banking actions will generally be designed to keep
credit and monetary expansion in line with the economy’s
growing capacity to produce and thereby to contain infla­
tionary pressures.
Unlimited expansion o f bank credit and money in these
conditions, in order to satisfy all demands for credit at pre­
existing interest rates, would enlarge the dollar amount of

118




IN TER EST RATES

both saving and spending without relieving the shortage o f
real resources. It would thus result mainly in rising prices
and expectations o f further rises. It would not check, ex­
cept perhaps temporarily, a pronounced tendency for inter­
est rates to rise. Thus for monetary policy to be an effective
influence toward stable prices and sustained economic
growth, interest rates need to fluctuate in response to vari­
ations in economic activity, the supply o f saving, and in­
vestment demands.
Interest Rate Inflexibilities
Some market rates o f interest, as was mentioned earlier,
do not reflect immediately changes in the supply o f credit
relative to demand but respond to such changes after a
lag. In some instances a stated interest rate may not change,
but the effective rate may be varied through other changes
such as the amount that banks require borrowers to leave
on deposit or the extent to which investors require com­
pensation for purchasing securities having a maximum
interest rate, such as Government-insured mortgages.
As credit demands press actively against the supply o f
funds in market sectors where interest rates tend to be less
flexible, lenders allocate funds among borrowers on a
basis other than price. Lenders, who always tend to be
selective to some degree in satisfying borrowers, adhere to
stricter lending standards and screen creditworthiness o f
borrowers more carefully when credit conditions are tight.
Borrowers then become obliged to shop more intensively
to find lenders whose loan standards and terms they can
meet, and some borrowers fail to find accommodation.
Thus, an increase in demand for funds relative to supply
not only causes interest rates to rise but also has a direct




119

T H E FED ER A L RESERVE SYSTEM

effect on the ease with which borrowers can obtain funds
and the amount they can obtain. Similarly, developments
that limit the supply o f funds relative to demand, includ­
ing those that restrict bank credit expansion, tend to be
accompanied by both rising interest rates and increased
nonprice allocation o f funds as lending standards become
more strict.
Monetary Policy and Interest Rates
Monetary policy in the short run focuses on the volume
and availability of bank reserves in relation to credit de­
mands being generated by current economic forces. In in­
fluencing bank reserves, monetary actions also affect
market interest rates in several ways. The main influence
o f monetary policy on interest rates is exerted by the in­
crease or decrease in the supply o f funds in the market that
results from multiple expansion or contraction o f bank
credit based on fractional reserve requirements. On the
average, however, only a small share o f aggregate credit
demand is satisfied through the bank credit expansion
that is associated with growth in money supply. Available
estimates indicate that the share so satisfied averaged less
than a tenth annually during the 1950’s.
The Federal Reserve can initiate a change in bank re­
serves through its open market operations or, when ap­
propriate and feasible, it can vary the reserve requirement
percentages, as explained in Chapter III. These changes
can be modified by member bank initiative in borrowing
from a Reserve Bank at the established discount rate.
Federal Reserve purchases and sales o f Government se­
curities in the open market, o f course, have some immediate
impact on market interest rates. In order to minimize this
120




IN TER EST RATES

impact, the System follows a practice o f conducting open
market operations in short-term securities, the market for
which is much broader than markets for longer issues. As
these operations bring about larger changes in the supply
o f funds through multiple expansion or contraction o f
bank credit, interest rates in all sectors o f the market will
come to be affected.
Flexible adjustment between short- and longer term
interest rates is an essential aspect o f a responsive credit
market. Such a market continuously reflects evolving
borrower and lender preferences in the commitment o f
financial resources into the future. Continuous market
adjustments enable the nation’s financial institutions to
function effectively in the public interest. Their principal
task is to mobilize the saving of numerous individuals and
other sources and to channel these savings into investments
consonant with their own liabilities to savers and with the
diverse wants of the people. Federal Reserve operations
are designed to interfere as little as possible with investor
and borrower decisions as to the specific commitment of
resources through time.
The Federal Reserve discount rate is related to and
interacts with interest rates in the market. As was explained
earlier, the Federal Reserve discount rate is kept in
close alignment with short-term interest rates in order to
avoid giving member banks either too much or too little
incentive for using a facility that is intended to meet bank­
ing contingencies and temporary needs for reserve funds.
While the discount rate is administered in relation to the
level and structure o f market interest rates, market rates
themselves are primarily the product o f the forces o f de­
mand for and supply o f credit.




121

THE FEDERAL RESERVE SYSTEM

Because of psychological factors in the market, bank
credit and monetary policy may have some effect on inter­
est rates in addition to, and even prior to, those resulting
from changes in bank reserve positions. However, interest
rate movements prompted by expectations o f prospective
reserve banking action are not likely to be long sustained,
unless accompanied by changes in basic supply and demand
conditions.
While the course of interest rates is necessarily influenced
by reserve banking action, monetary policy decisions are
themselves based primarily on judgment as to the flow of
bank credit and money that is appropriate for the economy,
and not on judgment as to some level and pattern of inter­
est rates that is deemed to be appropriate. To the greatest
extent possible, the setting of interest rates is left to the
interplay of supply and demand forces expressed in the
credit and security markets.

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CHAPTER VII

INFLUENCE OF RESERVE BANKING ON ECONOMIC
STABILITY. Federal Reserve influence on the flow o f bank credit
and money affects decisions to lend, spend, and save throughout the
economy. Reserve banking policy thus contributes to stable economic
progress.

E

ARLIER chapters have described the mechanism of
Federal Reserve influence on the flow o f bank credit
and money, explained the structure of credit markets, and
discussed important factors affecting movements in interest
rates. This chapter clarifies the relation of reserve bank­
ing measures to economic stability and growth.
Reserve banking or monetary policy attempts to pro­
vide a financial climate conducive to sustainable growth
in output, employment, and consumption under conditions
of relative price stability. However, financial stability and
sustainable economic growth cannot be attained through
reliance on monetary policy alone. Their accomplishment
also depends on fiscal and other policies of Government
and on policies of private institutions and organizations.




123

THE FEDERAL RESERVE SYSTEM

The posture of monetary policy at any moment—
whether restrictive or expansive—is a reaction to prevail­
ing economic conditions. Monetary policy functions restrictively only when inflationary tendencies are present.
In other circumstances, it functions expansively or as­
sumes a posture somewhere between stimulation and re­
straint. To help avoid the dangers of economic downturn,
reserve banking works to prevent speculative or otherwise
unsustainable expansion of bank credit.
The accompanying diagram shows in a simplified way
how Federal Reserve actions influence total spending and
thereby contribute to the ultimate objectives of high em­
ployment, maximum production, and stable prices. The
following discussion considers both the expansive and re­
strictive effects of reserve banking but, to avoid repetition,
it goes into detail only on responses to restrictive opera­
tions.
The Federal Reserve carries out its public interest
responsibility by influencing the reserve position of the
commercial banking system. Thus, as the diagram shows,
the initial impact of reserve banking policy is on the reserve
position of commercial banks. As commercial banks re­
spond to changes in the availability of reserve funds by
altering their lending and investment policies, reserve
banking comes to influence the supply of money, the avail­
ability of credit, and the cost o f money in various credit
markets.
Some observers stress the influence of reserve banking
in terms of its effects on the money supply, others stress
effects on over-all liquidity, and still others emphasize the
impact o f changes in the availability and cost of credit.
In the functioning o f the economy, each of these modes of
124







125

THE FEDERAL RESERVE SYSTEM

influence has a role and, in the discussion that follows,
each is taken into account.
R e a c t io n s o f C o m m e r c ia l B a n k s

What is the reaction of commercial banks to changes in
the supply of reserves? For example, what is their reaction
to limitations on reserves in a period of strongly expanding
loan demand? When they are in this situation and therefore
under reserve pressure, banks are more reluctant to make
new loans and interest rates on the loans they do make tend
to rise, as compared with periods when their reserves are
rising rapidly as the result of reserve banking policy.
In a period of restrictive monetary policy, a bank that
seeks to make additional loans may have to obtain funds
by selling Government or other securities (mainly short­
term) in the market, by permitting maturing issues to run
off, or by drawing down balances with, or borrowing from,
other banks. Discounting at Reserve Banks, as has been
emphasized before, is a facility primarily for meeting pass­
ing contingencies and is not a source of funds available to
individual banks for financing a permanent loan expansion.
If a bank sells securities, lets maturing issues run off, or
draws down its balance with another bank, its action will
necessarily affect other banks. In the case of security sales,
for example, the buyer will likely draw down his account
at another bank to make payment. Consequently, banks
as a group cannot expand their total loans and investments
in this way except when additional reserves are being pro­
vided by expansion in Federal Reserve credit. For the
banking system as a whole, such credit may take the form
of an increase in Reserve Bank holdings o f securities or in
Reserve Bank discounts.
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INFLUENCE ON ECONOMIC STABILITY

If many banks try to obtain additional reserves by selling
securities, the amount of short-term paper or securities in
the market will be significantly increased. This increased
supply tends to lower prices and to raise yields on all such
paper. Similar market pressures may result if banks, in
order to build up their reserves, allow maturing issues to
run off or draw upon balances with correspondents.
At the lower prices and higher yields, Government and
other short-term securities will be more attractive. In
order to buy them, nonbank investors may use temporar­
ily idle deposits or they may even be induced to economize
on cash balances held for current payments. When banks
sell short-term paper to other investors and use the pro­
ceeds to make loans, ownership of deposits may shift from
holders of idle balances to borrowers who are spenders and
will shortly disburse the proceeds. To the extent that this
occurs, the velocity o f existing deposits will increase. Total
bank reserves and total bank credit and deposits do not
increase in this process, but the volume of money transac­
tions increases as the existing supply of money is used more
actively.
As banks see their short-term securities or secondary
reserves declining, however, they become increasingly
reluctant to reduce these securities or reserves further in
order to make additional loans. This leads banks to adopt
more restrictive loan standards.
In addition, as market interest rates rise—a develop­
ment that is reinforced by bank sales of securities—secur­
ity prices decline and sales o f securities may involve book
losses. Banks are influenced to some extent by potential
capital losses on the securities in their portfolios and they
hesitate to sell securities at a loss. Income tax considera­




127

THE FEDERAL RESERVE SYSTEM

tions and strict earnings calculations, however, may mod­
erate or even negate the deterrent effect of such losses on
continued sales of securities.
At other times when monetary policy aims at counter­
acting recessionary tendencies, banks will find reserve
funds increasing and will undertake to employ these funds
profitably. They are likely to devote reserve accretions first
to the repayment of borrowings at the Reserve Banks,
particularly if loan demands are weak or declining as might
be expected under the conditions assumed. After they have
reduced their borrowings, banks will begin to purchase
short-term securities, thereby rebuilding their secondary
reserve positions and reinforcing any tendency already
existing in the market toward declining interest rates. They
will also begin to relax their restrictive loan policies and
this, together with reduced interest rates, may actively
encourage the extension of bank loans that were postponed
or that were not encouraged by lenders under the earlier
conditions o f credit tightness.
E f f e c t s o f C h a n g e s in M o n e y S u p p l y

Expansion or contraction in the rate at which bank
credit is rising will be accompanied by expansion or con­
traction in the rate at which the money supply is growing.
What is the response of the economy to changes in the rate
at which the supply o f money is growing, under the in­
fluence of monetary policy? At each level of income and
interest rates, there will be an amount of money that the
public wishes to hold for transactions, or for precaution­
ary or speculative purposes. Suppose that Federal Reserve
actions fail to provide the desired amount of money. In
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INFLUENCE ON ECONOMIC STABILITY

that event some reaction is likely to be registered both in
spending and in interest rates.
In an attempt to reestablish its desired level of balances,
the public may spend less, or it may sell off financial assets,
(or purchase fewer financial assets), with a consequent
rise of interest rates. As interest rates rise in this situation
they too influence spending and saving decisions. Also,
the rise in interest rates affects the demand for money
balances, as it leads people to accommodate themselves to
smaller cash balances.
On the other hand, a volume of money in excess of what
the public wishes to hold leads to increased spending and
lending and to reductions in interest rates.
Demand fo r Cash

In assessing the effect on economic activity of changes
in the money supply, it is important to recognize that there
is no simple automatic measure of the appropriate rela­
tionship between the amount of money outstanding and
the level of economic activity. A given volume of money,
for example, can be associated with either higher or lower
levels of total spending—that is, can finance more or fewer
transactions—depending on how often it is used. The
rate o f turnover, or velocity, of money indicates how much
work each unit of money does in financing transactions.
The quantity of active money is represented by the
holdings of currency and demand deposits by consumers,
businesses, nonbank financial institutions, State and local
governments, and foreigners. Each holder endeavors to
maintain his cash balance at a level appropriate to his
needs for payments.
Cash balances are held for a variety of reasons. A large




129

THE FEDERAL RESERVE SYSTEM

part o f their total represents working balances, that is,
amounts of demand deposits and currency held for financ­
ing regular transactions. The size of such balances varies
in part with the time lag between receipts and expendi­
tures. For example, the time elapsing between pay dates
is one factor affecting the size o f cash balances. People
who are paid each week have smaller cash balances on the
average than those paid monthly. The size of the balance
also varies with income. The higher a person’s income and
expenditures, the larger his cash balance for transactions
is likely to be.
Cash balances are held for other reasons too. They may
represent saving out of income, as a store of value for
precautionary reasons—to gain flexibility in choice and
timing of purchases, to provide against a rainy day, or
to anticipate future expenditures or investments. In
other instances, they may be held as a store of value for
speculative reasons, with the expectation of buying in case
of a sharp decline in security or commodity prices.
The size of the cash balances that businesses and indi­
viduals find it desirable to hold depends in part on the level
of interest rates. When interest rates are low, the holder
sacrifices relatively little in holding cash rather than an
asset that earns interest. The higher the level of interest
rates, the greater the sacrifice in holding idle cash instead
o f an interest-bearing financial asset. The form in which
contingency or speculative balances are held—whether as
demand deposits that bear no interest or as interest-earn­
ing assets—is highly sensitive to the interest return.
Several types of assets are close substitutes for cash in
its store-of-value function. These include savings and time
deposits at commercial banks, deposits at mutual savings
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INFLUENCE ON ECONOMIC STABILITY

banks, shares in savings and loan associations, and U. S.
Government savings bonds. Short-term market instru­
ments, especially obligations of the U. S. Government,
such as Treasury bills, are also close substitutes for cash
because they are generally convertible into cash with rela­
tively small risk of capital loss. Such assets possess high,
though varying, degrees o f liquidity; and a backlog of
these “near money” assets, together with some holding
of cash, gives the individual consumer or enterprise greater
discretion in spending decisions. For the economy as a
whole, a smaller or larger amount of such assets can be
said to influence spending and the resulting level of eco­
nomic activity.
Use o f Cash in Relation to Monetary Policy

Changing attitudes of people toward the amount o f their
cash balances and liquid asset holdings are an important
factor affecting the use or velocity of money. Changes in
the amounts o f cash and other liquid assets that individuals
wish to hold are influenced by many factors. Among
important influences are changes in the amount of trans­
actions to be financed; expectations as to future levels of
economic activity, interest rates, and prices; and other
motives and circumstances that determine spending and
saving decisions. In addition, changes in bank credit and
money themselves may set in motion forces, such as interest
rate changes, that lead to changes in the turnover of money
for a period o f time. Changes in the public’s willingness to
hold cash assets, it is evident, are related broadly to move­
ments in economic activity and, hence, are one indicator
of underlying conditions making for expansion or contrac­
tion of the economy.




131

THE FEDERAL RESERVE SYSTEM

Efforts of monetary policy to curb inflationary spending
by limiting expansion o f the money supply are generally
accompanied by more active use of cash balances by the
public. As incomes rise in such a period, however, people
will feel a growing need for transactions cash and it
will become increasingly inconvenient for them to econo­
mize on existing holdings. For this reason mainly, many
economists believe that a rise in velocity in this situation
will approach a definable limit.
Similarly, efforts to stimulate spending by encouraging
expansion of the money supply may be accompanied by a
less active use of cash balances. If economic activity is
declining, expansionary effects of additions to bank
reserves and the supply of money may be weakened by a
rise in the public’s desire to hold cash and by an accom­
panying decline in the velocity o f money. As a result,
countercyclical monetary action may not be accompanied
by a commensurate rise in spending.
With the changing use of cash balances a potential
countervailing force to restrictive or expansive monetary
policy, it is necessarily incumbent on the monetary authori­
ties to pay close attention to money velocity and to weigh
its strength carefully in determining possible actions.
Interest Rate Changes

Changes in interest rates associated with variations in
the money supply influence economic developments. In­
creases or decreases in interest rates, correlated with limita­
tions or expansion of money, affect decisions to spend, to
save, and to lend.
A rise in interest rates makes saving more attractive than
it would otherwise be and capital outlays less attractive,
132




INFLUENCE ON ECONOMIC STABILITY

while a decline in interest rates makes capital outlays more
attractive and saving less so. When the economy is operat­
ing at near-capacity levels and demand pressures are grow­
ing, rising interest rates, to the extent that they encourage a
larger flow of consumer or business saving, set in motion
forces to contain further inflationary expansion of aggre­
gate money demand. In this way the increased flow of
credit available out of current saving weakens the forces
that would otherwise sustain the rise in interest rates.
Restriction on expansion in the supply of money reduces
the extent to which inflationary credit demands can be
satisfied. Insofar as rising interest rates in this situation
lead to a greater preference for interest-earning assets,
however, some additional flow of credit may become
available out of what would otherwise be idle balances.
Such an addition to the flow of available credit tends
to offset somewhat the credit-restraining effects of antiinflationary monetary policy.
When economic activity is at a comparatively low level,
declining interest rates may encourage additional outlays
for goods and services, stimulate demands for credit,
and contribute to rising economic activity.
How

B o r r o w in g R e sp o n d s t o C r e d it C o n d itio n s

The extent to which borrowing is discouraged or en­
couraged by reserve banking policy depends on how
changes in the availability and cost o f credit affect business
and consumer demands for funds and their ability to ob­
tain them. Tightening credit has a restraining effect on
borrowing. This results in part from the greater difficulty
of obtaining loans as lenders find it necessary to make
more selective use of their relatively limited funds and in




133

THE FEDERAL RESERVE SYSTEM

part from the influence on borrower demand of higher in­
terest rates and the stiffening of other loan terms.
In periods when monetary policy is designed to en­
courage rather than restrain credit expansion and spend­
ing, the effects are just the reverse. Interest rates decline
and banks and other lenders seek opportunities to make
loans, and thus encourage spending projects that might
have been discouraged in times of credit restraint.
These effects of changes in the availability and cost ot
credit will not be uniform among borrowers and sectors
of the economy. Some borrowers will be affected more
than others because they rely to a greater extent on credit.
Business

In periods of monetary restraint, banks find themselves
under pressure to restrict their new loans. At the same time,
with market interest rates rising and demand for loans
strong, they have an incentive to raise the interest rates
they charge on new loans.
The pressure on banks to restrict the growth o f their
loan portfolios will lead them to discourage potential
business borrowers in various ways. Banks will ask some
borrowers to accept smaller loans and some to accept
shorter maturities. In other instances, banks may ask custom­
ers to postpone their borrowing altogether. The net effect is
likely to be a curtailment of spending by business. Insofar
as businesses finance inventories with bank credit, new in­
ventory commitments will be curbed. There may also be
cutbacks in planned spending for plant and equipment.
These curtailments in spending may not affect the major­
ity of businesses or the full amount of many loans, but
they will affect some borrowers and the amounts involved
134




INFLUENCE ON ECONOMIC STABILITY

in some loans. In other words, they will affect marginal
borrowers and marginal amounts of loans desired. The
result usually is a smaller increase in spending than
transactors desired rather than an actual contraction in
spending. For this reason, the curtailment in spending is
difficult to observe.
Similar developments will occur at lending institutions
other than commercial banks. In periods of prosperity
when restrictive monetary policy is in force, financial
institutions in general will find that borrowers’ demands
for loans tend to run ahead of the available supply of loan
funds. In part this is a result of basic forces making for ex­
pansion, but in part it represents response to the tightening
situation in bank credit. As banks limit their lending, bor­
rowers seek other sources of funds and this causes tighter
conditions at other institutions.
The brake on borrowing and spending represented by
the lessened availability of loan funds at banks and other
financial institutions will be reinforced by rising rates of
interest on bank loans and on credit generally. The sensi­
tivity of business borrowers to changes in interest rates
varies widely. Businesses borrow in the expectation that
the return from the use o f borrowed funds will exceed
interest costs by a significant margin. When the margin
is large and when it is fairly well assured, moderate in­
creases in interest rates may have little effect on the willing­
ness of a business to borrow. When the margin is smaller
or when the return is less certain, a rise in interest rates
discourages borrowers.
Interest costs are particularly significant in certain fields
of long-term investment, such as industrial and commercial
construction, public utilities, and railroads. In such fields




135

THE FEDERAL RESERVE SYSTEM

comparatively small increases in interest rates can result
in postponement of borrowing to finance capital outlays.
Even in fields where interest costs are less important,
fringe borrowers may be deterred from borrowing when
interest rates rise, and other borrowers may decide to get
along with less credit. The more long-term rates rise under
conditions that seem temporary, the more long-term bor­
rowers will tend to postpone investment outlays because
they expect to borrow later at lower interest costs.
A rise in interest rates not only increases the cost of
long-term borrowing but also influences the utilization of
productive resources through changes in the relationship
between prices of existing capital assets and the cost of
producing new assets. These changes direct some activity
away from production of long-lived, slowly depreciating
capital goods and thereby free resources for an immediate
increase in output of consumer goods or o f producers’
equipment to make consumer goods. 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 of business decisions toward
holding or buying old assets, and adapting such assets to
new uses, as compared with producing new ones.
The relationship between capitalized values of existing
assets and costs of producing new ones is indicated below.
The illustration pertains to an office building with a net
income from rent of $100,000 a year.
Estimated cost of constructing a new
building
Capitalized market value of an existing
building with earnings from rent (net
136




$1,500,000

INFLUENCE ON ECONOMIC STABILITY

o f all current costs and depreciation)
o f $100,000:
If current interest rate, with allow­
ance for risk, is 6 per cent

1,666,667

If current interest rate, with allow­
ance 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
of 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 of real estate would build a
new structure instead of buying an existing building, 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. The economic resources
that would have gone into constructing the new building
would then be available for other uses.
Consumer

Consumers make use o f both short- and long-term
credit. They use short- and intermediate-term credit
mainly to finance purchases of durable goods, home im­
provements, and other services. Most of their long-term
borrowing takes the form o f residential mortgages.
Short- and intermediate-term credit. Various types o f
institutions extend short- and intermediate-term credits
to consumers on fairly standardized terms and at relatively
high and inflexible charges. The bulk of such credit is re­
payable on an instalment schedule. The interest rate that a
consumer financing institution pays for the funds it bor­




137

THE FEDERAL RESERVE SYSTEM

rows is only one of the cost elements in the finance charge
to consumers. Thus, changes in market interest rates in
themselves have less effect on the cost of this type of credit
than they have in other sectors of the credit market.
Interest expense on borrowed funds is nevertheless an
important element in lenders’ total cost and it influences
their willingness to lend. General credit tightness or ease
will be transmitted to consumer credit through changes in
the strictness or leniency of credit standards applied by
institutions granting such credits. The variation of credit
standards affects the volume of new credit extended and
this in turn affects the volume o f consumer credit that is
outstanding.
Mortgage credit. Even though the mortgage market is
less highly organized than are markets for government and
corporate obligations, and interest rates on mortgages are
less sensitive to shifts in supply or demand pressures than
are rates on other securities, the financing available for
home purchases is considerably affected by credit condi­
tions and interest rates.
Some lending institutions increase or decrease sharply
the proportion of lendable funds they are willing to place
in mortgages when interest rates on competing investment
media fall or rise significantly. This tendency may be espe­
cially pronounced for Government-underwritten mortgages
— FHA-insured or VA-guaranteed — because adminis­
trative ceilings on their contract rates make their actual
market rates less flexible than market rates on other media.
As the availability of residential mortgage funds fluc­
tuates, potential borrowers may encounter more or less
difficulty in qualifying for mortgage loans. Borrowing to
buy houses is typically long-term and repayable in monthly

138




INFLUENCE ON ECONOMIC STABILITY

instalments. The ability of a potential borrower to qualify
for a mortgage usually depends on the relationship o f the
monthly payment to his income. The standards that
lenders apply in this respect depend on the availability of
mortgage funds, and standards become more stringent
as the amount of funds available for lending declines.
In addition, any increase in interest rates on mortgages
adds to the monthly payment. Thus marginal borrowers
are no longer able to qualify on the basis of existing loan
standards regarding the relation of the monthly mortgage
payment to monthly income. In periods of monetary re­
straint, when the over-all demand for goods and services
is tending to be excessive, decreases in the amount of
funds available and increases in interest costs tend to
discourage house building, or to encourage preferences for
lower priced houses. In periods of monetary ease, increases
in loanable funds and lower interest rates encourage resi­
dential construction.
H o w N o n b a n k L enders A re A ffected

Changes in credit conditions brought about by mone­
tary policy affect the various types of lenders in credit
markets in diverse ways. Some of these lenders, such as
finance companies and mortgage companies, obtain part
of their funds by borrowing from commercial banks.
Funds from this source will be less readily available and
more expensive in times of credit restraint than in times
of credit ease. As the volume of their borrowing is restricted
and its cost rises, nonbank lenders may find it necessary to
curtail their lending. They will also tend to charge their
customers higher rates of interest on loans or to seek invest­
ments with higher yields.




139

THE FEDERAL RESERVE SYSTEM

In periods of rising interest rates, financial institutions
will find that the value of their existing portfolio of assets
declines, sometimes sharply. In these circumstances, par­
ticularly when the potential capital loss (after tax) is large
relative to the increment to income from new loans, finan­
cial institutions will be reluctant to sell assets in order to
make loans.
The flow of new funds to nonbank lenders in credit
markets depends largely on the saving o f consumers.
Whenever the supply o f saving falls short o f the prevail­
ing demand for it, interest rates will rise. The rise in in­
terest rates tends to be limited, however, by the extent
to which it brings forth saving that would not otherwise
have been made. Motives to save are complex, and the
rate of interest return is only one of a number of incen­
tives. Whether total consumer saving will respond in given
circumstances to changes in interest rates is a matter of
some uncertainty. Nevertheless, changes in interest rates
do have discernible effects on the distribution of the flow
o f consumer saving among various financial investments
and also, to a degree, on the distribution of total consu­
mer saving between financial investments and investments
in capital goods.
In a period when interest rates are rising and monetary
policy is restrictive, an enlarged flow of financial saving
out of current income and its investment in financial
institutions helps correct forces making for inflationary
tendencies. This enables a larger proportion of borrowing
demands to be met out of increased financial saving,
through the facilities of these institutions. This process re­
duces pressures leading to bank credit and monetary ex­
pansion.
140




INFLUENCE ON ECONOMIC STABILITY
S e c o n d a r y E f f e c t s o n S p e n d in g

These initial effects of changes in the flow o f bank credit
and money are succeeded by secondary effects. At a time
when productive resources are intensively utilized, for
example, tightening credit conditions will mean in the
first instance that income payments to individuals do not
increase as they might have. As a result, consumers do
not gain additional money to spend for goods and services,
and the pressure of demand against the supply of goods will
abate.
Curtailed spending for consumer goods and other
finished products in turn will have a dampening effect
on producers’ demands for machinery and other equip­
ment required to make such goods. Consumers and in­
vestors may anticipate these secondary effects and, through
their attitudes and actions, may bring them about more
promptly and in greater degree. In a period of inflationary
pressures such developments work to restore stability in
the economy.
On the other hand, in a period when the total demand
for goods and services tends to be deficient, the initial
stimulation to spending that arises from easier credit con­
ditions will likewise be multiplied. Increased activity
arising from credit ease will add to the volume o f money
income available for subsequent spending, thereby ex­
panding the demands of consumers for goods and services
and strengthening business incentives to improve and add
to production facilities.
M o n e t a r y P o l ic y a n d G r o w t h

This chapter has described how the economy responds
to reserve banking efforts to maintain economic stability.




141

THE FEDERAL RESERVE SYSTEM

It has dealt primarily with responses to countercyclical
monetary policies — that is, with responses to a restrained
expansion in bank credit and money during inflationary
periods and to an encouraged expansion in periods of
economic recession.
In contributing to economic stability at high levels of
employment, monetary policy helps to create a favorable
environment for sustainable long-term growth. The rate
of growth of the economy over time depends in large part
on the extent to which resources are devoted to produc­
tion of goods and services that will increase both pro­
ductivity and total output in the future. Thus, it hinges on
the saving-investment process, described in Chapter VI.
That is, the volume of available resources dedicated to
raising future output and income depends on the nation’s
willingness to save and invest.
In our free society, choice in the use of resources is
made in part through public decisions as to taxation and
governmental spending, but it depends for the most part
on decisions of a multitude of individuals and businesses
expressed in competitive bidding in the market for goods,
services, and financial assets. Efforts by the reserve banking
authorities to minimize cyclical fluctuations and to encour­
age relative stability in average prices help to create an
environment in which the economy will be able to grow at
a pace consistent with the aspirations and energies of the
people.
Over the longer run, bank credit and money need to
expand sufficiently to facilitate whatever rate of economic
growth is consistent with the public’s investment and sav­
ing tendencies at high levels of employment. The appro­
priate rate of expansion in bank credit and money will be
142




INFLUENCE ON ECONOMIC STABILITY

influenced by the share of bank credit in total credit and
by changing habits of the public with respect to the kinds
of assets in which they hold liquidity. Thus, while mone-

GROSS NATIONAL PRODUCT AND
•

.......

■■ ■ ...
■■
■

M O N EY SUPPLY

RATIO OF G N P TO M O N E Y S U P P L Y
I N C O M E V E L O C I T Y OF M O N f T

tary authorities adapt their policies to continuing shortrun changes in economic conditions, they must also keep
in mind the public’s long-run needs for cash balances.




143




CHAPTER VIII

SUPERVISORY FUNCTIONS OF THE FEDERAL RESERVE, By keeping individual banks strong, bank supervision
helps to maintain an adequate and responsive banking system and
thus contributes to the smooth functioning o f economic processes.

E

FFECTIVE operation of individual banks is essential
to the orderly functioning o f the banking system. The
current financial needs of commerce, industry, and agricul­
ture are met in part through loans and investments made
by individual banks, and the bulk of the nation’s payments
are made through the checking accounts generated by these
lending and investing activities, as explained in earlier
chapters. As a factor of instability, failure of banks to meet
their liabilities can reach far beyond depositors and bor­
rowers and the immediate territory that the banks serve.
The business of 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




145

THE FEDERAL RESERVE SYSTEM

to the American banking system: first, a large number of
commercial banks differing greatly in size and in the type
of banking service offered; and second, the wide variety of
detailed State and national banking laws, and regulations
issued under these laws.
Fundamentally, bank supervision is directed to safe­
guarding and serving the community’s interest. In relation
to individual banks, the objective is to foster the mainte­
nance of each in sound and solvent condition and under
good management, in order to protect depositors and to
assure uninterrupted provision of essential banking serv­
ices. With respect to all banks, a further objective is to
help maintain a competitive banking system that will
adapt continuously and responsively to the financial needs
o f a growing economy.
Four groups have a direct and vital interest in bank
supervision: the banks subject to supervision; the cus­
tomers who have entrusted banks with their deposits and
who look to banks for credit accommodation and other
financial services; the investors who have purchased bank
stock; and those whose task it is to administer the super­
visory function.
Compass o f Bank Supervision

As a governmental activity, bank supervision encom­
passes a wide variety of technical functions relating to the
operations of banks. These concern the issuance and
enforcement of supervisory and other regulations; the
organization and chartering of banks; the periodic exami­
nation of banks and the requiring of steps by bank man­
agement to correct unsatisfactory or unsound conditions
found through such examination; the review and analysis
146




SUPERVISORY FUNCTIONS

of periodic reports of condition and o f earnings and
expenses; and the rendering of counsel and advice on bank
operating problems when requested, particularly in the
case of smaller banks.
In addition, bank supervision deals with approval of
proposed changes in the scope of corporate functions
exercised by individual banks and o f proposed changes
in their capital structures; authorization of branches and
of the exercise of trust powers; approval of bank mergers
and consolidations; regulation of bank holding com­
panies; and liquidation of banks, including the appoint­
ment of a conservator under certain conditions or a
receiver in other circumstances.
While bank supervision encompasses a wide variety of
technical functions that relate to the full life cycle of a
banking institution, its chief preoccupation is with banks
as going concerns. The main objective is to protect the
banking structure against weakness of the component
banks and whenever possible to assist them in becoming
stronger units. A complementary aim is to prevent undue
concentration of banking ownership and power.
Given these aims, the major responsibility of supervisory
authorities is to keep informed of the condition, opera­
tions, and management of the banks subject to their review
and to contribute to the prevention or correction of un­
sound situations.
Role o f Bank Examination

Bank examination is the best known form of supervisory
activity. Its purpose is to develop information that will
disclose the current financial condition of the individual
bank, ascertain whether the bank is complying with




147

THE FEDERAL RESERVE SYSTEM

applicable laws and regulations, and indicate the bank’s
future operating prospects.
The bank examiner in the field, therefore, is primarily a
fact finder and an appraiser. His duty is to report the facts
as he finds them and, if conclusions are to be drawn as to
asset quality, capital adequacy, and management perform­
ance, to base these conclusions on established facts.
Examination steps include verification of a bank’s assets
and proof of its liabilities; analysis and appraisal of its
assets; analysis of its liabilities; review and appraisal of
its management; review of the administration of its trust
department activities; determination of its capital and
liquidity position and operating trends; study of the bank’s
position in relation to community as well as general busi­
ness conditions; and consideration of the bank’s perform­
ance in the light of various statutory and regulatory
limitations affecting the conduct of its business.
In the light of examiners’ findings, the supervisory
authority formulates and expresses the appropriate super­
visory policy and prescribes such steps as may need to be
taken to correct criticized phases of a bank’s affairs. The
supervisory policy expressed and the corrective measures
prescribed for a particular bank necessarily reflect the com­
posite experience of the supervisory authority in examining
and supervising many banks over many years.
Uses of the examination information are threefold. In
the first place, the banking authorities make it the basis
of supervisory policy and action with respect to particular
institutions, including decisions whether to approve
branches, mergers, or competing bank charters. Second,
the directors and officers of examined banks use it as the
basis of action to strengthen their banks as well as to
148




SUPERVISORY FUNCTIONS

prevent future difficulties. Third, information accumulated
from many examinations guides the authorities in framing
or revising regulations and in shaping or reshaping super­
visory policies. Information derived from examination
processes has at times pointed the way to necessary or
desirable changes in banking laws. The data thus obtained
are an essential part of the nation’s economic intelligence.
Governmental Agencies Concerned with Supervision

The complex nature of this country’s banking system is
reflected in, and is in part the product of, the governmental
structure of bank supervision. State banks are chartered
by and operate under the laws of any one of the 50
States. National banks in all States and the District of
Columbia operate under Federal banking law, with mem­
bership in the Federal Reserve System mandatory. Sys­
tem membership is also available to State banks that meet
membership qualifications. A system of Federal insurance
of deposits is applicable to all member banks and to others
that desire and qualify for insurance
In such a structure of bank supervision there are neces­
sarily cases of overlapping responsibilities and functions.
All o f the supervisory authorities have similar basic objec­
tives, however, and by cooperating with each other in
developing effective working arrangements they have been
able to avoid much of the seeming duplication in activities.
Federal Government legislation to deal with 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 of the Currency, a bureau
of the Treasury Department established in 1863, has




149

THE FEDERAL RESERVE SYSTEM

charter and supervisory authority with respect to the
national banks of the country.
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 its members and also with
respect to all bank holding companies. In practice, the
System confines its field examinations to State member
banks and, whenever practicable, such examinations are
made jointly with State supervisory authorities.
The Federal Deposit Insurance Corporation, established
in 1933, has supervisory authority in connection with its
responsibility to insure deposits of Federal Reserve mem­
ber banks and of other banks that voluntarily become
members of the Corporation. The Corporation in practice
examines only those insured banks that are not subject
to examination by another Federal supervisory agency.
Scope o f System Supervisory Functions

The supervisory functions of the Federal Reserve are
varied. Its responsibilities in this area are concerned par­
ticularly with admission of State banks to membership
in the System; the field examination of State member
banks and review of operations of all member banks; the
correction of unsatisfactory conditions in or violation of
banking law by State member banks, including, if neces­
sary, disciplinary action to remove officers and directors
for unsafe or unsound banking practices or for continued
violation of banking law; and the issuance and enforce­
ment of regulations pertaining to member banks.
Other Federal Reserve supervisory functions include
authorization of national banks to exercise trust powers;
150




SUPERVISORY FUNCTIONS

approval of the establishment of branches or absorption
of other banks by State member banks; permission to
holding companies to acquire stock of banks and to vote
stock in member banks; chartering o f foreign banking and
financing corporations; granting permission to member
banks to engage in banking in foreign countries; and super­
vision related to regulation of loans by banks, brokers, and
dealers in securities for the purpose of purchasing or carry­
ing of stocks registered on national securities exchanges.
In carrying out these functions the Federal Reserve
authorities deal with complex and highly technical bank­
ing questions. For example, in passing upon an application
for approval of a proposed acquisition of bank shares
under the Bank Holding Company Act, the Board is
required to consider the financial history, condition, and
prospects of the institutions concerned; the character o f
their respective managements; the convenience, needs, and
welfare of the communities and area served; and whether
or not the effect of the acquisition would be to expand the
size or extent of the particular bank holding company
system beyond limits that are consistent with adequate and
sound banking, the public interest, and the preservation of
competition in the field of banking.
Under a policy of decentralization, the Board of Gov­
ernors has delegated to the Federal Reserve Banks some
phases of the field work involved in Federal Reserve super­
visory activities, notably the bank examination function.
The Board of Governors, however, directs and coordinates
the supervisory work of 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




151

THE FEDERAL RESERVE SYSTEM

Comptroller of the Currency, the Comptroller’s District
Chief Examiners furnish the Reserve Banks with copies
of reports of examinations of all national banks in their
respective districts, and in this way the two agencies avoid
duplicating examinations. Inasmuch as State member
banks are subject to examination by State supervisory
authorities, the Reserve Banks and these authorities co­
operate, whenever feasible, in joint or alternate examina­
tions. The established policy is for a Federal Reserve Bank
to conduct one regular examination o f each State member
bank every calendar year.
Bank Supervision and Monetary Policy

It is sometimes suggested that bank supervisory stand­
ards be adjusted flexibly to help in counteracting cyclical
instabilities in the economy. This suggestion would call
for a firming of examination and other supervisory stand­
ards in periods of inflationary or speculative boom and a
relaxation in periods of recession.
In considering this suggestion one should bear in mind
that bank supervision involves recurrent, and not con­
tinuous, inspection of individual banks and by its nature
entails a complex set of procedures evolved over many
years. Such a process scarcely accommodates itself to a
raising or a lowering o f examination standards in response
to changing economic conditions.
At the same time bank supervisory authorities are fully
aware that banking difficulties have at times in the past
intensified economic instability and that the risk of a
recurrence should be reduced. Accordingly, modem super­
visory appraisal of bank assets emphasizes sustainable
banking values rather than current market values. In this
152




SUPERVISORY FUNCTIONS

way, bank supervisory authorities and examiners try to
exclude from bank asset valuation the transitory influences
associated with economic fluctuations. All of the govern­
mental agencies concerned now use this approach to bank
supervision and examination.
As a result of this common approach, the interested agen­
cies have a greater uniformity o f supervisory policy than
they could achieve if examination standards were varied
countercyclically. Furthermore, by assuring equitable
treatment of different banks in different areas and over
time, the approach fosters public respect for bank supervi­
sion as a nondiscriminatory process. It also permits super­
visory regulations and requirements to be coordinated so
that individual banks are not handicapped or deterred in
making adjustments to changes in the banking environ­
ment.
While the general instruments of reserve banking are
the appropriate means for influencing economic stability
through credit policy, bank supervision contributes to
maintenance of stability through its effect on the internal
strength of banks. To the extent that bank supervision
helps individual banks under competent management to
remain strong, it makes for an effective and responsive
system of banks and enables banks to weather adverse con­
ditions and serve their communities constructively in bad
times as well as good.




153




CHAPTER IX

RELATION OF RESERVE BANKING TO CURRENCY.
The Federal Keserve is responsible fo r providing an elastic supply
o f currency'. In this function it pays out currency in response
to the public's demand and absorbs redundant currency.

A N important purpose of the Federal Reserve Act was
j f j L to provide an elastic supply of currency—one that
would expand and contract in accordance with the needs
o f the public. Prior to 1914 the currency consisted princi­
pally of Treasury notes secured by gold or silver and of
national bank notes secured by specified kinds of U. S.
Government obligations. These forms of currency were so
limited in amount that additional paper money could not
easily be supplied when the nation’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 develop­
ments, caused several financial crises or panics. One o f the
tasks of the Federal Reserve is to prevent such crises by
providing a kind of currency that responds in volume to




155

THE FEDERAL RESERVE SYSTEM

the needs of 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, a representative of
the Government, who is located at the Federal Reserve
Bank and has custody of its unissued notes.
The Reserve Bank obtaining notes must pledge with the
Federal Reserve Agent an amount o f collateral at least
equal to the amount of notes issued. This collateral may
consist of gold certificates, U. S. Government securities,
and eligible short-term paper discounted or purchased by
the Reserve Bank.1 The amount o f notes that 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 the total of its Federal Reserve notes in circulation
and its deposit liabilities. Gold certificates pledged as col­
lateral with the Federal Reserve Agent and gold certificates
deposited by the Reserve Bank with the Treasury of the
United States as a redemption fund against Federal Re­
serve notes both count as such reserves.
As our monetary system works, currency in circulation
increases when the public’s needs become larger and de­
clines when they become smaller. In the latter case mem­
ber banks, on receipt of currency from their depositors,
redeposit it with the Federal Reserve Banks, receiving
1 Gold certificates include those on hand or due from the Treasury of
the United States and recorded in the gold certificate fund.

156




RELATION TO CURRENCY

credit in their reserve accounts. The Reserve Banks can
then turn it over to the Federal Reserve Agents and redeem
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

KINDS

OF

JUN E

FORMS

CURRENCY
30,

1960

DENOMINATIONS

other kinds of currency are Treasury currency. Treasury
currency includes United States notes (a remnant of Civil
War financing), various issues of paper money in process
of retirement, silver certificates, silver coin, nickels, and
cents.




157

THE FEDERAL RESERVE SYSTEM

Since Federal Reserve notes are not issued in denomina­
tions smaller than $5, all of the $1 and $2 bills, as well as
some bills of larger denominations, are in other forms of
paper money, chiefly silver certificates and United States
notes. At mid-1960 the total amount of currency in circu­
lation was $32.1 billion, of which $27.1 billion was Federal
Reserve notes. Of the remainder, the largest amount con­
sisted 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 refer­
ence will be made to the total of currency in circulation
rather than to any particular kind.
Demand fo r Currency

It has already been stated that the amount of 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 of the week, for differ­
ent days of the month, and for different seasons. In agricul­
tural regions, need for currency is heavy at times when
crops are being harvested. Throughout the country the
need 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 before Christmas, when cash is used for Christmas
shopping and as gifts.

158




RELATION TO CURRENCY

After the holidays 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 on bank oper­
ations of holiday movements of currency, when they occur
at a week-end or month-end, is sometimes offset by other
influences.

In addition to seasonal changes in the demand for cur­
rency, there are changes that reflect variations in business
conditions. When business activity is rising, the need for
currency to make payments increases, and when business
activity declines, the need also declines. While most pay­
ments in this country are made by check, some types of
payments are made principally in currency. The most im­




159

THE FEDERAL RESERVE SYSTEM

portant of these are payments in retail trade and payrolls.
Statistical studies show that the amount o f currency in
circulation fluctuates in response to changes in the volume
of these two kinds of payments.
In 1941-45, during the war, the amount of currency in
circulation increased greatly in response to a variety of
influences: the growth of payrolls, retail trade, and travel;
many and widespread changes in places of residence; pay­
ments to members o f 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 circulation remained extraordinarily large.
Following the Korean crisis and the undertaking of a
large rearmament program in the early 1950’s, demand for
currency again strengthened. Over the ensuing years, the
amount in circulation has continued to expand gradually.
Effect o f Note Circulation on Federal Reserve Position

From the point o f view of the Federal Reserve and
member banks, changes in currency in circulation have a
special significance that arises out of the system o f reserve
requirements. As has been explained, reserve requirements
are expressed as percentages of bank deposits. If someone
borrows, say, $1,000 from a 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 by
only a fraction of this amount—for example, $200 if re­
quired reserves are assumed to be 20 per cent.
If, on the other hand, the borrower wishes to withdraw
the proceeds of the loan in currency and the member bank
has insufficient currency in its till, it must obtain the cur­
160




RELATION TO CURRENCY

rency from the Reserve Bank. The Reserve Bank will
charge the full am ount withdrawn to the member bank’s
reserve account, and the reserves of the bank—as well as
those of the banking system as a whole—will decline by
the full $1,000.
If the banking system had no excess reserves, it would
have to obtain additional reserves whether the loan were

C U R R E N C Y A N D FEDERAL RESERVE CREDIT
B il lio n s o f d o l l a r s

1959

I9 6 0

accompanied by an increased demand for checking de­
posits or for currency. The additional am ount o f reserves
needed, however, would differ. The increase would be only
$200 in the case o f the demand for $1,000 of checking
deposits, while it would be $1,000 in the case o f demand
for an equal am ount of currency. The Federal Reserve
could supply the reserves by buying an equivalent am ount




161

THE FEDERAL RESERVE SYSTEM

o f Government securities in the open market, if this were
considered desirable, or it could lend the needed funds to
member banks. Whichever procedure was followed, Fed­
eral Reserve credit — that is, Reserve Bank holdings of
discounts and securities — would increase.
Because the increase in demand for Federal Reserve
credit is so much larger 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, changes in
currency in circulation 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 of reserves in gold certificates against their Federal
Reserve notes in circulation as against their deposits (25
per cent). When the public’s demand is for $1,000 in cur­
rency, the Federal Reserve Banks pay out that amount of
Federal Reserve notes — and their reserve requirements
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, are required to increase by only $200 and the
reserves needed by the Reserve Banks increase by only $50
(25 per cent of $200). Under the circumstances assumed an
increase in currency would tie up five times as much of
the Reserve Banks’ reserves as would 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
162




RELATION TO CURRENCY

to the character o f the demand for such credit and, in
the interests o f economic stability, must be adapted to it.
It was principally because of the large growth in currency
in circulation during the war that the Federal Reserve
Banks’ ratio o f reserves to combined note and deposit
liabilities declined to a point where in 1945 it threatened
to impinge upon the Federal Reserve’s freedom o f policy
action. In these circumstances the 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 o f the public and absorbs any currency
the public does not need, it should not be concluded that
the volume of currency in circulation is free o f influence
by the Federal Reserve. The policies pursued by the
Federal Reserve affect the total volume of money in the
economy — that is, the amount o f currency in circulation
plus the amount of checking deposits. Thus, in providing
the economy with an elastic currency, the Federal Reserve
must endeavor to see that the two forms of money to­
gether are appropriately related to the volume of produc­
tion and trade. This means that their combined total
should neither be so large as to foster an excessive demand
for goods nor so small as to cause a deficiency in aggregate
demand.




163




CHAPTER X

RELATION O F RESERVE BANKING T O GOLD . Cold
and Federal Reserve credit are the principal sources o f member
bank reserves. Gold inflows reduce reliance o f banks on Federal
Reserve credit, and gold outflows increase it. Changes in

th e

countrys monetary gold stock are reflected in Federal Reserve
holdings o f gold certificates.

HERE are two main ways in which Federal Reserve
operations and policies are related to gold. First, re­
serves in gold, a generally accepted means of payment be­
tween nations, constitute a statutory base for Reserve Bank
power to create Federal Reserve credit. Second, the flow
of gold between the United States and other nations affects
the volume of member bank reserves and the use of Federal
Reserve credit as well as the reserves of the Federal Re­
serve Banks. Changes in the nation’s gold reserve po­
sition, along with the underlying causes of the changes,
are thus matters to be taken into account in determination
of reserve banking policy.
In the monetary system of the United States, the Treas­

T




165

THE FEDERAL RESERVE SYSTEM

ury is custodian o f all m onetary reserves held in the form
of gold. Reserves of the Federal Reserve Banks take the
form of certificates representing the gold. As a technical
matter, therefore, Federal Reserve holdings of gold certifi­
cates are a statutory base for its power to expand or ex­
tinguish Federal Reserve credit.
CHANGES IN 0 . S. GOLD STOCK
Billions of dollars

U nder existing law the Reserve Banks m ust hold a
stipulated proportion of gold certificates as reserve against
their liabilities for notes and deposits, respectively. The
legal gold ratio is 25 per cent for each category of liabilities.
In all but two years o f the System’s history, its actual gold
ratio has run well above the ratio required at the time by
law. Thus, the Reserve Banks have generally possessed a
substantial margin of what may be called “ free” gold, that
166




RELATION TO GOLD

is, gold in excess of the prescribed percentage of liabilities.
Also, the Board of Governors has always had authority to
suspend temporarily the reserve requirements of the Re­
serve Banks, subject to a tax on the deficiency.
Most changes in our country’s gold stock are the result
of transactions with foreign countries. When gold flows
out of the monetary system, the member banks have a need
for Federal Reserve credit if they are not to suffer a cor­
responding contraction in their reserve funds. This credit
is usually provided either by System open market oper­
ations or by member bank discounting at the Reserve
Banks. When gold flows into the monetary system, ad­
ditional reserves become available to member banks. This
reduces the need for Federal Reserve credit. In fact,
Reserve Bank credit may decline by the amount of the
gold inflow. This chapter explains in more detail the rela­
tionship between gold, member bank reserves, and reserve
banking policy.
Gold as Reserve Money

In the U.S. monetary structure the standard unit of
value — the dollar — is defined by statute as a weight of
gold. Gold, however, is not coined into money, and cur­
rency based dollar for dollar on gold, represented by gold
certificates, does not enter into circulation with the public
or into member bank reserves. Under the Gold Reserve
Act of 1934, private persons subject to U.S. jurisdiction
are not permitted to hold any gold in monetary form. Gold
nevertheless functions without restriction as reserve money
of the Federal Reserve Banks. It also functions as a means
of settling international balances. These relationships make
up our modified gold standard.




167

THE FEDERAL RESERVE SYSTEM

All of the gold entering the monetary mechanism be­
comes reserve money of the Reserve Banks, not directly
as gold but in the form of gold certificates or of credits in
a gold certificate liability account maintained on the books
of the U.S. Treasury. The Treasury buys monetary gold
at a price of $35 an ounce, minus a handling charge of %
of 1 per cent. It pays for this gold by drawing on its de­
posit account at the Reserve Banks. Against the gold
acquired, the Treasury credits an equivalent amount to the
gold certificate account, thus providing the basis for re­
storing its deposit account at the Reserve Banks.
The Treasury must hold gold at the rate of $35 an ounce
for all the gold certificates that it issues or credits to the
gold certificate account.1 Consequently, while the title to
the gold is in the Government, the greater part of it is
held as cover for gold certificates. The gold certificates
issued to the Reserve Banks or credited to their account
constitute their reserves and may not be used for any other
purpose. Only the Reserve Banks are permitted by law to
own gold certificates, and these certificates may not circu­
late outside the Reserve Banks.2
In addition to its responsibility as a buyer and holder
of monetary gold, the Treasury stands ready to sell gold
to foreign monetary authorities for the settlement of inter­
national balances at a price of $35 an ounce, plus a
handling charge of V of 1 per cent. Indeed, from the
4
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 $30 million of gold certificates issued before the Gold Reserve
Act of 1934, and not turned in to the Treasury when gold and gold certifi­
cates were withdrawn from circulation, are still regarded as outstanding in
the official statistics 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.
168




RELATION TO GOLD

point o f view of the United States, purchases and sales of
gold by the Treasury are an important part o f the mecha­
nism by which fluctuations o f exchange rates for the dollar
in terms o f other currencies are limited to a narrow
range.
Through these transactions, foreign monetary authorities
may convert dollars into gold, to increase their own gold
reserves or to use in international payments. Similarly,
foreign monetary authorities can always acquire dollars
when desired by selling gold to the Treasury. The Treasury
conducts most of its gold transactions through the Ex­
change Stabilization Fund.
At the end o f June 1960, the Treasury held $19.4 billion
o f gold. Of this amount $19.0 billion was cover for gold
certificates held by or for the Reserve Banks. Another $156
million was held as the statutory reserve against United
States notes and Treasury notes of 1890. Of the remainder,
$107 million was in the general fund of the Treasury and
so at its free disposal, while $30 million was cover for gold
certificates still in circulation. Another small amount, $40
million, was in the working balance of the Treasury’s
Exchange Stabilization Fund.
How Gold is M onetized

The process by which gold produced in the United
States or sold by foreign holders reaches the Treasury and
is reflected in additions to the reserves of member banks
and Federal Reserve Banks is described below.
The gold is taken to a U.S. assay office or to a U.S. mint.
If the seller is a domestic producer, the Treasury pays for
the gold by check. The seller will deposit this check with
his bank, usually a member bank, which in turn de­




169

THE FEDERAL RESERVE SYSTEM

posits it with a Reserve Bank, where it is added to the
member bank’s reserve balance and charged to the ac­
count of the Treasury. The Treasury will replenish its
account by crediting an equivalent amount to the System’s
gold certificate account and this is credited to the appropri­
ate Reserve Bank. Assume that the gold is worth $10
million. Then the gold stock of the Treasury, the gold
certificate account o f the Reserve Bank, the reserve balance
of the member bank, and the bank deposit of the seller of
the gold will each increase by $10 million.
For many years movements of gold into and out of this
country’s monetary reserves have reflected almost exclu­
sively transactions with foreign reserve banks and govern­
ments. When a foreign official authority sells gold, the
payment is made on the books of the Federal Reserve Bank
o f New York by transfer from the account of the Treasury
to the account of the foreign authority, and there is no
immediate increase in member bank reserve balances and
deposits. Such increases will occur, however, when the
foreign official authority draws on its deposit account at
the New York Bank to provide funds for goods and serv­
ices bought in American markets, to invest in money mar­
ket assets, or to transfer funds to commercial banks for
other reasons.3 The ownership of the newly gained gold
certificate reserves becomes distributed among the Reserve
Banks as a result of these various transactions.
On the other hand, when a foreign monetary authority
3 Foreign deposits with Federal Reserve Banks are relatively small and
generally kept at a minimum needed for working purposes. Most of these
deposits are at commercial banks. In considering the effect of foreign
factors on member bank reserves, changes in foreign deposits at the Federal
Reserve must be considered along with gold flows. A rise in such deposits
is a factor absorbing reserves, while a decline is a factor increasing reserves.
17 0




RELATION TO GOLD

wants to acquire, say, $10 million in gold, it instructs the
Federal Reserve Bank of New York to transfer that amount
from its account with the Bank to the Treasury’s account.
At the same time the Reserve Bank, as fiscal agent for the
Treasury, debits the gold certificate account by $10 million
and transfers that amount of gold to the foreign authority.
As a result of these transactions, the gold certificate account
of the Reserve Bank and the gold holdings of the Treasury
each decline by $10 million.
Prior to actual purchase of the gold, the foreign authority
will usually increase its account with the Reserve Bank by
transferring the needed amount from the market, either
from already existing deposits with member banks or from
funds acquired through the sale of Treasury bills or other
investments it had been holding. In either case both the
deposits of member banks and their reserve balances will
be reduced by an equal amount.
For use in balancing their international accounts, foreign
reserve banks and governments hold large amounts of
dollar assets in various forms, mainly short-term U.S.
Government securities. As already indicated, they hold
relatively small demand deposits with the Federal Reserve
Bank of New York.
Gold transactions with foreign countries are effected
regularly without a physical movement of gold into or
out of this country. A foreign monetary authority may
purchase gold in the United States and have it “earmarked,”
or segregated, for its account at the Federal Reserve Bank
of New York. Under such an arrangement the gold is
physically held in that Reserve Bank. Conversely, a foreign
authority may sell some of its earmarked gold to the U.S.
Treasury.




171

THE FEDERAL RESERVE SYSTEM

Earmarked gold belongs to foreign authorities. It is not
a part of the monetary gold stock of the United States.
Foreign purchases of gold to go into, and sales of gold to
come out of, earmarked accounts have the same effect on
our banking system as foreign purchases of gold for export
and foreign sales of newly imported gold. Transactions
involving earmarked accounts are spoken of as gold move­
ments.
The processes of monetizing gold described above are
essentially the same as they were when the Reserve Banks
actually held gold. 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 certificate account
on the books of the Treasury. The altered procedure has
not changed in any significant respect the ultimate effects
of gold flows on the reserves of Reserve Banks and member
banks and on bank credit and the total money supply.
Gold in International Payments

Movements of gold from one country to another are the
ultimate means by which international balances are settled.
On one side of the account are receipts from sales to
foreigners of commodities, services, and financial assets;
and on the other side are payments for commodities, serv­
ices, and financial assets bought from foreigners, as well
as payments resulting from U.S. Government grants and
loans.
If, after all of these items have been taken into account,
there is a balance due to the United States from abroad,
foreign countries may settle it in three ways: by drawing
down dollar deposits in U.S. banks, by selling additional
172




RELATION TO GOLD

financial assets or borrowing in U.S. markets, or, as an
ultimate resort, by selling gold to the U.S. Treasury. A
balance due to foreigners, on the other hand, leads to an
increase in foreign dollar holdings (including deposits and
other financial assets), unless the foreign country converts
all or part of the increase into gold.
Whether a foreign monetary authority will decide to let
its balance of international payments affect its dollar hold­
ings or its gold holdings will depend largely on its estab­
lished practices with regard to the form of its reserves.
Some countries, such as the United Kingdom, Belgium,
the Netherlands, and Switzerland, have made a practice of
holding all of their reserves in excess of working balances
in the form of gold. Any substantial short-run change in
their official dollar account, therefore, has been promptly
reflected in purchases or sales of gold. Some other coun­
tries have held part of their reserves in gold and part in
dollars; still others have found it advantageous to hold
most of their reserves in dollars.
In postwar years the balance of international transac­
tions has sometimes been in favor of foreign countries,
and sometimes — though less frequently — in favor of the
United States, as the chart on the following page shows.
Movements of gold into and out of the United States and
changes in the U.S. gold stock have generally reflected this
balance: when favorable, gold has flowed in; when un­
favorable, gold has flowed out.
Since early 1958 large amounts of gold have moved
abroad. The amounts have varied both with the total net
balance due to foreign countries and with the reserve
practices, just mentioned, of the individual countries to
which net balances were due. An additional cause o f varia­




173

THE FEDERAL RESERVE SYSTEM

tion in gold movements has been the desires of private
foreign persons to decrease (or increase) their dollar hold­
ings, causing an increase (or decrease) in foreign official
dollar accounts and therefore sometimes in purchases of
gold from (or sales to) the United States.
U. S. B A L A N C E OF P A Y M E N T S

The emergence in recent years of large net balances due
to foreigners can be traced to both structural and cyclical
elements. The improved competitive position of foreign
industrial countries has changed the structure of world
trade. Large investment outlays and rapid technological
174




RELATION TO GOLD

advances have enabled many foreign countries to offset
the advantages the United States enjoyed immediately
after World War II. Moreover, most countries of the free
world have restored stable monetary conditions.
The net balance of international transactions also tends
to reflect differences in cyclical fluctuations as between the
United States and foreign countries. For example, when
economic activity expands more rapidly in the United
States than it does abroad, payments to foreign countries
for imports are likely to increase faster than receipts from
foreign buyers for exports. On the other hand, when eco­
nomic activity expands more rapidly abroad, U.S. receipts
from exports are likely to rise relative to payments for
imports.
Gold and Federal Reserve Operations

It has been shown that gold purchases or sales by the
United States increase or decrease the reserves of Reserve
Banks. It has also been shown that, disregarding transitory
lead-and-lag effects associated with the use by foreign
official authorities of deposit accounts at Reserve Banks,
gold purchases or sales by the Treasury affect the reserve
position of member banks and hence their ability to make
loans and investments and expand their deposits.
The ultimate effect on member bank reserves of gold
movements is thus the same as that of Federal Reserve
open market or discount operations. When gold flows in,
it increases member bank reserves in the same way as
would an equivalent amount of open market purchases
or discounts by the Reserve Banks; when gold flows out,
it diminishes member bank reserves in the same way as
would the repayment of a discount by a member bank or




175

THE FEDERAL RESERVE SYSTEM

the sale o f a security by a Reserve Bank. This is why
demand for Reserve Bank credit tends to diminish when
gold comes in and to increase when gold goes out. Some­
times the Federal Reserve makes loans on gold to foreign
reserve banks. When the proceeds of such loans are dis­
bursed, this has the same effect on credit conditions in this
country as any other advance by a Reserve Bank.
The Federal Reserve’s holdings of “free” gold reserves
enable it to offset, when desirable, the credit and monetary
effects of any outward movement of gold. Offsetting oper­
ations can be accomplished through open market trans­
actions in combination with discount operations, or
through changes in reserve requirements. Thus, a cushion
of Federal Reserve “free” gold reserves minimizes the
extent to which gold outflows might interfere with reserve
banking policies to influence the flow of credit and money
in the interest of economic stability.
Changes in the nation’s gold reserve position have a
bearing on longer run monetary stability and, hence,
need to be taken into account in policy determination.
Reserve banking policies over a period of years, by helping
to avoid inflation in this country, can contribute to balanc­
ing our international receipts and payments and thus to
avoiding excessive gold movements.

176




CHAPTER XI

BALANCE SHEET OF THE FEDERAL RESERVE BANKS.
Federal Reserve Junctions are reflected in the consolidated balance
sheet o f the Reserve Banks, known as the weekly condition state­
ment. This statement shows how much Federal Reserve credit is
being used and the key items that account fo r its use.

AJOR reserve banking functions are reflected in
the combined balance sheet of the twelve Federal
Reserve Banks. The balance sheet, one of the most com­
plete statements of its kind, is released every Thursday
and shows the condition of the Reserve Banks at the end
o f the preceding day. The statement, known generally as
the weekly condition statement, appears in the Friday
issue of the principal daily newspapers of the country and
is usually accompanied by explanatory comment.
The Federal Reserve condition statement is necessarily
complex because its purpose is to provide an accounting
summary of all phases of Federal Reserve operations and
to show, in some detail, the use of Federal Reserve credit.
The nation’s demand for money converges on commercial

M




177

THE FEDERAL RESERVE SYSTEM

banks, especially the member banks, and through them on
the Reserve Banks. Accordingly, much can be learned
about current banking and financial trends by following
changes in the principal items of the statement from week
to week.
The combined balance sheet of the Federal Reserve
Banks for June 29, 1960, in condensed form, is presented
on the following page, with major items identified by
capital letters. Explanation of its items provides both a
review of many important points made in earlier chapters
and an opportunity to mention some technical aspects of
Federal Reserve operations not heretofore dealt with.
Explanation o f Asset Accounts
1. G o l d C e r t i f i c a t e R e s e r v e s . Although the law does
not permit the Federal Reserve Banks to own gold and
the circulation of gold certificates is forbidden, the law
does authorize the Treasury to issue gold certificates to
the Reserve Banks. The major portion of the gold certifi­
cate reserves consist of 'credits on the books of the Treas­
ury payable in gold certificates. These credits include the
gold certificate fund in the name of the Board of Governors
and the redemption funds for Federal Reserve notes, which
the Reserve Banks are required by law to maintain on
deposit in the Treasury.
2. Federal Reserve notes of other Reserve Banks. When
one Reserve Bank receives notes of another Reserve Bank,
it may pay them into circulation if fit. If they are not fit
for further circulation, it forwards them to the U.S.
Treasury for retirement. This item represents notes held
temporarily or in transit to Washington for retirement.
3. Other cash is coin and paper money (other than gold

178




BALANCE SHEET OF RESERVE BANKS

certificates and Federal Reserve notes) in the Reserve
Bank vaults.
C o m b in e d B a l a n c e S h e e t o f t h e R e s e r v e B a n k s

June 29, 1960
Millions
of dollars
ASSETS

1.
2.
3.
4.
5.
6.

G o ld C e r tific a te R e se rv e s ..................................................

Federal Reserve notes of other Reserve Banks....................
Other cash...............................................................................
D isc o u n ts f o r Member B a n k s .............................................
Other discounts and advances...............................................
Acceptances..............................................................................
7. U.S. G overnment Securities................................................
8. Cash items in process of collection........................................
9. Other assets.............................................................................
T o t a l A s s e ts ...............................................................

19,029
350
366
267
28
26,219

5,499
350
52,109

LIABILITIES

10. F e d e r a l R eserve N o te s .........................................................
11. D eposits:

27,421

(a) Member bank reserves.............................................
(b) U.S. Treasurer — general account...........................
(c) Foreign.....................................................................
(d) Other........................................................................
12. Deferred availability cash items..........................................
13. Other liabilities....................................................................

17,528
495
289
423
4,631
49

T otal L iabilities.....................................................

50,836

CAPITA L ACCOUNTS

14. Capital paid in....................................................................
15. Surplus................................................................................
16. Other capital accounts........................................................
T otal L iabilities

and

C apital A ccounts .............

17. The R eserve Ratio (per cent)..........................................

400
775
98
52,109
41.2

4.
D is c o u n t s f o r M em ber B a n k s, an item of great
interest to the money and financial markets, represent the
amount of Federal Reserve credit that member banks bor­




179

THE FEDERAL RESERVE SYSTEM

row and for which they have a direct repayment responsi­
bility. Member banks may borrow from the Reserve Banks
in either of two ways: first, by pure discounting (that is,
selling to the Reserve Banks with endorsement or recourse)
o f commercial, industrial, or agricultural paper of appro­
priate quality and short maturity; or second, by offering
their promissory notes secured by such eligible paper, by
Government securities, or by other satisfactory collateral.
Most member bank borrowings from Federal Reserve
Banks represent short-term advances secured by Govern­
ment securities. This reflects in part the key role of U.S.
Government securities among bank assets and in part the
greater convenience of using them as collateral. Borrowing
against Government securities or other eligible paper is
done at the established discount rate; borrowing secured
by other collateral satisfactory to Reserve Banks is charged
a rate not less than one-half percentage point higher.
5. 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 of direct obligations of the
United States. It is under the authority for this second
type of advance that the Reserve Banks may lend to non­
member banks as well as other institutions against Govern­
ment securities as collateral, subject to such regulations as
the Board of Governors may prescribe. Rates on such
loans are higher than the rates charged member banks.
Gold loans to foreign monetary authorities are made at the
prevailing discount rate. As of June 29, I960, no credits
o f either type were outstanding.
6. Acceptances are prime bankers* acceptances pur­
chased by the Federal Reserve Banks in the open market
180




BALANCE SHEET OF RESERVE BANKS

from acceptance dealers at prevailing interest rates. Some­
times such purchases are made under repurchase agree­
ment whereby the seller agrees to buy them back within
15 days or less. In June 1960 the Federal Reserve Banks
held no acceptances under repurchase agreement.
7.
U.S. G overnment Securities comprise Treasury
bills, certificates o f indebtedness, Treasury notes, and
Treasury bonds. Since Reserve Bank purchases o f Govern­
ment securities are the principal means by which the
Federal Reserve can create Reserve Bank credit on its own
initiative, changes in Reserve Bank holdings o f these se­
curities are watched closely by observers in the credit
market. A breakdown o f holdings, by type o f security, is
published each week in the full condition statement.
Federal Reserve holdings of Government securities
sometimes include purchases from nonbank dealers under
dealer agreements to repurchase them within a specified
period of 15 days or less; the amounts held on this basis
are shown separately in the complete weekly statement.
The System makes repurchase arrangements available in
periods o f temporary credit stringency to help meet market
needs for reserve funds and for credit when dealer inven­
tories of Government securities are unusually large. Use of
the facilities, when made available by the System, is at the
initiative of the dealers. On June 29, 1960, the Reserve
Banks held no Government securities under repurchase
agreements with dealers.
The law authorizes the Reserve Banks to hold at any
one time as much as $5 billion of Government obligations
acquired directly from the Treasury. These direct borrow­
ings by the Treasury are infrequent and of very short dura­
tion. They grow out of temporary imbalances between the




181

THE FEDERAL RESERVE SYSTEM

inflow and outflow of Treasury funds. The Treasury draws
checks for current payments on deposit accounts held with
the Reserve Banks. Just before tax collection dates, these
accounts sometimes fall below desirable working levels.
Because Treasury accounts at commercial banks through
which tax payments are received may also be low at
these times, the Treasury may be without adequate funds
for a few days to replenish its Reserve Bank balances.
When the Treasury’s balances fall below working
levels, the Treasury may sell special short-term certificates
of indebtedness to Federal Reserve Banks to forestall a
temporary overdraft in the Treasury’s checking accounts.
When these special obligations are outstanding on the
Wednesday statement date, they are reported separately
in the condition statement.
8. Cash items in process of collection are checks and
other cash items deposited with the Federal Reserve
Banks and in process of collection at the date of the state­
ment. The item has a counterpart in a technical account
on the liability side of the statement, described as deferred
availability cash items. The relationship o f these two
accounts yields a measure of so-called Federal Reserve
“float,” which is explained on page 185 under liabilities.
9. Other assets for this condensed statement consist of
accrued interest and other accounts receivable, premium on
securities owned, balances due from foreign central banks,
bank premises, and various items of lesser significance.
Explanation o f Liability Accounts

10. F ed e r a l R eserve N otes , which account for more
than five-sixths of the total currency and coin in circula­
tion, are liabilities of the Federal Reserve Banks and also
182




BALANCE SHEET OF RESERVE BANKS

obligations of the U.S. Government. They are a first lien
on all the assets of the issuing Reserve Bank and when
held as vault cash by member banks may be counted in
meeting their reserve requirements. Changes in the amount
of Federal Reserve notes in circulation occur in accord­
ance with changing demands of the public for currency
and with member bank holdings of vault cash.
11.
D eposits consist for the most part of the reserve
accounts of member banks. The aggregate of the member
banks’ balances in these accounts, along with their vault
cash, constitutes the operating base of the banking system.
The Federal Reserve influences the total flow of bank loans
and investments by conducting its own operations in such
a way as to regulate the volume of its deposit liabilities to
member banks, while at the same time supplying to banks
the amount of Federal Reserve notes needed for their own
vault cash and for the public’s hand-to-hand circulation.
A second category of deposit liabilities is the checking
accounts of the U.S. Treasury, which it uses to make pay­
ments for Government purchases of goods and services.
Weekly changes in the Treasury’s deposit account are
often fairly sizable. Although directly related on occasion
to accompanying changes in other balance sheet accounts,
these week-to-week changes are most often reflected in
opposite changes in the reserve accounts o f the member
banks.
The Treasury also maintains deposit accounts with
approved commercial banks for receiving taxes and the
proceeds of securities sold to the public. These accounts
are commonly known as tax and loan accounts. The
Treasury’s established practice is to maintain large enough
balances in its checking accounts at the Reserve Banks to




183

T H E FE D E R A L RESERVE SYSTEM

meet its current payments. It transfers funds from its
commercial bank accounts into its checking accounts in
accordance with its schedule of payments. Whenever the
Treasury account at the Reserve Banks exceeds desired
working levels, the excess may be redeposited with com­
mercial banks. By carrying the bulk of its deposits in
tax and loan accounts, the Treasury moderates the effect
on bank reserves o f fluctuations in its receipts and pay­
ments.
A third category of deposit liabilities is the deposits of
foreign central banks and governments, which are main­
tained with the Reserve Banks for international settlement
and foreign monetary reserve purposes. Changes in the
total of these deposits likewise affect member bank re­
serves. Such changes may also be immediately associated
with changes in other accounts, particularly in gold cer­
tificate reserves, when the Treasury buys or sells gold.
Nonmember banks that pay at par checks submitted to
them by Reserve Banks may keep check clearing accounts
with the Reserve Bank of their district as a matter of
convenience. These accounts are part of the fourth main
category, “other” deposit liabilities. Other depositors
whose balances are reflected here include certain Govern­
ment agencies and international organizations.
12.
The “deferred availability cash items” account was
mentioned on page 182 as the counterpart of “cash items
in process of collection,” an asset account. The former
arises from the fact that Reserve Banks do not give im­
mediate 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 or by other transfer media to the banks on which
184




BALANCE SH EET O F RESERVE BANKS

they are drawn. The maximum period for credit to be
deferred is now two business days. After the scheduled
deferment period, the member bank’s reserve account is
automatically credited.
Since the time actually taken to collect checks is often
longer than that allowed in the schedules, this crediting
frequently occurs before the account of the bank on which
the check is drawn is debited. The difference between the
asset account (cash items in process of collection) and the
liability account (deferred availability cash items) repre­
sents checks that, although not yet collected by the Reserve
Banks, have already been credited, in accordance with a
specified time schedule, to the reserve accounts of the
banks that deposited them. This difference, which is some­
times sizable, measures the amount of Federal Reserve
credit or float generated by the national check collection
process.
13. Other liabilities consist principally of unearned dis­
count on notes and securities, miscellaneous accounts pay­
able, and dividends accrued between the semiannual
dividend payment dates.
Explanation o f Capital Accounts
14. Capital paid in. Upon admission to membership in
the Federal Reserve System, each member bank is required
to pay for capital stock of the Reserve Bank of its district
equal to 3 per cent o f its own capital stock and surplus.
The shares do not carry the power through voting to
control the management o f the Reserve Bank as does
ordinary stock in private banks or corporations. The mem­
ber banks are entitled by statute to a cumulative dividend
of 6 per cent per annum on the paid-in value of their stock.




185

T H E FED ER A L RESERVE SYSTEM

Ownership of any share of Reserve Bank stock may not
be transferred, nor may the owning bank hypothecate its
shares.
15. Surplus represents retained net earnings of the Re­
serve Banks. The Reserve Banks may draw on their sur­
plus to meet deficits and to pay dividends in years when
operations result in loss, but they may not distribute it
otherwise to the stockholding member banks. Since the
surplus account has come to be approximately double the
capital stock account, no further additions are being made
to it, except when necessary to maintain this relationship
with paid-in capital. In 1959 the Federal Reserve adopted
a policy of paying to the Treasury as interest on Federal
Reserve notes all Reserve Bank net earnings in excess
of amounts needed to pay the statutory 6 per cent dividend
and to maintain the surplus at twice the capital stock ac­
count. The law provides that, if the Reserve Banks are dis­
solved, any surplus is to be paid to the U.S. Government.
16. Other capital accounts comprise unallocated net
earnings for the year to the date of the statement.
The Reserve Ratio
As explained earlier, Reserve Bank holdings of gold
certificates constitute their legal reserves and provide the
statutory limit to the expansion of Federal Reserve credit.
In recognition of the reserve function of gold, the reserve
ratio of the Reserve Banks is published regularly as a
memorandum item on their financial statement (item 17
in the statement on page 179).
The law prescribes that the Reserve Banks must main­
tain gold certificate reserves equal to at least 25 per cent
against their deposits and against their note liabilities. It
186




BALANCE SHEET OF RESERVE BANKS

also provides th at the Board of Governors may, if neces­
sary, suspend the requirement temporarily. D uring m ost
o f its existence, the Federal Reserve System has possessed
a sizable m argin o f free reserves so th at the reserve ratio
R E S E R V E S OF F E DE RA L R E S E R V E B A N K S
Bill io n s of d o ll a r s

1915

20

30

'4 0

50

'6 0

has been far in excess of the 25 per cent requirement. Thus,
needed Federal Reserve credit expansion has seldom been
hampered by a gold reserve limitation.
Use o f Federal Reserve Credit
The Federal Reserve Banks are not operated to m ake a
profit and do not extend additional credit simply because
they have enough reserves to do so. The use o f Federal
Reserve credit is determined, on the one hand, by the de­
m and o f the public for currency and bank deposits and,
on the other, by the policy pursued in the public interest




187

T H E FED ER A L RESERVE SYSTEM

by the Federal Reserve to encourage or discourage the
expansion o f bank credit and money.
The extent to which Federal Reserve credit is used de­
pends on movements o f other factors that affect com­
mercial bank reserves and hence the ability o f banks to
lend or invest and expand the money supply. How the use
o f Federal Reserve credit varies with changes in these other
factors affecting bank reserves is discussed in the next two
chapters.

188




CHAPTER XII

THE BANK RESERVE EQUATION. Cold, currency in
circulation, and Federal Reserve credit are the principal fa cto rs
th at influence the volume o f member bank reserves— the basis
o f bank credit and the money supply. The relationship among
these factors, together with other more technical ones, is sometimes
called the bank reserve equation.

EMBER bank reserves and all of the factors that
affect their volume can be combined into a bank
reserve equation. In this equation, simplified in presenta­
tion on page 190, factors supplying member bank reserve
funds are set opposite factors absorbing such funds. These
various factors come partly from the combined balance
sheet of the Federal Reserve Banks and partly from the
Treasury’s accounts. Together they reflect the numerous
forces in the country’s economic life that affect the activi­
ties of the banking system.
Over the longer run, the major factors affecting the
volume of member bank reserves are the monetary gold
stock, Federal Reserve credit, and currency in circulation.

M




189

T H E FE D E R A L RESERVE SYSTEM

Other factors, which are less important in the long run,
include Treasury currency; Treasury cash accounts; and
nonmember bank, foreign, and other accounts at the
Federal Reserve.
Any of the factors in the bank reserve equation can in­
crease or decrease member bank reserves. On the one hand,
F actors in the B ank R eserve E quation, J une 1960
(Averages of daily figures. In billions of dollars)
Factors accounting for supply of reserve funds:
Monetary gold stock.............................................. 19.3
Federal Reserve credit........................................... 27.8
Treasury currency..................................................
5.3
Total..................................................................... 52.4
Factors accounting for use of reserve funds:
Currency in circulation........................................ 131.9
Treasury cash accounts.......................................... 0.9
Nonmember bank, foreign, and other accounts
at the Federal Reserve....................................... 1.6
Total..................................................................... 34.4
Member bank reserve balances.......................... 2 18.0
Total..................................................................... 52.4
1 Includes all currency held in banks as vault cash.
2 Excludes member bank vault cash, allowable as reserves.

inflows of gold, decreases in currency in circulation, and
increases in Federal Reserve credit add to these reserves;
on the other hand, outflows of gold, increases in currency
in circulation, and contraction of Federal Reserve credit
diminish them. Each of these factors, and indeed other
more technical ones, may be highly variable over short
190




B A N K RESERVE E Q U A TIO N

periods. The interaction o f short-run variations is con­
sidered in the chapter that follows. This chapter discusses
the longer run interplay of the major factors in order to
put the role and function o f Federal Reserve credit in clear
perspective.
At mid-1960, gold and Federal Reserve credit accounted
for most of the supply o f reserve funds, as the table shows.
In addition to member bank reserve balances, currency in
circulation accounted for most of the use of reserve funds.
The relative importance o f these major factors changed
from time to time over the 1934-59 period, as shown in the
chart on page 193. Through 1941 the dominant factor was
growth in the gold stock, whereas during the war the pre­
dominant influences were increases in currency in circula­
tion and in Federal Reserve credit. Since 1945, changes in
these factors have been smaller and more varied than
in earlier periods.
Interplay o f Bank Reserve Factors
Gold flows are greatly affected by forces outside Federal
Reserve regulation. They necessarily depend on inter­
national economic, financial, and political forces as well
as on forces o f domestic origin. Currency movements are
influenced primarily by the level of business activity and
by the habits and preferences of the public for currency.
Federal Reserve credit is the balance wheel between
these two more or less independent factors and member
bank reserves. The extent to which the Federal Reserve
System uses its credit powers depends on current Federal
Reserve policy and on changes in bank reserves caused by
gold or currency movements.
If the effect o f gold and currency movements on bank




191

T H E FE D E R A L RESER V E SYSTEM

reserves is in harmony with current credit and monetary
policy, Federal Reserve offsetting action will not be neces­
sary. If the effect of the two independent factors is not in
harmony with current policy, offsetting action will be
undertaken. Thus, the kind of policy being pursued by
the Federal Reserve — whether one o f ease, one of tight­
ness, or somewhere in between — may be associated with
either increases or decreases in Federal Reserve credit,
depending on the movements in other factors in the reserve
equation. An example may make this clearer.
Suppose the Federal Reserve is attempting to ease
market conditions and to increase the reserves of commer­
cial banks. If other factors are not adding to bank reserves,
the Federal Reserve can buy Government securities, thus
increasing reserve funds by the amount of the purchase.
A policy of ease will then be associated with a rise in
Federal Reserve credit.
Suppose, on the other hand, that large foreign sales of
gold to this country and large inflows of currency to banks
occur at a time of ease in current reserve banking policy.
This reduces the need for Federal Reserve credit. These
gold and currency movements may even be so large as to
create reserve conditions that are too easy in view o f do­
mestic economic developments. In this case the Federal
Reserve can temper the excessive easing o f credit condi­
tions by selling securities. A policy of ease will then be
associated with some decline in Federal Reserve credit,
because other factors will have contributed more than
enough to an appropriate easing of bank reserve positions.
Member bank reserves, although affected by the three
other principal factors in the bank reserve equation, are not
an entirely passive element. They respond to economic
192




BANK RESERVE EQUATION
r

~

™

'

~

~

.............. ...

BANK RESERVE EQUATION
M A JO R

FA CTO RS

S U P P L Y IN G

B illio n s of d o l la r *
40

R ESER V E FU N D S

G O L D STO CK

FED ERAL R E S E R V E
CREDIT

M A J O R FACTORS U S I N G RESERVE FUNDS

CU R REN CY IN
C IR C U LA TIO N

M EM BER B A N K
R ESER V E BA LA N C ES

W O RLD
W A R II
j ___ i— i— i— L

1935

1940




1945

------ P O ST -A C C O R D
i----1 !----! I _ I_ I _ I _ I _ 1 _ I
—
__ _ _ _ _ _ _

1950

1955

1960

193

T H E FE D E R A L RESERVE SYSTEM

forces that are not necessarily reflected in gold or currency
movements, and their independent impulses can be re­
flected in member bank borrowing from the Reserve Banks.
For instance, at times o f vigorous demand for credit and
consequent growth in bank loans and deposits, member
banks need more reserves. The need for additional reserves,
if not being met by other factors, expresses itself in a de­
mand at the discount window for more Federal Reserve
credit.
The type of Federal Reserve action taken in response to
all these influences depends in general upon economic condi­
tions and the desirability at the time of enlarging the flow
of credit and money. The Federal Reserve ordinarily sup­
plies its credit through some combination of additional
discounts and open market purchases, but it may also meet
the demand by reducing the reserve requirements o f
member banks.
Prewar Changes in Member Bank Reserves
A brief account o f the interplay o f the major factors
in the bank reserve equation over the past 25 years
will illustrate the usefulness of the equation approach.
How these factors affected member bank reserves from
mid-1934, which was shortly after adjustment of the
monetary system to gold revaluation, until the United
States entered World War II is shown in the table.
It will be seen that the principal factor supplying reserve
funds was a huge increase in the gold stock and that the
principal factor absorbing reserve funds, aside from mem­
ber bank reserves, was the growth in currency in circula­
tion. This was a period of world depression and of unsettled
political conditions abroad. As the nation’s manpower and
19 4




B AN K RESERVE E Q U A TIO N

other resources were continuously underemployed, the
Federal Reserve pursued a policy of monetary ease to
encourage their fuller utilization. With reserve funds ac­
cumulating from the inflow of gold, this policy was
effectuated with little net change in Federal Reserve credit.
The effect of the gold movement on member bank re­
serves was substantial, and excess reserves became large. As
M ajor F actors in B ank R eserve E quation
C hange , J une 1934— D ecember 1941
(Monthly averages of daily figures.

In billions of dollars)

Factors supplying reserve funds:
Increase in gold stock............................................

14.9

Factors absorbing reserve funds:
Increase in currency in circulation......................
Reduction in Federal Reserve credit...................
Other factors (net)..................................................

5.6
0.1
0.2

Total.....................................................................
Increase in member bank reserves.......................

5.9
9.0

Total....................................................................

14.9

economic recovery progressed, it seemed desirable to
temper this effect and also to restore the contact of the
Federal Reserve Banks with the credit market. Accord­
ingly, in 1936 and 1937 the Federal Reserve authorities
raised the reserve requirements of member banks by steps
to their statutory maximum.
Some downward adjustments were made in reserve re­
quirements as business activity receded during 1938, and
requirements remained at the reduced levels until Novem­
ber 1941. At that time the Federal Reserve again raised




195

T H E FE D E R A L RESERVE SYSTEM

reserve requirements to their statutory maximums, in view
of the threat of excessive bank credit and monetary expan­
sion that resulted from the national defense emergency of
the early 1940’s. Over this entire period Federal Reserve
credit remained fairly stable, and banks made almost no
use of Reserve Bank discount facilities.
War and Postwar Adjustment Periods
After the United States entered the war and began to
provide exports under lend-lease, foreign gold sales to this
country stopped. During the war period the gold stock was
reduced, chiefly to pay for large-scale purchases of goods
from South American countries. The rise in gold reserves
resumed for a period after the war, but beginning in the fall
o f 1949 there was some reduction. This outward movement
accelerated in mid-1950 at the time of the outbreak of
hostilities in Korea. Taking the war period and the post­
war adjustment period as a whole, gold movements were a
factor operating on balance to absorb member bank re­
serves as the table on the following page shows.
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 of
which occurred during the war. During that period the
Federal Reserve System, in support of war finance, under­
took to supply enough Federal Reserve credit to enable the
banking system to purchase Government security offerings
not taken up by nonbank investors, to counteract the drain
on member bank reserves from the increase in currency in
circulation, and to support the more than doubling of
commercial bank deposits. Another objective of Federal
Reserve operations during the war period was to maintain
196




B AN K RESERVE EQ U ATIO N

a stable credit market so that Government and essential
industry could obtain credit promptly and cheaply.
To accomplish these purposes the Federal Reserve sup­
plied credit freely through open market operations. In 1942
the authorities reduced reserve requirements of central
reserve city banks to make them the same as those of
M ajor F actors in Bank R eserve E quation
C hange , D ecember 1941— J une 1951
(Monthly averages of daily figures.

In billions of dollars)

Factors supplying reserve funds:
Increase in Federal Reserve credit......................
Other factors (net)..................................................

21.5
2.6

Total....................................................................

24.1

Factors absorbing reserve funds:
Increase in currency in circulation......................
Decrease in gold stock..........................................

16.6
1.0

Total....................................................................

17.6

Increase in member bank reserves.......................

6.5

Total....................................................................

24.1

reserve city banks. With adequate reserve funds available
in these sources, member banks made little use of the dis­
count privilege even though Federal Reserve discount rates
were maintained at low levels throughout the war period.
The Federal Reserve authorities carried over into the
postwar period a policy of supporting prices of Govern­
ment 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 of credit and




197

T H E FED ER A L RESERVE SYSTEM

monetary ease. In this situation Federal Reserve credit was
freely available at the call of the market, and banks, indeed
all holders of Government securities, were able readily to
adjust their operating positions through transactions in
Government securities. Because of their easy reserve posi­
tions, member banks continued during the early postwar
period to have little need for borrowing at Reserve Banks.
There was a growing recognition in this period that
Federal Reserve support of Government securities prices
and yields at arbitrary levels was incompatible with
effective Federal Reserve regulation of the volume of bank
reserves. In March 1951 the Treasury and the Federal
Reserve agreed on discontinuance of the policy. The major
objective of the accord was to minimize the creation of
reserve funds at the initiative of banks and other investors
through sales of Government securities to the Federal
Reserve at pegged prices and yields.
Post-Accord Period
After a brief adjustment period during which the
Federal Reserve continued to buy some Government
securities in support of the market, Federal Reserve opera­
tions were readapted to the flexible use of its general
methods of influencing bank reserve positions in accord­
ance with the transitory and growth needs of the economy.
Over the next nine years, from mid-1951 to mid-1960, the
principal factors affecting bank reserve positions changed
by the amounts shown in the accompanying table. Taking
this period as a whole, the major factor supplying reserves
to member banks was Federal Reserve credit and the
major factor using reserves was growth of currency in cir­
culation. Gold was also a factor absorbing reserves.
198




BAN K RESERVE E Q U A T IO N

Changes in Federal Reserve credit during these nine
years reflected a combination of open market operations,
discount operations, and changes in reserve requirements.
Federal Reserve operations were continuously adapted
toward influencing member bank reserve positions accord­
ing to the current cyclical and growth needs of the economy
for bank credit and money.
M ajor F actors in B ank R eserve E quation
C hange , J une 1951— J une 1960
(Monthly averages of daily figures.

In billions of dollars)

Factors supplying reserve funds:
Increase in Federal Reserve credit......................
Other factors (net)..................................................

3.8
1.7

Total....................................................................

5.5

Factors absorbing reserve funds:
Increase in currency in circulation......................
Decrease in gold stock..........................................

4.4
2.4

Total....................................................................

6.8

Decrease in member bank reserves......................

1.3

There were three periods during which economic activity
expanded cyclically — from mid-1952 to mid-1953, from
late 1954 to the early fall of 1957, and from the spring of
1958 into 1960. And there were two periods of economic
recession — from mid-1953 to late 1954 and from the fall
of 1957 to the spring of 1958. These cyclical movements,
reflected in the fluctuations in total output of factories and
mines shown on the chart on the following page, called
for changes in Federal Reserve policy.
In the expansion periods Federal Reserve policy first




199

THE FEDERAL RESERVE SYSTEM

encouraged and then, after expansion gained momentum,
restrained increases in bank credit. The process o f restraint
entailed more limited provision of bank reserves through
open market operations than was called for by the demand
for bank credit. Under these circumstances member banks
adjusted their reserve positions in part by borrowing at the
discount windows of Reserve Banks.

IN D U S T R IA L P R O D U C T IO N

W H O LESA LE

C O M M O D IT Y P R IC E S

After study o f the discount mechanism and revision of
the Board’s Regulation A in early 1955, the use o f this
general instrument was coordinated more effectively with
open market operations. Discount rates, which had been
raised only once during the 1952-53 expansion, were raised
seven times during 1955-57 — from 1y2 per cent to 3y2
per cent — and five times in 1958-59 — from 13 per cent
4
2 0 0




B AN K RESERVE EQ U A TIO N

to 4 per cent. Member banks increased their borrowings
at the Reserve Banks to more than $1.5 billion in 1952-53
and to around $1 billion in both the 1955-57 and the
1958-59 periods.
As expansions tapered off and during the recession
periods, the Federal Reserve used open market purchases
to provide member banks with reserves and thus to ease
credit availability and to stimulate bank credit expansion.
Member banks paid off a substantial part of their borrow­
ing at Reserve Banks early in the recession periods, and
Reserve Bank discount rates were lowered in consonance
with the decline in market rates as recession progressed.
The Federal Reserve also used reductions in member bank
reserve requirements to encourage bank credit expansion
during recession periods.
In carrying out a program of countercyclical monetary
policy over the past decade, Federal Reserve operations
had to take account of effects on member bank reserve
positions o f movements of gold and currency that were
only partly related to domestic cyclical conditions. Aside
from reserve adjustments necessitated by seasonal changes
in currency in circulation during the year, the amount of
reserves absorbed by growth of currency was somewhat
larger in the two years from mid-1951 to mid-1953 than
in the remaining seven years. An increase in the gold stock
from mid-1951 to mid-1952, however, provided some o f the
reserves to meet this growth. A decline in the gold stock in
1953, and a larger decline from 1958 through mid-1960,
absorbed reserves and contributed to the need for Federal
Reserve open market operations in these years. During
1957 U.S. purchases of gold provided more reserves than
currency growth absorbed.




201

THE FEDERAL RESERVE SYSTEM

Concluding Comment
The foregoing analysis indicates how the major long-run
factors in the bank reserve equation are related, and
how ups and downs in any one of them may be offset by
changes in the others or may be reflected in changes in
member bank reserves. The discussion has also brought
out how Federal Reserve operations may be adjusted to
changes in the various factors affecting bank reserves.
Students of monetary and banking developments can
gain considerable insight into the developments o f any
particular period by arranging and analyzing the monetary
factors in terms of the bank reserve equation. The data
for these factors are published each month in the Federal
Reserve B u l l e t i n .

202




CHAPTER XIII

SHORT-TERM CHANGES IN BANK RESERVES. Reserve banking policy responds to all o f the elements affecting
member bank reserve positions. A fu ll accounting o f bank reserve
factors is published each week in a table accompanying the Re­
serve Bank condition statement.

ISCUSSION of the bank reserve equation in Chapter
XII dealt with the factors — gold, Federal Reserve
credit, and currency in circulation — that have been
central in longer run changes in the general level of mem­
ber bank reserves. Significant short-run or week-to-week
changes in the reserve position can be caused by still other
elements, such as Federal Reserve float, Treasury checking
accounts, and foreign deposits with the Reserve Banks.
Federal Reserve operations must be as responsive to
transient as to more lasting reserve changes.
From the standpoint o f an observer of the credit market
or of a participant in it, the fact that member bank reserves
have changed is o f paramount interest. But how the change

D




203

T H E FE D E R A L RESERVE SYSTEM

came about—that is, what specific factors produced it—is
of only slightly less interest to him. Since he is trying to
judge the current course of Federal Reserve policy, it is
important to him whether a given short-run change is the
result o f a positive banking action, of reserve banking
tolerance of the play of market forces, or of a chance
interplay of factors without policy significance.
From the standpoint of its own operations, the Federal
Reserve must have detailed knowledge o f the performance
characteristics and potentialities for fluctuation of each
reserve factor, and for this purpose it must maintain a
full statistical record o f each reserve element. Such back­
ground information makes it possible for the System to
identify promptly the nature and likely amount of pro­
spective changes in the various reserve factors and to decide
whether the resulting changes in member bank reserves
should be permitted or should be offset by System action.
As is true of any dynamic process, this mechanism for
administering the level of member bank reserves must
work with a margin of tolerance for the unpredictable, be­
cause innumerable economic forces are influencing all of
the reserve factors.
Interplay o f Elements
The weekly statement includes a table showing all of the
elements of the reserve equation. Balance-sheet data for
the Reserve Banks are consolidated with data from certain
accounts of the Treasury that relate to its cash holdings
and to its currency outstanding. Thus, the figures reflect
the effects o f the country’s gold and currency flows upon
member bank reserve positions.
The weekly reserve equation focuses on how much the
204




SH ORT-TERM CHA NG ES IN RESERVES

member banks have in their reserve accounts. Since it is
an average of member bank reserve balances rather than
the level on any single day that is significant, the figures
D e ta ile d B ank R eserve E qu ation

(Weekly averages of daily figures. In millions of dollars)
Factor or element

Week ended Change from
June 29,
week ended
1960
June 22, 1960

Supplying reserve funds:
Federal Reserve credit:
U.S. Government securities...............
Acceptances........................................
Member bank borrowings.................
Float...................................................

26,129
30
412
1,168

+118
+1
-138
-376

Total Federal Reserve credit. . . .

27,739

-395

Gold stock.............................................
Treasury currency outstanding..............

19,325
5,356

-2 1
+2

Total............................................

52,420

-414

Absorbing reserve funds:
Currency in circulation..........................
Treasury cash holdings..........................

31,867
406

-6 0
-6

Deposits with Reserve Banks:
Treasury.............................................
Foreign...............................................
Other..................................................
Other Federal Reserve accounts (net)..

505
249
415
971

-4 5
+24
-2 2
+1

Total...........................................

34,413

-108

Member bank reserves with Reserve
Banks..................................................

18,007

-3 0 6

Cash allowed as reserves.......................

335

+48

Total reserves held......................

18,342

-258

Required......................................
Excess.........................................

17,856
486

-1 8 6
-7 2




205

T H E FE D E R A L RESERVE SYSTEM

used in the reserve equation are ordinarily weekly averages
of daily figures. The figures for the week ending June 29,
1960, are given in the table on page 205.
The information is grouped under two headings —
factors supplying reserve funds and factors absorbing
reserve funds, with details concerning member bank reserve
positions under the latter. For elements under sources of
reserves, increases tend to add to member bank reserves
and decreases to reduce such reserves. For elements ab­
sorbing reserves, increases tend to reduce member bank
reserves, and decreases tend to increase them. To highlight
the role of particular elements and groups of elements in
that week and to facilitate discussion of them, the factors
may be rearranged as shown in the following table.
Identifying the Factors in Reserve Changes
At the outset, it should be noted that no great signifi­
cance can be attached to the changes occurring in a single
week, except as they may seem to be part of some longer
term movement. Any week’s figures may be affected by
fairly wide fluctuations of an unpredictable and short-run
nature in such monetary factors as those discussed here.
The more important factors increasing member bank
reserves during the week chosen for illustration, excluding
those stemming from direct monetary actions, were
decreases in currency in circulation, in Treasury deposits at
Reserve Banks, and in “other” deposits at Reserve Banks.
The public’s holdings of currency fluctuate sharply with
seasonal spending patterns. As commercial banks obtain
currency to meet the needs of customers, they pay for it
out of their reserve deposits at the Reserve Banks; as cus­
tomers return currency to the banks, the banks in turn
206




SH ORT-TERM C H A N G ES IN RESERVES

deposit it in their reserve balances at the Reserve Banks.
During the week under discussion, banks returned $60
million of currency to the Reserve Banks.
R earrangement of
D etailed Bank R eserve E quation

(Averages of daily figures. In millions of dollars)
Factor or element

Change,
June 22 to
June 29, I9601

A. Changes accounting for increases in bank reserves:
Increases in:

U.S. Government securities....................................
Acceptances.............................................................
Treasury currency outstanding...............................

118
1
2

Decreases in:

Currency in circulation...........................................
Treasury cash holdings............................................
Deposits with Reserve Banks:
Treasury...............................................................
Other....................................................................

60
6
45
22

Total................................................................

254

B. Changes accounting for decreases in bank reserves: j
!
Member bank borrowings.......................................
Federal Reserve float.............................................. j
Gold stock................................................................

Decreases in:

138
376
21

Increases in:

Foreign deposits with Reserve Banks.....................
Other Federal Reserve accounts............................. j
Total................................................................ I
C

24
1
560

Decrease in member bank reserve balances with j
Federal Reserve Banks (B—
A)...............................

306

1 Changes based on averages for the weeks ending on these dates.




207

T H E FE D E R A L RESERVE SYSTEM

The changes in Treasury deposits with Federal Reserve
Banks reflected Treasury payments for Government ex­
penditures made by drawing checks against Treasury
accounts with the Federal Reserve Banks. Treasury trans­
actions run into billions of dollars each month. Despite
careful supervision of its accounts, Treasury balances at
the Reserve Banks often fluctuate abruptly, with corres­
ponding effects (in the opposite direction) on member bank
reserves. Over the illustrative week, changes in these
balances added $45 million to reserve funds.
Among the factors absorbing reserve funds during this
week, excluding those stemming from overt monetary
action, the major one was the change in Federal Reserve
float. There were also smaller changes in gold stock and
in foreign accounts with the Reserve Banks.
Federal Reserve float represents Federal Reserve credit
that is extended to member banks, in the check collection
process, when checks are not collected by the Federal
Reserve before bank reserve accounts are credited in ac­
cordance with an established schedule. The amount of
float outstanding fluctuates from day to day primarily in
consequence of variations in the volume of check trans­
actions, but also as a result of weather and other factors
affecting the speed of collection. In our reference week a
decrease in float absorbed $376 million of reserve funds.
When payments are made out of foreign accounts at
the Reserve Banks, the recipients of the payments usually
deposit them with member banks, which then add them to
reserve accounts at the Reserve Banks. Conversely, when
foreign deposits are being built up — for example, as a
result of a balance of international payments favorable to
foreign countries—a corresponding drain on member bank
208




SHORT-TERM CHA NG ES IN RESERVES

reserves results. The increase in foreign accounts, together
with the decrease in gold stock, absorbed $45 million of
reserves in the week under review.
Summarizing changes during this week, the largest was
a reduction of $376 million in “float,” which tended to
reduce member bank reserves by an equal amount. Federal
Reserve purchases of $118 million of Government securi­
ties offset part of this, as did reductions in currency in
circulation and in Treasury deposits, totaling more than
$100 million. However, member banks also reduced their
borrowings from the Federal Reserve Banks by $138
million; and this accounted for a further reduction of that
amount in their reserve balances.
As a result of all the changes in the various factors,
reserve balances of member banks at the Reserve Banks
declined by $306 million. Their total reserves declined less,
however, because there was an increase of $48 million
during the week in the amount of vault cash they could
count as reserves.
Total reserves of member banks are divided between
required and excess reserves. The decline of $258 million
in total reserves for the week here reviewed was accom­
panied by a reduction of $186 million in required reserves.
Excess reserves declined by $72 million.
Meaning o f Net Reserve Position
The credit market gauges the emphasis of current mone­
tary policy — that is, whether it is tending to be stimu­
lative, restrictive, or neutral in its effects upon the volume
o f credit and money — by observing, among other things,
the trend of changes in the net reserve position of member
banks. The net reserve position is defined as the difference




209

THE FEDERAL RESERVE SYSTEM

between the excess reserves of member banks and member
bank borrowing.
The term “net free reserves” is used by the m arket to
refer to a position in which excess reserves are larger than
borrowings, while the term “ net borrowed reserves” refers

RESERVES A N D B O R R O W I N G S

B O R R O W IN G S

EX C ESS RESERVES

N ET FR EE R ES ER V ES

N ET B O R R O W E D R ESER V ES

to a position in which borrowings are larger than excess
reserves. As m onetary policy moves from a restrictive to a
stimulative posture, a net borrowed reserve position will
gradually give way to a net free position. These swings in
the reserve position will reflect prim arily changes in the
2 1 0




SH ORT-TERM C H A N G ES IN RESERVES

volume o f member bank borrowings rather than in their
excess reserves. The reason for this is that banks univer­
sally seek to avoid unemployed funds, thus keeping to
minimal levels their combined excess reserves and the
fluctuations in these reserves.
Referring again to the principal elements in the bank
reserve equation for the last week of June 1960, member
banks showed net free reserves of $74 million, the amount
by which their excess reserves o f $486 million exceeded
their borrowing of $412 million. Free reserves had in­
creased by $ 6 6 million from the preceding week (since
borrowings were reduced by $138 million while excess
reserves had declined by $72 million). The member
banks’ net reserve position over that period appears to
have moved significantly in the direction of further mone­
tary ease.
Considering the complexity of the forces affecting the net
reserve position in the short run — a fact reflected in the
many sizable and irregular fluctuations in this measure
from week to week — little or no significance can be
attached to one week’s shift. However, the trend in the net
reserve figure, from sizable net borrowed reserves to small
net free reserves over a period of several months preceding
this particular week, clearly confirmed that Federal Re­
serve policy had been working to foster a larger flow of
credit and money.
The net reserve position of member banks is not the only
index of credit and monetary tendencies of course. The
central task of monetary policy is to regulate expansion of
bank credit and money in appropriate relation to the ex­
pansion in real output. Thus, the movements of bank credit
and money, along with tendencies in interest rates, are also




211

T H E FED ER A L RESERVE SYSTEM

key indices of the monetary situation in the short- as well
as in the longer run.
While monetary policy necessarily influences the net
reserve position of banks, this position in the short run is
also much affected by bank responses to the many cross
currents that stem from the interplay of diverse market
forces. For short-run interpretation, therefore, the net
reserve position o f the banking system may not always
prove to be a reliable index of reserve banking policy. It is
only one index of the direction of policy, and it is not
always or necessarily the most important one.

212




CHAPTER XIV

SERVICE FUNCTIONS. The Federal Reserve hanks handle
the legal reserve accounts o f member banks, furnish currency fo r
circulation, facilitate the collection and clearance o f checks,
and act asfscal agents ( f the U.S. Government.

HE Federal Reserve System, in addition to its responsi­
bility for regulating the flow of credit and money,
performs a variety of regular services for member banks,
the U.S. Government, and the public. This chapter de­
scribes the principal service functions of the Federal
Reserve.
The annual volume of service operations performed by
the Reserve Banks for the banking system and the Treas­
ury runs into huge figures, as the table on the next page
shows. In 1959 these Banks handled one trillion dollars
of checks and transferred nearly two trillion dollars
of funds. Both the composition and the volume o f these
operations vary considerably with short-term fluctuations
in the level of production, trade, and prices. Over the half
century o f the Federal Reserve System’s existence, they

T




213

T H E FED ER A L RESERVE SYSTEM

have grown rapidly as the financial resources of the nation
have expanded.
V olume of Selected F ederal R eserve B ank O perations

1959
Type of operation

Number !
of pieces
handled j
(thousands)1 1

Amounts
handled
(thousands
of dollars)

Discounts and advances......................

26

105,058,505

Currency received and counted:
Paper currency............................... .
Coin.................................................

4,631,081
9,929,912

30,730,461
1,022,660

Checks handled:
Postal money orders........................
U.S. Government checks............... .
All other2........................................

279,939
393,860
3,257,839

5,078,641
106,724,118
1,130,235,860

Transfers of funds..............................

2,695

1,882,069,626

Issues, redemptions, and exchanges of
U.S. Government securities...........

196,063

545,489,154

1 Packaged items handled as a single item are counted as one piece.

2 Exclusive of checks drawn on the Federal Reserve Banks.

Handling Member Bank Reserve Accounts
A substantial part of the daily work of the Reserve
Banks relates to member bank reserve accounts. Member
banks use their reserve accounts much as individuals use
their bank accounts in day-to-day transactions, drawing
on them for making payments and replenishing them with
funds that are received. For example, entries are made in
these accounts as member banks obtain currency (paper
money and coin) to pay out to their customers or as they
redeposit currency in excess of the amount needed for
214




SERVICE FU N C T IO N S

circulation, and as checks are collected and cleared. Other
entries arise as Treasury deposits are transferred from
member banks to the Federal Reserve Banks, or as funds
are transferred by telegraph for various purposes, or as a
bank borrows from, or makes repayment to, a Federal
Reserve Bank. Various types of transactions are described
in subsequent paragraphs.
The Reserve Banks must record all transactions and
strike a daily balance for the reserve account of each mem­
ber bank. As explained in Chapter II, the average balance
that a member bank must maintain as a required reserve
is related to its deposits.
Distributing Currency
There are two principal ways by which any individual
gets paper money and coin. He may draw it out of his
bank and have it charged to his account, or he may receive
it as payment for his services or his merchandise. In the
latter event, the currency received has usually been drawn
out of a bank by someone else.
As was shown in Chapter IX, 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. Moreover, the demand varies for different
kinds of currency. Some communities use more coin and
less paper money than others, and some use more of certain
denominations than others do.
When the demand for currency increases, banks pro­
vide themselves with the amounts and kinds that the
people in their communities will want. When they need
to replenish their supplies, member banks order currency
from the Reserve Banks and have it charged to their




215

T H E FE D E R A L RESERVE SYSTEM

reserve accounts. Nonmember banks generally get their
supplies from member banks.
The twelve Federal Reserve Banks in turn keep a large
stock of paper money and coin on hand to meet this de­
mand. This includes both Federal Reserve notes, which are
Reserve Bank liabilities, and Treasury currency — silver
certificates, United States notes, and coin. A Reserve Bank
pays for currency obtained from the Treasury by cred­
iting the Treasury’s deposit account for the amount
obtained.
When the demand for currency abates, currency flows
back from the public and the nonmember banks to the
member banks. The member banks return the currency
to the Federal Reserve Banks, where it is credited to their
reserve accounts. The Federal Reserve adjusts its own
credit operations so that the outflow and return flow of
currency may take place with minimum tightening or eas­
ing effects on the general credit situation.
Until establishment of the Federal Reserve Banks in
1914, the means of furnishing currency for circulation were
unsatisfactory. A gap existed between the Treasury and
the banking system, and demands for currency could not
always be met promptly. This was the case in the panic of
1907. The experience of that year, as already noted, high­
lighted the need for a reserve banking system.
The currency mechanism provided under the Federal
Reserve Act has worked satisfactorily: currency moves
into and out of circulation automatically in response to an
increase or decrease in the public demand. The Treasury,
the twelve Federal Reserve Banks, and the thousands of
local banks throughout the country form a system that
distributes currency promptly wherever it is needed and
216




SERVICE FU N C TIO N S

retires surplus currency from circulation when the public
demand subsides.
Collectings Clearing, and Transferring Funds
Currency is indispensable, yet it is used only for the
smaller transactions of present-day economic life. A cen­
tury ago it was used far more generally. Since then the
use of bank deposits has increased to such an extent that
payments made by check are now many times larger than
those made with paper money and coin. The use of
checking deposits by business and the general public is
facilitated by the service of 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 sends the check (together with other
checks) to the Federal Reserve Bank of Boston for credit
in its reserve account. The Boston Reserve Bank sends the
check 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 of the depositor who
wrote it and has the amount charged to its own reserve
account at the San Francisco Reserve Bank. The Federal
Reserve Bank of San Francisco thereupon credits the
Federal Reserve Bank of Boston.
Because promptness in collecting checks is important,
the Federal Reserve Banks extend to member banks hav­




217

T H E FE D E R A L RESERVE SYSTEM

ing a substantial volume of checks payable in other
Federal Reserve districts the privilege of sending such
checks directly to other Federal Reserve Banks for collec­
tion. The Hartford bank, therefore, might have forwarded
the $1,000 check directly to the Federal Reserve Bank of
San Francisco for collection, at the same time informing
the Federal Reserve Bank of Boston of its action. On the
basis of this information the Federal Reserve Bank of
Boston would then have credited the Hartford bank’s
reserve account just as if the check had been sent through
the Boston Bank.
The volume of checks handled by the Federal Reserve
Banks has grown rapidly over the years, as the following
chart shows. During 1959 the number o f items exceeded
3.7 billion, amounting to $1,237 billion. Many other
checks are collected by city correspondents. For checks
that originate locally, banks collect through their local
clearing houses or by presenting the checks directly to
the banks on which they are drawn. In most cases, how­
ever, the settlement or payment for checks on member
banks is made, directly or indirectly, through their reserve
balances with the Federal Reserve Banks. Thus, the facili­
ties of the Reserve Banks aid in clearing and collecting
checks, whether they originate locally or 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 of 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 comprise all member banks and those nonmember
banks that have agreed to remit at par for checks forwarded
218




SERVICE FUNCTIONS

to them by the Federal Reserve Banks for payment. As of
m id-1960 m ore than 90 per cent of all commercial banks
and branches, accounting for about 98 per cent o f all
commercial bank deposits, were on the Federal Reserve
par list.

CH E C KS H A ND L ED BY R E S E R V E B A N K S
B il lio n s of d o l l a r s

lOOO

-

MM
1920

V

1930

1940

1950

I9 6 0

Over the years the process of clearing and collecting
checks has been greatly shortened and simplified. Both
commercial banks and the Federal Reserve Banks have
participated in this development. By doing so, they
have improved the means o f paying for goods and services
and o f settling m onetary obligations; they have also re­
duced the cost to the public of making payments and trans­
ferring funds. Ways to achieve further improvements, in­




219

T H E FE D E R A L RESERVE SYSTEM

eluding the application o f high speed electronic equipment,
are under continuous consideration.
In addition to checks, the Federal Reserve Banks 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. Each Reserve
Bank has a share in it. This fund represents a substantial
part of the gold certificate reserves of the Federal Reserve
Banks. Through it money is constantly being transferred
by telegraphic order from the account of one Reserve
Bank to that of another.
On an average business day more than $5 billion of
transfers and payments are made through this Fund.
These are for the most part settlements for checks col­
lected, transfers of balances for account of member banks
and their customers, and transfers for the U.S. Treasury.
The cost of clearing and collecting checks and of
supplying currency and coin is a major part of Federal
Reserve Bank expenses. The Reserve Banks provide these
services for member banks and the public free of charge.
This practice is consistent with the ideal of a money that
circulates at par in all regions of the country.
Fiscal Agency Functions
The twelve Federal Reserve Banks carry the principal
checking accounts of the U.S. Treasury, handle much of
the work entailed in issuing and redeeming Government
obligations, and perform numerous other important fiscal
duties for the U.S. Government.
220




SERVICE FU N C T IO N S

The Government is continuously receiving and spending
funds in all parts of 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 of the Treasury. Its funds are
disbursed mostly by check, and the checks are charged to
Treasury accounts by the Federal Reserve Banks.
When the Treasury offers a new issue of Government
securities, the Reserve Banks receive the applications o f
banks, dealers, and others who wish to buy; make allot­
ments of 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, most o f these
payments are made initially to member and nonmember
banks and are kept in Treasury tax and loan accounts at
these banks.
Each Federal Reserve Bank administers for the Treasury
the tax and loan deposit accounts of the banks in its dis­
trict. Both member and nonmember banks, by complying
with the Treasury’s requirements, may become “special
depositaries” o f the Treasury and carry tax and loan de­
posit accounts. The principal requirement is the pledge
with a Federal Reserve Bank, as fiscal agent o f the Treas­
ury, of enough Government securities or other acceptable
collateral to secure fully the balance in the account.
For the convenience o f the Treasury and also for the
convenience of investors in Government securities, it is
necessary to have facilities in various parts of the country
to handle public debt transactions. The Federal Reserve
Banks furnish these facilities. They redeem Government
securities as they mature, make exchanges of denomina­




221

T H E FE D E R A L RESERVE SYSTEM

tions or kinds, pay interest coupons, and do a number of
other things involved in servicing the Government debt.
In addition they issue and redeem U.S. savings bonds and
service the banks and other financial institutions designated
as issuing and paying agents for such bonds.
Another part of the fiscal agency activities of the
Federal Reserve Banks is their work in connection with
the so-called “V-loan program.” This program, authorized
by the Defense Production Act of 1950 and implemented
by Regulation V of the Board of Governors, is an arrange­
ment to assist competent contractors and subcontractors
who lack sufficient working capital to undertake defense
contracts for the production of essential goods and ma­
terials. For this purpose the Departments of the Army,
Navy, Air Force, Commerce, Interior, and Agriculture,
the General Services Administration, the National Aero­
nautics and Space Administration, and the Atomic Energy
Commission are authorized to guarantee loans made by
commercial banks and other private financing institutions,
and the Federal Reserve Banks act as fiscal agents for the
guaranteeing agencies in connection with such loans.
The Federal Reserve Banks may also perform fiscal
agency services in connection with the financial activities
of various Government lending agencies. The Federal
Reserve Banks are reimbursed by the U.S. Treasury and
other Government agencies for much of the expense in­
curred in the performance of fiscal agency functions other
than depositary functions.
Because of its location in one of the principal financial
centers of the world, the Federal Reserve Bank of New
York acts as the agent of the U.S. Treasury in gold and
foreign exchange transactions. It acts as depositary for the
222




SERVICE FU N C TIO N S

International Monetary Fund, the International Bank for
Reconstruction and Development, and other international
organizations. It also receives deposits of foreign monetary
authorities and performs certain incidental services as
their correspondent. These services include handling short­
term investments and holding gold under earmark.
All the Federal Reserve Banks participate in foreign
accounts carried on the books of the Federal Reserve Bank
of New York. In these matters the New York Reserve
Bank acts as agent for the other Federal Reserve Banks.
The Board of Governors in Washington exercises special
supervision over all relationships and transactions of
Federal Reserve Banks with foreign monetary authorities
and with international organizations.
Preparedness for National Defense
In 1956 the Board of Governors was assigned responsi­
bility for the development of national security prepared­
ness measures relating to bank credit and monetary
policies. In cooperation with the Department of the
Treasury (including the Comptroller of the Currency), the
Federal Deposit Insurance Corporation, and others, it
was also assigned responsibility for national security pre­
paredness programs relating to the operation of the bank­
ing system. These planning responsibilities of the Board of
Governors are a part of the over-all military and non­
military defense program of the Government to assure
continued improvement in the nation’s readiness to meet
economic and financial needs related to any emergency.




223




SELECTED FEDERAL RESERVE PUBLICATIONS
Bo a r d

of

G o v ern o rs

A n n u a l R e p o r t . ( N o c h a rg e .)

Monthly. (Subscription price, $6.00 a
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12 months. Reprints of selected articles are available free of charge
upon request.)

F e d e r a l R e se rv e B u lle tin .

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S t a t i s t i c s . Monthly. Annual subscription includes one issue of

Historical Supplement. (Subscription price, $6.00 a year or 60
cents a copy; in quantities of 10 or more copies of the same issue
for single shipment, 50 cents each; foreign mailing, $7.00 a year
or 70 cents a copy.)
Issued
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includes one issue of Supplement. (60 cents a copy; in quantities
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70 cents each.)

H i s t o r i c a l S u p p le m e n t t o F e d e r a l R e se rv e C h a r t B o o k .

A ll B a n k S t a t i s t i c s , 1896-1955. April 1959. 1,229 pages. ($4.00
a copy.)
B a n k i n g a n d M o n e t a r y S t a t i s t i c s . November 1943. 979 pages.
($1.50 a copy.)
D e b i t s a n d C l e a r i n g S t a t i s t i c s a n d T h e i r U s e . (rev. ed.) May
1959. 144 pages. ($1.00 a copy; in quantities o f 10 or more for
single shipment, 85 cents each.)
A Study by a Federal Reserve System
Committee. May 1959. I l l pages. ($1.00 a copy; in quantities
o f 10 or more for single shipment, 85 cents each.)

F e d e ra l F u n d s M a rk e t.

as amended through December 31,
1956, with an Appendix containing provisions of certain other
statutes affecting the Reserve System. 385 pages. ($1.00 a copy.)

T h e F e d e r a l R e se rv e A c t,

F lo w o f F u n d s in t h e U n ite d S ta te s ,

1939-53. December 1955.

390 pages. ($2.75 a copy.)




225

PUBLICATIONS

— 1959 R e v is io n . July 1960. 229 pages.
($1.00 a copy; in quantities of 10 or more for single shipment,
85 cents each.)

I n d u s tr ia l P ro d u c tio n

M o n e ta ry P o lic y a n d M a n a g em en t o f th e P u b lic
S e l e c t e d B i b l i o g r a p h y . This list (mimeographed)

D e b t: a

is revised

or supplemented annually. (No charge.)
T r e a s u r y - F e d e r a l R e se rv e S tu d y o f t h e G o v e rn m e n t S e c u ritie s
M a r k e t . Part I. July 1959. 108 pages. Part II. February 1960.

159 pages. Part III. February 1960. 112 pages. (Individual books
$1.00 each; set of 3 books $2.50.)
Copies of this book, T he F ed er a l R eserve S ystem — P urposes
F u n c t io n s , may be obtained without charge, either individ­
ually or in quantities for classroom and other use.

and

In addition to the publications listed, the Board issues periodic
releases, other special studies, and reprints. Lists of available
material may be obtained upon request. Inquiries regarding publica­
tions should be directed to the Division o f Administrative Services,
Board o f Governors of the Federal Reserve System, Washington
25, D.C.

226




PU BLIC A TIO N S

F e d e r a l R eserve B a n k s

CHICAGO
B a n k R e s e r v e s . Text and “T ac­
count” description of the money creation process and the fac­
tors affecting member bank reserves. 1960. 32 pages. (No charge.)

W o rk b o o k o n M o n e y a n d

MINNEAPOLIS
(rev. ed.) An
illustrated elementary discussion of the work of the Federal
Reserve System. 1957. 20 pages. (No charge.)

Y o u r M o n e y a n d t h e F e d e r a l R e s e r v e S y s te m

NEW YORK
by George Garvy. Novem­
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from educational institutions.)

D e p o s it V e lo c ity a n d i t s S ig n ific a n c e ,

F e d e r a l R e se rv e O p e r a tio n s in t h e M o n e y a n d G o v e rn m e n t
S e c u r i t i e s M a r k e t , by Robert V. Roosa. July 1956. 105 pages.

(No charge.)
F o r e ig n C e n t r a l B a n k in g : t h e In s tr u m e n ts
P o l i c y , by Peter G. Fousek. November 1957.

of

M o n e ta ry

116 pages. (No

charge.)
M o n e ta ry P o lic y U n d e r th e I n te r n a tio n a l G o ld S ta n d a r d ,

1880-1914, by Arthur I. Bloomfield. October 1959. 62 pages.
(50 cents a copy; 25 cents a copy on orders from educational
institutions.)
An explanation in nontechnical
language of the role of money in our economy. May 1955. 48
pages. (No charge.)

M o n ey : M a s te r o r S e rv a n t?

by Carl H. Madden. An account
of the workings of the New York money market. September 1959.
104 pages. (70 cents a copy; 35 cents a copy on orders from edu­
cational institutions.)

T h e M o n e y S id e o f “ T h e S t r e e t , ”

by Alan R. Holmes.
March 1959. 54 pages. (50 cents a copy; 25 cents a copy on orders
from educational institutions.)

T h e N ew Y o rk F o re ig n E x c h a n g e M a rk e t,




227

PU BLICATIONS

PHILADELPHIA
Exercises,
in simple “T account” form, indicating the essential nature o f
transactions affecting bank reserves. March 1955. 16 pages. (No
charge.)

E x e r c is e s i n t h e D e b i ts a n d C r e d i t s o f B a n k R e s e r v e s .

45 Y e a r s o f t h e F e d e r a l R e s e r v e A c t . [1959] 18 p a g e s . (No
c h a rg e .)

Five essays describing efforts to achieve
an efficient monetary system in the United States. 1954. 54 pages.
(No charge.)

T h e Q u e st f o r S ta b ility .

F i n a n c i a l B a r o m e t e r s . How to interpret reports of
member banks and the Federal Reserve Banks. October 1959.
48 pages. (No charge.)

W e e k ly

RICHMOND
A discussion of the nature of money and the
processes o f its creation and circulation. 1955. 47 pages. (No
charge.)

R e a d in g s o n M o n ey .

Each Federal Reserve Bank also publishes a monthly review of
credit and business conditions which will be sent regularly to anyone
requesting it. Some of the banks issue booklets on special subjects,
such as agricultural credit and economic indicators.
Requests for the reviews and other Bank publications, and
inquiries about quantity orders, should be sent to the Federal
Reserve Banks at the following addresses:
Federal Reserve Bank of Atlanta
Atlanta 3, Georgia
Federal Reserve Bank of Boston
Boston 6, Massachusetts
Federal Reserve Bank of Chicago
Chicago 90, Illinois
Federal Reserve Bank of Cleveland
Cleveland 1, Ohio

228




PU BLIC A TIO N S

Federal Reserve Bank o f Dallas
Dallas 2, Texas
Federal Reserve Bank of Kansas City
Kansas City 6, Missouri
Federal Reserve Bank of Minneapolis
Minneapolis 2, Minnesota
Federal Reserve Bank of New York
New York 45, New York
Federal Reserve Bank of Philadelphia
Philadelphia J, Pennsylvania
Federal Reserve Bank of Richmond
Richmond 13, Virginia
Federal Reserve Bank of St. Louis
St. Louis 66, Missouri
Federal Reserve Bank of San Francisco
San Francisco 20, California




229




INDEX
Acceptances, bankers’........................................................................ 180
Balance of international payments........................................ 172-175, 208
Balance sheet of Federal Reserve Banks........................................177-179
Bank:
credit (See Credit)
examination...........................................................................74, 147-152
Holding Company Act.................................................................. 151
reserve equation...........................................................189-202, 205, 207
reserve factors............................................................ 191, 195, 197, 203
reserves (See Reserves)
supervision:
Federal Reserve functions.......................................................145-153
government agencies and........................................................... 149
monetary policy and.................................................................. 152
scope...................................................................................... 146, 150
Banking Act of 1935.........................................................................
51
Banking system, operation of reserves in..........................................15, 16
Board of Governors......................................................................... 73-75
Business, source of credit..................................................................
92
Capital accounts................................................................................ 185
Capital assets, costs compared.......................................................... 136
Cash:
demand for.................................................................................... 129
monetary policy and...................................................................... 131
Central banks.................................................................................... 3, 184
Charts:
Bank Reserve Equation................................................................. 193
Change in Financial Position......................................................... 101
Changes in U.S. Gold Stock......................................................... 166
Checks Handled by Reserve Banks............................................... 219
Credit Expansion...........................................................................
86
Currency and Federal Reserve Credit........................................... 161
Currency in Circulation................................................................. 159
Deposits and Bank Lending...........................................................
25
Discount and Bill Rates................................................................
49
Disposition of Reserve Bank Earnings..........................................
72
Federal Reserve Credit..................................................................
59
Flow of Federal Reserve Influence................................................ 125
Gross National Product and Money Supply................................. 143




231

IN D E X

Charts: (Continued)
Gross National Saving...................................................................
90
Kinds of Currency......................................................................... 157
Long-and Short-term Interest Rates.............................................. 109
Member Bank Reserves.................................................................
29
Money and Bank Deposits............................................................
5
Organization of the Federal Reserve System.................................
80
Process of Deposit Expansion.......................................................
22
Production and Prices.................................................................... 200
Relation of Parts to Instruments of Credit Policy........................
81
Reserves and Borrowings.............................................................. 210
Reserves of Federal Reserve Banks............................................... 187
Selected Interest Rates................................................................... 110
U.S. Balance of Payments............................................................. 174
U.S. Government Marketable Debt............................................
40
Yields and Prices on U.S. Government Securities........................ 113
Check clearing and collection................................................. 184, 217-219
Commercial banks................................................................ 2, 65, 95, 126
Comptroller of the Currency................................................... 65, 149, 152
Condition statements, weekly....................................................... 177, 203
Conference of Chairmen of the Federal Reserve Banks...................
77
Conference of Presidents of the Federal Reserve Banks..................
77
Contract interest rates....................................................................... 106
Coupon rate...................................................................................... 106
Credit:
agencies......................................................................................... 82, 83
bank.........................................................................................4, 26, 165
demand......................................................................................... 98-100
Federal Reserve....................................................59, 165, 187, 191, 192
funds, supply and demand...................................................... 89, 94, 96
market:
competition for funds................................................................ 103
definition....................................................................................
85
geographical distribution...........................................................
88
interest rates............................................................................... 105
net reserve position and............................................................. 209
role of economic groups............................................................. 100
structure......................................................................................
87
mortgage........................................................................................ 138
policy:
System responsibility for......................................................72, 78, 79

232




INDEX
Credit: (Continued)
policy: (Continued)
effect on borrowers........................................ ...................... 134, 137
relation of parts to instruments of (chart)___ ..........................
8!
regulation of....................................................... ..........................
10
short- and intermediate-term............................. .......................... 137
sources............................................................... ............................89-96
stock market, regulation o f................................ ..........................
56
Credit and money:
4
bank.................................................................... ..........................
8
effect of changes in............................................ ..........................
11
forces affecting flow o f....................................... ..........................
regulation o f...................................................... ...............2, 10, 60,213
Currency:
before 1914......................................................... .......................... 216
circulation........................................................... ...............158-160, 195
demand for........................................................ ...............158, 215, 216
distribution o f.................................................... .......................... 215
elasticity of......................................................... ..........................1, 155
Federal Reserve credit and, (chart).................... .......................... 161
Federal Reserve notes.................................156, 157, 162, 166, 178, 182
kinds (chart)....................................................... .......................... 157
relation to reserve banking................................. .......................... 155
Treasury............................................................. ...................... 155, 157
Deposits:
7
as credit.............................................................. ..........................
bank lending and............................................... ..........................24,25
6
demand, as money.............................................. ..........................
demand, ratio of reserves to............................. ........................... 16-18
expansion (chart)................................................ ..........................
22
Federal Reserve Banks, gold certificate reserves. .......................... 162
foreign central banks.......................................... .......................... 184
liabilities............................................................. .......................... 183
Treasury account............................................... .......................... 183
Treasury tax and loan accounts........................ ...................... 183, 221
U.S. banks, June 30, 1960................................. ..........................
65
Discount administration........................................ ..........................
44
Discount operations.............................................. ..........................41, 60
Discount rates....................................................... . . . .42, 46-49, 121, 200
Discounting...........................................................




233

IN D E X

Discounts:
effect on reserves............................................................................
43
member bank............................................................................... 45,179
Directors:
Federal Reserve Banks..................................................................
70
member banks................................................................................ 150
Earnings, Reserve Bank....................................................................
72
Economic stability............................................................................. 123
Examinations, bank.............................................................. 4, 74, 147-152
Exchange Stabilization Fund............................................................. 169
Federal Advisory Council..................................................................
77
Federal Deposit Insurance Corporation......................................... 71, 150
Federal funds market........................................................................
50
Federal Open Market Committee.........................................32, 71, 75, 76
Federal Reserve Act................................................................ 1, 3, 65, 216
Federal Reserve Agent.................................................................... 70,156
Federal Reserve Banks:
balance sheet of..........................................................................177, 179
branches.........................................................................................68-70
capital stock...................................................................................
65
credit policy............................................................................. 72, 78, 79
directors.........................................................................................69, 70
districts.......................................................................................... 67-69
earnings..........................................................................................71, 72
examination....................................................................................
74
fiscal agency functions.................................................................... 220
foreign accounts......................................................................... 184, 222
obligations and privileges...............................................................
64
officers............................................................................................ 70, 71
service functions..........................................................................213-223
surplus..........................................................................................72, 186
Federal Reserve Bulletin................................................................... 202
Federal Reserve notes.....................................156, 157, 162, 166, 178, 182
Federal Reserve System:
authority, distribution of...............................................................
78
decentralization..............................................................................
70
establishment..................................................................................
1
functions.............................................. 1, 4, 145, 150, 213, 214, 217-223
influence, flow of (chart)............................................................... 125
influence on credit and money.......................................................10,11
map.................................................................................................
67

234




IN D E X

Federal Reserve System: (Continued)
membership....................................................................................
64
organization chart..........................................................................
80
structure.........................................................................................
63
Treasury accord with...................................................................... 198
Financial position changes (chart)..................................................... 101
Fiscal agency functions..................................................................220-222
Float................................................................................................... 208
Flow-of-funds data............................................................................ 104
Foreign banks........................................................................151, 184, 208
Franchise tax.....................................................................................
71
Gold:
bank reserve equation and........................................................191,192
certificate account.......................................................................... 170
certificates, Treasury issued........................................................... 178
“earmarked”.............................................................................. 171,172
international transactions...........................................................169-171
monetization of.............................................................................. 169
movements................................................................................. 172,175
price................................................................................................ 168
reserve banking and.................................................................... 165-176
reserve money................................................................................. 167
reserves, basis of Federal Reserve credit....................................... 165
stock, changes in U.S. (chart)........................................................ 166
title to ............................................................................................ 172
Treasury holdings........................................................................... 169
Gold certificate reserves................................................. 162, 166, 178, 186
Gold Reserve Act of 1934................................................................. 167
Government marketable debt (chart)................................................
40
Government securities........................................................... 113, 181, 221
Governments in credit markets.........................................................
92
Gross National Product and Money Supply (chart)......................... 143
Information program.........................................................................
12
Interdistrict Settlement Fund............................................................ 220
Interest, definition............................................................................. 115
Interest rates:
changes...................................................................................... 114,132
contract.......................................................................................... 106
definition........................................................................................ 105
differences...................................................................................... 108
fluctuations.................................................................................107, 117




235

IN D E X

Interest rates: (Continued)
inflexibilities................................................................................... 119
long- and short-term......................................................... 108, 109, 112
monetary policy and...................................................................... 120
movements..................................................................................... 110
selected (chart)............................................................................... 110
International Bank for Reconstruction and Development............. 82, 223
International Monetary Fund.........................................................83, 223
International payments in gold..................................................... 169, 172
Lending agencies, Federal and international.................................... 222
Loans and investments................................................................ 16-18, 24
Margin requirements.........................................................................
57
Member banks:
borrowing......................................................................................
44
deposits..........................................................................................
65
examination............................................................................... 150, 152
number and classes........................................................................
64
obligations and privileges.............................................................. 64, 66
officers and directors...................................................................... 150
reserves (See Reserves)
supervision..................................................................................... 145
Monetary instruments, coordination.................................................
57
Monetary policy:
aims............................................................................................... 123
bank supervision and................................................................... 152
economic growth and.................................................................... 141
effects on:
borrowers and lenders................................................................ 133
commercial banks...................................................................... 126
nonbank lenders......................................................................... 139
spending...................................................................................... 141
influences........................................................................................ 124
interest rates and........................................................................... 120
net reserve position and................................................................ 209
Treasury coordination....................................................................
79
Monetary regulation, instruments.....................................................
31
Money: (See also Credit and Money)
bank deposits and (chart).............................................................
5
creation of.....................................................................................
25
definition........................................................................................
5
gold as reserve money................................................................... 167

236




IN D EX

Money: (Continued)
“high powered” ............................................................................. 19, 27
market............................................................................................
87
supply............................................................................................. 128
Mutual savings banks:
number and deposits......................................................................
65
source of credit funds....................................................................
96
National Advisory Council on International Monetary and
Financial Problems........................................................................75, 84
National banks:
charters..........................................................................................
65
examination.................................................................................151-152
number and deposits......................................................................
65
reserves..........................................................................................
2
National Banking Act........................................................................
65
National defense................................................................................ 223
National Monetary Commission.......................................................
3
Net reserve position...................................................................... 209, 210
Nonbank lenders............................................................................... 139
Nonmember banks..........................................................................65,184
Office of the Comptroller of the Currency........................................ 149
Open market operations.......................................... 31-41, 60, 76, 77, 201
Par list............................................................................................... 219
Production and prices (chart)............................................................ 200
Regulations, Board of Governors:
A ..................................................................................................44,200
V..................................................................................................... 222
Repurchase agreements...................................................................... 181
Reserve:
balances..........................................................................................
28
banking.......................................................................................... 123
banks, foreign.................................................................................
3
money, multiplying capacity..........................................................
23
ratio........................................................................................ 16-18,186
Reserve requirements:
changes in............................................................................... 51-55,163
Federal Reserve Bank................................................................156, 162
member bank........................................................................... 14, 20, 52
Reserves:
changes, short-term....................................................................... 203
currency circulation and............................................................... 160




237

IN D E X

Reserves: (Continued)
function o f......................................................................................13-30
gold certificate.................................................................... 156, 162, 220
member bank:
balances..............................................................................28, 29, 213
bank reserve equation................................................................. 189
changes....................................................................................... 194
chart............................................................................................
29
excess..........................................................................................
30
gold purchases, effect.................................................................. 175
ratio........................................................................................... 16,17
Treasury payments, effect........................................................... 208
multiplying power..........................................................................20, 23
operation in banking system......................................................... 15, 16
wartime and postwar................................................................ 196, 197
Saving-investment process................................................................. 114
Saving, gross national (chart)............................................................
90
Savings and loan associations...........................................................
96
Savings institutions, in credit market................................................91, 93
Securities, sales...................................................................................
32
Service functions, Federal Reserve Banks...................................... 213-223
State member banks:
deposits..........................................................................................
65
examinations............................................................................4, 52, 150
number...........................................................................................
64
Stock market credit, regulation,....................................................... 32, 56
Supervisory functions, Federal Reserve.................................... 4, 145, 150
Surplus...............................................................................................
72
System Open Market Account....................................................32, 76, 77
Tax and loan accounts.................................................................. 183, 221
Transfer of funds............................................................................... 217
Treasury, U.S.:
currency.......................................................................................... 157
Federal Reserve accord................................................................35, 198
fiscal agency services for,...........................................................220, 221
gold certificate account.................................................................. 168
gold holdings.................................................................................. 169
notes............................................................................................... 155
payments........................................................................................ 208
tax and loan deposit accounts....................................................183, 221
V-loan program.................................................................................. 222
Weekly condition statement...........................................................177, 202

238





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102