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THE STRATEGY OF MONETARY POLICY
Raymond E. Lombra and Raymond G. Torto*
The following article is adapted from
a seminar paper presented at the Federal
Reserve
Bank of Richmond
on June 20, 1975.
EDITOR’S

NOTE:

I.

While

Introduction

much has been written

over the years con-

cerning monetary policy, there is apparently a discontinuity in the flow of information between policymakers, on the one hand, and academic researchers
and participants in financial markets, on the other.
Much of this lack of communication centers specifically on the formulation and implementation of monetary policy. As a result, much of the research into
the policy process is based on incorrect assumptions
concerning how policy is managed. Sherman Maisel,
a former member of the Federal Reserve Board of
Governors, argues that the Fed itself is a source of
this communications gap: “The Fed has always resisted being too specific about [its] methods and its
goals, clothing its operations in a kind of mystique
that left it more freedom to maneuver” [18, p. 26].
In the opinion of many policy observers, this
communications failure has real costs, both in terms
of public understanding
and the effectiveness
of
policy.
While the Fed is reluctant to specify its
procedures too explicitly in order to protect its freedom of action, “its attempt to protect itself from
both outside critics and internal disappointment . . .
weakens its ability to improve its performance”
[18,
p. 311].
Recently a number of papers have been directed
toward unraveling the mystique that surrounds monetary policy.1 The purpose of this article is to synthesize and extend the recent literature on this subject
and thereby provide an interpretation of the monetary
policy process and a model of current open market
strategy.
Hopefully, this article will contribute to a
* The authors are staff economist,
Board of Governors,
Federal
Reserve System, and Chairman, Department
of Political Economy,
University
of Massachusetts-Boston,
respectively.
The views expressed herein are solely those of the authors and do not necessarily
represent the views of the Board of Governors of the Federal Reserve
System, the Federal Reserve Bank of Richmond, or the University of
Massachusetts.
The authors express gratitude to Charles Cathcart. Lauren Dillard.
Cathy Gaffney,
Gary Gillum, Herbert
Kaufman.
Donald
Kohn.
Thomas Mayer, John Pippenger,
William Poole, Richard Puckett,
Steven Roberts, and the staff of the Federal Reserve Rank of Richmond, particularly
Alfred Broaddus and Joseph Crews, for very
helpful comments that have materially improved the paper.

better understanding
of current policy procedures
and will help to identify problem areas toward which
further research should be directed.”
This article consists of seven sections.
Section II
presents the background to the current strategy. The
following three sections describe long-run aspects of
current policy formulation, the linkages between the
long- and short-run policy process,
open market strategy, respectively.

and short-term
An analysis of

the effect of the constraint on interest rate volatility
on short-run policy actions is presented in Section
VI, followed by some final remarks in Section VII.
II.

The Evolution

of the Current

Strategy

An important paper by Jack Guttentag, published
in 1966, described the Federal Reserve’s policy procedures of the 1950’s and early 1960’s as the money
market strategy [10].
Under the money market
strategy, the Federal Reserve’s proximate focus was
on the “condition of the money market”-generally
understood to include the value of a constellation of
interest rates, free reserves, and the inventory positions and financing costs of securities dealers. With
such national economic goals as full employment and
price stability remote in time and causal connection
from conditions in the money market, the use of
money market conditions as a proximate
target
tended to focus policy too narrowly.
As a result,
Guttentag argued :
The main weakness of the [money market]
strategy is its incompleteness,
i.e., the fact that the
Federal
Open Market Committee
(FOMC)
does
not set specific quantitative target values for which
it would hold itself accountable
for the money
supply, long-term interest rates, or any other ‘strategic variable’ that could serve as a connecting link
between open market operations and system objectives; rather it tends to rationalize the behavior of
these variables after the fact [10, p. 1].

To correct the deficiencies in the money market
strategy, Guttentag suggested that the Fed adopt a
complete strategy-consisting
of quantifiable targets
specified over given control periods, with the sequence of targets linked empirically to the ultimate
price and output goals of the economy. Targets are

1 See, for example, the important articles by Axilrod and Beck [1],
Brimmer [3], Kane [12], Maisel [17], Pierce [22, 23], Pierce and
Thomson [25]. Poole [26], and Tschinkel [29].

FEDERAL RESERVE BANK

2 This discussion is not meant to imply that all monetary research
has been useless or that no one understands the essence of current
policy procedures.
With regard to the latter. it is clear that many
financial market analysts have considerable expertise
in assessing
the implications of day-to-day Federal Reserve actions.

OF RICHMOND

3

defined as strategic variables that policymakers can
affect by manipulating policy instruments.3
Included
in the set of targets are both intermediate targets
such as interest rates, bank reserves, and monetary
aggregates, and longer-term
final targets (or goal
variables)
such as output, employment, and prices.
Instruments are the magnitudes under direct policy
control and include open market operations, the discount rate, reserve requirements,
and interest rate
ceilings.
A control period is the time interval over which
the attainment of targets is planned.
A complete
policy strategy involves a number of control periods,
each giving primary emphasis to different target variables. For example, over a weekly control period, an
operating target such as the Federal funds rate or
nonborrowed reserves might receive emphasis ; over
a monthly or quarterly control period, an intermediate target such as the growth rate of M1 might receive emphasis.
In control periods as long as six
months or a year, long-term target variables such as
output and employment would be the major policy
goals.
A strategy is complete if its intermediate target
is a strategic variable, linked empirically
to the
economy’s long-term output, price, and employment
goals. This implies that the policymaker is cognizant
of the linkages among the various elements of the
strategy.
In a more formal sense, a model of the
monetary policy transmission
mechanism such as :
instrument
intermediate
target
long-term target
must be developed.4
Guttentag was careful to distinguish between policy
strategy, which involves the selection of the target
variables to be explicitly considered by policymakers,
and policy formulation, which involves the setting of
specific values, or dial settings, for the target variables.
In selecting these values, the policymaker
examines a set of policy determinants such as relevant financial
and economic data and forecasts.
Clearly the development of an overall policy strategy
is logically prior to policy formulation, since the particular policy determinants that the policymaker considers are dependent upon the strategy being pursued
and the transmission
mechanism it embraces
[7,
pp. 6-11].
The thrust of the Guttentag critique was reinforced by a number of events that increased public
3 Discussions of monetary policy have long been plagued by semantic
difficulties with such words as targets, indicators, guides, objectives.
etc., with the same words having different
meanings to different
writers.
Such problems have played a major role in several major
controversies
in monetary economics
[20].
4 The arrows indicate the direction of causation.
See [7] for a clear
discussion of the transmission
mechanism
in monetarist
and nonmonetarist models.

4

ECONOMIC

REVIEW,

awareness of monetary policy.
In the late 1960’s
the economic stimulus provided by the Vietnam war
and the delay of the 1968 tax surcharge and the
intellectual stimulus of the monetarist counter-revolution served to focus increasing public attention on
monetary policy.
During the same period, the development of large-scale econometric models reflected
the substantial impact of monetary policy on economic
activity and tended to emphasize quantification
of
policy targets.
In view of these developments, it is
perhaps not surprising that the Federal
Reserve
moved toward the development of a more complete
strategy.
In 1966 the FOMC
added a “proviso
clause” to its Directive, giving explicit weight to
movements in bank credit in determining policy actions.
In 1970 the FOMC first began to include
explicit references to monetary aggregates in its instructions to the Trading Desk. An important step
in this ongoing process was probably the appointment
of Arthur Burns as Chairman of the Federal Reserve
Board in early 1970. In this regard Maisel states:
“From the first day in office [Burns] put the weight
of his office behind greater quantification”
[18,
p. 70].
The result of this evolutionary
process can be
stated simply-monetary
aggregates
(e.g., M1, M2,
M3, and bank credit) now receive more weight in
policy deliberations and actions. The Directive-the
FOMC’s instructions to the Manager of the Trading
Desk-now
includes specific values for various strategic target variables, such as the Federal funds rate,
bank reserves, and the monetary aggregates5
It is
useful for expository purposes to divide the discussion of current policy procedures and strategy into
its long- and short-term aspects.
A description of
these components and their interrelationship
begins
in the next section.
Ill.

A View

of Long-Run

Strategy

The policy process begins at the Federal Reserve
Board with the development of staff forecasts for
GNP, prices, unemployment,
and other long-run
targets four quarters into the future.6
These basic
forecasts are undertaken three or four times each
5 The more specific the instructions contained in the Directive, the
less discretion
or latitude the Manager
has in executing
policy
actions.
One of Guttentag’s criticisms of the Fed’s operating procedures in the 1950’s and 1960’s was the ambiguity in the Directive.
He stated:
“It is natural and a type of poetic justice that the
words used by the Committee in giving instructions to the Manager
are thrown back to the Committee.
If the Committee instructs him
to follow an ‘even keel tipped on the side of ease’, for example, he
can report back that he ‘maintained
an even keel ...’
and the
Committee is not in a position to complain that it does not understand what these words mean” [10, p. 18].
6 This discussion draws heavily from the work of former members of
the Board staff:
Pierce [23], Pierce and Thomson
[25]; and the
work of former Governors Brimmer [2, 3] and Maisel [17, 18].

SEPTEMBER/OCTOBER

1975

year and are updated each month. The projections
are referred to as consensus forecasts, since judgmental and econometric inputs are combined into a
single forecast.
The econometric forecast is made using the Board’s
version of the SSRC-MIT-PENN
(SMP)
econometric model.7 Initially, model simulations are conducted using expected values of exogenous variables
not under Federal Reserve control, such as Federal
Government outlays, and a trajectory for an intermediate target variable under potential Federal Reserve control, such as the growth rate of the money
stock.
The same money stock trajectory,
for example a 5 percent annual growth rate, is also assumed by the judgmental forecasters.
The judgmental forecast, prepared by staff economists in
various sections of the Federal Reserve Board, is
often more accurate in the near term than the model
forecast [23, p. 12]. Differences in the econometric
and judgmental
forecasts are reconciled, and the
consensus forecast is prepared.
One should not infer that the econometric projections are “pure” in the sense of a mechanical application of an existing model ; as is true in most econometric work, a considerable degree of judgment is
involved.
This notion has been summarized by
Hymans :
No [model]
operator-at
least, one with much
success as a forecaster-lets
the computer center
run his model. Rather, the operator considers the
model to be nothing better than the best statement
of the internal
logic of the economy which he
happens to have available.
While he rarely tampers with the model’s interactive
logic, he recognizes that there are relevant
factors
which he
thinks he knows, and which he is sure the model
does not know, about current
realities
in the
economy.
In some way, he attempts to communicate this information
to the model. . . . And what
is most important, much of the relevant information which has to be communicated to the model is
simply not contained in the values of the exogenous
variables
[11, p. 537].

For the sake of completeness, it should also be noted
that the judgmental forecast is not independent of the
econometric
projections.
The various forecasters
interact continually and therefore a judgment about
the path of economic activity (especially over a long
time horizon) is no doubt influenced by the model
simulations.
Following the development of the consensus forecast, the Board staff usually produces a number of
alternative long-run scenarios of economic activity
for evaluation by the FOMC.
First the consensus
forecast is reproduced quarter-by-quarter,
variable7 See [5], [7], and [9] for discussions
mechanism of the SMP model.

of

the

policy

transmission

by-variable with the econometric model by adjusting
the constant terms in selected equations. Alternative
trajectories
of monetary growth are then fed into
the model to produce a consistent set of monetary,
GNP, price, and unemployment
estimates.8
The
FOMC then evaluates these alternative scenarios and
selects an explicit monetary growth path for the
forthcoming six- or twelve-month period.
It is important to note that the implicit dial settings for the final targets embedded in the staff forecast may not, for a variety of reasons, be accepted by
members of the FOMC.
For instance, an individual
member of the FOMC
may not believe the staff
forecast and may therefore foresee a different real
sector outcome.
Each Reserve Bank President has
his own staff’s view of the economic and financial
outlook to consider, and it is possible that his staff
has a forecast quite different from that of the Board
staff. More generally, there is no reason to assume
that each member of the FOMC will embrace the
estimates developed by the Board staff with regard
to the impact of monetary policy on economic activity.9
Alternatively,
an FOMC
member may have a
longer planning horizon for policy than the four- to
six-quarter projection horizon and, therefore, might
not believe that such a short-term projection should
be a major determinant of current policy actions. In
the current setting, for example, a policymaker may
desire to drive unemployment down to 4 percent by
mid-1976 but might feel that existing economic constraints, as well as structural relationships, make the
risk of intensifying inflationary pressures under such
a policy high. Hence, the return to full employment
should be, in this member’s view, more gradual and
occur over a two- to three-year

period.

Another possibility is that an FOMC member may
have little faith in any of the assorted projections
and instead may be strongly influenced by current
economic and financial conditions. This view implies
a shorter planning horizon than four to six quarters.
Pierce has summarized some reasons why this last
possibility may prevail from time to time:
It is very difficult to convince a policymaker
to
move an instrument
in what he views to be the
wrong direction.
That is to say, if income is ex8As Pierce has discussed [23], a less extensive forecasting
effort is
made each month just prior to a FOMC meeting.
This effort involves the updating of earlier forecasts through an extensive examination of incoming data and how they agree with, or have tended
to modify, the projections
presented in previous months.
See also
[2].
9 In recent testimony by Chairman Burns before the Senate Banking
Committee (July 24. 1975), members of the Senate Committee requested the release of the staff economic forecast conditional on a
particular growth rate in the money stock. Chairman Burns did not
appear to favor this suggestion,
and his response emphasized some
of the same points discussed in this and following paragraphs.

FEDERAL RESERVE BANK OF RICHMOND

5

panding very rapidly and the models are predicting
that it is going to fall in the future unless he eases
up, it is very difficult to get him to ease up because
that sort of policy recommendation
is contrary to
what is going on currently.
I must say that until
our models do a lot better, his wariness may be
justified.
Again, the problem is one of how to
handle risk: what if the model were wrong? What
if the economy were expanding very rapidly, the
policymaker eases up, but economic expansion becomes more rapid?
The cost of the error to the
policymaker would be very large [23, p. 18].10

A Model of the Long-Run

Strategy

The

targets by the staff assumes specific dial settings for
the intermediate
target variables, e.g., the money
stock, and also involves assumptions concerning all
of the above determinants of economic activity not
under the direct control of the Federal Reserve.12

longer-

term policy process described above conforms to a
general class of constrained optimum problems. That
is, policymakers
may be viewed as maximizing a
utility or preference function subject to the constraints imposed by the economic structure or by
other considerations.
Equation (1) states that the
utility of the policymaker is a function of the deviation of the final targets from their desired levels,
with greater utility being associated with smaller
deviations.11
Let U represent the policymaker’s
utility. Then :
maximize
subject

to

U=

f1(YA -

Y*)

YA = f2 (ML, XL)

(1)
(2)

and

(2a)

where Y is a vector of final target variables such as
GNP and prices.
The superscript A denotes the
actual value of the variable, and the asterisk denotes
a desired value.
The symbol
represents the
variance of some interest rate R,
is a constant, M
is the money stock, X represents other determinants
of the final targets, and the subscript L is a distributed lag operator,
The side constraints represented
by equations (2) and (2a) reflect the limitations
imposed on policymakers
by the structure of the
economy and by the volatility of interest rates.
The expected values of the final targets will generally depend upon the structure of the economy, the
particular dial settings for the intermediate target
variable selected by the central bank, dial settings for
fiscal policy selected by Congress and the President,
and the values of other determinants such as the
level of consumer and business confidence, price expectations, the degree of capacity utilization, and
international
developments.
The forecast of final
10 The issue here is quite complex.
The policymaker
must act in
the face of uncertainty
over structural parameters
and with the
knowledge
that there is a lag between actions and effects. In
addition, there is the distinct possibility that incoming data may be
revised substantially
and thereby alter the appropriate
policy response.
Against this background,
it is often difficult for policymakers to be convinced to move an instrument now to affect a final
target one year in the future.
Perhaps some of the recent applications of control theory to stabilization policy will prove helpful in
educating both policy advisers and policymakers.
11 To be more precise,
(f1)
is an inverse function;
that is, the
policymaker is minimizing disutility (or “losses”)
by minimizing the
deviations of the actual target values from desired levels.

6

This process is summarized by equation (2), which
condenses the SMP model and the consensus forecast for the final targets into a simple expression.13
It is presumed that the policymaker believes that
changes in the money stock lead in a systematic
fashion, albeit with a lag, to changes in prices, output,
and employment.14
Equation (2a) is included as a constraint to account for the Fed’s ongoing desire to avoid disorderly
conditions in financial markets that, in turn, might
frustrate the achievement of the final targets.
A
discussion of the constraint on interest rate volatility
is the subject of Section VI.
Before closing the discussion of the long-term
strategy, it is important to emphasize that many
members of the FOMC might object to the causal
sequence that seems to underlie equation (2) : open
market operations
money stock
economic activity.
More specifically, some might prefer:

ECONOMIC

REVIEW,

YA = f2 (RL,

XL)

where R is a short- or long-term interest rate, and
the implied causal sequence is more like the transmission mechanism of the SMP model [ 7, pp. 7-9].

In part the issue involved here concerns the endogeneity or exogeneity of R and M and which variable
ought to be the intermediate policy target [27].
For
purposes of this article, this complex issue is sidestepped for two reasons.
First if one ignores the
error term in the demand for money function, it may
be solved in terms of the interest rate or the money
stock, and either may be treated exogenously for
12 This being the case, the forecast may be wrong because the fiscal
policy assumption is wrong, the Federal Reserve does not achieve the
dial setting for the intermediate
target, the structural parameters
underlying the forecast are incorrect, or there is a stochastic shift
in a behavioral relationship.
One point relevant to this problem,
which has received all too little attention in the literature, is the
interdependence
of stabilization
policy actions.
For example, if a
restrictive monetary policy leads to a response by the Congress or
the President to ease fiscal policy, the forecaster
must anticipate
this reaction.
13 As noted above. each member of the FOMC might, in effect, have
a different specification
for equation (2) because of an alternative
view of structural
relationships.
In this regard, equation
(2)
despite its simplicity, should not be mistaken for so-called reduced
form models purporting
to link the money stock or the monetary
base to economic activity.
14Throughout this article error terms are generally ignored.
Clearly,
the staff should express the confidence intervals and standard errors
around a particular forecast for the final targets.

SEPTEMBER/OCTOBER

1975

forecasting
metric

purposes.15

model

may

That is, a large macroecono-

contain

a

correctly

estimated

money demand function :
M = a0 + a1y + a2R
where a0, a1, and a2 are estimated parameters,

M is

money demand, y is nominal income, and R is the
interest rate.
The forecast for the final targets is
independent

of whether the money demand equation

is solved for M or for R:
R=

M -

a0 -

a1y

The Linkage

Between

and Short-Run

to the long-run path may require an 8 percent growth
rate for M1 in the January-February
control period
(A).
Alternatively,
slower growth rates of 7 and 6
percent in the January-February
control period and
in several successive periods would return M1 to the
long-run path in May (B) and July (C), respectively. The process underlying the selection of these
alternative paths-i.e.,
the short-run formulation of
policy and the actual short-run alternative selected
by the FOMC-are

a2

discussed

in the following

sec-

tions.

Second, M is the assumed intermediate target variable in equation (2) because the FOMC has chosen
to index its policy stance publicly in terms of M1 and
other monetary aggregates.16
The use of the word
“index” is meant to imply that even though members
of the FOMC may have different views of the policy
transmission mechanism in general, and the causal
role of changes in the money stock in particular, the
FOMC has been able to reach an agreement to express its policy in terms of growth rates in the monetary aggregates.
IV.

but each requiring successively longer adjustment
periods.17 With reference to Figure 1, a rapid return

the Long-

Strategy

Having selected a long-run dial setting for money
stock growth, perhaps 5 percent over the next twelve
months, the FOMC must now guide its open market
operations monthly so as to achieve the desired longrun monetary growth path. It is important to recognize that there are an infinite number of monthly and
quarterly patterns of monetary growth for the money
stock that could turn out to average 5 percent over a
full year.
As will be shown, the monthly pattern
desired by the FOMC will generally depend upon
interest rate considerations and the current position
of the money stock vis-a-vis the long-run target.
The relationship between the short- and long-run
dial settings for M1 is illustrated in Figure 1. It is
assumed that a 5 percent long-run growth path for
M1 was adopted in December, and by the January
FOMC meeting M1 is well below its targeted longrun path. Under these circumstances the staff would
normally prepare three (or more) alternative shortrun money stock paths for FOMC
consideration,
each designed to return M1 to the long-term path

V.

A View

of the Short-Run

Strategy

The short-run strategy of the FOMC involves the
selection of a short-run dial setting for the money
stock and the development of an operating procedure
for achieving the desired monetary growth path. The
process begins with the staff presenting to the FOMC
each month a set of alternative
short-run
(twomonth) growth rates for the money stock. Associated
with each alternative short-run path for the money
stock will be a growth rate of bank reserves and a
level of the Federal funds rate.
In formulating
the short-run
strategy, income
movements are taken as given ; that is, income for the
coming two-month control period is interpolated from
17 Currently the control period for the FOMC’s short-run strategy is
two months-in
December the control period is December-January,
in January it is January-February,
etc.

15Such a procedure would not be legitimate for estimation purposes
because of the bias that would be introduced by treating a variable
exogenously if in fact it were endogenous.
See [16] for a discussion
of this latter point and how it is related to models of money stock
determination.
16 See the “Record of Policy
Federal Reserve Bulletin.

Actions”

appearing

each month

in the

FEDERAL RESERVE BANK OF RICHMOND

7

Table

ALTERNATIVE

I

SHORT-RUN

Note:
The growth
in reserves
at seasonally
adjusted
annual
pressed as a level.

DIAL SETTINGS

and the money stock are expressed
rates, while the funds rate is ex-

the quarterly projection of economic activity described
earlier.
The important assumptions underlying this
procedure are that the quarterly projection and the
monthly interpolation are correct and that there is
no significant simultaneity problem over a one- or
two-month period. To illustrate, again consider the
example used in Figure 1. Assume it is the end of
January, that the consensus forecast specifies 5 percent monetary growth from December to July, and
that the money stock actually declines in January.
Normally, in the face of this one-month shortfall in
the money stock, the staff would not revise its income
projection for the coming months.
This, in effect,
assumes the policy lag is greater than one or two
months and that subsequent policy actions will result
in growth in the money stock that will overshoot the
target by enough to offset the miss in the first month.
Given income and the current position of the
money stock vis-a-vis the long-run target path as
depicted in Figure 1, the staff might present at the
January FOMC meeting a set of short-run alternatives, as in Table I.18
The first row contains alternative short-run growth
rates that will return the money stock to its long-run
path. Alternative
(A) and the staff discussion accompanying it would indicate that to achieve an 8
percent growth rate in M1 and to return to the longrun path by February, the growth in reserves over
the January-February
period would have to be 8
percent and the level of the Federal funds rate required is 6 percent.19
18 The alternatives,
along with a discussion of the situation
that
might develop in financial markets under each option, appear in the
“Bluebook,”
which is prepared monthly for the FOMC.
See [2, p.
285]. The actual alternative selected by the FOMC is now published
with a 45-day lag as part of the policy record.
The alternatives
contained in the Record of Policy Actions
for the January 1974
FOMC meeting are the first available.
In the discussion that follows
we will, for simplicity, ignore M2, even though it appears with M1
under each alternative the FOMC considers.
19 It is worth noting that the FOMC has from time to time selected
an alternative that has included, for example, the money stock under
(A)
and the funds rate under (B).
In this case, the FOMC
decided the staff had misspecified the relationship between the funds
rate and monetary growth and has constructed
a new alternative
thought to be internally consistent.
Thus, the FOMC is free to
evaluate and to accept or reject the trade-offs among interest rates,
reserves, and money stock growth implied by the staff estimates.
See also n. 27.

8

ECONOMIC

REVIEW,

The Federal funds rates, shown in
table, are derived in two steps. First,
come given, a money demand function
the short-term interest rate necessary
alternative
short-run money path.

row 2 of the
assuming inis solved for
to achieve the
The required

Federal funds rate is then determined using a term
structure equation relating it to the short-term interest rate. As was true in the forecast of economic
activity, each alternative represents a staff consensus
based on econometric models and judgmental considerations.20
The third row of the table could in theory be derived by solving a money supply function for the
rate of growth in reserves necessary to achieve each
money stock alternative.
That is, if one viewed the
money supply as the product of a reserve aggregate,
such as reserves available to support private deposits
RPD,21 and a multiplier m, then the necessary
growth in reserves could be obtained by estimating
the multiplier,
calculating
the different
February
levels of the money supply M consistent with each
money stock alternative, and dividing one by the
other (RPD = M/m).22
In practice, as discussed by Axilrod and Beck
[1],
the approach is demand oriented. After projecting the
interest rates consistent with the short-run money
stock growth rate for each alternative, these rates are
used to estimate bank demand for required and excess
reserves [1, p. 89].
An important characteristic
of
this approach is that it results in the supply of reserves and money being perfectly elastic at the targeted level of the interest rate R and the volume of
reserves and money, therefore, being demand determined.
This is illustrated in Figure 2, where the
demand for reserves is expressed as a function of the
interest rate.23 Assume the position and slope of the
demand schedule for reserves TR1 have been estimated by the staff and that TR1 is the level of total
reserves in February that is derived from deposit
demand consistent with a 6 percent growth rate in
the money stock. Under the demand approach discussed above, the required interest rate is R1, and
20 Monthly financial models developed at
and the Federal Reserve Bank of New
this process.
For a discussion of these
Pierce and Thomson [24, 25] and Davis

the Federal Reserve Board
York are major inputs in
models, see the papers by
and Shadrack [8].

21 The reserve aggregate
currently employed by the FOMC in its
deliberations is called “reserves available to support private deposits”
RPD.
This magnitude is defined as total reserves minus required
reserves against government and interbank deposits.
It should be
noted here that there is little objective evidence that RPD’s have
received much weight in the formulation or implementation
of policy.
Speaking of the 1973 period, Tschinkel said: “The Manager
[reflecting the desires of the FOMC] found RPD of lesser importance
in the determination
of his response to the emerging patterns of
monetary growth”
[29, p. 105].
See also the recent evaluation of
Kane [12, pp. 841-3] and the discussion that follows.
22 The particular reserve aggregate one chooses (e.g., total reserves.
nonborrowed reserves. the monetary base, RPD. etc.) is not a critical
issue here.
23 While the following diagram relates the interest rate to reserves,
one could just as easily substitute the money stock for reserves.

SEPTEMBER/OCTOBER

1975

the System will
rate.
Thus the
This means that
mand (or money

supply reserves elastically at that
supply function TRS is horizontal.
stochastic shifts in the reserve dedemand) function, an error in the

income projection, or any other disturbance on the
demand side will, in the first instance, alter the
position of TRD to TR’D and lead to changes in the
quantity of reserves to TR2.24
This can be contrasted with a supply approach to
money stock control, which would lead to the interest
rate being demand determined. Again with reference
to Figure 2, the level of total reserves thought necessary to achieve the 6 percent

growth

in the money

stock remains TR1. Accordingly, the System would
supply the volume of reserves represented by the
vertical TRS function.
Any disturbance on the demand side will alter the interest rate to R2 and leave
the quantity of reserves (and money) unaffected. In
the absence of any disturbance (i.e., in a deterministic
system) both approaches yield the same result (R1
and TR1).
The point that must be emphasized is that one
should not infer from the appearance of a reserve
aggregate in Table I that the FOMC has adopted a
supply approach to money stock control.25 Evidence
that the growth in reserves has had a low weight in
the System’s reaction function (i.e., in the formulation and implementation of policy) is easily obtained.
Simply compare the specifications voted for reserves
RPD, the money stock, and the funds rate in 1974
with the actual outcomes, shown in Table II.26 This
exercise in revealed preference shows that the Federal Reserve rarely missed the funds rate range but
allowed reserves and the money stock to move away
from the specified range in about one-half of the
two-month control periods.
Assuming the initial
specifications were internally consistent, the conclusion must be that in the short run disturbances were
allowed to affect quantity and not price. While this
issue will be discussed in more detail in Section VI,
the evidence in Table II suggests the System was not
controlling reserves over the short run.27
24While income is a shift parameter in this two-dimensional
diagram, an increase in income would actually result in a movement
along the demand function for demand deposits, time deposits. and
reserves in three-dimensional
space.
25Brunner and Meltzer, Friedman, and the St. Louis Federal Reserve
Bank have long advocated such an approach.
26 As detailed in Section VI, the short-run dial settings selected by
the FOMC are actually expressed as ranges.
The rationale for the
ranges is explained on pp. 11-12.
27 An interesting feature of this approach to policymaking
is that a
member of the FOMC might vote for Alternative
(A) in Table I
even though he viewed monetary
policy as operating
primarily
through interest rates and thus really preferred the interest rate
under Alternative
(B).
In other words, members of the FOMC
may vote for individual elements in the table rather than columns.
Support for this interpretation
is provided by Maisel: “A possible
side advantage of this strategy is that it can be followed even though
it might be impossible to get agreement among the members of the
FOMC either as to ultimate goals, or the form or level of an intermediate monetary variable. or as to how to define what strategy is
being followed”
[17, p. 154].

A Model of the Short-Run
Strategy
The following set of equations may be used to link the Federal
funds rate to open market operations on. the one
hand and the money stock on the other:28
MD = f3 (yL, RL)

(3)

R= f4 (RFFL)
RFF =

(4)

f5 (TRD,

TRS)

(5)

TR = NBR + MBB = ER +

RR

NBR = FR + RR

(6a)
(6b)

where MD, is the demand for money, y is nominal
income, R is a short-term interest rate such as the
ninety-day commercial paper rate, RFF is the Federal funds rate, NBR is nonborrowed reserves, MBB
is member bank borrowings, ER is excess reserves,
FR is free reserves (ER - MBB),
RR is required
reserves, and TRD is the demand for and TRS the
supply of total reserves. The first three relations are
straightforward.
Equation (3) is a standard money
demand function ; equation (4) is a term structure
relation, where the short-term rate (e.g., the ninetyday commercial paper rate) is a function of a distributed lag on the funds rate (single-day maturity).29

Equation

28 For simplicity
fore M2.

FEDERAL RESERVE BANK

(5)

specifies

we will continue

to ignore

the funds rate as a
time deposits

and there-

29 See [14] for evidence that a major portion of the variance in
short-term rates can be explained by current and lagged movements
in the Federal funds rate.

OF RICHMOND

9

function

of the demand for and supply of total re-

serves.
In (6a)
total reserves are divided into
familiar components-required
reserves and excess
reserves-which,
by definition, must equal reserves
borrowed from the System and all other reserves
(nonborrowed reserves).
By rearranging terms, a
convenient identity (6b) can be formed. This latter
identity may be transformed into an equation with
behavioral content by considering the right-hand side
as reflecting the behavior of the public and the banks
and the left-hand side as reflecting the behavior of
the Fed.
That is, the banks’ demand for required
reserves is derived from the public’s demand for
deposits. This, together with the banks’ demand for
free reserves, must equal the total of nonborrowed
reserves supplied by the Federal Reserve open market operations.30
Other factors, such as the gold
stock, float, and Treasury deposits at the Federal
Reserve, also affect the supply of nonborrowed reserves.
However, holding these other factors constant or assuming that the System engages in socalled “defensive” open market operations to offset
movements in these factors, NBR is controllable by
policymakers.
For present purposes, these other
factors are held constant, and the change in nonborrowed reserves is assumed equal to the change in
the System’s holdings of securities.
Therefore,
the
change in nonborrowed reserves directly reflects open
30 See [5, Chapter 1] for a discussion of the key role of the free
reserves equation in the financial sector of the SMP model.

10

ECONOMIC

REVIEW,

market
operations
(i.e.,
NBR = OMO).
In
summary, the funds rate is determined by the supply
of nonborrowed reserves relative to the demand for
required reserves and free reserves.31
To close the model, the System’s short-run reaction function relating OMO to RFF must be specified.
Ignoring for the moment the constraint on
interest rate volatility, the desired level of the funds
rate RFF*
can be determined by solving equations
(1) to (4) recursively for a relationship between
long-run target values of the money stock and RFF:
RFF*

= f6(M*)

(7)

In practice it is the short-run target value for the
money stock, rather than the long-run target value,
that would usually appear in equation (7).
The
reason, as discussed in Sections IV and VI, is that
the change in the funds rate required to get the
money stock back on the long-run path (assuming it
is significantly off the path), is usually deemed too
large and disruptive by the policymaker.
Once equations (1) to (4) have been solved for
RFF*,
equation (8) follows from equation (5) and
the supporting identities :
NBR = OMO = f7(RFF*
31It should be emphasized
intended to be very genera1
plete model of the financial
Reserve policy.
This is a
paper.
As it stands the set
attempt is made to account

SEPTEMBER/OCTOBER

1975

-

RFFA)

(8)

that the set of equations presented is
and should not be construed as a comsector and its interaction with Federal
task beyond the scope of the present
of equations is under-identified.
and no
for various aspects of simultaneity.

it later if the money stock projections prove incorrect
and actual money growth is found to be close to that
desired.
This, of course, is another facet of the
System’s desire to minimize short-run interest rate
volatility and is discussed in the next section.

Simply put, the System will absorb (inject) reserves
by selling (buying)
securities when the funds rate
is below (above) the desired level. This policy approach ensures that the supply of reserves is perfectly
elastic at the desired funds rate and the quantity of
reserves is demand determined.
In the first instance,
deviations in the demand for reserves from the
FOMC specifications lead to an equivalent change in
the stock of reserves
rates.32
There

is in theory

pro-cyclical

VI.

movement in reserves.

that limits

= f8 (M*

-

The dynamics of

MA)

That is, movements in the funds rate depend upon
deviations of the money stock from its desired value.
To illustrate, assume incoming data on the money
stock suggest that monetary growth over the shortrun two-month target period will exceed the shortrun dial setting selected at the last FOMC meeting.
In response the Manager of the Trading Desk would
be expected to increase the dial setting for the funds
rate. In practice, however, the timing and magnitude
of the Manager’s initial response to apparent deviations of monetary growth from desired levels are
often not so straightforward.
If the tone of the securities markets is weak, for example, the FOMC
might decide not to change the funds rate for the
time being, even though the money stock is growing
above the desired rate.33
A more difficult problem contributing to cautious
adjustments of the funds rate is the uncertainty concerning the money stock forecasts.
This uncertainty
results from the fact that forecasts of the money
stock over the short run (e.g., one to three months
ahead) have not been very accurate [29]. This being
the case, the FOMC often may delay its response to
an apparent deviation of actual from desired monetary growth until more data are available to confirm the error.
The rationale is that the policymaker prefers to avoid “whipsawing” the marketi.e., raising the Federal funds rate now if money
growth appears to be exceeding desires and lowering

33
For a recent example of such an occurrence see the “Record
of
Policy Actions”
of the FOMC in the Federal
Reserve
Bulletin
(January 1975), p. 26.

Rate Volatility

and

Policy Targets

money stock are actually expressed as ranges.
Referring back to Table I, under alternative
(A) for
example, the entry for the money stock might be 7
to 9 percent and the entry for the Federal funds rate
might be 5½ to 6½ percent. From the viewpoint of
the staff, the ranges presented to the FOMC generally represent a standard error around a point estimate at the midpoint of the range. From the viewpoint of the FOMC, however, the ranges may have a
somewhat different meaning.
The range for the
money stock is typically viewed as a range of tolerance.
If the money stock is expanding at a rate
within its range, then the desired level of the Federal
funds rate will probably not be altered to any significant degree.34 Thus, in terms of equation (9), M*
is a range and
RFF* equals zero unless MA is
outside the range.
The following quotations suggest there are at least
two interpretations attached to the reasoning behind
any given range for the money stock adopted by the
FOMC:
(1)
“The
inherent short-run volatility of
the monetary aggregates is one reason why the Committee expresses its short-run guides in terms of
ranges of tolerance” [21, p. 334].
In this view the
range implies a standard error around a point estimate.
(2) “The Committee chose tolerance ranges
for M1 . . . that were at least as restrictive as the
alternatives presented by the staff and reduced the
lower ends of these ranges to indicate its willingness
to accept substantially slower growth in the near
term” [29, p. 108].
In this view the Committee
skews its preferences, perhaps in response to previous
deviations of actual from desired levels. Suppose the
staff presents an alternative
such as (C), which
implies that an 8 percent Federal funds rate will
translate into a 5-7 percent growth in the money
stock, the point estimate being 6 percent growth.
The FOMC, responding to past shortfalls in money
stock growth, might then modify this alternative by

(9)

32 A point worth mentioning
in this context is that a change in
reserve requirements
has virtually no impact on reserves or the
money stock unless accompanied
by a change in the funds rate
target.
If. for example, the System lowers the reserve requirement
on demand deposits, other things equal, this will push down the
funds rate.
However, as depicted in equation
(8), this will result
in the System selling securities and, therefore,
absorbing
the free
reserves.

with

Within the FOMC’s current strategy, the target
values for the Federal funds rate, reserves, and the

the

the inter-meeting phase of the short-run policy process are embedded in a feedback control loop that
can be summarized by:
RFF*

on Interest

Its Interaction

but to no change in the funds
a mechanism

The Constraint

34
This discussion assumes that incoming data and forecasts of nonfinancial developments are consistent with the projections
set out
when the long-run trajectory for the money stock was first selectedas a result. the FOMC has not modified the long-run money stock
target.

FEDERAL RESERVE BANK

OF RICHMOND

11

changing the range to 5-8 percent, indicating its
willingness to err on the side of more, rather than
less, monetary growth relative to projected levels.
Operationally,
this means that if the money stock
actually should grow at an 8 percent rate, this will
not result in a raising of the desired Federal funds
rate.
The significance of the Federal funds range is that
it specifically

limits

the degree of response

by the

Manager to a deviation of monetary growth from
the desired range. As shown in Table II, this range
in 1974 was typically 100-150 basis points.
If the
midpoint of the range selected is equal to the Federal
funds rate prevailing

just prior to the FOMC

meet-

ing, then the FOMC
has typically been willing to
tolerate a maximum change in the funds rate of SO-75
basis points in one direction over any given intermeeting period.35
Against this background, it is
interesting to note that the money demand functions
that underlie the specifications
presented
to the
FOMC exhibit very low interest elasticities [4; 8;
24; 25].
The monthly model discussed by Pierce
and Thomson
[25, p. 351], for example, indicates
that, other things equal, a 100 basis point change in
the Federal funds rate will lead to only about a 0.3
percentage point change in the annual growth rate of
the money stock over a one-month period and only
about a one percentage point change over a six-month
period. Assuming the interest elasticities embedded
in the monthly models are reasonably accurate, the
constraint on the monthly movement in the Federal
funds rate, as explicitly revealed by the range in the
Policy Record for the funds rate, suggests that the
FOMC is willing to tolerate relatively large short-run
deviations
of monetary growth from desired levels.36
Whether or not the constraint on month-to-month
movements in interest rates has significant destabilizing effects on output and prices depends on the
narrowness of the short-run constraint and whether
or not it frustrates
achievement of the long-run
money stock target.37
With regard to the narrowness of interest rate
tolerance bands, Pierce conducted some experiments
35 From time to time the FOMC has been willing to change the upper
or lower end of the range on the funds rate and thus permit a
larger inter-meeting
movement in the funds rate.
For a recent
example, see the “‘Record of Policy Actions”
of the FOMC in the
Federal Reserve Bulletin, (February
1975), p. 88. In addition, if
the funds rate prevailing at the time of the meeting is at the upper
or lower end of the adopted range, it is possible that the full 100-150
basis point range could be used during the inter-meeting
period.
36 In other words, short-run
monetary
control is considered
too
“costly”
because of the volatility of interest rates that seems to be
required.
For a critical review of this issue see [15].
For some
evidence that short-run
deviations of monetary growth from the
desired trajectory
might not be “costly” in terms of missing price
and output targets, see [6, p. 24].

with the SMP

model and concluded:

affecting

ECONOMIC

REVIEW,

results

the

achievement

of the

long-run

money

stock target. This is illustrated in Figure 3. Assume
the FOMC selected a 4-6 percent long-run growth
path for the money stock in month 1 of year 1,
growth in the money stock in months 5 and 6 of year
1 has been 8 percent, and the FOMC is meeting at
the beginning of month 7. Further, assume the prevailing Federal funds rate is 5 percent. As discussed
in Section IV, the short-run alternatives
for the
money stock presented to the FOMC by the staff will
typically be tied to a specific time path for returning
the growth of the money stock to the desired range.
For example, alternative (A) would envision only 2
percent growth in the money stock over the next
two months and thus an early return to the range.
This might require a sharp rise in the Federal funds
rate to perhaps 7 percent. Alternative (B), however,
would envision a slower return to the upper end of
the desired range ; the money stock might be expected
to grow at a 5 percent rate for five months and return
to the range by month 11. This alternative would
require a smaller current rise in the Federal funds
rate to perhaps 6 percent, possibly followed by further rises in subsequent months.38 An examination
of month-to-month movements in the funds rate: and
in monetary growth over the past several years suggests that the FOMC
has in practice more often
preferred to pursue an alternative such as (B).39
One significant area of concern with regard to this
policy approach is the possible existence, from time
to time, of a serially correlated error in the income
projection.
Suppose the staff is underestimating the
strength in aggregate demand and the money stock is
expanding more rapidly than desired.
Since the
38 It should be noted that one alternative may envision an immediate
return to the desired range without any significant
change in the
funds rate. The explanation accompanying
such an alternative may
be that the monthly pattern
of income growth
suggests smaller
increases in coming months and thus less strength in money demand.
Another possible explanation
is that the current spurt in monetary
growth is a random occurrence not likely to persist.

37 It also depends, of course, on the willingness of the FOMC to
modify the constraint
over time.
In this regard, the FOMC has
clearly been willing to tolerate larger swings in interest rates over
the first half of the 1970’s than it did over most of the 1960’s.

12

“The

indicate that the placement of sufficiently narrow
bounds on the change in the bill rate can have a large
impact on the simulated value of GNP” [22, p. 101].
It is worth emphasizing that if the band on interest
rate movements
is fairly narrow and inflexible,
it
is reasonable
to question whether or
not the money
stock is being “controlled”
at all.
In theory, at least, the current FOMC approach
to the formulation of policy is designed to guard
against short-run deviations of money stock growth

SEPTEMBER/OCTOBER

1975

growth of the money stock appears to be inconsistent

the FOMC

with the income projection

its meeting early in month 7.

and the associated

esti-

is presumed

to adopt alternative
The long-run

mate of the demand for money, the initial tendency

remains 4-6 percent but is calculated

may be for the policymaker

rather

than

subtle

ratcheting-up

monetary

growth

to discount the jump in

and wait

would confirm greater
and money demand.

for

strength

further

data

that

in economic activity

The incorrect

presumption

is

monetary

from

growth

month

1.40

(or

(C)

target

from month 6

Unfortunately,

down)

at

of

the

rate could exacerbate

this

long-run

the cyclical

swings in output and prices.41

that the spurt in monetary growth is the result of a
stochastic
implications

shift

in money

demand.

of accommodating

more pro-cyclical

The

long-run

this growth

are

VII.

a

policy than desired and, given the

lags in the effect of policy, the need later on for a
very sharp tightening in policy to offset past excesses.
An important problem for monetary control that
can result from a series of short-run deviations of
monetary growth is that the FOMC might give up
on the long-run money stock target de facto by continually resetting the starting (or base) date of the
control period over which the target value is to be
attained.
This might happen, for example, if the
policymakers find it impossible to tolerate the large
increases in interest rates necessary to offset past
excesses in monetary growth.
This is illustrated in
Figure 4, which is similar to Figure 3 except that

This

article

Reserve’s

Some Final Remarks

has presented

current

implementation

approach

of monetary

general interpretation
amined,

the discussion

strategy

carefully

a view of the Federal
to the formulation
policy.

and

It is hoped the

presented will be critically
of particular

scrutinized,

phases

ex-

of the

and the models that

40
The FOMC recently made such a shift in the base of its current
long-run money stock target.
On May 1, 1976, Chairman Burns
announced before the Senate Banking Committee that the FOMC
planned money stock growth of 5 to 7½ percent over the period
March 1975-March 1976. On July 24, 1975, the Chairman announced
before the House Banking Committee that the targeted growth rate
was the same. but the period over which it was to be obtained was
the second quarter of 1975 to the second quarter of 1976. Since the
money stock grew at nearly a 9 percent rate in the second quarter
of 1975, this change in the base, in effect, accepts much of the
intervening monetary expansion.
41
See Poole’s recent paper [26, pp. 25-30] for some further
pitfalls within the current strategy.

FEDERAL RESERVE BANK

OF RICHMOND

possible

13

This should

14.

result in a clearer understanding of current monetary
policy procedures, more carefully developed advice
for policymakers on how to improve their perfor-

Lombra, Raymond and Leigh Ribble.
“The Linkages Among Short-Term
Interest Rates.”
Paper
presented
at the Eastern
Economic
Association
Meetings.
October 1974.

15.

and Frederick Struble. “Monetary
gate Targets and the Volatility of Interest
Unpublished manuscript,
August 1975.

16.

and Raymond G. Torto. “An Endogenous
Central Bank and Its Implications
for Supply and
Demand Approaches
to Money Stock Determination,” Quarterly
Review of Economics
& Business,
(Summer 1975), 71-9.

17.

Maisel, Sherman.
“Controlling
Monetary Aggregates,” in Controlling
Monetary
Aggregates.
Federal Reserve Bank of Boston, 1968, pp. 152-74.

underlie the strategy

mance, and greater

empirically

tested.

success in achieving

the goals of

monetary policy.

References
1.

Axilrod, Stephen and Darwin Beck. “Role of Projections with Monetary Aggregates
as Policy Targets,” in Controlling
Monetary
Aggregates
II: The
Implementation.
Federal Reserve Bank of Boston,
1973, pp. 81-102.

2.

Brimmer, Andrew.
“Tradition
and Innovation
in
Monetary Management,”
in Monetary
Economics:
Readings.
Ed. Alan Entine, Belmont, California:
Wadsworth,
1968, pp. 273-89.

3.

“The Political Economy of Money: Evolution and Impact of Monetarism
in the Federal
Reserve
System,”
American
Economic
Review,
(May 1972), 344-52.

4.

Ciccolo, John H. “Is Short-Run
Monetary Control
Feasible?”
in Monetary
Aggregates
and Monetary
Policy.
Federal Reserve Bank of New York, 1974,
pp. 82-91.

Development
of the Monetary
5. Cooper, J. Phillip.
Sector, Prediction
and Policy Analysis
in the FRBMIT-PENN
Model.
Lexington:
D. C. Heath, 1974.
6.

7.

Corrigan,
E. Gerald.
“Income Stabilization
and
Short-Run
Variability
in Money,” in Monetary
Aggregates
and Monetary
Policy.
Federal Reserve
Bank of New York, 1974, pp. 92-103.
Crews, Joseph
M.
“Econometric
Models : The
Monetarist and Non-Monetarists
Views Compared,”
Monthly
Review,
Federal
Reserve Bank of Richmond, (February
1973), 3-12.

8.

Davis, Richard and Frederick C. Schadrack. *‘Forecasting the Monetary
Aggregates
with ReducedForm Equations,”
in Monetary
Aggregates
and
Monetary
Policy.
Federal Reserve Bank of New
York, 1974, pp. 60-71.

9.

DeLeeuw, Frank
and Edward
Gramlich.
“The
Federal Reserve-MIT
Econometric
Model,” Federal
Reserve Bulletin,
(January
1968), 11-40.
of Open Market
of
Economics,

Norton,

. Managing
1973.

the Dollar.

New York:

W. W.

19.

“The Economic and Finance Literature
and Decision Making,” Journal
of Finance,
(May
1974), 313-22.

20.

Mason, Will E.
Clarification
of the Monetary
Standard.
University Park: Penn State University
Press, 1963.

21.

“Numerical
Specifications
of Financial
Variables
and Their Role in Monetary Policy,” Federal
Reserve Bulletin,
(May 1974), 333-7.

22.

Pierce, James. “The Trade-off
Between Short- and
Long-term Policy Goals,” in Open Market Policies
and Operating
Procedures-Staff
Studies.
Washington, D. C.: Board of Governors of the Federal
Reserve System, 1971, pp. 97-105.

23.

“Quantitative
Analysis for Decisions at
the Federal
Reserve,” Annuals
of Economic
and
Social Measurement,
(March 1974), 11-19.

24.

and Thomas Thomson.
“Some Issues in
Controlling
the Stock of Money,” in Controlling
Monetary
Aggregates
II:
The Implementation.
Federal Reserve Bank of Boston, 1973, pp. 115-36.

25.

nancial
Journal

and Thomas Thomson.
Models at the Federal
of Finance,
(May 1974),

“Short-Term
FiReserve
Board,”
349-57.

26.

Poole, William.
“The Making of Monetary Policy:
Description and Analysis,” New England Economic
Review,
Federal Reserve Bank of Boston, (MarchApril 1974), 21-30.

27.

“Optimal Choice of Monetary
Policy
Instruments
in a Simple Stochastic Macro Model,”
Quarterly
Journal
of Economics,
(May 1970), 197216.

28.

Sims, Christopher.
“Optimal Stable Policies for
Unstable Instruments,”
Annuals
of Economic
and
Social Measurement,
(January
1974), 257-65.

10.

Guttentag,
Jack.
“The
Operations,”
Quarterly
(February
1966), l-30.

11.

Hymans, Saul. “Comment” in Econometric
Models
of Cyclical
Behavior.
Ed. Bert
Hickman,
New
York: National Bureau of Economic Research.

29.

12.

Kane, Edward.
“All for the Best:
The Federal
Reserve Board’s 60th Annual Report,” American
Economic
Review,
(December 1974), 835-50.

Tschinkel,
Sheila.
“Open Market Operations
1973,” Monthly Review,
Federal Reserve Bank
New York, (May 1974), 103-16.

30.

13.

.
Journal
of
(November

Weintraub,
Robert.
“Report on Federal Reserve
Policy and Inflation
and “High Interest
Rates,”
Reserve
Policy
and Inflation
and High Interest
Rates. U. Congress.
S.
House Committee on
Banking
and Currency,
93rd Congress
(JulyAugust 1974), pp. 31-76.

14

Strategy
Journal

18.

AggreRates.”

“The Re-Politicization
of
Financial
and Quantitative
1974), 743-52.

the Fed.”
Analysis,

ECONOMIC

REVIEW,

SEPTEMBER/OCTOBER

1975

in
of

LOAN COMMITMENTS TO BUSINESS
IN UNITED STATES BANKING HISTORY
Bruce

The practice

of guaranteeing

future

J. Summers

Even though recognition of the importance

credit avail-

ability to business enterprises,
or what is today
called the making of loan commitments, has existed
since the beginning of banking in the United States.
Although the specific forms of such practices have
changed considerably in the past two hundred years,
the basic concept has nonetheless been ubiquitous
from post-Revolutionary
times until the present.
Banks originally extended loan commitments only to
commercial and industrial businesses, but today they
also routinely extend such guarantees to financial
businesses and individuals.
Commitments to nonfinancial businesses have retained their traditionally
prominent position, however, and now represent approximately three-quarters
of the dollar volume of
total loan commitments.
It has only been since the mid-1960’s that the topic
of commercial bank loan commitment policies has
become an explicit issue in banking circles. Increasing interest in these policies has recently been expressed by the various groups concerned with the
banking industry, including bank regulators, students
of monetary policy and, of course, bankers themselves.
This increased interest is centered on commitment policies involving credit guarantees for nonfinancial businesses, and this article has the same
focus. Two recent developments have caused the
increased attention being given bank-business
loan
commitments.
First, the demand for such commitments by business seems to have enlarged considerably. Second, banks have become more willing and
able suppliers of loan commitments, and their liberalized approach has led to concern about the potential
effects that vastly increased commitment positions
might have on the liquidity, and thus the soundness,
of individual institutions.
These developments have
also resulted in an increased awareness of the impact
of loan commitments on the magnitude and direction
of credit market flows. It is for these reasons that
the topic of commercial bank loan commitment policies has emerged, after many years of quiescence, as
one of the more important issues in contemporary
banking.1
1 For an example of how the loan commitments
issue is viewed by
regulatory officials, see Arthur F. Burns. “Maintaining
the Soundness of Our Banking System,” an address before the 1974 American
Bankers Association
Convention, October 21, 1974, reprinted in the
Monthly Review, Federal Reserve Bank of New York, Vol. 56, No.
11, November 1974, 263-7.

loan commitment

policies

is currently

of bank

widespread,

the reasons for this change in status have not been
fully explored:

there has been no formal attempt to

explain why businesses
obtain guarantees
the banking
demands.

of future credit availability

system

is so willing

unusual,

tionary process
remains

eager to
or why

to satisfy

these

The lack of such an analysis should not be

considered

however,

for the entire

leading up to the current

somewhat

explicitly

are now especially

unclear.

evolu-

situation

The body of literature

dealing with commercial

bank loan com-

mitment policies is relatively new, and its orientation
has been practical,

not analytical.

tempts to fill the analytical
torical

development

mitment

policies

This

of commercial

from

article

gap by tracing

the

early

at-

the his-

bank loan comdays of banking

through the present.
To study the development
ment policies is, essentially,
of the commercial

of bank loan commit-

to study the development

loan, for the use of loan commit-

ments is simply a refinement
credit is advanced

of the process by which

from lender

to borrower.

article shows that the evolutionary

This

process has been

motivated by changes in business credit requirements
under different economic and financial circumstances
and that

the banking

guided by prevailing
duct.

Accordingly,

system’s

response

has been

theories of proper banking conloan commitments

are examined

within the framework of the various liquidity theories
that have guided banking
States.

The

financial

environment

loan

commitments

experiences
liabilities
trine

hypothesis

with

in the United

is developed

encourages

by business
credit

management

allows banks

practices

the

conception

for

of recent

Further,
of banking

this demand

doing violence to their professional

today’s

demand

because

stringency.

to satisfy

that

the
doc-

without

code of conduct.

The first section of the article provides introductory
descriptive background and definitions about currentday loan commitment

practices,

tion develops the historical

FEDERAL RESERVE BANK

summarizes
OF RICHMOND

and the second sec-

review.

the major conclusions

The final section
reached.
15

Current

Types of Loan

Agreements

Commitment

reached between borrower

with the purpose of establishing
credit availability
arrangements.

actions

guarantees

makes it difficult

needs,

not to force
patterns.

to distinguish

basic patterns

according

basic

patterns

Short-term

sonal and transaction

take, there are

are classified

of the intended

here

advance,

of the use to which

loans are made for sea-

needs, intermediate-term

loans

for working capital needs and interim financing,
long-term
rower

loans for investment

demands

in fixed assets.

for loan commitments

specific types of capital
One other important
mitment

arrangements

and those that are not.

is between

com-

requirements.
distinction
that are

legally

The majority

basis, either verbally

enforceable

of arrangements

however,

is prepared.

documentation

on an

or in correspondence.
guarantee

mitment arrangements

Borthese

In cases where an unequivocal
legal

and

reflect

are made between banks and their customers
informal

this

sharply among the

is a good indicator

funds are put.

all trans-

to which these arrangements

to the maturity

for maturity

to fit

Although

various forms that loan commitments
These

lend-

loans and loan commitments

borrower

conform.

of future

The current trend in commercial

into preconceived

certain

and lender

are referred to as loan commitment

ing is to structure
individual

Arrangements

is desired,
Com-

legally binding to the bank are

almost always accompanied

by a fee that is typically

computed on a daily basis against the unused portion
of the commitment.
These fees are justified on the
grounds that legally binding commitment arrangements place the bank in a position from which it
must be prepared to advance funds without recourse.
For the same reason it is common practice for the
fee to be retained even if the customer does not
utilize his commitment.2
As a practical matter, however, loan commitments backed by the moral obligation of a bank are honored with the same degree of
seriousness as those backed by a legal obligation,
because failure to meet commitments
for reasons
other than cause would destroy a bank’s credibility
in the financial community.
Any commitment disclosed to the customer, therefore, has the status of a
serious obligation to be honored by a bank if at all
possible. The equal status given all types of disclosed
commitments is reflected in a survey of eight large
Midwestern banks, which found uniform satisfaction
2 Eli S. Silberfeld,
“Loan Commitment
Fees-Some
Legal Points,”
The Journal
of Commercial Bank Lending, Vol. 56, No. 6, February
1974, 65.

16

ECONOMIC

REVIEW,

of all commitments

during the 1969-1970

period of

tight money.3
Commitments

for Short-Term

commitments
short-term
credit.

loan

to business firms that have an intended

use for credit take the form of a line of

Lines of credit, which account for most of the

volume of loan commitments,
types:

Bank

Uses

are classified

the open line of credit

credit.

into two

and the firm line of

The open line of credit is very informal

in

nature, usually taking the form of a letter from the
bank stating a general

willingness

to lend funds up

to some maximum limit over a specific period of time,
generally

not more than one year in length.

The

commitment

letter does not specify the terms of the

arrangement,

which the bank may change while the

letter

is outstanding.

The

customer

may borrow

under the open line of credit at his discretion,
interest
credit

being charged
he uses.

with

only on the actual amount of

Continuous

borrowing

under open

lines of credit is discouraged,

and most banks require

that their lines be “cleaned

up” (the

level of bor-

rowing must return to zero) at some time during the
year.

This

tradition

credits granted
uses only.
of credit

reinforces

the intention

The fact that advances
are

short-term

treated

this intention.
the customer

note, further

by

emphasizes

In return for an open line of credit,
is required to pay an implicit fee in the
demand deposit balances.

line of credit

line with the exception

closely

resembles

but in terms

an open

that a fee is paid based on the

unused portion of the arrangement.
status

direct

always being accompanied

promissory

form of compensating
A firm

under open lines

the same way as are

borrowings,

the customer’s

that

under open lines are for short-term

of service

It thus has legal

rendered

offers

the

customer nothing more than an open line of credit.
Commitments
for Intermediate-Term
Uses
The
revolving credit is a device that has come into use in
response to needs for short-term
but continuous
credit or for credit of uncertain duration.
It guarantees the customer use of fluctuating amounts of
bank credit over an extended period of time, usually
two or three years, and has legal status. An explicit
fee based on the unused portion of the commitment
is always involved, and recently a number of banks
have instituted an additional charge based on the
3 Douglas A. Hayes, Bank Lending Policies: Domestic
and International, Michigan Business Series, Vol. XVIII, No. 4, The University of Michigan,
1971, p. 79.

SEPTEMBER/OCTOBER

1975

entire amount of the commitment.*
The fee commonly charged on the unused portion is one-half of
one percent per annum, while that levied on the
entire commitment is one-quarter of one percent per
annum. Compensating balances are also required.
Given the formal character of revolving credit
arrangements,
a rate charged on borrowing under
commitment is specified.
The rate usually has a
fixed relation to the prevailing prime rate, and in
this way the bank is assured of a return that is realistically related to existing credit market conditions.
The customer’s borrowing privilege depends upon
his ability to meet certain financial conditions specified in a set of protective covenants contained in the
contract, a feature designed to protect the bank from
adverse changes in credit risk.
Commitments
for Long-Term
Uses
Business
credit needs related to the acquisition of fixed assets
can sometimes be satisfied using bank term loans
that have a maximum maturity of about ten years.
Term loans represent a popular type of debt financing
for moderately-sized
companies that do not have
access to public credit markets and for larger corporations that may find bank credit terms more
flexible than either public debt issues or equity financing. When made directly, term loan commitment
arrangements obligate the bank to extend up to a
specified maximum amount of credit upon request,
provided the customer meets certain financial requirements contained in the contract.
Funds can
be taken down as needed or the entire amount can
be obtained at one time, but either way a long-term
promissory note is made out. A fee is charged based
on the unused portion of the commitment over its
life. The volume of direct term loan commitments
is not large relative to other types of loan commitments.
Often revolving credits are supplemented with a
term loan option that allows the customer to convert
the unused portion of his commitment into a term
loan at the arrangement’s expiration.
The revolving
credit with a term loan option is a very flexible
arrangement that appeals to businesses engaged in
projects that take several years to complete.
The
revolving credit feature of the contract provides
“bridge” financing that can be activated as necessary,
while the term loan feature provides an optional
source of long-term financing, should conditions in
the bond or equity markets prove unfavorable at the
time a project is completed.
’ “Citibank Increases Loan-Pledge Fees Charged Big Firms,” Wo,U
Stmct Journal, September 24, 1974, D. 29, and Ben Weherman,
“Holland Says Credit Line Commitment Prices Should be More Than
Doubled.” Anwrican Banker, November 12. 1974, p. 1.

Loan Commitment

Policies and

Theories

of Bank liquidity

The Commercial
Loan Theory
of Credit
The
first theory to govern banking practices in the United
States was imported from Great Britain, for in this
matter, as in so many others, early American thought
was strongly influenced by prevailing opinion in the
mother country. Thus the real-bills doctrine, a most
persistent and popular British conception of proper
banking conduct, came to play a key role in the early
development of U. S. banking theory and practice.
The real-bills doctrine assumed form in 18th century British banking circles, where an oral tradition
grew up regarding its various aspects. Adam Smith
provided the first systematic exposition of the doctrine in his Wealth of h’ations (1776)) and thereafter
many writers contributed to its refinement.
During
the 19th century, a turbulent formative period for
U. S. banking practices and legislation, it was the
focal point of debate and discussion in British banking. For the British banking school, the real-bills
doctrine represented a central thesis, and its relevance to both banking and monetary management
was stressedP
Basically a theory of asset management that emphasized liquidity, the doctrine held
that banks should restrict their earning assets to
“real” bills of exchange (discounted paper financing
the movement of goods) and short-term, self-liquidating advances for commercial purposes.
In this
way, it was argued, individual banking institutions
could maintain the liquidity necessary to meet the
requirements
of deposit withdrawals
on demand.
Under a somewhat modified character
this basic
doctrine came to be known in the U. S. as the commercial loan theory of credit, and it remained the
rubric of banking until the 1920’s.
For about the first fifty years of U. S. banking
history, the commercial loan theory of credit was
easily compatible with practical standards of conduct,
which were quite primitive.
The development of
commercial banking in this country had a very slow
beginning, due largely to the limited demands and
special preferences of the colonists for credit.
In
Colonial times, of course, the economy was largely
agrarian, and a flourishing manufacturing
industry
with heavy capital demands simply did not exist.
Given the relatively backward state of the economy,
therefore, aggregate credit demand was not large.
Existing requirements for financial assistance were
5 With respect to monetaw management, it was argued that adherence to the real-bills doctrine would cause aggregate liabilities of the
banking system (notes and demand deposits) to vary in quantity
according to the state of real economic activity. In effect. then, the
money supply would always he maintained at the most desirable
level in a virtually self-regulated manner.

FEDERAL RESERVE BANK OF RICHMOND

17

mer-

mercial

transactions.6

chants), Colonial governments, and colonizing companies.
English banks also counted as important
sources of credit for Colonial enterprise.
In short,
important banking functions were performed without
the aid of domestic banks, and this combination of
circumstances acted to retard the development of a
commercial banking industry. It was not until after
the Revolutionary
War that the first bank in this
country, the Bank of North America, was established
in 1782 in Philadelphia.

satisfactorily

met

by

individuals

(especially

practice

became more overt as banks began to rely

Merchants formed the Bank of North America, as
they did most other early banks, in order to make
credit more conveniently available for financing trade.
The loans of these early banks were of a self-liquidating nature, and they conformed to the appropriate
type of asset prescribed
by the commercial
loan
theory of banking.
Also, it is reasonable to assume
that banks customarily
entered into informal loan
commitment arrangements with businesses requiring
funds for actual short-term purposes.
This happy
situation did not prevail for long, however.
In the
second quarter of the 19th century, the U. S. entered
a period of sustained and vigorous economic growth.
This process required large amounts of capital,
especially of a long-term nature, and these demands
were partly directed toward the banking system.
Consequently, banks were confronted with the problem of meeting credit demands directly at variance
with their accepted code of conduct, which emphasized short-term lending.
Without

doubt commercial

demands for longer-term
ciated with fixed

banks did satisfy these

credit, including those asso-

investment

programs.

Yet

it is

also true that, in form at least, a facade of short-term
This

lending was maintained.
of

exchange,

so prominent

slowly disappeared

occurred

from

as the bill

Colonial

times,

and was replaced by the promis-

sory note as the most common credit instrument,
transition
War.

largely

Through

completed

a

by the end of the Civil

use of the promissory

note on a basis

of continuous renewals, banks were able to conform to
the letter of the law, as far as theory was concerned,
and still meet the long-term
ness.

By informally

credit demands of busi-

guaranteeing

renewal of short-

term notes, banks in effect began granting
mitments

for long-term

So completely

credits

to their

did the short-term

loan comcustomers.

promissory

note

fulfill the various credit demands of business through
repeated

extensions

accommodation

that it came to be regarded

paper, to be used for general

needs and not exclusively
18

for self-liquidating
ECONOMIC

as

credit
com-

on financial

Starting

statement

in the 1870’s,

analysis as a basis for mak:ing

advances.

The use of loan proceeds

and more

to the discretion

who, upon examination,
sound.

The

term,

earliest

The

of business

customers

were found to be financially

analysis

of the uses of shortmade for the several

preceding

1918, places at 20 per-

the proportion

capital.’

was left more

bank loans,

unsecured

years immediately
cent

this

used for

same source

40 and 50 percent

investment

estimates

of short-term,

in fixed

that between

unsecured

loans

made at banks in large cities were commonly renewed
at maturity.”

This, it seems, was the state of affairs

that existed prior to 1920, the beginning
major

period of evolutionary

The commercial
solete both because
impracticality.

of the next

change in banking.

loan theory of credit became obof its conceptual

A critical

underlying

flaws and its
assumption

of

the theory held that short-term
commercial loans
were desirable because they would be repaid with
income resulting from the commercial
transa.ction
financed by the loan. It was realized that this assumption would certainly not hold during a general
financial crisis even if bank loan portfolios did conform to theoretical standards, for in most commercial
transactions
the purchaser
of goods sold by the
original borrower had to depend to a significant extent on bank credit. Without continued general credit
availability, therefore, even short-term loans backing
transactions involving real goods would turn illiquid.
Rigid adherence to the orthodox doctrine was, furthermore, a practical impossibility if banks were to
play a role in the nation’s economic development.
Moreover, the practice of continually renewing shortterm notes for the purpose of supporting long-term
capital projects proved unacceptable.
The faihne or
inability of banks to tailor loan arrangements to the
specific conditions encountered with longer-term uses
in fact contributed to the demise of the practice.
By
the 1920’s these factors became strong enough to
work a change in basic banking doctrine.
The Shiftability
Theory
and the Doctrine
Anticipated
Income
The shiftability
theory
liquidity replaced the commercial
loan theory
BHar~

of
of
of

33. Miller. Bankilag Thcwies in the United Statis Before
Harvard Universim Press. 1927. p. 179..

1860.Cambridrw

‘H.
G. Moulton, “Commercial Banking and Capital Formation,
Part II,” The Journal of Political Economy, Vol. XXVI, No. 6. June
1918, 648.
SH. G. Moulton, “Commercial Banking and Capital Formation.
Part III.” The .Joumal of Political Economy. Vol. XXVI, NO. 7.
July 1918, 707.

REVIEW, SEPTEMBER/OCTOBER 1975

credit about 1920, and it remained
the late 1940’s,

prominent

when it was supplemented

until
by the

doctrine of anticipated income.
Formally developed
by Harold G, Moulton in 1915, the shiftability theory
held that banks could most effectively protect themselves against massive deposit withdrawals by holding, as a form of liquidity reserve, credit instruments
for which there existed a ready secondary market.g
Included in this liquidity reserve were commercial
paper, prime bankers’ acceptances and, most importantly as it turned out, Treasury bills. Under normal
conditions all these instruments met the tests of marketability and, because of their short terms to maThe shiftability theory was
turity, capital certainty.
enhanced during the 1930’s and 1940’s by the rapid
growth in volume of short-term U. S. Government
obligations.
Unlike the old commercial loan theory of credit,
the shiftability theory provided a theoretical framework that could accommodate new and innovative
approaches to business lending by commercial banks.
This was so because liquidity meant the ability to
exchange secondary reserve assets for cash, an approach that relaxed the constraints previously placed
on loan arrangements.
As bank holdings of U. S.
Government securities grew, the thrust of the liquidity question was increasingly transferred from loan
to investment portfolios.
Bank lending techniques
changed dramatically
against this background,
a
process that was stimulated as a result of changes in
business credit demands after the Great Depression.r”
It is under the shiftability theory of liquidity that
commercial bank loan commitment practices began
to assume the form that prevails today.
Perhaps
during

the biggest breakthrough

this period

concept

was explicit

of term lending,

a change

clear break with the commercial

in bank lending

recognition

of the

that signified

a

loan theory of credit.

Term lending was first introduced in the early 1930’s
and came as a response to conditions imposed by the
Great

Depression.

continuously
amounted

renewing

to long-term

the period 1929-1933.
of the concept
commitment
conform

The

tradition
short-term

credit

of making
loans

for

and
what

needs broke down in

One result was a purification

of loan commitments.

arrangements

Henceforth,
would more realistically

to the intended uses of credit, a much im-

v Ibid., p. 123.
‘@The change in debt financing techniques over the period 19201940,
has heen described as
4‘. . . especially with regard to bank lending, in its significance as
a technical revolution as far-reaching
technical advances in industrial production, transportation 0~ agriculture.”
See Neil H. Jseoby and Raymond J. Saulnier, Business
Fimmce and Banking, National Bureau of Economic Research, E. L.
Hildreth and Company, 1947, p. 139.

proved situation that would contribute
fulness

to their use-

and respectability.lr

Even though many short-term loans were extended
with the understanding that they would be used for
purposes that would not realistically permit repayment of principal in the short run, some banks were
forced into demanding repayment as a result of runs
These demands for repayment
on their deposits.
occurred at a time of depressed business conditions
and general financial difficulty and resulted in a
The unfortunate
number of business bankruptcies.
lessons learned from this set of circumstances led to a
more realistic consideration of the need for a true
long-term bank credit instrument.
Additionally, the
post-Depression
years found many industrial firms
with outdated and deteriorated plant and equipment,
renovation of which increased the demand for longterm credit. Acquisition of funds through debt and
equity capital offerings was discouraged by the high
yields on such issues relative to the prime rate on
bank loans and by the restrictive provisions of the
Securities Act of 1933 and the Securities Exchange
Act of 1934.r2 In the business revival that began in
1932, therefore, banks represented a preferred source
of long-term credit, and the need for a lending instrument to accommodate these demands was that much
greater.
Acceptance of the term loan by bank regulatory
authorities was not long in coming. Two events in
particular gave the new practice an official air of
respectability.
The first was an amendment to the
Federal Reserve Act through the Banking Act of
1935, by which banks were extended the privilege of
borrowing from the Federal Reserve Banks against
the security of nny sound asset acceptable to the
Reserve Bank at a penalty rate of one-half of one
percent per annum higher than the highest discount
rate in effect on eligible paper.r3 Prior to this amendment, this privilege was available for use only in
“exceptional
and exigent circumstances”
when a
member bank’s supply of assets eligible for rediscount
was exhausted.
This amendment extended the scope
of the shiftability theory by allowing long-term assets,
I1 An argument that continuous borrowins for capital investment
purposes remained prevalent at least through 1955 is made in
“Continuous Borrowing Through ‘Short-Term’ Bank Loans.” Business Review. Federal Reserve Bank of Cleveland. September 1956,
6-13. This thesis seems unlikely given the strong acceptance of term
lending. While there is no doubt that continuous business indebtedness was and still is common, it can more easily be explained in
terms of separate borrowings for distinct short-term credit uses.
Commercial loan officers do encounter situations where short-term
loan funds are channeled into longer-term uses, but these are
generally unintended exceptions to the general norm.
1sA good synopsis of these background conditions is provided in
George S. Moore, “Term Loans and Interim Financing,” in Benjamin H. Beckhart, fed.). Business Loans of American Commercial
Banks, New York: The Ronald Press Company, 1959, pp. 210-11.
I* Federal Reserve Act 8 10(b). 12 U.S.C. g 34713, as amended by
p 204 of the Banking Act of 1935 (49 Stat. 705).

FEDERAL RESERVE BANK OF RICHMOND

19

including

term

loans,

advances

from

the

to be used as collateral

Federal

Reserve

Banks.

for
The

second event was the 1938 change in bank examination standards
tion for bank
teria.14

This

that abandoned
assets

the “slow” classifica-

based solely

examining

change

on maturity

recognized

cri-

the fact

that banks had to substitute new forms of loans for
their lost volume of short-term commercial loans and
emphasized intrinsic soundness
through quick maturity.

rather than liquidity

The results of a bank term loan survey conducted
in 1941 reveal that term lending grew rapidly in the
1930’s and represented
an important part of total
loan vo1ume.l” Eighty-one of 99 respondent banks,
most of which were large institutions,

held significant

amounts of term credit at mid-year 1941; for 50 of
these banks, term loans constituted 22 percent of
total loans and discounts.
Historical data provided
by 56 of the banks revealed that their outstanding
term loans increased three and one-half times from
1935 to 1940, reaching a level of $967 million.
It
appears, however, that direct term loan commitments
were not employed to a very significant degree in the
1930’s and 1940’s. Term loan commitment arrangements were available under the name of call credits,
for which standby fees were charged.16
The revolving credit also appeared about the same
time as the term loan and probably originated as part
of the new long-term lending arrangement.
Early
discussions treat the revolving credit as a form of
term lending because of its multi-year contractual
nature, even when the term loan option is not part
Nevertheless
it is significant
of the arrangement.
that the revolving credit did appear, for it represents
another advance in financial technique.
Early usage
of revolving credits was very limited, their number
being estimated as only 5 percent of the number of
term loans outstanding in 1941.“’
There appears to
have been some resistance on the part of banks to
enter revolving
credit arrangements,
presumably
due to the uncertainties involved with credit usage.
After 1947 an interest escalator provision based on
the Federal Reserve
discount rate in the district
where the loan was made was usually included to
help mitigate interest rate uncertainties.‘*

A major defect was discovered in the shiftability
theory similar to the one that led to abandonment of
the commercial loan theory of credit, namely that in
times of general crisis the effectiveness of seconclary
reserve assets as a source of liquidity vanishes for
lack of a market.
The role of the central bank as
lender of last resort gained new prominence, especially in view of the changes of 1935 that broadened
its potential role, and ultimately liquidity was perceived to rest outside the banking system. Furthermore, the soundness of the banking system came t.o be
identified more closely with the state of health of the
rest of the economy, since business conditions had a
direct influence on the cash flows, and thus the repayment capabilities, of bank borrowers.
The shiftability theory survived these realizations under a
modified form that included the idea of ultimate liquidity in bank loans resting with shiftability to the
Federal Reserve Banks.
Under this institutional
scheme, the liquidity concerns of banks were partially
returned to the loan portfolio, where maintenance.of
quality assets that could meet the test of intrinsic
soundness was paramount.
The doctrine of anticipated income, as formalized by Herbert V. Prochnow in 1949, embodied these ideas and equate:d intrinsic soundness of term loans, which were of growing importance, with appropriate repayment schedules adapted to the anticipated income or cash flow
of the borrower.*9
The credit demands of business were well accommodated under this system of banking policy, and the
use of loan commitments was freely pursued into the
1950’s.
This is shown in the Survey of hlember
Bank Loans for Commercial and Industrial Purposes,
conducted by the Federal Reserve System as of October 5, 1955, which found that 56 percent of the
2,000 participating banks extended lines of credit.20
In this survey virtually all banks with deposits of
$100 million and over extended credit lines as did
38 percent of the banks with less than $20 million in
deposits.

Changing

placed extra

demands

economic

on the banking

IsNeil H. Jacoby and Raymond J. Saulnier, Term. Lend&g to
Btiness,
National Bureau of Economic Research, Camden: The
Haddon Craftsmen Inc., 1942, pp. 135-40.
16Herbert V. Prochnow, Term Loans and Theories of Bank Liquiditv. New York: Prentice-Hall, Inc., 1949. pp. 25-6.

however,

system

that

resulted in a new approach to balance sheet management, and businesses faced new financial challenges as
the 1960’s progressed.

Under this emerging

affairs, bank loan commitment
14 Board of Governors of the Federal Reserve System, Annual Report,
19.38, pp. 37-8.

conditions,

play a more important

state of

policies would come to

part in the credit process.

Liabilities Management

This country

sustained

credit

period

of rapid

entered a
expansion in the

17Jacoby and Saulnier. Term Lending to Business. p. 77.

“‘Ibid., P. 402.

1s Herbert V. Prochnow. Term Loans and Theories of Bask Liquidity, P. 25.

10 Caroline H. Cacle, “Credit Lines and Bfinimum Balance Reauim
men&” Federal Reserve Bulletin, Vol. 42, No. 6, June 1956, 573-9.

20

ECONOMIC

REVIEW, SEPTEMBER/OCTOBER 1975

1950’s that acquired explosive proportions in the
Banks were eager to participate in this
1970’s.
process and share in the profit opportunities that it
implied. They succeeded but only by radically changing the approach to liquidity that had been main-

Table I

TOTAL FUNDS
FUNDS

balance sheet, the only exception being occaborrowing at the discount window.
In the
they turned to the liability side of the balance
on a massive scale, and liabilities, especially

short-term liabilities in nondeposit form, came to be
This approach,
viewed as completely controllable.
which prevails today, is known as the liabilities management theory of liquidity.
Table I shows the extent of increases in credit
from the 1950’s to the 1970’s, along with the changing
importance of commercial banks in supplying this
credit. In the eight-year period 1952-1959, a yearly
average of $33.2 billion was raised in U. S. credit
markets, and commercial banks provided 21 percent
of this amount. By the 1970’s, the yearly average of
funds raised increased to $148.6 billion, of which 41
percent was supplied by the banking system.
Corporate business played an important part in this
credit expansion, its yearly average increase in funds
raised moving from $8.0 billion in the 1950’s to $49.3
billion in the 1970’s; the banking system advanced
21 percent of these funds in the 1950’s and 34 percent
in the 1970’s.
The flow of funds supplied by the banking system
to the nonfinancial business sector has not been
smooth, especially since the late 1960’s.
Chart 1, a
plot of the three-month moving average of growth
rates in bank business loans stated at annual rates,
illustrates the magnitude and frequency of swings in
bank business credit since 1960 and highlights the
instability that has become prevalent in the last
decade. Since the mid-1960’s, there have been several
major swings toward tightness that have been induced primarily as a result of restricted credit supply.
These episodes have had an important expectational
effect on the behavior of businesses.
As a result of
these episodes, business financial managers have been
encouraged to seek protection against the possibility
of recurring periods of tight credit, a behavioral trend
especially noticeable since the “credit crunch” of
1966.
In 1966 the Federal Reserve adopted measures designed to restrict
had accelerated
investment

the rate of credit creation,

rapidly in conjunction

spending

and Government

which

with business
espenditures

IN CREDIT MARKETS*
BY COMMERCIAL

AND

BANKS

Average Annual Flows
$ Billions

tained from the earliest days of banking.
From the
1780’s through the 1950’s, banks sought to assure
their liquidity almost exclusively on the asset side
of the
sional
1%0’s
sheet

RAISED

SUPPLIED

Nonfinancial Corporate
Business Sector

All
Nonfinancial Sectors

- Period

Bank
Business
Loans

FlJIldS

Bank
Locms
P

Funds
-Advanced

Advanced

1952-l 959

33.2

7.1

8.0

1.7

1960-1969

64.4

22.3

19.8

6.1

1970- 1974

148.6

61.4

49.3

16.8

* Excluding equities.
source: Board
Flow of Funds.

of

Governors

of

the

Federal

Reserve System,

for the Vietnam War.
This had a direct impact on
commercial banks and, through them, on the financial
For some time prior to 1966,
markets in general.
commercial banks had been restructuring their asset
portfolios
to include more higher-yielding
assets,
especially commercial loans and municipal bonds, at
the expense of short-term
Government
securities.
The emphasis on commercial lending, depicted in
Chart 1 by high growth rates for 1965 and the first
half of 1966, was supported by sales of CD’s. When
the yield on competing money market instruments
rose above the 5.5 percent maximum rate on new CD
issues in the summer of 1966, the Federal Reserve,
contrary to past policy, did not raise Regulation Q
ceiling rates.
With this source of loanable funds
effectively cut off, banks reacted by liquidating their
holdings of municipal bonds. Given other unfavorable conditions in the municipal bond market, this
action had the result of lowering prices dramatically,
making further sales impossible. Banks found themselves with no other choice than to curtail business
lending, and credit became unobtainable at any price
-except
for businesses with prearranged loan comIf any doubts about the possibility of
mitments.
recurring shortages of credit persisted after 1966, a
similar experience in 1969 certainly acted to dispel
them.
It is no coincidence that business demands for
bank

loan

reached

commitment

unprecedented

tight money

episodes

events demonstrated
tary

arrangements

policy

of economic

could result in severe credit shortages.

FEDERAL RESERVE BANK OF RICHMOND

the

1969,

that the vigorous

for purposes

ness of businesses

and

following

proportions
of 1966 and

surged

to enter

for these

use of monestabilization
The eager-

into loan commitment
21

arrangements for defensive reasons, and to intensify
their use of such arrangements during tight money
periods, is clearly attested to in at least one bank’s
case history.21

In this example

the dollar volume

of

disclosed lines of credit rose moderately but steadily
from mid-1960 to mid-1966 and then leveled off
before resuming an upward trend in 1969. Total firm
commitments trended slightly downward from 1960
through early 1964 but then began a rapid climb that
lasted through 1966.
This rapid upward trend in
total firm commitments was also present in the first
half of 1968 and 1969 before falling off in response to
an internal policy designed to reduce their volume.
While the ratio of borrowings under disclosed lines
of credit to total disclosed lines of credit showed only
modest positive changes in 1966 and 1%9-1970,
the
similar ratio for firm commitments increased remarkably in response to tight money.
In the eighteenmonth period from the beginning of 1965 to the
middle of 1966, the ratio of total borrowings under
firm commitments
to total firm commitments
increased from about 35 percent to over 55 percent; in
the two and one-half year period from early 1968 to
u The behavior of aggregate firm commitments and lines of credit
at Mellon National Bank and Trust Company over the period 19991972 is described in James Ii. Higgins, “Loan Commitments,” The
Joumd of Commercicrl Banh Lending. Vol. 54, No. 11, July 1974.
2-9. The techniques for managing lOan cornmitments presented in
thii article are widely considered to be a mo de1 for other banks to
follow.

22

ECONOMIC

mid-1970, the ratio increased from about 37 percent
to about 60 percent.
It appears that aggregate demand for loan commitments continued to increase rapidly in the early
1970’s. The results of a sample survey of large commercial banks revealed that the dollar volume of
unused loan commitments to business firms increased
by 68 percent between July 1970 and July 1972. The
respective percentage increases were 55, 45, and 200
for confirmed lines of credit, revolving credits, and
term loans.
Certain alterations in Regulation Q implemented
between 1970 and 1973 signaled a change in emphasis
for monetary policy away from credit availabil:ity toward the price rationing mechanism.
By removing
interest rate ceilings on CD’s, a process completed in
July 1973, banks were provided with the opportunity
to remain active competitors for funds even in periods
of rising interest rates. This basic change indicated
to business borrowers that in future periods of tight
money, the banking system would have the freedom
to meet their credit demands, although at increased
cost. While this may have initially reduced the perceived need of businesses for loan commitment arrangements, it has since become clear that, even under
this new set of ground rules, periods may still occur
that find banks unable to fulfill all lousiness credit
demands directed to them. The first esample of this

REVIEW, SEPTEM5ER/OCTOBER 1975

situation occurred in the summer of 1974, when a
two-tiered market for regional and money center
bank CD’s developed, which made it difficult for some
banks to maintain or achieve desired liability positions.22
It appears, then, that conditions continue to exist
that make loan commitment arrangements
desirable
as protection against periods of credit stringency.
At the same time, however, the willingness of banks
to enter confidently and freely into such arrangements may have been reduced as a result of imperfections discovered in the liabilities management concept of liquidity. Given their adaptability in meeting
many types of special business financial requirements
throughout the history of U. S. banking, there is
every reason to suppose that banks will also meet the
current-day need for protection of credit availability.
The current mood of prudence and caution will hopefully act to keep bank compliance with such demands
within a range that can be reasonably managed under
all possible financial market conditions.
Summary

and

Conclusions

Commercial banks have engaged in the practice of
making loan commitments to business enterprise from
the beginning of modern banking in the United
States.
Since the mid-1960’s,
however, there has
been a significant change in approach to loan commitments that has resulted in enlarged demand and
liberalized supply, thus increasing contemporary interest in the topic. This article traces the historical
development of commercial bank loan commitment
policies and offers an explanation for their recent
increase in importance, using as a reference framework the various liquidity theories that have governed banking conduct in the U. S.
From the 1780’s through the 1950’s, commercial
banks, according to prescribed theory, insured their
liquidity by concentrating
on asset management.
Under the commercial loan theory of credit, theoretical restrictions on asset composition prevented
banks from making long-term business loans.
Informal renewals of short-term loans, implying guarantees of continuing credit, reconciled theory and the
necessity to meet business demands for longer-term
credit. Beginning in the 1920’s with the shiftability
theory of liquidity, an atmosphere more tolerant of
E The financial market disturbances in 1974 involving bank liabilities
solicitation are treated in “Banking Developments in 1974,” Federal
Reserve Bank of Richmond, Annual Report. 1974, p. 13.

innovation was introduced and prevailed.
Term
lending began in 1933 and then grew rapidly, one
result of which was to purge loan commitment practices of those arrangements
whereby continuously
renewed short-term loans supported long-term business investment.
Term loan commitments and revolving credits were developed in this period, although they did not acquire early importance.
The liabilities management concept of liquidity
became prevalent in the 1960’s, at a time when
aggregate credit demands were growing rapidly and
as financial markets showed increasing instability.
Business demands for loan commitments as a defense
against credit shortages increased in the late 1960’s,
especially in response to the tight money episodes of
1966 and 1969, and were accommodated by banks
operating under the liabilities management framework. While the perceived needs of businesses for
defensive loan commitment arrangements may have
moderated between 1970 and 1973 as a result of the
removal of the ceilings on CD yields, the experience
of restricted CD markets and credit availability in
the summer of 1974 had the opposite effect.
The
general conditions that encourage demands for loan
commitments continue to prevail, and past experience
indicates banks will aggressively
attempt to meet
these demands.
The legitimacy of prudently managed loan commitment practices cannot be disputed, for they represent
an economically useful service. Today loan commitments are especially important to businesses as a type
of hedge against financial uncertainty.
It does seem,
however, that commercial banks and bank regulatory
authorities should modernize their thinking to keep
up with contemporary changes in the use of loan
commitments. For their part, banks should recognize
that loan commitments have become a distinct financial service and treat these arrangements accordingly.
This includes the careful monitoring of loan commitment positions as part of the overall planning process
and adoption of expanded fee schedules that fully
cover the risk exposure connected with providing
such services.
Regulatory authorities should make
an explicit determination of what constitutes appropriate bank involvement in the commitments area
and apply these standards in the examination process.
In these ways, ambiguity will be reduced, and some
assurance will be provided that loan commitments
will not occupy the position of a potential hazard to
the banking system’s stability.

FEDERAL RESERVE BANK OF RICHMOND

23

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