Full text of Business Review (Federal Reserve Bank of Philadelphia) : July 1970

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The Inflation That
May Not stop?
The Nation and
District
Manufacturers
T w o Faces of
Bank Liquidity
Foreign-Exchange
and Euro-Dollar
Markets

JULY 1 9 7 0



The Inflation That
May Not Stop?

The current strategy against inflation has been
aimed at first eliminating excess demand from
the economy, and then keeping output short
of capacity. American experience vouches for
the appropriateness of this approach, for in the
past, a slower paced economy has been enough
to dampen inflationary fires. In the current as­
sault on rising prices, there is no doubt that
cooling an overheated economy was a necessary
step in unwinding inflation. But with prices
continuing to rise rapidly, the critical question
now is whether the creation of excess capacity
will also be sufficient this time around to choke
off inflation. Or, are there elements in the cur­
rent scene which may thwart the efforts of
inflation-fighters and prevent history from re­
peating?

by Edward G. Boehne

Digitized for2 FRASER


STRATEGY AGAINST INFLATION

The rationale for the current strategy against
rising prices is that excess demand initiated and
fueled the current inflationary spiral, and that ex­
cess supply will reverse the current course and,
in time, reduce the pace of inflation to tolerable
levels. Chart 1 shows the relationship between
aggregate demand and supply and rising prices.
In the upper part of Chart 1, the economy’s
potential supply of goods and services is shown
by the straight line. It slopes upward because
the capacity of the economy to produce goods
and service expands over time with the addi­
tion of better skilled workers as well as more
efficient plant and equipment. The jagged line
represents what consumers, business, govern­
ment, and foreigners actually demand from the
economy.
Whenever potential GNP exceeds actual
GNP, excess capacity exists in the economy. In
other words, what could have been supplied is
more than what is actually demanded. In con-

Whenever productive capacity is strained, higher rates of inflation follow. Also, lower
rates of inflation follow—often with a lengthy lag—periods of excess capacity.
ACTUAL

AND

P O T E N T IA L

AND

GROSS

IN F L A T IO N

N A T IO N A L

JU LY 1970

CHART 1

PRODUCT

(1 9 5 8 D O LLA R S )

1955

1956

1957

1958

1959

1960

1961

1962

1963

1964

1965

1966

1967

1968

1969

1970

‘ Trend line of 3 l/ 2% through middle o f 1955 (from 1st quarter 1952) to 4th quarter 1962, 3 % % from 4th quarter
1962 to 4th quarter 1965, and 4 % thereafter.
Sources: Council of Economic Advisers and U.S. Department of Commerce

trast, sometimes total demand is greater than
what the economy can normally supply. During
these periods, excess demand prevails in the
economy.
For most of the period since 1965, the Amer­
ican economy has been plagued by excess de­
mand. The result, as shown in the lower part
of Chart 1, has been escalating inflation. By
contrast, during the early part of the ’60’s, the
economy was relatively free of inflation because
of the presence of unused capacity. Hence, the




combined thrust of monetary and fiscal policies
over the last 18 months has been to eliminate
excess demand and to create excess capacity—
but not too much excess capacity, because this
would mean recession and socially unacceptable
rates of unemployment. So the Game Plan calls
for a small gap between actual and potential
GNP which should spur a slow but steady easing
of inflationary pressures. (See Chart 1.)
The anticipated chain of events goes some­
thing like this. As restrictive monetary and fiscal

FEDERAL RESERVE B AN K O F P H ILA D E L P H IA

B U S IN E S S R E V IE W

Billions of Dollars

3

policies take hold, total spending in the economy
slows. As the sales pace is dampened, inven­
tories build up and production schedules are cut
back. With declining sales and production and
rising costs, profits shrink. To cut costs, busi­
nessmen trim overtime and actually lay off some
workers. With profits weakening, employers
offer stiffer and stiffer resistance to rising wage
demands. At the same time, a softening labor
market makes workers willing to settle for less.
The result, if the Game Plan works, is a slow­
down in wage increases; although, because of
the momentum and severity of inflation, prog­
ress on the wage front is slow in coming.
Finally, with excess demand eliminated and cost
pressures subsiding, the inflationary spiral un­
winds— although again progress is slow, but
nevertheless tangible.

THE WEIGHT OF HISTORY

History is very much on the side of this slow­
down strategy. No slowdown in the postwar
period has failed to bring some relief from rising
prices. As Chart 2 indicates, whenever the
economy has slowed, prices— whether measured
at the wholesale or consumer level— have either
stopped rising, have risen less rapidly, or have
actually declined.
There is often a lag, however, between the
time the economy slows and prices respond.
Prices, in other words, can be “ sticky.” Why
this rigidity? One reason is that in some indus­
tries a single firm or only a few firms control
enough of the market to be able to exert con­
siderable influence over prices. As profits de­
cline, the response of these firms often is to
raise prices, even if it means further drops in

CHART 2

Wholesale and consumer prices have either stopped rising, have risen less rapidly, or
have actually declined during or after business slowdowns.
P R IC E T R E N D S

Percent (1957-1959 = 100)

Source: U.S. Department o f Labor

4



As recessions wear on, worker productivity begins rising and wage increases respond
to softer labor markets. The result is that unit labor costs do decline—but typically the
decline has considerably lagged the contractionary phase of post-war slowdowns.

JU LY 1970

CHART 3

*
P E R U N IT O F R E A L C O R P O R A T E

Dollars (Log Scale)

Dollars (Log Scale)

GROSS

PRODUCT

Dollars (Log Scale)

Source: U.S. Department o f Commerce
•C urre nt Dollars

sales and production. But historically, sales fall
faster than production. As goods pile up in ware­
houses and on store shelves, the climate for
further price hikes becomes less favorable. Cus­
tomers find that shopping around becomes more
advantageous as “ deals” become more available.
Further, if price boosts persist, imports are en­
couraged and domestic producers come under
additional pressure to hold the line on prices.
Still another reason why prices may not re­
spond immediately to a slackening of demand
arises from the cost side. As shown in Chart 3,
labor costs per unit of output usually keep right
on climbing even as the economy begins to con­
tract. Only after considerable delay do labor
costs begin to ease. Why? First, output per man­
hour typically falls during periods of contraction
because layoffs are usually not proportional to
production cutbacks. Second, wage rates con­
tinue to rise. Workers locked into multi-year
contracts during inflationary periods seek to
catch up with previous inflation and to stay
ahead of future price hikes.
But as the slowdown wears on, and indeed




as the economy starts to recover, worker produc­
tivity begins rising again. Also, wage increases
do respond to softer labor markets and easing
of inflationary expectations. The result, again
shown in Chart 3, is that labor costs do decline
—but typically the decline has considerably
lagged the contractionary phase of postwar
slowdowns. Most of the relief from labor costs
actually has come during the recovery phase.
WILL HISTORY REPEAT?

Restrictive monetary and fiscal policies have
slowed the economy, excess capacity prevails,
and unemployment is rising. The stage is set
for the classical unwinding of inflation. But so
far there are few signs that history is repeat­
ing. Consumer prices continue to rise at about
last year’s pace (Chart 4 ). Largely because of
increases in food supplies, price increases at the
wholesale level have dropped off in recent
months. However, prices for industrial com­
modities at wholesale— a critical measure of
inflationary pressures— have shown no improve­
ment.

B U S IN E S S R E V IE W

COST

FEDERAL RESERVE B A N K O F P H ILA D E L P H IA

LABOR

5

CHART4

So far there are few signs that inflation is responding to a slower-paced economy.
Although wholesale prices have risen less rapidly in recent months, the pace of inflation
for industrial commodities and consumer purchases has not abated.
Q U A R T E R L Y C H A N G E S IN P R IC E S

Per Cent

I

Per Cent

II

III
1969

IV

I

IP
1970

I

II

III
1969

IV

I

II
1970

"A p ril and May
Source: U.S. Department o f Labor

Lack of tangible results to date raises some
nagging thoughts that perhaps this time around
inflation may not be licked with the classical
cure. It is not that what monetary and fiscal
authorities have done is wrong; it is that what
they have done may not be enough or socially
tolerable for a long enough period.
There is, first of all, the asymmetry of trying
to cure the worst inflationary ill in twenty years
with the shallowest slowdown of the postwar
period. The rate of inflation has increased every
year since 1963, and most dramatically since
1965 (Chart 1). The last time inflation became
imbedded in the economic system, in the 1950’s,
the economy experienced three full-fledged re­
cessions, with the unemployment rate reaching
7.5 per cent before inflationary psychology
was finally rooted out. And judging from the
intensity and duration of the current price
spiral, the inflationary psychology now must
certainly be as deeply implanted in the system


6


as it was in the 1950’s— and perhaps even
more so.
Moreover, while the level of unemployment
sufficient to choke off inflationary psychology
may be the same or even higher than it was a
decade and a half ago, the nation’s tolerance for
unemployment has been sharply reduced. Social
values now rival economic values. The focus has
shifted from how many are unemployed to who
are unemployed.
The table shows that when the overall un­
employment rate rises 1.0 percentage point, for
example, the rate of unemployment for teen­
agers on the average rises 1.4 percentage points;
for women over 20 years of age, 0.8; and for
men, 1.2 percentage points.
But in an age when social justice ranks high
on the priority scale, the relative impact of
higher unemployment on Negroes and whites
is critical. The data leave little doubt who usu­
ally bears the brunt of rising unemployment; it

Average change in unemployment rates (percentage
points) when the total rate of unemployment rises
1.0 percentage point:

Total
Men, 20 years and o v e r ............................. 1.2
Women, 20 years and o v e r ......................... 0.8
Teenagers, 16 to 19 y e a r s ......................... 1.4

White

................................................................... 0.9

Men, 20 years and o v e r ............................. 1.0
Women, 20 years and o v e r ......................... 0.7
Teenagers, 16 to 19 y e a r s ......................... 1.5

Negroes ............................................................... 1.8
Men, 20 years and o v e r ............................. 2.6
Women, 20 years and o v e r ......................... 1.3
Teenagers, 16 to 19 y e a r s ......................... 0.8
Source: U. S. Department of Labor.

is the black man. For every 1.0 percentage point
rise in the total unemployment rate, the Negro
rate of unemployment on the average increases
1.8 percentage points— double the 0.9 for
whites. When the white breadwinner’s— men
over twenty— unemployment rate goes up 1.0
percentage point, the unemployment rate for
his Negro counterpart jumps 2.6 percentage
points. Clearly, the burden of a slowdown is
borne very unequally, and this uneven impact
places a major social constraint on the severity
of any economic slowdown as a remedy for in­
flation.
Depth vs. Duration. A way around this social
constraint on the level of unemployment is to
trade the sharper, shorter slowdowns of the
’50’s for a milder, longer one. In other words,
keep the rate of unemployment within social




Enter Incomes Policy. The increasing aware­
ness of this time constraint has prompted a
growing chorus of voices to suggest an incomes
policy as a supplement to monetary and fiscal
restraint. Although stopping well short of direct
wage and price controls, many advocates sug-

JU LY 1970
B U S IN E S S R E V IE W

TABLE

tolerances, but still less than full employment.
In terms of Chartl, this means avoiding the high
unemployment rates of 1957-58 and 1960-61.
Let actual output fall short of potential, but
only by a modest amount. In this climate, social
irritations would be minimized, but economic
conditions favorable towards disinflation would
prevail. Then, we could simply wait until infla­
tion fades.
For this gradual approach to work, though,
monetary and fiscal policies have to tread a very
narrow path between too much ease and too
little restraint. A deviation in either direction
would accelerate the momentum of inflation or
cause unacceptable levels of unemployment.
Assuming policymakers are able to tread this
difficult path, the national patience may have to
be patient, indeed. The recession remedy for
inflation is an old cure, but a gradual slowdown
followed by a planned period of modest excess
capacity is a major variation on this old prescrip­
tion. And with inflation as stubborn as it ap­
pears to be, we may have to wait a considerable
time for meaningful results.
How long we may have to wait for tangible
progress and how long the public is willing to
wait for it, therefore, are two key variables in
the current strategy against inflation. There are
no hard answers to either question. But if the
national patience grows thin and inflation sub­
sides too slowly, time could become as much a
constraint on policymakers as the rate of un­
employment.

FEDERAL RESERVE B A N K O F P H ILA D E L P H IA

The burden of a slow dow n is borne un­
equally. N egroes and teenagers b ear the
brunt of rising unem ploym ent. On the av er­
age, when the total rate of unemploym ent
rises 1.0 percentage point, Negro unem ploy­
ment adv an ces 1.8 percentage points.

7

gest an incomes policy that would include some
sort of wage and price guidelines. Enforcement
would depend primarily upon the sensitivity of
businessmen and workers to adverse public at­
tention as well as whatever direct pressure
government could bring to bear on inflationary
wage-price decisions. The hope is that an in­
comes policy of this type, acting as a voluntary
check on wage and price boosts, would shorten
the transitional period between economic slow­
down and a slowdown in the rate of inflation.
Even if this transitional period were not ma­
terially shortened, the introduction of an in­
comes policy conceivably still could have a
placebo effect; people would just feel better
psychologically knowing that “ more” is being
done to curb rising prices. More importantly,
while the nation waits to ascertain the effective­
ness of an incomes policy, a slack economy has
more time to yield significant relief from infla­
tion.
Of course, there could be some longer run
costs to this approach, particularly if inflation
and the threat of inflation persist. One cost,
certainly, is that wage-price guidelines could
escalate into wage-price controls. A second and
perhaps not so obvious cost is that to employ
an incomes policy now may preclude its more
appropriate use in the future. For example, sup­
pose that cost-push pressures now are just too
strong to be checked by wage-price guidelines.
Some months from now, therefore, the guide­
line approach is branded a failure and is junked.
Later on, though, when cost-push pressures have
subsided, an incomes policy may be able to
provide just the needed assist for monetary and
fiscal policy to maintain price stability. But
because of past “ failure,” guidelines are rejected.
In other words, an ill-advised use of an incomes

Digitized for 8FRASER


policy now might preclude its profitable use in
the future.
On balance, though, particularly if one re­
mains confident in the stabilizing power of
monetary and fiscal measures, an incomes policy
is still attractive. At best, an incomes policy
might end inflation more quickly, if only margin­
ally so; even if this were not the case, it would
soothe public impatience for awhile and allow
monetary and fiscal policies additional time to
work their effects through the economy. In
either event, an incomes policy lessens the time
constraint and, therefore, in the short run at
least, improves somewhat the prospect of bring­
ing inflation to heel.
Assessing Overall Odds for Success. Social con­
straints preclude high rates of unemployment
which in the past were used to control serious
inflation. These social constraints, in turn, mean
that the latitude for maneuver on the part* of
economic policymakers is diminished— and,
hence, the chance for them to err is greater.
Moreover, the current strategy may be hemmed
in by a time constraint, although an incomes
policy could allow monetary and fiscal policies
a little more time to check rising prices. None­
theless, the nation is growing impatient with
inflation.
Despite these obstacles, however, history and
traditional economic logic remain very much
on the side of the current strategy for bringing
inflation under control. Certainly, without the
elimination of excess demand, inflationary pres­
sures could not possibly be dampened. But
whether the current slowdown, even with the
addition of an incomes policy, will be enough
to reduce the pace of inflation to an acceptable
level is still less than a shoo-in.




MANUFACTURING— THE VOLATILE SECTOR

Swings in activity of manufacturers have an im­
pact upon the District disproportionate to the
size of manufacturing. Although factories ac­
count for less than a third of this region’s
employment, they are associated with more than
two-thirds of fluctuation in total employment.
One reason is that manufacturing is highly vola­
tile. During the last 15 years, employment in
manufacturing in this District has fluctuated over
seven times more than has employment in other
industries. Another reason is that reductions in
( Continued on page 12)

JU LY 1970
B U S IN E S S R E V IE W

by Richard W. Epps

FEDERAL RESERVE B A N K O F P H ILA D E L P H IA

The Nation and
District Manufacturers

It seems that on every street corner one finds
an economist prognosticating the future of the
economy. This is evidence not so much of the
surfeit of economists, however, as of the im­
portance of the outlook for the economy. Many
business decisions— on production, on invest­
ment, on hiring— are based upon bets about the
future state of the economy. Forecasts, however,
usually are national in scope. Businessmen deal­
ing in regional markets are left largely to their
own devices in deciding what the national out­
look implies for their own region.
Businessmen in one large east coast region
— the Third Federal Reserve District— may in­
deed have an easier time of forecasting than do
businessmen elsewhere. Fluctuations in the re­
gion, including markets served by firms in at
least 13 metropolitan areas, appear to mirror
closely those in the nation. Over the last 15
years, most local fluctuations in output by manu­
facturing, the region’s most volatile sector,
corresponded with national fluctuations. District
and national swings in output occurred at nearly
the same time and were about the same relative
size.

9

Two Faces of Bank Liquidity*
Monetary restraint in response to a fast-paced
economy has many people concerned over the
liquidity of our economy. However, liquidity
often puts on more than one face for us to see.
And, one face may be less ominous than the
other. These two different faces nowhere are
more apparent than at the nation’s large com­
mercial banks.
The traditional standard of bank liquidity is the
ratio of loans to deposits. This measure clearly
shows a deterioration in liquidity of large banks
when December, 1969, is compared to Decem­
ber, 1966, the end of the last period of monetary
restraint. Among the largest of the large (banks
with deposits over $1 billion), the decline in
this measure of liquidity has been especially
sharp.

But when banks make loans or investments, they
need not be overly concerned whether the funds
come from deposit or nondeposit sources, as
long as they can be counted on to support lend­
ing activity. Since Euro-dollar borrowings, fed­
eral funds, and commercial paper provide funds
to banks which may be no more volatile than
funds obtained from many depositors, a more
appropriate measure of liquidity might be the
ratio of loans to all liabilities, including these
nondeposit sources of funds. When viewed in
this way, there was little difference in the
liquidity position of most large banks between
the end of 1966 and the end of 1969.

R A T IO S O F L O A N S A D J U S T E D
T O L IA B IL IT IE S A D J U S T E D O F
W E E K L Y R E P O R T IN G M E M B E R
B A N K S B Y D E P O S IT S IZ E
■B i DECEMBER, 1966

L O A N T O D E P O S IT R A T IO S O F
W E E K L Y R E P O R T IN G B A N K S B Y
D E P O S IT S IZ E

W M DECEMBER, 1969

All Weekly
Reporting
Banks

Over $1
Billion

$500 Million
Less than
to $1 Billion $500 Million

NOTE: Data for 1966 are ratios of total loans to total liabil­
ities. For 1969, ratios are total loans adjusted for loan
sales to bank holding companies and affiliates to total
liabilities including commercial paper issued by bank holding
companies and affiliates.
All Weekly
Reporting
Banks

Over $1
Billion

$500 Million
Less than
to $1 Billion $500 Million

NOTE: Ratios for the different groups of banks are averages of
individual bank ratios. Dates are for December 21, 1966
and December 24, 1969. These dates were selected to ex­
clude the influence of year-end financial developments.

Digitized for 10
FRASER


* Based on data contained in remarks by Andrew F.
Brimmer, Member of the Board of Governors of the
Federal Reserve System, entitled “ Liquidity Demands,
Fiscal Policy, And The Tasks of Monetary Manage­
ment,” given before the 17th Annual Monetary Con­
ference of the American Bankers Association on May
18, 1970, at Hot Springs, Virginia.

1970
JU LY

L O A N T O D E P O S IT R A T IO S O F
W E E K L Y R E P O R T IN G B A N K S B Y
TYPE O F BANK

Multinational
Banks

Multinational
Banks

Major
Regional
Banks

Other
Large
Banks

NOTE: Multi-national and major regional banks are identified
by a number of criteria including size, volume of business loans,
importance in the Federal Funds market in particular and the
money market in general, volume of foreign lending, and par­
ticipation in the Euro-dollar market. Major regional banks, how­
ever, are generally smaller than multi-national banks and each
region of the country was represented.




Major
Regional
Banks

Other
Large
Banks

To some observers, the loan to deposit ratio
is an outmoded relic of the past. To others, the
ratio of loans to all liabilities, while it may re­
flect a changed view of banking, is a statistical
face-lift which merely conceals the severe
liquidity stress under which banks currently
operate. It may be that both views contain
some truth. Liquidity is a difficult concept to
define, and probably no single measure is ade­
quate for all purposes. Yet, while now is not the
time to be complacent, it would seem that bank
liquidity may not be as bad as many people
fear.

B U S IN E S S R E V IE W

R A T IO O F L O A N S A D J U S T E D
T O L I A B IL IT IE S A D J U S T E D O F
W E E K L Y R E P O R T IN G M E M B E R
BA N K S BY TY P E O F BANK

FEDERAL RESERVE B A N K OF P H ILA D E L P H IA

The same picture emerges when the same large
banks are labeled according to the market they
serve. The traditional measure, the loan to de­
posit ratio, portrays deterioration in the liquidity
position of multi-national and major regional
banks.

But, when their growing reliance on non­
deposit sources of funds is taken into account,
liquidity remains essentially unchanged between
the two dates.

11

(Continued from page 9)
spending by manufacturers and their workers
caused by production slowdowns affect the level
of activity in nonmanufacturing sectors. In
Philadelphia, for example, more than 30 per cent
of variation in nonmanufacturing employment
over the last 15 years is associated with move­
ments in factory employment.
WHY SO VOLATILE?

Manufacturing activity tends to fluctuate so
much because of the nature of its product and
production process. Although buyers cannot
delay expenditures across-the-board, they can
postpone their purchase of many manufactured
goods. The old car can be made to run for

another year; the too-small refrigerator can
remain stuffed a while longer. But food must be
purchased regularly, and illnesses must be
treated when they strike. So, when national
monetary or fiscal policy begins to hold down
the growth of income, manufacturers are the
first to lose the buyer’s dollar.
The reaction of producers to declining de­
mand causes a double-barreled impact. Unlike
many nonmanufacturing firms, which produce
output as needed, manufacturers maintain sub­
stantial inventories of finished goods and goodsin-process. When sales and production decline,
these inventories quickly begin to look exces­
sive and provide further motivation for a plunge
in output.

CHART 1
D I S T R I C T M A N U F A C T U R I N G S T A Y S IN S T E P W I T H
M A N U F A C T U R IN G
TOTAL

MANHOURS

USED

IN

P R O D U C T IO N

OF

N A T IO N A L

NONDURABLE

GOODS

Percentage quarterly changes, adjusted for seasonal influence and for trend

TOTAL M ANHO URS USED

IN P R O D U C T IO N O F D U R A B L E G O O D S

Percentage quarterly changes, adjusted for seasonal influence and for trend

Source for national data: SURVEY OF CURRENT BUSINESS, United States Department of Commerce

Digitized for 12
FRASER


JU LY 1970
B U S IN E S S R E V IE W

put corresponding to national fluctuations in
production. (See Table 1.) But the relationship
between District and nation is not exact. Pro­
duction of nondurable goods in the District
appears to fluctuate somewhat more than na­
tional production of nondurable goods— an aver­
age quarter-to-quarter change of 1.6 per cent
for the District and 1.1 per cent for the nation.
Local durables production, in contrast, appears
somewhat more stable than national production
of durables— a 2.5 per cent quarter-to-quarter
change for the District and 2.9 per cent level
for the nation.
An additional contrast between this region
and the nation is found in the timing of fluctua­
tions in production. As shown in Table 1, while
most national and District swings coincide, there
is a slight tendency for the activities of District
producers to lag those of national producers.

This characterization fits manufacturers re­
gardless of location— in this District or else­
where. Insofar as most major fluctuations in
buying are caused by national phenomena such
as monetary or fiscal policy, manufacturing in
this District may be expected to display about
the same movements as does production in other
regions. There is, then, a strong reason to sus­
pect that, relative to national movements, fac­
tory owners here find themselves reducing their
output at about the same time and in about the
same proportion as do manufacturers across the
nation.
As shown in Chart 1, manufacturers in this
region do follow nearly the same course as their
counterparts elsewhere. In fact, association
between District movements in manufacturing
activity and national movements is strong, with
at least 70 per cent of local fluctuations in out­

TABLE 1
A S S O C I A T I O N O F M A N U F A C T U R I N G IN T H E D I S T R I C T

The table presen ts the resu lts of a statistical an aly sis of the association betw een the
quarterly changes in m anhours in the D istrict and in the nation show n in Chart 1.
Colum ns 1 through 5 list the percentage change in D istrict m anhours asso ciated with a
1 per cent change in m anhours used by national m anufacturers. Each of the five columns
correspon d s to a different timing of response. Column 1, for exam ple, lists the D istrict
in crease in one period asso ciated with a national in crease in m anhours two quarters
earlier. Column 6 lists the total effect of a 1 p er cent change in national m anhours.
TIME OF NATIONAL CHANGE*

District
Industries
Durables Mfg.
Nondurables Mfg.
UPTURNS
Durables Mfg.
DOWNTURNS
Durables Mfg.

Two
Quarters
Earlier

One
Quarter Same
Earlier Quarter

One
Quarter
Later

Two
Quarters
Later

.00

-.0 6

1.02

.11
.11

.02
.01

1.04
1.08

80.2%
70.6

,22

.24

.83

.12

-.1 9

1.22

84.2

.12

.04

.52

.10

.17

.95

84.2

M

JA

m

* Underlined values are statistically significant at least at the .05 level.




District
Variation
All
Accounted
Quarters
For

FEDERAL RESERVE B AN K O F P H ILA D E L P H IA

A N D IN T H E N A T I O N . 1 9 5 4 - 1 9 6 9

13

LOCAL FLAVOR

Two principal local factors underlie these differ­
ences between District and nation— the markets
of local industries and the competitiveness of
local industries.
1. Industrial Markets. Unlike the output of
local government, medicine, education, and many
more other nonmanufacturing industries, most
products of manufacturing industries can be
transported and then traded in national markets.
Because of these ties with widely dispersed mar­
kets, we may expect manufacturing industries in
this District to experience the same forces as do
their counterparts all over the nation.
However, local factors do enter. Aggregate
manufacturing consists of many heterogeneous
industries, each serving a product market with
its own cyclical pattern. Areas with a relatively
greater concentration of the more cyclical sorts




of industries will be more unstable. In addition,
plants within a given industry may sell in na­
tional markets when located in one region, but
trade only in local markets when situated in
another region. Although difficult to document,
these patterns of selling will influence the degree
to which the production of a local industry re­
flects that of its national counterpart. Two kinds
of market considerations, then, help set the local
pattern of production— the composition of in­
dustries and the size of market served by each
industry.
The local composition of industries may in­
deed underlie some of the contrasts between the
Third Federal Reserve District and the nation
in fluctuations of output of manufacturing.
There are some differences between the structure
of industries located in this District and that of
industries in the nation. (See Chart 2.) In par­
ticular, the District has a heavier-than-normal

CHART 2
A M AJOR REASON FOR TH E C O R R E SPO N D E N C E
S IM IL A R IT Y O F IN D U S T R IA L S T R U C T U R E
M A N U F A C T U R IN G
IN

THE

T H IR D

EMPLOYMENT

D IS T R IC T ,

1968

IS

M A N U F A C T U R IN G
IN

THE

U N IT E D

EMPLOYMENT
STATES,

1968

Source: 1969 BUSINESS STATISTICS United States Department of Commerce

concentration of apparel producers and steel
mills, but is light on food processors and manu­
facturers of transportation equipment. Apparel,
a member of the nondurable class, is more vola­
tile than food processing and this may cause the
nondurables group in the District to out-gyrate
the national industry. Conversely, steel produc­
tion is somewhat less cyclical than production of
transport equipment. This may cause the rela­
tively stable local record among the durables
industries.
2. Competitiveness of Local Firms. The com­
petitiveness of local producers may also alter
the relationship between this District and the
nation. If costs of production in factories located
in this region are higher than those in factories
situated elsewhere, or if local producers incur
inordinately high costs of transportation in get­
ting their goods to market, local factories will
tend to operate at peak capacity only when
demand in the nation is at its highest. More com­




petitive producers would bid away business
when demand is less than the national capacity
of the industry.
Although competitiveness is difficult to ob­
serve directly, its effects may be observed. Out­
put of plants in less competitive regions will
tend to decline earlier than that of factories
elsewhere in a national downturn and to rise
later in an upturn. As shown in Table 1, the
District tends to follow this pattern, but only
partially. Local production does lag national
activity on upturns. It stays in step with the
nation on downturns, however.

PROGNOSIS

While the production pattern of individual firms
and industries in this District may differ from
that of their counterparts across the nation,
there is a strong thread of similarity between
the experiences of producers here and elsewhere.
Taken in the aggregate, over 70 per cent of the

swings in District production are associated with
fluctuations in national production. This similar­
ity could be attributable to chance, but that
seems doubtful. The composition of industries
here is not much different than that in the
nation. Furthermore, industries in the District
probably feel the same influences in the markets
for their product here as do industries else­
where. There is good reason, then, to suppose
the strong relationship found between District
and national production will continue.

The implications are twofold. First, business­
men and community leaders interested in the
outlook of local manufacturing may rely, with
confidence, on national projections. National
forecasts tend to be more authoritative than
local ones, because more is known about the
national economy and because most economic
policies with near-term effect are set at the
national level. Second, for the present period,
it means that the District may expect to share
the brunt of the current slowdown.

M E A S U R IN G IN D U S T R IA L O U T P U T
Most of the influence of the nation upon District manufacturers runs along
final product lines. National policy causes a reduction in demand for output
of manufactured goods, and District producers feel some of this pinch. In
seeking to measure the relationship between District and national producers,
therefore, one would preferably deal in measures of output. Unfortunately,
information about levels of output does not exist for subnational areas.
Records of “ value-added” by manufacturers do exist on an annual basis,
but for too few years to allow an examination of the relationship between
District and nation.
Therefore, proxies must be used in place of output measures—proxies relat­
ing to inputs into production. In this article we have used manhours
involved in production. The adequacy of this proxy depends upon the
stability of the productivity of labor. If labor productivity were constant,
manhours of labor used in production would be an exact proxy for output.
In fact, the productivity of labor tends to vary over business cycles—often
increasing on upswings and decreasing on downswings. Manhours will tend,
therefore, to understate the movements in output, and may tend to lag the
turns of output. In order to offset this bias, manhours have been used to
measure output for both the nation and for the District.
For the nation, for which indices of both output and manhours are
available, fluctuations in output account for better than 90 per cent of
the variation in manhours. (See Table.) And manhours show a one-to-two
quarter lag in their response to changes in output.

Digitized for16
FRASER


A S S O C IA T IO N

OF

M ANHOURS

T U R ER S AND TH E

USED

BY

FEDERAL RESERVE

M ANUFAC­
IN D E X O F

IN D U S T R IA L P R O D U C T IO N , F O R T H E N A TIO N ,
1954-1969

Colum ns 1 through 6 list the percentage change in m anhours
associated with a 1 per cent change in in dustrial production.
Column 7 lists the total proportion of variation of m anhours
asso ciated with variation in industrial production.
TIME OF CHANGE IN INDUSTRIAL PRODUCTION*

Industry
Durables
Nondurables

Variation
in
Manhours
Two
Two
One
One
All Accounted
Quarters Quarter Same Quarter Quarters
Earlier Earlier Quarter Later
Later
Quarters
For
.95
92.6%
0
JO
.04
.06
.13
1.15
96.3
.91
.09
-.0 7
.14
.05

*Underlined numbers are significant at .05 level.

V A L U E -A D D E D T A X
The value-added tax is again in the new s. To help clarify issu es,
you m ay w ant to read “ A Balance Sheet for the V alue-A dded
T a x ,” by Edw ard G. Boehne. F irst published in the June, 1969,
B u sin ess Review , this article describ es and a ss e sse s the argu­
m ents for this form of corporate taxation. To secure copies of
this selection, ad d ress your request to Public Services, Federal
R eserve Bank of Philadelphia, Philadelphia, Pennsylvania 19101.




This is the second in a series of three arti­
cles which deal with the balan ce of p ay ­
ments, foreign-exchange m arkets, and
problem s and p rop osals for reform ing the
international m onetary system . The series
is designed for the general reader rather
than the expert in international econom ics.

Foreign-Exchange and
Euro-Dollar Markets
by Clay J. Anderson**




If a single currency were used in all international
transactions, effecting payment would be as sim­
ple as in domestic trade and finance. Receipts
from abroad would enlarge deposits denomi­
nated in the currency; payments abroad would
reduce them.
The problem is not so simple, however, when
a number of national currencies are involved.
An American firm exporting automobiles to
France wants to be paid in dollars; the French
importer, however, does business in francs. An
English importer of American goods sells them
for sterling but needs dollars to pay the United
States exporter. An American importer of French
goods sells for dollars but needs francs to pay
the French exporter. In a large volume of inter­
national transactions, receipts and payments
involve a currency which the participant does
not use domestically. Effecting payment requires
exchanging one currency for another.
Purchases and sales of currencies of the major
trading nations total hundreds of millions of
dollars every business day. Markets in which
foreign currencies are bought and sold are com­
monly referred to as foreign-exchange markets.
This article deals with the foreign-exchange
market in the United States, factors influencing
foreign-exchange rates, and a related but differ­
ent type of market— the Euro-dollar market.
FOREIGN-EXCHANGE MARKET

A foreign-exchange market has the principal fea­
tures of any market: buyers and sellers, facilities
for bringing the two together, and stock-in-trade,
that is, things which are actually bought and
sold.1
* Dr. Anderson, now retired, formerly was Economic
Advisor of the Federal Reserve Bank of Philadelphia.
1 For a more complete analysis of the foreign-exchange
market in the United States, see Alan R. Holmes and
Francis H. Schott, “The New York Foreign-Exchange
Market,” a booklet published by the Federal Reserve
Bank of New York.

Institutional Structure. A foreign-exchange
market is not an organized market such as a
stock or commodity exchange. There is no single
marketplace where buy and sell orders are exe­
cuted; there are no meeting places where buyers
and sellers assemble to arrange transactions.
Instead, foreign-exchange transactions are con­
summated by telephone and, in the case of over­
seas transactions, mainly by cable and mail. For
simplicity of exposition, we can break down the
market structure into several main segments.
First are the dealers, mainly commercial
banks, who conduct transactions with business
firms and individuals desiring to buy or sell bills
of exchange denominated in a foreign currency.
A few specialized dealers limit their activities
mainly to foreign bank notes. But transactions
for any sizable amount are ordinarily in terms
of bank deposits. Consequently, customers want­
ing to buy or sell foreign exchange usually go to
their own commercial bank. Customers selling
a bill of exchange are paid by credits to their
deposit accounts; purchasers of foreign exchange
make payment by checks on their deposit
accounts.
Banks buying these foreign bills acquire in­
struments payable abroad in a foreign currency.
They build up foreign currency balances abroad.
The banks can draw on these balances to sell
foreign exchange to their customers.
Most commercial banks do not want to main­
tain foreign currency deposits abroad, which
they must do if they are to operate directly in
the foreign-exchange market. They prefer to
handle such transactions through a large corre­
spondent which has a foreign-exchange depart­
ment and maintains deposit balances abroad.
Thus, the bulk of the transactions arranged by
commercial banks in various financial centers is
funneled into the primary market in New York.




Only a small number of banks, mostly in New
York, maintain deposits abroad in the principal
foreign currencies. Several branches and agencies
of foreign banks in New York City are also
active participants in the foreign-exchange mar­
ket. The bulk of the foreign-exchange business,
however, is accounted for by about a dozen large
New York commercial banks.
A second segment of the market is the foreignexchange broker. As already noted, purchases
of foreign exchange by banks dealing directly in
the market build up their foreign currency bal­
ances abroad; sales of foreign exchange draw
them down. Banks build up balances abroad
when purchases exceed sales and reduce balances
when purchases fall short of sales. Banks dealing
in foreign exchange want to maintain working
balances in the principal currencies sufficient for
day-to-day operations; however, because of the
risk of rate fluctuations, they try to avoid bal­
ances in excess of operating needs. Frequent
adjustments in foreign-exchange positions are
therefore necessary.
An important medium for adjusting foreignexchange positions is the inter-bank market in
New York. For example, at the end of the day,
some banks might have a larger position in ster­
ling than they want; others might have a short­
age. Instead of dealing directly to adjust their
positions, banks use the services of foreignexchange brokers. Brokers maintain close con­
tact with the foreign-exchange departments of
commercial banks in order to be able to put
banks desiring to sell in touch with those want­
ing to buy a particular currency. For each trans­
action he arranges, the broker receives a small
commission, paid by the seller. Banks prefer
dealing through a broker because of convenience
and time saved, and because brokers will not
reveal names of banks wanting to sell or buy

until a transaction is arranged. In a highly com­
petitive market, there may be advantages in
maintaining secrecy as to a participant’s position
in foreign currencies.
A third segment of the market is transactions
with foreign banks. Banks cannot always fully
adjust their positions in the New York inter­
bank market. Sometimes total purchases in the
New York market may exceed total sales of
certain foreign currencies or vice versa. In that
event, practically all of the participating banks
may have excess balances or shortages at the
same time. If sterling positions are deficient,
New York banks may turn to their counterparts
in London to buy sterling. Likewise, London
banks may be short of dollars and, therefore, be
glad to exchange sterling for dollars. Foreignexchange positions are thus adjusted primarily
in an inter-bank market— via transactions with
other domestic banks and with banks abroad.
The foreign-exchange market may also be
classified in terms of the foreign currencies
traded, that is, markets for sterling, Canadian
dollar, mark, and Swiss franc. The volume of
activity in a currency depends on demand for it
and supply available for sale.
The volume of activity in sterling is largest
among the markets for individual currencies in
New York. The broad market in sterling reflects
a substantial volume of trade, service, and finan­
cial transactions with the United Kingdom, and
use of sterling in transactions with a number of
other countries, especially those in the sterling
area. Next in size, perhaps, is the market in the
Canadian dollar. Trade, travel, and financial
activities between the United States and Canada
create substantial demand for and supplies of
the Canadian dollar. There are also sizable mar­
kets in New York for the German mark and
Swiss franc.




Less active markets exist in a number of
other foreign currencies, such as the French
franc, Dutch guilder, Italian lira, and Japanese
yen. Inasmuch as the large commercial banks in
New York maintain deposit balances in many
foreign countries, and many foreign banks, in
turn, maintain dollar balances in the United
States, it is possible to buy or sell practically
any foreign currency.
Stock-in-Trade. What is actually bought and
sold in a foreign-exchange market? The bulk of
transactions is in bank deposits denominated in
foreign currencies; that is, the transaction results
in the transfer of a specified amount from the
deposit balance of the seller to that of the buyer.
For example, an importer in New York desiring
to make payment in London goes to his bank
and buys a certain amount of sterling; the New
York bank authorizes its correspondent in Lon­
don to transfer the amount from its deposit ac­
count to that of the company or bank specified
by the importer. The transaction is effected by
the transfer of sterling from one deposit account
to another in one or two banks in London.
Deposit transfers arising from foreign-exchange
transactions are usually authorized by cable be­
cause payment is effected more promptly. Some
transfers, however, are authorized by mail. Use
of air mail has drastically reduced the time for­
merly required in effecting payment by sea mail.
Perhaps our New York importer prefers to
send his payment directly to the English ex­
porter. If so, he buys a sterling draft from his
New York bank for the agreed amount and
sends it to the exporter. The draft is an order
by the New York bank, drawn on its deposit in
a London bank, to transfer the specified amount
from its account to the account of the exporter
or his bank. In either case, payment is effected

by a deposit transfer from the New York bank’s
balance in the London bank to the exporter’s
bank.
Drafts, or bills of exchange as they are com­
monly called, are still used in arranging payment
for exports. A United States exporter selling
goods to an importer in London may, as part
of the agreement, draw a draft on the importer’s
bank for the amount of the sale. The importer,
of course, would first have to arrange for his
bank to pay or accept the draft. The exporter
draws the draft, according to the terms of the
agreement, and sells it to his bank which credits
his deposit with the dollar proceeds. The bank
then sends the draft directly, or through its
correspondent, to the bank on which it is drawn
for payment. The final result is an increase in
the exporter’s dollar deposit in his bank for the
proceeds of the draft and a corresponding in­
crease in the purchasing bank’s sterling deposits
abroad. The importer’s balance in his bank
would be reduced similarly.
A draft or bill of exchange may be payable
on sight or at a specified future date. If the lat­
ter, it must be “ accepted” by the bank or busi­
ness firm on which it is drawn— acceptance
represents agreement to pay at the time speci­
fied. Time bills, if accepted by a bank, are known
as bankers’ acceptances; if accepted by business
firms, as commercial or trade acceptances. Divi­
dend checks and interest coupons payable in
foreign currencies are similar instruments traded
in the foreign-exchange market.
Foreign paper currency and coin are also
bought and sold, but the volume of trading is
small. Travelers going abroad are an important
source of demand; travelers returning from
abroad are a source of supply.
Buyers and Sellers. Buyers and sellers of
foreign exchange in the United States consist




of a large number of business firms and individ­
uals engaging in a great variety of transactions
with their counterparts in foreign countries. A
large part of our exports and imports is invoiced
and paid in dollars; hence, many foreign-exchange transactions involved in our foreign
trade bypass the United States market. The
exchange of foreign currencies for dollars is
made mostly in foreign-exchange markets abroad
rather than in the United States.
The supply of foreign exchange offered for
sale in the United States market comes from
several sources. Payment for some of our exports
is still effected by means of drafts drawn on for­
eign banks and payable in foreign currencies,
as already stated. Such drafts are sold to United
States banks or other foreign-exchange dealers.
Drafts payable in foreign currencies are some­
times drawn in payment of securities sold abroad
and by United States companies remitting in­
terest, dividends, and profits from overseas
branches and subsidiaries. Foreign tourists and
visitors in the United States may cash travelers’
checks payable in foreign currencies or draw
drafts in foreign currencies under letters of
credit. Speculators may sell foreign exchange
purchased previously, and, of course, United
States banks which maintain balances in foreign
currencies abroad also sell foreign exchange to
meet demands of their customers.
Basically, the demand for foreign exchange
comes from those who need to make payment
abroad. American importers buy drafts to pay
for goods invoiced in foreign currencies. This is
still a common method of payment in certain
commodities, such as rubber, jute, and tin,
which are often invoiced in sterling, and imports
of Swiss watches, usually invoiced in Swiss
francs. Other sources of demand in the United
States for foreign exchange are investors desir­

ing to pay for securities purchased abroad;
United States companies remitting interest, divi­
dends, and profits on funds borrowed from
abroad; American tourists traveling abroad;
agencies of foreign banks desiring to return
funds previously transferred here; and specula­
tors who buy foreign currencies expecting to
sell them later at a higher price.
The mechanics of making payment should not
obscure the fact that international transactions
result in the exchange of one currency for an­
other. United States payments abroad supply
dollars to foreigners— they result in the conver­
sion of dollars into foreign currencies or transfer
the ownership of dollars to foreigners. Receipts
from abroad (foreign payments to the United
States) result in an increase in foreign balances
owned by Americans or a reduction of dollar
deposits owned by foreigners. Therefore, a net
deficit in the United States balance of payments
tends to build up deposits owned by foreigners
in United States banks; a net surplus tends to
build up our deposits abroad in foreign curren­
cies.

FOREIGN-EXCHANGE RATES

Foreign-exchange rates are prices— prices of for­
eign currencies expressed in a country’s own
money. The following quotations (in dollars)
are selling prices for cable transfers; i.e., “ spot
rates,” for delivery in one or two days. Buying
prices are slightly lower. The difference between
buying and selling price is the dealer’s income
for handling the transaction. No commission is
charged. The par value of the foreign currency
in terms of the United States dollar is given
above in parenthesis.
Practically all nations belong to the Inter­
national Monetary Fund and, as members, agree
to maintain the market rate of exchange within
1 per cent above and 1 per cent below par.2
Market rates of exchange fluctuate within this
narrow band in accordance with changing
supply-demand relationships. Rate fluctuations
during a day are typically very narrow— only a
small fraction of a cent. Increased demand for
sterling, for example, might nudge the market
2 Some countries maintain market rates for their cur­
rencies within a narrower band.

FRIDAY, APRIL 10, 1970
Selling prices for bank transfers in the U. S. for payment abroad, as
quoted at 4 p.m. (in dollars):
Country and Par Value
Canada (Dollar, .925)
Great Britain (Pound, 2.40)
30-Day Futures
90-Day Futures
Australia (Dollar)
New Zealand (Dollar)
South Africa (Rand)
Austria (Schilling, .0384615)
Belgium (Franc, .02)
Source: T he W all S tre e t J o u rn a l, April 13, 1970.

Digitized for
22FRASER


Friday

Previous
Day

.9320
2.4062
2.4052
2.4029
1.1230
1.1260
1.4035
.0388
.020125

.9321
2.4057
2.4049
2.4029
1.1227
1.1257
1.4035
.0388
.020125

price from $2.3985 to $2,399; an increased sup­
ply might lower it to $2,398. More persistent
shifts in demand-supply forces, however, may
lift the market rate to the “ ceiling” or lower it
to the “ floor,” that is, the support levels above
and below par value.
The balance of payments reflects the basic
supply-demand forces influencing the exchange
rate for a nation’s currency. As explained in the
previous article, the United States’ persistent
balance-of-payments deficit put a growing sup­
ply of dollars at the disposal of foreign holders.34
The supply tended to exceed demand for dollars
in foreign-exchange markets abroad. Dollars
tended to be cheap in terms of foreign curren­
cies; alternatively, the price of foreign currencies
tended to be high in New York.'1
A balance-of-payments surplus would have the
opposite effects. An excess of receipts over pay­
ments would create a strong demand abroad for
dollars (or a large supply of foreign currencies
in New York). The price of the dollar in
foreign-exchange markets would tend to rise;
prices of foreign currencies in New York would
fall.
Seasonal and temporary factors also influence
day-to-day foreign-exchange rate fluctuations.
A seasonal rise in exports or other foreign re­
ceipts may weaken market rates of certain for­
eign currencies; a seasonal rise in imports and
other payments abroad may strengthen them.
Anticipation of future market trends may
touch off speculative purchases or sales. Specu­
lative purchases may become massive, if, for
example, a foreign country is expected to raise
the value of its currency. A recent case was the
3 Clay J. Anderson, “ Balance of Payments,” Business
Review, Federal Reserve Bank of Philadelphia, June,
1970.

4 The impact on our gold reserve is explained in the
next article.




German mark. Expectations that a country may
devalue its currency in the near future may lead
to a wave of speculative sales of the currency.

THE FORWARD MARKET

Most major foreign currencies can be bought
and sold for future as well as immediate ( spot)
delivery. Future transactions in foreign cur­
rencies are commonly referred to as forward
exchange.
Forward-exchange markets are similar in im­
portant respects to futures markets for com­
modities. In forward purchases and sales, the
date of delivery and price are agreed upon when
the contract is made. For example, in foreign
currencies for which there is an active forward
market, purchases and sales for delivery in
thirty days on up to six months are common.
Longer terms of one year or more are some­
times negotiated, but dealers enter into such
contracts only when they can hedge their posi­
tion.
Option contracts which provide some leeway
as to date of delivery and payment are frequently
negotiated. A United States exporter, for exam­
ple, may not be able to determine in advance
the exact date his goods will be shipped and,
therefore, when he will have his foreign draft
for sale. Importers also are often unable to
determine the day on which they will need to
make payment abroad. Because of such uncer­
tainties, foreign-exchange dealers enter into for­
ward contracts giving the seller or buyer the
option of offering or taking delivery on his future
contract at any time within a 10-day period,
such as the first 10 days of the month. Rates on
option contracts are likely to be a shade above
or below comparable futures maturing on a
fixed date.

Uses of Forward Market. A forward-exchange

market enables traders and others participating
in international transactions to hedge against the
risk of fluctuations in exchange rates. By means
of forward sales or purchases, they can transfer
all or most of the exchange-rate risk to someone
else. To illustrate, let’s assume an importer con­
tracts to buy goods from an English exporter
for 1,000 pounds sterling, which at a current
rate of $2.40 would yield $2,400; if, however,
the price of sterling has gone up by the time the
goods arrive and payment is to be made, the
cost will be more than the importer anticipated.
He could protect himself against the exchangerate risk when he contracts to buy the goods by
purchasing 1,000 pounds sterling for delivery
at the time he expects to make payment.
An exporter who has priced his goods in a
foreign currency to yield a certain number of
dollars may likewise find his dollar proceeds
reduced because of a drop in the price of the
foreign currency. He can protect himself by sell­
ing the foreign currency for future delivery or,
in the terminology of the market, by selling
forward exchange.
Commercial banks and other foreign-exchange
dealers use the forward market to hedge their
positions in foreign currencies. If a bank buys
100,000 pounds sterling in the spot market, it
can cover its position by selling sterling forward.
If the price of sterling rises, and spot and for­
ward rates move together, the gain on holdings
of 100,000 pounds sterling would offset the loss
on the forward transaction. If, on the other
hand, the price declines, the gain on the forward
transaction would offset a loss on the sterling
holdings acquired at a higher price. Dealers also
use the spot market to hedge their positions in
forward contracts.
United States purchasers of foreign securities
may cover the exchange risk involved through




the forward market. If interest rates on short­
term investments are higher abroad, there is an
inducement to invest in short-term foreign assets
to take advantage of the higher yield. A United
States investor buying 90-day British Treasury
bills would have to buy spot sterling to pay for
them. At maturity 90 days hence, he would
receive the face value of his bills in sterling. If
in the meantime the price of sterling has de­
clined, he would suffer a loss when converting
his sterling into dollars. The investor could pro­
tect himself against loss by selling sterling for
90 days future delivery at the time he purchases
British Treasury bills. If 90-day sterling is selling
at a discount, the difference between the for­
ward and spot rates represents the cost of
“ covering” his exchange risk.
Role of Speculator. A speculator is one who
engages in foreign-exchange transactions hpping
to profit from exchange-rate fluctuations. Trad­
ers, dealers, and other participants in the
foreign-exchange market can hedge against the
risk of rate fluctuation only because someone
else— the speculator— is willing to take it.
Speculators can operate in the spot market.
If a rise in the price of a foreign currency is
anticipated in the near future, they could buy
the currency and hold it for resale later; if, how­
ever, the price is expected to decline, they could
sell the currency short— i.e., borrow the cur­
rency for delivery. To terminate the latter trans­
action, the short seller would have to go into
the market later and buy the currency— hope­
fully at a lower price— to repay the amount
borrowed. Buying and holding a currency to
resell later or borrowing a currency to sell it
short involves costs. In the former case, there
is an interest cost or loss of interest that could
otherwise be earned on the funds tied up in

Relation Between Spot and Forward Rates. Spot
and forward-exchange rates are closely linked.
Expectations and interest-rate differentials are
two of the more significant ties. Fluctuations in




JU LY 1970
B U S IN E S S R E V IE W

spot rates are limited in accordance with agree­
ments of member nations with the International
Monetary Fund; however, such agreements do
not cover forward rates.
Expectations about foreign-exchange rates in­
fluence both spot and forward rates. If, for
example, sterling is expected to depreciate, pro­
spective recipients would sell it forward; specu­
lators also would sell it forward. Banks and
other dealers, in buying these forward sales con­
tracts, build up their forward positions in ster­
ling. They may sell spot sterling to hedge their
forward positions, thus putting downward pres­
sure on the spot rate. Anticipations of a rising
rate would tend to have the opposite effects.
Interest-rate differentials among international
financial centers is another linkage between spot
and forward rates. For instance, unless the
spread between spot and forward rates for a
foreign currency is such that the cost of cover­
ing the exchange risk is about equal to the dif­
ference in comparable interest rates in the
United States and the foreign country, there is
an inducement to shift funds to take advantage
of the higher rates.
An outflow of funds to take advantage of a
higher net return on British bills would tend to
eliminate the profit opportunity. As already in­
dicated, a United States purchaser of 90-day
British bills would buy spot sterling to pay for
them and sell 90-day forward sterling to cover
his exchange risk. The resulting increased de­
mand for spot delivery and increased supply of
forward sterling would widen the spread be­
tween the two rates and increase the cost of
hedging an investment in British Treasury bills.
The outflow of short-term funds would tend to
raise interest rates here and lower them in
England. Thus, interest-arbitrage transactions
tend to narrow the differential in interest rates

FEDERAL RESERVE B A N K O F P H ILA D E L P H IA

foreign currency holdings; in the latter, there
are costs involved in borrowing the currency for
spot delivery.
Such costs can be avoided largely by operat­
ing in the forward market. Speculators who are
bullish on a certain currency can buy it for
future delivery and payment; bears can sell for
future delivery and payment. Inasmuch as for­
ward transactions are negotiated only with those
considered creditworthy, margins are usually not
required.
The line of demarcation between a speculator
and one who enters the foreign-exchange market
to settle a trade or financial transaction is not
always clear-cut. Exporters and other prospec­
tive recipients of a foreign currency may not
hedge by selling for future delivery if there is
general expectation that the price of the cur­
rency will rise. They may wait until the foreign
currency receipts arrive, hoping to sell at a
higher price. Likewise, importers and others
having to make future payments abroad may
make a forward purchase if they expect the
price of the foreign currency to rise or delay the
purchase if the price of the currency is expected
to fall.
It is sometimes alleged that informed specula­
tion broadens a market and tends to cushion
price or rate changes. Speculation in foreign
exchange, however, has been disruptive and no­
tably destabilizing at times. Expectation that a
currency may be devalued or revalued upward
may touch off a massive volume of speculative
activity which puts strong downward or upward
pressure on the exchange rate.

25

and widen the spread between spot and forward
rates.
Interest-arbitrage transactions operate toward,
but do not necessarily maintain, equality be­
tween interest-rate differentials and cost of
covering exchange risk. Other factors influence
the relationship between spot and forward rates.
Some investors buy higher yielding foreign secu­
rities without covering the exchange risk. Specu­
lators buy and sell foreign exchange, hoping to
profit from rate fluctuations. Many investors in
the United States, either because of legal re­
strictions or unfamiliarity with foreign-exchange
practices, are unable or unwilling to engage in
interest-arbitrage transactions. Hence, the vol­
ume of arbitrage transactions is often insuffi­
cient to maintain the spread between spot and
forward rates at “ interest-rate parity.”
EURO DOLLAR MARKET

A large part of United States exports and a
smaller but substantial part of imports are in­
voiced in and paid in dollars. Dollars are also
widely used in payment of international trans­
actions which do not involve United States
participants. Many foreign-exchange transactions
involving other currencies go through the dol­
lar; that is, payment from Germany to France
being effected by converting marks to dollars and
dollars to francs. The dollar is extensively used
as a “ vehicle” currency, and transactions in
dollars constitute the major segment of most
foreign-exchange markets abroad.
Foreign-exchange operations of most foreign
central banks and other official institutions to
maintain the rate on their currency within agreed
limits are executed in dollars. They pay out
dollars for their own currency when the rate
falls to the support level; they take in dollars
for their own currency when the rate approaches
the ceiling.

Digitized for26
FRASER


Because of the widespread use of the dollar as
a means of international payment and as a vehi­
cle currency, commercial banks, other foreignexchange dealers, and central banks need dollar
working balances in order to conduct their daily
foreign-exchange operations. Foreign-owned de­
mand and time deposits in United States com­
mercial banks and liquid dollar assets, such as
United States Treasury bills and commercial
paper, total more than $40 billion.5 The bulk of
these foreign-owned dollars and dollar assets is
held by commercial banks and central banks
abroad.
General acceptability and extensive use of the
dollar in settling international transactions have
induced foreign official institutions to hold a
part of their international monetary reserves in
dollars. One advantage of dollars over gold is
that a portion of the dollar reserve can be held
in the form of a highly liquid earning asset, such
as a time deposit in a United States bank or
Treasury bills. Foreign central bank and official
institutions’ holdings of dollar deposits and
liquid dollar assets exceed $12 billion. The
United States dollar ranks next to gold as the
second largest component of free world mone­
tary reserves and constitutes over one-third of
the total.
Structure of the Euro-dollar Market. Euro­
dollars are deposits, denominated and payable
in dollars, in a foreign bank. They are the de­
posit liability of a foreign bank, not the liability
of a United States commercial bank to pay de­
posits held by foreigners. Perhaps the distinc­
tive aspects of Euro-dollars will be clearer if one
examines various ways in which they may
originate.
Foreigners receiving payment in dollars—
5 This includes about $12 billion of claims on U . S.
banks held by their foreign branches.

6 Bank for International Settlements, Fortieth An­
nual Report, June 8, 1970.




JU LY 1970
B U S IN E S S R E V IE W

To be in a position to pay depositors dollars on
demand or at an agreed time, such banks typi­
cally hold a reserve of deposits in United States
banks.7 Just as in domestic banks, it is unlikely
that all depositors will demand payment at once;
hence dollar “ reserves” in United States banks
will be less than the total volume of Euro-dollar
deposits. Again, as in the case of domestic banks,
loans result in additional deposits, Euro-dollar
deposits, being made available to borrowers. To
the extent experience reveals that reserves held
against deposits can be less than 100 per cent,
Euro-dollar banks ( as a group) in making loans
may enlarge the total volume of Euro-dollar
deposits. The proportion of reserves held, and
maximum multiple expansion of credit and de­
posits depend on leakages as Euro-dollars flow
from one bank to another. Euro-dollars are not
commonly used as a means of payment in domes­
tic transactions. For this and other reasons, leak­
age here is likely to be much greater than for
commercial banks in the United States.
Recent Development and Growth. The Russians

initiated in the 1950’s what was perhaps the
forerunner of the present Euro-dollar market.
They wanted to keep dollar balances, but pre­
ferred to hold them where they could not be
impounded by the United States Government.
Consequently, dollar deposits were maintained
in some West European banks.
Two developments established the conditions
essential for development of a sizable Euro­
dollar market. Growing use of the dollar in
international transactions and as a vehicle cur­
rency created a broad demand for United States
dollars. Restoration of currency convertibility
~ An individual bank might consider Euro-dollar de­
posits in another bank as reserve; however, ultimate
ability of the banks as a group to pay dollars derives
from deposits held in United States banks.

FEDERAL RESERVE B A N K O F P H ILA D E L P H IA

checks, drafts, bills of exchange payable in dol­
lars— may deposit the proceeds, denominated in
dollars, in their bank instead of converting the
dollars into their own currency. Foreigners with
deposits in United States banks may transfer
them to a foreign bank. Holders of foreign cur­
rencies may sell them for dollars and deposit the
dollar proceeds in a foreign bank. Americans
may transfer dollars to a foreign bank. These
sources of dollar deposits in foreign banks may
be thought of as primary deposits— holders of
dollars deposit them in a foreign bank. New
Euro-dollars may be created when foreign banks
make dollar loans against their dollar deposits,
as explained below.
The market in Euro-dollars, while not cen­
tralized, is an organized market. The term refers
to a large number of banks, mostly in London
and Western Europe, that accept demand and
time deposits in dollars and extend credit to
borrowers in dollars. Maturities of deposits
other than demand range from overnight, seven
and 30 days, up to one year. The average
maturity, however, is probably less than three
months. London is the center of the market, and
banks in the United Kingdom hold about onehalf the Euro-dollar total. Foreign branches of
United States commercial banks are a dominant
factor in the Euro-dollar market. Banks in West­
ern Europe are other important holders of Euro­
dollars. Total Euro-dollars outstanding at the
end of 1969 was estimated at $46 billion.6
The Euro-dollar market differs from a foreignexchange market in which dollars are bought
and sold for other currencies. It is really a bank
credit market conducted in dollars by foreign
banks. These banks accept deposits payable in
dollars; loans to borrowers are made in dollars.

27

and relaxation or removal of exchange restric­
tions made possible the free flow of funds neces­
sary in conducting a market.
The Euro-dollar market has grown substan­
tially in the past decade, especially in the latter
part of the 1960’s. Several factors contributed
to its growth.
United States Government regulations stimu­
lated the flow of dollars into the Euro-dollar
market. Payment of interest on demand deposits
in U.S. commercial banks is prohibited, and
there are ceilings on rates that can be paid on
various classes of time deposits. Euro-dollar
deposits often earn more than comparable de­
posits in United States banks. There was also a
shortage of attractive money-market instruments
in West European countries suitable for invest­
ment. Relatively high interest rates and con­
venient maturities attracted dollars from a
variety of sources. Recurrent uncertainty about
the future value of currencies, such as sterling
and the French franc, induced conversion of
foreign currencies into Euro-dollars. Finally,
growth itself made the market better-known
and more attractive as an outlet for short-term
funds.
Rising demand was an essential condition for
growth. An expanding volume of international
trade and financial transactions enlarged the
need for short-term financing in a currency gen­
erally acceptable in international transactions.
The Euro-dollar market often served as a sup­
plement to domestic sources of credit.
Recent developments have expanded both
supply of, and demand for Euro-dollars. Rates
on Euro-dollar deposits have generally been
higher than rates on alternative short-term in­
vestments. More stringent controls on United
States direct investments abroad induced a
substantial rise in bond flotations in foreign

Digitized for 28
FRASER


markets by United States corporations. The pro­
ceeds often were placed temporarily in Euro­
dollars. Apparently, substantial amounts of for­
eign funds were diverted from purchases of
United States securities, especially in 1969, to
the Euro-dollar market.
Temporary forces also have augmented de­
mand for Euro-dollars. Our voluntary credit
restraint program diverted some credit demand
from United States banks to the Euro-dollar
market, particularly to branches of United States
banks. Both foreign and United States commer­
cial banks at times turn to the Euro-dollar mar­
ket to adjust liquidity and reserve positions, and
for supplementary funds to meet customer credit
demands. Demand of large United States com­
mercial banks soared in the latter part of 1968
and in 1969. Pressure on reserves, losses of
negotiable CD ’s, and exceptionally strong credit
demand induced these banks to borrow heavily
in the Euro-dollar market.
The Euro-dollar market has become a widely
used international short-term money market.
The market performs internationally the basic
functions that a domestic money market per­
forms within a country— it provides a mecha­
nism for shifting funds from banks, corporations,
and others with temporary surpluses to those
with temporary shortages.
Euro-Bonds. Euro-bonds refer to issues de­
nominated in a single currency and sold simul­
taneously in several countries by a multi-national
underwriting syndicate. Most issues are denomi­
nated in United States dollars (interest and
principal payable in dollars), the most widely
accepted currency internationally; however, occa­
sionally an issue is denominated in sterling, Ger­
man marks, or another major currency.
Euro-bonds emerged in 1963, largely as a re­

IMPLICATIONS FOR POLICY

Foreign-exchange rates, if established solely by
market forces, might fluctuate widely at times.
Speculation, in particular, could be a serious
destabilizing force. Volatile exchange rates create
uncertainty and tend to inhibit international
transactions. Stable exchange rates is one of the
key provisions of the International Monetary
Fund. But the policy question of fixed versus
flexible exchange rates has many ramifications.




1970
JU LY
B U S IN E S S R E V IE W

They are explored in the next article in this
series which deals with the international mone­
tary system.
The Euro-dollar market has two principal
policy implications: its effect on our balance
of payments and its significance for monetary
policy.
The United States balance of payments for
1968 affords a good illustration of how the
Euro-dollar market may affect a surplus or defi­
cit. The reduction in liabilities to foreign offi­
cial institutions reflected indirectly a substantial
flow of funds to the Euro-dollar market. High
Euro-dollar rates attracted foreign funds, result­
ing in conversion of foreign currencies into dol­
lars. Also, the high rates probably induced some
private holders to put their dollars in the Euro­
dollar market instead of turning them in to the
central bank. Large borrowing of Euro-dollars
by United States commercial banks was a con­
tributing factor; the tendency was to push up
Euro-dollar rates, thereby making conversion of
foreign currencies into dollars more profitable.
Conversion of foreign currencies into dollars
put downward pressure on such currencies in
foreign-exchange markets. As exchange rates
approached the floor, central banks sold dollars
for their own currencies. High rates, by dis­
couraging private holders from turning in dol­
lars to the central bank, also tended to reduce
United States liabilities to foreign official insti­
tutions. The net effect was to increase our
balance-of-payments surplus on the official set­
tlements basis.
Withdrawal of funds from the Euro-dollar
market would tend to have the opposite effect.
Conversion of dollars into foreign currencies in
sufficient volume would lift exchange rates on
these currencies toward the ceiling. Support
operations by foreign central banks would in-

FEDERAL RESERVE B A N K O F P H ILA D E L P H IA

suit of restrictions imposed on foreign borrow­
ing in the United States. Initially, use was
limited to a few European public and private
institutions that formerly had borrowed in the
New York market. However, use of Euro-bonds
has grown rapidly in the past few years. More
borrowers in more countries have turned to the
market, and funds are mobilized from an everwidening area.
Euro-bonds have the advantages of avoiding
restrictions imposed in many countries on for­
eign borrowing in a local currency, and of giving
borrowers access to a much larger pool of funds.
European countries now serve as a channel for
funds drawn from most parts of the free world.
Intensified restrictions on foreign direct invest­
ments of United States corporations in 1968
provided a further stimulus. United States cor­
porations turned to Euro-bonds and recently
have become the dominant borrowers in that
market. A substantial part of the proceeds of
such issues was placed temporarily in Euro­
dollars.
Exceptionally high rates on Euro-dollars have
recently diverted funds from Euro-bonds. In
addition, several European countries have im­
posed restrictions on domestic bank participa­
tion in Euro-bond issues in order to limit the
resulting outflow of capital.

29

volve converting their own currencies into dol­
lars. Private holders might turn more of their
dollars in to the central bank. The additional
dollars acquired would increase United States
liabilities to foreign official institutions, thereby
tending to reduce an official settlements surplus
or enlarge a deficit.
The impact on the liquidity basis surplus or
deficit is not so clear-cut. Placing foreign-owned
dollar deposits in United States banks into the
Euro-dollar market transfers ownerships from
one foreign holder to another; total liquid lia­
bilities to foreigners do not change. Borrowing
by United States commercial banks from their
branches abroad is likely to result in only a shift
in the form of the liability. A transfer of
domestically owned deposits to the Euro-dollar
market, however, would increase short-term lia­
bilities to foreigners, thereby tending to reduce
a surplus or enlarge a deficit on the liquidity
basis. Inasmuch as private liabilities to foreign­
ers are omitted, such transactions would have
no effect on the official settlements surplus or
deficit.
Euro-dollar transactions could affect the
liquidity basis surplus or deficit by altering the
maturity composition of our liabilities to for­
eigners. For example, if foreign-owned long­
term United States securities were sold and the
proceeds placed in the Euro-dollar market, short­
term liabilities would be increased. This rise in
short-term liabilities to foreigners would tend to
decrease the surplus (increase the deficit) on a
liquidity basis.
Recently, the Euro-dollar market has stirred
considerable controversy over possible effects on
monetary policy. Intensified pressure on reserve
positions sent commercial banks scrambling for
new sources of funds. More attractive market
rates resulted in a marked decline in negoti­

Digitized for 30
FRASER


able CD’s. Large banks, especially those with
branches abroad, turned to the Euro-dollar mar­
ket for additional funds. In analyzing the impli­
cations for monetary policy, two types of effects
should be distinguished.
Of greatest significance is the impact on total
reserves and the capability of the Federal Re­
serve to affect total bank credit and the money
supply. The direct effect of Euro-dollar opera­
tions on total reserves available to United States
commercial banks appears to be minor. Recall­
ing the various ways that Euro-dollar deposits
may come into existence, we find none alters the
total volume of our bank reserves. Placing dol­
lars in the Euro-dollar market, whether from
foreign dollar receipts or conversion of foreign
currencies into dollars, results in a transfer of
ownership with no change in total deposits and
total reserves of United States commercial banks.
Funds shifted by United States residents from
domestic to Euro-dollar banks increase foreignowned deposits but have no effect on total
United States commercial bank deposits and
reserves.
One type of transaction, however, may alter
total required reserves. Borrowing of United
States banks from their branches abroad shifts
the form of liability from a deposit. Reserves
are required against deposits, and, until re­
cently, the effect was to reduce required reserves
of the borrowing banks. The Board of Gover­
nors recently imposed a reserve requirement
against bank borrowings from foreign branches
and banks in excess of the amount outstanding
in a certain base period. This new reserve re­
quirement reduces the impact of borrowing
from foreign branches on the volume of re­
quired reserves.
Even though Euro-dollar operations have
little effect on the total reserve position of




JU LY 1970
B U S IN E S S R E V IE W

attractive Euro-dollar rates.
The impact of the Euro-dollar market on
United States commercial banks, as a system
and individually, has numerous ramifications.
Nevertheless, analysis indicates two general con­
clusions are valid. One, the effect on total avail­
able reserves, if any, is very small— far too small
to impair Federal Reserve capability to alter
total reserves and thereby monetary aggregates
linked to the reserve base. At the maximum,
Euro-dollar operations might complicate calcu­
lating day-to-day estimates of reserve positions,
thereby making it slightly more difficult to use
open market operations to achieve very short­
term objectives. The second conclusion is that
access to the Euro-dollar market apparently does
not seriously distort distribution of the effects
of monetary restraint among banks. The few
large banks with foreign branches do have direct
access to this source of funds, but the net bene­
fit derived may easily be exaggerated. The advan­
tages appear to be no greater than their size
affords in tapping domestic sources of funds.

FEDERAL RESERVE B A N K O F P H ILA D E L P H IA

United States banks, what about the impact on
individual banks? Do Euro-dollars enable a few
large banks with foreign branches to escape re­
straint imposed by a tight-money policy? At
present, Euro-dollars are a practical source of
funds for only a relatively small number of
United States banks. Borrowing from foreign
branches does augment somewhat funds avail­
able for loans; however, these funds are likely
to be more expensive than domestic sources, and
the newly imposed reserve requirement further
reduces the advantage of such borrowing. Sec­
ondary effects may reduce still further the net
advantages of borrowing Euro-dollars. As al­
ready noted, strong demand from United States
banks was a significant factor in lifting Euro­
dollar rates to unusually high levels. These high
rates attracted funds from a variety of sources,
including residents of the United States. Inas­
much as these Americans would likely be
customers of the larger banks, borrowing Euro­
dollars may to some extent only recapture at a
high cost deposits siphoned away by unusually

31

FOR THE RECORD

SU M M ARY

United States

Per cent change

Per cent change

from
mo.
ago

year
ago

5
mos.
1970
from
year
ago

May 1970
from
mo.
ago

year
ago

•

•

5
mos.
1970
from
year
ago

LO C A L
CH AN GES
Standard
Metropolitan
Statistical
Areas*

- i
- i
- i
- i
-60
+ 9

+
+
-

i
4
2
1
9
1

+ 3
- 2
- 1
+ 3
+ 54
- 3

i

-

3

-

1

+
+
+
+
+

0
1
2
3
2
6t

- 2
+ 6
- 6
- 9
- 3
+ 17t

+ It

•Production workers only
••Value of contracts
•••Adjusted for seasonal variation




+ 7t

Check
Payments**

Total
Deposits* ••

Per cent
change
May 1970
from

Per cent
change
May 1970
from

Per cent
change
May 1970
from

Per cent
change
May 1970
from

Wilmington . .

year
ago

0

Trenton ...........
-2 0
+ 6

-23
+ 5

+ 3
+ 4

- 3
+ 6
- 9
-1 4
- 5
+ 14f

0
0
0
0
0
- 1

0
+ 5
- 1
- 5
+ 2
+ 10

- 1
+ 7
- 6
-1 2
- 1
+ 11

+ 7t

0
0

+ 4
+ 6

+ 4
+ 6

PRICES
Wholesale ...........................
Consumer ...........................

Payrolls

0

mo.
ago

year
ago

mo.
ago

year
ago

mo.
ago

year
ago

-

-

-

2

+ 15

-

-

-

4

+ 12

+ 2

2

1

Atlantic City .

BANKING
(All member banks)
Deposits .............................
Loans ...................................
Investments .....................
U .S. Govt, securities.
Other ................................
Check payments**'* . . .

Employ­
ment

mo.
ago

MANUFACTURING
Production ........................
Electric power consumed
Man-hours, total* . . .
Employment, total . . . .
Wage income* ................
CONSTRUCTION* • ...........
COAL PRODUCTION . . . .

Banking

Manufacturing

Third Federal
Reserve District

May 1970

•

1 15 SMSA’s
^Philadelphia

6

4

+ 10

0

-

4

-

2

+ 1

+ 36

-

1

+ 12

+22

-

2

+ 4

-

1

+ 4

+ 7

+ 15

+ 1

+ 6

Harrisburg . . .

-

1

-

0

+ 3

+ 3

+ 19

+ 1

+43

Johnstown . . .

-

1

0

-

2

-

+ 8

+ 6

+ 2

+ 7

-

Altoona ...........

3

Lancaster . . . .

0

0

Lehigh Valley.

0

+ 1

1

-

4

-

Philadelphia

.

-

Reading...........

-

1

-

2

Scranton . . . .

-

1

-

3

Wilkes-Barre .

-

1

-

3

Y o r k ...................

-

1

+ 1

1

1

+ 6

+ 3

+ 16

+ 1

-

0

+ 6

+ 8

+ 5

+ 1

-

7

1

-

+ 6

+20

-

-

2

3

1

4

4

+ 1

+ 4

+ 11

+ 1

+ 5

0

+ 1

+ 9

+ 13

+ 2

+ 7

2

0

+ 2

+ 11

+ 1

-25

+ 2

+ 3

0

+ 19

+ 1

-

-

7

•Not restricted to corporate limits of cities but covers areas of one or
more counties.
••All commercial banks. Adjusted for seasonal variation.
•••Member banks only. Last Wednesday of the month.