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Federa I Reserve Bank of Richmond

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Federal Reserve Bank of St. Louis

Federal Reserve Bank of Richmond • Richmond, Virginia • 1988

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Federal Reserve Bank of St. Louis

A Primer on the Fed

TABLE OF CONTENTS
PREFACE .................................................

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
SYSTEM FUNCTIONS AND OBJECTIVES. . . . . . . . . . . . . . . . . . . . . 3
Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liquidity and Stability of Financial Markets . . . . . . . . . . . . . . . . . . . . .
Regulation and Supervision of Banks and Other Financial Institutions . . .
Consumer and Community Affairs. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Relationships with the U.S. Treasury and Services to It . . . . . . . . . . . . .
Services to Depository Institutions . ...........................

3
5
6
9
10
11

STRUCTURE AND ORGANIZATION OF THE FED ............. 13
Internal Structure . ........................................ 14

Board of Governors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Federal Open Market Committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Federal Reserve Banks ....................................
Member Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Advisory Committees . ....................................

14
16
17
20
21

Position of the Fed within the Overall Structure of the Government . . 22

THE FED AT WORK: THE IMPLEMENTATION OF
MONET ARY POLICY . .................................... 25
Strategy, Procedures, and Mechanics of Monetary Policy . .......... 25

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Strategy of Monetary Policy and Monetary Targeting ...........
The Tactics of Monetary Policy: Instruments . ....................
The Tactics of Monetary Policy: Operating Procedures ..............
The Policymaking Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
International Dimensions of Monetary Policy ....................

25
27
34
45
50
55

Some Major Recent Developments and Issues in Monetary Policy. . . . 59

The Acceleration of Infiation after 1965 ........................ 59
October 6, 1979 to late 1982: The Turn to Disinfiation ............. 62
Late 1982-1986: Problems with Monetary Targeting ............... 66
CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

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iii

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Federal Reserve Bank of St. Louis

A Primer on the Fed

PREFACE

For many years the Federal Reserve Bank of Richmond published
and distributed an introduction to the Federal Reserve System and the
role of the Fed in the U.S. economy, titled "The Federal Reserve at
Work." This booklet was written originally by B.U. Ratchford and
Robert P. Black and was subsequently updated by Aubrey N. Snellings.
Because of its popularity, the booklet went through six editions and
numerous printings between 1961 and 1974. The present booklet
replaces "The Federal Reserve at Work." Like the earlier publication it is
intended for laymen who wish a nontechnical but substantive description of the Federal Reserve and its role in the formulation and
implementation of U.S. economic policy. It outlines the System's
structure and its various functions and then discusses the conduct of
monetary policy with particular attention to events in the late 1970s and
early 1980s.
The author wishes to thank Sandra D. Baker and Patricia G. Rhodes
for valuable assistance in the preparation of the article. Thanks also go to
Kenneth H. Anderson for the cover design.

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ALFRED BROADDUS
Senior Vice President and
Director of Research

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Federal Reserve Bank of St. Louis

A Primer on the Fed

INTRODUCTION

Most Americans have heard of the Federal Reserve System-or, more
simply, "the Fed," as the institution is widely known in financial and
political circles, or "the System," as it is frequently referred to by its
employees and others. Most Americans also know that the Fed is the
nation's central bank and that its policies and actions are frequently in the
news and the subjects of intense debate. Many citize~s, however, have only
a vague and imprecise idea of what the System actually does. Ask the man
on the street what the Fed does, and he will likely respond that the Fed
"controls interest rates," or that it "takes care of the money supply," or that
it "watches over banks." When he is pressed, however, to say what interest
rates the Fed "controls," or how it exercises this control, or what the money
supply is, or exactly what the Fed's responsibilities regarding the banking
system are, he will frequently come up short.
The purpose of this article is to answer some of these questions for
people who would like to know more about the System, but who do not
have the time to study the institution in detail. Particular attention will be
paid to the effects of the Fed's actions on the general economy and on
banking and other financial markets, but all of its major functions will be
discussed. The article is organized as follows. Section 1 describes the Fed's
principal functions and its basic objectives in performing each function.
Section 2 outlines the Fed's somewhat complex organizational structure and
indicates how this structure developed. Finally, Section 3 discusses Fed
monetary policy. Although the Fed has important responsibilities regarding
the regulation of financial institutions and the maintenance of the nation's
payments mechanism, its preeminent task is to formulate and implement
national monetary policy. In addition to outlining some of the mechanical
aspects of monetary policy, Section 3 will also attempt to convey some of
the flavor of current policy issues.

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A Primer on the Fed

SECTION 1:

SYSTEM FUNCTIONS AND
OBJECTIVES
The Fed's principal functions are similar to those performed by most
other central banks throughout the world. Specifically, the Fed is responsible for conducting monetary policy, maintaining the liquidity, safety, and
soundness of the banking system, and assisting the fiscal authority-in this
case the U.S. Treasury-in carrying out some of its duties. In addition, the
Fed actively participates in the maintenance and operation of the U.S.
payments system and in the continuing effort to increase the efficiency and
safety of this system. In recent years Congress has also charged the Fed
with promulgating several new laws designed to (a) protect consumers in
their transactions with banks and other financial institutions and (b)
promote community development and reinvestment.

Monetary policy As noted above, the preeminent function of the
Fed is the conduct of monetary policy. In its broadest sense, the term
monetary policy can refer to any action or actions a government or a
central bank takes that influence the institutional character of a nation's
monetary system or, at a particular time, monetary and financial
conditions in the country. In the United States in the 1980s, the term
typically refers to Fed actions affecting the growth rate of the nation's
money supply, interest rates, and other financial and economic variables, either in the short run or over a longer time period.
Although the Fed conducts monetary policy on a day-to-day basis,
the basic objectives of policy are mandated by Congress. The initial
objective of the System, as seen by the authors of the Federal Reserve

Act, was to provide a more elastic currency to reduce the incidence of
banking and financial panics, which had plagued the American economy in the nineteenth and early twentieth centuries. As time has
passed, however, the mandate has been broadened as monetary policy
has rightfully come to be recognized as a central element of overall

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national economic policy. The most direct statement of the present
mandate is given in Section 2A of the Federal Reserve Act, as amended
by the Full Employment and Balanced Growth Act (the so-called
Humphrey-Hawkins Act) of 1978:
The Board of Governors of the Federal Reserve System and the Federal Open
Market Committee shall maintain long-run growth of the monetary and
credit aggregates commensurate with the economy's long-run potential to
increase production, so as to promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest rates.

Further, in formulating policy in the short run, the System is to take
account of " ... past and prospective developments in employment,
unemployment, production, investment, real income, productivity,
international trade and payments, and prices .... " This mandate is
obviously very comprehensive and subject to differing interpretations.
In broad terms, however, it is generally understood to mean that the Fed
should maintain monetary conditions which encourage real economic
growth at a rate consistent with stability in the price level and in
financial markets, and balance in international transactions.
Two points should be made about the Fed's monetary policy
mandate and the objectives it includes. First, since the broad goals of
monetary policy are essentially the same as the longer-run objectives of
overall national economic policy, monetary policy should work in
concert with the other elements of national policy rather than at
cross-purposes with them. It is particularly desirable that monetary
policy and fiscal policy (i.e., the federal government's budgetary policy)
be mutually supportive in a joint pursuit of the broad goal of sustainable
real economic growth with stability of the price level. For example, a
highly expansive fiscal policy, as indexed by rapid growth in federal
expenditures, might result in political pressure on the Fed to finance the
growth in expenditures through monetary expansion, which would risk
increasing the rate of inflation. Some economists and others have argued
that excessively expansive fiscal policy in the 1980s has put upward
pressure on U.S. interest rates and the foreign exchange value of the
U.S. dollar, which in turn has produced a more expansive monetary
policy than is consistent with longer-run price level stability. Alternatively, an excessively expansive or contractionary monetary policy
would obviously disrupt and perhaps defeat the efforts of other arms of
the government to promote growth, high employment, and economic
stability.
4

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Second, even though the legislative mandate cited above explicitly
mentions a large number of economic variables, including production,
employment, prices, interest rates, and international trade, experience
suggests that it would be unwise, and potentially detrimental to the
achievement of the broader goals of national economic policy, to
conclude that the Fed can "fine-tune" the economy with monetary
policy. During the 1960s, some economists and policymakers believed it
was possible to determine empirically the trade-offs between certain
important economic variables, such as employment and the rate of
inflation, and subsequently to achieve rather precisely specified combinations of economic results via the adroit manipulation of monetary and
fiscal policy instruments. Disappointment with the actual results of this
approach to policy has produced a greater awareness of the limitations
of macroeconomic policy in general and monetary policy in particular.
Specifically, the research of Milton Friedman and others indicated that
the Fed's monetary policy actions affect the economy with lags or delays
that are both long and difficult to predict. 1 As a result of these lags and
their variability, efforts to manipulate the economy via monetary policy
may be destabilizing. Further, the "rational expectations" school of
monetary economics, which developed in the 1970s, has emphasized
how the public's tendency to anticipate Fed policy actions reduces or
eliminates the effect of these actions on real variables such as employment and output. 2 Against this background, some students of monetary
policy have suggested that the Fed's policy mandate be narrowed to
emphasize and give priority to the System's responsibility to maintain
price stability on the grounds that price stability is the only feasible
objective of monetary policy. 3

Liquidity and stability of financial markets Closely related to the
monetary policy responsibilities just outlined is the Fed's responsibility
to maintain the liquidity and stability of banking and other financial
markets. At the time the System was created, in 1913, commercial banks
were the dominant financial institutions. Therefore, maintenance of the
liquidity and stability of the financial system amounted largely to
maintenance of the liquidity and stability of the commercial banking
system. The principal tool available to the Fed for this purpose is the
1

See Friedman [11].

For an excellent nontechnical discussion of rational expectations, see McCallum [17].

See Black [2].

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so-called discount window, through which the Fed is able to loan
reserve funds to banks and other depository institutions under certain
specific conditions. Most such loans are very short term and are made to
enable borrowers to cover unanticipated deposit outflows, temporary
difficulties in obtaining funds from other sources and similar contingencies. Longer-term loans-referred to as "extended credit"-are also
available to deal with seasonal liquidity problems and certain other
circumstances. Prior to 1980, only commercial banks that were members
of the System had regular access to the discount window. The Monetary
Control Act of 1980 extended access to all institutions having deposits
subject to the System's reserve requirements, which, in addition to
commercial banks, includes savings banks, savings and loan associations, credit unions, and U.S. branches and agencies of foreign banks.
This extension of access to the window was appropriate in view of the
increasing importance of nonbank financial institutions in the American
financial system.
It should be emphasized that the Fed's responsibility to ensure the
liquidity of the financial system is indeed a responsibility to the system
rather than to individual institutions. The purpose of the Fed's lending
activities is to prevent liquidity problems at a single institution or a small
number of institutions from spreading and disrupting the financial
system as a whole. Therefore, in managing the discount window and
establishing operational policies for the window, the Fed is guided by
concern for the financial system. Also, the Fed strongly encourages
institutions to seek funds from other sources before coming to the
window. In its role as guardian of the liquidity of the financial system,
the Fed is sometimes referred to as the "lender of last resort."
In addition to the discount window, the Securities and Exchange
Act of 1934 required the Fed to regulate extensions of credit by securities
brokers, banks, and other lenders for the purpose of buying or carrying
specified securities-primarily stocks and related instruments. The
purpose of these so-called margin requirements, which the System
administers under its Regulations G, T, U, and X, is to limit potentially
destabilizing fluctuations in financial asset prices that might result from
excessively leveraged financial transactions.

Regulation and supervision of banks and other financial institutions
In addition to its desire for a more elastic currency, Congress also
intended, in creating the Fed, to improve the regulation and supervision
of commercial banks as another way of reducing the incidence of bank
6

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failures and resulting financial panics. To this end, the Fed has a number
of regulatory and supervisory duties aimed at ensuring the safety and
soundness of the banking system and the efficiency of its operations.
Many of these responsibilities were specified in the original Federal
Reserve Act; others have been added by amendments to that Act and
other legislation. The System shares these responsibilities with other
federal financial regulatory agencies and with state regulatory agencies
in accordance with applicable federal and state laws.
The terms regulation and supervision are often used loosely as
synonymous, but they actually refer to distinct Fed duties. Regulations
are rules that the System establishes and administers in conformance
with federal law, such as the various regulations aimed at maintaining a
competitive banking market structure. Supervision, in contrast, refers to
the System's oversight-largely through on-site examinations-of individual banks, bank holding companies, and certain other institutions to
ensure that they are being operated and managed in a safe and sound
manner. In addition to regulating and supervising the domestic activities of U.S. banks and bank holding companies, the Fed now regulates
and supervises the activities of foreign banking organizations in the
United States and many of the activities of U.S. banking organizations in
foreign countries. These internationally oriented duties have assumed
increased importance in recent years due to the dramatic increase in
international banking activities.
There have been substantial changes in both the form and content
of the Fed's regulatory duties in the 1980s, due partly to the landmark
Depository Institutions Deregulation and Monetary Control Act of 1980
(DIDMCA). Before 1980, the Fed's reserve requirements (to be discussed
in greater detail in Section 3 of this article) applied only to commercial
banks that were members of the System. The DIDMCA extended these
requirements to nonmember banks and other depository institutions.
While expanding the scope of the Fed's regulatory authority in this
respect, the Act reduced it in several other areas. Especially important
were (1) the phased elimination of interest rate ceilings on time deposits,
which the Fed had regulated for many years under its Regulation Q, and
(2) the authorization, effective at the beginning of 1981, of interestbearing NOW (for negotiable order of withdrawal) accounts nationwide.
The combined effect of these two changes was to eliminate, by the end
of the phase-out period in early 1986, all interest ceilings on all deposits
except ordinary demand deposits for which the prohibition of the payment of interest remains in effect. Since NOW accounts are functionally

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equivalent to demand deposits, however, interest can now be paid on
transactions accounts, and the rate is not subject to a ceiling. These
changes are what most people have in mind when they speak of the
lfbanking deregulation" of the 1980s. By increasing the cost of many
sources of funds, the changes have had a substantial impact on the
day-to-day management and operations of depository institutions. They
have also affected the way the public manages its money balances and
other liquid assets. Consequently, while deregulation has reduced the
Fed's regulatory duties in a formal way, it has presented new challenges
during the transition in both the supervisory area and in the conduct of
monetary policy. 4
In addition to the effect of deregulation, the economic turbulence of
the early 1980s has strongly challenged the Fed's supervisory resources
as well as those of other federal supervisory agencies and state agencies.
The severe recession in 1981 and 1982, the decline in agricultural land
values and farm income that accompanied the recession and persisted
after it ended, and the sharp drop in petroleum prices and some other
commodity prices in 1985 and 1986 reduced the quality of some assets
held by individual banks and led to a significant increase in the rate of
individual bank failures. Faced with these problems, the Fed took steps
in late 1985 to strengthen its supervision of state member banks and
bank holding companies.
Although the Fed has only limited formal regulatory and supervisory duties outside the commercial banking sector, it is increasingly
recognized that the System's overall responsibility for the health and
stability of the financial system requires it to assist in dealing with
specific problems in other financial sectors and markets. Specifically, the
Fed played an active role in containing certain short-run disruptions that
arose in the largely unregulated government securities markets in the
1980s. This role was a natural one since, as discussed in Section 3, the
Fed participates actively in this market in the course of conducting its
daily operations implementing monetary policy. Also, the System
played an important behind-the-scenes role in efforts to resolve serious
problems that affected certain state-insured thrift institutions in Ohio
and Maryland in 1985. This activity was also appropriate since the
DIDMCA extended both Fed reserve requirements and access to the
discount window to thrifts.
4

For a survey of these developments, see Broaddus [6] .

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Consumer and community affairs Congress has given increased
attention to the welfare of consumers and the condition of local
communities in the 1970s and 1980s, as evidenced by the passage of a
number of laws designed to protect consumers in their business dealings
and to promote local economic development. The Fed has been given
the responsibility to write regulations implementing many of the laws
that govern consumer credit and other consumer financial transactions
and community reinvestment and development. In doing so, the System
seeks to ensure that the objectives of each law are fully and efficiently
met.
Among the most important statutes covering consumer financial
transactions are the Truth in Lending Act, the Fair Credit Billing Act, the
Equal Credit Opportunity Act, the Fair Credit Reporting Act, the
Consumer Leasing Act, the Real Estate Settlement Procedures Act, and
the Electronic Fund Transfer Act. In general, all these laws attempt to
ensure that consumers are given adequate information to make informed and intelligent financial decisions, and that they are treated
fairly by the institutions they do business with. As an example, the
Equal Credit Opportunity Act prohibits financial institutions from
discriminating in granting credit on the basis of sex, race, religion,
marital status, and other similar criteria. The Fed's Regulation B sets out
specific procedures to implement this prohibition, such as a requirement
that applicants who have been denied credit be notified of the reasons
for the denial. In the case of some of the laws, the Fed and other
regulatory authorities conduct periodic examinations to determine
whether financial institutions are complying with the requirements of
the laws. The System is advised by a Consumer Advisory Council in
carrying out all of its consumer-related regulatory responsibilities. The
Council, which meets several times each year, has 30 members representing consumer interests, lending institutions, and other sectors.
The principal statutes governing community reinvestment and
development are the Home Mortgage Disclosure Act and the Community Reinvestment Act. The Home Mortgage Disclosure Act requires
depository institutions to disclose where their mortgage and home
improvement loans have been made so that depositors, potential
depositors, and others can make informed judgments regarding
whether or not specific institutions are meeting the needs of the local
community for housing-related credit. The Community Reinvestment
Act (CRA) encourages banks and other institutions to help meet the
housing and other credit needs in their respective communities,

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including needs in low- and moderate-income areas, provided such
credit is consistent with the safety and soundness of the lenders.
Compliance with this law is evaluated during bank examinations, and
the extent of compliance is taken into account by the System when it
considers certain applications for branches, bank mergers, and bank
holding company formations and acquisitions.
The Fed has developed an extensive internal mechanism to discharge its responsibilities under the CRA. In particular, a Community
Affairs Officer has been appointed at each of the 12 Federal Reserve
Banks. Among other things, these officers and their staffs provide
information to depository institutions regarding private and public
resources available to assist in community development. They also
attempt to facilitate communication between borrowers, lending institutions, local government agencies, and others in matters relating to the
financing of community development initiatives. Under current procedures, community and neighborhood groups can protest bank merger
applications and bank holding company applications in cases where
they believe the institutions involved are not complying with the
requirements of the CRA. The Community Affairs Officers play a
leading role in efforts to resolve the issues underlying these protests.
Relationships with the U.S. Treasury and services to it The central
bank has a close relationship with the fiscal authority in virtually all
countries, and in some countries the central bank is actually under the
direct control of the fiscal authority. Whatever the formal relationship,
the actual working relationship in practice determines the extent to
which the central bank can exert an independent influence on the
economy through monetary policy. In the United States, the Fed works
closely with the U.S. Treasury both in the larger task of formulating and
implementing national economic policy and in the day-to-day accomplishment of routine fiscal operations. The System is independent of the
Treasury, however, both in a legal sense and, since the celebrated
"Accord" between the Fed and Treasury in 1951, in the sense of its
ability to formulate and carry out monetary policy free of any immediate
and direct constraint imposed by the Treasury.
At an operational level, the Fed performs a variety of relatively
routine fiscal tasks for the Treasury as its "fiscal agent." 5 The Fed is
5

More precisely, the 12 Federal Reserve Banks discussed in Section 2 of this article serve as the
Treasury's fiscal agents.

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essentially the Treasury's banker since it maintains an account at the Fed
and makes most of its payments-both for purchases of goods and
services and transfers such as social security disbursements-from this
account. The majority of these payments are made by Treasury checks,
which are cleared and paid by the Fed. A minority of repetitive
payments, such as for some government employee salaries, are made
through automated clearinghouses, most of which are operated by the
Fed.
The Fed also carries out, on behalf of the Treasury, the routine
operations related to issuing, servicing, and redeeming Treasury securities, such as accepting tenders from individuals and institutions that
wish to purchase securities, collecting payments, and paying interest
coupons. Treasury securities are no longer issued in the form of physical
certificates. Instead, they are simply recorded in "book-entry" form at
the Fed for the account of depository institutions, which may, in turn,
be holding some of the securities for the accounts of customers.
Apart from coordinating with the Treasury on the broader questions
of monetary and fiscal policy, the Fed works closely with the Treasury
on a daily operational basis in actually implementing monetary policy.
As noted in Section 3, the Treasury's disbursements and receipts affect
the volume of reserves available to the banking system. Since the
reserve position of the banking system is a central instrument the Fed
uses in conducting monetary policy operations, the Treasury informs
the Fed early each business day of its projected expenditures and
receipts, which enables the Fed to take offsetting actions.

Services to depository institutions In addition to the fiscal services
it provides to the Treasury, the Fed offers a number of services to
depository institutions and, through these institutions, to the general
public. These services are actually provided by the 12 Federal Reserve
Banks discussed in Section 2, and most of them are related to the
operation of the nation's payments mechanism. One of the principal
reasons the Fed was created was to provide a safe and efficient system
for transferring funds, especially between different localities, to supplant
the slow and inefficient mechanism that existed at the time. Against this
background, a major underlying reason for the Fed's participation in the
payments mechanism, both in the past and at present, has been to
increase the system's efficiency and to assist it in advancing technologically as well as to provide a source for specific services. This broader
mandate was renewed by Congress in 1980 in the DIDMCA. The

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DIDMCA also substantially altered the terms under which the Fed
provides services. Prior to the Act's passage, the System offered these
services without charge, but only to member banks. The Act extended
direct access to the services to all depository institutions, but it required
the Fed to charge fees that cover their full cost over the longer run,
including the taxes and capital costs the Fed would incur if it were a
private firm. The purpose of the fees is to encourage efficient use of the
services and to enable private institutions to compete in their provision
where appropriate.
Among the most important of the Fed's payments services are (1)
the distribution, through depository institutions, of coin and currency to
the public in accordance with its needs, and (2) the clearing and
settlement of checks. The introduction of service fees initially reduced
the number of checks presented to the Fed for processing. In 1985,
however, the number increased 4.8 percent to approximately 15.5
billion. The System also provides several electronic payments services
including wire transfers of funds and automated clearinghouse (ACH)
services. The FedWire electronic transfer network enables depository
institutions to transfer large amounts of funds nationwide with great
speed. Such transfers can be used, among other things, to settle
transactions in Federal funds, Treasury securities, and other securities,
and therefore contribute substantially to the breadth, efficiency, and
liquidity of the nation's money and capital markets. During 1983,
approximately 38 million individual transfers valued at about $84 trillion
were executed over FedWire. ACHs use magnetic tapes to effect
recurring transfers such as salary payments, payment of regular insurance payments and the like. Since ACHs eliminate paper checks, it is
widely believed that they can significantly increase the speed with
which routine payments are made as well as reduce their cost and risk.
To date, however, the public's use of ACH facilities has been surprisingly limited.
In addition to the services already described, the Fed also provides
net settlement services which private wire transfer services, ACHs, and
other facilities can use to effect final net payment among their respective
users on the books of the Fed. The System also provides certain
nonpayments services including (1) the safekeeping and transfer of U.S.
government and agency securities, and state and local government
securities and (2) so-called noncash collection services where the System
collects payments for certain specified noncash items including maturing
state and local government securities and bankers acceptances.
12

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Federal Reserve Bank of St. Louis

A Primer on the Fed

SECTION 2:

STRUCTURE AND ORGANIZATION
OF THE FED

The structure of the Federal Reserve is a complex mixture of (a) private
and public elements and (b) centralized authority and decentralized
authority. Further, the institutional position of the Fed within the overall
structure of the federal government is distinctive and unusual. These
structural characteristics reflect both the longer-run history of central
banking in the United States and the political compromise that surrounded
passage of the Federal Reserve Act in 1913. Specifically, both the public and
private sectors of the economy have participated in U.S. central banking
activities from the earliest days of the Republic. The First Bank of the United
States, established in 1791, performed a mixture of central and private
banking functions, and its capital was provided by both the federal
government and private individuals. This same mingling of private and
public elements also characterized the much larger Second Bank of the
United States, which operated between 1816 and 1836, and the national
banking system created by the National Banking Act of 1863. When a new
central bank was proposed in the early 1900s, a debate arose between (a)
banking and financial interests in the large cities of the Northeast, which
favored a highly centralized institution dominated by private bankers, and
(b) agrarians, populists, and others in the South and West, who preferred a
less centralized structure, but one in which the public sector would play a
considerable role. The Federal Reserve Act and the central banking
structure it established constitute the compromise that arose out of this
conflict. The present structure, of course, also reflects broad financial and
political trends over the period since 1913.

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A. Internal Structure
Figure 1 depicts the internal organizational structure of the Fed. The
following paragraphs describe the powers and responsibilities of each of the
principal elements of the organization in turn.
Board of Governors The Board of Governors is the central governing
body in the System. It is an agency of the federal government and consists
of seven members appointed by the President of the United States with the
advice and consent of the Senate. The full term of a member of the Board is
14 years, with one member's term expiring every even-numbered year. The
purpose of this long term of office is to insulate members from routine
day-to-day political pressures. A member who has served a full term may
not be reappointed, although members who have served part of an
unexpired term may be reappointed to a full term. The President appoints
one of the members Chairman and another Vice Chairman for four-year
terms, again with the advice and consent of the Senate. The Chairman of
the Board is the dominant figure in the System and is typically regarded by
the general public as one of the most influential individuals in the
government.
The Board of Governors has general cognizance over all of the System's
activities described in Section 1 of this article. Its principal responsibility is
the formulation and implementation of monetary policy and its role in this
function is preeminent within the Fed. As Figure 1 indicates, the members
of the Board comprise a majority of the voting members of the Federal Open
Market Committee, which directs the Fed's open market operations (i.e.,
the System's purchases and sales of U.S. Treasury securities and other
securities in the open financial markets) and oversees the general conduct of
monetary policy. 6 The Board also reviews and approves all discount rate
actions taken by the Federal Reserve Banks, and it has the authority to alter
the reserve requirements of depository institutions within certain limits
specified by law. Outside the area of monetary policy, the Board has final
responsibility for all of the regulatory and supervisory activities, margin
requirement responsibilities, and consumer protection and community
affairs activities described in Section 1. It also has a specific mandate to
assist in the maintenance and further development of a safe and efficient
national payments mechanism. In addition to these duties, the Board
exercises general supervisory authority over the activities of the Federal
Reserve Banks. As noted in Figure 1, the Board appoints three of the nine
members of the board of directors of each Bank, and it must approve the
6

The Federal Open Market Committee, open market operations, and the other tools of monetary
policy are discussed in greater detail in Section 3.

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Fig. 1

ORGANIZATION OF THE FEDERAL RESERVE SYSTEM
FEDERAL
OPEN MARKET
COMMITTEE

BOARD OF
GOVERNORS
7 Members
appointed by
the President
of the
United States
and
confirmed by
the Senate

( 12 Members)

7 Members of
Board
+
5 of the 12
Presidents of
F.R. Banks

FEDERAL
RESERVE BANKS

MEMBER
BANKS

12 Banks operating
25 Branches
and 11 additional
offices for
processing checks

6,018 banks
as of
11/30/86

3 Class A-Banking
3 Class B-Public

.__ _ _ _ _A_P_'P_oi-·n_ts_____....__, 13 Class C-Public

Advise

FEDERAL
ADVISORY
COUNCIL
(12 Members)
1 from each F.R. Bank

Officers
and Employees

1-1

\JI

Note: Information correct as of Nov. 1986. Source: Board of Governors of the Federal Reserve System.

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Elect

Large
Medium
Small

Each size group
elects one Class A
and one Class B
Director
in each F.R. District

Approves appointments and salaries

Approves salaries

SIZE GROUPINGS

EACH BANK WITH
9 DIRECTORS

appointment of each Bank's president and first vice president. The Board
also examines the Banks annually and approves their annual operating
budgets and any major construction expenditures.
The Board is directly responsible to Congress. It reports to Congress
and Congressional committees on its activities on a continuing basis
through testimony and other means. It also makes a variety of statistical and
other information related to its activities available to Congress and the
public in its annual report, a monthly Federal Reserve Bulletin, and other
publications. The Board funds its expenditures through assessments on the
Federal Reserve Banks rather than via Congressional appropriations. Its
financial accounts are audited annually by a public accounting firm, and
these accounts are also subject to audit by the General Accounting Office.
Federal Open Market Committee As noted above, the Federal Open
Market Committee directs the Fed's domestic open market operations,
which are the principal mechanism used to carry out monetary policy
actions on a day-to-day basis. It also oversees the System's activities in
foreign exchange markets. The Chairman of the Board of Governors is
traditionally Chairman of the Committee. In addition to the seven
members of the Board of Governors, the Committee at any point in time
includes five of the Reserve Bank presidents as voting members. The
President of the Federal Reserve Bank of New York is a permanent
voting member and traditionally Vice Chairman of the Committee in
recognition of the important role this Bank plays in actually carrying out
open market operations. The other 11 Reserve Bank presidents share the
four remaining voting memberships on a rotating basis. In recent years
the Committee has held eight regular meetings per year in Washington.
It also meets via telephone conference from time to time when
circumstances warrant.
The role of the Federal Open Market Committee in the Fed's
monetary policymaking process will be discussed in greater detail in
Section 3. The important point to note about the Committee from an
organizational standpoint is its inclusion of Reserve Bank presidents as
voting members. It is true that the members of the Board of Governors
constitute a majority of the voting members of the Committee. Nonetheless, the presidents add an important dimension to the Committee's
deliberations since they do not reside in Washington, and they are in
direct contact with leading business people and others in their respective
Districts. This partially decentralized feature of the Committee's organizational structure is consistent with the intent of the authors of the
Federal Reserve Act to preserve a degree of regional autonomy in the
16

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Fed's overall structure. Because the presidents are not appointed by the
President of the United States or confirmed by the Senate, several
lawsuits in recent years have challenged the constitutionality of their
role in the Committee. None of these suits has been successful to date.
Federal Reserve Banks There are 12 Federal Reserve Banks whose
head offices are located in the following cities: Boston, New York,
Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Each of these Banks
serves a particular, numbered geographic Federal Reserve District as
shown by the map in Figure 2. There are also Federal Reserve Bank
Branches in 25 other cities as well as facilities that provide particular
operational services in several additional cities.
As suggested earlier, the Federal Reserve Banks represent the more
decentralized and private elements of the Fed's overall structure. The
corporate structure of the Reserve Banks is similar to that of private
commercial banks. Like private banks, each Reserve Bank has a board of
directors consisting of private individuals, which elects the Bank's
officers and oversees the general operations of the Bank. The Banks also
issue capital stock, and their officers carry titles similar to those used in
most private financial institutions. While similar to private companies in
these respects, however, the Reserve Banks are different in many other,
fundamental respects. First, because the Banks' principal general responsibility is to promote the public interest rather than the narrower
interests of their stockholders, profit considerations do not play a
dominant role in determining the Banks' actions, even though the Banks
earn substantial profits as a by-product of their routine operations. As
noted earlier, the Board of Governors has general supervisory authority
over the Banks, and for this reason the powers and privileges of the
Banks' stockholders are more limited than in most private corporations.
Second, in the unlikely event that any of the Banks was ever liquidated,
any assets remaining after the stock was redeemed at face value would
be transferred to the federal government.
Each of the Reserve Bank boards of directors has nine members
structured to be broadly representative of both the Bank's stockholders
and the public served by the Bank. Specifically, each board has three
Class A directors, three Class B directors, and three Class C directors.
The Class A directors are usually commercial bankers. They represent
banks that are members of the Federal Reserve System, since these
banks are the Reserve Bank stockholders. Class B directors represent the

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Boundaries of Federal Reserve Districts and Their Branch Territories

Fig. 2

■ Boston

Minneapolis ■

• Wi dsor Locks
Ctanjord .-:fe;icho

eland • ew York
Des Moines Chi
■ -Pittsburgh,ie
• ■ Philadelphia
Salt Lake City
Omaha•
•
cago
timore
·1
Indianapolis&
• • Co~mb~ * l
Denver
•
• Cincinnati
"
~
■
ichmond
Kansas City ■
■
Charleston
St. Loats' ; Louisville .

•

)

•Cqarlotte

Jacksonville

•Miami

1-12 Federal Reserve Districts

HAWAII ~ ~

- - - Boundaries of Federal Reserve Branch Territories

* Federal
Board of Governors/Washington, D.C .
.Reserve Bank Cities
■

ALASKA
Source: Board of Governors of the Federal Reserve System

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• Federal Reserve Branch Cities
• Regional Check Processing Offices
• Culpeper Communications Records Center

public and are drawn from diverse sectors, including agriculture,
business, and labor. They may not be officers, directors, or employees of
any bank. As indicated in Figure 1, the Class A and B directors of each
Reserve Bank are elected from that Bank's District by the member banks
in the District. The Class C directors also represent the public and are
appointed by the Board of Governors. The Board of Governors also
appoints one of the Class C directors chairman of the board and another
deputy chairman. In addition to the 12 Reserve Bank boards, each
Reserve Bank Branch has a board consisting of either five or seven
members, a majority of whom are appointed by the respective Bank
boards.
The Reserve Bank boards have several important responsibilities.
First, they oversee the management and operation of their respective
Banks, subject to the general supervision of the Board of Governors.
Second, they establish the discount rates that the Banks charge on loans
to depository institutions in their Districts, subject to the approval of the
Board of Governors. Third, they appoint the president and first vice
president of their respective Banks, subject again to the approval of the
Board of Governors. Finally, the members of each Bank and Branch
board provide the System with regular information on business and
financial conditions in specific industries, sectors, and geographic
regions. Although several of the specific actions of the Reserve Bank
boards must be approved by the Board of Governors, these boards are
highly influential within the Fed because of the caliber, experience, and
diversity of individual members. The information they provide on
business conditions, in particular, often provides an early warning of
emerging developments in the economy, in financial markets, and in
banking and financial institutions. Further, the directors' participation in
setting the discount rate gives them a specific role in the monetary
policymaking process, since-as discussed in more detail in Section 3--the discount rate is one of the instruments of monetary policy.
Each Reserve Bank currently derives approximately 95 percent of its
earnings from its proportionate share of the interest on the System's
portfolio of domestic securities acquired in the course of conducting
monetary policy. Practically all of the remainder is derived from its share
of the interest earned on the System's holdings of foreign currencies, the
interest from its loans to depository institutions, profits from the sale of
securities and foreign exchange, and the fees for its services to
depository institutions. Each Bank's earnings are allocated first to (1) the
payment of the Bank's expenses, (2) an assessment to cover its

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proportionate share of the expenses of the Board of Governors, (3) the
payment of a statutory 6 percent dividend to the Bank's stockholders,
and (4) any addition to the Bank's surplus needed to maintain surplus
equal to paid-in capital. Remaining earnings are then transferred to the
U.S. Treasury. In 1985, the total current income plus additions of the 12
Reserve Banks was approximately $19.4 billion, and the amount transferred to the Treasury was approximately $17.8 billion.
Several informal bodies exist within the Fed to facilitate communication among the Reserve Banks and between the Reserve Banks and
the Board of Governors on issues of mutual concern. A Conference of
Chairmen of the Federal Reserve Banks meets at the Board of Governors
offices in Washington twice a year. In addition, a Conference of
Presidents of the Reserve Banks meets several times each year at one of
the Federal Reserve offices and maintains close contact with the Board of
Governors. There is also a Conference of First Vice Presidents. While
these Conferences were not formally established by the Federal Reserve
Act as were the Federal Open Market Committee and the Reserve Bank
boards, in practice they are important forums for the discussion and
resolution of high-priority issues and problems.
Member banks At the end of 1985, about 6,000 of the approximately
14,000 commercial banks in the United States were members of the
Federal Reserve System. All national banks are required to be members,
and state-chartered banks may voluntarily become members if they meet
the requirements for membership established by the Board of Governors. As suggested earlier, membership carries both responsibilities and
privileges. For example, member banks are required to subscribe to the
stock of their respective Reserve Banks, and they are supervised and
examined by the Reserve Banks, but they elect six of the nine members
of the Reserve Bank boards, and they receive the annual 6 percent
dividend on Reserve Bank stock.
Prior to 1980, the duties and privileges of member banks delineated
them more sharply from nonmember institutions than presently, because only members were subject to Fed's reserve requirements, and
only members had access to the Fed's payments and other operational
services, which were provided without charge. Also, only member
banks had access to the Fed's discount window. As pointed out in
Section 1, the Depository Institutions Deregulation and Monetary
Control Act of 1980 subjected all depository institutions to Fed reserve
requirements, although some smaller institutions do not actually hold
20

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required reserves because their reservable liabilities are below an
exempted amount.7 At the same time, the Act extended access to the
discount window to all nonmember depository institutions with deposit
liabilities subject to Fed reserve requirements. It also extended access to
the Fed's operational services to all depository institutions that are
eligible for federal deposit insurance and required the Fed to charge all
institutions explicit fees for these services.

Advisory committees In addition to the principal arms of the Fed
discussed above, there are a number of advisory councils and committees in the System that exist for specific purposes. The Federal Advisory
Council, which is shown in Figure 1, has 12 members-one elected
annually by each of the 12 Reserve Bank boards. The members are
typically prominent commercial bankers. The Council meets at least four
times a year with the Board of Governors to discuss current issues
related to Fed monetary and regulatory policies and other relevant
matters. Other advisory groups include the Consumer Advisory Council, made up of 30 members with an interest in consumer affairs, and the
Thrift Institutions Advisory Council, which comprises representatives of
savings and loan associations, savings banks, and credit unions. The
Consumer Advisory Council keeps the System informed of major
consumer issues in view of the Fed's statutory responsibilities in this
area discussed in Section 1. The establishment of the Thrift Institutions
Advisory Council in the early 1980s reflected the extension of Fed
reserve requirements and access to the discount window and Fed
operational services to thrifts by the DIDMCA. In the mid-1980s, each
Reserve Bank established a Small Business and Agricultural Advisory
Committee to provide a channel for direct communication between the
Fed and representatives of these two sectors from all regions of the
country. Several members of each of these Committees meet as a group
with the Board of Governors each year.

A central purpose of the DIDMCA was to resolve the problem created by the accelerated
attrition of member banks during the late 1970s that had resulted from the steep rise in interest
rates during that period. This increase in rates significantly increased the opportunity costs of
holding required reserves.

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B. Position of the Fed within the Overall
Structure of the Government
One of the most frequently misunderstood aspects of the Fed is its
institutional position within the federal government. There have been
numerous instances throughout recorded history where the centers of
political power within governments-monarchs or prime ministers or
legislative bodies-have abused the power to control the monetary system.
The framers of the Federal Reserve Act were aware of this risk and sought
to insulate the Fed to some extent from routine political pressures through
various provisions of the Act. For this reason, the Fed is often described as
"independent."
It is true that the Fed has somewhat greater freedom to act than some
other government entities, since its actions do not have to be formally
ratified by the President, its expenses are funded from its own earnings
rather than through the regular Congressional appropriations process, and
the full terms of members of the Board of Governors are lengthy. The
System is not independent of the rest of the government, however, in any
general sense, either as an institutional matter or in practice. In particular, it
is not a separate branch of the government protected by the Constitution
like the judicial system. It is, instead, essentially a creature of Congress. It
exists by virtue of an act of Congress, and it could be significantly altered or
even abolished at any time Congress wished to do so. Further, while the
Fed does not report directly to the President or any other arm of the
Executive Branch, it is a generally accepted principle that Fed monetary
policy should complement the fiscal and other economic policies and
programs of the Administration wherever possible in seeking to attain the
longer-run national economic goals of high employment and stability in the
price level. It would be difficult if not impossible for the Fed to follow a
policy substantially at odds with the policies favored by a clear majority of
the rest of the government.
The close working relationship between the Fed and other federal
entities is manifested in a variety of ways. The Chairman of the Board of
Governors and other Board members testify frequently before Congressional committees on the state of the economy and monetary policy,
domestic and international financial developments, regulatory matters, and
a variety of other issues. Since monetary policy and many of the other
policy areas in which the Fed is active are inherently controversial, these
Congressional hearings are sometimes contentious, and the Fed's representatives are typically required to explain and defend the System's actions in
depth. In addition to its relations with Congress, the Fed is in close contact
22

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with the Executive Branch and other government agencies. The Chairman
of the Board of Governors meets with the President from time to time and
has regular consultations with the Secretary of the Treasury and other high
officials on a variety of issues. There are also frequent contacts between
members of the Fed's permanent staff and their counterparts in other
agencies, particularly the Treasury. In short, through a variety of formal
and informal contacts, the Fed is kept fully apprised of the views of other
officials and agencies on issues of mutual concern, and it has ample
opportunity to communicate its own views on these matters.

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A Primer on the Fed

SECTION 3:

THE FED AT WORK:
THE IMPLEMENTATION OF
MONET ARY POLICY

This section describes Fed monetary policy in the context of events and
major policy developments in the late 1970s and early 1980s. As noted in the
introduction to this article, monetary policy is the preeminent responsibility
of the Fed, and the special attention given to this particular Fed function in
this section reflects its importance. Monetary policy is a complex field, and
it is the subject of an extensive technical literature. The purpose of what
follows is to provide a reasonably thorough nontechnical overview of the
topic along with some of the flavor of major recent developments and policy
issues.

A. Strategy, Procedures, and Mechanics of
Monetary Policy
Overview The term monetary policy, again, refers to the actions the
Fed takes to influence national and international monetary and financial
conditions with a view to helping achieve the nation's basic economic
objectives of price level stability, high employment, and reasonable
balance and stability in its trade and payments relations with other
nations. This conception of monetary policy implies certain relationships. First, the Fed must be able to influence monetary and financial
conditions. Second, monetary and financial conditions must have some
impact on at least some of the objectives-or, to employ the jargon of
economists, the "goal variables"-of economic policy such as stability in
the price level.
It is generally recognized that the Fed, like other central banks, can
influence domestic monetary and financial conditions. It is also agreed

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that the Fed can influence international monetary conditions, given the
importance of the U.S. monetary system and financial markets in the
world economy. It should be understood, however, that the System's
influence over most financial variables is indirect. Everyone who works
in a policymaking capacity at the Fed for any length of time is eventually
asked what the Fed plans to "do" to interest rates and the money supply
at some point in the future. The System has direct administrative control
over only one interest rate, however, the discount rate, and it has no
direct control over the several aggregations of currency, bank deposits,
and other liquid assets that comprise the various measures of the
national money supply. What the Fed can influence directly is the
volume and growth of reserves held by private commercial banks and
other depository institutions-that is, balances held by depository
institutions at Federal Reserve Banks. 8 Through this influence on bank
reserves, the Fed can indirectly affect interest rates and the growth of
money and credit. For example, if the public's demand for money and
credit is substantial, due, perhaps, to strong growth in the general
economy, a restrictive approach to the provision of reserves by the Fed
tends to put immediate upward pressure on the Federal funds rate,
which is the short-term interest rate charged for the use of reserves
when they are sold (lent) and bought (borrowed) in the so-called Federal
funds market. The rise in the Federal funds rate, in turn, causes other
interest rates to rise, which acts to reduce both the supply and demand
for money and credit and hence their growth. Conversely, if the Fed
supplies reserves generously in relation to the demand for money and
credit, interest rates will come under downward pressure, and the
growth of money and credit will tend to increase.
The second basis for the conduct of monetary policy is the
presumption that relationships exist between the monetary and financial
variables that the Fed can influence, on the one hand, and the goal
variables of economic policy on the other. The nature of these relationships and their empirical characteristics have been the subject of
extensive research and analysis by monetary economists for many years.
Despite its extent, the results of this research are still not fully
8

These reserves totaled a little over $28.5 billion at the end of 1985. The use of the word influence
rather than control in this sentence was deliberate . The Fed cannot control total reserves
precisely in the short run under present institutional arrangements, because total reserves
include reserves borrowed from the discount window, and depository institutions play a
significant role in determining the level of borrowing in the short run. The Fed can, however,
control nonborrowed reserves with considerable precision in the short run.

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conclusive, and much disagreement remains on particular points. Most
economists agree that a stable and predictable positive relationship
exists over the long run between the rate of growth of the money supply
and the rate of inflation: specifically, a sustained rise in the growth rate
of the money supply is followed eventually by a rise in the trend rate of
inflation. Some economists also believe that short-run relationships exist
between (1) changes in the growth rates of monetary variables, and (2)
real economic variables such as the rates of growth of production and
employment. As suggested in Section 1, however, views regarding the
nature of these short-run relationships and their usefulness as a basis for
monetary policy have changed substantially over the last two decades.
In particular, the research of the rational expectations school of
economists has produced a growing consensus that the only changes in
the growth rate of the money supply that affect real economic variables
are those that are not anticipated by the public. Since the public's
anticipations are difficult to observe and quantify accurately on a current
basis, this view implies that these short-run relationships cannot be
predicted reliably, and for that reason the Fed cannot exploit them to
fine-tune the economy. As pointed out in Section 1, this attitude toward
what can be achieved through monetary policy is considerably less
ambitious than the view held by many economists and policymakers in
the 1960s.
The strategy of monetary policy and monetary targeting This
evolution of prevailing views regarding the nature of the relationships
between monetary and other economic variables has had a substantial
impact on the strategy of monetary policy over time: that is, on the
procedures the Fed employs to achieve its longer-run objectives. It is
probably fair to say that the Fed did not have a clear and wellarticulated, longer-run strategy for monetary policy prior to the 1970s.
The rising inflation and other dislocations in that decade, however,
forced the System to lengthen its horizon in formulating policy. Further,
the growing influence of monetarist doctrine in the economics profession, among policymakers, and in some quarters of the Congress
probably caused the Fed to give greater-although by no means
exclusive-attention to the behavior of monetary aggregates in conducting policy. These developments culminated in 1975 in the passage of
House Concurrent Resolution 133 in which Congress expressed its sense
that the Fed should manage the longer-run growth of monetary and
credit aggregates and keep that growth consistent with the nation's

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broad economic goals. 9 The System had been setting internal monetary
growth targets for several years before the passage of this Resolution.
Following the passage of the Resolution, however, it began to report the
targets to the Congress in public testimony. In 1978, the Full Employment and Balanced Growth Act (the Humphrey-Hawkins Act) made the
requirements of the Resolution law.
In accordance with the terms of the Humphrey-Hawkins Act, the
Fed has developed a formal procedure for establishing targets for the
growth of various monetary and credit aggregates and reporting these
targets to Congress. Under the present procedure, the Federal Open
Market Committee typically sets target ranges for three monetary
aggregates, Ml, M2, and M3, and a monitoring range for one credit
aggregate, Domestic Nonfinancial Debt Outstanding, at its meeting in
February of each year for the period running from the fourth quarter of
the preceding year to the fourth quarter of the current year. The base for
each target range is the actual level of the relevant aggregate in the
fourth quarter of the preceding year, calculated as an average of daily
Fig. 3

- ~ - TARGET RANGE FOR Ml, 1984
I

••

- - • Actual Growth Rate: 5.2%

•

1983

1984

Source: Board of Governors of the Federal Reserve System. "Monetary Policy Objectives for 1985,"
Summary of Report to the Congress on Monetary Policy pursuant to the Full Employment and
Balanced Growth Act of 1978. February 20, 1985, p.6.
9

The language of the Resolution's reference to monetary and credit aggregates is identical to that
in the Humphrey-Hawkins Act of 1978 quoted in Section 1 of this article.

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data over the quarter. The upper and lower endpoints of each range are
quarterly average levels in the fourth quarter of the current year.
Although it would be possible to discuss the targets in terms of dollar
levels, they are normally discussed in terms of growth rates, and the
widths of the ranges are always established in terms of so many
percentage points difference between the growth rate implied by the top
of a range and the growth rate implied by the bottom of a range. The
ranges have typically been three or four percentage points wide, but
they have sometimes been wider.
As an example, Table 1 shows the target ranges established by the
Committee for 1984 at the beginning of that year. As Table 1 shows, the
range for Ml in 1984 had a four-percentage-point spread, while the
ranges for the other aggregates had three-point spreads. The target
ranges are frequently depicted graphically both in official publications
and the financial press. Figure 3 depicts the Ml range for 1984 in terms
of the traditional target "cone," along with the actual growth path
during that year. Because the width of the cone (in terms of dollar levels)
is much narrower at the beginning of a target period than at the end, its
usefulness for monitoring progress toward achieving the target during
the early quarters of the period is limited. For this reason, the Fed began
to supplement the cone in 1985 with so-called parallel bands of constant
(dollar level) width throughout the period, as shown in Figure 4. This
chart shows the target range for 1985 and M2. As the chart shows, the
actual level of M2 was above the top of the cone throughout much of this
target period, but it was always at or below the top parallel band, and it
finished the year within the range.
Table 1

TAR GET RANGES FOR
MONETARY GROWTH, 1984
Measured from fourth quarter 1983 to fourth quarter 1984
M2

6 to 9 percent

4 to 8 percent

Total Domestic Nonfinancial Debt

8 to 11 percent

Source: Board of Governors of the Federal Reserve System.

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Fig. 4

TARGET RANGE FOR M2, 1985

1984

1985

Source: Board of Governors of the Federal Reserve System. "Monetary Policy Objectives for 1986,"
Summary of Report to the Congress on Monetary Policy pursuant to the Full Employment and
Balanced Growth Act of 1978. February 19, 1986, p .6.

As noted above, the Fed typically sets ranges for three monetary
aggregates and one credit aggregate. Table 2 lists the principal components of the monetary measures. 10 Ml is the narrowest of these
aggregates and attempts to measure the public's transactions balances.
M2 includes Ml and several other categories of liquid assets. M3
includes M2 and still other categories of relatively liquid assets. The
credit aggregate, referred to as Domestic Nonfinancial Debt Outstanding, is essentially the total debt outstanding in U.S. credit markets less
borrowings by foreigners and financial institutions. 11 The latter elements
are excluded because, unlike other components of total debt, they are
not closely related to U.S. economic activity. Ranges have been
established for Ml, M2, and M3 since the formal targeting procedure
was initiated in 1975. A range has been set for domestic nonfinancial
debt only since 1983.
In addition to the target-setting at the beginning of the year, the
Federal Open Market Committee reevaluates all of the targets at its
10

More precise and detailed definitions of these aggregates are provided in the footnotes to Table
1. 10 of the monthly Federal Reserve Bulletin.

See Board of Governors of the Federal Reserve System [5], Table 2.2, pp. 24-25.

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Table 2

COMPONENTS OF Ml, M2, AND M3
March 1984
Billions of dollars, seasonally adjusted except as noted

Aggregate and component

Ml
Currency
Travelers checks of nonbank issuers
Demand deposits
Other checkable deposits at all depository institutions
M2 1

Ml
Overnight RPs issued by commercial banks2
Overnight Eurodollars held by U.S. residents at overseas
branches of U.S. banks 2
Money market mutual fund shares (general-purpose and
broker/dealer, taxable and nontaxable) 2
Savings deposits at all depository institutions
Money market deposit accounts at all depository
ins ti tu tions 2
Small-denomination time deposits at all depository
institutions3
M3 1
M2

Large time deposits at all depository institutions4
Money market mutual funds (institution-only)2
Term RPs at all depository institutions2•5
Term Eurodollars held by U.S. residents 2
1

Amount

535.3
150.9
5.0
244.0
135.4
2,230.0
535.3
47.0
11.3
144.8
305.5
392.5
803.4
2,767.8
2,230.0
347.9
45.0
55.9
93.9

M2 and M3 both differ from the sums of their components because of consolidation
adjustments and the seasonal adjustment technique. The consolidation adjustment
for M2 represents the amount of demand deposits and vault cash at commercial
banks owned by thrift institutions that is estimated to be used in servicing their time
and savings deposits. The consolidation adjustment for M3 is the estimated amount
of overnight repurchase agreements and overnight Eurodollars held by institutiononly money market mutual funds. The nontransaction component in M2 and the
nontransaction component in M3 alone are seasonally adjusted only as aggregates.
The individual seasonally adjusted series included in these nontransaction components in the table are not used in calculating seasonally adjusted M2 or M3.

Not seasonally adjusted.

Time deposits in amounts of less than $100,000; includes retail repurchase agreements.

Time deposits in amounts of $100,000 or more.

Excludes retail repurchase agreements.

Source: Board of Governors of the Federal Reserve System, The Federal Reserve System:
Purposes and Functions. 1984, pp. 22-23.

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meeting in July to determine whether or not they are still appropriate in
the light of economic and financial developments since the initial
setting. The Committee has made several changes in specific targets at
its July meeting over the years. These changes have taken the form both
of changes in the percentage growth rates and changes in the base
period for the target. Changes in the base (referred to as "rebasing")
have usually involved moving the base period forward from the fourth
quarter of the preceding year to the second quarter of the current year.
For example, at its meeting in July 1985, the Committee moved the base
for the Ml target forward to the second quarter of that year. Also, the
growth rate range for Ml was widened from the 4 to 7 percent range
established at the February meeting to 3 to 8 percent.
To fulfill the reporting requirements of the Humphrey-Hawkins
Act, the Fed Chairman reports the results of the Committee's targetsettings in Congressional testimony shortly after the February and July
meetings. These appearances have become focal points for the public
discussion of monetary policy in recent years, and they therefore receive
substantial attention in the media and elsewhere.
Several comments regarding this strategy and procedure are in
order. First, although the Humphrey-Hawkins Act required the Fed to
report its intentions regarding the growth of money and credit, neither
the letter nor the spirit of the law required the Fed to make the target
ranges the exclusive basis for the conduct of monetary policy, and the
Fed has not done so. The Fed has consciously allowed the actual growth
of particular aggregates to deviate from their ranges on a number of
occasions, especially in the early- and mid-1980s, when it felt that the
actions it would have had to take to bring growth back within the ranges
might have damaged the economy. It has also given substantial
attention to other economic and financial variables in formulating and
implementing policy such as interest rates, foreign exchange rates, and
various measures of overall economic activity, such as the gross national
product. Further, as indicated in greater detail in Section 3B, it has
frequently changed the weights it has attached both to the monetary and
credit aggregates it explicitly targets and the other financial and
economic variables it monitors. For example, it has explicitly reduced the
weight given to Ml on several occasions in the 1980s due to the unusual
behavior of the velocity of Ml in this period; that is, the reduced
predictability of the empirical relationship between Ml and GNP.
This generally flexible and discretionary approach to the conduct of
monetary policy has many defenders among professional economists
32

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and others, both inside and outside the Fed. Those who favor this
approach point out that flexibility is particularly necessary in a period of
rapid institutional change, such as the extensive deregulation in banking
and financial markets in the 1980s. Others, however, especially monetarist economists and adherents to the rational expectations school,
believe that a highly discretionary policy may tend to destabilize the
economy rather than stabilize it over the longer run. These economists
generally favor a monetary policy strategy where the Fed's reaction to
emerging economic and monetary developments would be determined
to a greater extent than at present by preannounced rules and would
therefore be easier for the general public and financial market participants to anticipate. The full range of this debate is beyond the scope of
this article. With respect to the Fed's monetary targeting strategy, those
who favor a greater reliance on rules have criticized several features of
the procedures outlined above. First, they have pointed out that
targeting several measures of the money supply and shifting the
emphasis among them reduces the potentially healthy discipline that
targeting imposes on the Fed itself. Since the growth rates of the various
aggregates the Fed targets frequently diverge in the short run, the Fed
may at times avoid reacting to the aberrant behavior of one aggregate by
transferring its attention to another. Although such shifts in emphasis
may be justifiable in some cases, they may not be desirable in others.
Also, the shifting reduces the usefulness of the targets as statements of
the System's policy intentions to the public. Second, those who favor
rules have criticized the practice of using the actual level of an aggregate
in the fourth quarter of the preceding year as the base for the target in
the current year on the grounds that doing so leads to the automatic
ratification of any deviation from the preceding year's target, regardless
of whether the deviation was desirable for economic reasons or not. 12
Whether or not the Fed's monetary targeting strategy has actually
improved the conduct of monetary policy over the years it has been used
is still an open question. The growth of the Ml aggregate exceeded the
top of its range significantly in both 1977 and 1978, and some economists
believe that the rapid growth occasioned by these averages and the
accompanying upward ''base drift'' contributed to the high inflation and
resulting financial turmoil in 1979, 1980, and 1981. In short, the targeting
12

This phenomenon has come to be known as "base drift." For a discussion of the problems
posed by base drift, see Broaddus and Goodfriend (8]. For a more sympathetic view of the
phenomenon, see Walsh (23].

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procedure does not appear to have been very useful in assisting the Fed
to achieve price level and financial stability in this period. On the other
hand, the existence of the targeting strategy has probably served as a
useful and continuous reminder to the public, Congress, and the Fed
itself of the longer-run goals of monetary policy. The strategy will
probably continue to be useful in the future, although modifications may
be required in the light of the watershed financial deregulation of the
1980s. 13

The tactics of monetary policy: Instruments It is not enough for the
Fed to have a longer-run strategy in conducting monetary policy. Like
other institutions, it lives in the short run, and it must respond to an
endless series of economic and financial disturbances-some of which
can be anticipated, but most of which cannot-in implementing policy.
For this reason, the Fed uses a set of tactical procedures to assist in
implementing the longer-run strategy outlined above and in attaining its
strategic objectives. This subsection and the next two describe the three
principal elements of this tactical apparatus: the instruments or tools of
monetary policy, the tactical operating procedures, and the policymaking process in the short run.
The Fed uses three principal instruments in conducting monetary
policy on a day-to-day basis: open market operations, the discount rate,
and reserve requirements. 14 Of these, open market operations are the
most important. The following paragraphs briefly describe the mechanical aspects of these instruments. The next subsection describes how the
System welds the specific actions it takes with these various instruments
in to a coordinated tactical procedure.

Open market operations, as the name implies, are simply purchases
and sales of securities by the Fed in the open money and bond markets.
The purpose of these purchases and sales is to affect the aggregate
reserve position of depository institutions; that is, the level and growth
of the non-interest-bearing reserve deposits these institutions hold, in
13

For a useful nontechnical discussion of some of the broader current issues surrounding the
Fed's monetary targeting strategy see Federal Reserve Bank of Minneapolis [10]. See also
McCallum [16].

The Fed has used other tools in the past, notably direct credit controls and interest rate ceilings,
although many economists do not regard these tools as appropriate instruments of monetary
policy. The Fed's power, noted in Section 1, to set margin requirements on certain classes of
securities is sometimes regarded as an instrument of monetary policy, but it is not regarded as
an important tool in practice under the Fed's present operating procedures.

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the aggregate, at Federal Reserve Banks. 15 The basic mechanics of these
operations are quite simple. If the Fed wishes to increase the level of
reserves, it purchases securities in the open market. It ultimately pays
for the purchase by crediting the reserve account of some depository
institution for the amount purchased, which increases the level of
aggregate reserves by that amount. Conversely, if the Fed wants to
reduce the level of reserves it sells securities in the market. (Or, more
importantly in practice, if it wishes to reduce the rate of growth of
reserves, it buys securities at a less rapid pace.) Payment for the sales is
eventually effected by reducing some depository institution's reserve
account for the amount of the sale, which reduces the aggregate level of
reserves. This description of the mechanics of open market operations
focuses on individual transactions in isolation. In reality, of course, such
individual transactions are part of a continuous stream of transactions
involving the public and other institutions in addition to the Fed.
Therefore, it is not generally useful in practice to think of Fed open
market operations in terms of the isolated effect of particular purchases
and sales. Instead, the focus is on the broader effects of operations on
the growth of reserves over time: purchases tend to increase growth;
sales reduce it.
The Fed's open market operations are controlled and supervised by
the Federal Open Market Committee. They are executed in the market,
under the Committee's direction, by the Federal Reserve Bank of New
York acting as the Committee's agent. A department at the New York
Bank, known popularly as the "Trading Desk," or simply the "Desk,"
actually carries out the operations. A Manager for Domestic Operations,
who is a senior officer of the New York Bank, supervises the Trading
Desk. The Manager has direct day-to-day control of open market
operations. He reports directly to the Committee and receives his
instructions from the Committee.
Although in principle the Fed could conduct open market operations using any public or private securities, it is restricted by law to the
use of U.S. government (i.e., U.S. Treasury) securities, obligations
issued or guaranteed by agencies of the United States, and a few
short-term securities. In practice, the vast majority of operations are
carried out using Treasury securities, and they would undoubtedly be
15

In addition to affecting reserves themselves, these operations also affect the Federal funds rate,
which is the interest rate charged for the use of reserve funds in the open market. The Federal
funds rate has played a key role in the implementation of monetary policy in the 1970s and
1980s as indicated in subsequent sections of this article.

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concentrated in Treasuries even in the absence of legal restrictions. To
be effective in an economy and financial system as large as that of the
United States, it is essential that the Fed be able to conduct large
purchases and sales flexibly without unduly disrupting the market. The
market for U.S. government securities is extremely broad and active,
and is therefore ideal for open market operations.
The Fed's open market operations are an important factor affecting
the aggregate volume of reserves available to depository institutions, but
by no means the only factor. Independent actions on the part of the
general public and the U.S. Treasury also have important effects on
reserves. When the public's demand for currency increases, for example, as it typically does before important holidays, depository institutions obtain the currency from the Fed. They pay for it through
reductions in their reserve balances at the Fed, which reduce aggregate
reserves. Conversely, a reduction in the public's desire for currency
increases reserves. As pointed out in Section 1, the Treasury maintains
an account on the books of the Fed and uses this account to make
routine payments for the federal government's purchases of goods and
services and in connection with transfers such as medicare disbursements. When the Treasury makes such a payment, the Treasury account
at the Fed is drawn down, and the funds flow into the reserve account of
some depository institution, which increases aggregate reserves. The
reverse occurs when the public makes payments to the Treasury, such
as tax payments. These examples cover just a few of the myriad factors
other than the Fed's open market operations that continuously influence
the aggregate reserve position of depository institutions. 16 In order to
manage the reserve position the Fed must neutralize these other factors.
It does this on a continuous basis through so-called defensive open
market operations, which constitute the majority of its operations.
Indeed, as can be seen in Table 3, the total dollar volume of Fed open
market transactions in a given year typically exceeds the net change in
the System's portfolio of securities by a substantial amount.
Against this background, the Fed's open market operations can be
divided into two broad categories: (1) outright, permanent purchases or
sales and (2) temporary purchases or sales in the form of "repurchase
agreements" (for temporary purchases) or "matched sale-purchase
transactions" (for temporary sales). Outright transactions are most likely
16

For a detailed treatment of all factors affecting reserves, see Board of Governors of the Federal
Reserve System [5], Appendix to Chapter 3, pp. 45-56.

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Table 3

FEDERAL RESERVE OPEN MARKET TRANSACTIONS, 1985
Type of transaction

Mil. of dollars

5 to 10 years
Gross purchases . . . ....... . ........ .
Gross sales ... .. ... . ..... . ....... . .

U . S. GOVERNMENT SECURITIES

Outright transactions
(excluding matched transactions)
Treasury bills
Gross purchases .. . ..... ... ..... .
Gross sales ................... . . .

~~~~~~~o~; :: ::::::::::: :::::::
Others within 1 year
Gross purchases . . . . ...... . . . .. . .
Gross sales ... . ... . . . .. . ........ .
Maturity shift ...... . . .. ......... .

~~~~~~~o~;:: ::::::::::::::::::
1 to 5 years
Gross purchases . ... .. . .. . . . .. .. .
Gross sales ... .. . . ..... . ... .. .. . .
Maturity shift . ..... . .. . ......... .
Exchange . . .... ............ .. . . .

Type of transaction

22,214
4,118
0
3,500

1,349
0
19,763
-17,717
0

2,185
0
- 17,459
13,853

Mil. of dollars

Type of Transaction

Mil. of dollars

FEDERAL AGENCY OBLIGATIONS

Wx~~a~1/~i~t- : : : : : : : : : : : : : : : : : : : : : :

458
100
- 1,857
2,184

More than 10 years
Gross purchases ................... .
Gross sales . . ... . ... . ....... . ..... .
Maturity shift . .. .. . ........... . ... .
Exchange . . . .. . .... ..... ....... . . . .

293
0
-447
1,679

All maturities
Gross purchases ..... . ... . .. . ..... . .
Gross sales ...... .. . . ......... . ... .
Redemptions .. .. .... . ............. .

26,499
4,218
3,500

Matched transactions
Gross sales ...... . ........ . . .. . .. . . . .
Gross purchases .. . . . . ..... .. ........ .

866,175
865,968

Repurchase agreements
Gross purcnases . .... ... ............ . .
Gross sales .... . . ... ................ .

134,253
132,351

Net change in U.S. government
securities . .. . ....... . .... . . . .. .

20,477

Outright transactions
Gross purchases . ... . .. ... ... . . ..... . .
Gross sales ..................... . .. . .
Redemptions ......... . .. . . . . .. .. . .. . .

0
0
162

Repurchase agreements
Gross purchases ..... . .. . . . .. . ....... .
Gross sales . . ..... . ... . ... .... . . . ... .

22,183
20,877

Net change in federal agency
obligations . . ....... . ..... . . . . . .

1,144

BANKERS ACCEPTANCES

Repurchase agreements, net . . .. . . . .. . .

Total net change in
System Open Market Account . . . . . . .

21,621

Note: Sales, redemptions, and negative figures reduce holdings of the System Open Market Account; all other figures increase such holdings.
Details may not add to totals because of rounding.
Source: Board of Governors of the Federal Reserve System, Annual Report. 1985, pp. 208-9.

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to be used when the Fed wants the operation to have a lasting effect on
reserves. Outright purchases might be used in the autumn months, for
example, to offset the persistent seasonal drain of reserves caused by the
buildup of currency in the hands of the public prior to Christmas.
Repurchase agreements and matched sale-transactions agreements are
used when the Fed expects to want to reverse the effect of an operation
on reserves within a few days or weeks. Under a repurchase agreement,
the Fed buys securities from a dealer who agrees to repurchase them by
a specified date at a specified price, which increases reserves over the
duration of the agreement. Matched sale-purchase transactions involve
an immediate sale of securities to a dealer matched by an agreement for
the Fed to repurchase the securities by a specified date at a specified
price. In this case, reserves are reduced over the duration of the
agreement. Repurchase agreements or matched sale-purchase transactions might be used, for example, to offset anticipated temporary effects
of fluctuations in the Treasury's balance at the Fed on reserves.
The Fed carries out the majority of its operations in the market with
40 so-called primary securities dealers, about a third of which are
departments of large money center banks and the remainder securities
brokerage houses. All of these dealers make regular markets in Treasury
and federal agency securities, and are therefore prepared at all times to
quote prices at which they will buy securities and prices at which they
will sell them. The Fed executes most of its transactions, both outright
and temporary, using an auction-like procedure, where it announces
what securities it wishes to buy or sell and in what amounts, receives
price or interest rate proposals from the various primary dealers for the
transaction, and accepts the proposals most favorable to the Fed up to
the dollar amount of the operation.
Although the majority of its operations are carried out with primary
dealers, the Fed can also affect reserves via its financial dealings with
foreign central banks and other foreign official institutions. On any
given day, the Fed has orders from some of these "customers" to invest
funds overnight. In this situation the Fed has a choice: it can either
temporarily sell securities to these institutions from its own account,
which reduces reserves, or it can pass the orders through to private
dealers, in which case reserves are not affected. The choice on a
particular day reflects the overall objectives of the Fed's operations on
that day.
Table 3 summarizes the Fed's open market transactions in 1985 and
illustrates some of the points made above. As already noted, the table

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shows that the total volume of transactions in 1985 greatly exceeded the
net change in the System's portfolio of approximately $21.6 billion. The
table also indicates that the volume of repurchase agreements and
matched sale-purchase transactions was much larger than the volume of
outright purchases and sales. Finally, the table shows that the vast
majority of operations are carried out using U.S. Treasury securities.
Further, since most repurchase agreements and matched sale-purchase
transactions are conducted with short-term Treasury bills and, as the
table indicates, a sizable portion of outright transactions are done with
bills, it is clear that a majority of the Fed's total operations are conducted
using bills. The liquidity of bills makes them especially suitable for open
market operations. 17
The second instrument or tool of monetary policy is the discount
rate. As pointed out in Section 1, all depository institutions with
reservable deposits may borrow reserves from the Fed's discount
window for short-term adjustment purposes and a limited number of
other reasons, subject to certain administrative restrictions contained in
the System's Regulation A. The discount rate is the interest rate charged
on these loans. As a technical matter, a depository institution can
borrow from the window in two ways: (1) by "discounting," that is,
selling loans or other assets carrying its endorsement to the Fed, or (2)
through an advance, which is a loan from the Fed to the institution on
the institution's note, which must be secured by acceptable collateral. At
present, nearly all borrowing at the window is via advances because of
their greater convenience. In the early days of the System, however,
discounting was the more common procedure, and this historical legacy
is the origin of the terms discount window and discount rate. Most
borrowing at the window is at the basic discount rate. Higher rates are
charged for certain categories of extended credit.
Each of the 12 Federal Reserve Banks has a discount window
managed by a discount officer, and the boards of directors of the Banks
set the rates for their respective Banks subject to the approval of the
Board of Governors. When the System was created, it was anticipated
that discount rates would vary from one Bank to another in recognition
of differing economic conditions across Federal Reserve Districts. At
present, the discount rates are generally uniform across the country
17

For an excellent nontechnical description of open market operations, see Meek [18]. See also
Partlan, Hamdani and Camilli [20].

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except for brief transitional differences when the rate is being adjusted
either upward or downward.
As noted in Section 1, providing loans through the discount
window is one of the Fed's most important functions in the context of its
broad responsibility for the liquidity and stability of U.S. financial
markets. The focus of the present discussion, however, is on the role of
the discount rate as an instrument of monetary policy. Essentially, the
Fed uses the discount rate to reinforce its efforts to manage reserves
through open market operations. Although many depository institutions are reluctant to borrow from the window, and all institutions are
subject to various rules and administrative constraints when they do
borrow, a discount rate that is low in relation to other short-term rates
tends to encourage borrowing, and, conversely, a high discount rate in
relation to other rates tends to discourage borrowing. Therefore, if the
Fed, for example, were trying to restrain the growth of reserves, and this
restraint were putting upward pressure on the Federal funds rate and
other market rates, the maintenance of an unchanged discount rate
might tend to raise the aggregate level of borrowing at the window at
least temporarily, which would work against the thrust of open market
operations. In this situation, the Fed might raise the discount rate to
reinforce its open market operations. In addition to its direct impact on
borrowing, the announcement of the discount rate increase would be a
strong signal of the direction of Fed policy to both the financial markets
and the general public, because such changes are highly visible and
receive considerable attention from the news media. 18 Similarly, if the
Fed were trying to stimulate reserve growth through open market
operations, it might reduce the discount rate at some point. 19
While it can be broadly said that the Fed reinforces its open market
operations with changes in the discount rate, in general this reinforcement is highly discretionary and judgmental with respect to both the
magnitude and timing of discount rate changes. Stated differently, there
are no specific rules or formulas controlling the manner in which the Fed
manages the discount rate in conjunction with its other policy actions,
and the timing and magnitude of changes in the rate in particular
18

For a detailed analysis of the effects of discount rate announcements, see Cook and Hahn [9] .

In addition to changing the basic discount rate, on some occasions in the recent past the Fed
has added surcharges to the basic rate as a means of reinforcing restrictive open market
operations. For example, in 1980 and 1981 the System added a two to four percentage point
surcharge to adjustment borrowing by larger institutions that borrowed in two successive
weeks or in more than four weeks in a 13-week period.

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instances reflect a variety of external factors including the strength of the
monetary or economic trends the Fed may be reacting to and its
perception of expectations in the financial markets. At the same time,
the short-run impact of discount rate changes on market interest rates
depends to some extent on the particular short-run operating procedures the Fed is using in implementing policy, and the Fed has to take
these relationships into account in deciding on discount rate actions in
particular circumstances. Specifically, changes in the discount rate have
generally stronger and more immediate effects on market rates under
the operating procedures the Fed has used in the 1980s. 20
Although the Board of Governors exercises final control over the
discount rate, the participation of the Reserve Bank boards of directors
in the process of setting the rate has considerable practical importance.
Specifically, when a Reserve Bank board proposes a change in the rate,
the Board of Governors must consider the proposal and make an explicit
decision to approve it, disapprove it, or table it for later consideration. In
this way, the Board is made aware of the thinking of a cross section of
well-informed citizens from a variety of backgrounds and regions
regarding the appropriate level of the rate and, more generally, the
appropriate direction of monetary policy as a whole.
The third major instrument or tool of monetary policy is reserve
requirements. Under current law, all depository institutions operating in
the United States (including not only domestic commercial banks but
also savings banks, savings and loan associations, credit unions, Edge
Act and agreement corporations, and U.S. branches and agencies of
foreign banks) must hold required reserves against their (1) net
transactions accounts, (2) nonpersonal time deposits, and (3) Eurocurrency liabilities. 21 These required reserves must be held in the form
either of vault cash or deposits at a Federal Reserve Bank. The Board of
Governors of the Fed establishes these requirements in terms of
percentages of particular categories of reservable liabilities. The panel on
the right-hand side of Table 4 shows the reserve requirements in effect in
June 1986. As the table indicates, at that time depository institutions had
to hold reserves equal to 12 percent of their net transactions accounts in
excess of $31.7 million, and so forth. Under the law, the Board sets the
requirements within specific ranges for each category of reservable
20

See Broaddus and Cook [7).

In this context, the term Eurocurrency liabilities refers to funds that U.S. depository institutions
raise abroad for use in the United States.

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Table 4

RESERVE REQUIREMENTS OF DEPOSITORY INSTITUTIONS
Percent of Deposits

Type of deposit, and
deposit interval

Member bank requirements
before implementation of the
Monetary Control Act
Percent

Effective date

7
9½
1H'4
12¥4
16¼

12/30/76
12/30/76
12/30/76
12/30/76
12/30/76

Time and

3/16/67

savings2 •3

Savings ...............................
Time4
$0 million-$5 million, by maturity
30-179 days ........................
180 days to 4 years .................
4 years or more ....................
Over $5 million, by maturity
30-179 days ........................
180 days to 4 years .................
4 years or more ....................

Percent

Effective date

3
12

12/31/85
12/31/85

3
0

10/6/83
10/6/83

11/13/80

Net transaction accounts7 •8

Net demand 2
$0 rnillion-$2 million ...................
$2 rnillion-$10 million ..................
$10 million-$100 million ................
$100 million-$400 million ...............
Over $400 million ......................

Ty£e of deposit, and
eposit interval5

Depository institution requirements
after implementation of the
Monetary Control Act6

$0-$31. 7 million ........................
Over $31.7 million ......................

Nonpersonal time deposits 9
By original maturity
Less than 1½ years ...................
1½ years or more ....................

Eurocurrency liabilities
All types ............................

3
2½
1

3/16/67
1/8/76
10/30/75

6
2½
1

12/12/74
1/8/76
10/30/75

Note: This table shows percentage reserve requirements as of June 1986 without important supplemental information. This information is
provided in the detailed footnotes to the table showing reserve requirements in the monthly Federal Reserve Bulletin. See, for example, Table 1. 15
on page A7 of the Federal Reserve Bulletin for June 1986.
Source: Board of Governors of the Federal Reserve System.

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liabilities. The range for net transactions deposits (in excess of an initial
tier, which was $31.7 billion in June 1986) is 8 to 14 percent, and the
range for nonpersonal time deposits is Oto 9 percent. There are no limits
on the requirements that can be established for Eurocurrency liabilities.
In addition to the regular requirements shown on the right-hand side of
Table 4, the Board can also place a supplemental requirement of up to 4
percentage points on net transactions accounts, and, for periods up to
180 days, it can establish requirements outside the regular ranges and on
other liabilities. When it imposes these supplemental requirements and
extensions, however, the Board must follow certain procedures prescribed by law.
With regard to monetary policy and monetary control, reserve
requirements affect the quantitative relationship between the aggregate
reserves held by depository institutions and the various monetary
aggregates the Fed seeks to influence, all of which include some
reservable liabilities. More precisely, reserve requirements put limits on
the volume of reservable deposits and other liabilities that can be
supported by any given volume of aggregate reserves. Therefore, the
Fed could, if it chose to, manipulate reserve requirements to reinforce its
other policy actions. For example, if it had adopted a generally
restrictive posture, it might raise reserve requirements, and vice versa.
In practice, the Fed rarely uses reserve requirements in this way.
Frequent changes in the requirements would obviously be a substantial
administrative burden on both the Fed itself and the institutions subject
to the requirements. Further, even relatively small changes in reserve
requirements can have a sizable impact on the availability and cost of
reserves and are therefore not appropriate for effecting the generally
incremental changes in reserve conditions the Fed is usually trying to
achieve on a day-to-day basis. For this reason, the System tends to focus
on reserve requirements as a central element of the institutional
apparatus linking reserves quantitatively to the monetary aggregates
rather than as an instrument to be manipulated. In this light, a topic of
continuing interest is how the structure and coverage of the requirements might be changed to make the quantitative relationship between
reserves and the monetary aggregates more predictable.
The structure and coverage of reserve requirements have in fact
been changed in important ways in recent years. As noted earlier, the
Depository Institutions Deregulation and Monetary Control Act of 1980
extended reserve requirements to all depository institutions. Prior to the
passage of this Act, the requirements had applied only to member banks

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and a few other categories of institutions. The Act also simplified the
structure of the requirements by making them more uniform within
particular deposit categories and eliminating the requirements against
personal savings and time deposits. (The left panel of Table 4 shows the
structure of the requirements prior to 1980, which can be compared to
the present structure shown on the right.) Both of these changes were
consistent with making the structure of the requirements potentially
more efficient for controlling the monetary aggregates, especially the
narrow Ml aggregate. Specifically, the extended coverage makes all of
the deposits included in Ml reservable, while reducing the coverage of
assets not in Ml. The greater simplicity of the requirement structure can
increase the predictability of the quantitative relationship between
reserves and the monetary aggregates by reducing the impact on this
relationship of changes in the distribution of deposits across different
deposit categories and different size classifications of depository institutions.
In addition to these changes in structure and coverage, one other
recent change in reserve requirements potentially relevant to monetary
control should be pointed out. Prior to 1984, all reserve requirements
were lagged: reserves were held in a given week against reservable
liabilities held two weeks earlier. Since 1984, the requirements against
net transactions accounts have been nearly contemporaneous. Specifically, depository institutions must maintain some average level of
reserves (determined by the percentage requirement) over a two-week
"maintenance period" ending on a Wednesday against the average level
of net transactions deposits held over a two-week "computation period"
ending on the Monday two days earlier. Depository institutions may
adjust their balance sheet positions more rapidly in response to Fed
actions affecting reserves under this new contemporaneous accounting
procedure than under the former fully lagged system. If so, these more
rapid adjustments might facilitate the control of Ml. 22
22

The adjustment-forcing character of contemporaneous accounting is reduced to some extent by
carry-over privileges, which allow institutions to carry a reserve deficiency of up to 2 percent of
requirements forward to the next maintenance period. (Excess reserves up to 2 percent of
requirements can also be carried forward.) In addition to the carry-over allowance, the

existence of the discount window, where, under current procedures, the discount rate is
typically below the Federal funds rate, also reduces the incentive for rapid adjustment, which
has led some economists to suggest that the discount rate be set at a penalty level above the
Federal funds rate. For a thorough analysis of the ramifications of contemporaneous reserve
accounting, see Goodfriend [14] .

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Although reserve requirements are a potentially important element
in the Fed's strategy of controlling monetary aggregates, it should be
noted that this potential importance varies with the particular tactical
procedures the Fed employs. 23 The structure of reserve requirements
would be highly significant in a regime where the Fed was controlling
the monetary aggregates using total reserves as the control instrument,
since the empirical relationship between reserves and the aggregates
and the predictability of this relationship would be critically important in
such a regime. Reserve requirements play a less important role in other
operating regimes. 24
The tactics of monetary policy: Operating procedures This subsection describes the Fed's tactical operating procedures; that is, the
procedures the System uses in conducting monetary policy over a
short-run horizon of several weeks. The purpose of the procedures is to
link the Fed's day-to-day open market operations with its longer-run
strategic objectives. In essence, the operating procedures guide open
market operations with a view to making them as consistent as feasible
at any point in time with the System's longer-run strategy.
Because the Fed's strategy since the mid-1970s has been to pursue
the nation's basic economic goals by controlling monetary aggregates,
the System's operating procedures in recent years have aimed at
facilitating monetary control. In general, there are two kinds of
short-run procedures that the Fed (or any other central bank, for that
matter) can use to control the monetary aggregates. One approach is to
control them from the supply side by controlling total reserves. The
other is to control them from the demand side by controlling conditions
in the money markets as indexed by some short-term interest rate or
some other money market variable.
Each of these two broad categories of control procedures requires
further explanation. In a regime in which total reserves was the control
variable, the Fed would use its target ranges for the growth of the
monetary aggregates to construct a desired path for the growth of total
reserves. This path would take account of both the necessary growth of
required reserves, given the monetary targets and the level of reserve
requirements, and any excess reserves depository institutions might be
23

These procedures are discussed further in the next subsection.

In a detailed study, Goodfriend and Hargraves [15] argue that reserve requirements have
played only a minor role in the conduct of monetary policy in the United States historically.

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likely to hold above required reserves. The Fed would then conduct
open market operations in such a way as to make the actual growth of
total reserves conform as closely as feasible to the desired path. In doing
so, of course, it would continuously update the desired path on the basis
of new information bearing on the relationship between the growth of
total reserves and the monetary aggregates.
In practice the Fed has never used a total reserve control procedure
because it has not been able to control total reserves closely in the short
run under either past or present institutional arrangements. While the
System can control nonborrowed reserves through open market operations, it cannot control total reserves, because the level of borrowing at
the discount window is determined in the short run by the preferences
of depository institutions. In order to control total reserves, it would be
necessary for the System to make institutional changes that would allow
it to determine the level of borrowing at the same time it is independently determining the level of nonborrowed reserves. Two alternative
institutional changes that would have this effect would be (1) to make
the discount rate a continuous penalty rate, or (2) to control the total
level of borrowing closely by administrative fiat.
The other broad approach to controlling the monetary aggregates is
from the demand side via control of a short-term interest rate or some
other variable that is a good barometer of short-term money market
conditions. There is wide agreement among economists that the public's
demand for money balances is strongly influenced by the behavior of
short-term interest rates . The reason for this relationship is as follows.
Two of the most important components of any definition of money are
currency and demand deposits, neither of which pays explicit interest.
Therefore, a change in market rates affects the opportunity cost of
holding money balances, as an alternative to interest-bearing nonmoney
assets, and hence the public's money demand. For example, an increase
in market rates increases the opportunity cost and therefore reduces the
demand for money. Similarly, a reduction in rates reduces the opportunity cost and increases demand. Hence, the Fed could work to restrain
money growth by acting to make money market conditions tighter,
which would put upward pressure on short-term interest rates, and vice
versa. Obviously, this procedure in principle would be more appropriate

for controlling the narrow Ml measure of money than the broader
aggregates, such as M2 and M3, since non-interest-bearing currency and
demand deposits are a larger proportion of Ml than of M2 or M3.
Whether or not this approach to monetary control is effective in practice,

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of course, depends on the predictability of the empirical relationship
between the particular money market variable selected and the monetary aggregates.
The Fed had used three variants of the latter, money market
conditions approach to monetary control between the mid-1970s, when
it first began to announce target ranges for the aggregates, and the
mid-1980s. 25 Prior to October 1979, the System attempted to estimate the
level of the Federal funds rate-the overnight interest rate on reserve
funds in the open money market-consistent with the rate at which it
wanted Ml and the other monetary aggregates to grow. It then used
open market operations to hold the Federal funds rate within a narrow
range around that level in the short run. An important disadvantage of
this approach in practice was that when the public became fully aware
that the Fed was using the Federal funds rate in this way, financial
markets became very sensitive in the short run to even small changes in
the rate, and small adjustments in the rate sometimes produced strong
political reactions. Both conditions made it difficult for the Fed to adjust
the rates as frequently as necessary for effective control of the monetary
aggregates.
Against this background, in October 1979 the Fed stopped using the
Federal funds rate as its direct control instrument and began to focus on
various reserve measures in order to improve its monetary control
performance. Even though there has been a general shift of focus
toward reserves, however, it is important to distinguish these recent
control procedures from controlling the aggregates by controlling total
reserves. From October 1979 until late 1982, the Fed used nonborrowed
reserves as its instrument. In this regime, the System set a path for
nonborrowed reserves that it believed was consistent with the desired
paths of the monetary aggregates. With nonborrowed reserves thus
predetermined, any change in depository institution demand for total
reserves occasioned by a deviation of the monetary aggregates from
their desired paths had to be accommodated by a corresponding change
in the level of borrowing at the discount window, either upward or
downward. This change in borrowing, in turn, affected the Federal
funds rate and other short-term interest rates and hence the demand for

For a more detailed account of what follows, see Wallich [22].

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money. 26 For example, if the growth of the monetary aggregates began
to exceed the desired paths, the demand of depository institutions for
total reserves would rise, which would cause the level of borrowing at
the window to increase. The increased borrowing would then put
upward pressure on the Federal funds rate and other market rates,
given the general reluctance to borrow and the Fed's administrative
restrictions on borrowing. The rise in rates, finally, would reduce the
demand for money and the growth of the monetary aggregates.
In many ways the nonborrowed reserves procedure was potentially
the strongest monetary control procedure the Fed has employed in
practice, because when followed strictly, it generated an automatic
response of reserve market conditions and interest rates to deviations of
the monetary aggregates from their paths. For various reasons explained
further in Section 3B below, the Fed dropped this approach in the fall of
1982 and began to use the level of borrowing as its instrument. In this
regime the System aims at maintaining the level of borrowing in some
relatively narrow desired range and then accommodates changes in
depository institution demand for reserves by adjusting nonborrowed
reserves through open market operations. This post-1982 approach is
similar in essence to the pre-October 1979 procedure of controlling the
Federal funds rate, because in this regime, as in the pre-October 1979
regime, the Fed influences the growth of the aggregates by affecting the
level of the Federal funds rate and other market rates. The difference is
that instead of controlling the Federal funds directly and tightly, in the
borrowed reserve regime the System influences the rate indirectly, and it
does not generally attempt to control it as tightly.
This description of the three operating regimes the Fed has used in
recent years requires two rather detailed but important and related
qualifications-or at least clarifications. First, although some economists
regard the nonborrowed reserve procedure used between October 1979
and the fall of 1982 as intermediate between the total reserve and money
market condition classes of operating procedures delineated above, a
case can be made that in its implementation the nonborrowed reserve
procedure belonged to the class of money market condition procedures.
Although market forces played a larger role in determining the level of
the Federal funds rate in the short run in the nonborrowed reserve
26

At a technical level, the relationship between borrowing at the window and short-term market
rates was the central relationship in the nonborrowed reserve regime. See Goodfriend [12] for
a thorough analysis of the nonborrowed reserves operating procedure.

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regime than in the other two regimes, the average level of the funds rate
was still a central indicator of the Fed's operating stance in the short run.
Second, the nonborrowed reserves procedure was not always followed
slavishly in the 1979-82 period. Specifically, the nonborrowed reserve
path was sometimes altered to accommodate at least part of the impact
of unanticipated movements in the monetary aggregates on required
reserves. To the extent that such alterations were made, the changes in
required reserves did not have to be accommodated at the discount
window, and they did not affect the Federal funds rate and other money
market conditions. In short, in practice the differences between the
1979-82 regime and the other two regimes were not as great as the
description above might suggest.
Two final points regarding the Fed's tactical procedures should be
made. First, under all of the approaches that have been used-especially
the pre-October 1979 approach and the post-1982 borrowed reserve
procedure-it is possible to "look through" the monetary aggregates to
the final goal variables of policy. In this way, one can think of the
process as running directly from the Fed's influence on money market
conditions to broader credit market conditions and long-term interest
rates, and then to such goal variables as aggregate spending, income,
and employment. It is probable that many individual policymakers who
have a generally neo-Keynesian view of the monetary policy transmission mechanism regard the process in this manner. Further, this view of
the process probably became more widespread in the 1980s due to the
unusual and unpredictable behavior of monetary velocity that accompanied the extensive financial deregulation in this period.
Second, as suggested in the discussion of the discount rate in the
preceding subsection, the role of the discount rate has been enhanced to
some degree by the nonborrowed reserve and borrowed reserve control
procedures of the 1980s. In both of these regimes, where the Federal
funds rate tends to vary somewhat more flexibly than in the pre-October
1979 regime, and the aggregate level of borrowing tends to be somewhat
less flexible, changes in the discount rate are often followed by roughly
equal changes in the Federal funds rate in the same direction. This
occurs because the level of borrowing in the short run is strongly
influenced by the width of the (typically positive) spread between the
Federal funds rate and the discount rate. With borrowing relatively
constant in the short run under these regimes, a change in the discount
rate requires a corresponding change in the Federal funds rate to
maintain a relatively constant spread.

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The policymaking process The process by which specific decisions
are made within the strategic and tactical framework outlined in the
preceding subsections is of considerable interest to participants in
financial markets, because many market professionals believe that
knowledge of the process may be helpful in anticipating the timing of
the Fed's major policy actions and may therefore be profitable. The
process centers around two events: (1) meetings of the Federal Open
Market Committee (FOMC) and (2) the establishment of the discount
rate by the boards of the Reserve Banks with the concurrence of the
Board of Governors.
At present the FOMC has eight regular meetings each year, all of
which are held at the offices of the Board of Governors. 27 The nonvoting
Reserve Bank presidents as well as the voting presidents attend each
meeting and participate fully in the discussion. Senior members of the
Board of Governors staff also attend, and each Reserve Bank president is
accompanied by one member of his staff, usually the director of his
Bank's research department. Prior to the meeting, all participants will
have received and studied a considerable volume of documentation
prepared by the staffs of the Board of Governors and the Trading Desk
at the New York Reserve Bank. The most important documents are the
so-called Greenbook and the Bluebook. The Greenbook contains comprehensive macroeconomic and financial projections for several quarters
in the future. The staff uses a large structural model of the economy in
preparing these forecasts, but the model output is modified extensively
by judgmental adjustments in developing the final projections. The
Bluebook summarizes recent financial and monetary data and presents a
set of two or three alternative specifications for the short-run operating
instructions to be included in the "directive" to the Manager for
Domestic Operations. These alternatives are based on a combination of
econometric and judgmental estimates of the short-run relationship
between (1) the operating instrument the FOMC is using (the level of
borrowing at the discount window in late 1986) and (2) the monetary
aggregates. Further, if the FOMC is considering the longer-run target
ranges for the monetary aggregates at a particular meeting, the Bluebook
presents alternative sets of ranges, sometimes with projections of
important economic variables such as the growth of real GNP and the
27

The structure and composition of the FOMC is discussed in Section 2. The frequency of FOMC
meetings has varied historically. Through much of the 1970s, for example, meetings were held
each month.

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implicit GNP price deflator, thought to be consistent with each alternative. All FOMC participants are briefed on the content of these
documents by their respective staffs, since much of the discussion at the
meeting itself begins with the projections and policy alternatives
presented in these materials.
The agenda for FOMC meetings in recent years has been fairly
standard. The meetings typically begin with a report of the Manager for
Foreign Operations at the Federal Reserve Bank of New York, who
conducts foreign currency operations as agent for both the FOMC and
the Treasury. 28 His report is usually followed by a discussion of
international financial and monetary developments. The Manager for
Domestic Operations (i.e., the Manager of the Trading Desk) then
reports on domestic open market operations during the period since the
last FOMC meeting. The burden of this report is to show that the Desk's
actions were consistent with the directive given him by the FOMC at the
last meeting. 29
Following consideration and acceptance of the Domestic Manager's
report, the Committee discusses current economic conditions and the
economic outlook in detail as background for the deliberation on
monetary policy that follows. This portion of the meeting begins with a
presentation by the Director of the Division of Research and Statistics at
the Board of Governors which summarizes and explains the economic
projections in the Greenbook. Each of the participants then has an
opportunity (which he usually takes) to state his individual view of the
economy. These statements typically include the speaker's reactions to
the projections in the Greenbook-particularly points of disagreement
regarding either the broad profile of the forecasts or detailed parts of it.
The Reserve Bank presidents may present projections that have been
developed independently by their own research staffs, and they often
provide information regarding regional conditions in their Districts that
might have a bearing on the national outlook. Many of the participants
also relay anecdotal information to supplement the formal statistical
information provided in the Greenbook. 30
28

The international dimensions of Fed monetary policy are discussed in the next subsection.

The content of the directive is discussed below.

Prior to each FOMC meeting, each of the Reserve Banks sends a report on conditions in its
District to the Board of Governors. These reports are compiled in a so-called Beigebook that is
distributed to all FOMC participants and also transmitted to Congress.

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After the economic "go-around" is completed, the Committee turns
its attention to monetary policy. The Staff Director for Monetary and
Economic Policy of the Board of Governors staff summarizes the various
short-run policy alternatives presented in the Bluebook. The Committee
discusses these options-usually in a go-around in which all participants
indicate their preferences-and decides on the particular position it
wishes to adopt, which may or may not coincide with one of the
alternatives in the Bluebook. It then considers and votes on a written
short-run directive to be issued to the Manager of the Desk to guide
open market operations over the period to the next FOMC meeting. At
its meetings in February and July, the Committee also considers and sets
(or reaffirms) long-run ranges for the monetary aggregates. In doing so,
it follows the targeting procedure outlined earlier in this article. The
discussion of the long-run ranges at these meetings occupies a separate
position on the agenda from the discussion of the short-run situation,
and the Committee's decision on the ranges is arrived at through a
separate vote. Also, as pointed out earlier, the Fed Chairman publicly
announces decisions on the long-run ranges in Congressional testimony
shortly after these meetings in accordance with the requirements of the
Humphrey-Hawkins Act.
The short-run directive is very important because, in addition to
instructing the Manager, it provides a relatively precise public record of
the substantive short-run actions taken by the FOMC at a particular
meeting. In order to interpret the directive, however, it is necessary to
understand its structure. 31 The directive is usually about six paragraphs
long. The first several paragraphs provide background information on
domestic economic and financial developments and conditions in
foreign exchange markets. A later paragraph states or restates the
Committee's long-run target ranges for the monetary and credit aggregates and any special circumstances relevant to these ranges. The final
paragraph is the key paragraph. It contains the detailed short-run
operational instructions to the Manager.
The structure of the operational paragraph evolves slowly over time
in accordance with changes in the FOMC' s tactical operating procedures
and other developments, but financictl market professionals are usually
31

Under the procedures in effect in late 1986, the directive issued at an FOMC meeting is
included in the "Record of Policy Actions" for the meeting, which is released to the public
shortly after the next meeting of the Committee. In this way, the public is never informed of the
directive currently in effect. The desirability of this practice has become a matter of considerable
debate. See Goodfriend (13].

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aware of the structure at any given time and hence are able to interpret
the meaning of relatively small changes in language and other nuances.
As an example, the operational paragraph of the directive (see Box)
issued at the FOMC meeting on September 23, 1986, when, as noted in
the preceding subsection, the Committee was using borrowed reserves
as its operating instrument. Experienced market observers interpreted

Box

OPERATIONAL PARA GRAPH OF DIRECTIVE
ISSUED AT FOMC MEETING ON
SEPTEMBER 23, 1986
In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions.
This action is expected to be consistent with growth in M2 and M3 over the
period from August to December at annual rates of 7 to 9 percent. While
growth in Ml is expected to moderate from the exceptionally large increase
during the past several months, that growth will continue to be judged in
the light of the behavior of M2 and M3 and other factors. Slightly greater
reserve restraint would, or slightly lesser reserve restraint might, be acceptable depending on the behavior of the aggregates, taking into account the
strength of the business expansion, developments in foreign exchange
markets, progress against inflation, and conditions in domestic and international credit markets. The Chairman may call for Committee consultation if it
appears to the Manager for Domestic Operations that reserve conditions
during the period before the next meeting are likely to be associated with a
federal funds rate persistently outside a range of 4 to 8 percent.
Votes for this action: Messrs. Volcker, Corrigan, Angell,
Guffey, Heller, Mrs. Horn, Messrs. Johnson, Melzer, Morris,
Rice, and Ms. Seger. Vote against this action: Mr. Wallich.

Note: Emphasis added.
Source: Board of Governors of the Federal Reserve System.

this particular directive as follows. The first sentence said in effect that
for the period immediately following the meeting, the objective for
borrowed reserves had not been changed. The phrase "degree of
pressure on reserve positions" was understood to refer to the borrowing
objective, and the word "maintain" indicated that the objective had
been left unchanged. The second and third sentences discussed the

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short-run behavior of the monetary aggregates believed to be consistent
with an unchanged borrowing objective. At the time of this meeting, the
Committee was giving somewhat less attention, in relative terms, to the
behavior of the narrow Ml measure of money than to the broader M2
and M3 measures because of the unusual behavior of the velocity of Ml
at the time. 32 This ordering was indicated by (1) the statement of the
expected short-run M2 and M3 growth rates before the reference to Ml,
and (2) the absence of an explicit expected growth rate for Ml. The
fourth sentence indicated how the Manager should adjust the borrowing
objective in the light of new information regarding the aggregates and
economic and financial developments. The key words in this sentence
were "would" and "might." Because would is a somewhat stronger term
than might, the sentence suggested that the Committee was somewhat
more inclined to raise the borrowing objective-that is, "tighten" its
short-run policy position-in the light of emerging developments than
to ease its position.
To summarize, the directive shown in the Box instructed the
Manager (1) to maintain the existing short-run policy stance initially,
and (2) to move somewhat more aggressively to tighten policy than to
ease it if conditions changed in one direction or the other. Market
analysts interpreted these instructions as constituting a very slight
"snugging" or tightening of the FOMC's overall posture compared with
the directive it had issued at its preceding meeting on August 19. At that
meeting, the Committee had voted to "decrease slightly" the pressure
on reserve positions. As shown in the Box, one member of the
Committee voted against the action taken at the September 1986
meeting. Such dissents are fairly frequent, since the FOMC must often
make its policy decisions in the face of substantial uncertainties. The
Record of Policy Actions that includes a particular directive also includes
a brief statement of the reasons for any dissenting votes.
The other principal element of the policymaking process is the
setting of the discount rate. The boards of directors of the Reserve Banks
(or the executive committees thereof) are required by law to consider
and set the basic discount rate and related rates at least every 14 days.
Before making its decisions on the rate, the boards are briefed in detail
on recent national economic and financial developments by the research

staffs at the Banks. The focus on national considerations is appropriate
because, as indicated above, the discount rate is uniform across all
32

The behavior of the monetary aggregates in this period is discussed further in Section 3B.

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Reserve Banks except for brief transition periods when the rate is being
changed. Therefore, if the Board of Governors approves a change at one
Bank, the change will quickly be followed at all Banks. All Reserve Bank
actions on the discount rate, including renewals as well as changes, are
transmitted immediately to the Board of Governors, which considers
them and either approves, disapproves, or tables them. If the Board
approves a change in the rate, the change is announced publicly on the
same day. Such announcements are usually made late in the afternoon
after U.S. financial markets have closed in order to avoid disrupting the
markets. A summary of the Board's discount rate actions is published
each year in the Board's Annual Report.
As suggested earlier, the significance of the role of the Reserve Bank
boards in setting the discount rate should not be underestimated even
though the Board of Governors must approve all actions on the rate. The
members of the Reserve Bank boards are knowledgeable citizens from a
wide variety of backgrounds. If several of the boards are simultaneously
recommending a change in the rate in the same direction, the Board of
Governors will naturally give this circumstance considerable weight in
deciding whether or not to approve the proposal. Also, under current
procedures, the boards of the Banks routinely convey the reasons for
their actions to the Board of Governors, which then takes these reasons
into account in reaching its final decisions.
In the period prior to October 1979, when the FOMC was using the
Federal funds rate rather than borrowed reserves as its operating
instrument, there was a looser short-run relationship between the
Federal funds rate and the discount rate than in the 1980s. Therefore,
there was less reason before 1980 than subsequently to coordinate
discount rate changes with the FOMC's actions affecting open market
operations and the Federal funds rate. As already noted, discount rate
actions have a direct and relatively predictable short-run impact on the
Federal funds rate in the nonborrowed reserve and borrowed reserve
regimes of the 1980s. For this reason, somewhat greater attention has
been given to the need to coordinate discount rate actions and open
market operations at FOMC meetings in the 1980s than earlier.
International dimensions of monetary policy Up to this point the
discussion has focused on the domestic aspects of Fed monetary policy.
Fed policy has an increasingly important international dimension,
however, because of the dramatic growth of U.S. trade and financial
relationships with other countries in recent years. Financial markets are

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now highly integrated throughout the industrial world. As a result, the
Fed's monetary policies can have significant impacts, especially in the
short run, on economic and financial developments in other countries,
and, conversely, the monetary policy actions of central banks in other
developed countries can influence events in the United States. For this
reason, the Fed necessarily takes account of international economic and
financial conditions in pursuing its domestic economic objectives, and it
communicates regularly with other central banks around the world to
facilitate attainment of the shared goal of stability in international
product and financial markets. It should be noted that this need to take
account of international factors in conducting monetary policy continues
to exist in the present regime of floating exchange rates. In principle, a
floating exchange rate regime can insulate the economies of individual
countries from the effects of the monetary policy actions of other
countries. In reality, however, lags in the adjustment of exchange rates
to the policy actions of particular countries allow the impacts of such
changes to cross borders. More importantly, the current regime is not a
"pure" float in which exchange rates are determined entirely by private
market conditions. Instead, central banks intervene in the exchange
markets individually and jointly from time to time to achieve specific
exchange rate objectives.
As an example of circumstances where the Fed might allow
international conditions to influence its policy actions, consider a
hypothetical situation where the U.S. economy had been growing at a
persistently slow pace and the current rate of domestic inflation was
relatively low. Under these conditions, the Fed might want to consider
easing its short-run policy stance somewhat to include, perhaps, a
reduction in the discount rate. If the dollar were coming under strong
downward pressure in the exchange markets for some reason, however,
the Fed might delay taking such action in order to avoid weakening the
dollar further, particularly if it seemed likely that monetary policy might
also be eased in one or more other important countries in the near
future. It should be emphasized here that although the Fed gives
continuous attention to international developments in deciding on
particular policy actions, the domestic objectives of policy remain
paramount. Therefore, as in this example, international considerations
are more likely to affect the timing of the Fed's actions than the
longer-run substance of policy in most cases.
In addition to taking account of international events and conditions
in conducting domestic monetary policy, on occasion the Fed also carries

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out certain foreign currency operations that can directly affect exchange
rates in the short run. These operations are actually conducted by a
Manager for Foreign Operations at the Federal Reserve Bank of New
York under (1) an Authorization for Foreign Currency Operations and
(2) a Foreign Currency Directive established by the FOMC. These
operations are approached in a very different manner, however, from
the domestic open market operations discussed earlier. Specifically,
whereas the directive for domestic open market operations is typically
adjusted each month in accordance with emerging economic and
financial developments, the Foreign Currency Directive is not usually
changed. In general, the latter directive instructs the Manager for
Foreign Operations to make purchases and sales in foreign exchange
markets (i.e., to "intervene" in these markets) as appropriate to counter
any disorderly conditions that may arise in the current floating rate
regime. The Manager reports his actions at each FOMC meeting, and
the Committee must ratify them as a way of ensuring they have been
consistent with the continuing directive. It is important to point out here
that the Fed conducts its foreign currency operations in close coordination and cooperation with the U.S. Treasury, which is responsible for
managing the nation's overall reserve position. It should also be noted
that the potential effect of both the Fed's foreign currency operations
and those of other central banks on the reserve position of U.S.
depository institutions is routinely "sterilized" or offset in the course of
domestic open market operations. In other words, neither the Fed's
interventions in foreign exchange markets nor those of other central
banks are allowed to affect U.S. money market conditions.
Although the principal purpose of foreign currency operations in
the floating rate regime of the 1970s and 1980s has been to counter
disorderly exchange market conditions, in recent years the System has
intervened on some occasions to achieve broader goals, as illustrated
particularly by events in the second half of 1985. The U.S. dollar
appreciated sharply against other major currencies in the early 1980s,
probably largely as a result of fiscal policy initiatives in this period that
increased the real after-tax rate of return to capital investment in the
United States. This appreciation had a severely depressing effect on
many U.S. business firms that export or that compete with imported
goods in U.S. markets. Against this background, a depreciation of the
dollar that began in February 1985 was greeted with considerable relief.
In August and September of that year, however, the dollar reversed
course and began to appreciate sharply, which intensified growing

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demands in Congress for protectionist legislation. In this situation,
representatives of the G-5 countries met in New York in late September,
and following this meeting these countries intervened actively and
concertedly in the exchanges to encourage the appreciation of nondollar
currencies. From the time of this meeting through November, the Fed
and the Treasury together sold approximately $3.3 billion, and the other
G-5 countries sold about $9.7 billion. Following these operations, the
dollar turned back down and declined another 12 percent over the
remainder of the year.
The foreign currency operations of both the Fed and other major
central banks have been greatly facilitated in recent years by the
existence of a so-called "swap" network of reciprocal currency exchange
arrangements. Under these arrangements the Fed can acquire foreign
currencies from its counterparts abroad when needed to support the
dollar in the foreign exchange market, and foreign central banks can
acquire dollars from the Fed to support their respective currencies. As of
January 31, 1986, the Fed had swap arrangements with 14 foreign central
banks and the Bank for International Settlements. The total amount of
these facilities on that date was $30.1 billion.
An individual currency swap involves a spot transaction and a
simultaneous forward transaction. In the spot transaction the Fed swaps
(i.e., exchanges) dollars for a foreign currency with another central
bank. In the forward transaction the two banks agree to reverse the
swap three months later. The bank that initiates the swap is said to
make a swap "drawing" and is typically thought of as the "borrower" in
the transaction. As an example, the Fed might obtain German marks for
the purpose of supporting the dollar by drawing on its swap arrangement with the German Bundesbank. In the spot transaction the Fed
would exchange dollars for marks, which it would then use to purchase
dollars in the open market. At the same time it would make a forward
commitment to reverse the exchange three months later. At the end of
the three months, the Fed would have to reacquire the marks-which it
would typically do in the market-to meet its forward obligation.
Both the Fed and its partner central banks in the swap network have
used the arrangements actively at various times since the network came
into being in the early 1960s. The Fed, for example, used the network to
acquire substantial amounts of several foreign currencies for intervention operations when the dollar was under sharp downward pressure in
the late 1970s. More recently, the central bank of Mexico made sizable

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drawings of dollars through the facility during the liquidity crisis in that
country in 1982.

B. Some Major Recent Developments and Issues in
Monetary Policy
This section will present a brief and highly selective overview of the
recent history of Fed monetary policy and certain key current issues
regarding policy. In general the focus will be on the period from approximately 1973, when the first of the two oil price "shocks" of the 1970s
occurred, to the end of 1985. Although this 12-year period is relatively brief
in the context of the longer-run history of Fed policy, it has been a period of
rapid and dramatic change in both the actual conduct of policy and the
economic analysis related to policy. In particular, the U.S. economy in this
period has gone through a transition from a situation in the late 1970s
where the inflation rate was rising steadily and alarmingly to a sustained
condition of significantly lower and more stable inflation in the mid-1980s.
The following discussion attempts to illuminate the role Fed policy played
in this transition and to extract any lessons these events may contain
regarding the overall conduct of policy. 33

The acceleration of inflation after 1965 The period from the end of
the Korean War, in 1953, to 1965 was distinguished by remarkable price
stability in the United States by historical standards. The average annual
inflation rate during this 12-year span as measured by the implicit GNP
deflator was 2.3 percent. Further, the annual rates ranged narrowly
between a high rate of 4.0 percent in 1956 and a low rate of 1.2 percent
in 1963. 34
This tranquil price behavior ended in the late 1960s due at least in
part to the concurrent initiation of major new federal social programs
and the military buildup in Vietnam. The inflation rate rose from 3.0
percent in 1965 to 5.8 percent in 1968 and then held at 5.5 percent in
1969 and 5.2 percent in 1970 despite a downturn in the economy.
Although a 5.2 percent inflation rate may seem moderate when viewed
from the perspective of the mid-1980s, it was almost universally
regarded as unsatisfactory in 1971 and presented a major political

problem to the Administration and Congress. Consequently, President
33

For a more complete summary of this period, see Axilrod [1]. See also Wallich [22] .

The inflation and money supply growth data referred to in this section are summarized in
Table 5.

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Table 5

INFLATION AND Ml GROWTH RATES

Year 1

1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985

Inflation
Rate 2

4.7%
2.9
2.8
-0.4
2.7
3.4
4.0
2.8
2.0
2.3
1.3
1.3
2.5
1.2
1.5
3.0
4.1
2.5
5.8
5.5
5.2
6.1
4.4
8.2
10.0
8.3
5.7
6.8
8.0
8.9
9.9
8.7
5.2
3.6
3.6
3.3

Ml
Growth
Rate 3

-%
-

0.5
2.9
1.8
4.0
4.4
4.4
2.8
6.4
7.3
3.9
5.0
6.7
8.4
5.8
4.8
5.0
6.2
8.1
8.2
7.5
7.3
5.1
8.7
10.4
5.4
11.9

Fourth quarter of each year.

Inflation measured by the increase in the Gross National Product Implicit Price

Deflator.
Comparable data for 1950-1959 are not available. The definition of Ml has been
revised, and published historical data begins in January 1959.
Source: U.S. Department of Commerce, Bureau of Economic Analysis and the Board
of Governors of the Federal Reserve System.

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Nixon announced a comprehensive wage and price control program on
August 15, 1971, that endured in various forms until early 1974. This
program may have temporarily restrained price increases in its early
phases, since the inflation rate declined from 6.1 percent in 1971 to 4.4
percent in 1972. Any such effect, however, was short-lived, as the rate
climbed back to 8.2 percent in 1973 and rose further to 10.0 percent in
1974. At a superficial level, this sharp acceleration of inflation in the
mid-1970s reflected the progressive dismantling of the price control
program. More fundamentally, it almost certainly reflected (1) a significant acceleration in the growth of Ml in 1971 and 1972 and, (2) after
1973, the impact of the OPEC petroleum embargo and the first oil price
shock.
Probably as a result in part of the restrictive actions taken by the Fed
in 1973 and 1974 to contain the inflation, the economy passed through a
prolonged and severe recession between the fourth quarter of 1973 and
the first quarter of 1975. After growing at an average annual rate of 5.0
percent in 1972 and 5.2 percent in 1973, real (i.e., inflation-adjusted)
GNP declined at a 0.5 percent rate in 1974 and at a 1.3 percent rate in
1975. The weakness in the economy reduced the upward pressure on
prices temporarily, but to a much smaller degree than in the years
immediately following other postwar downturns. From its 10.0 percent
peak in 1974, the rate declined to 8.3 percent in 1975 and 5.7 percent in
1976. It then turned back up and rose persistently to 6.8 percent in 1977,
8.0 percent in 1978, and 8.9 percent in 1979 before peaking at 9.9 percent
in 1980.
Economists and others have given considerable attention to the
reasons for this sharp and sustained rise in inflation in the late 1970s and
early 1980s. Part of the increase probably reflected the lingering impact
of the first oil price shock and subsequent dislocations in other
commodity markets. Further, the second oil price shock in 1979
following the revolution in Iran was very likely a factor in the rise in the
price level in that year and in 1980. Beyond their direct effects, these
highly visible increases in the prices of key commodities, in conjunction
with the observed persistent increase in the general price level, created
an atmosphere in which the public began to expect a sustained rise in

inflation, and as time passed these inflationary expectations, in turn,
helped fuel further increases in wages and prices.
In addition to these pressures from particular commodity markets,
however, many if not most economists now believe that fiscal and
monetary policy played an important role in the inflationary process.

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After rising to a then record level of $70.5 billion in fiscal year 1976 as a
result of the 1974--75 recession, the federal budget deficit declined only
moderately to the $50-$55 billion range in fiscal years 1977 and 1978.
Some economists believe these high deficits contributed to the acceleration of inflation. Others focus more attention on monetary developments. The growth rate of Ml rose sharply in the late 1970s and
exceeded 8 percent in both 1977 and 1978. Moreover, the growth of Ml
frequently exceeded the tops of its long-range targets during this
period, 35 which very probably reduced the credibility in the eyes of the
public of the Fed's announced strategy of controlling the growth of the
money supply in order to reduce inflation. Any loss of credibility that
occurred would have tended to heighten inflationary expectations and
thereby fuel the rise in inflation.
October 6, 1979 to late 1982: The turn to disinflation Whatever its
causes, by the second half of 1979 the acceleration of inflation and the
accompanying intensification of inflationary expectations had created a
precarious and potentially unstable condition in the U.S. economy. In
particular, there was a clear risk that the public's fear of still further
increases in inflation would lead to speculative excesses in commodity
markets and other markets. Indeed, there was evidence of speculative
pressures in the markets for precious metals in the late summer of 1979.
More disturbingly, the U.S. dollar, which had declined dramatically in
the foreign exchange markets in late 1978, came under renewed
downward pressure in September 1979, which suggested that the
reduction in the credibility of the Fed's anti-inflationary stance had
become international in scope.
In these circumstances the Federal Open Market Committee decided at an extraordinary Saturday meeting on October 6, 1979, to make
a more determined effort to control the growth of the monetary
aggregates in order to enhance the credibility of its effort to restore price
stability. Specifically, as noted earlier, the Committee shifted its operational focus from the Federal funds rate to nonborrowed reserves as the
principal operating variable for controlling the aggregates. As Chairman
Volcker put it in Congressional testimony:
35

Between 1975, when the longer-run target ranges were first used, and the end of 1978, a
four-quarter-ahead target was set in each quarter of the year. In 1978, the current practice of
setting only one target for any given calendar year was instituted in accordance with the terms
of the Humphrey-Hawkins Act.

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Consequently, we are now placing more emphasis on controlling the
provision of reserves to the banking system-which ultimately governs the
supply of deposits and money-to keep monetary growth within our
established targets . In changing that emphasis, we necessarily must be less
concerned with day-to-day or week-to-week fluctuations in interest rates
because those interest rates will respond to shifts in demand for money and
reserves .... What is involved is a tactical change in the approach to control
of the money stock. 36

Much has been written and said about the FOMC's October 6, 1979,
action, especially in the light of subsequent events. As noted in the
general discussion of the Fed's operating procedures in Section 3A, the
nonborrowed reserve targeting procedure adopted in October 1979 was
not equivalent to targeting total reserves as advocated by some monetarist economists. It was, however, a significant change. In particular, by
ceasing its attempt to control the highly visible (and politically sensitive)
Federal funds rate tightly in the very short run, it was believed that the
Committee would be able to move more boldly and promptly in the
future to take the operational actions necessary to hold the monetary
aggregates under control.
An interesting and important issue here is the extent to which the
October 6 change in procedure, per se, contributed to the longer-run
decline in inflation in 1982. It is quite possible that the shift in
operational focus and the publicity it received helped, in the months
immediately following the action, to relax some of the more extreme
inflationary pressures that had been building in some markets. The
growth rate of Ml, which had reached 10.0 percent in the second quarter
of 1979 and 10.4 percent in the third quarter declined to 4.3 percent in
the fourth quarter and 5.7 percent in the first quarter of 1980. Further, in
keeping with Chairman Volcker's reference to interest rates in the
quotation above, the Federal funds rate was allowed to fluctuate
considerably more widely in the days and weeks immediately following
the action than before the action. These developments may well have
persuaded financial market participants and others that the action
constituted an important and substantive change in the Fed's behavior,
and this perception, in turn, may have reduced inflationary expectations
to some degree.
36

The quotation is from Chairman Volcker's statement to the Subcommittees on Domestic
Monetary Policy and on International Trade, Investment and Monetary Policy of the House
Committee on Banking, Finance and Urban Affairs, November 13, 1979. See Federal Reserve
Bulletin, December 1979, pp. 958-62, for the full statement.

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It is less clear, however, that the change in operating procedure in
October 1979 as such was the dominant factor leading to the broad and
sustained reduction in inflation after 1981. Because of a variety of
technical complexities, comparing the actual growth of the monetary
aggregates with their target ranges after the fact is not as straightforward
as one might expect. Table 6 shows the results of one attempt to do so. 37
These data indicate that the "effective" 38 growth of Ml exceeded the top
of its target range in 1980, the first full year following the October 1979
change. In 1981, the effective growth rate fell below the bottom of the
target range for that year. Finally, in 1982, the growth rate exceeded the
top of the range by a substantial amount. 39 To be sure, several
unanticipated events occurred during this period that may account for
part of these deviations of actual growth from the targets. For example,
the sharp acceleration of Ml in the second half of 1980 may have been
due in part to the end of the special credit control program in effect in
the spring of that year. Nevertheless, the persistent deviations of actual
Ml growth from its target ranges during the period of nonborrowed
reserve targeting indicated in Table 6 suggest that the move to
nonborrowed reserve targeting in October 1979 did not in itself improve
monetary control significantly. For this reason, although the change
may have enhanced the credibility of the Fed's anti-inflationary program
to some extent-or at least prevented a further significant erosion of
credibility-it does not appear that the change played a decisive role in
bringing about the later sustained reduction in inflation and inflationary
expectations. 40
If the October 1979 change in operating procedures was not a
dominant factor in the later decline in inflation, what factors were
important? The data in Table 6 suggest a plausible hypothesis: specifically, that the sharp decline in effective Ml growth in 1981, as distinct
from the change in operating procedures in 1979, was the dominant
37

Table 6 reproduces Table II in an article by Broaddus and Goodfriend [8] . The text of this article
discusses the construction of the data in the table in detail . In particular, the data are adjusted
for certain shifts between different types of deposits during the period covered that occurred as
a result of interest rate deregulation and the introduction of new types of deposit accounts such
as NOW (negotiable order of withdrawal) accounts. It should be emphasized that the data are

the responsibility of the authors of this article. They are not official Federal Reserve statistics.
38

See [8], pp. 5-8, for a detailed elaboration of the meaning of the term "effective" in this context.

It should be noted that the nonborrowed reserve procedure was essentially dropped well
before the end of 1982.

For a somewhat different view see Axilrod [1], p. 18.

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Table 6

EXPRESSED OR IMPLIED ANNUAL TARGET RANGES
FOR EFFECTIVE Ml AND CORRESPONDING
ACTUAL EFFECTIVE Ml GROWTH, 1975-1984
Midpoint of
Target Range

Target Period

Target Range

4Q75-4Q76

4.5-7.5

6.0

5.8

4Q76--4Q77

4.5-6.5

5.5

7.9

4Q77--4Q78

4.~.5

5.25

7.2

4Q78--4Q79

4.5-7.5

6.0

6.8

4Q79--4Q80

4.~.5

5.25

6.9

4Q80--4Q81

3.5-6.0

4.75

2.4

4Q81--4Q82

2.5-5.5

4.0

9.0

4Q82--4Q83

4.0-8.0

6.0

10.3

2Q83--4Q83

5.0-9.0

7.0

7.4

4Q83--4Q84

4.0-8.0

6.0

5.2

Actual

Notes:
1. The ranges in this table are the same as, or were derived from, the target ranges
that were announced by the Federal Reserve at the beginning of the year to which the
target applied. For 1979 and subsequent target years announcements have been
contained in the Federal Reserve's annual Monetary Policy Report to Congress, which
is usually published in the March issue of the Federal Reserve Bulletin. For 1976, 1977,
and 1978, the announcements are contained in Bums (1976), Bums (1977), and Miller
(1978), respectively.
2. The target ranges for 1979 and 1981 are adjusted for anticipated shifts into or out of
NOW accounts or similar accounts as explained in the text. The ranges for the periods
4Q79-4Q80 and 4Q80-4Q81 are the ranges that were set for what was then referred to
as M-lB.
Source: Alfred Broaddus and Marvin Goodfriend, "Base Drift and the Longer Run
Growth of Ml: Experience from a Decade of Monetary Targeting," Economic Review,
Federal Reserve Bank of Richmond (November/December 1984), p. 7.

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event. As the table shows, after rising for four consecutive years at rates
near or in excess of 7 percent, the actual effective growth rate of Ml
dropped sharply to 2.4 percent in 1981. This decline followed a period in
late 1980 and early 1981 when market interest rates had risen sharply, as
indexed by increases in the daily average Federal funds rate to close to
20 percent and yields on longer-term Treasury securities just under 13
percent. Probably as a result of these monetary and financial developments, the economy sank into a deep recession in the third quarter of
1981 that lasted through the fourth quarter of 1982, during which the
unemployment rate rose to a postwar record high of 10.7 percent. Few
observers would argue that the Fed deliberately engineered the recession to reduce inflation. The Fed's willingness to allow this painful
disinflation process, however, rather than easing policy aggressively to
end it, almost certainly raised the public's awareness not only of the
Fed's concern with the long-term risks posed by high and rising inflation
and inflationary expectations but also its determination to bring both
under control. If this hypothesis is valid, it is consistent with the
generally accepted view that the credibility of the Fed's stance against
inflation increased in the early 1980s. An increase in credibility based on
a perceived willingness to tolerate the temporarily painful disinflation
process and allow it to gain momentum, however, is not necessarily
equivalent to credibility based on the perception of improved monetary
control due to the change in operating procedures.
Late 1982-1986: Problems with monetary targeting As already
indicated, the period of nonborrowed reserve targeting ended in late
1982. The nonborrowed reserve procedure was dropped at the same
time that Ml was de-emphasized in relation to the other monetary
aggregates as an intermediate target of monetary policy. The discussion
of the Fed's monetary targeting strategy in Section 3A pointed out that
the strategy is based on the assumption of a steady and predictable
relationship in practice between the monetary aggregates and broader
measures of aggregate economic activity. Ml was de-emphasized as a
monetary target in the fall of 1982 because there was a growing concern
at the time that the predictability of the relation between Ml and the
economy was breaking down, at least temporarily. More precisely, there
was a growing concern that the public's demand for the assets included
in Ml, given the aggregate level of national income, was becoming
unpredictable.
66

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There were several reasons for this concern. 41 First, a substantial
volume of the temporarily authorized "all-savers" certificates were
scheduled to mature in October 1982. Since most certificate holders
could not reinvest in the certificates, a sizable share of the proceeds was
expected to be placed in transactions accounts included in Ml for some
uncertain time period until more permanent substitute investments
could be found. These temporary flows of funds were expected to
produce a temporary acceleration of Ml growth of some unknown
magnitude that it would be inappropriate to resist with monetary policy,
because the increase would not be due to basic economic trends.
Further, the scheduled authorization of money market deposit accounts
at depository institutions later in the year was expected to further
disrupt the relationship between Ml and the economy. Beyond these
relatively short-run dislocations, however, there was a belief that the
public's longer-run demand for Ml balances, given the level of income,
might be changing in ways that were not yet clear. In particular, the
newly authorized interest-bearing transactions accounts such as NOW
accounts, which by late 1982 were included in the Ml aggregate, were
growing very rapidly. There was reason to believe that the public's
demand for balances in this type of account differed from the demand
for ordinary non-interest-bearing demand deposits. Moreover, to the
extent that the public used these interest-bearing accounts as a vehicle
for savings as well as transactions, the long-term relationship between
an Ml that included a large proportion of these accounts and the
economy might differ significantly from historical relationships. These
concerns were reinforced at an empirical level by the behavior of the
velocity of Ml in the early 1980s. 42 After rising fairly smoothly at an
average annual rate of 3.1 percent through most of the postwar period,
Ml velocity slowed noticeably in 1980 and declined in 1982.
In these circumstances, the FOMC decided formally to deemphasize Ml at its meeting in October 1982. At the same time, it

For a fuller statement of these reasons, see Axilrod [1], pp. 18-19.

The velocity of Ml is the ratio of the level of GNP in current dollars to the dollar level of Ml and
can be thought of roughly as the number of times an average dollar is spent in a year. Rapid
growth in velocity implies that GNP is growing rapidly in relation to the growth of the money
stock, which in turn implies that the public's demand for money is low in relation to the growth
of income. Conversely, slow growth in velocity implies that money is growing rapidly in
relation to GNP and hence that the demand for money is high in relation to income.

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replaced the nonborrowed reserve operating procedure with the borrowed reserve operating procedure discussed in Section 3A. As indicated there, the borrowed reserve target is similar in important respects
to the pre-October 1979 operating procedure when the monetary
aggregates were controlled via direct control of the Federal funds rate.
Under the borrowed reserve procedure, the funds rate is influenced
indirectly through the level of borrowing rather than directly.
From the vantage point of late 1986, it appears that the decision to
de-emphasize Ml as a monetary target was appropriate. Ml grew 11.9
percent between the second quarter of 1982 and the second quarter of
1983. In the past, such sharp accelerations in money growth have often
been followed by rising inflation and strengthened inflationary expectations. The 1982-83 acceleration, however, was not followed by a
significant rise in inflation either immediately or with a lag, and the
sustained decline in nominal interest rates in the period suggests
diminished rather than strengthened inflationary expectations.
During the second half of 1983 and in 1984, Ml velocity stopped
declining and appeared to be resuming its upward trend. As a result, it
seemed possible that it might be feasible to return to a firmer monetary
targeting strategy. Although the nonborrowed reserve operating procedure was not reinstituted, the FOMC did formally restore Ml to a
position of equal weight with the other monetary aggregates at its
meeting in July 1984.
In 1985 and 1986, however, Ml velocity dropped sharply again. The
decline appeared to be related in part to the substantial decline in
nominal interest rates during the period, in an environment in which
restrictions on the interest depository institutions could pay on most
types of deposit accounts were being progressively dismantled. 43 In this
situation, the opportunity costs of holding the interest-bearing transactions accounts included in Ml became progressively lower until, by the
second half of 1986, they had virtually disappeared. This steady
reduction in opportunity costs, in turn, probably contributed to a
significant increase in the demand for Ml and hence to very rapid
growth in Ml in both 1985 and 1986.
As a result of these developments, by late 1986 the Fed's monetary
targeting strategy had been significantly diluted. The measured growth
rate of Ml was nearly 15 percent from the fourth quarter of 1985 to the
43

All interest restrictions on all types of accounts except demand deposits were phased out by
March 31, 1986.

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fourth quarter of 1986, 7 percentage points above the upper limit of the
4 to 8 percent target range set for the period. In view of the decline in
velocity, however, the FOMC did not attempt to bring the growth rate
down to the target range-or, for that matter, to reduce the growth rate
significantly at all. In effect, the Committee simply monitored the
growth of Ml in the context of the behavior of velocity. 44 Some weight
was given to the behavior of the broader M2 and M3 aggregates in this
period, but it is probably fair to say that in practice at least equal weight
was given to the current state of the general economy and the near-term
outlook for the economy. In short, in late 1986 the strategy of monetary
policy was essentially to react in a discretionary manner to the signals
provided not only by the monetary aggregates but a number of other
economic and financial variables as well.
There are legitimate grounds for debate regarding whether the
Fed's present discretionary approach to the conduct of monetary policy
is justified by the technical difficulties described above. It is certainly
true that a reasonable case can be made that such an approach is in fact
justified, especially when institutional and political considerations as
well as purely economic factors are taken into account. Many economists
would argue, however, that the Fed would risk losing the credibility as
an inflation fighter it earned in the late 1970s and early 1980s if it
attempted to pursue a highly discretionary and judgmental policy
indefinitely, since the credibility of policy in a discretionary regime is
entirely dependent on the public's confidence in the determination of
the Fed's current leadership at a particular time. The existence of
objective longer-term criteria for policy helps the Fed maintain credibility. For this reason, some observers hoped that the System would be
able to return to a firmer monetary targeting strategy once the disruptive
impact of recent deregulatory actions on the relationship between the
monetary aggregates and the economy has diminished.
One final point is worth making here. Although the elimination of
many interest rate regulations in the early 1980s almost certainly
contributed to the unpredictable behavior of the velocity of the monetary
aggregates in this period, the reduction in inflation that followed the
sharp tightening of monetary policy in 1981 also probably played an
important role. This disinflation was unusually pronounced by peacetime standards, and its speed and extent were probably largely
44

The real growth of the economy in 1986 was relatively sluggish throughout most of the year.

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unanticipated. In these circumstances, it should perhaps not be surprising that the public's demand for money balances and therefore monetary velocity behaved unpredictably. If the price level remains relatively
stable, however, the disruption of the behavior of velocity from this
source should diminish, which would tend to favor a firmer monetary
targeting strategy.

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A Primer on the Fed

CONCLUSION
This article has reviewed the Fed's principal functions and responsibilities, described its structure, and discussed both the mechanics of conducting monetary policy and major current policy issues. Since considerable
ground has been covered, it may be useful to summarize briefly some of the
article's major points.
1. The Fed has a wide variety of responsibilities in the areas of
monetary policy, the maintenance of liquidity and stability in financial
markets, the regulation of depository institutions, the provision of services
to the Treasury and depository institutions, the maintenance of an efficient
national payments mechanism, and the promotion of community development and redevelopment. While these responsibilities may appear diverse
at first glance, they are all essential aspects of the Fed's general mandate to
maintain a stable and efficient national monetary system.
2. With regard to monetary policy specifically, the Federal Reserve Act
as amended requires the Fed to conduct policy with a view to achieving
certain objectives involving a number of macroeconomic variables including
production, employment, the price level, interest rates, and international
trade. It is not clear, however, that it is feasible for the Fed to pursue all of
these objectives simultaneously. In particular, some economists believe that
the only feasible objective for the Fed over the long run is price stability.
3. An important and somewhat unique feature of the organizational
structure of the Fed is the participation of the regional Federal Reserve
Banks in the conduct of monetary policy. Although the Board of Governors
is the dominant governing body in the System, both the boards of directors
and the senior officers of the Reserve Banks have a voice in the formulation
of policy, and in practice their views can have a substantive effect on policy
decisions.
4. The current longer-run strategy of Fed monetary policy is to control
the growth of certain monetary aggregates over time in order to foster
stability in the price level and stable longer-run economic growth. The
strategy is implemented by establishing annual target ranges for the growth
of the various aggregates.

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5. The Fed has used three short-run operating procedures for controlling the growth of the monetary aggregates since the longer-run targeting
strategy was formally instituted in 1975. From 1975 to 1979, the Fed sought
to influence the aggregates by tightly controlling the Federal funds rate.
Between late 1979 and late 1982, the System used nonborrowed reserves as
its operating instrument. Although this procedure was not equivalent to
controlling the monetary aggregates by controlling total reserves as advocated by some monetarist economists, it was potentially a strong monetary
control procedure because if followed closely it produced a relatively
automatic response of reserve and money market conditions to deviations
of the monetary aggregates from their target ranges. Since late 1982 the
System has used borrowed reserves as its operating instrument, which is
similar in important respects to the pre-October 1979 Federal funds rate
regime.
6. At a mechanical level, the Fed uses three tools in conducting
monetary policy on a day-to-day basis: open market operations, the power
to change the discount rate, and reserve requirements. Of these, open
market operations and the discount rate are the two actively used tools. The
role of the discount rate has been more important in the post-1979
nonborrowed and borrowed reserve operating regimes than in the earlier
Federal funds rate regime.
7. A major event in the recent history of monetary policy was the
actions the Fed took in the 1979-82 period, which have been followed by a
sustained reduction in both inflation and inflationary expectations. Although the FOMC's change to a nonborrowed reserve operating procedure
on October 6, 1979, probably contributed to the reduced inflation and the
accompanying rise in the credibility of the Fed's anti-inflationary program,
this article took the position that the sharp reduction in the effective growth
of Ml in 1981, as distinct from the change in operating procedure, and the
recession in 1981 and 1982 were probably the dominant factors.
8. The role of monetary targeting in the conduct of monetary policy
was diminished in practice in the mid-1980s because of the disruptive
impact of interest rate deregulation on the predictability of the relationship
between the monetary aggregates and economic activity. As of late 1986,
the Fed was following a discretionary and judgmental approach to policy
that probably gave as much weight to current general economic conditions
as to the behavior of the monetary aggregates. Some observers are
concerned that the credibility of the Fed's longer-run stance against inflation
might be impaired if it followed this discretionary approach to policy for too
long a time.

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A Primer on the Fed

REFERENCES

1. Axilrod, Stephen H. "U.S. Monetary Policy in Recent Years: An Overview." Federal
Reserve Bulletin 71 (January 1985), pp. 14-24.
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pp. 787-95.
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Federal Reserve Bank of St. Louis

16. McCallum, Bennett T. "On Consequences and Criticisms of Monetary Targeting." Journal
of Money, Credit and Banking 17 (November 1985), pp. 570-97.
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pp. 692-700.

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Full text of A Primer on the Fed

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