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Tie-in Sales and Banks
John A. Weinberg


bank is a multiproduct firm. While its products can be grouped into
two broad categories, credit and deposit services, each of these categories comprises many distinct products. In addition to these “traditional banking services,”1 some banks, either directly or through affiliated
companies, offer a wider array of financial services. A continuing trend toward
deregulation is likely to further expand the set of activities and markets open
to banking organizations.
Some of the services offered by banks are sold to distinct sets of buyers. On
the other hand, there are broad classes of bank clientele who regularly obtain
multiple services. A business firm’s relationship with a bank, for instance, may
include deposit and cash management services as well as regular extensions of
credit. The typical household is also a user of multiple bank services.
It is not uncommon for a multiproduct firm to undertake joint marketing
efforts. The costs incurred to generate sales for the various products sold cannot
always be neatly allocated across products. Such joint actions might occur in
all aspects of marketing. A seller might, for instance, seek to develop a single
brand identity for a variety of products so that expenditures on promotion of the
brand might enhance the sales of all the products. Joint efforts might also show
up in the pricing of products. For instance, a seller might give discounts on
one product that are contingent on the buyer’s purchase of some other product
from the same seller. Or a seller might choose to sell two products only as a
bundle, not separately. It is this sort of tying, or bundling of products, that has
attracted a fair amount of attention in discussions of the law and economics of

The author thanks Tom Humphrey, Tony Kuprianov, Jeff Lacker, and Ned Prescott for comments on an earlier draft. The views expressed in this article are the author’s and do not
necessarily represent the views of the Federal Reserve Bank of Richmond or the Federal
Reserve System.
1 In the context of the body of legislation and regulations discussed in this article, the phrase
“traditional banking services” refers specifically to loans, discounts, deposits, and trust services.

Federal Reserve Bank of Richmond Economic Quarterly Volume 82/2 Spring 1996



Federal Reserve Bank of Richmond Economic Quarterly

If tying is to raise concerns from an antitrust point of view, it must be that
the firm engaged in the practice has some amount of market power. This article
examines tying as a use of market power, with the goal of understanding and
evaluating restrictions that banks face with regard to such pricing behavior.
After reviewing those restrictions and comparing them to the broader antitrust
treatment of tying, the article focuses on a particular motivation for tied sales;
this pricing strategy can facilitate price discrimination among diverse buyers.
This focus suggests that the welfare implications of tying can be ambiguous
and that public policy and antitrust law should approach the practice on a caseby-case basis.

In antitrust legislation and case history, the tied sale of multiple products has
been attacked as an attempt by a seller with a monopoly position in one market
to extend its power into a second market.2 Specifically, section 3 of the Clayton
Antitrust Act makes it unlawful for a seller to make a sale on the condition
that the buyer refrain from dealing with the seller’s competitors. This section has been interpreted as a prohibition on tying contracts. For instance, in
1936 the Supreme Court found that IBM violated the Clayton Act by requiring
that lessees of its punch-card tabulating machines purchase only punch cards
supplied by IBM.
The legal treatment of allegedly anticompetitive practices typically takes
one of two forms. A particular practice might be treated as per se illegal. In
such a case, violation of the law is established simply by a demonstration that
the practice in question took place. It is also possible for the legality of a
practice to depend on the particular circumstances in the case at hand. In such
instances, a “rule of reason” is said to apply. The Court’s language in the 1936
IBM decision strongly suggested that the Clayton Act intended for tying to be
treated as per se illegal.
The uncertainty in the treatment of tying, as in many antitrust issues, revolves around the interpretation of statutes stating that a given practice is illegal
if its use may “tend to lessen competition or create a monopoly.” Such phrases,
found in most antitrust legislation and in the relevant banking legislation, leave
it to the courts to determine if a given practice can only be anticompetitive or
if there may be other, legitimate, reasons for sellers to engage in the practice.
In the general antitrust case history on tying arrangements, there has been a
movement over time from a treatment of the practice as per se illegal (or nearly
so) toward a rule-of-reason approach.
While the Clayton Act’s prohibition of tying has not been applied to
banks, the Bank Holding Company Act’s (BHCA) 1970 amendments extended a

A description of the legislative and case history are found in Seplaki (1982).

J. A. Weinberg: Tie-in Sales and Banks


similar prohibition to banking organizations.3 This restriction, contained in section 106 of the amended BHCA, was introduced in an environment in which
banks were being given the power to expand into new activities; Congress
therefore may well have been reacting to a fear that banks would use restrictive
contracts to monopolize new markets.4
The prohibition of tying arrangements in the BHCA is quite stringent.
While there are some broad classes of exemptions, little room is left for considering the specific conditions arising in a case that does not fall into one of
those broad classes.5 For instance, there is, in general, no consideration given to
the competitive conditions prevailing in the markets for the products involved.
In other words, the BHCA rules seem to treat tying as a practice that is per se
illegal, so that the legal rules governing tying by banks are at least as rigid as
the more general rules contained in the Clayton Act.6
The Federal Reserve Board has recently expanded the set of exemptions.
In 1995, the Board allowed bank and nonbank subsidiaries of bank holding
companies to offer discounts to customers maintaining minimum combined
balances across the affiliates’ products. More recently, the Board has allowed
banks to require some credit card customers to maintain deposit balances at
affiliated thrifts.7 There remain, however, broad classes of activities to which
a strict prohibition of tying still applies. This is particularly true of the tying
of a bank’s product to a nonbanking product of the bank’s affiliate.
The treatment of tying as an anticompetitive practice is based on the idea
that a seller with monopoly power in one market can leverage that power into
an advantaged position in a second market (one in which it faces competition).
In this scenario, the good for which the seller is a monopolist is referred to as
the tying good, while the other good, for which there are competing sellers,
is the tied good. The seller, then, might make a discount on the tying good
available only to those buyers who also purchase the tied good from him.8
His position as a monopoly seller of the tying good enables him to charge a
premium for the tied good. In this manner, the seller gives up some of his
monopoly profits in exchange for being able to earn greater-than-competitive
profits in the second market.

3 While the 1970 amendments referred to tying by banks, the same restrictions have been
applied to BHCs and their nonbank subsidiaries and to non-BHC affiliated depository institutions
as well.
4 Shull (1993) makes this point with reference to the legislative history.
5 Section 106 allows tie-ins when both products are “traditional banking products” offered
by a bank (as opposed to nonbank affiliates within a holding company).
6 This comparison is made by Shull (1993).
7 American Banker, April 15, 1996.
8 It is worth noting that the selling of two goods only as a bundle can be seen as an extreme
case of tying, in which the tying good is only available to those who buy the tied good and the
prices of the two goods are not quoted separately.


Federal Reserve Bank of Richmond Economic Quarterly

An extreme form of the leverage argument holds that, through a strategic
use of tying arrangements, a seller can deter potential entrants from even trying
to compete in the market for the tied good. In this view, tying is not just a
use of monopoly position in one market but is, further, a way of creating a
monopoly position in another market. This extreme form of leverage is referred
to as foreclosure.
If leverage or foreclosure were the only possible motivations for tying
provisions, then per se illegality of the practice would be justified. A great deal
of commentary on tying, however, has identified a number of other possible
motivations. For instance, a seller may profitably make use of tying the sale of
two products that are complements in production or consumption. Two goods
are complements in production if the marginal cost of producing one good is
less if the other good is produced by the same firm. There is complementarity
in consumption between two goods if a buyer’s willingness to pay for one good
is enhanced by the consumption of the other.9
When there are complementarities between two products, the monopolist
seller of one product has a natural advantage over competitors of the other
product. It is not clear that the seller needs to use a tying arrangement to benefit from that advantage. Complementarities will allow the seller to be a more
aggressive competitor in the nonmonopoly market, even if the two products are
priced independently. Hence, complementarities alone may not be enough to
justify tying arrangements. On the other hand, if the seller enjoys cost complementarities from providing two goods to a particular buyer, then bundled sales
of the two products may be the best way for the firm to realize the potential
cost savings.
Another justification for tying is that it allows the seller to price discriminate among the buyers of the monopolized product. By offering different prices
for customers who buy different combinations of goods, a seller can separate
buyers according to their demand characteristics in a way that might not be
possible with independent pricing of all goods. This discrimination allows the
seller to increase profits by extracting greater revenue from those buyers who
are most willing and able to pay. When tying is used to facilitate price discrimination, its overall effect is typically to reduce the economic efficiency
cost of monopoly power. This conclusion derives from the fact that tying two
products tends to increase the quantity sold of the monopolized (or more monopolized) product. Consequently, the justification for an absolute rule against
such practices is weakened, even in the absence of obvious cost or demand

9 White (1995) provides a discussion of tying by banks when their products are linked by
demand-side complementarities.

J. A. Weinberg: Tie-in Sales and Banks


The next section presents a discussion of tying as price discrimination by
a multiproduct monopolist. The following sections then discuss the effect of
introducing competition for one of the products and the implications of interpreting the monopolized product as a banking product. The banking product
chosen for this discussion is small business lending. This may be one area of
operation in which some banks continue to exercise market power sufficient
to raise questions about the possible competitive effects of tying. It is also an
area in which some have expressed concern about the effects of continuing consolidation in the banking industry. For instance, Berger, Kashyap, and Scalise
(1995) have suggested that one effect of consolidation will be a decline in the
availability of credit to small business borrowers. One implication of such a
decline might be that certain lenders would enjoy increased market power over
their small business borrowers. If so, questions concerning how banks use what
market power they might possess would become increasingly important.
A last reason to focus on small business lending is that what little private
litigation there has been under the BHCA’s restrictions on tying has almost exclusively involved small business lending.10 In most of this litigation, the courts
have found no violation of anti-tying statutes, often because both the tying and
tied products were “traditional banking products.” Such a case fits into the broad
exemption allowed by the rules. One might question, however, whether there
is any meaningful economic difference between traditional banking products
and others. Possibly one is more likely to find demand and cost complementarities among banking products. For products more remotely related, perhaps
some other motivation is more likely. The above discussion focuses on two
possibilities: the extension of market power or price discrimination. These two
motivations have very different implications for the effects of tying on overall
economic welfare.

Questions concerning the possible anticompetitive effects of tying or bundling
clearly require an analytical framework that includes a theory of interfirm competition. To the extent that tying is primarily a tool for price discrimination,
however, a model of competition is not necessary for understanding the basic
mechanics of the practice. To this end, this section presents a model of a
seller that is a monopolist in two markets. This model follows the analysis first
developed in Adams and Yellen (1976).
The monopolist in this model faces an array of potential customers who
are differentiated in terms of the value that they place on the two products.
Specifically, if the goods are labeled a and b, a typical buyer places a value
of va and vb on the consumption of the goods. Each buyer consumes at most

See Shull (1993).


Federal Reserve Bank of Richmond Economic Quarterly

one unit of each good. Hence, if an individual buys both goods, that individual
enjoys net utility of va vb e, where e is the total expenditure made purchasing
the two goods. If the goods are priced independently, then e pa pb , while
if they are sold as a bundle, e is the price of the bundle.
Each potential buyer is represented by a pair of valuations (va , vb ). Hence,
the population as a whole is characterized by a cumulative distribution function
F(va , vb ), giving the fraction of potential buyers who have valuations for both
products that are less than the specified values (va , vb ). Treating one good in
isolation, the marginal distribution of buyers’ valuations of good a is denoted
by Fa (va ). This function gives the fraction of the population whose valuation
of product a is less than the specified value. The marginal distribution, Fb (vb )
has a similar definition.
One possible simple assumption about these distributions is that va and
vb are uniformly and independently distributed on the interval from 0 to 1.
Uniformity means that the fraction of buyers who place a value on product a
of at least v is equal to 1 v, for all v between 0 and 1 (and similarly for
product b). Independence means that this distribution of va is the same for any
given level of vb .
The distribution of buyers’ valuations plays a central role in determining
the relative values to the seller of alternative pricing strategies. In fact, as
Adams and Yellen demonstrated, general results are difficult to obtain. Some
broad insights about the use of bundled pricing can be obtained without making
specific assumptions about the distribution of valuations, while the simple assumption of independent, uniform distributions may also be useful in thinking
about the basic problem facing the seller.
Suppose first that the seller prices the two products separately. For each
good, the seller faces a downward sloping demand curve given by the marginal
distribution of buyer valuations. At a price of pa , the firm will sell product a
to all buyers with va pa . There are N(1 Fa (pa )) such buyers, where N is the
total number of potential buyers. Hence, as price rises, sales fall. In the case of
the uniform distribution, the relationship between sales, xa , and price is simply
xa (1 pa )N.
Facing these demand curves, the seller sets a profit-maximizing price for
each product. Assume that the marginal cost of producing a unit of each product is zero, so that the profit-maximizing price for each product is simply that
which maximizes revenue.11 These unbundled prices, denoted by pu (i a, b),
effectively divide the population of buyers into four groups, as depicted in
Figure 1. Each buyer’s identification is a (va , vb ) pair, with the maximum value
of va (vb ) given by va(¯ b ). The box labeled A in Figure 1 contains all buyers
¯ v

11 An equivalent assumption is that the lowest possible buyer’s valuation for each product
is at least as great as its marginal cost of production.

J. A. Weinberg: Tie-in Sales and Banks


Figure 1 Independent Pricing and Pure Bundling










va + v = pu + p b
Independent pricing by a two-product monopolist divides the
market into those that buy a only (A), b only (B), both goods (C),
and neither good (D). Pure bundling divides the market along the
(dashed) diagonal. Those above the diagonal buy the bundle, and
those below do not.

for whom va
pu and vb
pu . All of these buyers purchase only product
a. Similarly, box B contains the valuations of all buyers who purchase only
product b. Box C gives the buyers who purchase both products, while box D
gives those who purchase nothing.
If instead of selling the products separately the seller decides to offer them
only as a bundle, the population of buyers divides into two groups: those who
buy the bundle and those who do not. The boundary between these two groups
is made up of all buyers for whom va vb
e. Such an equation would be
represented by a line with a slope of minus 1, as shown by the dashed line
in Figure 1. This is the line for which e
pu pu . With this price for the
bundle, all buyers with valuation pairs to the northeast of the dashed line buy
the bundle, while those to the southwest do not.


Federal Reserve Bank of Richmond Economic Quarterly

Figure 1 is drawn for the special case of independent, uniform distributions.
In this case, each of the four areas (A,B,C,D) represents the same number of
buyers. This special case also has the property that the dashed line cuts areas
A and B in half. Under these particular conditions, the revenue generated by
selling the goods independently at prices pu and pu is identical to that genera
ated by selling only bundles at the price e pu pu . To see this, note that in
switching from separate to bundled pricing revenue collected from area C is
unaffected. In area A, half the buyers switch from buying only a at price pu
to buying nothing, and the other half switches from buying only a to buying
both for the bundled price. Given the symmetry in this special case, the lost
sales of good b are exactly offset by the increased sales of good a. The effect
on area B parallels that on area A.
The equivalence of the revenues under the two pricing practices in Figure
1 demonstrates that bundled pricing is at least as profitable as independent
pricing, since pu and pu are the revenue maximizing independent prices. This
comparison, however, does not establish that e pu pu is the optimal buna
dled price; bundling may be strictly preferred. In fact, if one considers a more
general class of pricing practices, then the seller can certainly do better than
independent pricing. In particular, the seller can set both the price for the
bundle of goods (e) and the prices for the goods sold separately (pa and pb ).
Note that this mixed pricing policy is distinct from independent pricing only
if e pa pb . Otherwise, buying the bundle is never preferred to buying the
goods separately. To see that profits can be increased by a mixed pricing policy,
suppose the seller leaves the price of the bundle at eu pu pu and sets a price
for good a alone just below va . The effects of this mix of prices are shown
in Figure 2. Sales of the bundle are the same as in the bundled pricing case
of Figure 1, except for the shaded box at the top left-hand corner. This box
gives the valuations of buyers who purchase only good a at price pa . All other
buyers above the diagonal purchase the bundle.
Given the symmetry of the case depicted in Figures 1 and 2, the buyers of
a alone can be divided into two groups of equal size. Those above the diagonal
would buy the bundle if a were not separately available, while those below
the diagonal would otherwise buy nothing. On sales to the former, the seller
loses revenue of eu and gains revenue of pa (per buyer). On the latter, the seller
gains pa . Since there are the same number of buyers in each group, the net
change in revenues is proportional to 2pa eu . This change is positive under
the assumptions of this case. Setting a high separate price for product b can
generate a similar gain.
The mixed pricing strategy described above is very close to observed tying
practices, as they are usually described. The seller makes product a available
at the relatively low price of pu , but only if the buyer also purchases b for
pu . Otherwise the buyer must pay the higher price for a. This is a profitable
strategy, because it allows the seller to extract different revenues from buyers,

J. A. Weinberg: Tie-in Sales and Banks


Figure 2 A Tied Discount for Good a







va + vb = e

Buyers in the shaded box in the upper left-hand corner buy
only product a at price p a . All other buyers above the
diagonal buy the bundle at price e = pu + pu .

based on their valuations. In other words, it allows the seller to more finely
sort buyers according to their willingness to pay.
While the analysis of the special case depicted in Figures 1 and 2 demonstrates the nature of the gains that a monopolist can generate by selling two
products jointly, it is hard to draw general conclusions from the specialized assumptions regarding costs and the distributions of buyers’ valuations. Indeed,
Adams and Yellen provide examples in which pure bundling is more profitable
than independent pricing and other examples in which the reverse is true.
The literature that has followed Adams and Yellen, as surveyed by Varian
(1989), has produced some more general conclusions. For instance, a mixed
strategy, like the one described in Figure 2, will be more profitable than independent pricing if the valuation distributions of the two products are independent.


Federal Reserve Bank of Richmond Economic Quarterly

Note also that mixed bundling is always preferred to pure bundling, as the
latter is a special case of the former.
The two figures show by example how the profit-maximizing independent
prices for two goods might be improved upon by some form of joint pricing.
The figures do not show the profit-maximizing bundled pricing configuration
(pure or mixed). The typical optimal pricing structure will include prices for
the goods purchased separately that are no lower than the independent monopoly prices and a price for the bundle that is no greater than the sum of the
independent monopoly prices. Such a pricing structure rewards those buyers
with relatively high valuations for both products and imposes a high price on
those with a high valuation of one product and a low valuation of the other.
Hence, bundling benefits the seller and some consumers while hurting other
consumers. The sum of all buyers’ consumer surplus and the seller’s profit
is typically increased by (mixed) bundling relative to independent pricing.12
Hence, bundling reduces the dead-weight loss from market power.

The above discussion shows that a seller with monopoly power in the markets
for two goods can benefit from a pricing strategy that gives preference to buyers
who purchase both products. This gain to the seller is independent of any effect
of the pricing practice on competition, actual or potential. The concerns that
have led to legal restrictions on tied pricing arise from the possibility of such
competitive effects. Can the monopolist seller of one product foreclose the
market for another product to competitors by tying the sale of the two products
together? The answer to this question appears to depend on the nature of the
competition in the second market.
As a first approach to the problem of tying in the presence of competition,
suppose that one of the markets, that for product b, is perfectly competitive.
That is, suppose that there is a perfectly elastic supply of product b at the
price pb cb , where cb is the (constant) marginal cost of producing the good.
The monopolist seller of product a can choose to participate as well in the
competitive market. If the monopolist sells both goods and prices them independently, then the population of buyers is divided as in Figure 3. Buyers with
pu purchase good a, while those with vb
cb purchase good b. Some
fraction of the latter sales goes to the monopolist, but he earns no profits on
this competitively priced good. Assuming, as before, that the marginal cost of
producing product a is zero, the monopolist’s profits are equal to the revenues
from selling a.

The consumer surplus enjoyed by a buyer who purchases only good a(b) is
va pa (vb pb ),
while one who buys the bundle receives surplus of va vb e.

J. A. Weinberg: Tie-in Sales and Banks


If the monopolist offers the two goods only as a bundle for a price of e,
he can guarantee his market for b by forcing anyone seeking good a to also
obtain b. Can he profit by doing so? Buyers will prefer the bundle to buying
nothing if va vb
e. They will prefer the bundle to buying only b at its
competitive price if va vb e vb cb , or va e cb . The sales resulting
from a particular value of e are given by the area above the shaded area in
Figure 3. For each unit of the bundle sold at price e, the monopolist earns net
revenues of e cb . The total net revenues from these sales, then, can be no
greater than the net revenue from selling a alone at a price e cb . The latter earns

Figure 3 Tying by a Product a Monopolist when Market b is
Perfectly Competitive






va + v = e
All buyers in the shaded area buy the bundle at price e. Buyers
below the shaded area and to the right of cb buy product b at
the competitive price c b .



Federal Reserve Bank of Richmond Economic Quarterly

the same net revenue per sale, but on a larger volume of sales. Since the price pu
maximizes revenues (and profits) from selling a alone, the monopolist cannot
increase profits by tying the sale of two goods when there is a competitive
market for the tied good b.
A perfectly competitive market leaves no buyers unserved for whom the
value of the product exceeds its cost. Hence, the seller of the monopolized
good has no room to price discriminate among buyers according to the mix of
willingness to pay for the two goods. If, instead, the market for product b is
characterized by imperfect competition, the monopolist seller of product a may
find tying to be a profitable pricing strategy. Here, the monopolist’s optimal
strategy depends on the price set by the competitors in market b. Suppose
this price is pb
cb . The monopolist’s problem is essentially the same as
that depicted in Figures 1 and 2. Given the price pb , the seller can act as a
monopolist toward the set of buyers with vb
pb and va
va . Hence, it is
certainly possible that, given a competitor’s price, the seller’s optimal response
is to tie the sale of the two products.
Of course, the actual pricing structure chosen by the monopolist is the
result of the strategic interaction between that firm and its competitors in the
market for product b. If product b is homogeneous across sellers, then the
resulting equilibrium price may be no different from the perfectly competitive
price. For tying to be valuable to the monopolist, competition in the market
for the tied good must be such that, in equilibrium, competitors’ prices exceed
marginal cost.
Whinston (1990) examines a model in which the market for the tied good
is a duopoly, with the two sellers’ products being imperfect substitutes. In that
setting, tying can be profitable for the reasons outlined above; the tying seller
acts as a multiproduct monopolist on the market for the tying product and the
residual market for the tied product, given the competitor’s actions. Whinston
shows further that, in the presence of fixed costs, tying can reduce the competitor’s prospective profits and thereby induce the competitor to withdraw from
the market.
Whinston’s market preemption result comes close to the concerns that seem
to have motivated the antitrust treatment of tying; monopolists might be able
to extend their monopoly power into new markets by reducing the profit opportunities of their rivals. Even here, however, the consequences of tying for
overall economic welfare are ambiguous. Market preemption is a side-effect
of the seller’s desire to price discriminate among heterogeneous buyers.13 This

13 Whinston identifies conditions under which preemption of a rival’s market opportunities
does operate independently from the price discrimination effects of tying. This case requires that
the monopolist be able to precommit (before the rival incurs fixed costs of entering the market)
to offering the goods only as a bundle. Absent the price discrimination benefits, the seller would
break that commitment if given a chance.

J. A. Weinberg: Tie-in Sales and Banks


price discrimination, as above, has a tendency to be welfare-enhancing since
it typically increases total sales of the products. Working against the price
discrimination effect may be the effect of reducing the output of rivals in the
market for the tied good. Certainly tying produces gains for some buyers and
sellers and losses for others, but the overall effect cannot be determined in
Note that the two products in the model can be given the interpretation of
the same good at different points in time. Under this interpretation, “tying” may
appear as the use of a long-term contract by a seller with initial market power
to deter entry by future potential competitors. As with the general case of tying
with imperfect competition, this arrangement has both a competitive effect and
a price discrimination effect; offering long-term arrangements together with
unbundled “spot” prices at each point in time allows the seller to discriminate
among buyers with differing patterns of preferences for the good over time.

Banks engage in many types of joint pricing or bundling of products. Depositors who maintain a minimum balance might receive free checking or other
services at reduced or no fee. A borrower might be asked to keep compensating
balances on deposit at the bank. Many such practices might be driven primarily
by cost complementarities between the products. For instance, the probability
of incurring the costs of dealing with a check drawn on an account with insufficient funds is lower the greater the balance is in an account. It is also
possible that such practices achieve a certain amount of price discrimination.
Recall, however, that price discrimination is a way in which sellers increase
their gains from monopoly power. This use of market power is quite different
from that envisioned by the market foreclosure view, under which power in
one market is used to create power in a second market. In both of these views,
however, tying is an activity undertaken by a seller with market power.
The adoption of tying restrictions in the 1970 BHCA amendments was a
response to a concern that the granting of expanded powers to banks would
enable them to gain an unfair advantage in the new markets they entered. This
advantage would come from the ability of banks to tie new products to products
in their traditional markets, in which they were shielded from competition by
an array of legal restrictions. Since that time, however, financial innovation
and deregulation have eroded the advantaged position and power over prices
enjoyed by banks in many of the markets in which they participate.14


The changes experienced by banking are surveyed in Berger, Kashyap, and Scalise (1995).


Federal Reserve Bank of Richmond Economic Quarterly

One area in which banks may continue to hold market power is in small
business lending. Changes in the financial system over the last few decades
have opened new options and sources of funds to larger firms. Small firms,
however, have remained relatively bank-dependent. Small business lending,
then, might be a product for which the price discrimination effects of tying are
potentially significant.
To treat one of the products in the model presented above as the extension
of credit, some slight modification is necessary. Specifically, suppose that there
is a set of potential borrowers, each of whom seeks a loan of a fixed size,
say $1. With a probability of , a borrower successfully produces revenues to
repay the loan. Otherwise, the borrower produces nothing and defaults on the
loan. For simplicity, suppose that all borrowers have the same probability of
success, , but that they differ in the revenue they will generate if successful.
This revenue, y, is distributed between 0 and y.
A monopolist lender in this market would set a loan price, R (payment due
outside of default), to maximize profits given its cost of funds, r. This lender
faces a downward sloping demand curve for credit, since for any price, R, all
borrowers with y R will seek loans.
To analyze the effect of tying between credit and a second product, assume
that the lender is one of two providers of product b and that this product is
differentiated across sellers. Product differentiation allows a precise specification of the product b demand that the lender faces, given the other firm’s price.
Specifically, one can imagine that the two sellers are located at the endpoints
of a line interval. The lender is located at point 1 and the rival at point 0. This
spatial differentiation can have literal geographic interpretation; the sellers’
stores are at two different locations. Alternatively, the differentiation can be
in terms of some characteristic of the product. In either case, assume that a
consumer’s preferences between the two varieties of product b is given by the
consumer’s location on the same line interval (between zero and one).
A buyer located at point x incurs a cost of t(1 x) when obtaining product
b from the lender and a cost of tx in obtaining the product from the other seller.
Hence, the net value to a buyer purchasing from the lender at a price of pb
is v
t(1 x) pb
wb (x, pb ). If, instead, the same buyer buys from the
competitor at a price of pc , the net value is (v
tx pc ) wc (x, pc ).
In Figure 4, credit takes the place of product a from the earlier figures.
Accordingly, the vertical axis measures y, the revenue generated by a successful
borrower. The horizontal axis gives a borrower/consumer’s location with regard
to product b; buyers further (horizontally) from the origin have a greater relative
preference for the lender’s variety of product b.
The monopolist lender’s optimal unbundled price of credit is denoted Ru ,
while the competitive price is r/ . Both the lender and a competitor sell product
b. The competitor’s price is set at pc , in response to which the lender sets an

J. A. Weinberg: Tie-in Sales and Banks


Figure 4 Tying the Extension of Credit to the Sale of a
Differentiated Product

( t + e - p ) /φ














φ y + 2tx = t + e - pc
With independent pricing, pb = p b , and each consumer buys product
b from the closest seller. Therefore, all buyers with x > 1/2 buy from
the lender, while those with x < 1/2 buy from the competitor. Loans
are made to all with y > R u. With a tied discount for credit, buyers in
IV, V, VII, IX, and XII obtain the bundle at price e. All others buy b
from the competitor, with those in I and II obtaining unbundled loans
at price R .

unbundled price of pu .15 Given these prices, all buyers with wb (x, pu )
wc (x, pc ) buy b from the lender, while all others buy from the competitor.16
Given prices pu and pc , all buyers with x
(pu pc )/2t purchase from
15 As mentioned earlier, fixing the competitor’s price abstracts from the form of strategic
interaction in market b. Although the actual price levels depend crucially on this interaction, many
of the qualitative characteristics of tied pricing are independent of the equilibrium level of prices.
16 This section includes the additional assumption that v is big enough (and/or t is small
enough) that all buyers purchase product b from someone.


Federal Reserve Bank of Richmond Economic Quarterly

the lender, and those with x below this level purchase from the competitor. In
the credit market, all buyers with y Ru take out loans.
The division of the market with unbundled pricing, as shown in Figure
4, reflects the (unique) symmetric price equilibrium in the market for product
b (pu
pc ). Accordingly, all buyers with x
( ) 1/2 buy from the lender
(competitor). With unbundled pricing, loans go to all buyers in the areas with
the following labels in Figure 4: I, II, III, IV, V. Buyers in areas I, II, III, IV,
VI, VII and X purchase b from the competitor, while those in V, VIII, IX, XI,
and XII purchase from the lender.
The lender can tie the extension of credit to sales of product b by setting
two loan prices, R and RT R , and making the lower price available only to
borrowers who purchase b at the price pT . In comparing the option of buying
the tied products to other options, it is often useful to focus on the expected
total payment, e
RT pT . The bundle has net value to a particular buyer
of y v
t(1 x) e. Buyers have two other options, beside buying the
bundle at price e. A buyer can purchase b from the competitor and either not
obtain credit, or borrow at the unbundled price of R .17 With no credit, such
a buyer earns net value of wc (x, pc ), and with credit, the buyer’s net value is
wc (x, pc )
Buying the bundle at price e is the most preferred option for all buyers
with x
(e pc
y)/2t and x
(e pc
R )/2t. These buyers
are all those in areas IV, V, VII, IX, and XII in Figure 4. All others buy b from
the competitor, while those in areas I and II also receive unbundled credit.
Figure 4 assumes that the competitor’s price for product b does not depend
on whether the lender is tying or pricing independently. While the figure is
drawn to capture equilibrium when the lender prices independently, the competitor’s pricing behavior is likely to be different when the lender offers a bundle
instead. Rather then showing an equilibrium in this case, the figure shows how
the lender’s adoption of a tied pricing strategy affects buyers’ decisions for a
particular price of the competitor’s product. The equilibrium, however, would
share the important qualitative characteristics of Figure 4.
While the actual prices chosen depend on demand and cost conditions as
well as on strategic considerations, the figure is drawn to capture some general
tendencies. Foremost among these is that sales of the tying good (credit in
the present case) tend to be higher than under independent pricing. Added
extensions of credit are represented by the areas VII, IX, and XII. On the other
hand, loans that would be made under independent pricing but are not made
under tied pricing are represented by area III.18
17 Again, the maintained assumption is that preference parameters are such that all buyers
purchase product b.
18 Note that equating areas to sales assumes a more-or-less uniform distribution of buyer
characteristic pairs (y, x).

J. A. Weinberg: Tie-in Sales and Banks


As is typically the case, tying tends to increase the overall welfare (surplus)
of borrowers with high credit quality who also place a high value on the tied
product. Customers who place a high value on one product and a low value
on the other see their well-being decline from tying. This is true, in particular,
of those who obtain credit at the high, unbundled price (areas I and II). As
discussed above, the effect of tying on overall economic welfare is difficult
to determine, since these effects depend on the strategic interaction among the
sellers of the tied good.
In Figure 4, an important aspect of the effect of tying is the distribution
between the two rivals of sales of product b. With unbundled pricing, this
market is divided evenly, with the marginal buyer (who is just indifferent be1/2. This division of buyers minimizes
tween the two sellers) located at x
the total “transportation” costs in the market, where buyer x’s transportation
cost is t(1 x) if buying from the lender and tx if buying from the competitor.
With the market divided at 1/2, each buyer goes to the “closest” seller. Tying
introduces a distortion into this market. In Figure 4, buyers in areas IV and
VII obtain b from the lender, even though they are “closer” to the other seller.
Similarly, buyers in areas VIII and XI incur extra transportation costs in buying
b from the competitor. Hence, while tying may result in an increase in total
extensions of credit, reducing the social cost of monopoly power in the credit
market, this positive effect may be offset by the increased transportation costs
in the market for the tied good.
Tying has some interesting implications for the allocation of credit. Note
first that there are some creditworthy borrowers who do not receive loans. These
borrowers appear in areas III, VI, and VIII. Many of these borrowers, however,
also would not receive loans under independent pricing. This limitation on the
extension of credit is merely the result of the assumed market power in the
loan market. Indeed, there are also borrowers (areas VII, IX, and XII) who
are excluded under independent pricing but not under tying. This set may even
include borrowers who are not creditworthy when loan terms are considered in
isolation from the rest of the customer relationship (area XII). Borrowers for
whom y
r/ would not receive loans if credit were independently and competitively priced; these are borrowers from whom maximum expected return is
less than the cost of funds. Nevertheless, these borrowers’ willingness to pay
for product b is high enough to make it profitable for the lender to maintain a
multiproduct relationship with them.
An outsider, viewing the credit decisions made by the bank in isolation
from the rest of the bank’s customer relationships, might conclude that the
bank was making unsound loans. Even worse, the bank appears to be making
some unprofitable loans while profitable opportunities are left on the table.
Such a view, however, would be misleading, because it does not evaluate the
bank’s activities as a whole. In a multiproduct business, the isolated evaluation
of parts of the product line can give a distorted view of the whole.


Federal Reserve Bank of Richmond Economic Quarterly

How might the analysis of tying by a bank change if one recognizes banks’
unique status as issuers of liabilities insured by the government? In terms of
Figure 4, one might simply interpret deposit insurance as a subsidization of
the lender’s cost of funds, r. While it is true that tying results in a riskier
loan portfolio, those risks should not necessarily be of concern to the deposit
insurer. From the point of view of the safety and soundness of the entire bank,
the increased risks in the loan portfolio may be offset by increased profits in
the sale of the tied good.

The U.S. banking industry is in the midst of a period of dramatic change.
Interstate banking is likely to give further impetus to the ongoing trend toward
consolidation. Some have expressed the concern that this trend will work to the
disadvantage of the most bank-dependent class of borrowers, small businesses.
If this fear is justified, it must in part be so because consolidation will increase
the market power enjoyed by at least some banks with regard to their small
business borrowers. One step that might prevent such a decline in credit might
be to ease the restrictions that banks face on the joint marketing of “bank”
and “nonbank” products. When such joint marketing takes the form of tied
pricing, its effect is often to expand sales of the products over which sellers
enjoy market power.
When tying is used as a means of practicing price discrimination, it serves
as a method by which businesses seek to maximize the benefits from whatever natural (comparative) advantage they may have over competitors. The
statement holds true when tying is used to take advantage of cost or demand
complementarities between products. On the other hand, the antitrust concern
with tying is that it could be used by a seller with a natural advantage in one
market to create an unnatural advantage in another market. It is only in this last
case that tying increases the social cost of monopoly power. A broad restriction
on banks’ ability to jointly market multiple products will certainly prevent uses
of tying that have anticompetitive effects as well as many that do not. An
alternative approach is to grant banks broad discretion in their entry into new
markets, with anticompetitive practices to be guarded against by litigation on a
case-by-case basis. This approach would make the treatment of tying by banks
consistent with the modern antitrust perspective on such practices.

J. A. Weinberg: Tie-in Sales and Banks


Adams, William James, and Janet L. Yellen. “Commodity Bundling and the
Burden of Monopoly,” Quarterly Journal of Economics, vol. 90 (August
1976), pp. 475–98.
Berger, Allen N., Anil K Kashyap, and Joseph M. Scalise. “The Transformation of the U.S. Banking Industry: What a Long, Strange Trip It’s Been,”
Brookings Papers on Economic Activity, 2:1995, pp. 55–218.
Seplaki, Les. Antitrust and the Economics of the Market. New York: Harcourt
Brace Jovanovic, Inc., 1982.
Shull, Bernard. “Tying and Other Conditional Agreements under Section 106
of the Bank Holding Company Act: A Reconsideration,” The Antitrust
Bulletin, vol. 38 (Winter 1993), pp. 859–86.
Varian, Hal R. “Price Discrimination,” in Richard Schmalensee and Robert
D. Willig, eds., Handbook of Industrial Organization. Amsterdam: NorthHolland, 1989.
Whinston, Michael D. “Tying, Foreclosure, and Exclusion,” American Economic Review, vol. 80 (September 1990), pp. 837–59.
White, Lawrence J. “Tying, Banking, and Antitrust: It’s Time for a Change,”
Contemporary Economic Policy, vol. 13 (October 1995), pp. 26–35.

Sterilized Foreign Exchange
Intervention: The Fed
Debate in the 1960s
Robert L. Hetzel


n early 1962, the Federal Reserve System (the Fed) began to buy and sell
foreign currency. The decision to intervene in foreign exchange markets
was controversial and generated considerable internal debate. The debate
involved the fundamental issue of the Fed’s independence from the Treasury.
The Treasury has primary responsibility for official foreign exchange operations
in the United States. Hence, participation with the Treasury in foreign exchange
operations could jeopardize Fed independence. Moreover, the Federal Reserve
Act safeguards this independence by requiring that acquisition of Treasury debt
by the Fed be done in the open market, that is, at the Fed’s discretion rather
than at the behest of the Treasury. The practice of acquiring foreign exchange
directly from the Treasury in support of the Treasury’s operations could erode
that safeguard.
Former Secretary of the Treasury George Shultz (Shultz and Dam 1978,
p. 9) stated flatly, “. . . the Fed takes direction from the President, through
the Treasury Department, on international monetary affairs.” Stephen Axilrod
(Burk 1992, p. 41), formerly Staff Director for Monetary and Financial Policy
at the Board of Governors, noted
. . . there is a deep distinction in the U.S. (unlike the U.K.) between international and domestic monetary policy: the Fed is totally and utterly independent
when making a domestic monetary policy decision; not only is there no clearance with the Treasury—to attempt it would cause a constitutional crisis.
The international arena is more complicated: here the Fed’s independence
is unknown and has not been fully tested, but in practice it is limited. The
Treasury controls international finance.

The opinions expressed herein are the author’s and do not necessarily represent those of the
Federal Reserve Bank of Richmond or the Federal Reserve System.

Federal Reserve Bank of Richmond Economic Quarterly Volume 82/2 Spring 1996



Federal Reserve Bank of Richmond Economic Quarterly

The debate also dealt with whether the Federal Reserve Act authorized
the Fed to transact in foreign exchange. This article reviews the debate and
briefly addresses subsequent developments. As background, the article begins
with a brief historical overview of the Bretton Woods system and the Treasury’s
Exchange Stabilization Fund.

In 1962, the United States was part of the Bretton Woods system. That international monetary arrangement attempted to recreate key parts of the gold
standard, which had collapsed in the Depression. Member countries other than
the United States pegged their currencies to the dollar. The United States agreed
to maintain convertibility of the dollar to gold at the rate of $35 per ounce. As
required by the Federal Reserve Act, before 1968 Federal Reserve notes were
collateralized in part by gold.
If the United States ran a balance of payments deficit and lost enough gold,
the Fed would have to contract the money stock. According to the classical view
of the gold standard, a reduction in the money stock would reduce the price
level and make U.S. goods cheaper to foreigners, who would increase their
purchases of U.S. goods. The resulting decline in the external deficit would
end the gold outflow. Under the Bretton Woods system, as under the classical
gold standard, the price level was supposed to adjust to achieve balance in the
country’s external accounts.
By early 1959, the currencies of the countries in the European Economic Community had become fully convertible into the dollar (for current
account transactions). (This review draws on Coombs [1976], Roosa [1967],
and Solomon [1982].) These countries, however, established exchange rates
that overvalued the dollar (made U.S. goods too expensive). Consequently, the
United States ran a significant, persistent balance of payments deficit. Foreign central banks financed part of the U.S. payments deficit by accumulating
dollars, and foreign investors financed part of it by willingly holding dollar
assets. However, between 1959 and 1961, the U.S. Treasury had to finance the
remainder of the deficit through sales of gold to foreign central banks. Countries
relying on the United States for defense (Germany, Japan, and Italy) refrained
from gold purchases. Other countries (like Belgium, the Netherlands, and Great
Britain) were fearful of being caught with a devalued dollar in their portfolios
and enforced the Bretton Woods discipline by asking the U.S. Treasury for
gold. By the end of 1960, U.S. gold losses had become front-page news in
papers like The New York Times.
In the early 1960s, monetary policymakers walked a tightrope requiring
them to balance internal and external objectives. The 1960 recession pushed
U.S. short-term interest rates below those in Europe. That difference in rates

R. L. Hetzel: Sterilized Foreign Exchange Intervention


spurred a capital outflow, widened the payments deficit, and aggravated the
loss of the Treasury’s gold reserve. While in the middle of the 1960 presidential campaign, the country faced both a domestic recession and a balance of
payments deficit, each requiring conflicting policy responses.
In 1954, Britain had reopened the London gold market. By 1960, it had
acquired a status comparable to the long-term bond market of today. Quotations
for the price of gold were a “barometer of confidence in both the gold-dollar
parity and the Bretton Woods system generally” (Coombs 1976, p. 14). Through
most of the 1950s, sales of gold by South Africa and the Soviet Union had
kept the free market price at $35 per ounce. In 1960, however, the concern
arose in Europe that a Democrat might win the U.S. presidency and pursue
expansionary domestic policies.
On October 20, 1960, the London gold price suddenly shot up from close
to $35 an ounce to $40 an ounce. That created an arbitrage opportunity for
foreign central banks willing to sell gold in London and replace it by asking
the U.S. Treasury for gold. The Treasury decided to maintain the $35 price of
gold in the London market with gold sales. On October 31, 1960, candidate
John Kennedy promised that if elected he would maintain convertibility at the
$35 parity. Later as the President, in his February 6, 1961, message on the
balance of payments, he promised that the $35 price of gold was “immutable.”
The immediate crisis passed, but the drain of gold continued as Kennedy took
office in January 1961, and the position of the dollar remained precarious.
The Federal Open Market Committee (FOMC) Minutes in 1961 reveal a
persistent concern over the U.S. balance of payments deficit, offset by a concern
for unemployment. For example, the Minutes (Board of Governors 1961, pp.
935–36) paraphrase one governor:
Mr. Mitchell noted that the Chairman of the Council of Economic Advisers
had said recently that if unemployment did not decline, it would be up to the
Administration to create jobs. However, he (Mr. Mitchell) felt that it would
be better if the private economy could be persuaded to create jobs. Monetary
policy should do whatever it could to make this possible. . . . Foreigners
wanted to know how this country was going to get its payments position into
balance, but he did not feel that anyone in this country knew the answer to
this question. As he saw it, the Federal Reserve could do just one thing about
the balance-of-payments problem. It could encourage foreigners to leave their
money in this country by making interest rates competitive with those in key
European countries. In his opinion, however, carrying this policy much farther
than it had been carried in recent months would be too high a price to pay at
the moment, considering the importance of a somewhat lower level of interest
rates to stimulate the domestic economy.

In 1961, the FOMC raised interest rates twice out of a concern for the
external deficit. At the October 24, 1961, meeting, the FOMC raised bill rates
from about 21/4 to 21/2 percent. New York Fed President Hayes, who as vice


Federal Reserve Bank of Richmond Economic Quarterly

chairman presided over the meeting in the absence of Chairman Martin, commented (Board of Governors 1961, pp. 897–98)
That at least a goodly number of those around the table had expressed some
concern about the international problem and had recognized that there was
perhaps something the System could do to help, in a minor way, to show that
it was aware of the problem, without doing danger to the domestic economy.

Governor Mills expressed the general sentiment for an increase in rates at
the December 19 meeting (Board of Governors 1961, p. 1079):
Patently, time is of the essence in reorienting the existing monetary and credit
policy in the direction of moderate restraint. . . . What I consider as having
been an unpardonable delay in pursuing that objective has permitted distrust
in the exchange value of the U.S. dollar to grow and will consequently vitiate
counteroffensive interest rate efforts to stem the loss of gold from this country.
Reliance on collective central bank and International Monetary Fund actions
to protect the U.S. dollar should have been reserved for secondary emergency
application and not suggested for continuing use, in that public notice of resort
to these media will be regarded by cynical investors as acts of desperation and
not as curatives to temporary problems of international currency imbalances.

Initially, Chairman Martin urged postponement of a rise in rates, but he
then relented (Board of Governors 1961, pp. 1089–90 and 1136):
He questioned whether the situation had really come to the point where a
significant change of policy was required. . . . He would hope that the System
would not get itself in the position, following the increase in the maximum
permissible interest rates on time and savings deposits, of being charged with
causing the commercial bank prime rate to be increased at this particular
juncture. [The Board of Governors had decided to raise the Reg Q ceiling on
deposits held for one year or more from 3 to 4 percent, effective January 1,
Following additional discussion, Chairman Martin restated his conception
of the consensus of the meeting. As he saw it, the consensus was along the
lines of concentrating on a bill rate in the upper part of the range of 21/2 - 23/4

The external deficit kept the FOMC from lowering market rates in July
1962 in response to weakness in economic activity. The bill rate, however, only
began to rise significantly in June 1963 when it first reached 3 percent.
With monetary policy basically immobilized because of weakness in the
domestic economy, the United States was left with only ad hoc measures to
deal with the balance of payments deficit. In 1961, it reduced the duty-free allowance on goods purchased abroad by American tourists from $500 to $100.
The United States moved to limit the demand for its gold stocks by making
it illegal for Americans to buy gold abroad. In 1962, it set up the London
Gold Pool among central banks to curb central bank free market purchases

R. L. Hetzel: Sterilized Foreign Exchange Intervention


of gold. The U.S. government asked Germany to pay more of the expense of
maintaining U.S. troops in Germany.
The Treasury issued bonds denominated in foreign currencies, named
Roosa bonds after Treasury Under Secretary Robert Roosa, to obtain foreign
currency to purchase dollars. The Treasury and the Fed also began Operation
Twist, whereby the Fed began to hold longer-term securities, and the Treasury
began to issue mainly shorter-term securities. The resulting decrease in the supply of longer-term securities relative to shorter-term securities was supposed to
lower longer-term interest rates relative to shorter-term interest rates. The idea
was to encourage both domestic investment and short-term capital inflows. Although the balance of payments exercised some influence on monetary policy,
the FOMC was unwilling to subordinate domestic to external considerations.

In 1961, the Exchange Stabilization Fund (ESF) of the U.S. Treasury began
to intervene in the foreign exchange markets. Its ability to intervene, however,
was limited by its resources. In 1934, Congress had created the ESF with the
Gold Reserve Act. Congress capitalized it with $2 billion of the profits created
by that Act’s revaluation of gold from $20.67 to $35.00 per ounce. It put
the ESF under the control of the Treasury and authorized it to intervene in
the foreign exchange markets to stabilize the value of the dollar. In 1945, the
Bretton Woods Agreements Act transferred $1.8 billion of the ESF’s capital to
the International Monetary Fund (IMF). The ESF, therefore, was left with $200
million in its capital account and no alternative funding sources apart from
money appropriated by Congress (see Todd [1991, 1992]). However, over the
years, the ESF had earned profits through its purchases and sales of gold. It
invested these profits in domestic and foreign securities. With the income from
those securities, by June 30, 1961, it had accumulated about $336 million in
assets. (Figures on the balance sheet of the ESF come from U.S. Treasury
Annual Reports.)
By 1962 the ESF had committed much of its resources through provision
of foreign aid, especially to Latin American countries. In 1960, it had acquired
Argentine pesos. In May 1961, the ESF agreed to exchange up to $70 million
dollars for Brazilian cruzeiros (U.S. Treasury 1961, p. 369). On January 1, 1962,
the ESF entered into an exchange agreement with Mexico for $75 million, and
in the middle of 1962 it entered into a swap agreement with the Philippines
(U.S. Treasury 1963, p. 57).1
1 At times, the ESF obtained the foreign exchange needed to purchase dollars in the foreign exchange market by borrowing from foreign central banks through an arrangement called a
“swap.” At other times, when the ESF needed dollars, in an arrangement called “warehousing,”
it would organize a trade with the foreign exchange in the Fed’s inventory in return for dollars.
The appendix explains the details of these two kinds of transactions.


Federal Reserve Bank of Richmond Economic Quarterly

Because so much of its resources were tied up, the ESF intervened mainly
in the forward markets. In that way, it would only need foreign exchange if it
had to close out a position at a loss. “Reference was made to the extent of operations of the ESF in the forward market, as opposed to spot transactions, and
Mr. Coombs [manager of the New York Fed’s foreign exchange desk] said the
basic reason was that the ESF was short of money” (Board of Governors 1962,
p. 169). The dollar often traded at a large discount in the forward market. The
Treasury entered into commitments to furnish foreign currencies in the future
in order to reduce this discount. In doing so, it hoped to encourage individuals
to hold dollar-denominated assets by reassuring them that the dollar would not
depreciate in value.
In March 1961, the British pound weakened while the German mark and
Dutch guilder strengthened. Germany and the Netherlands revalued their currencies by 5 percent.2 Because many in the foreign exchange markets believed
that a 10 percent revaluation would be required to eliminate the German balance of payments surplus, capital continued to flow into Germany. In forward
markets, the mark commanded a 4 percent premium.
German exporters . . . hedged by borrowing dollars . . . and converting these
dollars into deutsche marks immediately, counting on the future dollar receipts
to repay the dollar loans on maturity. Activities of this nature significantly
increased the volume of dollars being offered on the exchange market, compelling the German Bundesbank to acquire dollars in huge amounts. . . .
U.S. authorities were confronted with the possibility that the Germans would
have to purchase gold in order to prevent a further drop in their already low
gold/dollar ratio (U.S. Treasury 1962a, p. 3; Foreign 1962).

By the end of June, the ESF had entered into forward contracts agreeing
to deliver more than $250 million deutsche marks for dollars in the future.
Fortunately, the Treasury was able to unwind these positions without putting
pressure on the dollar in the summer because the Berlin Wall crisis produced
a weakening of the deutsche mark.
The Berlin crisis, however, produced capital flight to Switzerland, and the
Swiss franc commanded a premium of 11/2 percent in the forward market. Starting in July, the ESF began to sell Swiss francs forward to Swiss commercial
banks, which then became willing to hold the dollars instead of turning them
over to the Swiss National Bank. If the Swiss National Bank had been forced
to purchase the dollars, it would have been under pressure to use them to buy
gold from the Treasury. Toward the end of 1961, the Italian lira became the
strongest European currency, and the Italian central bank came under pressure
2 The following discussion draws on a memo (U.S. Treasury 1962a; Foreign 1962) that
“Secretary Dillon promised Chairman Martin we would furnish to the Board of Governors.”
The memo summarizes a letter from Robert Knight, Treasury General Counsel, to Ralph Young,
Adviser to the Board of Governors, February 9, 1962.

R. L. Hetzel: Sterilized Foreign Exchange Intervention


to exchange the dollars it was accumulating for gold. In an attempt to encourage Italian commercial banks to hold dollars rather than turn them over to
the central bank, the ESF entered into $200 million in forward contracts. The
forward commitments of the ESF in lira and Swiss francs amounted to $346.6
million in early 1962.
Forward commitments, however, carried the risk of loss if the dollar did
not appreciate. Given the risk exposure due to the size of its forward commitments, the Treasury felt that the ESF had insufficient cash on hand. To provide
it with additional cash, the Treasury wanted the Fed to buy the ESF’s foreign
currencies such as the deutsche mark. The ESF could then acquire the lira and
Swiss francs it needed to meet its forward commitments without having to
incur the ire of other central banks by dumping their currencies on the market
in return for lira and Swiss francs.
A Treasury memo (Foreign 1962; U.S. Treasury 1962b, p. 2) noted
Total resources of the Fund at the present time amount to about $340 million. Against these resources there are outstanding $222 million in Exchange
Stabilization agreements with Latin American countries, and some additional
agreements may be made from time to time. The free resources of the Stabilization Fund are consequently quite small. . . . Spot holdings of foreign
exchange now amount to about $100 million . . . . These spot holdings must
in general be thought of as providing backing for outstanding forward exchange contracts (currently about $340 million equivalent). The entrance of
the Federal Reserve System into foreign exchange operations will therefore
provide particularly needed resources.

As Charles Coombs (1976, p. 71) put it later, “. . . the money-creating
authority, the Federal [Reserve] could rise to almost any financial emergency,
whereas the Treasury was confined, in the absence of new Congressional appropriations, to the existing $330 million resources of its Stabilization Fund.”

On June 27, 1961, Ralph Young, Adviser to the Board of Governors, distributed
to FOMC members a memo proposing that the Fed become involved in the
coordinated foreign exchange intervention started by other central banks in
response to the March sterling crisis. When the pound sterling had weakened,
the Bank of England used its dollar reserves to buy pounds. The resulting
outflow of dollars ended up at other European central banks. Although those
banks recycled the dollars by lending them to the Bank of England, the U.S.
Treasury was concerned that the banks might use the dollars to buy gold from
the United States. To safeguard against such an event, Young recommended
that the Fed open swap lines with other central banks as a way of acquiring


Federal Reserve Bank of Richmond Economic Quarterly

foreign exchange to buy dollars if necessary.3 He also recommended that the
Fed stand ready to replenish the ESF’s dollar holdings by purchasing its foreign
exchange through a procedure later termed “warehousing.”4
Young’s (1961, p. 8; Foreign 1961) memo stated
The assets of the Stabilization Fund cannot, without Congressional action,
be increased beyond the present amount of about $360 million. Part of this
amount is immobilized under present exchange agreements with Latin American countries. The rest is not sufficient to cope with the swings in holdings
of foreign exchange . . . in periods of disturbed exchange market conditions.

Chairman Martin first raised the issue of foreign exchange intervention at
an FOMC meeting on September 12, 1961. He let William Treiber, first vice
president of the New York Fed, take the lead. Treiber (Board of Governors
1961, pp. 798–99) noted the weakness in the dollar and the ESF’s lack of
[The ESF’s] present size is about $1/3 billion, of which a large amount is
already tied up by stabilization agreements with certain Latin American countries. The scope of acquisition of hard currencies by the Fund is probably not
much over $100 million. While the Treasury may eventually ask the Congress
to authorize an increase in the resources of the Fund, I understand that in
any case the Treasury would welcome Federal Reserve acquisition of foreign
exchange as a helpful supplement. . . . Abrupt declines of the dollar to the
floor of the foreign exchanges have excited speculation as to possible changes
in currency parities . . . an adequate supply of the major foreign currencies
. . . [would] restrain a snowballing of speculative anticipations.

Young noted that the Treasury would like the Fed to become involved in
foreign exchange intervention so that it could use the ESF’s funds for other
Mr. Young pointed out . . . that the Treasury has other jobs in connection with
the Stabilization Fund. That was one of the reasons why the funds available
for the particular kinds of operations under discussion were so limited. He
gathered that the Treasury might be happy if it were left free to use the
Stabilization Fund for the other things with which it had to deal (p. 815).

Carl Allen (Board of Governors 1961), president of the Chicago Fed, began
a discussion of the legality of Fed intervention in foreign exchange markets
3 As explained in Appendix A, in a swap the Fed or the ESF places dollar deposits with
a foreign central bank, which in return places deposits in its currency with the Fed. Appendix
A explains how the foreign exchange acquired through swaps was used to insure foreign central
banks against loss of value of their dollar holdings in the event of a devaluation of the dollar. In
this way, the United States persuaded foreign central banks not to purchase gold.
4 As explained in Appendix A, with warehousing the Fed credits the Treasury’s deposits
with the Fed in exchange for foreign exchange held by the ESF.

R. L. Hetzel: Sterilized Foreign Exchange Intervention


and Karl Bopp, president of the Philadelphia Fed, raised the issue of whether
the Fed could retain its independence while working with the Treasury:
Just because a thing was legal, that did not mean that he [Allen] would always
want to do it. On the legality of the proposed operations, however, he did have
a question . . . whether it seemed clear that it would be legal for the System
to undertake such operations (p. 801).
. . . The Chairman then turned to Mr. Hackley [Board Counsel], who
commented that legal questions had, of course, been raised in the past. Nearly
30 years ago, as indicated in Mr. Young’s memorandum, the Board took a
position, which it did not publish, that would seem to preclude the implementation of the program such as suggested. However, for reasons that did not
need to be gone into today, he felt that the Board could well reinterpret the
law in a somewhat different manner, and in his view such a step would be
desirable. . . . Chairman Martin then stated that he had mentioned this subject
informally—not formally—to the Chairmen of the Senate and House Banking
and Currency Committees. . . . It would not be fair to say that the Committee
Chairmen had given any clearance of any kind (p. 802).
The Chairman went on to comment. . . . There was a very real point . . .
that the primary direction must come from the Treasury and that anything done
by the Federal Reserve must be coordinated with the Treasury. . . . Everyone
. . . ought to keep in mind what the framework was. Also, before entering
into any such operations, the System ought to do as the memorandum from
Mr. Young suggested; namely, take the matter up formally with the Chairmen
of the Banking and Currency Committees (p. 803).
Mr. Bopp said that as nearly as he could recall . . . one reason for its
[ESF’s] creation was dissatisfaction with the idea of the Federal Reserve handling foreign exchange operations. . . . Through the Stabilization Fund . . . the
Treasury was to have the authority in case of any conflict. . . . In the longer
run, he noted, a possible conflict could develop between Treasury policy and
Federal Reserve policy in this area. This was a thing to keep in mind . . . the
sense in which the Treasury could direct Federal Reserve operations in this
field even though Federal Reserve funds were used (p. 804). . . . Mr. Bopp
then commented that he was sympathetic to the approach suggested in Mr.
Young’s memorandum (p. 805).

Governor Robertson [Board Vice Chairman] was especially skeptical:
Mr. Robertson said . . . while he would not want to argue that the proposed
operations would be illegal, he thought that the point was highly questionable
(p. 805). . . . It seemed to him this whole problem was not fundamentally
the problem of the Federal Reserve, but rather of the Treasury. If so, Federal
Reserve operations of the kind suggested might be construed as bailing out
the Treasury. . . . Accordingly, before any operations were undertaken, he
felt that the Congress should have a chance to take a look, at least through
the Banking and Currency Committees, to see whether it was felt that the
Federal Reserve had the power to proceed. . . . In other countries there was
a much closer relationship between the central bank and the executive branch
of the Government than in this country. . . . While this problem [weakness of


Federal Reserve Bank of Richmond Economic Quarterly
the dollar] did exist, he would not want to see the Federal Reserve take the
position that it could construe the statute [Section 14 of the Federal Reserve
Act] in any way it wished (p. 806).

FOMC members then raised a variety of questions:
Mr. Swan [president of the San Francisco Fed] noticed . . . that the Stabilization
Fund had certain amounts committed under existing stabilization agreements
with Latin American countries, whereas presumably Federal Reserve operation
would not involve such uses of funds (p. 808). . . . Mr. Wayne [president of the
Richmond Fed] said . . . he would feel much more comfortable if the Federal
Reserve had an official commitment from the Congress that operations of the
kind under consideration were clearly within its power (p. 809). . . . Mr. Allen
said . . . he had some doubt about the legality of Federal Reserve operations.
. . . He was inclined to think that the intent of Congress had been . . . to
have the Stabilization Fund do this job (p. 810).

The Federal Reserve Act does not explicitly authorize the Fed to influence
the value of the dollar by intervening in the foreign exchange market or to
acquire foreign exchange for that purpose by swapping deposits with foreign
central banks (establish swap lines). It also does not explicitly authorize the Fed
to acquire foreign exchange from the Treasury (warehousing). This omission
of powers undoubtedly reflected the adherence of the authors of the Federal
Reserve Act to the two dominant assumptions of their era: the discipline of
the gold standard and the real bills doctrine. Adherence to the gold standard
(continued in the Bretton Woods system) required that the Fed raise the discount rate in response to gold outflows. It seems unlikely that the authors of
the Federal Reserve Act would have authorized actions designed to avoid this
discipline. Also, according to the real bills doctrine, a central bank should
extend credit only through discounting commercial bills (bills of exchange),
that is, on the basis of debt arising from the financing of real productive activity. Again, it seems unlikely that the authors of the Federal Reserve Act
would have authorized deposit creation for U.S. and foreign governments in
return for direct asset sales. (Foreign central banks were typically under direct
government control.)
Section 14 of the Federal Reserve Act states “Any Federal reserve bank
may . . . purchase and sell in the open market, at home or abroad, either from or
to domestic or foreign banks, firms, corporations, or individuals, cable transfers
and bankers’ acceptances and bills of exchange.” Given the existence of the
gold standard and the acceptance of the real bills philosophy at the time of the
writing of the Federal Reserve Act, the simplest understanding of the power to
buy and sell foreign exchange (cable transfers in the language of the Federal
Reserve Act) would be as a power facilitating transaction abroad by the Fed

R. L. Hetzel: Sterilized Foreign Exchange Intervention


in gold or bankers’ acceptances and bills of exchange. H. Parker Willis (1926,
p. 488), who drafted the Federal Reserve Act for Carter Glass, discussed the
intention of this part of the Federal Reserve Act. He wrote that the power to
deal in cable transfers facilitated the ability of Reserve Banks to purchase gold
abroad. These foreign gold purchases could be used to supplement the domestic
stockpiles of the Reserve Banks. Such purchases could also be used to avoid
unnecessary trans-Atlantic movements of gold. For example, a Reserve Bank
could use its holdings of gold in London to meet the needs of an individual
in London wanting to exchange dollars for gold and thus avoid the need for
shipment of gold from New York.
The Federal Reserve Bank of New York had opened swap lines in the
1920s with foreign central banks desiring to make their currencies convertible. 5
In 1932, however, Carter Glass, senator from Virginia and author of the Federal
Reserve Act, denounced on the Senate floor those swap lines as inconsistent
with the Federal Reserve Act. As a consequence, in the Banking Act of 1933,
Congress added language to the Federal Reserve Act giving the Board of Governors the power to prevent the New York Fed from dealing directly with
foreign banks. “. . . the Board subsequently (in 1933 and 1934) construed
section 14(e) as limiting foreign accounts to the purchase of bills of exchange”
(U.S. Congress 1962, p. 147).

At the request of Chairman Martin, Board Counsel Howard Hackley wrote a
memorandum outlining a legal basis for Fed participation in foreign exchange
operations. The FOMC discussed the memo at its December 5, 1961, meeting. (The full memorandum is reprinted in U.S. Congress [1962]. Appendix B
summarizes the legal arguments of the memorandum.)
President Swan had already expressed his doubts in a November 30, 1961,
letter to Ralph Young (Foreign 1961). He argued that the memo was a “shaky
foundation for proceeding with a full-blown operation” because “the real bills
doctrine of the 1914 law” made it doubtful that the Federal Reserve Act would
authorize opening foreign accounts for purposes other than buying bills of
exchange. Most FOMC members shared the sentiments expressed by George
Clay (Board of Governors 1961, p. 1035), president of the Kansas City Fed:

Coombs (1976, p. 75) said of the swap arrangements he was discussing with other central
banks in January 1962, “Such swaps of one currency for another, with a forward contract to
reverse the transaction, say 90 days hence, had long been a standard trading instrument in the
foreign exchange markets. Moreover, back in 1925, the New York Federal [Reserve Bank] under
Governor Strong had arranged with the Bank of England a similar swap arrangement of $200
million of United States gold against sterling.”


Federal Reserve Bank of Richmond Economic Quarterly
Mr. Clay went on to say that he had a basic feeling against Government
agencies taking unto themselves authorities that had never been specifically
granted. . . . He felt that Congress should be given an opportunity, and in
fact urged, to assign this authority to the agency that in its wisdom it would

Governor King (Board of Governors 1961, p. 1043) commented:
He did not think the Federal Reserve was the proper place for these operations
if they were to be conducted. Instead, he felt that a political agency or body
would be the proper place to lodge the responsibility. As he had heard it said
on various occasions, if the System should get into politics at any stage it
could founder.

President Bopp (Board of Governors 1961, p. 1046) stated:
Like others who had spoken, he was concerned about the legal basis for
System operations in foreign currencies. The legal authority was not based on
specific provisions of the law but rather on a construction of the statutes. . . .
In a democratic process it was important . . . to have specific authorization.

President Bryan (Board of Governors 1961, pp. 1048–49) of the Atlanta Fed
urged the FOMC to concentrate on maintaining convertibility through the appropriate domestic policies. “Sometimes . . . a great deal more harm can be
done, with good intentions, by intervening to save the patient some pain than
by letting him realize he is sick.”
Governor Robertson (Board of Governors 1961, pp. 1037–42) argued that
sterilized foreign exchange intervention by the Fed was bad law, bad politics,
and bad economics:
It does not follow that the power to maintain foreign accounts—basically an
incidental power—can be regarded as an authorization to exercise the broad
policy functions contemplated by the instant proposal. In other words, even if
foreign accounts may be maintained in connection with functions other than
dealing in bills of exchange, these must be functions that are authorized by
the Federal Reserve Act. Nowhere in the Act can authority be found for the
stabilization function that is the core of this proposal (italics in original).
Even if its legality were to be assumed, I think the proposed action would
be highly questionable because it is inconsistent with explicit Congressional
authority. . . . Purchasing foreign exchange from the Stabilization Fund whenever that fund has been used up or by operating in the same field on its own
. . . could be interpreted as circumventing the will of Congress by making
available more dollars for the purpose of “stabilizing the exchange value of
the dollar” than Congress contemplated. . . . Such a function [selling foreign
exchange] . . . involves very sensitive international diplomatic relationships,
with which the Federal Reserve is not in the best position to cope. The function
would seem to be more appropriately one for the Treasury (which Congress
has already designated to handle the problem).
Federal Reserve operations in foreign currencies . . . would merely camouflage the difficulty, which is one of dealing with the balance of payments

R. L. Hetzel: Sterilized Foreign Exchange Intervention


problem. . . . If the amount of that fund [the ESF] is insufficient, then the
Treasury should request Congress to expand the fund. . . . There are no gimmicks by which the position of the dollar can be maintained in the world. It
would be unwise to resort to devices designed to hide the real problems and
assuage their symptomatic effects. . . . The United States must practice what
it has long preached about the need for monetary and fiscal discipline.

The main defenders of Fed involvement in the foreign exchange markets were
Governor Balderston, Charles Coombs, and President Hayes of the New York
Fed. Balderston (Board of Governors 1961, p. 1058) argued that the Fed should
intervene in the foreign exchange market because “it was so close to the function carried on by the Open Market Committee in domestic affairs.” Coombs
(Board of Governors 1961, p. 1052) argued that “speculative pressures could
boil up within a matter of minutes in the exchange market. . . . It would be
desirable to have the resources to deal with such periodic emergencies, so that
exchange operations could resist speculative trends before they had gone too
far.” Hayes (Board of Governors 1961, p. 1054) argued that, since the ESF
was not in a position to intervene in foreign exchange markets, the Fed should
do so.
As to the roles of the Treasury and Federal Reserve, some of those who commented had suggested that the Stabilization Fund was set up for this kind of
purpose. Actually, however, the Fund had been used for a lot of other purposes.
It had been used to assist United States foreign policy in relation to various
weaker currencies that needed shoring up, as a kind of State Department

In a poll conducted by Chairman Martin, thirteen of the eighteen FOMC
participants registered the opinion that “legislation is desirable” before beginning to intervene in the foreign exchange market. (The poll is recorded
in the notes of Richmond’s President Wayne and are in the Richmond Fed
archives for the December 5, 1961, FOMC meeting.) One of the five in favor
of intervention, Governor Mills, expressed reservations. “He had no great faith
that operations of this kind could be conducted successfully or without serious
danger to the independent status of the Federal Reserve System.” Another of the
five in favor, Delos Johns, president of the St. Louis Fed, believed the FOMC
should seek enabling congressional legislation at the same time it proceeded.
Chairman Martin ended the meeting by saying that he would explore the matter
of legislation with the Treasury and report back to the Committee at its next
At the December 19, 1961, FOMC meeting, Chairman Martin, supported
by President Hayes, asked the Committee’s permission to discuss a working


Federal Reserve Bank of Richmond Economic Quarterly

relationship with the Treasury for foreign exchange intervention. 6 Most members agreed that Chairman Martin should continue discussions with the Treasury, but agreed with President Deming of the Minneapolis Fed “that he would
regard operations in foreign currencies as a proper activity for the central bank
if statutory clarification could be obtained” (Board of Governors 1962, p. 1151).
At the January 9, 1962, FOMC meeting, Chairman Martin asked Hackley
to report to the FOMC on his discussions with the Treasury’s general counsel, Robert Knight. Hackley noted that the Treasury’s general counsel and the
Attorney General concurred with his opinion. He also noted that the Treasury
opposed seeking legislation for three reasons (Board of Governors 1962, p. 61):
The international situation was very tender. . . . If there were discussions
on the Hill, they might be agitating to the markets. Second . . . it might be
better to seek such legislation after the Open Market Committee had some
experience in order to determine what its problems and limitations were.
. . . Third, there was a range of ideas on the Hill with regard to the Federal Reserve System. . . . Legislation, if sought, might become a vehicle for
adding various amendments the nature of which could not be foretold.

Chairman Martin said that he had conferred with the Secretary of the
Treasury, and they agreed that “regarding the question of seeking legislation
. . . there were real problems involved.” Martin suggested that he confer with
the chairmen of the House and Senate Banking Committees. “If the Committee
Chairmen . . . should feel strongly that the introduction of legislation would
cause a great deal of stir, it might be better not to embark on that course”
(Board of Governors 1962, p. 63). Governor King then commented
The Federal Reserve was being asked to go a little too far in the name of
cooperation. As he understood it, the Treasury was suggesting that it might
not favor legislation because of apprehension as to the outcome (p. 63).

The Committee then authorized Chairman Martin to confer with the chairmen
of the congressional banking committees.
At the January 23, 1962, meeting Chairman Martin reported to the FOMC
“on the general problem of obtaining legislation that would clarify the Committee’s authority to conduct foreign currency operations.” Although the Minutes
do not explain why, Chairman Martin no longer considered legislation an option. The Minutes note then that the FOMC had a roundtable discussion. They
record a reference to the opinions of the Committee’s and Treasury’s general
6 On December 18 the Secretary of the Treasury had sent a letter to Chairman Martin asking
for prompt resolution of the issue of FOMC involvement in foreign exchange intervention and
offering the advice of the Treasury’s legal staff. “I realize that the Committee might be hesitant
to embark on operations in which it has not engaged since the establishment of the Stabilization
Fund under the Gold Reserve Act of 1934. If the Committee should be interested in the opinion
of the Treasury’s General Counsel . . . the Treasury’s legal staff will be ready to cooperate with
yours” (Board of Governors 1961, p. 1146).

R. L. Hetzel: Sterilized Foreign Exchange Intervention


counsels that the “System’s existing statutory authority, although in some respects limiting, did provide a general sanction for Committee operations,” but
otherwise state only that “differing viewpoints were expressed.” The Minutes
(Board of Governors 1962, pp. 111–12) then state
In bringing the discussion to a head, it was moved by Mr. Balderston and
seconded by Mr. Hayes that the Committee go on record at this session as
favoring in principle the Committee’s initiation on an experimental basis of
a program of foreign currency operations; that Mr. Young, the Committee’s
Secretary, and Mr. Coombs, Vice President in charge of foreign operations
of the New York Federal Reserve Bank, be authorized to explore for the
Committee with the Treasury the needed guidelines for actual operations . . .
and further that Chairman Martin be authorized to refer to this development in
his statement and testimony before the Joint Economic Committee scheduled
for January 30, 1962.

Ten of the twelve voting FOMC members voted in favor and two (Governors
Robertson and Mitchell) dissented.
At its February 13, 1962, meeting, the FOMC discussed the issue of “the
needed guidelines for actual operation.” The exchange was charged because it
dealt with the issue of Fed independence. Because foreign exchange intervention involved U.S. relations with foreign governments, many FOMC members
were afraid that the Fed would inevitably become a junior member to the
Treasury. Earlier, in a November 30, 1961, letter to Ralph Young, President
Fulton of the Cleveland Fed (Foreign 1961) had written
There is a danger that if the System takes on the functions of the executive,
it will end up as a captive of the executive branch of the government. . . . It
might be safer for the Congress to designate the Treasury Department as the
principal locus of responsibility for exchange operations. . . . This approach
. . . would not rely on a tenuous Treasury-Federal Reserve “accord,” which
might not endure with different personalities and under different conditions.
For another thing, Congress would retain its traditional control over the purse

At the February 13 meeting, Governor King argued for explicit assurance
that the Fed could refuse to finance the activities of the ESF (Board of Governors 1962, pp. 175–77):
Mr. King raised a question with respect to the comment made earlier by Mr.
Young that there would be no specific rules at the outset on relationships
between the Treasury and the Federal Reserve, the thought being that these
might evolve out of experience. He asked whether it might not be better to
have such rules.
In response, Mr. Young expressed the view that no general rule was
needed. . . . He did not think that the Treasury would be apt to come to the
System with the idea of selling from the Stabilization Fund unless something
happened in the development of the over-all program of foreign currency


Federal Reserve Bank of Richmond Economic Quarterly
operations that would make it seem desirable, from the Treasury’s standpoint,
to get unloaded. There could always be that development. For example, an
underdeveloped country might need temporary help and there would be no
way to arrange it except to give a commitment from the Stabilization Fund.
In that event, the Treasury might need to convert some of its resources.
Mr. Robertson inquired as to the advantages seen—aside from the Federal
Reserve’s “unlimited pocketbook”—in having two agencies operating in this
field instead of one, and Mr. Coombs replied that he did not think there were
any. . . . He [President Swan] asked whether it was not possible that the
Federal Reserve would just be in the role of supplying funds to the Treasury
rather than conducting foreign currency operations.
[Chairman Martin] considered it difficult to sit down and attempt to draw
up such principles while the Federal Reserve was in the process of learning.

Chairman Martin then advanced a proposal that the Board of Governors, not
the full FOMC, have responsibility for foreign exchange intervention. Hackley
explained the proposal, which he had advanced in a memo dated February
8, 1962: “He [Hackley] did feel that in at least some respects this approach
might be more defensible from a legal standpoint” (Board of Governors 1962,
p. 177). The New York Fed and many other regional banks, however, objected
to being excluded. Most FOMC members felt that exclusion of the regional
banks would weaken the federal character of the System:
[Governor] Shepardson said that . . . either approach involved an interpretation
of the law that was rather nebulous. . . . On the assumption that the original
proposal would be legally supportable . . . participation of the entire Open
Market Committee would be desirable from the standpoint of System unity
(Board of Governors 1962, p. 186).

As part of this discussion, Chairman Martin recommended that decisions
about foreign exchange intervention be made by a subcommittee consisting of
the Chairman and Vice Chairman of the FOMC and the Vice Chairman of the
Board of Governors. Earlier, Delos Johns (Board of Governors 1961, p. 1051),
president of the St. Louis Fed, had opposed such a delegation of authority:
He had real doubt about the power of the Committee to delegate its responsibilities. That was an old question. . . . He was not quite satisfied by the
argument that a subcommittee that supervised the operations was not making
policy. The executive committee was abolished because the Committee became convinced that it was not confining its activities to administration and
instead was actually making policy. This is almost inevitably the result, he
suggested, when delegations of authority are made to a small group.7

7 Prior to 1955, only the Executive Committee (consisting of the Fed chairman, two
governors, the president of the New York Fed, and one other regional Bank president) met
regularly to make monetary policy. The full FOMC met only four times a year, with two of
those meetings separated by only a weekend.

R. L. Hetzel: Sterilized Foreign Exchange Intervention


There was, however, no real opposition to delegating to a small subcommittee
authority over operations in the foreign exchange markets. Any other arrangement appeared impractical.
Chairman Martin then asked for approval of guidelines for initiating foreign currency purchases. Although the Board staff had circulated on December
12, 1961 (Foreign 1961), a draft of congressional legislation that would give
the Federal Reserve explicit authority to transact in foreign exchange, Martin
(Board of Governors 1962, p. 193) argued
There were those . . . who felt that the law was not sufficiently clear. It might
be desirable to seek legislation in this area at some time, but at the moment he
doubted whether it would be feasible, with so little experience, to determine
what kind of legislation was needed. . . . The availability of those decisions
[Hackley’s memorandum and the opinions of the Treasury’s general counsel
and the Attorney General], along with a lack of System experience in foreign
currency operations, would handicap the System if it tried to get legislation.
The System would be asked what kind of additional legislation it needed, and
the Congress probably would not want to put itself in the position of approving
something if the Federal Reserve was not clear about its wishes in the matter.

In the words of Coombs (1976, p. 72), the FOMC then “somewhat apprehensively approved on February 13, 1962, the undertaking of market operations
in foreign currencies.”
At the March 6, 1962, FOMC meeting, discussion again centered around
the issue of whether the Fed, by participating in foreign exchange operations,
would be taking orders from the Treasury. The Treasury had two immediate
problems. First, a number of foreign governments, especially France, wanted
gold for their dollars. The problem was acute:
Mr. Coombs reiterated that a number of European central banks holding large
amounts of dollars had been deliberately refraining from taking gold. If any
bank should come in for a large amount of gold, an “every man for himself”
proposition could possibly develop (Board of Governors 1962, p. 273).

On February 28, in a telephone poll, the FOMC had approved entering into a
swap arrangement with France.8 Among the seven governors, King and Robertson had dissented and Mitchell had abstained.
The Treasury’s second problem was that the ESF needed dollars so it could
buy Swiss francs to meet its forward commitments:
Mr. Mitchell inquired of Mr. Coombs whether a purchase by the System of
marks from the Stabilization Fund might not be the kind of operation that
would leave the System open to the charge of bailing out the Stabilization
Fund. . . . At times . . . the Federal Reserve had been dominated by the
8 See the discussion in the appendix in the memo of Ralph Young, dated October 17, 1963,
on using swaps to offer foreign central banks protection against dollar devaluation.


Federal Reserve Bank of Richmond Economic Quarterly
Treasury, so there was always a problem of maintaining a kind of arms-length
relationship. On the present occasion, the objectives of the Treasury and the
Federal Reserve tended to coincide, but a different situation could possibly
develop (Board of Governors 1962, pp. 277 and 280).
Reference was made by Mr. Thomas [Board economist] to the fact that
the Federal Reserve could not purchase U.S. government securities directly
from the Treasury. . . . Mr. Hackley [said] that the law clearly indicates that
direct purchases of U.S. government securities from the Treasury are not open
market transactions. As to foreign currency operations, he had come to the
conclusion, however, that in this sense the Stabilization Fund was a part of
the open market (Board of Governors 1962, pp. 279 and 283).

After Coombs noted that “the Stabilization Fund was strained to the utmost at
this moment” (Board of Governors 1962, p. 285), the Committee voted to buy
marks from the ESF.

On February 27 and 28, 1962, the House Committee on Banking and Currency
held hearings on legislation (U.S. Congress 1962) to increase the resources of
the IMF. Chairman Martin (U.S. Congress 1962, pp. 91–92) used these hearings
to announce that the Federal Reserve had become involved in foreign exchange
The Federal Reserve has recently acquired small amounts of several convertible currencies widely used in international transactions from the Treasury
Stabilization Fund and has opened accounts with several European reserve
banks. . . . While in time it may be desirable to recommend amendment of the
Federal Reserve Act to provide greater flexibility than we now have under the
act in carrying out these operations, it would be impractical to request such
legislation before operating experience under existing authority has provided
a clear guide as to the need for it.

Rep. Reuss (U.S. Congress 1962, pp. 102 and 140) criticized the use of
the “nearly unlimited money creative powers of the system” to intervene in the
foreign exchange markets:
Much of the operation that you are doing . . . seems to me to duplicate the
foreign exchange stabilization operation that the Secretary of the Treasury has
very properly undertaken pursuant to the Gold Reserve Act of 1934. To me
this is a tremendous power you have taken upon yourself, and I must serve
notice on you right now that I consider this an usurpation of the powers of
Congress. . . . You come in here and tell us that you propose to go off on, if
I may say so, a frolic of your own, involving unspecified sums without the
slightest statutory guidance.

Chairman Martin (U.S. Congress 1962, p. 140) challenged Rep. Reuss’
representation. “Now, you may disagree as a lawyer with the lawyers for the

R. L. Hetzel: Sterilized Foreign Exchange Intervention


Federal Reserve Board as to our existing authority on this, Mr. Reuss. But as I
reiterate, our lawyers said we had the authority, the Treasury counsel concurred,
and the Attorney General concurred with them.” Copies of the Hackley Memorandum, the opinion of the Treasury’s general counsel and the concurrence
of the Attorney General were provided to the Committee at its request and
published in the hearing record.9

From the time of the first swap arrangement with France for $50 million in
1962 to the closing of the gold window in August 1971, Fed swap lines grew
to $11.7 billion. The entrance of the Fed into the foreign exchange markets initially produced considerable internal debate. On the one hand, Coombs (1962, p.
469) considered foreign exchange intervention to be integral to maintaining the
international monetary order. “[W]hen the exchange markets become seriously
unsettled by political or other economic uncertainties, normally beneficial speculation may quickly become transformed into a perverse, and sometimes even
sinister, force.” On the other hand, Governor Robertson (Board of Governors
1962, p. 185) was critical:
9 The Fed’s conduct of foreign exchange operations has continued to be the subject of much
discussion in the years since the internal FOMC debate chronicled in this article. In commenting
on an earlier draft of this article, members of the Board of Governors’ staff suggested that the
following additional information be included for completeness:
Since 1962, Congress has reviewed the foreign currency operations of the Federal Reserve
in hearings on related issues. The Hackley Memorandum was published a second time in a 1973
hearing record of the House Banking Committee on the Par Value Modification Act of 1972.
In addition, the Annual Reports of the Board have described and provided data on the Federal
Reserve’s foreign currency operations, and the Federal Reserve Bank of New York has submitted
quarterly reports to Congress on Treasury and Federal Reserve foreign currency operations. Although Congress can properly be considered to have been fully aware of these published materials,
it has not acted to restrict the authority of the Federal Reserve to engage in these operations.
In fact, Congress has recognized and facilitated the Federal Reserve’s foreign currency operations by amending a related provision of the Federal Reserve Act to permit the investment of
foreign exchange obtained through those operations. In 1980, Congress amended Section 14(b)(1)
of the Act to grant Reserve Banks the authority to invest foreign exchange in “short-term foreign
government securities.” The provision was enacted as part of the Monetary Control Act of 1980
in response to a long-standing request from the Board. Its enactment demonstrated congressional
awareness and suggested tacit acceptance of the Federal Reserve’s foreign currency operations.
Finally, in 1989 and 1990 the Federal Reserve conducted a comprehensive study and review
of System foreign exchange operations. This material was discussed and reviewed by the FOMC
at its meeting on March 27, 1990. All aspects of the operations, including the policy and legal
basis of such operations, were thoroughly examined. After consideration of the material, the
FOMC voted in favor of increasing the limits on the System’s holding of foreign currencies and
on the amount of eligible foreign currencies the System was willing to warehouse for the Treasury
and the ESF. The discussion and the votes were reported in the published FOMC minutes. Three
members dissented from these decisions. Two of the dissenters cited concerns about the absence
of definitive congressional intent in this area but only in reference to the warehousing increase.


Federal Reserve Bank of Richmond Economic Quarterly
Mr. Robertson recalled that he had opposed the whole program of operations
in foreign currencies on legal, practical, and policy grounds because it had
seemed to him that the only basis for the entrance of the Federal Reserve
into this field would be to supplement the resources of the Stabilization Fund
and because the program was being undertaken without specific congressional

The place of the Federal Reserve System within the U.S. government is
different from the place of central banks in other countries because the U.S.
government is different. The U.S. government is characterized by a division
of powers, with fiscal policy assigned to Congress. As discussed in Appendix
A and Broaddus and Goodfriend (1995), the sterilized foreign exchange intervention and warehousing practiced by the Fed since the early 1960s constitute
fiscal policy, not monetary policy. That fact raises fundamental issues about
the Fed’s operations in the foreign exchange markets. Policymakers vigorously
debated many of these issues when the Fed first became involved in the foreign
exchange markets in the early 1960s. Those debates remain helpful today in
assessing the proper role of the Federal Reserve System.



The Fed can obtain the foreign exchange it requires to buy dollars in the foreign
exchange market through a swap of currencies with another central bank. In a
swap, the Fed agrees to establish dollar deposits on its books for the German
Bundesbank in exchange for the Bundesbank establishing mark deposits for the
Fed. At the same time, the Fed agrees via a forward transaction to reexchange
the same amount of marks for the Bundesbank’s dollars at a given date in the
future. Before the breakdown of the Bretton Woods system of fixed exchange
rates, the United States used swaps to provide cover for the dollar holdings
of foreign central banks. That is, as a consequence of maintaining the fixed
exchange rate with the dollar, the Bundesbank might have to buy dollars it did
not want to hold. It would have liked to exchange them for gold at the U.S.
Treasury, but the Treasury did not want to deplete its stockpile of gold.
The U.S. Treasury could persuade the Bundesbank to hold the unwanted
dollars by guaranteeing the Bundesbank against loss in case of a devaluation of
the dollar. The Treasury did so by having the Fed take marks acquired by the
latter in a swap transaction and use them to buy dollars from the Bundesbank.
Counting the dollars in its swap account, the Bundesbank ended up with the
same amount of dollars as before the swap, but more of the dollars it did
hold were protected against devaluation. The reason is that if the Bundesbank

R. L. Hetzel: Sterilized Foreign Exchange Intervention


decided not to renew the swap agreement, it could just exchange at the old
exchange rate its dollars at the Fed for the marks in the Fed’s deposit at the
Bundesbank. The Fed, however, since it had used its marks to buy the Bundesbank’s dollars, would have to go into the market to buy the marks. (In practice,
the Treasury always protected the Fed from loss in buying the necessary foreign
Ralph Young (1963; Swap), Director of the Board’s Division of International Finance, provided the following explanation:
Foreign monetary authorities were increasingly unwilling to hold additional
dollar claims on an uncovered basis. . . . When the System draws foreign
currencies for temporary use under a swap arrangement, the foreign central
bank comes into additional dollar holdings that are covered against exchange
risk in an amount corresponding to the System’s drawing. As the System uses
the currencies that it has drawn . . . through a direct sale against dollars with
the foreign monetary authority, the uncovered dollar holdings of the foreign
monetary authority are reduced . . . by a corresponding amount. In this way,
although the foreign central bank in question ends up holding the same amount
of total liquid dollar assets that it would have held in the absence of the swap
drawing . . . its uncovered dollar holdings can be held down to the amount
that . . . it is content to hold. And in this way, gold sales by the U.S. Treasury
are avoided (italics in original).

After the breakdown of the fixed parities of the Bretton Woods system in
the early 1970s, the Fed began using the foreign exchange acquired in swap
transactions to intervene directly in the foreign exchange markets in response to
weakness in the external value of the dollar. At that time, swaps assumed their
more modern function of attempting to influence market psychology. Charles
Coombs (Board of Governors 1971), Manager of the System foreign exchange
account, and Fed Chairman Arthur Burns (Board of Governors 1972), respectively, expressed the change:
Mr. Coombs remarked that the rationale of the swap network rested on two
main considerations. First, the network enabled the System to shield the Treasury gold stock and other reserve assets by providing the alternative of an
exchange guarantee to foreign central banks having dollars they wished to
convert. . . . That part of the rationale had now fallen away, since the decision
of August 15 [1971, closing the gold window] had made the dollar inconvertible into gold or other reserve assets (p. 1101). . . . More generally, the swap
network had come to be regarded in the market as the very symbol of central
bank cooperation (p. 1102).
By demonstrating that the United States was prepared to cooperate with
other nations . . . such operations [in the foreign exchange markets] could
have a major impact on market psychology (pp. 734–35).

Swaps constitute a fiscal policy, not a monetary policy, action. (See Goodfriend and King [1988] on monetary and fiscal policy.) Consider a swap line
with Mexico that involves the acquisition of peso deposits by the Fed in return


Federal Reserve Bank of Richmond Economic Quarterly

for dollar deposits at the Mexican central bank. If the Mexican central bank
tries to prop up the value of its currency by using its dollar deposits to buy
pesos on the foreign exchanges, the U.S. monetary base increases. The Fed will
sterilize this increase in the base by selling U.S. Treasury securities out of its
portfolio. As a result, the Fed’s portfolio will come to include fewer U.S. assets
and more peso assets. Because the monetary base ends up unchanged, the Fed
has not undertaken a monetary policy action. Neither the U.S. money stock
nor interest rates changes. However, when the Fed sells Treasury securities,
the supply of U.S. Treasury securities in the hands of the public increases. The
effect is the same as though the Treasury had lent money to Mexico by selling
Treasury securities to the general public. The Fed has undertaken a fiscal policy
Warehousing is one way the Treasury obtains funds for either intervening
in the foreign exchange market or lending to a foreign government. It also
involves a fiscal policy action by the Fed (Goodfriend 1994). With warehousing, the Fed puts dollars into a deposit account of the U.S. Treasury in return
for assets denominated in foreign currencies from the Treasury. At the same
time, the Fed and the Treasury agree to reverse the transaction at a future date.
Warehousing is equivalent to a repurchase agreement in which the Fed makes
a loan to the Treasury using the foreign assets as collateral. When the Treasury
uses the dollars it has gained to intervene in the foreign exchange market, the
Fed offsets the resulting increase in the monetary base by selling a Treasury
security. As above, government debt in the hands of the public increases. It
is as if the Treasury issued debt to obtain dollars with which to buy foreign
If the Fed provides a loan to Mexico via a swap or to the Treasury via
warehousing, the measured federal government deficit does not rise because for
accounting purposes the Fed is assumed to be part of the private sector. What
is relevant for fiscal policy, however, is government debt in the hands of the
taxpaying public. If the Fed acquires an additional government security, it will
return the interest it receives to the Treasury. Interest paid on the debt is a wash.
In contrast, if the private sector acquires an additional government security, the
U.S. government must come up with additional funds to pay the interest. Swap
lines and warehousing that finance sterilized foreign exchange intervention are
fiscal policy actions because they increase the debt that taxpayers must fund.10
Because of the separation of powers at the federal level that characterizes
the U.S. framework of government, the involvement by the Fed in fiscal policy
raises a number of issues. The U.S. Constitution assigns the major decisions
10 The additional interest the Treasury owes because of the increase in its debt outstanding
can be offset by the interest gained on the acquisition of a foreign asset. The redistribution of
assets, however, is still fiscal policy. With warehousing or a swap, the Fed has extended credit to
the Treasury or a foreign government, but has not changed the monetary base.

R. L. Hetzel: Sterilized Foreign Exchange Intervention


about fiscal policy to Congress. When the Fed undertakes a fiscal policy action,
it is off-budget; that is, it is not subject to the regular congressional budget
process. For further discussion, see Broaddus and Goodfriend (1995).

The Hackley Memorandum outlining a legal basis for transactions by the Fed in
the foreign exchange market dealt with the three ways the Fed acquires foreign
exchange: (1) directly from the Treasury in return for crediting the dollar deposits of the Treasury at the Federal Reserve; (2) directly from foreign central
banks in exchange for dollar deposits placed with those banks; and (3) in the
open market in exchange for dollar deposits at private banks.
In his memo, Hackley pointed to the language of Section 14 of the Federal
Reserve Act, which lists transacting in foreign exchange (cable transfers) as an
express power.11 (“Any Federal reserve bank may . . . purchase and sell in the
open market, at home or abroad, either from or to domestic or foreign banks,
firms, corporations, or individuals, cable transfers and banker’s acceptances
and bills of exchange.”) He argued that not only does this language allow the
Fed to intervene in the foreign exchange market but also to acquire foreign
exchange directly from the Treasury. In taking this position, Hackley made
two assertions: “Within the meaning of . . . Section 14,” the United States
(the Treasury) is a “corporation” and Federal Reserve purchases of foreign
exchange “from the Stabilization Fund may reasonably be regarded as ‘open
market’ purchases.” He defended the first assertion by reference to Chief Justice
Marshall’s definition of a “corporation” in the Dartmouth College case as “an
artificial being, invisible, intangible and existing only in contemplation of law”
(U.S. Congress 1962, p. 149).
He defended the second assertion by arguing that the Treasury is part of
“the open market” for purposes of transacting in foreign exchange, but not for
transacting in government debt because the Treasury does not issue the foreign
exchange, but it does issue debt (U.S. Congress 1962, p. 149):
By the Banking Act of 1935, Congress prohibited such purchases of Government obligations except in the “open market.” . . . It seems clear, however, that
this limitation on direct purchases of Government obligations was intended to
prevent the Federal Reserve System from lending its resources to the Treasury
in a manner that might be inconsistent with the System’s monetary and credit
11 The discussion of Section 14 in the section of this article entitled “Background to the
Debate” dealt with intent or purpose. Hackley’s discussion deals exclusively with powers. The
purpose of granting someone a license to drive a car may be to allow him to drive to the store.
The power to drive the car, however, is different from the motivation for granting the power.


Federal Reserve Bank of Richmond Economic Quarterly
responsibilities. These considerations, of course, are not applicable to purchases of cable transfers from the Treasury. In other words, an “open market”
in cable transfers may be regarded as embracing any person with whom a
Reserve bank may feel free to deal, including the United States Treasury,
which is a part of that market; whereas an “open market” in Government
obligations may be regarded as excluding the United States Treasury, which
issues such obligations and consequently is not part of that market. . . . On
balance, it is my opinion that a Reserve bank’s purchases of cable transfers
from the Stabilization Fund may be regarded as “open market” purchases from
a “domestic corporation.”

In outlining a legal basis for swap transactions with foreign central banks,
Hackley (U.S. Congress 1962, p. 149) turned to paragraph (e) of Section 14,
“Foreign Correspondents and Agencies:”
Every Federal reserve bank shall have power . . . with the consent or upon
the order and direction of the Board of Governors . . . to open and maintain
accounts in foreign countries, appoint correspondents, and establish agencies
in such countries wheresoever it may be deemed best for the purpose of purchasing, selling, and collecting bills of exchange . . . (or acceptances) arising
out of actual commercial transactions which have not more than ninety days
to run.

Interpretation of this language turns on the qualifying language “wheresoever
it may be deemed best.” An interpretation consistent with the real bills doctrine
is that this language allows the Fed only “to open and maintain accounts in
foreign countries . . . for the purpose of purchasing, selling, and collecting bills
of exchange.”
Hackley, however, argued that the wheresoever clause does not limit the
Fed’s authority to open accounts in foreign countries as a way of engaging in
swaps.12 In defending this position, Hackley (U.S. Congress 1962, p. 146) first
argued that the language does not unambiguously limit the opening of accounts
just to dealing in bills of exchange:
. . . perhaps the strongest argument for the more liberal construction of the
statute may be based upon the ambiguous nature of the phrase “wheresoever
it may be deemed best.” . . . It does not expressly require such accounts . . .
to be utilized only for the purpose of buying and selling bills of exchange. It
is susceptible of the construction that such accounts may be opened wherever
geographically it may be reasonably contemplated that they might be used at
some time for such purpose but that they need not be limited to that purpose
(italics in original).
12 Hackley said later in commenting on the legality of swap arrangements with the Bank of
England, “There was no express authority in the [Federal Reserve] Act for the Federal Reserve
to extend credits to foreign banks, although such an action might be justified under the authority
for the Federal Reserve Banks to open accounts with foreign banks” (Board of Governors 1967,
p. 1244).

R. L. Hetzel: Sterilized Foreign Exchange Intervention


Hackley then notes that Section 14(e) concludes by stating that once “any
such account has been opened . . . by a Federal reserve bank . . . any other
Federal reserve bank may . . . carry on . . . any transaction authorized in this
section.” That is, foreign deposit accounts can be used for any purpose, not
just transacting in bills of exchange.

Board of Governors of the Federal Reserve System. Annual Report, 1993.
. Minutes of Federal Open Market Committee, 1961, 1962, 1967,
1971, and 1972.
Broaddus, J. Alfred, Jr., and Marvin Goodfriend. “Foreign Exchange Operations
and the Federal Reserve.” Federal Reserve Bank of Richmond Annual
Report, 1995.
Burk, Kathleen, and Alec Cairncross. Goodbye, Great Britain: The 1976 IMF
Crisis. New Haven: Yale University Press, 1992.
Coombs, Charles A. The Arena of International Finance. New York: John
Wiley & Sons, 1976.
. “Treasury and Federal Reserve Foreign Exchange Operations,
March 1961–August 1962,” in U.S. Treasury Annual Report, 1962.
“Foreign Currency Memos, 1961 and 1962.” Federal Reserve Bank of
Richmond archives.
Goodfriend, Marvin. “Why We Need an ‘Accord’ for Federal Reserve Credit
Policy,” Journal of Money, Credit, and Banking, vol. 26 (August 1994),
pp. 572–80.
, and Robert G. King. “Financial Deregulation, Monetary Policy,
and Central Banking,” Federal Reserve Bank of Richmond Economic
Review, vol. 74 (May/June 1988), pp. 3–22.
Roosa, Robert V. The Dollar and World Liquidity. New York: Random House,
Shultz, George P., and Kenneth Dam. Economic Policy Beyond the Headlines.
New York: W. W. Norton & Company, 1978.
Solomon, Robert. The International Monetary System, 1945–1981. New York:
Harper & Row, 1982.
“Swap Arrangements between the System and Foreign Central Banks, 1962–
1963.” Federal Reserve Bank of Richmond archives.


Federal Reserve Bank of Richmond Economic Quarterly

Todd, Walker F. “Disorderly Markets: The Law, History, and Economics
of the Exchange Stabilization Fund and U.S. Foreign Exchange Market
Intervention,” in George G. Kaufman, ed., Research in Financial Services:
Private and Public Policy, Vol. 4. Greenwich, Conn.: JAI Press, 1992.
. “Disorderly Markets: A Fresh Look at the Law, History, and
Economics of the Exchange Stabilization Fund (ESF) and United States
Foreign Exchange Market Intervention.” Mimeo, Federal Reserve Bank of
Cleveland, February 1, 1991.
U.S. Congress, House of Representatives, Committee on Banking and Currency.
“Bretton Woods Agreements Act Amendment.” Hearings, 87 Cong. 2 Sess.
Washington: Government Printing Office, 1962.
U.S. Treasury. “Treasury Experience in the Foreign Exchange Markets.”
Treasury memorandum, February 9, 1962a.
. “Treasury Memorandum on Treasury and Federal Reserve Foreign Currency Operations and Policies—Relationships and Coordination,”
February 6, 1962b.
. Annual Report, 1961 and 1963.
Willis, H. Parker. Federal Reserve Banking Practice. New York: D. Appleton
and Company, 1926.
Young, Ralph A. “Rationale of the System’s Swap Arrangements.” Board of
Governors memorandum, October 17, 1963.
. “Federal Reserve Holdings of Foreign Currencies.” Board of
Governors memorandum, June 26, 1961.

Limits on
Interest Rate Rules
in the IS Model
William Kerr and Robert G. King


any central banks have long used a short-term nominal interest rate
as the main instrument through which monetary policy actions are
implemented. Some monetary authorities have even viewed their
main job as managing nominal interest rates, by using an interest rate rule for
monetary policy. It is therefore important to understand the consequences of
such monetary policies for the behavior of aggregate economic activity.
Over the past several decades, accordingly, there has been a substantial
amount of research on interest rate rules.1 This literature finds that the feasibility and desirability of interest rate rules depends on the structure of the
model used to approximate macroeconomic reality. In the standard textbook
Keynesian macroeconomic model, there are few limits: almost any interest rate

Kerr is a recent graduate of the University of Virginia, with bachelor’s degrees in system
engineering and economics. King is A. W. Robertson Professor of Economics at the University of Virginia, consultant to the research department of the Federal Reserve Bank of
Richmond, and a research associate of the National Bureau of Economic Research. The
authors have received substantial help on this article from Justin Fang of the University of
Pennsylvania. The specific expectational IS schedule used in this article was suggested by
Bennett McCallum (1995). We thank Ben Bernanke, Michael Dotsey, Marvin Goodfriend,
Thomas Humphrey, Jeffrey Lacker, Eric Leeper, Bennett McCallum, Michael Woodford, and
seminar participants at the Federal Reserve Banks of Philadelphia and Richmond for helpful
comments. The views expressed are those of the authors and do not necessarily reflect those
of the Federal Reserve Bank of Richmond or the Federal Reserve System.

This literature is voluminous, but may be usefully divided into four main groups. First,
there is work with small analytical models with an “IS-LM” structure, including Sargent and Wallace (1975), McCallum (1981), Goodfriend (1987), and Boyd and Dotsey (1994). Second, there
are simulation studies of econometric models, including the Henderson and McKibbin (1993) and
Taylor (1993) work with larger models and the Fuhrer and Moore (1995) work with a smaller one.
Third, there are theoretical analyses of dynamic optimizing models, including work by Leeper
(1991), Sims (1994), and Woodford (1994). Finally, there are also some simulation studies of
dynamic optimizing models, including work by Kim (1996).

Federal Reserve Bank of Richmond Economic Quarterly Volume 82/2 Spring 1996



Federal Reserve Bank of Richmond Economic Quarterly

policy can be used, including some that make the interest rate exogenously
determined by the monetary authority. In fully articulated macroeconomic
models in which agents have dynamic choice problems and rational expectations, there are much more stringent limits on interest rate rules. Most basically,
if it is assumed that the monetary policy authority attempts to set the nominal
interest rate without reference to the state of the economy, then it may be
impossible for a researcher to determine a unique macroeconomic equilibrium
within his model.
Why are such sharply different answers about the limits to interest rate rules
given by these two model-building approaches? It is hard to reach an answer to
this question in part because the modeling strategies are themselves so sharply
different. The standard textbook model contains a small number of behavioral
relations—an IS schedule, an LM schedule, a Phillips curve or aggregate supply
schedule, etc.—that are directly specified. The standard fully articulated model
contains a much larger number of relations—efficiency conditions of firms and
households, resource constraints, etc.—that implicitly restrict the economy’s
equilibrium. Thus, for example, in a fully articulated model, the IS schedule
is not directly specified. Rather, it is an outcome of the consumption-savings
decisions of households, the investment decisions of firms, and the aggregate
constraint on sources and uses of output.
Accordingly, in this article, we employ a series of macroeconomic models
to shed light on how aspects of model structure influence the limits on interest
rate rules. In particular, we show that a simple respecification of the IS schedule, which we call the expectational IS schedule, makes the textbook model
generate the same limits on interest rate rules as the fully articulated models.
We then use this simple model to study the design of interest rate rules with
nominal anchors.2 If the monetary authority adjusts the interest rate in response
to deviations of the price level from a target path, then there is a unique equilibrium under a wide range of parameter choices: all that is required is that the
authority raise the nominal rate when the price level is above the target path
and lower it when the price level is below the target path. By contrast, if the
monetary authority responds to deviations of the inflation rate from a target
path, then a much more aggressive pattern is needed: the monetary authority
must make the nominal rate rise by more than one-for-one with the inflation
rate.3 Our results on interest rate rules with nominal anchors are preserved
when we further extend the model to include the influence of expectations on
aggregate supply.

2 An important recent strain of literature concerns the interaction of monetary policy and
fiscal policy when the central bank is following an interest rate rule, including work by Leeper
(1991), Sims (1994) and Woodford (1994). The current article abstracts from consideration of
fiscal policy.
3 Our results are broadly in accord with those of Leeper (1991) in a fully articulated model.

W. Kerr and R. G. King: Limits on Interest Rate Rules


In the textbook IS-LM model with a fixed price level, it is easy to implement
monetary policy by use of an interest rate instrument and, indeed, with a pure
interest rate rule which specifies the actions of the monetary authority entirely
in terms of the interest rate. Under such a rule, the monetary sector simply
serves to determine the quantity of nominal money, given the interest rate
determined by the monetary authority and the level of output determined by
macroeconomic equilibrium. Accordingly, as in the title of this article, one may
describe the analysis as being conducted within the “IS model” rather than in
the “IS-LM model.”
In this section, we first study the fixed-price IS model’s operation under a
simple interest rate rule and rederive the familiar result discussed above. We
then extend the IS model to consider sustained inflation by adding a Phillips
curve and a Fisher equation. Our main finding carries over to the extended
model: in versions of the textbook model, pure interest rate rules are admissible
descriptions of monetary policy.
Specification of a Pure Interest Rate Rule
We assume that the “pure interest rate rule” for monetary policy takes the form
Rt = R + xt ,


where the nominal interest rate Rt contains a constant average level R.
(Throughout the article, we use a subscript t to denote the level of the variable
at date t of our discrete time analysis and an underbar to denote the level of the
variable in the initial stationary position). There are also exogenous stochastic
components to interest rate policy, xt , that evolve according to
xt = ρxt−1 + εt ,


with εt being a series of independently and identically distributed random variables and ρ being a parameter that governs the persistence of the stochastic
components of monetary policy. Such pure interest rate rules contrast with
alternative interest rate rules in which the level of the nominal interest rate
depends on the current state of the economy, as considered, for example, by
Poole (1970) and McCallum (1981).
The Standard IS Curve and the Determination of Output
In many discussions concerning the influence of monetary disturbances on real
activity, particularly over short periods, it is conventional to view output as
determined by aggregate demand and the price level as predetermined. In such
discussions, aggregate demand is governed by specifications closely related to
the standard IS function used in this article,
yt − y = −s rt − r ,



Federal Reserve Bank of Richmond Economic Quarterly

where y denotes the log-level of output and r denotes the real rate of interest.
The parameter s governs the slope of the IS schedule as conventionally drawn
in (y, r ) space: the slope is s−1 so that a larger value of s corresponds to a
flatter IS curve. It is conventional to view the IS curve as fairly steep (small s),
so that large changes in real interest rates are necessary to produce relatively
small changes in real output.
With fixed prices, as in the famous model of Hicks (1937), nominal and
real interest rates are the same (Rt = rt ). Thus, one can use the interest rate
rule and the IS curve to determine real activity. Algebraically, the result is
yt − y = −s (R − r) + xt .


A higher rate of interest leads to a decline in the level of output with an “interest
rate multiplier” of s.4
Poole (1970) studies the optimal choice of the monetary policy instrument
in an IS-LM framework with a fixed price level; he finds that it is optimal
for the monetary authority to use an interest rate instrument if there are predominant shocks to money demand. Given that many central bankers perceive
great instability in money demand, Poole’s analytical result is frequently used
to buttress arguments for casting monetary policy in terms of pure interest rate
rules. From this standpoint it is notable that in the model of this section—which
we view as an abstraction of a way in which monetary policy is frequently
discussed—the monetary sector is an afterthought to monetary policy analysis.
The familiar “LM” schedule, which we have not as yet specified, serves only
to determine the quantity of money given the price level, real income, and the
nominal interest rate.
Inflation and Inflationary Expectations
During the 1950s and 1960s, the simple IS model proved inappropriate for
thinking about sustained inflation, so the modern textbook presentation now
includes additional features. First, a Phillips curve (or aggregate supply schedule) is introduced that makes inflation depend on the gap between actual and
capacity output. We write this specification as
πt = ψ (yt − y),


where the inflation rate π is defined as the change in log price level, πt ≡
Pt − Pt−1 . The parameter ψ governs the amount of inflation (π) that arises
from a given level of excess demand. Second, the Fisher equation is used to
describe the relationship between the real interest rate (rt ) and the nominal
interest rate (Rt ),
Rt = rt + Et πt+1 ,
4 Many macroeconomists would prefer a long-term interest rate in the IS curve, rather than
a short-term one, but we are concentrating on developing the textbook model in which this
distinction is seldom made explicit.

W. Kerr and R. G. King: Limits on Interest Rate Rules


where the expected rate of inflation is Et πt+1 . Throughout the article, we
use the notation Et zt+s to denote the date t expectation of any variable z at
date t + s.
To study the effects of these two modifications for the determination of
output, we must solve for a reduced form (general equilibrium) equation that
describes the links between output, expected future output, and the nominal
interest rate. Closely related to the standard IS schedule, this specification is
yt − y = −s[(R − r) + xt ] + sψ [Et yt+1 − y].


This general equilibrium locus implies that there is a difference between temporary and permanent variations in interest rates. Holding Et yt+1 constant at y, as
is appropriate for temporary variations, we have the standard IS curve determination of output as above. With Et yt+1 = yt , which is appropriate for permanent
disturbances, an alternative general equilibrium schedule arises which is “flatter” in (y, R) space than the conventional specification. This “flattening” reflects
the following chain of effects. When variations in output are expected to occur
in the future, they will be accompanied by inflation because of the positive
Phillips curve link between inflation and output. With the consequent higher
expected inflation at date t, the real interest rate will be lower and aggregate
demand will be higher at a particular nominal interest rate.
Thus, “policy multipliers” depend on what one assumes about the adjustment of inflation expectations. If expectations do not adjust, the effects of
increasing the nominal interest rate are given by ∆R = −s and ∆R = −sψ ,
whereas the effects if expectations do adjust are


= −s/[1 − sψ ] and

= −sψ /[1 − sψ ]. At the short-run horizons that the IS model is usually
thought of as describing best, the conventional view is that there is a steep
IS curve (small s) and a flat Phillips curve (small ψ ) so that the denominator
of the preceding expressions is positive. Notably, then, the output and inflation
effects of a change in the interest rate are of larger magnitude if there is an
adjustment of expectations than if there is not. For example, a rise in the
nominal interest rate reduces output and inflation directly. If the interest rate
change is permanent (or at least highly persistent), the resulting deflation will
come to be expected, which in turn further raises the real interest rate and
reduces the level of output.
There are two additional points that are worth making about this extended
model. First, when the Phillips curve and Fisher equations are added to the
basic Keynesian setup, one continues to have a model in which the monetary
sector is an afterthought. Under an interest rate policy, one can use the LM
equation to determine the effects of policy changes on the stock of money,
but one need not employ it for any other purpose. Second, higher nominal
interest rates lead to higher real interest rates, even in the long run. In fact,
because there is expected deflation which arises from a permanent increase in


Federal Reserve Bank of Richmond Economic Quarterly

the nominal interest rate, the real interest rate rises by more than one-for-one
with the nominal rate.5
Rational Expectations in the Textbook Model
There has been much controversy surrounding the introduction of rational expectations into macroeconomic models. However, in this section, we find that
there are relatively minor qualitative implications within the model that has
been developed so far. In particular, a monetary authority can conduct an unrestricted pure interest rate policy so long as we have the conventional parameter
values implying sψ < 1. In the rational expectations solution, output and inflation depend on the entire expected future path of the policy-determined nominal
interest rate, but there is a “discounting” of sorts which makes far-future values
less important than near-future ones.
To determine the rational expectations solution for the standard Keynesian
model that incorporates an IS curve (3), a Phillips curve (5), and the Fisher
equation (6), we solve these three equations to produce an expectational difference equation in the inflation rate,
πt = −sψ [(Rt − r) − Et πt+1 ],


which links the current inflation rate πt to the current nominal interest rate and
the expected future inflation rate.6 Substituting out for πt+1 using an updated
version of this expression, we are led to a forward-looking description of current inflation as related to the expected future path of interest rates and a future
value of the inflation rate,
πt = −sψ (Rt − r) − (sψ )2 Et (Rt+1 − r) . . .
−(sψ )n Et (Rt+n−1 − r) + (sψ )n Et πt+n .


For short-run analysis, the conventional assumption is that there is a steep IS
curve (small s) because goods demand is not too sensitive to interest rates and a
flat Phillips curve (small ψ ) because prices are not too responsive to aggregate
demand. Taken together, these conditions imply that sψ < 1 and that there is
substantial “discounting” of future interest rate variations and of the “terminal
inflation rate” Et πt+n : the values of the exogenous variable R and endogenous
variable π that are far away matter much less than those nearby. In particular, as
we look further and further out into the future, the value of long-term inflation,
Et πt+n, exerts a less and less important influence on current inflation.
5 This implication is not a particularly desirable one empirically, and it is one of the factors
that leads us to develop the models in subsequent sections.
6 Alternatively, we could have worked with the difference equation in output (7), since the
Phillips curve links output and inflation, but (8) will be more useful to us later when we modify
our models to include price level and inflation targets.

W. Kerr and R. G. King: Limits on Interest Rate Rules


Using this conventional set of parameter values and making the standard
rational expectations solution assumption that the inflation process does not
contain explosive “bubble components,” the monetary authority can employ
any pure nominal interest rate rule.7 Using the assumed form of the pure interest rate policy rule, (1) and (2), the inflation rate is
(R − r) +
xt .
1 − sψ
1 − sψρ

πt = −sψ


Thus, a solution exists for a wide range of persistence parameters in the policy
rule (all ρ < (sψ )−1 ). Notably, it exists for ρ = 1, in which variations in the
random component of interest rates are permanent and the “policy multipliers”
are equal to those discussed in the previous subsection.8

Developments in macroeconomics over the last two decades suggest the importance of modifying the IS schedule to include a dependence of current output
on expected future output. In this section, we introduce such an “expectational
IS schedule” into the model and find that there are important limits on interest
rate rules. We conclude that one cannot or should not use a pure interest rate
rule, i.e., one without a response to the state of the economy.
Modifying the IS Schedule
Recent work on consumption and investment choices by purposeful firms and
households suggests that forecasts of the future enter importantly into these
decisions. These theories suggest that the conventional IS schedule (3) should
be replaced by an alternative, expectational IS schedule (EIS schedule) of the
yt − Et yt+1 = −s rt − r .


Figure 1 draws this schedule in (y, r) space, i.e., we graph
rt = r − (yt − Et yt+1 ).

More precisely, we require that the policy rule must result in a finite inflation rate, i.e.,
|πt | = |sψ
j=0 (sψ ) Et (Rt+j − r) | < ∞. Since sψ < 1, this requirement is consistent with a
wide class of driving processes as discussed in the appendix.
8 With sψ ≥ 1, there is a very different situation, as we can see from looking at (9): future
interest rates are more important than the current interest rate, and the terminal rate of inflation
exerts a major influence on current inflation. Long-term expectations hence play a very important
role in the determination of current inflation. In this situation, there is substantial controversy
about the existence and uniqueness of a rational expectations equilibrium, which we survey in
the appendix and discuss further in the next section of the article.


Federal Reserve Bank of Richmond Economic Quarterly

Figure 1 The Expectational IS Schedule

IS with y = E y
t t+1


IS with Et yt+1 held fixed


log of output (y)

In this figure, expectations about future output are an important shift factor in
the position of the conventionally defined IS schedule.
The expectational IS schedule thus emphasizes the distinction between
temporary and permanent movements in real output for the level of the real
interest rate. If a disturbance is temporary (so that we hold expected future
output constant, say at Et yt+1 = y), then the linkage between the real rate
and output is identical to that indicated by the conventional IS schedule of the
previous section. However, if variations in output are expected to be permanent,
with Et yt+1 = yt , then the IS schedule is effectively horizontal, i.e., rt = r is
compatible with any level of output. Thus, the EIS schedule is compatible with
the traditional view that there is little long-run relationship between the level
of the real interest rate and the level of real activity. It is also consistent with
Friedman’s (1968a) suggestion that there is a natural real rate of interest (r )
which places constraints on the policies that a monetary authority may pursue.9
9 In this sense, it is consistent with the long-run restrictions frequently built into real business
cycle models and other modern, quantitative business cycle models that have temporary monetary
nonneutralities (as surveyed in King and Watson [1996]).

W. Kerr and R. G. King: Limits on Interest Rate Rules


To think about why this specification is a plausible one, let us begin with
consumption, which is the major component of aggregate demand (roughly
two-thirds in the United States). The modern literature on consumption derives
from Friedman’s (1957) construction of the “permanent income” model, which
stresses the role of expected future income in consumption decisions. More
specifically, modern consumption theory employs an Euler equation which may
be written as
σ Et ct+1 − ct = rt − r ,
where c is the logarithm of consumption at date t, and σ is the elasticity of
marginal utility of a representative consumer.10 Thus, for the consumption part
of aggregate demand, modern macroeconomic theory suggests a specification
that links the change in consumption to the real interest rate, not one that links
the level of consumption to the real interest rate. McCallum (1995) suggests
that (12) rationalizes the use of (11). He also indicates that the incorporation of
government purchases of goods and services would simply involve a shift-term
in this expression.
Investment is another major component of aggregate demand, which can
also lead to an expectational IS specification in the following way.11 For
example, consider a firm with a constant-returns-to-scale production function,
whose level of output is thus determined by the demand for its product. If
the desired capital-output ratio is relatively constant over time, then variations
in investment are also governed by anticipated changes in output. Thus, consumption and investment theory suggest the importance of including expected
future output as a positive determinant of aggregate demand. We will consequently employ the expectational IS function as a stand-in for a more complete
specification of dynamic consumption and investment choice.
Implications for Pure Interest Rate Rules
There are striking implications of this modification for the nature of output
and interest rate linkages or, equivalently, inflation and interest rate linkages.
Combining the expectational IS schedule (11), the Phillips curve (5), and the
Fisher equation (6), we obtain
yt − y = −s[(R − r ) + xt ] + (1 + sψ )(Et yt+1 − y).


The key point is that expected future output has a greater than one-for-one
effect on current output independent of the values of the parameters s and ψ .
10 See the surveys by Hall (1989) and Abel (1990) for overviews of the modern approach to
consumption. In these settings, the natural real interest rate, r, would be determined by the rate of
time preference, the real growth rate of the economy, and the extent of intertemporal substitutions.
11 In critiquing the traditional IS-LM model, King (1993) argues that a forward-looking
rational expectations investment accelerator is a major feature of modern quantitative macroeconomic models that is left out of the traditional IS specification.


Federal Reserve Bank of Richmond Economic Quarterly

This restriction to a greater than one-for-one effect is sharply different from
that which derives from the traditional IS model and the Fisher equation, i.e.,
from the less than one-for-one effect found in (7) above.
One way of summarizing this change is by saying that the general equilibrium locus governing permanent variations in output and the real interest rate
becomes upward-sloping in (y, R) space, not downward-sloping. Thus, when we
assume that Et yt+1 = y, we have the conventional linkage from the nominal
rate to output. However, when we assume that Et yt+1 = yt , then we find that
there is a positive, rather than negative, linkage. Interpreted in this manner,
(13) indicates that a permanent lowering of the nominal interest rate will give
rise to a permanent decline in the level of output. This reversal of sign involves
two structural elements: (i) the horizontal “long-run” IS specification of Figure
1 and (ii) the positive dependence on expected future output that derives from
the combination of the Phillips curve and the Fisher equation.
The central challenge for our analysis is that this model’s version of the
general equilibrium under an interest rate rule obeys the unconventional case
for rational expectations theory that we described in the previous section, irrespective of our stance on parameter values. The reduced-form inflation equation
for our economy, which is similar to (8), may be readily derived as12
(1 + sψ )Et πt+1 − πt = sψ (Rt − r ) = sψ [(R − r ) + xt ].


Based on our earlier discussion and the internal logic of rational expectations
models, it is natural to iterate this expression forward. When we do so, we find
πt = −sψ [(Rt − r ) + (1 + sψ )Et (Rt+1 − r ) + . . .
+ (1 + sψ )n Et (Rt+n − r )] + (1 + sψ )n+1 Et πt+n+1 .


As we look further and further out into the future, the value of long-term inflation, Et πt+n+1 , exerts a more and more important influence on current inflation.
With the EIS function, therefore, it is always the case that there is an important
dependence of current outcomes on long-term expectations. One interpretation
of this is that public confidence about the long-run path of inflation is very
important for the short-run behavior of inflation.
Macroeconomic theorists who have considered the solution of rational expectations models in this situation have not reached a consensus on how to
proceed. One direction is provided by McCallum (1983), who recommends
12 The ingredients of this derivation are as follows. The Phillips curve specification of our
economy states that πt = ψ (yt − y). Updating this expression and taking additional expectations,
we find that Et πt+1 = ψ (Et yt+1 − y). Combining these two expressions with the expectational
IS function (11), we find that Et πt+1 − πt = ψ (Et yt+1 − yt ) = sψ (rt − r ). Using the Fisher
equation together with this result, we find the result reported in the text.

W. Kerr and R. G. King: Limits on Interest Rate Rules


forward-looking solutions which emphasize fundamentals in ways that are similar to the standard solution of the previous section. Another direction is provided
by the work of Farmer (1991) and Woodford (1986), which recommends the
use of a backward-looking form. These authors stress that such solutions may
also include the influences of nonfundamental shocks. In the appendix, we
discuss the technical aspects of these alternative approaches in more detail, but
we focus here on the key features that are relevant to thinking about limits
on interest rate rules. We find that the forward-looking approach suggests that
no stable equilibrium exists if the interest rate is held fixed at an arbitrary
value or governed by a pure rule. We also find that the backward-looking
approach suggests that many stable equilibria exist, including some in which
nonfundamental sources of uncertainty influence macroeconomic activity.
Forward-Looking Equilibria
One important class of rational expectations equilibrium solutions stresses the
forward-looking nature of expectations, so that it can be viewed as an extension
of the solutions considered in the previous section. These solutions depend on
the “fundamental” driving processes, which in our case come from the interest
rate rule. McCallum (1983) has proposed that macroeconomists focus on such
solutions; he also explains that these are “minimum state variable” or “bubble
free” solutions to (14) and provides an algorithm for finding these solutions in
a class of macroeconomic models.
In this case, the inflation solution depends only on the current interest
rate under the policy rule (1) and (2). To obtain an empirically useful solution using this method, we must circumscribe the interest rate rule so that the
limiting sum in the solution for the inflation rate in (15) is finite as we look
further and further ahead.13 In the current context, this means that the monetary
authority must (i) equate the nominal and real interest rate on average (setting
R − r = 0 in (10) and (ii) substantially restrict the amount of persistence (requiring ρ < (1 + sψ )−1 ). These two conditions can be understood if we return
to (15), which requires that πt = −sψ [(Rt − r ) + . . . + (1 + sψ )n Et (Rt+n − r )]
+ (1 + sψ )n+1 Et πt+n+1 . First, the average long-run value of inflation must be
zero or otherwise the terms like (1 + sψ )n+1 Et πt+n+1 will cause the current
inflation rate to be positive or negative infinity. Second, the stochastic variations in the interest rate must be sufficiently temporary that there is a finite
sum (Rt − r) + (1 + sψ )Et (Rt+1 − r ) + . . . + (1 + sψ )nEt (Rt+n − r ) =
xt + (1 + sψ )ρxt + . . . (1 + sψ )n ρn xt as n is made arbitrarily large.
How do these requirements translate into restrictions on interest rate rules
in practice? Our view is that the second of these requirements is not too important, since there will always be finite inflation rate equilibria for any finite-order

Flood and Garber (1980) call this condition “process consistency.”


Federal Reserve Bank of Richmond Economic Quarterly

moving-average process. (As explained further in the appendix, such solutions
always exist because the limiting sum is always finite if one looks only a finite
number of periods ahead). However, we think that the first requirement (that
R − r = 0) is much more problematic: it means that the average expected
inflation rate must be zero. This requirement constitutes a strong limitation on
pure interest rate rules. Further, it is implausible to us that a monetary authority
could actually satisfy this condition, given the uncertainty that is attached to
the level of r.14 If the condition is not satisfied, however, there does not exist
a rational expectations equilibrium under an interest rate rule if one restricts
attention to minimum state variable equilibria.
Backward-Looking Equilibria
Other macroeconomists like Farmer (1991) and Woodford (1986) have argued
that (14) leads to empirically interesting solutions in which inflation depends on
nonfundamental factors, such as sunspots, but does so in a stationary manner.
In particular, working along the lines of these authors, we find that any inflation
process of the form
πt =

1 + sψ

πt−1 +

1 + sψ

(Rt−1 − r ) + ζt


is a rational expectations equilibrium consistent with (14).15 In this expression,
ζt is an arbitrary random variable that is unpredictable using date t − 1 information. Such a “backward-looking” solution is generally nonexplosive, and
interest rates are a stationary stochastic process.16
There are three points to be made about such equilibria. First, there may
be a very different linkage from interest rates to inflation and output in such
equilibria than suggested by the standard IS model of Section 1. A change in
the nominal interest rate at date t will have no effect on inflation and output at
date t if it does not alter ζt : inflation may be predetermined relative to interest
rate policy rather than responding immediately to it. Second, a permanent increase in the nominal interest rate at date t will lead ultimately to a permanent
increase in inflation and output, rather than to the decrease described in the
14 One measure of this uncertainty is provided by the controversy over Fama’s (1975) test
of the link between inflation and nominal interest rates, which assumed that the ex ante real
interest rate was constant. In a critique of Fama’s analysis, Nelson and Schwert (1977) argued
compellingly that there was sufficient unforecastable variability in inflation that it was impossible
to tell from a lengthy data set whether the real rate was constant or evolved according to a random
15 It can be confirmed that this is a rational expectations solution by simply updating it one
period and taking conditional expectations, a process which results in (8).
16 By generally, we mean that it is stationary as long as we assume that sψ > 0, as used
throughout this paper.

W. Kerr and R. G. King: Limits on Interest Rate Rules


previous section of the article.17 Third, if there are effects of interest rate
changes on output and inflation within a period, then these may be completely
unpredictable to the monetary authority since ζt is arbitrary: ζt can therefore
depend on Rt − Et−1 Rt . We could, for example, see outcomes which took the
πt =
πt−1 +
(Rt−1 − r) + ζt (Rt − Et−1 Rt ),
1 + sψ
1 + sψ
so that the short-term relationship between inflation (output) and interest rate
shocks was random in magnitude and sign.
Combining the Cases: Limits on Pure Interest Rate Rules
Thus, depending on what one admits as a rational expectations equilibrium
in this case, there may be very different outcomes; but either case suggests
important limits on pure interest rate rules.
With forward-looking equilibria that depend entirely on fundamentals, there
may well be no equilibrium for pure interest rate rules, since it is implausible
that the monetary authority can exactly maintain a zero gap between the average
nominal rate and the average real rate (R − r = 0) due to uncertainty about r.
However, if one can maintain this zero gap, there are some additional limits on
the driving processes for autonomous interest rate movements. Thus, for the
autoregressive case in (2), interest rate policies cannot be “too persistent” in
the sense that we must require ρ(1 + sψ ) < 1.
With backward-looking equilibria, there is a bewildering array of possible outcomes. In some of these, inflation depends only on fundamentals, but
the short-term relationship between inflation and interest rates is essentially
arbitrary. In others, nonfundamental sources of uncertainty are important determinants of macroeconomic activity. If such an equilibrium were observed in an
actual economy, then there would be a very firm basis for the monetarist claim
that interest rate rules lead to excess volatility in macroeconomic activity, even
though there would be a very different mechanism than the one that typically
has been suggested. That is, the sequence of random shocks ζt amounts to an
entirely avoidable set of shocks to real macroeconomic activity (since, via the
Phillips curve, inflation and output are tightly linked, πt = ψ (yt − y)).18 While
feasible, pure interest rate rules appear very undesirable in this situation.
Under either description of equilibrium, the limits on the feasibility and
desirability of interest rate rules arise because individuals’ beliefs about
17 That is, there is a sense in which this Keynesian model produces neoclassical conclusions
in response to interest rate shocks with a backward-looking equilibrium.
18 This policy effect is formally similar to one that Schmitt-Grohe and Uribe (1995) describe
for balanced budget financing. Perhaps these changes in expectations could be the “inflation
scares” that Goodfriend (1993) suggests are important determinants of macroeconomic activity
during certain subperiods of the post-war interval.


Federal Reserve Bank of Richmond Economic Quarterly

long-term inflation receive very large weight in determination of the current
price level. Inflation psychology exerts a dominant influence on actual inflation
if a pure interest rate rule is used.

In this section, building on the prior analyses of Parkin (1978) and McCallum
(1981), we study the effects of appending a “nominal anchor” to the model of
the previous section, which was comprised of the expectational IS specification,
the Phillips curve, and the Fisher equation. Such policies can work to stabilize
long-term expectations, eliminating the difficulties that we encountered above.
We look at two rules that are policy-relevant alternatives in the United States
and other countries.
The first of these rules, which we call price-level targeting, specifies that
the monetary authority sets the interest rate so as to partially respond to deviations of the current price level from a target path P t , while retaining some
independent variation in the interest rate xt . We view the target price level path
as having the form P t = P 0 + π t , but more complicated stochastic versions
are also possible. In this section, we shall view xt as an arbitrary sequence of
numbers and in later sections we will view it as a zero mean stochastic process.
The interest rate rule therefore is written as
Rt = R + f (Pt − P t ) + xt ,


where the parameter f governs the extent to which the interest rate varies in
response to deviations of the current price level from its target path.
The second of these rules, which we call inflation targeting, specifies
that the monetary authority sets the interest rate so as to partially respond
to deviations of the inflation rate from a target path π t , while retaining some
independent variation in the interest rate. Algebraically, the rule is
Rt = R + g(πt − π ) + xt .


We explore these target schemes for two reasons. First, they are relevant to
current policy debate in the United States and other countries. Second, they
each can be implemented without knowledge of the money demand function,
just as pure interest rate rules could in the basic IS model. 19
The difference between these two policies involves the extent of “base
drift” in the nominal anchor, i.e., they differ in terms of whether the central
19 This latter rule is related to proposals by Taylor (1993). It is also close to (but not exactly
equal to) the widely held view that the Federal Reserve must raise the real rate of interest in
response to increases in inflation to maintain the target rate of inflation (such an alternative rule
would be written as Rt = R + g(Et πt+1 − π ) + xt ).

W. Kerr and R. G. King: Limits on Interest Rate Rules


bank is presumed to eliminate the effects of past gaps between the actual and
the target price level.20 In each case, for analytical simplicity, we assume that
the central bank can observe the current price level without error at the time it
sets the interest rate.
Inflation Targets with an Interest Rate Rule
It is relatively easy to use (14) to characterize the conditions under which
an interest rate rule can implement an inflation target without introducing a
multiplicity of equilibria. To analyze this case, we replace Rt in (14) with its
value under the interest rate rule, which is Rt = R + g(πt − π ) + xt . The result
(1 + sψ )Et (πt+1 − π ) − (1 + sψ g)(πt − π ) = sψ [xt + (R − π − r )].
It is clear that there is a unique solution of the standard form if and only if
g > 1. This solution is
πt − π = −

1 + sψ g


1 + sψ
1 + sψ g


[Et xt+j + (R − π − r )] .


Thus, to have the inflation rate average to π we must impose (R − π − r ) = 0
and use the fact that the unconditional expected value of each of the terms
Et xt+j is zero. However, if the equilibrium real interest rate were unknown by
the monetary authority, as is plausibly the case, then there would simply be
an average rate of inflation that differed from the target level persistently. In
particular and in contrast to the analysis of “pure” interest rate rules above,
there would not be any difficulty with the existence of rational expectations
equilibrium. That is, the form of the interest rate rule means that there is a
“discounted” influence of future inflation in (19); the central bank has assured
that the exact state of long-term inflation expectations is unimportant for current
inflation by the form of its interest rate rule.21
Price-Level Targets with an Interest Rate Rule
There is a somewhat more complicated solution when an interest rate rule is
used to target the price level. However, this solution embodies the very intuitive
result that an interest rate rule leads to a conventional, unique, forward-looking
20 In both of these policy rules, to make the solutions algebraically simple, we assume that
R = r + π. This does not correspond to an assumption that the central bank knows the real
interest rate—it is only a normalization that serves to make the average and target inflation rates
or price level paths coincide.
21 Interestingly, if one modifies the rule so that it is the expected rate of inflation that is targeted, Rt = R + g(Et πt+1 − π ) + xt , then the same condition for a standard rational expectations
equilibrium emerges, g > 1. It is also the case that g > 1 is the relevant condition for a model
with flexible prices, which may be verified by combining the Fisher equation and the policy rule.


Federal Reserve Bank of Richmond Economic Quarterly

equilibrium so long as f > 0. More specifically, imposing (R − π − r ) = 0, we
can show that the unique stable solution takes the form
Pt = µ1 Pt−1 +

1 + sψ




(f P t+j − Et xt+j − π ) ,



where the µ parameters satisfy µ1 <
and µ2 > 1 if f > 0.22 The form
(1+sψ )
of this solution is plausible, given the structure of the model. The past price
level is important because this is a model with a Phillips curve, i.e., it is a
sticky price solution. Expectations of a higher target price level path raise the
current price level. Increases in the current or future autonomous component
of the interest rate lower the current price level.
This simple and intuitive condition for price level determinacy prevails in
all of the models studied analytically in this article and in many other simulation models that we have constructed. (For example, it is also the case that
f > 0 is the relevant condition for a model with flexible prices, which may be
verified by combining the Fisher equation and the policy rule as in Boyd and
Dotsey [1994]). All the monetary authority needs to do to provide an anchor
for expectations is to follow a policy of raising the nominal interest rate when
the price level exceeds a target path. 23

In this section, we consider the introduction of expectations into the aggregate
supply side (or Phillips curve) of the model economy. Given the emphasis that
macroeconomics has placed on the role of expectations on the aggregate supply
side (or the “expectations adjustment” of the Phillips curve), this placement
may seem curious. However, we have chosen it deliberately for two reasons,
one historical and one expositional.

To reach this conclusion, we write the basic dynamic equation for the model (14) as
sψ Rt + (1 + sψ )π = [(1 + sψ )F − 1][ F − 1]Et Pt−1,


using the lead operator F, defined so that Fn Et xt+j = Et xt+j+n . Inspecting this expression, we see
that the two roots of the polynomial H(z) = (1 + sψ )[z− (1+sψ ) ][z−1] are 1 and (1+sψ ) . More
2 − Sz+P] = A(z−µ )(z−µ ), the sum
generally, for any second order polynomial H(z) = A[z
of the roots is S and the product of the roots is P. If there is a price level target in place, then we
require Rt = R + f (Pt − P t ) + xt , which alters the polynomial to (1 + sψ )[z− (1+sψ ) ][z−1] − f z,
i.e., we perturb the sum, but not the product, of the roots. Accordingly, one root satisfies µ1 <
and the other satisfies µ2 > 1.
(1+sψ )
23 This difference between price level and inflation rules is very suggestive. That is, by
binding itself to a long-run path for the price level, the monetary authority appears to give itself a
wider range of short-run policy options than if it seeks to target the inflation rate. We are currently
using the models of this article and related fully articulated models to explore these connections
in more detail.

W. Kerr and R. G. King: Limits on Interest Rate Rules


We started our analysis of interest rate rules by studying the textbook ISLM-PC model that became the workhorse of Keynesian macroeconomics during
the early 1960s.24 In the late 1960s, a series of studies by Milton Friedman
suggested an alternative set of linkages to the IS-LM-PC model. First, Friedman
(1968a) suggested that there was a “natural” real rate of interest that monetary
policy cannot affect in the long run. He used this natural rate of interest to argue
that the long-run effect of a sustained inflation due to a monetary expansion
could not be that suggested by the Keynesian model discussed in Section 1
above, which associated a lower interest rate with higher inflation. Instead, he
argued that the nominal interest rate had to rise one-for-one with sustained
inflation and monetary expansion due to the natural real rate of interest. Friedman thus suggested that this natural rate of interest placed important limits on
monetary policies. In Section 2 of the article, using a model with a natural rate
of interest but with a long-run Phillips curve, we found such limits on interest
rate rules. By focusing first on the role of expectations in aggregate demand
(the IS curve), we made clear that the crucial ingredient to our case for limits
on interest rate rules is the existence of a natural real rate of interest rather
than information on the long-run slope of the Phillips curve.
Friedman (1968b) argued that a similar invariance of real economic activity
to sustained inflation should hold, i.e., that there should be no long-run slope to
the Phillips curve. He suggested this invariance resulted from the one-for-one
long-run expected inflation on the wage and price determination that underlay
the Phillips curve. We now discuss adding expectations in aggregate supply,
working first with flexible price models and then with sticky price models.
Flexible Price Aggregate Supply Theory
In an influential study, Sargent and Wallace (1975) developed a log-linear model
that embodied Friedman’s ideas and followed Lucas (1972) in assuming rational
expectations. Essentially, Sargent and Wallace took the IS schedule and Fisher
equation from the Keynesian model of Section 1, but introduced the following
expectational Phillips curve:
πt = ψ (yt − y) + Et−1 πt .


Initial interest in the Sargent and Wallace (1975) study focused on a “policy
irrelevance” implication of their work, which was that systematic monetary
policy—cast in terms of rules governing the evolution of the stock of money—
had no effect on the distribution of output. That conclusion is now understood

24 Our model was somewhat simplified relative to the more elaborate dynamic versions of
these models, in which lags of inflation were entered on the right-hand side of the inflation
equation (5), perhaps as proxies for expected inflation.


Federal Reserve Bank of Richmond Economic Quarterly

to depend in delicate ways on the specification of the IS curve (3) and the
Phillips curve (22), but it is not our focus here.
Another important aspect of the Sargent and Wallace study was their finding
that there was nominal indeterminacy under a pure interest rate rule. To exposit
this result, it is necessary to introduce a money demand function of the form
used by Sargent and Wallace,
Mtd − Pt = δyt − γRt ,
where Md is the demand for nominal money, Mt .
Since nominal indeterminacy in the Sargent-Wallace model arises even if
real output is constant, we may proceed as follows to determine the conditions
under which such indeterminacy arises. First, we may take expectations at
t − 1 of (22), yielding Et−1 yt = y. Second, using the standard IS function
(3), we learn that this output neutrality result implies Et−1 rt = r, i.e., that the
real interest rate is invariant to expected monetary policy. Third, the Fisher
equation then implies that Et−1 Rt = r + Et−1 πt+1 . Fourth, the pure interest rate
rule implies that Et−1 Rt = R + Et−1 xt . Combining these last two equations,
we find that expected inflation is well determined under an interest rate rule,
Et−1πt+1 = (R −r )+ Et−1xt , but that there is nothing that determines the levels
of money and prices, i.e., the money demand function determines the expected
level of real balances, Et−1 (Mt − Pt ) = δy − γEt−1 Rt , not the level of nominal
money or prices.
It turns out that our two policy rules resolve this nominal indeterminacy under exactly the same parameter restrictions as are required to yield a determinate
equilibrium in Section 3 above. For example, it is easy to see that the inflation
rule, which implies that Et−1 Rt = R + g(Et−1 πt − π ) + Et−1 xt , requires g > 1 if
the implied dynamics of inflation Et−1 πt+1 = (R − r ) + g(Et−1 πt − π ) + Et−1xt
are to be determinate, which leads to a determinate price level. A similar line
of argument may be used to show that f > 0 is the condition for determinacy
with a price-level target.
Practical macroeconomists have frequently dismissed the Sargent and Wallace (1975) analysis of limits on interest rate rules because of its underlying
assumption of complete price flexibility. However, as we have seen, conclusions
concerning indeterminacy similar to those arising from the Sargent-Wallace
model occur in natural rate models without price flexibility.25

25 From this perspective, the Sargent-Wallace analysis is of interest because there is a natural
real rate of interest without an expectational IS schedule. Instead, the natural rate arises due to
general equilibrium conditions. Limits to interest rate rules thus appear to arise in natural rate
models, irrespective of whether these originate in the IS specification or as part of a complete
general equilibrium model.

W. Kerr and R. G. King: Limits on Interest Rate Rules


Sticky Price Aggregate Supply Theory
An alternative view of aggregate supply has been provided by New Keynesian
macroeconomists. One of the most attractive and tractable representations is
due to Calvo (1983) and Rotemberg (1982), who each derive the same aggregate price adjustment equation from different underlying assumptions about the
costs of adjusting prices.26 To summarize the results of this approach, we use
the alternative expectations-augmented Phillips curve,
πt = βEt πt+1 + ψ (yt − y),


which is a suitable approximation for small average inflation rates. This relationship has a long-run trade-off between inflation and real activity, ψ /(1 − β).
Since the parameter β has the dimension of a real discount factor in this model,
β is necessarily smaller than unity but not too much so, and the long-run inflation cost of greater output is very high. Thus, while the Calvo and Rotemberg
specification is not quite as classical as that of Sargent and Wallace, in the long
run it is still very classical relative to the naive Phillips curve that we employed
With the Calvo and Rotemberg specification of the expectations-augmented
Phillips curve (23), the expectational IS function (11) and the Fisher equation
(6), we can again show that there are limits to interest rate rules of exactly the
form discussed earlier. Further, we can also show that the necessary structure of
nominal anchors is g > 1 for inflation targets and f > 0 for price level targets.27
That is, we again find that the monetary authority can anchor the economy by
responding weakly to the deviations of the price level from a target path, but
that much more aggressive responses to deviations of inflation from target are

In this article, we have studied limits on interest rate rules within a simple
macroeconomic model that builds rational expectations into the IS schedule
and the Phillips curve in ways suggested by recent developments in macroeconomics.
We began with a version of the standard fixed-price textbook model. Working within this setup in Section 1, we replicated two results found by many
prior researchers. First, almost any interest rate rule can feasibly be employed:
26 Calvo (1983) obtains this result for the aggregate price level in a setting where individual
firms have an exogenous probablility of being permitted to change their price in a given period.
Rotemberg (1982) derives it for a setting in which the representative firm has quadratic costs of
adjusting prices. Rotemberg (1987) discusses the observational equivalence of the two setups.
27 The derivations are somewhat more tedious than those of the main text and are available
on request from the authors.


Federal Reserve Bank of Richmond Economic Quarterly

there are essentially no limits on interest rate rules. In particular, we found
that a central bank can even follow a “pure interest rate rule” in which there
is no dependence of the interest rate on aggregate economic activity. Second,
under this policy specification, the monetary equilibrium condition—the LM
schedule of the traditional IS-LM structure—is unimportant for the behavior
of the economy because an interest rate rule makes the quantity of money
demand-determined. Accordingly, as suggested in the title of this article, we
showed why many central bank and academic researchers have regarded the
traditional framework essentially as an “IS model” when an interest rate rule
is assumed to be used.
We then undertook two standard modifications of the textbook model so
as to consider the consequences of sustained inflation. One was the addition
of a Phillips curve mechanism, which specified a dependence of inflation on
real activity. The other was the introduction of the distinction between real and
nominal interest rates, i.e., a Fisher equation. Within such an extended model,
we showed that there continued to be few limits on interest rate rules, even
with rational expectations, as long as prices were assumed to adjust gradually
and output was assumed to be demand-determined.
Our attention then shifted in Section 2 to alterations of the IS schedule,
incorporating an influence of expectations of future output. To rationalize this
“aggregate demand” modification, we appealed to modern consumption and
investment theories—the permanent income hypothesis and the rational expectations accelerator model—which suggest that the standard IS schedule is
badly misspecified. These theories predict a relationship between the expected
growth rate of output (or aggregate demand) and the real interest rate, rather
than a connection between the level of output and the real interest rate. (That
is, the standard IS schedule will give the correct conclusions only if expected
future output is unaffected by the shocks that impinge on the economy, which
is a case of limited empirical relevance). We showed that such an “expectational IS schedule” places substantial limits on interest rate rules under rational
expectations. These limits derive from a major influence of expected future
policies on the present level of inflation and real activity. Analysis of this
model consequently required us to discuss alternative solution methods for rational expectations models in some detail. We focused on the conditions under
which such equilibria exist and are unique.
Depending on the equilibrium concept that one employs, pure interest rate
rules are either infeasible or undesirable when there is an expectational IS
schedule. If one follows McCallum (1983) in restricting attention to minimum
state variable equilibria, in which only fundamentals drive inflation and real
activity, then there is likely to be no equilibrium under a pure interest rate
rule. Equilibria are unlikely to exist because existence requires that the pure
interest rate make the (unconditional) expected value of the nominal rate and
the expected value of the real rate coincide, i.e., that it make the unconditional

W. Kerr and R. G. King: Limits on Interest Rate Rules


expected inflation rate zero. We find it implausible that any central bank could
exactly satisfy this condition in practice. Alternatively, if one follows Farmer
(1991) and Woodford (1986) in allowing a richer class of monetary equilibria,
in which fundamental and nonfundamental sources of shocks can be relevant
to inflation and real activity, then there are also major limits or, perhaps more
accurately, drawbacks to conducting monetary policy via a pure interest rate
rule. The short-term effects of changes in interest rates on macroeconomic
activity were found to be of arbitrary sign (or zero); the longer term effects are
of opposite sign to the predictions of the standard IS model.
In Section 3, we followed prior work by Parkin (1978), McCallum (1981),
and others in studying interest rate rules that have a nominal anchor. First,
we showed that a policy of targeting the price level can readily provide the
nominal anchor that leads to a unique real equilibrium: there need only be
modest increases in the nominal rate when the price level is above its target
path. Second, we also showed that a policy of inflation targeting requires a
much more aggressive response of nominal interest rates: a unique equilibrium
requires that the nominal interest rate must increase by more than one percent
when inflation exceeds the target path by one percent. Our focus on these two
policy targeting schemes was motivated by their current policy relevance.
In Section 4, we added expectations to the aggregate supply side of the
economy, proceeding according to two popular strategies. First, we considered the flexible price aggregate supply specification that Sargent and Wallace
(1975) used to study interest rate rules. Second, we considered the sticky price
model of Calvo (1983) and Rotemberg (1982). Both of these extended models
required the same parameter restrictions on policy rules with nominal anchors
as in the simpler model of Section 3, thus suggesting a robustness of our basic
results on the limits to interest rate rules and on the admissable form of nominal
anchors in the IS model.
Having learned about the limits on interest rate rules in some standard
macroeconomic models, we are now working to learn more about the positive
and normative implications of alternative feasible interest rate rules in smallscale rational expectations models. We are especially interested in contrasting
the implications of rules that require a return to a long-run path for the price
level (as with our simple price level targeting specification) with rules that allow the long-run price level to vary through time (as with our simple inflation
targeting specifications).


Federal Reserve Bank of Richmond Economic Quarterly

This appendix discusses issues that arise in the solution of linear rational expectations models, using as an example the first model studied in the main
text. That model is comprised of a Phillips curve (πt = Pt − Pt−1 = ψ (yt − y)),
an IS function (yt − y = −s(rt − r )), the Fisher equation (rt = Rt − Et πt+1 )
and a pure interest rate role for monetary policy (Rt = R + xt ). Combining the
expressions we find a basic expectational difference equation that governs the
inflation rate,
πt = θEt πt+1 − θ(R − r + xt ),


where we define θ = sψ so as to simplify notation in this discussion. Iterating
this expression forward, we find that

πt = −


θ j+1 Et R − r + xt+j

+ θ J Et πt+J .


Our analysis will focus on the important special case in which
xt = ρxt−1 + εt ,


where ε is a serially uncorrelated random variable, but we will also discuss
some additional specifications.28
The Standard Case
The standard case explored in the literature involves the assumption that θ < 1
and ρ < 1. Then, the policy rule implies that the interest rate is a stationary
stochastic process and it is natural to look for inflation solutions that are also
stationary stochastic processes. It is also natural to take the limit as J → ∞ in
(25), drop the last term, and write the result as
πt = −


θ j+1 Et R − r + xt+j



Figure A1 indicates the region that is covered by this standard case. Under
the driving process (26), it follows that the stationary solution is one reported
many times in the literature:
πt = −

R−r +
xt .
1 − θρ


If we write a general autoregressive driving process as xt = qvt and vt =
j=0 j t−j
+ εt , then one can always (i) cast this in first-order autoregressive form and (ii) undertake a
canonical variables decomposition of the resulting first-order system. Then, each of the canonical variables will evolve according to specifications like those in (26) so that the issues
considered in this appendix arise for each canonical variable.

W. Kerr and R. G. King: Limits on Interest Rate Rules


Figure A1 Alternative Solution Regions


θ 2.0













This solution will be a reference case for us throughout the remainder of the
discussion: it can be derived via the method of undetermined coefficients as in
McCallum (1981) or simply by using the fact that Et xt+j = ρ j xt together with
the standard formula for a geometric sum.
In Figure A1, the region ρ = 0 is drawn in more darkly to remind us that
it implicitly covers all driving processes of the finite moving average form,

xt =

δh εt−h ,

some of which will get more attention later.
Extension to ρ ≥ 1
There are a number of economic contexts which mandate that one consider
larger ρ. Notably, the studies of hyperinflation by Sargent and Wallace (1973)
and Flood and Garber (1980), which link money rather than interest rates to
prices, necessitate thinking about driving processes with large ρ so as to fit the
explosive growth in money over these episodes.


Federal Reserve Bank of Richmond Economic Quarterly

It turns out that (28) continues to give intuitive economic answers when
ρ = 1 even though its use can no longer be justified on the grounds that it
involves a “stationary solution arising from stationary driving processes” as in
Whiteman (1983). Most basically, if ρ = 1, then shifts in xt are expected to be
permanent in the sense that Et xt+j = xt . The coefficient on xt is therefore equal
to the coefficient on R − r, which is natural since each is a way of representing
variation that is expected to be permanent.
In Figure A1, the entire region E, as defined by ρ ≥ 1 and θρ ≤ 1, can
be viewed as a natural extension of the standard case. This latter condition is
important for two reasons. First, it requires that the geometric sum defined in
(27) be finite. Sargent (1979) refers to this as requiring that the driving process
has exponential order less than . Second, it requires that a solution of the
form (28) has the property that
lim θ J Et πt+J = − lim θ J Et



R−r +
1 − θρ

= 0,

so that it is consistent with the procedure of moving from (25) to (27). Violation
of either the driving process constraint or the limiting stock price constraint
implies that defined in (25) is infinite when J → ∞. Parametrically, these two
situations each occur when θρ ≥ 1 in Figure A1. Following the terminology of
Flood and Garber (1980) these outcomes may be called process inconsistent,
so that this region—in which equilibria do not exist—is labelled PI.
Extension to θ ≥ 1
There are also a number of models that require one to consider larger θ than
in the standard case. In this case, McCallum (1981) has shown that there is
typically a unique forward-looking equilibrium based solely on exogenous fundamentals. There may also be other “bubble” equilibria: these are considered
further below but are ignored at present.
To understand the logic of McCallum’s argument, it is best to start with
the case in which ρ = 0 and R − r = 0. In this case, (24) becomes
πt = θEt πt+1 − θεt .
Since interest rate shocks are serially uncorrelated and mean zero, it is natural
to treat Et πt+1 = 0 for all t and thus to write the solution as
πt = −θεt .

Thus, there is no difficulty with the finiteness of ∞ θj+1 Et [xt+j ] in this case
since Et [xt+j ] = 0 for all j > 0. There is also no difficulty with limJ→∞ θJ
Et πt+J since Et πt+J = 0 for all J > 0.
There are two direct extensions of this “white noise” case. First, with
any finite order moving average process (xt = H δh εt−h ), it is clear that
similar solutions can be constructed that depend only on the shocks in the

W. Kerr and R. G. King: Limits on Interest Rate Rules


moving average.29 In this case, it is also clear that ∞ θ j+1 Et [xt+j ] < ∞ since
Et [xt+J ] = 0 for all J > H. Likewise, it is clear that limJ→∞ θ J Et πt+J = 0
since Et πt+J = 0 for all J > H. Second, for any ρ ≤ , it follows that the
stationary solution (28), which is πt = −

1−θρ t


in this case, is a rational

expectations equilibrium for which the conditions ∞ θj+1 Et [xt+j ] < ∞ and
limJ→∞ θ J Et πt+J = 0 are fulfilled since ρθ < 1. The full range of equilibria
studied by McCallum is displayed in the area of Figure A1.
As stressed in the main text, there is also a central limitation associated
with this region—there cannot be a constant term in the “fundamentals” that
enter in equations like (24), which implies that in this context that R = r.
The reason that this constant term is inadmissable when θ ≥ 1 is direct from
(25): if it is present when θ ≥ 1, then it follows that the limiting value of
the fundamentals component is infinite. While potentially surprising at first
glance, this requirement is consistent with the general logic of McCallum’s
solution region—as indicated by Figure A1, it is obtained by requiring driving
processes that have exponential order less than , so that a constant term is
generally ruled out along with ρ = 1 since, as discussed above, each is a way
of representing permanent changes.
To this point, we have considered only solutions based on fundamentals. Let
us call these solutions ft and write the inflation rate as the sum of these and a
bubble component bt :
πt = ft + bt .
In view of (24), the bubble solution must satisfy
bt = θEt bt+1
or equivalently
bt + ζt+1 ,
where ζt+1 is a sequence of unpredictable zero mean random variables (technically, a martingale difference sequence). Thus, in the standard case of θ < 1,
the bubble must be explosive—this sometimes permits one to rule out bubbles
on empirical or other grounds (such as the transversality condition in certain
optimizing contexts). By contrast, in the situation where θ > 1 then the bubble
component will be stationary.
bt+1 =


The form of this solution is πt =
θ j+1 δ

h+j .


ωh εt−h , where the ω coefficients satisfy ω h =


Federal Reserve Bank of Richmond Economic Quarterly

These conditions arise because the bubble enters only in the term in (25)
with the “exponential coefficient” θJ . If θ < 1, the future is discounted: we
require that very large changes in expectations about the future must take place
to produce a bubble of a given size today. By contrast, with θ > 1, a very small
change in long-term expectation can induce a bubble of a given size today
because it is “emphasized” rather than discounted by the term θ J .
Bubble solutions are sometimes written as
πt =

πt−1 + Rt−1 + ξt ,


where ζt+1 is a sequence of unpredictable zero mean random variables as in
Farmer (1991). In this solution, the lagged inflation rate appears as a “state
variable” and there is no evident effect of shocks to Rt on πt . This latter
implication is apparently inconsistent with the πt = ft + bt decomposition that
we used earlier. However, upon substitution, we find that
πt = ft + bt =

(ft−1 + bt−1 ) + Rt−1 + ξt ,

and using θEt−1 ft = bt−1 + θRt−1 , we find that
(ft − Et−1 ft ) + (bt − Et−1 bt ) = ξt ,

where Et−1 bt = θ bt . Thus, in the representation (29), ξt could depend on shocks
to Rt since it is arbitrary. Alternatively, (bt − Et−1 bt ) could “offset” shocks to
(ft − Et−1 ft ), leaving no effects of changes in the interest rate within period t.

Abel, Andrew B. “Consumption and Investment,” in Benjamin M. Friedman
and Frank H. Hahn, eds., Handbook of Monetary Economics, Vol. 2.
Amsterdam: North-Holland, 1990.
Boyd, John, and Michael Dotsey. “Interest Rate Rules and Nominal Determinacy,” Working Paper. Richmond: Federal Reserve Bank of Richmond,
Calvo, Guillermo A. “Staggered Prices in a Utility Maximizing Framework,”
Journal of Monetary Economics, vol. 12 (September 1983), pp. 383-98.
Fama, Eugene F. “Short-Term Interest Rates as Predictors of Inflation,”
American Economic Review, vol. 65 (June 1975), pp. 269-82.
Farmer, Roger E. A. “Sticky Prices,” Economic Journal, vol. 101 (November
1991), pp. 1369-79.

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Flood, Robert, and Peter M. Garber. “An Economic Theory of Monetary
Reform,” Journal of Political Economy, vol. 88 (February 1980), pp.
Friedman, Milton. “Factors Affecting the Levels of Interest Rates,” United
States Savings and Loan League Conference Proceedings on Savings and
Residential Financing, 1968a, pp. 11-27.
. “The Role of Monetary Policy,” American Economic Review, vol.
57 (March 1968b), pp. 1-17.
. A Theory of the Consumption Function. Princeton: Princeton
University Press, 1957.
Fuhrer, Jeffrey, and George Moore. “Inflation Persistence,” Quarterly Journal
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Goodfriend, Marvin. “Interest Rate Policy and the Inflation Scare Problem:
1979-1992,” Federal Reserve Bank of Richmond Economic Quarterly,
vol. 79 (Winter 1993), pp. 1-24.
. “Interest Rate Smoothing and Price Level Trend Stationarity,”
Journal of Monetary Economics, vol. 19 (May 1987), pp. 335-48.
Hall, Robert E. “Consumption,” in Robert J. Barro, ed., Modern Business
Cycle Theory. Cambridge, Mass.: Harvard University Press, 1989.
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Basic Monetary-Policy Regime Pairs: Analytical and Simulation Results
from Simple Multiregion Macroeconomic Models,” in Ralph C. Bryant,
Peter Hooper, and Catherine L. Mann, eds., Evaluating Policy Regimes.
Washington: The Brookings Institution, 1993.
Hicks, John R. “Mr. Keynes and the ‘Classics’: A Suggested Interpretation,”
Econometrica, vol. 5 (April 1937), pp. 147-59.
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and Nominal Rigidities,” Ph.D. dissertation. Yale University, 1996.
King, Robert G. “Will the New Keynesian Macroeconomics Resurrect the
IS-LM Model?” Journal of Economic Perspectives, vol. 7 (Winter 1993),
pp. 67-82.
, and Mark W. Watson. “Money, Prices, Interest Rates, and the
Business Cycle,” Review of Economics and Statistics, vol. 78 (February
1996), pp. 35-53.
. “The Post-War U.S. Phillips Curve: A Revisionist Econometric
History,” Carnegie-Rochester Conference Series on Public Policy, vol. 41
(December 1994), pp. 157-219.
Leeper, Eric M. “Equilibria Under ‘Active’ and ‘Passive’ Monetary and Fiscal
Policies,” Journal of Monetary Economics, vol. 27 (February 1991), pp.


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Lucas, Robert E., Jr. “Expectations and the Neutrality of Money,” Journal of
Economic Theory, vol. 4 (April 1972), pp. 103-24.
McCallum, Bennett T. “Topics in Monetary Theory and Policy,” Lectures at
the Institute for Advanced Studies, Vienna, Austria, May 1995.
. “On Non-Uniqueness in Rational Expectations Models: An
Attempt at Perspective,” Journal of Monetary Economics, vol. 11 (March
1983), pp. 139-68.
. “Price Level Determinacy with an Interest Rate Policy Rule and
Rational Expectations,” Journal of Monetary Economics, vol. 8 (November
1981), pp. 319-29.
Nelson, Charles R., and William G. Schwert. “Short-Term Interest Rates as
Predictors of Inflation: On Testing the Hypothesis That the Real Rate of
Interest is Constant,” American Economic Review, vol. 67 (June 1977),
pp. 478-86.
Parkin, Michael. “A Comparison of Alternative Techniques of Monetary
Control under Rational Expectations,” Manchester School of Economic
and Social Studies, vol. 46 (September 1978), pp. 252-87.
Poole, William. “Optimal Choice of Monetary Policy Instruments in a Simple
Stochastic Macro Model,” Quarterly Journal of Economics, vol. 84 (May
1970), pp. 197-216.
Rotemberg, Julio J. “The New Keynesian Microfoundations,” in Stanley
Fischer, ed., NBER Macroeconomics Annual. Cambridge, Mass.: MIT
Press, 1987.
. “Sticky Prices in the United States,” Journal of Political Economy,
vol. 90 (December 1982), pp. 1187-1211.
Sargent, Thomas J. Macroeconomic Theory. New York: Academic Press, 1979.
, and Neil Wallace. “Rational Expectations, the Optimal Monetary
Policy Instrument, and the Optimal Money Supply Rule,” Journal of
Political Economy, vol. 83 (April 1975), pp. 241-54.
. “Rational Expectations and the Dynamics of Hyperinflation,”
International Economic Review, vol. 14 (June 1973), pp. 328-50.
Schmitt-Grohe, Stephanie, and Martin Uribe. “Balanced-Budget Rules, Distortionary Taxes and Aggregate Instability,” Working Paper. Washington:
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Whiteman, Charles. Linear Rational Expectations Models: A User’s Guide.
Minneapolis: University of Minnesota Press, 1983.
Woodford, Michael. “Monetary Policy and Price Level Determinacy in a
Cash-in-Advance Economy,” Economic Theory, vol. 4 (1994), pp. 345-80.
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of Chicago, September 1986.

The Economics of Electronic
Benefit Transfer Payments
David B. Humphrey


urrently, federal and state agencies transfer almost $500 billion in
benefits to recipients each year. This includes cash benefits, food
stamps, Social Security, student loans, unemployment, retirement, and
other benefit payments. Almost 70 percent of these payments are paper-based.
Paper is used for 60 percent of the more than $400 billion in federal benefits.
And it constitutes close to 100 percent of the $95 billion in state benefits.
Most benefit recipients have checking or savings accounts at depository
institutions and increasingly receive their payments electronically as a direct
deposit to their account. Indeed, 58 percent of Social Security recipients now
receive their payments electronically. However, many of the recipients participating in other benefit programs—including food stamps and Aid to Families
with Dependent Children (AFDC)—do not have an account at a depository
institution. These recipients rely on paper-based delivery of their estimated
$112 billion in benefit payments.
Overall, 10 percent of all U.S. households do not have a deposit account.
These households are the so-called “un-banked” and are unable to receive an
electronic direct deposit. For low income households, this figure is even higher.
For households in the lowest income quintile (lowest one-fifth of income), 26
percent do not have a deposit account. And for families receiving AFDC, general assistance, or food stamps, the figure is higher still: almost 75 percent do
not have a deposit account (Wood and Smith 1991, Tables 1 and 2).
Targeted at families without a deposit account, electronic benefits transfer
(EBT) will allow these families to draw their benefits electronically through

The author is the F. W. Smith Eminent Scholar in Banking and Professor of Finance at Florida
State University. Comments and suggestions by Margaret Andrews, Tom Humphrey, John
Kirlin, Jeff Lacker, John Walter, and John Weinberg are appreciated. The views expressed
are those of the author and do not necessarily represent those of the Federal Reserve Bank
of Richmond or the Federal Reserve System.

Federal Reserve Bank of Richmond Economic Quarterly Volume 82/2 Spring 1996



Federal Reserve Bank of Richmond Economic Quarterly

automated teller machines (ATMs) and retail point-of-sale (POS) terminals
instead. As envisioned by federal and state benefit-issuing agencies, benefit
recipients will have the convenience of an integrated electronic delivery system that they can access with a single card. EBT is estimated to also cost
less than the current paper-based benefit delivery system. The annual savings
from EBT are estimated to be $195 million per year. Additional advantages
will include a reduction in fraud and increased assurance that benefits are used
for their intended purpose. Overall, surveys from pilot programs indicate that
the majority of benefit recipients, banks, and retailers all prefer EBT over the
existing paper-based system.
This article focuses on economic issues related to EBT. Its primary purpose
is to (1) outline who would be affected by EBT and how it would work; (2)
illustrate its likely impact on U.S. payment structure; (3) report cost/benefit results based on EBT pilot programs; (4) assess how EBT costs may be affected
by scale economies; and (5) note the replacement of checks by EBT and other
electronic payments.

Table 1 lists the major federal and state benefit programs and the percent that
beneficiaries and their families are of the total U.S. population. Because some
recipients receive benefits from more than one program, adding up the percentages shown in column 1 (totaling 47 percent) will overstate the percent of
the population receiving benefits.1 A more accurate and conservative estimate
would be that around one-third of all U.S. families receives one or more benefit
payments, ranging from food stamps to Social Security to military, state, and
federal retirement payments.
Benefit Recipients without a Deposit Account
EBT focuses on those benefit recipients that do not have a deposit account.2
As seen in column 2, the percent of recipients without an account ranges
from 8 percent for recipients of military, state, and federal retirement pensions
to 75 percent for recipients of AFDC. These are the recipients targeted for
EBT. Recent estimates of the EBT caseload (with some double counting) are
1 Food stamps and AFDC, for example, have an especially large overlap since 80 percent
of AFDC households also receive food stamps while 43 percent of food stamp households also
receive AFDC.
2 Even those with deposit accounts are being encouraged to switch away from governmentissued checks, at both the federal and the state level, to electronic direct deposit of payroll, Social
Security, retirement, and other benefits. Indeed, recent federal legislation requires most federal
government payments to be made electronically by 1999 (Marjanovic 1996).

D. B. Humphrey: Electronic Benefit Transfer Payments


Table 1 Benefit Recipients in U.S. Population and Recipients Without
Deposit Accounts (1985)
Benefit Program

Percent of Families
in U.S. Population∗

Percent of Families
without Accounts

Food Stamps



Aid to Families
with Dependent Children



Food Programs for
Women, Infants, and Children



General Assistance



Social Security



Security Income








and Student Loans
∗ Percent

of families receiving benefits approximates percent of population.
Source: Adapted from U.S. General Accounting Office (1988), p. 44 (as reported in Wood and
Smith [1991]).

shown in Table 2. There are potentially some 31 million users of EBT out
of perhaps a total of 86 million benefit recipients (estimated to be one-third
of the U.S. population of 258 million). In sum, EBT would directly affect
about 12 percent of the U.S. population and involve $112 billion in payment
How Benefits are Delivered
An illustration of how EBT works is provided in Figure 1. The flow of the
payment instrument or payment information is shown with a solid line; the
actual movement of funds is represented by a dotted line. Under paper-based
delivery of benefits, checks or food stamps (the current payment instruments)
are distributed by mail or picked up by recipients at local benefit offices. Recipients then cash their benefit check at a bank, check-cashing outlet, or store
3 The push for EBT has come from the executive branch of the federal government; primarily, Vice President Gore, officials in the Treasury Department and the Office of Management
and Budget (to improve efficiency), the Department of Agriculture (to improve the food stamp
program), and the Department of Health and Human Services (to improve federal and state welfare


Federal Reserve Bank of Richmond Economic Quarterly

Table 2 EBT Caseload and Value of Benefits
(Pooled Federal and State Benefits, 1993)

Value of
($ billions)



Aid to Families
with Dependent Children



Food Programs for
Women, Infants, and Children



General Assistance



Social Security



Security Income






and Student Loans





Benefit Program
Food Stamps


caseload refers to families, not number of individuals covered.
military, railroad, and veterans’ pensions.
Source: Federal EBT Task Force (1994), p. 8.

2 Federal,

and trade food stamps for permitted food items at participating supermarkets.
The cashed benefit checks and redeemed food stamps are processed within the
banking system and then physically presented to the issuing agency or paying agent, often a Federal Reserve Bank. As few programs are funded before
transactions occur, it is at this point that the actual transfer of funds takes
place—from government agency to the banks and finally to the food stores and
other entities that accepted the payment instrument.
With EBT, the arrangement is somewhat different. First, the government
agency (or its paying agent) provisionally credits the benefit recipient’s account
at the EBT vendor. The provisional credit equals the value of the benefits to be
received (the payment information).4 Using a personal identification number,
or PIN, the recipient withdraws cash through an ATM and/or debits his EBT
4 The EBT vendor may or may not be a bank: it all depends on who submitted the winning
bid for the EBT contract.

D. B. Humphrey: Electronic Benefit Transfer Payments


Figure 1 Paper and EBT Flow










(debit card)




Audit Trail




Audit Trail


The flow of payment instruments or payment information.
The actual movement of (good and final) funds.


account using a debit card. The initial crediting process enables the benefit
recipient to buy groceries at stores that accept debit cards through their POS
network and, in some cases, pay rent at housing offices using the same debit
card. At the end of the day, EBT vendors determine the total cash withdrawn
and the sum of POS debits made to all EBT accounts. This audit information
is provided to the benefit-issuing government agency, who then transfers the
necessary covering funds to the banks. The banks in turn reimburse the ATM


Federal Reserve Bank of Richmond Economic Quarterly

owners and credit the accounts of businesses where the POS transactions occurred. Thus the essential difference between the two benefit transfer sequences
shown in Figure 1 is the substitution of electronic payment information via EBT
for paper-based check and food stamp payment instruments.

Current Payment Structure
Cash transactions are by far the most numerous. They have been estimated
to account for perhaps 83 percent of all U.S. payments, with similarly high
percentages in other countries as well.5 Since the average value per transaction
is quite low (estimated to be less than $10 in the United States), cash payments
account for only a small percent of the value of all payments.6
With EBT, the main focus is on the substitution of electronic for paperbased payment methods. Excluding large-value wire transfers, the current structure of noncash transactions is shown in Table 3.7 Checks account for 78 percent
of noncash transaction volume and 89 percent of their value. Checks are now,
and always have been, the dominant noncash payment method in the United
States. Electronic payments include credit card, debit card (POS), and automated clearing house (ACH) payments. ACH payments include direct debits
(preauthorized bill payments), direct deposits (direct deposit of payroll, Social
Security, and retirement income), and corporate cash management debits. As
seen in Table 3, credit cards are currently the most important class of electronic
payments in terms of transaction volume (17 percent) while ACH is the most
important in terms of value (10 percent, due to large-value corporate cash
management debits).
While EBT will expand consumers’ use of ATMs as a way to obtain cash
(instead of cashing a benefit check), the net effect of EBT will be to shift
a significant portion of “cash-like” paper transactions to electronic payments.
Food purchases made with food stamps—which are like cash—will shift to

5 Cash accounts for 86 percent of all transactions in Germany, 78 percent in the Netherlands,
90 percent in the U.K. (Boeschoten 1992, pp. 73–74), and is probably higher still in Japan, where
cash is used heavily.
6 One important area for cash transactions concerns the 2.7 million vending machines where
cold drinks, candy, and other products are dispensed. Vending machine transactions totaled 26
billion in 1994 with an average value of just over $0.60 each (Vending Times 1995).
7 Wire transfers average $4.3 million per transaction and clearly are not representative of
normal consumer or even standard business payments. These payments represent less than 1
percent of noncash transactions but, due to their large average amount per transaction, account
for 86 percent of payment value.

D. B. Humphrey: Electronic Benefit Transfer Payments


Table 3 The Structure of U.S. Noncash Payments
(1994 percent composition and average dollar amounts)
Transaction Volume:

Transaction Value:
$ Billions








Credit Card






Debit Card (POS)






Direct Debit & ACH









Source: Annual data computed from Bank of International Settlements (1995).

noncash electronic debit card transactions at grocery stores. In addition, the
number of government checks issued, mailed, received (and possibly mishandled), will be reduced. Benefits now provided by check will shift to ATMs (for
cash withdrawal) and to POS as a portion of food, housing, clothing, and other
transactions previously handled with cash, food stamps, payment vouchers, or
money orders moves to an EBT (debit) card.
Changes in Payment Structure from EBT
Debit card payments have been growing quite rapidly (Caskey and Sellon 1994)
and currently are over a billion transactions a year. If EBT were fully implemented today, the number of debit card transactions could double or triple.8
As seen in Table 3, such an increase in debit card transactions would expand
their role to 3 to 4 percent of noncash payments, thus equaling or exceeding
the level of direct debits and other ACH payments (at 3 percent). 9 A rise in
debit card payments from the current level of 1.4 percent of noncash payments up to a level of 3 to 4 percent may not sound important. However, it is
8 Based on experience with EBT pilot programs, Abt Associates has estimated that two
benefit programs—food stamps and AFDC—could add 0.8 billion new POS transactions (Kirlin
et al. 1990, p. 230). These two programs account for 47 percent of the estimated EBT caseload
in Table 2. If the other benefit programs generate similar POS use, then EBT by itself may lead
to an additional 1.7 billion POS transactions. Another source suggested an additional 3 billion in
POS transactions from EBT (Piskora 1995, p. 14).
9 While EBT would also increase ATM transactions from their current base of around 8
billion, ATM transactions primarily involve the withdrawal of cash (not electronic payments).
ATM transactions are composed of cash withdrawal (86 percent), cash or check deposit (10
percent), and account transfer (3 percent), with only 1 percent involving an electronic bill
payment (Board of Governors 1991).


Federal Reserve Bank of Richmond Economic Quarterly

significant when compared to the past growth of ACH transactions, which were
specifically designed to be a direct substitute for the paper check. 10 The ACH
was established in 1972 and it has taken over twenty years for this electronic
payment method to reach its current level of 3 percent of noncash payments.
Viewed in this light, it is clear that EBT will have an important impact on the
composition of retail payments over a relatively short time period.

Experience with a number of EBT pilot programs permits a cost/benefit comparison of electronic versus paper benefits transfer. During the planned seven-year
EBT implementation period from 1994 to 2000, an ongoing government investment is needed to purchase, install, and operate new POS terminals. Reflecting
the multiyear lifetime of these terminals, this fixed cost is amortized over a
period of years. As benefit delivery is increasingly shifted from paper to EBT
during this period, the reduction in paper costs is expected to be sufficient not
only to pay back this terminal investment but also to provide net savings to U.S.
taxpayers of over $250 million overall. Once the program is fully established,
as shown in Table 4, the net savings are estimated to be $195 million annually.
The virtue and value of EBT is that it is predicted to deliver benefits at
a lower cost as checks and food stamps are replaced by debit cards and ATM
use. The largest ongoing expense of a mature EBT program is the electronic
payment processing cost incurred by the benefit issuer and the EBT processor.
As noted below, the few studies that exist have shown that electronic payments
are cheaper than paper-based payments, both in the United States and in other
Additional benefits from EBT are obtained from enhancing security and
reducing fraud associated with counterfeit food stamps. And, although difficult
to quantify, there will be greater assurance that benefits will go toward their
intended purpose. For example, EBT will eliminate “cash change” in food
stamp transactions. It will also reduce the opportunity for diversion of benefits
to secondary markets—where some recipients sell their stamps, at a discount,
in order to purchase nonbenefit items. Finally, the electronic cash registers now
in place in most supermarkets can be programmed to control the purchase of
items not covered through benefit programs (e.g., alcoholic beverages, rather
than food items).
The EBT cost estimate in Table 4 includes $116 million a year to account
for the possible expense from theft or misuse of EBT cards. However, some
experts think this estimate is too low. The Federal Reserve Board has waived
10 Unlike ACH, credit card transactions started out as paper transactions. Only recently have
almost all portions of the credit card transaction been switched over to electronics.

D. B. Humphrey: Electronic Benefit Transfer Payments


Table 4 Federal EBT Costs and Benefits
Annual Values
in Year 2000
and After
($ millions)
Federal EBT Cost:
Administration, Design and Development


Federal EBT Benefit:
Reduction in Paper-Based
Benefit Delivery Cost
Annual EBT Savings over Paper Delivery of Benefits:


Source: Federal EBT Task Force (1994), p. 38.

until 1997 any extension to EBT of protections currently available to consumers
from Regulation E. Regulation E sets an upper limit on losses cardholders can
face (currently $50) if they promptly report the theft or loss of their ATM,
credit, or debit card to the card issuer. This permits the issuer to stop further
transactions and thereby limit losses. Some estimates of the possible additional
expense of extending Regulation E consumer protections to EBT are as high
as $500 million to $800 million a year (Stix 1994, p. 86). If this level of extra
expense for EBT from Regulation E were incurred, it would more than offset
the forecasted net benefits of the program shown in Table 4.
At present, procedures are being investigated that would minimize losses
in the event that some or all of the consumer protections offered by Regulation
E are extended to EBT. Pilot tests are underway in two states (New Jersey and
New Mexico) to provide accurate estimates of the potential expense involved.
Under Regulation E, issuers of benefits could not limit their losses—as banks
now can—by refusing to serve high-risk recipients who make repeated claims
of lost or stolen cards and benefits.
A reasonable compromise may be to provide beneficiaries with the same
sort of (limited) protections from loss and theft that they currently receive under
the existing paper-based system. Although less comprehensive than Regulation
E, such an arrangement would not disadvantage beneficiaries relative to their
current position. It is important to note that loss of an EBT card by itself would


Federal Reserve Bank of Richmond Economic Quarterly

not lead to recipient or card issuer losses. This is because both the card and
the recipient’s PIN number have to be used to obtain cash from an ATM or
authorize a POS transaction. The same is not now the case for fraudulent use
of consumer credit cards (where only a signature is required) but does apply
to use of consumer ATM and debit cards.
The Ratio of EBT to Paper Payment Costs
In Table 4, the ratio of estimated annual EBT costs ($241 million) to the
documented cost of paper-benefit delivery ($436 million) is 0.55. For the level
of benefits to be delivered, the cost of EBT card use in store POS debit card
terminals and ATM cash withdrawals is thus apparently a little more than half
of the current cost of issuing checks and food stamps. This overall cost comparison is supported, in part, by some results from a recent EBT pilot program.
Although all costs were not tallied, those associated with smart card off-line
EBT and food stamp coupons were compared: the resulting EBT card/food
stamp cost ratio was 0.57 (Food and Nutrition Service 1994).11
A more comprehensive cost comparison, although on a per-transaction
basis, is to contrast the estimated social cost of an electronic payment with
that for a check. Social cost includes payer, retailer, bank, and payee expenses
while the costs in Table 4 concern government (and bank and some retailer)
costs. The ratio of the estimated social cost of a debit card POS payment
(approximately equivalent to an EBT POS transaction) with that for a check is
0.59 (Humphrey and Berger 1990, p. 50). A more recent study compares the
social cost of an electronic ACH payment with that for a check and obtains an
(average) ratio of 0.45 (Wells 1994, p. 40). Finally, a study of Norwegian payer
and payee bank costs of processing an electronic POS debit (including terminal
costs) versus that of a check yielded a ratio of 0.32 while the cost ratio for an
ATM transaction to that of a check was 0.25 (Robinson and Flatraaker 1995,
p. 211). What this demonstrates is that whether one compares the government
per-transaction cost of EBT versus food stamps, or the social cost of debit card
or ACH payments versus that of a check, or the bank costs of a POS debit or
an ATM transaction versus checks, in every case electronic payments are less
costly than those relying on paper (checks or food stamps). This result gives
indirect support for the EBT/paper cost comparison results of Table 4.
EBT Card Technology: Magnetic Stripe Versus Smart Card
The cost estimates for EBT assume the use of a card with a standard magnetic stripe and dial-up (telephone) access to EBT account information for
11 Exhibit 1 in this source was used after converting the retailer and financial institution
costs shown there to a per-case-month basis (dividing these costs by 1,000/190).

D. B. Humphrey: Electronic Benefit Transfer Payments


verification of transactions, either through ATMs or POS.12 A 1993 congressional Office of Technology Assessment study, however, suggested that new
“smart-card” technology applied to EBT may yield even lower longer-run costs.
Smart cards have an apparent operating cost advantage over magnetic stripe
cards. Use of a smart card would allow EBT authorization and transaction information to be handled at the terminal itself. The chip in the card would
periodically be credited with “value” due a beneficiary. A program in the
chip would identify the beneficiary, authenticate each transaction, and debit
the stored value each time the card was used. Once a day, smart card (off-line)
terminals would be accessed to determine the value of funds the benefit-issuing
agencies would need to provide to pay for the beneficiary transactions made
that day.13 In contrast, magnetic stripe cards require, at a minimum, the use
of dial-up authorization for each transaction and, with standard on-line ATM
and POS systems, the even more costly capability to debit or place a hold
on the cardholder’s account for the amount of the transaction at the time the
transaction occurs.
While the smart card may have a lower operating cost once an EBT system
is in place, the cost of the cards themselves and the need to deploy a new type
of terminal would cause the government’s initial investment to be higher than
with magnetic stripe cards. This is because some 109,000 ATMs and 376,000
POS terminals that read magnetic stripe cards already are in the marketplace
and most of them already have the on-line communication capability needed
for EBT applications (Caskey and Sellon 1994). Therefore, the higher government investment required for smart cards at a time when budgets are being
cut, coupled with the sunk cost in existing magnetic stripe cards and terminal
equipment, along with the uncertainty regarding use of an unfamiliar technology, will all probably mean that magnetic stripe cards will be the instrument
of choice for EBT in the foreseeable future.
The Experience of EBT Pilot Programs
Since 1984, there have been pilot programs in eight counties and cities which
have tested various aspects of EBT. These results, including relative costs
and implementation procedures, have been extensively documented by Abt
12 Access to account information for transaction verification involves comparing a user’s
card and PIN number against a data file containing valid card and PIN numbers for transaction
authorization. It need not also involve the immediate debiting (or placing a hold on) the cardholder’s account and the transfer of funds to the payee. When these additional steps are taken at
the end of the day, the terminal network is classified as being “off-line”; if these steps are taken
at the same time the transaction is authorized, the terminal network is “on-line.”
13 In pilot programs, however, these costs have been higher than expected. This has resulted
from a need to (1) update off-line terminals each day with a list of unauthorized (lost/stolen) cards,
raising communication costs; (2) replace lost cards and issue new ones as beneficiaries move into
and out of benefit programs; and (3) reconcile card and account balances due to terminal errors.


Federal Reserve Bank of Richmond Economic Quarterly

Associates and others. Recipients, retailers, and banks participating in the pilot
programs have consistently shown a preference for EBT compared to current
paper-based benefit transfer methods. At present, ten states have operational
EBT programs. Three states (Maryland, New Mexico, and South Carolina) are
operating statewide and others are expanding in that direction. Over thirtythree states have active plans to implement EBT in the near future (Food
and Consumer Service 1995). Some of these programs will involve multistate

Previous studies have shown that large scale economies exist for ATM terminal
use and ACH electronic payment processing. Economies associated with POS
terminals also likely exist and would probably be similar to those reported
for ATMs. In contrast, empirical analyses indicate that scale economies in
check processing are much lower than for electronic payments and have already
been largely realized (Humphrey 1985; Bauer and Hancock 1992). Given scale
economies in ATM, ACH, and (by implication) POS, it is expected that future
EBT costs may fall substantially as volume rises. As shown below, there are
important limits to this expected result.
ATM and Other Payment Scale Economies
Payment scale economies exist when the percent increase in total costs from
a rise in transaction volume is less than the percent increase in transactions,
so the average cost of a payment transaction falls. Holding other cost influences constant, check processing expenses rise by an average of 8.8 percent for
each 10 percent increase in transaction volume (Bauer 1993) while ATM costs
only rise by 3 to 5 percent for each 10 percent increase in volume (Walker
1978; Humphrey 1994). Although check processing scale economies are less
than those for ATMs, there is an upper limit to the ATM economies. Busy or
actively used ATMs have queuing problems. Customers who have chosen to
use an ATM because it is more convenient than waiting in a teller line when
a branch office is open have a similar problem at an ATM when the volume
of transactions per machine exceeds 7,000 to 8,000 per month.14 At this point,
banks typically supply an additional terminal to address the peak-time queuing
problem. The additional terminal expense raises the average cost per ATM
transaction so that scale economies are realized only up to a certain volume
level per ATM.
14 If an ATM transaction occurred every three minutes, there would be 300 transactions
for a day that began at 8:00 a.m. and ended at 11:00 p.m. Over a month, there could be 9,000
transactions per terminal. However, peak load problems would create queues at substantially
lower levels of monthly use.

D. B. Humphrey: Electronic Benefit Transfer Payments


There is another limitation to ATM scale economies. As banks have discovered, the increased convenience for consumers of using an ATM for cash
withdrawal, as opposed to withdrawing cash at a branch office or writing
a check for cash at a retail outlet, has led bank customers to expand their
use of ATMs. Banks expected to reduce operating costs by shifting customer
transactions—primarily cash withdrawal—to ATMs since an ATM transaction
costs about half as much as the same transaction at a bank branch office (Berger
1985). However, ATMs are extraordinarily convenient. Customers now choose
to “stop at the ATM” for cash twice (or even three times) as frequently as they
used to visit their banks to cash a check. As a result, the gains banks were
planning on from lower costs and scale economies at ATMs have been largely
offset by an unexpected rise in frequency of use. While the cost per transaction
of a customer cash withdrawal fell by around one-half when an ATM was used
instead of a teller, the frequency of use effectively doubled, leaving total costs
relatively unchanged overall (Humphrey 1994).
The same convenience benefits that have led to greater-than-expected use
of ATMs by bank customers will also exist for EBT recipients.15 To deal with
this, after a certain number of free transactions each month, EBT recipients
may incur a fee that covers the average cost of additional ATM transactions
until the next benefit month rolls around. Such a pricing arrangement will help
control EBT costs. It may also lead banks to adopt a more cost-based pricing
arrangement for ATM services provided to depositors. Currently, only around
25 percent of banks charge their customers for using the bank’s own ATMs.
Fees almost always apply for customer use of a “foreign” ATM—an ATM
owned by another bank.16
Like ATMs, POS terminals would face an upper limit for scale economies
due to queuing problems associated with very intensive use. In addition, a
number of POS terminals would have to be placed in relatively low volume
locations to provide the same degree of access with EBT as now occurs with
food stamps. Thus, while POS terminals could potentially see the same degree
of scale economies that have been measured for ATMs, the realization of these
economies will be limited. Over time, however, EBT could “pull” more nonEBT consumers into using point-of-sale EBT and debit card terminals, due
merely to their increased availability. If this occurs, POS scale economies will
15 In pilot tests, the frequency of shopping trips rose with EBT compared to when food
stamps were used. This would increase the frequency of POS transactions and add to EBT costs.
16 The average fee for customer use of its own bank’s ATM is around $0.40 while the fee
for use of a foreign ATM is around $1.00 (Barthel 1993). Even so, use of foreign ATMs has
grown from 15 percent of all ATM transactions in the mid-1980s to around 50 percent today
(McAndrews 1991). Compared to a traveler’s check, a $1.00 fee for use of a foreign ATM is
cost-effective if more than $100 is withdrawn (since the fee for a traveler’s check is typically 1
percent of the dollar value purchased). More recently, some ATM owners (including some owned
by banks) have imposed an additional surcharge (often around $1.00) for use of a foreign ATM.


Federal Reserve Bank of Richmond Economic Quarterly

be more fully realized by jointly serving these two groups at locations where
EBT volume per terminal may be low.
ACH Scale Economies
When magnetic stripe cards are used, EBT will require dial-up access to beneficiary account information for authorization of each ATM or POS transaction. It
will usually also require the on-line debiting of (or placing a hold on) the cardholder’s EBT account, which is typical today with ATM or debit card use. The
flow of funds and final settlement for these transactions (involving government
to bank to retailer funds transfers for each day’s EBT transactions) will usually
be through overnight ACH interbank transfers. ACH costs increase by 6 to 7
percent for each 10 percent rise in transaction volume so scale economies exist
here too (Humphrey 1985; Bauer and Hancock 1995). While ACH average costs
fall as volume increases, the cost reduction is not as fast as one might have
expected. ACH costs are composed of computer processing expenses (which
experience strong scale economies) along with interbank communication costs
(which face few such economies). In setting up the ACH, the Federal Reserve
connected all banks, rather than only those with sufficiently high volume. Thus
scale economies from computer transaction processing were partially offset by
the high cost of communicating with banks with low ACH volume. In addition,
since ACH applications tended to be concentrated at certain times of the month
for bill payments and payroll disbursements, rather than spread more evenly on
a day-to-day basis, peak-load processing problems occurred. Thus the potential
for scale economies associated with a relatively constant ACH volume flow
were eroded because of substantial excess (and unused) ACH capacity during
most of the month.
The overall implication for EBT from scale economies in ATM and POS
terminals and ACH processing is that major future reductions in EBT costs
from this source should not be expected. While EBT costs may fall somewhat
over time, this will likely be due as much to standard learning curve effects
as it is to realizing scale economies in electronic payments. In repetitive tasks,
learning curve effects often lead to reductions in initial unit cost of from 10
percent to 20 percent (sometimes more) as cumulative output expands over
time (Mansfield 1996).

Electronic payments have long been touted as a potentially lower-cost payment
method that could replace many check and some cash transactions. The first
electronic substitute specifically designed to replace checks was the ACH, the
prototype of which was launched in California in 1972. Only recently has

D. B. Humphrey: Electronic Benefit Transfer Payments


the ACH made much headway in this replacement effort. Substitution has occurred chiefly through programs that replaced checks with direct deposit of
Social Security, retirement, and government and private payrolls, along with
pre-authorized direct debits for recurring bill payments. Even so, it has taken
over twenty years for the ACH to account for 3 percent of noncash transaction volume (Table 3). The 2.3 billion in ACH transactions during 1994 are
presumed to have replaced this many checks.
Introduced in 1971, ATMs have likely been more successful than the ACH
in terms of check replacement. Before ATM use became common, approximately 8 percent of all checks were written to obtain cash (Bank Administration Institute 1979). In 1994, there were 8.3 billion ATM transactions.
Approximately 86 percent or 7.1 billion of these transactions represented cash
withdrawal. Since customers use the ATM to withdraw cash over twice as
often as they cashed checks for the same purpose, the 7.1 billion ATM cash
withdrawal transactions likely displaced over 3.5 billion checks. Thus ATMs
are estimated to have replaced 3.5 billion check transactions while the ACH
has only replaced around 2.3 billion.
In terms of overall transaction volume, the most important electronic substitute for a check has been the credit card. Credit card transactions were initially
paper-based but now are almost wholly electronic. Credit cards account for
over 13 billion transactions. While some credit card transactions have probably
replaced cash, the vast majority represent check replacement (since the average
value of a credit card transaction is $53 while that for cash is less than $10).
As noted above, EBT will shift check and food stamp transactions to cash
withdrawals at ATMs and POS electronic debit card payments. This increase
in POS use may expand debit card transactions from their current level of 1.4
percent of noncash payments to 3 to 4 percent. This translates into a possible
check replacement of from 1.7 billion to 3 billion from EBT alone.17 Thus,
overall, EBT by itself may replace as many checks over a short period of time
as have been replaced by ACH over the past twenty years. While this result is
not a “revolution” in payment practices, it will reduce further the already slow
growth in per-person use of checks. Preliminary forecasts are that per-person
use of checks in the United States will turn negative in the next few years, a
result that should be accelerated by the expansion of EBT.

17 Additional check replacement may follow the increase in availability of POS terminals
associated with EBT. About 600,000 POS terminals may be needed in a mature, nationwide EBT
system (Kirlin et al. 1990, p. 202). Many food stores participating in the food stamp program
would have to be supplied with new terminals even though there are almost 500,000 POS
terminals in place today.


Federal Reserve Bank of Richmond Economic Quarterly

Federal and state benefits total almost $500 billion a year and range from food
stamps to Social Security to Aid to Families with Dependent Children to military retirement. Many benefit recipients have accounts at depository institutions
and increasingly receive benefits through an electronic direct deposit. However,
one-third of recipients do not have a deposit account and are the focus of
electronic benefits transfer. EBT delivers benefits electronically through ATMs
(for cash withdrawal) and retail POS debit card terminals. An EBT transaction
is expected to cost only about half of what a paper-based benefit transaction
(check, food stamp) costs. Overall, EBT is projected to disburse $112 billion
in benefits each year, cover 31 million families (12 percent of the population),
and may save $195 million annually by the year 2000.
Currently, 78 percent of all U.S. noncash transactions are made by check,
while 22 percent are made electronically (mostly credit cards). As EBT expands, POS use may double or triple from its current level of 1.4 percent of
noncash transactions up to 3 to 4 percent of these payments. Thus EBT could
by itself expand electronic payments by perhaps 2 percentage points, lowering
check use to 76 percent of noncash transactions. Overall, EBT will contribute
to check replacement, improve the efficiency of delivering benefit payments
at the federal and state level, and should also provide greater availability of
POS debit card terminals (and thereby promote further the ongoing shift to
electronic payments).

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, and Diana Hancock. “Scale Economies and Technological Change
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