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50th Anniversary Edition
The Federal Reserve System
1913
★
1963
THE
Federal Reserve System
PURPOSES AND FU N C TIO N S
B O A R D OF G O V E R N O R S
tit
r K
i* i
.
of the Federal Res&#jj£ System
Washington, D. C., 1963
, X
1939
Second E dition - N ovember 1947
T hird E dition - A pril 1954
F ourth E dition - F ebruary 1961
F ifth E dition - D ecember 1963
F irst E ditio n - M ay
Library of Congress Catalog Card Number 39-26719
FOREWORD
HIS fifth edition of The Federal Reserve System:
Purposes and Functions commemorates the fiftieth
anniversary of the signing of the Federal Reserve Act by
President Woodrow Wilson on December 23, 1913. As
with earlier editions, the book is dedicated to a better
public understanding of the System’s trusteeship for the
nation’s credit and monetary machinery.
To this end, this new edition has been expanded to
include chapters on the organization of the Federal Re
serve System for policy-making, on the open market policy
process, and on the balance of payments. These and other
changes that have been made throughout the text are de
signed to clarify the System’s role and functioning in light
of changes that have occurred in the national and world
economies and in light of further advances in monetary
knowledge. Improvement in content and organization
has been undertaken with the single objective of making
the subject matter more understandable to the reader.
This edition, like former ones, is a collaborative product
of the Board’s staff. Ralph A. Young, Adviser to the
Board, was responsible for coordinating and supervising
the staff work that went into its preparation.
T
B oard of G overnors
F ederal R eserve S ystem
of the
Washington, D. C.
December 1963
vii
ACKNOWLEDGMENTS
HE content and arrangement of this anniversary
edition has benefited from suggestions by many
readers and critics of previous editions, by members of
the Board’s staff, and by other readers in the Federal
Reserve System. All of these suggestions are here acknowl
edged with appreciation.
The preparation of the present edition, with its consid
erable reorganization and expansion, has been carried out
with the close collaboration of Stephen H. Axilrod, Senior
Economist, Division of Research and Statistics. He as
sumed responsibility for planning and development of the
content and had immediate charge of integrating revised
text.
The new chapter on the balance of payments was pre
pared by A. B. Hersey, Adviser, Division of International
Finance, and the chapter on the open market policy
process by Peter M. Keir, Senior Economist, Division of
Research and Statistics. Other members of the Board’s
staff who contributed to the improvement of various
chapters were: Frederic Solomon, Director, Division of
Bank Examinations; J. Herbert Furth, Adviser, Division
of International Finance; and Lewis N. Dembitz and
Robert Solomon, Associate Advisers, Division of Re
search and Statistics. In addition, special acknowledgment
is made to Guy E. Noyes, Director, Division of Research
and Statistics, for his criticisms of substance during the
revision of the book.
T
IX
ACKNOWLEDGMENTS
Valuable suggestions in their special areas were received
from Robert C. Masters, Associate Director, Division of
Bank Examinations; M. B. Daniels, Assistant Director,
Division of Bank Operations; Charles A. Yager, Chief of
the Government Finance Section, Division of Research
and Statistics ;Normand R.V. Bernard, Economist, Division
of Research and Statistics; and Henry N. Goldstein and
Margaret R. Garber, Economists, Division of Interna
tional Finance.
For editorial work in preparing the text for publication,
special credit is due to Elizabeth B. Sette, Chief of the
Economic Editing Unit, Division of Research and Sta
tistics. Helen R. Grunwell supervised the illustrations, and
Jean King prepared the index.
The previous edition of the book benefited greatly from
the interest and suggestions of Woodlief Thomas, former
ly Adviser to the Board, and of Susan S. Burr, formerly
Associate Adviser, Division of Research and Statistics.
Many of their contributions to the preceding edition
carry over into this one.
R alph A . Y o u n g
CONTENTS
CHAPTER
I.
PAGE
F unction of the F ederal R eserve System___
1
An efficient monetary mechanism is indispensable to
the steady development of the nation’s resources and
a rising standard of living. The function of the Fed
eral Reserve System is to foster a flow of credit and
money that will facilitate orderly economic growth,
a stable dollar, and long-run balance in our inter
national payments.
II. Structure of the F ederal R eserve System. . .
15
Administration of monetary policy and other Federal
Reserve functions is carried out through the Feder
al Reserve System, which includes twelve Federal
Reserve Banks, the Board of Governors in Washing
ton, and the Federal Open Market Committee. All
national banks and many State banks are members
of the System. This organization is especially adapted
to a banking system with many independent banks.
III. Instruments
of
M onetary R egulation ............
The principal means by which monetary policy
achieves its objectives are open market purchases
and sales, mainly of U. S. Government securities
but also of foreign currencies; discount operations;
and changes in reserve requirements. Regulation of
stock market credit supplements these means of
influence. Use of all the instruments is closely
coordinated.
xi
29
CONTENTS
CHAPTER
IV.
PAGE
F unction
of
B a n k R eserves....................................
63
Bank reserves constitute both the legally required
basis and the functional basis of bank deposits.
Changes in the reserve position of banks, therefore,
directly affect the flow of bank credit and money.
In carrying out its central responsibility, the Fed
eral Reserve System relies primarily on its ability
to increase or decrease the volume and cost of bank
reserves.
V. T he C redit M arket ...................................................
83
Commercial banks are part of the national credit
market, which is made up of many interrelated
markets. Developments in all parts of the market
interact on other parts. Neither the banking sector
nor the nonbanking sectors of the market can be
understood by themselves.
VI.
Interest R ates...........................................................
107
Interest rates are the prices paid for borrowed
money. They are established in credit markets as
supplies of and demands for loanable funds seek
balance. Movements of interest rates are influenced
by the nation’s saving and investment, by market
expectations, and by the flow of bank credit and
money.
VII.
Influence of R eserve Banking on E conomic
Stability ......................................................................
Federal Reserve influence on the flow of bank credit
and money affects decisions to lend, spend, and save
throughout the economy. Reserve banking policy
thus contributes to stable economic progress.
xii
127
CONTENTS
CHAPTER
VIII.
PAGE
T he B alance
of
P aym ents ........................................
149
Our economy is part of the world economy. Prices
and interest rates here interact with prices and inter
est rates abroad, and the interrelationships affect our
international balance of payments. In its decisions
on monetary policy the Federal Reserve has to take
the U. S. balance of payments into account. Opera
tions by the System in foreign exchange markets help
to cushion unusual supply or demand pressures in
these markets.
IX. R elation
of
R eserve B anking to G o l d ............
165
Gold flows, which generally reflect balance of pay
ments conditions, are an important influence on
member bank reserves. Inflows of gold reduce the
reliance of banks on Federal Reserve credit, and out
flows of gold increase it. Changes in the country’s
monetary gold stock are reflected in Federal Reserve
Bank holdings of gold certificates.
X.
R elation of R eserve B anking to C urrency . . .
177
The Federal Reserve System is responsible for pro
viding an elastic supply of currency. In this function
it pays out currency in response to the public’s de
mand and absorbs redundant currency.
XI. Balance Sheet of the F ederal R eserve Banks .
Federal Reserve functions are reflected in the con
solidated balance sheet of the Reserve Banks, known
as the weekly condition statement. This statement
shows how much Federal Reserve credit is being used
and the key items that account for its use.
xiii
187
CONTENTS
CHAPTER
XII.
PAGE
T he B a n k R eserve E q u a tio n ...................................
199
Federal Reserve credit, gold, and currency in circula
tion are the principal factors that influence the
volume of member bank reserves—the basis of bank
credit and the money supply. The relationship among
these factors, together with other more technical
ones, is sometimes called the bank reserve equation.
XIII.
S h o r t -T erm C h a n g es in B a n k R eserves ...........
215
Reserve banking policy responds to all of the ele
ments that affect member bank reserve positions. A
full accounting of bank reserve factors is published
each week in a table accompanying the Reserve Bank
condition statement.
XIY.
O r g a n iz a t io n for M o n e t a r y P o l ic y ...................
225
The Board of Governors has a central role in achiev
ing coordinated use of all of the instruments of
monetary policy, and it maintains close relations with
other policy-making agencies in the Government.
Federal Reserve Banks play an important part in
System policy through representation on the Federal
Open Market Committee and through their responsi
bilities for discount operations.
XV.
T he O p e n M ar k et P o licy P r o c e ss .........................
In deciding on reserve banking policy, account must
be taken of all the economic forces at work in the
domestic economy as well as of those affecting rela
tions with the rest of the world. Complexities of the
economic situation require that reserve banking
instruments be used flexibly, with the nature of the
xiv
235
CONTENTS
CHAPTER
PAGE
banking process making for central reliance on
open market operations. As a result, the formulation
of open market policy and the conduct of operations
in the market are at the heart of the policy process.
XVI.
S uperv iso r y
Fu n c t io n s of the F ed er al R eserve 257
By keeping individual banks strong and by main
taining competition among banks, bank supervision
helps to maintain an adequate and responsive bank
ing system. This contributes to the effective func
tioning of monetary policy and of economic proc
esses generally.
XVII.
S ervice F u n c t io n s ...........................................................
267
The Federal Reserve Banks handle the legal reserve
accounts of member banks, furnish currency for
circulation, facilitate the collection and clearance of
checks, and act as fiscal agents of the U.S. Govern
ment.
S elected F ed er al R eserve P u b l ic a t io n s ...........
279
I n d e x ........................................................................................
287
XV
ILLUSTRATIONS
PAGE
Money and Near-Moneys..............................................
Map of the Federal Reserve System..............................
The Federal Reserve System: Organization...................
Government Security Transactions, 1962.......................
Discount and Bill Rates.................................................
Federal Reserve Credit..................................................
Process of Deposit Expansion.......................................
Deposits and Bank Lending.................................
Member Bank Reserves.................................................
Credit Expansion..........................................................
Rates on Bank Loans to Business.................................
U. S. Government Marketable Debt..............................
Change in Financial Position.........................................
Gross National Saving..................................................
Coupon Rate, Market Yield, and Price........................
Long- and Short-Term Interest Rates............................
Selected Interest Rates...................................................
Yields and Prices on U. S. Government Securities.......
Flow of Federal Reserve Influence................................
Gross National Product and Money Supply..................
U. S. Balance of Payments............................................
xvii
7
16
22
36
48
59
72
76
79
84
86
89
93
94
109
Ill
113
115
129
146
153
ILLUSTRATIONS
PAGE
Total U. S. Gold Stock............................................................
168
Reserves o f Federal Reserve Banks.......................................
173
Kinds o f Currency.....................................................................
179
Currency in Circulation............................................................
181
Currency and Federal Reserve Credit...................................
183
Disposition o f Federal Reserve Bank Earnings.................
196
Bank Reserve Equation............................................................
203
Production and Prices...............................................................
209
Reserves and Borrowings.........................................................
222
The Federal Reserve System: Relation to Instruments o f
Credit Policy............................................................................
227
Relationships among Reserve Measures..............................
250
Checks Handled by Reserve Banks.......................................
272
xviii
The Federal Reserve System
CHAPTER I
FUNCTION OF THE FEDERAL RESERVE SYSTEM. An
efficient monetary mechanism is indispensable to the steady develop
ment off the nation’s resources and a rising standard off living. The
function off the Federal Reserve System is toffoster a flow off credit
and money that will ffacilitate orderly economic growth, a stable
dollar, and long-run balance in our international payments.
N December 23, 1913, President Woodrow Wilson
signed the Federal Reserve Act establishing the
Federal Reserve System. Its original purposes, as expressed
by its founders, were to give the country an elastic cur
rency, to provide facilities for discounting commercial
paper, and to improve the supervision of banking.
From the outset, there was recognition that these original
purposes were in fact parts of broader objectives, namely,
to help counteract inflationary and deflationary move
ments, and to share in creating conditions favorable to a
sustained, high level of employment, a stable dollar,
growth of the country, and a rising level of consumption.
O
1
THE FEDERAL RESERVE SYSTEM
Acceptance of the broader objectives has widened over
the years.
Over the years, too, the public has come to recognize
that these domestic objectives are related to the country’s
ability to keep its flow of payments with foreign countries
in reasonable balance over time. Today it is generally
understood that the primary purpose of the System is to
foster growth at high levels of employment, with a stable
dollar in the domestic economy and with over-all balance
in our international payments.
How is the Federal Reserve System related to produc
tion, employment, the standard of living, and our inter
national payments position? The answer is that the Federal
Reserve, through its influence on credit and money, affects
indirectly every phase of American enterprise and com
merce and every person in the United States. The purpose
of this book is to describe the ways in which the Federal
Reserve System exerts this influence.
Background o f the Federal Reserve System
Before establishment of the Federal Reserve System, the
supply of bank credit and money was inelastic. This
resulted in an irregular flow of credit and money and con
tributed to unstable economic development.
Commercial banks in smaller cities and rural regions
maintained balances with commercial banks in larger
cities, which they were permitted to count as reserves
against the deposit accounts of their customers. Large
amounts of these reserve balances were maintained in
New York and Chicago. Many banks, furthermore, as a
matter of convenience and custom and as a means of
utilizing idle funds, kept in the financial centers any
2
FUNCTION
deposit balances over and above their required reserves.
In New York, Chicago, and St. Louis, designated as
central reserve cities, national banks were required to
maintain all their legal reserves in the form of cash in
their own vaults.
Under these circumstances, when banks throughout the
country were pressed for funds by their depositors and
borrowers, these demands ultimately converged on a few
commercial banks situated in the financial centers. In
ordinary times the pressures were not excessive, for while
some out-of-town banks would be drawing down their
balances, others would be building theirs up. But in periods
when business was unusually active and the public needed
larger amounts of currency for hand-to-hand circulation,
the demand on city banks for funds would become wide
spread and intense. Because of the relatively large role
played by agricultural production in that period, credit
demand each year was particularly strong during the cropmoving season. At such times banks all over the country
would call on banks in the financial centers to supply funds.
Since no facilities were available to provide additional
funds, including currency, the credit situation would be
come very tight. To meet the out-of-town demand for
funds, the banks in the financial centers would sell securi
ties and call loans or would refuse to renew existing loans
or make new ones. As a result, security prices would fall,
loans would have to be liquidated, borrowing from banks
as well as other lenders would become difficult, and interest
rates would rise sharply. Every few years difficulties of this
kind would lead to a sharp liquidation of bank credit.
These liquidations were called money crises.
The problem had been under public discussion and study
3
THE FEDERAL RESERVE SYSTEM
for a long time when, following a crisis of unusual severity
in 1907, Congress appointed the National Monetary Com
mission to determine what should be done. After several
years of thorough consideration, Congress adopted legisla
tion embodying the results of study by the Commission
and by other authorities. This legislation was the Federal
Reserve Act, which became law on December 23, 1913.
The establishment of the Federal Reserve System — which
comprises twelve regional Reserve Banks, coordinated by
a Board of Governors in Washington — provided machin
ery by which varying demands for credit and money by
the public could be met.
All of the principal nations have institutions, commonly
called central banks, to perform functions corresponding
to those of the Federal Reserve System. In England it is
the Bank of England, which has been in existence since
the end of the seventeenth century; in France it is the
Bank of France, established by Napoleon I; in Canada
it is the Bank of Canada, which began operations in 1935.
The principal function of the Federal Reserve is to regu
late the flow of bank credit and money. Essential to the
performance of this main function is the supplemental one
of collecting and interpreting information bearing on
economic and credit conditions. A further function is to
examine and supervise State banks that are members of
the System, obtain reports of condition from them, and
cooperate with other supervisory authorities in the de
velopment and administration of policies conducive to a
system of strong individual banks.
Other important functions include the provision of
cash-balance and payment services to the member banks
of the Federal Reserve System, the U.S. Government, and
4
FUNCTION
the public. These services are chiefly the following:
handling member bank reserve accounts; furnishing cur
rency for circulation and making currency shipments;
facilitating the clearance and collection of checks; effecting
telegraphic transfers of funds; and acting as fiscal agents,
custodians, and depositaries for the Treasury and other
Government agencies.
Since the main concern of the Federal Reserve is the
flow of credit and money, these words must be given
meaning at the outset. This can best be done by considering
these four questions: (1) What is money and how is it used?
(2) How is money related to other assets with somewhat
similar characteristics? (3) By what means does the Federal
Reserve regulate credit and money? (4) How do changes
in credit and monetary conditions affect people’s lives ?
Money and Its Uses
Money is most meaningfully defined in terms of how it is
used. Money serves as: (1) a means of payment; (2) a
standard of value; and (3) a store of purchasing power.
As a means of payment, money allows individuals to
concentrate their productive efforts on those activities for
which they are best equipped and in which they are trained
to engage. Money is what people receive in return for their
services and what they use to buy the goods and other
things they need for themselves and their families.
As a standard of value, money provides the means by
which a day’s work can be equated with, for example, a
family’s food, housing, and other bills, including what is
set aside for old age or for children’s education. It is thus
the measuring rod in terms of which producer and con
sumer choices can be assessed and decided.
5
THE FEDERAL RESERVE SYSTEM
As a store of purchasing power, money enables us to
set aside some of our present income for future spending
or investing. It is a way in which remuneration for labor
and work in the present can be stored for meeting the
many contingencies, needs, or opportunities that indi
viduals and families are likely to face in the future.
The wide variety of uses for money make it vital and
necessary to the functioning of our economic system. If
money were impaired as a means of payment, or a standard
of value, or a store of purchasing power, the economy’s
ability to grow and to produce and distribute goods in
accordance with the needs and wishes of the people would
be jeopardized.
Money and Near-Moneys
In the United States circulating paper money and coins
of all kinds (currency) and the demand deposits held by
commercial banks perform all the functions of money.
When a person has $10 of paper money and coin in his
pocket and $100 in his checking account in the bank, he is
in a position to spend $110 at any time. These two sums
represent his active cash balance; they serve the same
general purpose, and each can be converted into the other
at any time; that is, currency can be converted into a
demand deposit by taking it to a bank, and a demand
deposit can be converted into currency by taking it out
of a bank.
The amounts of currency and of demand deposits at
the end of 1962 are shown in the chart. It will be seen that
the amount of demand deposits in commercial banks is
far greater than the amount of currency in circulation.
Commercial banks also hold savings and other time
6
FUNCTION
deposits, on which an interest return is paid. These deposits
are one of the so-called near-moneys shown in the chart.
Savings and time deposits at banks differ importantly
from demand deposits. They are not transferable by check.
M O N E Y A N D N E A R -M O N E Y S
EN D O F 1 9 6 2
M O N EY -
TH E M EA N S O F P A Y M E N T
■C U R R E N C Y
D EP O SIT S IN P R IV A T E C H E C K IN G A C C O U N T S
S EL E C T E D N E A R - M O N E Y S
.T IM E AN D S A V IN G S D EPO SITS AT C O M M E R C IA L B A N K S
SH O R T-TER M U. S. G O V T . S EC U R IT IES
50
100
150
Bi llions of d o ll a r s
While convertible into demand deposits or currency, sav
ings deposits of individuals are subject to prior notice of
conversion. In practice, however, they may generally be
withdrawn on request. Other time deposits are not payable
before maturity except in emergencies. Thus savings and
time deposits, while serving a store-of-value function, are
7
THE FEDERAL RESERVE SYSTEM
not in themselves means of payment; only currency and
demand deposits serve in this active monetary role.
In addition to time and savings deposits in commercial
banks, there are other interest-bearing assets that serve a
store-of-value function and that can be turned into money
with little inconvenience and little or no risk of loss in value.
Such assets include deposits in mutual savings banks, shares
in savings and loan associations, short-term U.S. Govern
ment securities, and U.S. Government savings bonds.
For many years now, individuals and businesses have
shown a growing preference for near-moneys. But there
are limits on the extent to which people can reduce their
money balances in favor of other assets. The growing
volume of transactions in an expanding economy neces
sarily requires the ready availability of funds in checking
accounts or of hand-to-hand currency.
How the Federal Reserve Influences Credit and Money
Practically all of the money that people use reaches
them, directly or indirectly, through banks. They may
receive their pay in cash, but the employer who pays them
will have cashed a check at a bank or may have borrowed
from a bank before making up his payroll. Therefore, the
flow of money in the country depends greatly on the ability
of commercial banks to make loans and investments.
The ability of commercial banks to extend credit and
provide cash-balance and payment services to the people
depends on the amount of reserve funds the banks have.
This amount is directly affected by Federal Reserve opera
tions. Banks can extend credit to customers or invest
money in securities only in proportion to the reserves at
their disposal. The way the system of reserves works, and
8
FUNCTION
the fact that under it the banks can lend in the aggregate
several times as much as they have in reserves, is discussed
in Chapter IV.
What needs to be understood first is that the Federal
Reserve, by influencing the availability and cost of addi
tional bank reserves, can influence the amount of credit
that banks may extend to the public through loans and
investments. The reserve position of banks affects directly
the willingness of banks to extend credit and the cost, or
rate of interest, that borrowers from banks have to pay
to obtain it.
As banks extend credit by exchanging bank deposits for
the various assets they acquire — promissory notes of
businesses and consumers, mortgages on real estate, and
Government and other securities — they create demand
deposits. These deposits can in turn be used to make pay
ments by check or can be withdrawn for use in the form of
currency. Ultimately, they may find their way into banks’
time and savings deposits if the public prefers to save in
that form. In any event, by affecting the volume of reserves
available to member banks, the Federal Reserve has the
power to influence the country’s over-all credit situation
and its money supply.
While the Federal Reserve directly influences the avail
ability and cost of bank credit and thereby affects the total
flow of credit, a great variety of other forces also affect
the flow of credit in the economy. These include, among
others, governmental policies in regard to expenditures,
taxes, and debt; the distribution of income among different
groups of the population and the allocation of income
between current consumption and saving; the bargaining
strength and policies of management, labor, agriculture,
9
THE FEDERAL RESERVE SYSTEM
and other sectors of the economy; the course of foreign
trade and foreign investment; the prospects for peace or
war; and the expectations of businesses and consumers as
to future economic changes, especially price changes.
Thus, the Federal Reserve alone cannot assure favorable
economic conditions. Nor can it direct whether bank credit,
or any other type of credit, shall flow into particular chan
nels. But it can affect the general flow of bank credit and
money as economic conditions change and thus help to
counteract instability resulting from other forces. The
crucial question for the Federal Reserve is how much
expansion in bank credit and money it should encourage
in view of current and prospective developments in the
domestic economy and in our balance of payments.
How Changes in Credit and Money Affect People
Superficially, it might seem that the more credit and
money people have the better off they are. In fact, however,
it is not the number of dollars that all the people have
available that is important, but what those dollars will
buy today as compared with earlier periods and as com
pared with the future.
People have different tests of whether they as indi
viduals have enough money. To the manufacturer, the
test is whether he has or can borrow at a reasonable cost
enough dollars to buy his raw materials, pay the wages of
his employees, and make other payments necessary to a
profitable operation and to a sustained strong credit po
sition. The farmer and the merchant have similar tests.
To the consumer, the test is whether he has or can bor
row enough money, at a cost and on repayment terms that
he can meet, to buy what he needs. Essentially, people are
10
FUNCTION
concerned mainly with what they can do with the dollars
they earn, are indebted for, or need to borrow.
The ultimate test, in other words, is the purchasing
power of the dollar over time in terms of goods and serv
ices. In this respect the usefulness of money is enhanced
if the dollar’s value, as indicated by the average price
level for goods and services, remains reasonably stable.
In a dynamic and growing economy, enough credit and
money is that amount which will help to maintain high
and steadily rising levels of production, employment,
incomes, and consumption and to foster a stable value for
the dollar. When credit, including bank credit, becomes
excessively hard to get and costs too much, factories and
stores may curtail operations and lay off employees.
Smaller payrolls mean hardship for workers, who curtail
their purchases; merchants feel the decline in trade and
reduce their orders for goods. Manufacturers in turn find
it necessary to lay off more workers. A serious depression,
unemployment, and distress may follow.
When credit is excessively abundant and cheap, the
reverse of these developments — an inflationary boom —
may develop. An increase in the volume and flow of money
resulting from an increase in the supply and availability
of credit, coupled with a lowering of its cost, cannot in
itself add to the country’s output. If consumers have or
can borrow so much money that they try to buy more
goods than can be produced by plants running at capacity,
this spending only bids up prices and makes the same
amount of goods cost more. If merchants and others try
to increase their stocks so as to profit by the rise in prices,
they bid up prices further. Manufacturers may try to
expand their plants in order to produce more. If so, they
11
THE FEDERAL RESERVE SYSTEM
bid up interest rates, wages, and prices of materials. In the
end they raise their own costs.
The nation as a whole does not profit from conditions of
price inflation. These conditions are typified by closely
linked advances in material costs; in wages of workers in
industry, trade, and services; in prices of finished products;
and in the cost of living generally. In such a situation, the
many individuals whose incomes are relatively inflexible
suffer a decline in living standards. At some point the up
ward spiral will break, perhaps because prices of finished
goods get so high that ultimate consumers, even though
many of them receive higher wages, can no longer buy
the goods produced. Then a downward spiral will develop.
The more values have risen because of inflation, the more
abruptly and lower they are likely to fall and the greater
will be the associated unemployment and distress.
Efforts to attain domestic prosperity and price stability
go hand in hand with efforts to attain balance in inter
national payments. If this country obtains less funds from
its exports of goods and services or from long-term capital
inflows than it spends or invests abroad, then we add to
our short-term debt to foreign countries and we lose gold
from our national monetary reserves. The persistence of
such a situation can lead to general loss of confidence in
the dollar internationally, to an accelerated outflow of
funds from this country, and to a more rapid drain on the
nation’s gold stock. Thus expansion in bank credit and
money has to be evaluated in terms of both its impact on
domestic economic growth and its effect on the balance of
international payments.
Here, two points that concern the relationship of the
balance of payments to domestic economic activity may
12
FUNCTION
be noted briefly. First, in the long run an expansion in
bank credit and money consistent with reasonable domes
tic price stability will contribute to balance in our inter
national payments by helping keep goods produced here
competitive with foreign products. Secondly, in the short
run it is necessary to take account of the influence that
domestic credit conditions and costs have on international
capital flows, because movements of capital among coun
tries in response to differences in the availability and cost
of credit can have disruptive effects on international pay
ments flows and domestic financial markets.
The above recital is oversimplified in that it does not
include all the factors that affect the level of economic
activity or the flow of payments to other countries. Never
theless, it does show how the economy is affected if,
on the one hand, credit is too scarce or hard to get and too
dear or if, on the other hand, it is too plentiful or easily
obtainable and too cheap. By influencing the flow of bank
credit, with resulting effects on the flow of money and the
flow of credit generally, the Federal Reserve System influ
ences the economic decisions that people make, which are
reflected in the level of economic activity, in price de
velopments, and in the balance of international payments.
13
CHAPTER II
STRUCTURE OF THE FEDERAL RESERVE SYSTEM.
Administration o j monetary policy and other Federal Reserve Junc
tions is carried out through the Federal Reserve System, which
includes twelve Federal Reserve Banks, the Board o f Governors in
Washington, and the Federal Open Market Committee. All
national banks and many State banks are members o f the System.
This organization is especially adapted to a banking system with
many independent banks.
HE Federal Reserve System is designed to combine
public and private participation and to serve the public
welfare efficiently. Federal Reserve functions are carried
out through twelve Reserve Banks and their twenty-four
branches and through central coordination by the Board
of Governors in Washington. A diversity of experience
and knowledge is brought together through this broadly
based and unique banking mechanism. This chapter will
explain the structure and membership of the Federal
Reserve System, while a later chapter will describe how the
System is organized for policy-making purposes.
T
15
STRUCTURE
Federal Reserve Banks
In order that the Federal Reserve might serve the large
area and the diverse resources of the United States effec
tively, the Federal Reserve Act provided that the System
be divided into twelve districts. These are shown in the
map on the opposite page. The boundaries of the Federal
Reserve districts do not always follow State lines, and in
many instances part of a State is in one district and part
in another.
In each district there is a Federal Reserve Bank, and
most of the Reserve Banks have branches. A list of the
districts and branches is given below:
Federal Reserve Bank of Boston
District Number 1
Federal Reserve Bank of New York
Branch at Buffalo, New York
District Number 2
Federal Reserve Bank of Philadelphia
District Number 3
Federal Reserve Bank of Cleveland
Branches: Cincinnati, Ohio
Pittsburgh, Pennsylvania
District Number 4
Federal Reserve Bank of Richmond
Branches: Baltimore, Maryland
Charlotte, North Carolina
District Number 5
Federal Reserve Bank of Atlanta
Branches: Birmingham, Alabama
Jacksonville, Florida
Nashville, Tennessee
New Orleans, Louisiana
District Number 6
Federal Reserve Bank of Chicago
Branch at Detroit, Michigan
District Number 7
17
THE FEDERAL RESERVE SYSTEM
Federal Reserve Bank of St. Louis
Branches: Little Rock, Arkansas
Louisville, Kentucky
Memphis, Tennessee
District Number 8
Federal Reserve Bank of Minneapolis
Branch at Helena, Montana
District Number 9
Federal Reserve Bank of Kansas City 1
Branches: Denver, Colorado
Oklahoma City, Oklahoma
Omaha, Nebraska
District Number 10
Federal Reserve Bank of Dallas
Branches: El Paso, Texas
Houston, Texas
San Antonio, Texas
District Number 11
Federal Reserve Bank of San Francisco 2
Branches: Los Angeles, California
Portland, Oregon
Salt Lake City, Utah
Seattle, Washington 2
District Number 12
Decentralization is an important characteristic of the
Federal Reserve System. Each Reserve Bank and each
branch office is a regional and local institution as well as
part of a nationwide system, and its transactions are with
regional and local banks and businesses. It gives effective
representation to the views and interests of its particular
region and at the same time helps to administer nationwide
banking and credit policies.
Each of the twelve Federal Reserve Banks is a corpora
tion organized and operated for public service. The Federal
1 Kansas City, Missouri.
2 Alaska is part of the Seattle Branch territory and Hawaii part of the
head office territory of the District.
18
STRUCTURE
Reserve Banks differ from privately managed banks in that
profits are not the object of their operations and in
that their shareholders—the member banks of the Federal
Reserve System—do not have the proprietorship rights,
powers, and privileges that customarily belong to stock
holders of privately managed corporations.
The provisions of law circumscribing the selection of
Reserve Bank directors and the management of the Reserve
Banks indicate the public nature of these Banks. Each
Federal Reserve Bank has nine directors. Three of them
are known as Class A directors, three as Class B directors,
and three as Class C directors. The Class A and Class B
directors are elected by member banks, one director of each
class being elected by small banks, one of each class by
banks of medium size, and one of each class by large banks.
The three Class A directors may be bankers. The three
Class B directors must be actively engaged in the district
in commerce, agriculture, or some other industrial pursuit
and must not be officers, directors, or employees of any
bank. The three Class C directors are designated by the
Board of Governors of the Federal Reserve System. They
must not be officers, directors, employees, or stockholders
of any bank. One of them is designated by the Board of
Governors as chairman of the Reserve Bank’s board of
directors and one as deputy chairman. The chairman, by
statute, is designated Federal Reserve Agent and has
special responsibilities on behalf of the Board of Governors
in Washington.3
Under these arrangements, businessmen and others who
3 The Federal Reserve Agent, subject to approval by the Board of
Governors, appoints such assistant Federal Reserve agents as he may need
in the performance of his duties, which are noted in Chapter X.
19
THE FEDERAL RESERVE SYSTEM
are not bankers constitute a majority of the directors of
each Federal Reserve Bank. The directors are responsible
for the conduct of the affairs of the Reserve Bank in the
public interest, subject to supervision of the Board of
Governors. They appoint the Reserve Bank officers, but
the law requires that their choice of president and first
vice president, whose terms are for five years, be approved
by the Board of Governors.
Each branch of a Federal Reserve Bank also has its
own board of directors. A majority are selected by the
Reserve Bank; the remainder, by the Board of Governors.
Board o f Governors
The Board of Governors of the Federal Reserve System
consists of seven members appointed by the President of
the United States and confirmed by the Senate. Board
members devote their full time to the business* of the
Board. They are appointed for terms of fourteen years,
and their terms are so arranged that one expires every two
years. No two members of the Board may come from the
same Federal Reserve district.
One of the Board’s duties is to supervise the operations
of the Federal Reserve System. As already indicated, the
Board appoints three of the nine directors of each Federal
Reserve Bank, including the chairman and the deputy
chairman. And appointments of the president and first
vice president of each Federal Reserve Bank are subject
to the Board’s approval. The Board also issues regulations
that interpret and apply the provisions of law relating to
Reserve Bank operations. It directs Reserve Bank activities
in examination and supervision of banks and coordinates
the System’s economic research and publications.
20
STRUCTURE
Each of the twelve Federal Reserve Banks submits its
budget to the Board for approval. The salaries of all
officers and employees of the Reserve Banks and branches
are subject to the Board’s approval. Certain other expendi
tures—such as those for construction or major alteration
of bank buildings—are also subject to the Board’s specific
approval. The Board’s staff analyzes reports showing
expenses of the Federal Reserve Banks and also makes
surveys at the Reserve Banks of operating procedures and
of other matters relating to their expenses and cost
accounting systems.
Each Federal Reserve Bank and branch is examined
at least once a year by the Board’s field examiners, who
are directed to determine the financial condition of the
Bank and compliance by its management with applicable
provisions of law and regulation. The scope of examination
includes a comprehensive review of the Bank’s expendi
tures to determine if such expenditures are properly con
trolled and are of a nature appropriate for a Reserve Bank.
It is also the practice to have representatives of a public
accounting firm observe the examination of one Reserve
Bank each year, to provide an outside evaluation of the
adequacy and effectiveness of examination procedures.
In addition to the annual examination by the Board’s
examiners, the operations of each Reserve Bank are
audited by the Bank’s internal auditing staff on a yearround basis under the direction of a resident General
Auditor. He is responsible to the Bank’s board of directors
through its chairman and its audit committee. Each year
the Board’s examiners review thoroughly the internal audit
programs at all of the Banks to see that the coverage is
adequate and the procedures effective.
21
THE FEDERAL RESERVE SYSTEM: ORGANIZATION
BOARD
FED ER AL R ESER VE
APPOINTS
M EM BER
CONTRIBUTE
OF
GO VERN O RS
,, _____
SE V E N M E M B E R S
BAN KS
112 B A N K S O P E R A T I N G
24 B R A N C H E S )
FED ERAL
O PEN M A R K ET
CO M M ITTEE
E A C H B A N K WITH
9 D IR ECT O RS
A P P O IN T E D BY
THE P R E SID EN T
OF THE
U N IT E D STATES
AND
C O N F IR M E D BY
THE S E N A T E
◄ ------------
BANKS
CAPITAL
I A B O U T 6 , 1 00 |
E A C H G R O U P ELECTS
O N I C lA S S A A N D
MEMBERS
REPRESENT'
r O F THE
B O A R D OF
A T IV ES
OF F.R.
GOVERNORS
BANKS
3 C lA S S A
B A N K IN G
3 C lA S S B
b u s in e s s )
3 C lA S S C
O N E C lA S S 8
OtRSC TO R IN EACH
F.R. DISTR IC T
PUBLIC
171
IS)
POINTMENTS AN
SALARIES
D IR ECT O R S
\ r E A CH P R . BAN K
I
A P P O IN T
URGE
ABOUT 650
I
FEDERAL
P RE SID EN T
FIRST V ICE PRESID EN T
A D V ISO R Y
AND
CO U N C IL
OTH ER OFFIC ERS
A N D EM PLOYEES
112 M E M B E R S )
M E D IU M
A B O U T 2,100
SM ALL
ABOUT
3,3 50
THE FEDERAL RESERVE SYSTEM
K>
NJ
STRUCTURE
The Board represents the Federal Reserve System in
most of its relations with executive departments of the
Government and with congressional committees. It is
required to exercise special supervision over foreign con
tacts and international operations of the Reserve Banks.
The Board submits an annual report to Congress and
publishes a weekly statement, as described in Chapter XI,
of the assets and liabilities of the Federal Reserve Banks.
Expenses incurred by the Board in carrying out its duties
are paid out of assessments upon the Reserve Banks, and
the Board’s accounts are audited each year by qualified
certified public accountants.
Federal Open Market Committee
Systemwide coordination in the administration of
monetary policy is accomplished in part through the
Federal Open Market Committee, a statutory body that
meets at the Board’s offices in Washington at frequent
intervals. Its membership comprises the seven members of
the Board of Governors and presidents of five of the
Federal Reserve Banks. It is assisted by a staff of econo
mists drawn from the staffs of the Board and the Banks.
The Committee has responsibility for deciding on changes
to be made in the System’s portfolio of domestic securities
and holdings of foreign currencies. The Federal Reserve
Banks, in their operations in the open market, are required
by law to carry out the decisions of the Open Market
Committee.
Federal Advisory Council
To establish a further link and channel of communica
tion between the Board and representatives of the banking
23
THE FEDERAL RESERVE SYSTEM
and business community, the Federal Reserve Act pro
vides for a Federal Advisory Council consisting of one
member from each Federal Reserve district. Each Federal
Reserve Bank by its board of directors annually selects
one Council member, usually a representative banker in
its district. The Council meets in Washington at least four
times a year. It confers with the Board of Governors on
business conditions and makes advisory recommendations
regarding the affairs of the Federal Reserve System.
Other Advisory Committees
In dealing with the many operating and functional prob
lems that call for a coordinated approach and solution to
make a decentralized system effective, the System makes
use of a number of conferences and committees that help
in reaching an understanding on common problems. Of
these the most important are the Conference of Presidents
and the Conference of Chairmen of the Federal Reserve
Banks. The former Conference meets at least three times a
year, while the latter usually meets once a year, at the
Board’s offices in Washington.
Membership in the Federal Reserve System
The blending of private and public, and regional and
national, interests in the Federal Reserve System has
created an organization especially well adapted to a
dynamic, private enterprise economy such as ours and to
a banking system with many independent banks. On
June 30, 1963, the Federal Reserve System had 6,058
member banks out of a total of 13,993 banks in the
country. Of those that were members, 4,537 were national
banks, which are required to belong to the System, and
24
STRUCTURE
1,521 were State-chartered banks. Banks with State
charters may join the System if qualified for membership
and if accepted by the Federal Reserve.
While somewhat less than one-half of the banks in the
United States belonged to the System on June 30, 1963,
these banks held nearly three-fourths of the country’s total
bank deposits. Furthermore, they held about 85 per cent
of all demand deposits, which, along with currency, serve
as means of payment. Consequently, Federal Reserve
policies have a direct influence on institutions holding
nearly nine-tenths of the bank deposits that constitute the
major component of the country’s money supply.
The different kinds of banks in this country in mid-1963
and the amounts of their demand and time deposits are
shown in the accompanying table.
B anks in the U nited States, June
Kind of bank
Number
30, 1963
Deposits 1
(in millions of dollars)
Demand
Time
86,550
62,271
Member bank 2.................................
Nonmember bank.............................
6,058
7,935
121,308
23,705
Total..........................................
13,993
145,013
148,820
Classes of member banks:
National2......................................
State ..............................................
4,537
1,521
78,425
42,884
58,462
28,088
Classes of nonmember banks:
Commercial...................................
Mutual savings..............................
7,424
511
23,376
330
19,353
42,918
1 Excludes interbank deposits.
2 Includes one national (member) bank in the Virgin Islands.
N o t e . —Details may not add to totals because of rounding.
25
THE FEDERAL RESERVE SYSTEM
Obligations and Privileges o f Member Banks
When banks join the Federal Reserve System, they be
come eligible to use all of the System’s facilities. At the
same time they undertake to abide by certain rules, pre
scribed by law or developed by regulation in accordance
with the law, for the protection of the public interest.
National banks are chartered by the Comptroller of the
Currency, a Federal Government official, and are subject
in their operations to the National Bank Act as well as to
the Federal Reserve Act. State-chartered banks that
become members of the Federal Reserve System retain
their charter privileges but agree to be subject to the require
ments of the Federal Reserve Act. Since these banks join
the System voluntarily, they have the privilege of withdraw
ing from membership on six months’ notice.
Every member bank is required to subscribe to the
capital of its Reserve Bank. Its paid-in subscription is an
amount equal to 3 per cent of its capital and surplus, and
another 3 per cent is subject to call. On June 30, 1963, all
member banks together held about $480 million of paid-in
capital stock of the twelve Federal Reserve Banks.
Banks that become members of the Federal Reserve
System must assume several important obligations. They
must maintain legally required reserves either on deposit
without interest at the Reserve Bank or as cash held in
their own vaults; remit at par for checks drawn against
them when presented by a Reserve Bank for payment; and
comply with various Federal laws, regulations, and condi
tions of membership regarding the adequacy of capital,
mergers with other banking institutions, establishment of
branches, relations with holding company affiliates and
26
STRUCTURE
bank holding companies, interlocking directorates, loan
and investment limitations, and other matters. If the
member bank is chartered by a State, it must be subject to
general supervision and examination by the Federal
Reserve System.
In return, member banks are entitled to the following
principal privileges, among others: (1) to borrow from the
Federal Reserve Banks when temporarily in need of addi
tional funds, subject to criteria for such borrowing (cus
tomarily called discounting) set by statute and regulation;
(2) to use Federal Reserve facilities for collecting checks,
settling clearing balances, and transferring funds to other
cities; (3) to obtain currency whenever required; (4) to
share in the informational facilities provided by the Sys
tem; (5) to participate in the election of six of the nine
directors of the Federal Reserve Bank for their district;
and (6) to receive a cumulative statutory dividend of 6 per
cent on the paid-in capital stock of the Federal Reserve
Bank.
Use of these privileges by member banks throughout the
country enables the nation’s banking system to operate
more effectively in providing the credit and banking facili
ties needed in a growing and diverse economy.
27
CHAPTER III
INSTRUMENTS OF M ONETARY REG ULATION.
The
principal means by which monetary policy achieves its objectives
are open market purchases and sales, mainly o j U. S. Government
securities but also o j foreign currencies; discount operations;
and changes in reserve requirements. Regulation o f stock market
credit supplements these means o f infuence. Use o f all the instru
ments is closely coordinated.
EDERAL Reserve monetary policy is exercised prin
cipally through three related and complementary in
struments affecting the reserve position of the banking
system. These are open market operations in domestic
securities, discount operations, and changes in reserve
requirements. Open market operations in foreign curren
cies also affect bank reserve positions to some extent, but
their focus is on orderly achievement of balance in the
supply of and demand for dollars in the foreign exchange
market.
Changes in bank reserves result in a multiple expansion
or contraction of bank loans and investments and of the
F
29
THE FEDERAL RESERVE SYSTEM
money supply, as explained in some detail in the next
chapter. The lending and investment activities of banks in
turn influence conditions in the nation’s credit market.
Thus, actions by the Federal Reserve System to create or
extinguish bank reserves not only exert a powerful in
fluence on the flow of bank credit and money but also have
a marginal influence on the levels of interest rates and on
liquidity and the availability of credit in general.
In addition to its use of general monetary policy instru
ments to affect bank reserves, the Federal Reserve has
authority to influence directly the volume of stock market
credit. This limited-purpose instrument is specially de
signed to prevent the excessive use of bank and other credit
in stock market speculation.
The timing and degree of the use of these Federal Reserve
instruments and their coordination are of major impor
tance in making credit and monetary policy effective in
relation to domestic economic conditions and our inter
national balance of payments.
O pe n M arket O peratio n s
The bulk of Federal Reserve operations affecting the
reserve positions of banks relate to short-term variations
in the economy’s needs for bank credit and are effected
by the use of open market operations. These operations
consist of purchases or sales of securities in the open
market. Regardless of who may sell the securities pur
chased or who may buy the securities sold by the Federal
Reserve, these transactions have a direct impact on the
volume of member bank reserves. A distinctive aspect of
open market operations is that they are undertaken solely
on the initiative of the Federal Reserve.
30
INSTRUMENTS OF REGULATION
How Operations Are Conducted
Open market purchases or sales of securities are made
by the Manager of the System’s Open Market Account
under instruction of the Federal Open Market Committee,
which is responsible for making the open market decisions
of the entire System. Open market transactions are in U.S.
Government securities primarily, but sometimes they
include relatively small amounts of bankers’ acceptances.
The purchases or sales of foreign currencies, when required
by the economy’s external position, are also under the
direction of this Committee.
The System Open Market Account buys securities from
or sells securities to dealers, who transact orders for their
own account as well as for others. Purchases for the Open
Market Account are made at the lowest prices, and sales
at the highest prices, that are available in the market at the
time of the transaction.
When the Federal Open Market Account buys securities
in the open market, the dealer receives a check on a
Reserve Bank in payment, which he deposits in his own
bank account. When a member bank receives these funds,
they are credited to its reserve account with a Reserve
Bank. Federal Reserve purchases of securities thus add
to the reserve balances of member banks. Conversely, sales
of securities reduce the reserve balances of member banks.
The resulting changes in reserve positions affect the ability
of these banks to make loans and to buy securities.
Federal Reserve open market sales are made outright.
Purchases, on the other hand, may be outright or under
repurchase agreement. When such agreements are made,
the selling dealer agrees to repurchase the securities within
a specified period of fifteen days or less. This kind of
31
THE FEDERAL RESERVE SYSTEM
arrangement provides Federal Reserve credit on a tem
porary basis — puts out the funds with a string tied to
them, as it were. It also provides temporary financing of
dealer inventories at a time when funds for dealer loans
are not readily available in the market and the System
is willing to supply bank reserves for a limited period.
Repurchase agreements may be terminated before maturity
at the option of either party.
Open Market Procedures
The effectuation of credit and monetary policy has been
the principal objective of open market operations since
the early 1950’s. For several years before World War II
and for a few years thereafter, however, maintenance of
orderly conditions in the money and securities markets
was officially declared to be a main purpose of System
open market operations. During the period of war and
early postwar finance, orderliness became extended to
include stability of market prices and yields. Thus, the
Federal Reserve bought and sold Government securities
with the purpose of stabilizing prices and yields. As a
result, all Government securities — whether short-term or
long-term — could be converted into cash with equal ease.
In other words, all Government securities had full market
liquidity.
This experience demonstrated that use of open market
operations to stabilize market prices and yields of Govern
ment securities prevents the System from regulating bank
reserves in the interest of the whole economy. When offer
ings of securities in the market exceeded the private
demand for them, the Federal Reserve was obliged to buy
them to keep the market stable. As a result, commercial
32
INSTRUMENTS OF REGULATION
bank reserves were expanded automatically, even at times
when such expansion was adverse to the public interest.
By functioning as residual buyer, the System created bank
reserves mainly at the initiative of the market rather than
on its own initiative.
This operating dilemma came into sharp focus when the
Korean crisis in 1950 caused a rapid increase in credit
demands and a surge of inflationary pressures. To resolve
the dilemma, an accord was reached with the Treasury
early in 1951 that the Federal Reserve System would dis
continue stabilizing prices and yields of Government
securities. Following this accord, the Federal Open Market
Committee was able to conduct open market operations
with the principal objective of implementing credit and
monetary policy, including the correction of disorderly
market situations should any occur.
The Open Market Committee has always followed a
policy of reviewing and reaffirming or changing its estab
lished operating procedures each year, or whenever neces
sary. Changes in procedure have been made over the years,
as economic conditions have changed. Over most of the
1950’s, for instance, when the U.S. balance of payments
was not a principal concern, practically all emphasis was
placed on domestic economic conditions. In the early
1960’s the balance of payments became a more pressing
problem, and open market operations and procedures
came to reflect this. For instance, the Open Market Com
mittee began to operate regularly in U.S. Government
securities of all maturities in order to have a more direct
effect on interest rates, especially short-term rates, which
have an influence on the flow of liquid funds between the
United States and foreign countries.
33
THE FEDERAL RESERVE SYSTEM
While operating procedures have changed from time
to time over the years since 1951, the basic position of the
System in relation to the Treasury or to the Government
securities market has always included the following major
elements. First, effectuation of credit and monetary policy
has been the principal objective of open market operations,
although correction of disorderly market conditions has
been necessary at times. Second, decisions about operations
in particular securities have been made in the light of
economic and financial circumstances, although the bulk
of open market operations have been in short-term securi
ties because they have the largest market and because
transactions can be consummated without undue market
disturbance. And third, the System has undertaken no
operations to peg U.S. Government securities or to
create artificial market conditions at times of new security
offerings by the Treasury. At the same time it has tried
not to introduce substantial changes in Federal Reserve
policy during financing periods.
Effectuation o f policy. Open market operations are
administered so as to affect bank reserve positions, and
thereby the flow of bank credit and money. As with other
domestic policy instruments, they are used to help minimize
short-term fluctuations in economic activity, to facilitate
the expansion of money and credit necessary to continuing
economic growth, and to help maintain relative stability
in average prices of goods and services.
The efficient conduct of open market operations requires
a well performing Government securities market. In such
a market, prices and yields at which willing buyers and
willing sellers can arrange transfers of ownership are con
tinuously being established. These prices and yields affect
34
INSTRUMENTS OF REGULATION
the allocation of funds within the market and between it
and other markets and uses. It is important that operations
of monetary policy be designed so that the process of pro
viding bank reserves interferes with basic market functions
as little as possible.
The credit market, however, does not always function
effectively and well. It sometimes reflects unusual psycho
logical tensions growing out of overly optimistic or overly
pessimistic expectations as to some prospective develop
ment, economic or political and domestic or international.
Monetary policy must be responsive to such destabilizing
developments and counteract them when they occur.
Market disturbances are usually limited in extent, and
the self-correcting tendencies characteristic of a sensitive
market mechanism keep the flow of trading continuous
and orderly. There is always a possibility, however, that
a market disturbance will become self-feeding and that
the market situation will become disorderly. Under these
circumstances, the System undertakes open market trans
actions to correct disorderly conditions.
Security operations. In its day-to-day operations the
System relies on open market operations as its most sensi
tive and flexible instrument for affecting bank reserves.
The System is continuously buying and selling securities
in the open market as it accommodates seasonal demands
for money and credit, attempts to offset cyclical eco
nomic swings, and supplies the bank reserves needed for
long-term growth. The net change in its securities port
folio tends to be comparatively small over, say, a year,
but over the same period the System undertakes a large
volume of transactions — purchases and sales together —
in response to seasonal and other temporary variations in
35
THE FEDERAL RESERVE SYSTEM
reserve availability that might otherwise lead to undesir
able market instabilities.
To minimize the direct impact on markets of continual
and sizable day-to-day purchases and sales, much the
larger part of open market operations are carried out in
short-term securities. But operations have also been under
taken, when appropriate, in intermediate- and long-term
securities. These have been purchased at times to take
immediate downward pressure off short-term rates in order
to discourage outflows of liquid capital from the United
States and thereby to help our balance of payments, while
still encouraging domestic credit expansion.
* Less than $0.5 billion. N o t e .— Excludes transactions among U.S.
Government securities dealers and also Federal Reserve exchanges, re
demptions, and repurchase agreements.
36
INSTRUMENTS OF REGULATION
In 1962, System open market transactions in securities
maturing within a year amounted to $15 billion, while
transactions in maturities of one to five years were about
$2 billion, and in longer-term securities less than $0.5
billion. As can be seen from the table on the preceding
page, over-all activity in the market also declined as
maturity lengthened.
Experience shows that changes in commercial bank
reserve positions brought about by System open market
operations, whether in short- or long-term securities, do
affect the entire Government securities market and also
the market for other securities in some degree. Many insti
tutional investors, especially commercial banks and savings
institutions, hold securities of longer term along with some
of shorter term. In adapting the maturity distribution of
their portfolios to their special needs, the managers of these
portfolios are necessarily alert and sensitive to changes in
demand and supply in the market and are continuously
adjusting their portfolios as they assess and reassess pros
pects for the market. Thus they adapt their portfolios to
changing market conditions and in this process transmit
the effects of Federal Reserve operations throughout the
range of maturities of debt obligations outstanding.
Periods o f Treasury financing. During the period of
World War II and through early postwar years, when the
Federal Reserve System was stabilizing the market, it
purposely used its open market instrument to support
Treasury borrowing operations. To this end the System
engaged in open market transactions in maturing issues,
in securities announced for issuance (“when issued”
securities), and in outstanding issues of maturities com
parable to those being offered by the Treasury in a par
37
THE FEDERAL RESERVE SYSTEM
ticular refinancing. With its virtually unlimited resources,
the System competed with market traders in such trans
actions and the latter, in consequence of the System’s
dominant role in the market, tended to limit the volume
of their own trading.
The risk to System policy from this situation was not
only the undesired release to the banks during Treasury
financings of additional reserve funds but also the inter
ference, when not necessarily warranted, with the process
by which the market allocates funds among competing
users. In order to avoid or limit this risk, the System dis
continued this kind of operation in 1953. Discontinuance
of the practice of facilitating Treasury borrowings also
had as a broad objective the fostering of a more selfreliant Government securities market.
This action, however, could not resolve all aspects of
the market relationship between debt management and
monetary administration. The marketable and convertible
part of the Federal debt held by the public at the end of
1962 amounted to more than $160 billion. The periodic
refinancing of this debt and the need from time to time
for new cash borrowing require that the Treasury engage
frequently in financing operations, other than its weekly
auctions of Treasury bills. While the System has believed
that its powers to create money should not be used to
support these financings, it has recognized that concurrent
monetary actions may affect their success. Consequently,
the Federal Reserve has come to pursue whenever feasible
what is known as an “even keel” monetary policy immedi
ately before, during, and immediately after Treasury
financing operations.
Maintenance of an “even keel” in monetary manage
38
INSTRUMENTS OF REGULATION
ment during Treasury financing periods helps to keep
abrupt changes in bank credit conditions from interfering
with Treasury financings. It has the disadvantage of shifting
to periods before or after such financings whatever changes
in monetary action may be appropriate in the prevailing
economic situation from the standpoint of the public
interest. These shifts in the timing of action, however, are
not frequent and in any event can be accomplished with
out destabilizing effects upon the economy.
Foreign currency operations. In early 1962 the Federal
Reserve began to buy and sell foreign currencies for the
Open Market Account in the exchange markets and in di
rect transactions with foreign monetary authorities. These
operations in foreign currencies are especially related to
the state of balance in the international payments of the
United States and hence need to be considered in con
nection with that subject, as is done in Chapter VIII. It
may be noted here that such operations help to retard out
flows of gold from this country during periods of payment
deficits and to fortify the dollar in foreign exchange mar
kets during periods of actual or potential speculative
pressure.
Foreign currency transactions by the Federal Reserve
do have an effect on domestic bank reserves, but in view
of the actual size and nature of operations the net effect
is quite small. Sales of foreign currencies, like sales of U.S.
Government securities, absorb reserves, while acquisitions
of such currencies add to reserves. In deciding on the extent
of day-to-day open market operations in U.S. Government
securities, the System of course takes into account the
effect of these operations and of all other factors affecting
bank reserves.
39
THE FEDERAL RESERVE SYSTEM
D isc o u n t O perations
An important advantage to a commercial bank of
being a member of the Federal Reserve System is that it
may obtain additional reserves on occasion by borrowing
from a Federal Reserve Bank. As a matter of fact, provi
sion of facilities for such borrowing was a main objective
of reserve banking as established in this country.
Mechanics o f Discounting
Member banks may borrow from a Reserve Bank in
two ways. First, they may rediscount short-term commer
cial, industrial, agricultural, or other business paper, with
recourse on the borrowing bank. Second, they may give
their own promissory notes secured by paper eligible for
discounting, by Government securities, or by other satis
factory collateral. Borrowings by the first method are
called discounts; by the latter, advances. The custom has
developed of referring to both types of Reserve Bank
lending as discounting, and the interest charge appli
cable to such lending is known as the discount rate.
Actually, most member bank borrowing has come to be
in the form of advances — that is, against notes with
Government securities as collateral. This form of borrow
ing is more convenient and time-saving for the bank, be
cause the collateral is free of credit risk, is instantly
appraisable as to value, and can be more readily supplied
in large amounts conforming to the borrowing needs of
individual banks. Many member banks leave Government
securities with their Reserve Bank for safekeeping; this
arrangement makes it easy to pledge such securities as
collateral when they need to borrow.
40
INSTRUMENTS OF REGULATION
When a member bank borrows at a Reserve Bank, the
proceeds of the loan are added or credited to its reserve
balance on deposit at the Reserve Bank. Conversely, when
it repays its indebtedness, the amount of repayment is
deducted from or charged against its reserve balance.
Federal Reserve advances to or discounts for member
banks are usually of short maturity — up to fifteen days.
From the viewpoint of the individual member bank, a
decision to discount is usually prompted by the need to
avoid a deficiency in its legal reserve. Such a deficiency is
likely to result from a loss of deposits and therefore of
reserves to another bank. In adjusting to such a reserve
drain, an individual bank has a number of alternatives.
It can restrict its lending, call in correspondent balances
it keeps with other banks, sell securities in the market,
borrow from another member bank, or borrow from a
Reserve Bank.
These alternatives are not equally desirable or possible
for all member banks. For instance, a member bank will
seek to preserve continuity in providing credit to custom
ers, so it is more likely at first to choose other methods of
reserve adjustment. The alternative of calling in corre
spondent balances is open mainly to smaller banks, which
keep such balances with large city banks. Use of this
method is limited, though, since banks generally keep
these balances above some minimum level in return for
services provided by the correspondent bank. Of the re
maining methods of reserve adjustment mentioned —
selling securities and borrowing from another bank or
from the Federal Reserve — the bank will choose bor
rowing from a Federal Reserve Bank when this method
is cheaper or when it seems advantageous for other reasons.
41
THE FEDERAL RESERVE SYSTEM
Described in this way, the discount facilities of the
Reserve Banks would appear to be mainly a convenience
to member banks that enables them to adjust their reserve
positions to unexpected shifts in deposits by temporary
borrowing rather than by an alternative type of adjustment.
From the standpoint of the amount of reserve funds avail
able to the banking system, however, borrowing from
Reserve Banks is clearly more than a convenience.
Apart from offsetting influences, any increase in Reserve
Bank discounts for member banks adds to the total
reserves of member banks, and any reduction in the volume
of such discounts reduces them. In contrast, when banks
that experience reserve drains make their adjustments by
selling assets in the market or by interbank borrowing,
there may be no effect on total bank reserves. The reserve
funds acquired by the banks that are adjusting their
reserves may then come from the reserves of other banks.
Discount Administration
Federal Reserve Banks do not discount eligible paper
or make advances to member banks automatically. The
discount facilities are made available as a privilege of
membership in the System and not as a right. Although
actual discount operations focus mainly on the temporary
financing needs of banks in the normal course of their
business, the statutory and regulatory provisions also
cover the needs of banks confronted with an emergency
situation. The broad discretion that Reserve Banks have
in determining satisfactory collateral facilitates borrowing
by banks to adjust to exceptional drains on reserves.
Under Regulation A of the Board of Governors, appli
cable to the discount process, each Federal Reserve Bank
42
INSTRUMENTS OF REGULATION
in accommodating member bank applications for discount
credit adheres to the following guiding principles:
Federal Reserve credit is generally extended on a short-term
basis to a member bank in order to enable it to adjust its asset
position when necessary because of developments such as a
sudden withdrawal of deposits or seasonal requirements for
credit beyond those which can reasonably be met by use of the
bank’s own resources. Federal Reserve credit is also available
for longer periods when necessary in order to assist member
banks in meeting unusual situations, such as may result from
national, regional, or local difficulties or from exceptional
circumstances involving only particular member banks. Under
ordinary conditions, the continuous use of Federal Reserve
credit by a member bank over a considerable period of time
is not regarded as appropriate.
In considering a request for credit accommodation, each
Federal Reserve Bank gives due regard to the purpose of the
credit and to its probable effects upon the maintenance of
sound credit conditions, both as to the individual institution
and the economy generally. It keeps informed of and takes
into account the general character and amount of the loans and
investments of the member banks. It considers whether the
bank is borrowing principally for the purpose of obtaining a
tax advantage or profiting from rate differentials and whether
the bank is extending an undue amount of credit for the specu
lative carrying of or trading in securities, real estate, or com
modities, or otherwise.
Member Bank Reluctance to Borrow
The Federal Reserve policy of emphasizing to member
banks that the use of its discount facilities should be
temporary is reinforced, in practice, by a well established
tradition among this country’s banks against operating
on the basis of borrowed reserves — at least, for any
extended period. This tradition does not mean that mem-
43
THE FEDERAL RESERVE SYSTEM
ber banks feel reluctant to rely on Federal Reserve lending
facilities to meet temporary or unusual cash drains. But
it does mean that under normal conditions these banks
manage their affairs so that they do not need to resort to
Reserve Bank borrowing except for necessary contin
gencies. And once in debt, they seek to repay such debt
promptly. Continuing pressures on their reserve positions
and other special developments may, at times, weaken this
reluctance to borrow, but it nonetheless persists as a factor
affecting member bank borrowing.
Member bank attitudes toward operating with bor
rowed funds vary from bank to bank. Many banks never
borrow from a Reserve Bank. They prefer to make reserve
adjustments in other ways, including, when necessary,
restriction of their lending to customers. Reluctance to
borrow, as well as incentive to repay promptly, results
from the disposition of depositors, especially larger busi
ness and financial depositors, to be critical of bank borrow
ing since, in case of insolvency, creditors’ claims take
precedence over the claims of depositors.
Because of the tradition against borrowing — and
because the Federal Reserve does not consider the con
tinuous use of the discount window by member banks
to be appropriate — banks indebted to a Reserve Bank
tend to retire this indebtedness from the funds that
become available to them before adding to their loans
and investments. The act of repayment by one bank is
likely to reflect net transfers of reserve funds to that bank
from other banks, which may then borrow to replenish
their reserve balances and so in turn will need to repay their
borrowing. In this way the restrictive effect of mem
ber bank indebtedness on their lending tends to spread
44
INSTRUMENTS OF REGULATION
through the whole banking system. Experience generally
shows that tightness in the availability of bank credit to
customers is related to a large volume of member bank
discounts outstanding, and easy credit conditions to a
small volume of borrowing from Reserve Banks.
Discount Rates
Discount rates are the cost to member banks of reserve
funds obtained by borrowing from Reserve Banks. Each
Reserve Bank must establish its own discount rate, subject
to review and determination by the Board of Governors in
Washington, every fourteen days. These rates are publicly
announced.
The financial community thinks of Reserve Bank dis
count rates as pivotal rates in the credit market. The key
role assigned to them derives largely from the fact that
they have been established by the administrative action of
a public body having special information and competence
to judge whether expansion of bank credit and money is
consistent with the economy’s over-all cash needs for
transactions and liquidity. In the light of this fact, it is
only natural that the business and financial community
should commonly interpret a change in the level of
Reserve Bank discount rates as an important indication
of the trend in Federal Reserve policy.
There are no simple rules for interpreting changes in
discount rates, however. In general, changes in the discount
rate tend to occur when short-term rates of interest in the
market have moved away from alignment with the exist
ing discount rate considered to be consistent with the
posture of monetary policy and economic circumstances
at the time. In some situations, the change represents
45
THE FEDERAL RESERVE SYSTEM
merely a technical adjustment of discount rates to a shift
in market rates stemming from forces that are largely
independent of System policy. In other circumstances,
earlier action by the System to affect bank reserve availa
bility may have been an influence on the movement of
market rates. Adjustment of the discount rate then becomes
necessary to assure that the discount mechanism will
function effectively in line with current policy. In some
periods — and depending on the changes then occurring
in economic activity — the level of discount rates may be
changed several times in fairly close succession.
Tendency Toward Uniform Rates
The founders of the Federal Reserve System contem
plated that Reserve Bank discount rates would be set in
accordance with regional financial conditions. They
expected that variations in regional conditions would lead
to variations in discount rates among the Reserve Banks.
In recent decades, however, rates have tended to be
uniform, although there have been temporary periods in
which different rates have obtained. Basically, this tendency
toward uniformity reflects improvements in the facilities
and speed of communication and transport as well as
further geographical integration of industrial, commercial,
and financial enterprise.
Credit is a fluid resource. It tends to flow to the market
of highest yield. Along with growth in widely known
regional or national enterprises, which can seek financing
in the most advantageous market, demands for funds too
have become more mobile. The highly sensitive central
money markets — that is, the markets for Treasury bills
and other prime short-term instruments — provide a
46
INSTRUMENTS OF REGULATION
mechanism through which the forces of fluid supply and
mobile demand are registered promptly.
Thus, the regional credit and money markets have really
become only segments of a closely knit national market,
as will be explained in Chapter V, and this fact has found
expression in a tendency toward uniformity of discount
rates among the twelve Reserve Banks. Increasingly,
Federal Reserve discount rate policy is referred to and
considered in terms of “the discount rate” rather than in
terms of twelve Reserve Bank rates.
Relation o f the Discount Rate to Market Rates
The level of the discount rate in relation to market rates
of interest affects a member bank’s decision as to the most
desirable way for it to make an immediate adjustment in
its reserve position. The cost of adjusting a reserve position
by borrowing is, of course, the interest charge incurred.
When a bank sells securities to acquire funds, it measures
the cost by the interest earnings sacrificed. Thus, a bank’s
preference as among Federal Reserve discounting, bor
rowing from other banks, or selling securities is influenced
to a large extent by the relation of the discount rate to the
cost of borrowing from banks and to market yields on
Treasury bills and other securities it holds as liquid assets
or as a second line of reserves.
As the chart on page 48 shows, the movement of the
Federal Reserve discount rate is closely related to the
movement of short-term market interest rates. In a period
when credit demands are expanding strongly, short-term
market rates tend to rise. One reason for the rise is that
when their loans expand rapidly banks sell Treasury bills
and other paper of ready marketability to obtain funds.
47
THE FEDERAL RESERVE SYSTEM
If short-term market rates rise above the discount rate,
member banks have a greater tendency to borrow at
Reserve Banks rather than to adjust their reserve positions
by sale of their liquid paper through the market. Sooner
or later under these circumstances, the Reserve Banks are
DISCOUNT AND BILL RATES
Per cent p er annum
----- 1------ .............................................................................................................
...........
■
"
I".’ 5
likely to raise the discount rate in order to keep the dis
count mechanism functioning as a deterrent to unduly
rapid expansion of bank credit. Failure to raise the dis
count rate, in other words, would encourage and enlarge
member bank use of the discount window.
On the other hand, if the discount rate is raised above
market rates, member banks are likely to prefer to adjust
their reserves by selling Government securities, because
48
INSTRUMENTS OF REGULATION
the cost would be less. But such sales, by increasing the
market supply of short-term securities relative to the
demand, tend to drive short-term interest rates up toward
or moderately above the discount rate. Thus, in a period
of strong credit demands, short-term market rates and
the discount rate are likely to rise in fairly close sequence
until the demand pressures have spent their force.
Federal Funds Rate
In a banking system with as many independent units
and with as widely varying banking conditions as prevail
in this country, individual banks will at times be deficient
in reserves while other banks will have excess reserves.
Since total reserve funds are limited in supply, a practice
has developed whereby banks with reserve balances in
excess of needs offer to lend them on a day-to-day basis
to banks deficient in reserves. Thus, in addition to borrow
ing at Federal Reserve Banks or selling securities in the
market, commercial banks may adjust their reserve posi
tions by borrowing from other banks in a fairly well
organized market known as the Federal funds market.
Banks are the principal participants in this market, but
U.S. Government security dealers and others also borrow
and lend in the market from time to time.
The interest rate on Federal funds fluctuates in response
to the supply of and demand for bank reserves, but it very
seldom rises above the discount rate. In fact, the discount
rate acts as a kind of ceiling for the Federal funds rate,
since member banks naturally prefer discounting if this
is less costly.
Conditions of supply and demand in the Federal funds
market, which tend to vary directly with general credit
49
THE FEDERAL RESERVE SYSTEM
conditions, influence member bank borrowing from the
Reserve Banks. When general credit conditions are easy,
for example, Federal funds are usually available in greater
volume than when conditions are tight, and the margin
of the Federal funds rate below the discount rate widens.
In these circumstances, use of the discount facility by
member banks is reduced.
C h an g es in R eserve R equirem ents
Federal Reserve authority to vary the required reserve
percentages was first made available on a temporary basis
in the emergency banking legislation of 1933 and was made
a permanent instrument of reserve banking by the Banking
Act of 1935. Under present law, the Board of Governors
may set within specified limits the required reserve per
centages for each of the two classes of member banks —
reserve city banks and other banks, which are usually
referred to as country banks.
Changes in requirements may be applied to one or both
classes of banks at the same time, but they must be kept
within the limits set for each class and must be uniform
for all banks within a class. The following table shows for
each class the range of Federal Reserve discretion over
reserve percentages and the percentage requirements in
effect in December 1963 and the number of member banks
and the distribution of their deposits in mid-1963.
Operation o f the Instrument
Action to change the level of reserve requirements does
not itself affect the amount of total member bank reserve
balances, but it does affect the amount of deposits and of
loans and investments that member banks can legally
50
INSTRUMENTS OF REGULATION
maintain on the basis of a given amount of reserves. As
explained in Chapter IV, a given amount of member bank
reserves can support more or less bank credit and money
depending on the level of required reserve percentages.
M ember B a n k R eserve R equirem ents , D ecember
1, 1963
Class o f bank
Item
Reserve
city
Other
Net demand deposits
Reserve requirements (per cent of deposits):
Statutory range..............................................
In effect............................................................
10 to 22
161/2
7 to 14
12
Deposits (percentage distribution, June 30)..
62
38
Time deposits
Reserve requirements (per cent of deposits):
Statutory range...............................................
In effect............................................................
3 to 6
4
3 to 6
4
Deposits (percentage distribution, June 30)..
55
45
Number of member banks (June 30)............
219
5,839
Two things happen when required reserve percentages
are changed. First, there is an immediate change in the
liquid asset or secondary reserve position of member banks.
If reserve percentages are raised, banks that do not have
enough excess reserves to cover the increase in require
ments must find additional reserve funds by selling liquid
assets in the market or by borrowing from other banks
or from the Reserve Banks; the banking system as a whole,
however, can obtain the additional reserve funds required
51
THE FEDERAL RESERVE SYSTEM
only if the Federal Reserve provides them through its
open market operations or if member banks borrow at
Reserve Banks.
If reserve percentages are lowered, individual banks find
themselves with excess reserves available for investment
in earning assets and for debt repayment. Since banks
sustain their earnings at the highest levels consistent with
solvency by keeping their own resources as fully invested
as possible and by avoiding debt, their usual response to a
lowering of reserve requirements — after retiring any
indebtedness — is to acquire earning assets. At first, they
are likely to purchase short-term market paper of high
liquidity to hold temporarily.
A second effect of a change in the required reserve per
centages is an immediate change in the deposit-expansionmultiplier for the entire banking system. If the required
reserve percentage is 20 per cent, $1 of reserves will
support $5 of deposits, but if it is reduced to 15 per cent,
$1 of reserves will support $6.67 of deposits, as Chapter IV
explains in detail. Thus a 15 per cent requirement will
support one-third more deposits than a 20 per cent require
ment. In practice, the effect of a change in required reserve
percentages on the deposit-expansion-multiplier depends
in part on the distribution of deposits by type — demand
or time and savings — and on the distribution of deposits
by class of bank.
Role o f Reserve Requirement Changes
As an instrument of monetary management, changes in
required reserve percentages are less flexible and continu
ously adaptable than the open market and discount instru
ments. For one thing, changes in reserve requirements
52
INSTRUMENTS OF REGULATION
affect at the same time and to the same extent all member
banks subject to the action, regardless of the reserve needs
of individual banks on the occasion. For another, even a
small change in reserve requirements — say, one-half of
one percentage point — results in relatively large changes
in the total available reserves and in the liquidity position
of member banks as a group. If, to avoid a large reserve
effect, a change is limited to a particular class of bank, this
raises a perplexing problem of equity as between classes
of banks.
Moreover, a change to a new level of reserve require
ments cannot be made gradually over a period of time,
but must become effective on a selected preannounced
date. The credit market is forewarned that on this date
either demand or supply pressures will be accentuated,
with the risk of disturbance and instability in the prices of
and yields on securities at the time.
For the individual member bank the required reserve
percentage is the basis for current and forward decisions
by management concerning composition and maturity of
loans and investments. Accordingly, frequent abrupt
changes in the required percentage may unduly complicate
the task of bank management in a system of many inde
pendent banks of diverse size and portfolio structure.
Many of these banks, especially smaller “country banks,”
are inadequately equipped to make prompt adjustment to
frequent, even though small, changes in the reserve
requirement percentages.
In the System’s experience, changes in reserve require
ments have been applied most advantageously in meeting
bank reserve situations that had more than temporary
significance — that is, would not require reverse opera
53
THE FEDERAL RESERVE SYSTEM
tions in the near future — or that did not require careful
probing and adjustments as credit markets and the econ
omy responded. In the 1930’s the System increased reserve
requirements in order to absorb an unnecessarily large
volume of excess bank reserves. In early postwar years it
increased the percentages in an attempt to absorb the re
serves it had supplied by supporting prices of Govern
ment securities. The market effect of these increases,
however, was such as to necessitate additional purchases
to maintain the support.
Since reestablishment of flexible monetary operations
in the early 1950’s, the Federal Reserve has reduced reserve
requirement percentages in recession periods in order to
supply bank reserves simultaneously to all parts of the
economy. These counter-recession decreases in require
ments were facilitated by the fact that existing levels of
reserve requirements were high in relation to past periods
and also in relation to the standards for nonmember banks
adhered to by many States.
In accordance with legislation enacted in 1959, there
were reserve requirement changes in 1960 having mainly
a structural objective. These adjustments, which at the
time released reserves on balance, were for the purpose of
unifying reserve requirements for central reserve city banks
(a classification in existence at that time) and reserve city
banks and of offsetting in part the effects on reserves of
making vault cash eligible for meeting reserve require
ments. Before this legislation, member banks were not
permitted to count vault cash in meeting their reserve
requirements.
In the fall of 1962, in an effort to keep short-term interest
rates from falling in view of the balance of payments prob
54
INSTRUMENTS OF REGULATION
lem, the Federal Reserve reduced the reserve requirement
against time and savings deposits for the first time in eight
years. The reduction, which helped to provide reserves for
economic growth, was timed so as to accommodate the
large seasonal demand for bank credit and money that
normally occurs over the holiday period. In addition, it
provided the reserves in such a way as to take direct down
ward pressures off short-term interest rates. In the absence
of such a reduction the System would have provided these
reserves mainly through open market purchases of short
term securities.
R eg u l a t io n of S to ck M arket C redit
Since 1933 the Federal Reserve has been directed by law
to restrain the undue use of bank credit for speculation in
securities, real estate, or commodities. Since 1934 the
System has been specifically authorized to curb the exces
sive use of credit for purchasing or carrying securities by
setting limitations on the amount that brokers and dealers
in securities, banks, and others may lend on securities for
that purpose. At brokers and dealers the regulatory limita
tion applies to any type of corporate security; at banks it
applies only to corporate stocks registered on national
securities exchanges. The regulatory limitation does not
apply to any loan for other purposes, even though stocks
may be pledged as collateral for the loan.
The mechanism of stock market credit regulation is
readily illustrated. The amount that lenders may advance
against securities is always less than the current market
value of the securities to be pledged as collateral. The
lender calls the difference between the two the customer’s
margin. For example, if a loan of $6,000 is secured by
55
THE FEDERAL RESERVE SYSTEM
stock having a market worth of $10,000, the customer’s
margin is $4,000, or 40 per cent, and the loan value of the
stock is 60 per cent of its market value. Thus, by pre
scribing the loan value of the securities, the customer’s
margin may be controlled; the less the amount that can
be lent, the greater the margin required. In recent years
the margin required by Federal Reserve regulation has
varied from 90 per cent to 50 per cent.
Federal Reserve regulation requires the lender to obtain
the specified margin in connection with the purchase
of the security. If the market value of the security that
is collateral for the loan subsequently declines, the
regulation does not make it necessary for the borrower
either to put up additional collateral or to reduce the
indebtedness. However, the banker or broker making the
loan may require additional collateral if he deems it
to be necessary.
If the Federal Reserve raises the margin requirement,
borrowers need not reduce existing loans (or increase the
amount of collateral deposited with the broker or with
the bank), but borrowers with under-margined accounts
have to apply half of the proceeds from any sales of the
securities they have pledged as collateral to reduce their
indebtedness.
Regulation of stock market credit by the margin require
ment, though applied through the facilities of the lender,
puts restraint on the borrower and thus dampens demand
for credit. An important aspect of this restraint is that it
limits the amount of pyramiding of borrowing that can
take place in a rising market as higher prices create high
er collateral values and permit more borrowing on the
same collateral.
56
INSTRUMENTS OF REGULATION
The purposes of regulation through margin requirements
are to minimize the danger of excessive use of credit in
financing stock market speculation and to prevent the
recurrence of speculative stock market booms based on
credit financing, such as culminated in the price collapse
of 1929 and the subsequent severe credit liquidation. A
stock market boom followed by collapse is always pos
sible, but without excessive feeding by credit-financed
speculation it is not likely to assume the proportions or to
have the effects that it had in earlier periods.
C o o r d in a tio n of M o net a r y I n str u m en ts
Provision of bank reserves to meet the economy’s long
term growth and shorter-term cyclical and seasonal needs
is accomplished through coordinated use of the three basic
instruments of monetary policy. Reserves provided through
open market operations and changes in reserve require
ments are at the initiative of the Federal Reserve. On the
other hand, reserves provided through discounting or lend
ing to member banks are at the initiative of banks, although
use of this initiative is influenced by Federal Reserve ac
tions affecting the discount rate and market conditions.
In the banking system of the United States the great
bulk of reserve funds in the possession of banks are nonborrowed reserves. They represent the result of cumulative
actions taken in the past at the initiative of reserve banking
authorities. Some of these are the results of decisions to
supply reserves through use of policy instruments; some,
of decisions not to use policy instruments to offset in
creases in reserves from other sources, such as gold inflows.
Since the early 1930’s banks in the United States have
generally confined their use of the discount window to
57
THE FEDERAL RESERVE SYSTEM
meeting temporary needs for reserve funds. Hence in this
period the Federal Reserve has provided bank reserves to
support long-term growth of the economy in part by open
market operations and in part by changes in reserve
requirements. It has also changed reserve requirement
levels in special situations where large changes in the
volume of bank reserves, such as those stemming from
unduly large and persistent movements of gold into or out
of this country, needed to be offset or cushioned.
In practice, the bulk of day-to-day Federal Reserve
operations are in response to the short-term seasonal and
cyclical changes in economic and financial conditions. In
these circumstances open market operations as a tool of
policy are complemented by discount operations. System
initiative affecting bank reserves in order to accommodate
seasonal needs and to temper cyclical swings in the econ
omy is accomplished mainly through open market opera
tions in U.S. Government securities. But also individual
member banks, especially in communities that are subject
to unusually wide seasonal or cyclical fluctuations in busi
ness payments and credit demands, may cushion or spread
out somewhat the reserve adjustments they find it neces
sary to make through resort to the discount mechanism.
How the Federal Reserve carries out its shorter-term
policy adjustments by the joint use of open market and
discount policy is a complex process. An important char
acteristic of the process is that member bank demands for
borrowing from Reserve Banks in general tend to vary
inversely with the volume of reserves that the System is
supplying through open market operations.
When the Federal Reserve curtails reserve funds by
open market sales of securities in a period of high and rising
58
INSTRUMENTS OF REGULATION
economic activity, for example, member banks can accom
modate expanding demands for credit only by increased
use of the discount window.
To limit incentives for member bank discounting in such
periods the System may need to raise the discount rate in
accordance with changes in the general credit situation
and with the increases that are likely to be occurring in
market rates of interest. The active use of the open market
and discount instruments jointly to slow down the pace of
bank credit and monetary expansion will not be extended
indefinitely, but only long enough to contain unduly
expansive tendencies in these quantities.
Interaction of the open market and discount instruments
59
THE FEDERAL RESERVE SYSTEM
is also involved when countercyclical monetary policy is
directed toward accelerating the expansion of bank credit
and money. If member banks are heavily indebted to the
Reserve Banks, they will use the reserve funds made avail
able to them by enlarged open market purchases first to
reduce their Reserve Bank discounts. With conditions in
credit markets showing progressive ease — reflected espe
cially by declining rates of interest on short-term securi
ties — the discount rate may be lowered in one or more
steps. The continued inflow of reserve funds to banks
under these conditions will soon result in observable
acceleration in the rise of total member bank reserves
and in the pace of bank credit and monetary expansion.
In connection with the problem of moderating cyclical
swings in the flow of bank credit and money, it should be
noted that, in a growing economy, developments seldom
call for a full halt in or an all-out stimulation of bank credit
expansion. Adaptations in the joint use of the monetary
instruments, therefore, are generally gradual, that is, made
in greater or lesser degree according to the needs shown by
the stream of current economic information. Although in
this process day-by-day changes in the availability of
reserve funds may vary considerably, monetary policy
typically is geared to restraint or stimulus over a period
of many months.
The System also makes joint use of monetary instru
ments as it adapts them to attainment of objectives for
both domestic economic activity and the balance of pay
ments. Its open market operations to provide reserves for
domestic economic expansion may be associated with
downward pressures on interest rates, especially on short
term rates, which in turn may lead to outflows of capital
60
INSTRUMENTS OF REGULATION
from this country. If these outflows occur at times when
they add to deficits in the U.S. balance of payments or
threaten to activate large destabilizing speculative pres
sures, use of the instruments must be jointly adapted to
take these outflows into account.
To some extent the System may make open market
security purchases in intermediate- or long-term securities
to take immediate downward pressures off short-term
rates. The Treasury, it should also be mentioned, may at
the same time issue short-term securities in an effort to
offset downward rate pressures. Meanwhile, the Federal
Reserve discount rate may be maintained above market
rates; this encourages member banks to cover whatever
reserve deficiencies emerge by selling securities, especially
short-term issues, and thus puts upward pressure on short
term interest rates. And finally the Federal Reserve may
sell foreign currencies to help forestall drains on our gold
stock and to reduce associated speculative pressures.
Regulation of stock market credit supplements the
instruments affecting the bank reserve base. It deals
directly and selectively with the possibility of unstable
and undue absorption of bank and other credit in stock
market speculation. Since fluctuations in stock market
activity correlate generally with those in over-all econom
ic activity, changes in margin requirements tend to be
similarly correlated. The availability of the margin require
ment instrument means that the more general bank reserve
instruments do not have to be specially directed to the
avoidance of excessive stock speculation financed on
credit. Such use of the general instruments, to be effective,
would necessarily run the risk of undesirable, broader
effects.
61
CHAPTER IV
FUNCTIO N OF BANK RESERVES.
reserves constitute
both the legally required basis and the functional basis o f bank
deposits. Changes in the reserve position o f banks, therefore,
directly offect the f o w o f bank credit and money. In carrying out
its central responsibility, the Federal Reserve System relies pri
marily on its ability to increase or decrease the volume and
cost o f bank reserves.
ONETARY policy actions initially affect bank
reserves. Therefore, it is important — in tracing
the impact of monetary policy on the economy — to under
stand the function of bank reserves and the relation be
tween changes in bank reserves and changes in bank credit
and deposits.
Commercial banks, like other businesses, are organized
to make a profit. The bulk of a commercial bank’s earnings
come from the returns it receives on the loans and securities
it holds. Hence, it is usually a bank’s policy to put into
loans and investments as much as possible of the money it
receives as capital and deposits. In practically all States,
M
63
THE FEDERAL RESERVE SYSTEM
however, such banks are required by law to hold as reserve
assets an amount of uninvested funds equal to a designated
proportion of their deposits.
Historically, reserve requirements were imposed by law
for the purpose of protecting depositors — to assure that
banks maintained enough cash to meet temporary drains
on reserve funds caused by their depositors’ withdrawals
as well as to elicit depositors’ confidence in the banks’
ability to redeem their deposits when called upon to do so.
This was before establishment of the Federal Reserve
System, when there was no reserve bank from which com
mercial banks could obtain additional reserves in time of
temporary need.
Reserve requirements, although they restrained credit
expansion, did not effectively protect depositors during
periods of stress, for the banks could not continuously
pay out for their depositors’ benefit the cash they were
required to keep as reserves without drawing such reserves
down below legal requirements and threatening their
ability to continue active operations. Since other ways of
protecting depositors have been developed (for example,
insurance of deposits by the Federal Deposit Insurance
Corporation), required bank reserves have become for the
most part a medium through which the flow of bank
credit and money is influenced.
Thus, reserve requirements now serve mainly as a base
for monetary regulation. They do this in two ways. First,
the existence of reserve requirements enables the Federal
Reserve to gauge more accurately than it otherwise could
the likely impact on bank credit of operations affecting the
availability of bank reserves; in this sense, reserve require
ments are a fulcrum for monetary policy. Secondly, the
64
FUNCTION OF BANK RESERVES
possibility of making changes in reserve requirements, as
discussed in Chapter III, provides a means by which the
deposit-expansion-multiplier for the banking system can
be altered, when desirable, to affect the over-all avail
ability of bank credit and money.
Member Bank Reserve Requirements
Each bank that was a member of the Federal Reserve
System as of December 1, 1963, was required to keep as
reserves the following percentages of its demand deposits:
Reserve city banks...............................................
Other member banks (often described as
“country banks”) .............................................
16l/ i
12
These reserves must be on deposit with a Federal Reserve
Bank, except for any amounts that the member bank
may choose to hold in actual cash. As explained in Chap
ter III, the Federal Reserve changes the required percent
ages within the limits specified by law when credit condi
tions make such a change appropriate and feasible. Banks
that are not members of the Federal Reserve System are
subject to reserve requirements that vary by State.
The function of bank reserves may be easily explained
in a general way. For instance, assume that banks are
required to hold a 20 per cent reserve against demand
deposits. This 20 per cent figure is higher than the actual
percentages given above, but it is a convenient round
figure for illustrative purposes.
In this example, when a member bank receives a demand
deposit of $100, in currency or in the form of a check on
another bank, it must hold $20 as required reserves against
the deposit. These reserves must be deposited with a
65
THE FEDERAL RESERVE SYSTEM
Federal Reserve Bank, unless held in currency in the bank’s
own vault. The bank is free to lend or invest the remaining
$80. If there is an adequate demand for loans from cus
tomers or a supply of suitable securities in the market, the
bank will lend or invest practically all of the $80.
How the Banking System Works
To further clarify the role of reserves in the banking
system, let us imagine that there is only one commercial
bank in the United States, that it is the sole member bank
in the Federal Reserve System, and that all of its liabilities
to customers are in the form of demand deposits. Further
more, let us give this single member bank enough resources
to represent all the commercial banks in the country. Let
us assume that the relevant items in its balance sheet are
as follows (in billions):
Loans and investments........................................ $ 80
Reserves with the Federal Reserve....................
20
Demand deposits..................................................
100
Ratio o f reserves to demand deposits...........20 per cent
Let us again assume that this 20 per cent ratio of reserves
to demand deposits is the legal minimum. Under the cir
cumstances the bank would not be in a position to make
any additional loans or investments, for its funds are
already in use up to the limit permitted by law.
Now let us assume that the Federal Reserve finds that
additional loans are desirable to meet the credit needs of
the country, and let us also assume that it purchases
$10 billion of securities in the market and pays for them
by funds that get credited to the seller’s demand deposit
account in the member bank and are added to the bank’s
66
FUNCTION OF BANK RESERVES
reserve balance at the Federal Reserve. Then the simpli
fied balance sheet of the bank would be (in billions):
Loans and investments........................................ $ 80
Reserves................................................................
30
Demand deposits..................................................
110
Ratio o f reserves to demand deposits........27.3 per cent
The member bank would have a higher ratio of reserves
to deposits (27.3 per cent) than is required by law (20 per
cent). Therefore, it could make additional loans and invest
ments. A little figuring will show that the bank has the
$22 billion of reserves required for its deposits of $110
billion and also has $8 billion of reserves above require
ments, or excess reserves.
Let us next assume that the public is eager to get addi
tional money and wants to borrow as much as the member
bank will lend; let us assume also that the proceeds of the
loans will remain on deposit with the bank. This is not a
far-fetched assumption, because borrowers most likely
want the money in order to pay other depositors in the
bank. While there will be transfers from one deposit ac
count to another, no deposits will be withdrawn from the
bank, and the total of deposits will stay at the higher
level made possible by the increase in reserves.
Another calculation will show that on the basis of the
$8 billion of excess reserves the member bank can add
$40 billion to its loans and investments. The bank’s balance
sheet would then be (in billions):
Loans and investments........................................ $120
Reserves................................................................
30
Demand deposits..................................................
150
Ratio o f reserves to demand deposits...........20 per cent
67
THE FEDERAL RESERVE SYSTEM
This simplified picture indicates that a deposit of $10
billion of reserve money with the member bank gave rise
to a growth of $40 billion in loans and investments and of
$50 billion in demand deposits. The calculation, which
leaves out of account many complications, shows what a
powerful instrument of monetary regulation reserve bank
ing action can be. It can provide the basis for an increase in
the money supply not merely by the amount that it adds to
the bank’s reserves, but by a multiple of the additional
reserves — five times in this example.
Suppose now that there is too much money and that
Federal Reserve action reduces the $20 billion of reserves
the member bank had in the first place by $5 billion, at the
same time lowering deposits by an equal amount. The
balance sheet would then read (in billions):
Loans and investments........................................ $ 80
Reserves................................................................
15
Demand deposits..................................................
95
Ratio o f reserves to demand deposits........15.8 per cent
On the basis of a 20 per cent legal reserve requirement,
the member bank would be deficient in reserves to the
extent of $4 billion. The bank would have to call loans or
sell investments, and thus absorb deposits to the extent of
five times its deficiency in reserves, that is, by $20 billion.
If its depositors repaid $20 billion in loans or repurchased
that amount of investments by drawing on their deposits,
the result would be (in billions):
Loans and investments........................................ $ 60
Reserves................................................................
15
Demand deposits..................................................
75
Ratio o f reserves to demand deposits.......... 20 per cent
68
FUNCTION OF BANK RESERVES
Once more we see the powerful impact of reserve bank
ing action, this time in the direction of contraction. A
reduction of $5 billion in the member bank’s reserves can
bring about a liquidation of $20 billion in loans and
investments and a reduction of $25 billion in demand
deposits, or money.
The all-important fact brought out by this discussion
is that the Federal Reserve, by adding to or extinguishing
the member bank’s reserves, can influence the bank to
increase or decrease its loans and its demand deposits (the
major component of the money supply) by several times
the amount added or extinguished. This is why the dollars
created by Federal Reserve action that become bank
reserves are often called “high-powered” dollars to dis
tinguish them from ordinary deposit dollars.
Other Influences
In the exposition so far we have considered one member
bank, large enough to represent all the banks in the
country, as doing all the banking business. We have as
sumed that the bank lends or invests as much money as
the law permits, and that this action results in the creation
of an equal amount of demand deposits. We have also
assumed a reserve requirement of 20 per cent and that all
the money lent by the bank will be kept on demand de
posit. In practice, however, the public generally withdraws
some of the money in currency or transfers some of the
money to savings or other time deposits.
The changes that occur from time to time in the public’s
demand for currency will be described in a later chapter.
For this chapter, the main point is that the people’s
demand for currency is related to the total money supply
69
THE FEDERAL RESERVE SYSTEM
(currency and demand deposits) held by the public, and
that such demand reflects merely the share of the money
supply that the public desires to hold in the form of cur
rency. Since currency and demand deposits are inter
changeable at the option of the public, the major factor
increasing or decreasing the money supply is the loans and
investments of commercial banks. It should be noted,
however, that currency withdrawals from banks reduce
bank reserves dollar for dollar. For this reason, currency
withdrawals affect the expansion potential of a given
volume of new reserve funds.
The transfer of funds from a demand to a savings or
other time deposit reflects the preference of the depositor
for an asset that earns interest rather than an asset that
earns no return but has immediate usefulness as a means
of payment. A time deposit cannot have checks drawn
against it, and its conversion into cash is subject to certain
limitations.
Commercial banks in this country have both demand and
time deposits, and their loans, investments, and reserves
form a common pool of assets backing the two kinds of
deposits. Whereas member banks must keep reserves of
about 15 per cent, on the average, against demand de
posits, they are required to keep only 4 per cent against
savings and other time deposits. If holders of demand
deposits transfer them to time deposits, there is a release
of reserve funds from the required reserve category — the
difference between 15 per cent and 4 per cent — on the
basis of which the bank can expand its loans and invest
ments and its demand deposits. Conversely, if holders of
time deposits shift them into demand deposits, the bank
finds it necessary to reduce its loans and investments or to
70
FUNCTION OF BANK RESERVES
obtain additional reserve funds in some other way in order
to meet the higher reserve requirements against its de
mand deposits.
Multiplying Power o f Bank Reserves
The process of reserve operation in the imaginary situa
tion in which one member bank does all the banking
business may now be translated into the actual and more
complex situation in which thousands of member banks
make loans and investments and hold deposits.
It has been seen that our hypothetical bank can expand
its loans and investments by as much as $40 billion if
Federal Reserve action adds $10 billion to its reserves. In
practice, of course, there are a great many banks in this
country, and no one bank can do that since borrowers may
wish to take the money out of the lending bank.
In fact, a borrower is likely to use the demand deposit
created by his loan to write checks to pay various people.
His banker cannot assume that the funds thus paid out
will return to his bank in the form of deposits. Conse
quently, he does not lend more than he has in reserve
funds in excess of requirements; if he did, he might not
be able to honor the checks of his other depositors. How,
then, can all banks together lend four times as much as
they obtain in reserves from the Federal Reserve ?
The process by which this happens is simple and under
standable. It is illustrated in the following chart and table,
which show how deposits are built up as reserve funds are
diffused throughout the banking system, and may be
sketched as follows: Suppose that new reserve funds of
$100 are made available to member banks in a manner that
also increases deposits by that amount at one bank. The
71
THE FEDERAL RESERVE SYSTEM
member bank at which $100 is deposited needs to hold $20
in required reserves, in keeping with our earlier assump
tion, and it may lend or invest the remaining $80.
Suppose that all the money is lent. The amount lent is
first credited to the borrower’s deposit account. This money
is then paid out at once by the borrower to someone who
deposits it at another bank. The cash holdings and newly
created deposits of the first bank are thus drawn down and
transferred to a second bank.
The second bank receives $80 in cash reserves and in
new deposits; it holds $16 as required reserve against the
deposit received and can lend the remaining $64. Similarly,
the borrower here may draw down the additional newly
created deposit at once, but the funds will merely be
72
FUNCTION OF BANK RESERVES
shifted to a third bank, which in turn can lend 80 per cent
of $64, thereby adding a further $51.20 to deposits.
This sequence can be traced through many banks until
$500 of demand deposits have grown out of the original
$100 deposit. On the asset side of their books, the banks
hold $100 in reserves (20 per cent of $500) and $400 in
loan or investment paper.
M u l t ip l y in g C a p a c it y of R eserve M o ney
T h r o u g h B a n k T r a n s a c t io n s 1
(In dollars)
Set aside
as
reserves
Transactions
Deposited
in checking
accounts
Bank 1 ......................................
2 ......................................
3 ......................................
4 ......................................
5 ......................................
100.00
80.00
64.00
51.20
40.96
80.00
64.00
51.20
40.96
32.77
20.00
16.00
12.80
10.24
8.19
6 ......................................
7 ......................................
8 ......................................
9 ......................................
1 0 ......................................
32.77
26.22
20.98
16.78
13.42
26.22
20.98
16.78
13.42
10.74
6.55
5.24
4.20
3.36
2.68
Total for 10 banks...........
446.33
357.07
89.26
Additional banks......................
53.67
2 42.93
2 10.74
Grand total, all banks. . .
500.00
400.00
100.00
Lent
1 Assuming an average member bank reserve requirement of 20 per cent
of demand deposits.
2 Adjusted to offset rounding in preceding figures.
Thus, an individual bank does not lend more than it
receives, but the banking system as a whole expands by
a multiple of the new reserve funds made available to it.
The fact that individual member banks are required to
73
THE FEDERAL RESERVE SYSTEM
hold only a fraction of their deposits as reserves and the
fact that payments made with the proceeds of bank loans
are eventually redeposited with banks make it possible for
additional reserve funds, as they are deposited and invested
through the banking system as a whole, to generate deposits
on a multiple scale.
An Apparent Banking Paradox ?
The foregoing discussion of the working of the banking
system explains an apparent paradox that is the source
of much confusion to banking students. On the one hand,
the practical experience of each individual banker is that
his ability to make the loans or acquire the investments
making up his portfolio of earning assets derives from his
receipt of depositors’ money. On the other hand, we have
seen that the bulk of the deposits now existing have
originated through expansion of bank loans or investments
by a multiple of the reserve funds available to commercial
banks as a group. Expressed another way, increases in
their reserve funds are to be thought of as the ultimate
source of increases in bank lending and investing power
and thus of deposits.
The statements are not contradictory. In one case, the
day-to-day aspect of a process is described. In a bank’s
operating experience, the demand deposits originating in
loans and investments move actively from one bank to
another in response to money payments in business and
personal transactions. The deposits seldom stay with the
bank of origin.
The series of transactions is as follows: When a bank
makes a loan, it credits the amount to the borrower’s
deposit account; the depositor writes checks against his
74
FUNCTION OF BANK RESERVES
account in favor of various of his creditors who deposit
them at their banks. Thus the lending bank is likely to
retain or receive back as deposits only a small portion of
the money that it lent, while a large portion of the money
that is lent by other banks is likely to be brought to it by
its customers.
From the point of view of the individual bank, therefore,
the statement that the ability of a single bank to lend or
invest rests largely on the volume of funds brought to it
by depositors is correct. Taking the banking system as a
whole, however, demand deposits originate in bank loans
and investments in accordance with an authorized multiple
of bank reserves. The two inferences about the banking
process are not in conflict; the first one is drawn from the
perspective of one bank among many, while the second
has the perspective of banks as a group.
The commercial banks as a whole can create money only
if additional reserves are made available to them. The
Federal Reserve System is the only instrumentality endowed
by law with discretionary power to create (or extinguish)
the money that serves as bank reserves or as the public’s
pocket cash. Thus, the ultimate capability for expanding
or reducing the economy’s supply of money rests with the
Federal Reserve.
New Federal Reserve money, when it is not wanted by
the public for hand-to-hand circulation, becomes the
reserves of member banks. After it leaves the hands of the
first bank acquiring it, as explained above, the new reserve
money continues to expand into deposit money as it
passes from bank to bank until deposits stand in some
established multiple of the additional reserve funds that
Federal Reserve action has supplied.
75
THE FEDERAL RESERVE SYSTEM
How the process of expansion in deposits and bank loans
and investments has worked out over the years is depicted
by the accompanying chart. The curve “deposits and cur
rency” relates to the public’s holdings of demand deposits,
time deposits, and currency. Time deposits are included
because commercial banks in this country generally engage
in both a time deposit and a demand deposit business and
do not segregate their loans and investments behind the
two types of deposits.
DEPOSITS A N D BANK LENDING
B illio n s of d o lla rs
__________ & _______ L
250
Jj
2 00
150
DEPO SITS
#
A N D CU RREN CY / - A
/► '
if
//
ft
100
B A N K LO A N S
A N D IN V ESTM EN TS
50
-
1._____ I . . , , 1 , . , J _________1 , ,
1915
'2 0
'3 0
, , ,,.1 .. ,
'4 0
.
, ,1 ,
’ SO
'6 0
■i
0
Additional Aspects o f Bank Credit Expansion
At this stage of our discussion, three other important
aspects of the functioning of the banking system must be
noted. The first is that bank credit and monetary expansion
on the basis of newly acquired reserves takes place only
76
FUNCTION OF BANK RESERVES
through a series of banking transactions. Each transaction
takes time on the part of individual bank managers and,
therefore, the deposit-multiplying effect of new bank
reserves is spread over a period. The banking process thus
affords some measure of built-in protection against unduly
rapid expansion of bank credit should a large additional
supply of reserve funds suddenly become available to
commercial banks.
The second point is that for expansion of bank credit to
take place at all there must be a demand for it by credit
worthy borrowers — those whose financial standing is
such as to entail a likelihood that the loan will be repaid
at maturity — and /or an available supply of low-risk
investment securities such as would be appropriate for
banks to purchase. Normally these conditions prevail,
but there are times when demand for bank credit is slack,
eligible loans or securities are in short supply, and the
interest rate on bank investments has fallen with the result
that banks have increased their preference for cash. Such
conditions tend to slow down bank credit expansion. In
general, market conditions for bankable paper and atti
tudes of bankers with respect to the market exert an im
portant influence on whether, with a given addition to the
volume of bank reserves, expansion of bank credit will be
faster or slower.
Thirdly, it must be kept in mind that reserve banking
power to create or extinguish high-powered money is
exercised through a market mechanism. The Federal
Reserve may assume the initiative in creating or extinguish
ing bank reserves, or the member banks may take the
initiative through borrowing or repayment of borrowing
at the Federal Reserve.
77
THE FEDERAL RESERVE SYSTEM
Sometimes the forces of initiative work against one
another. At times this counteraction may work to avoid
an abrupt impact on the flow of credit and money of pres
sures working to expand or contract the volume of bank
reserves. At other times, banks’ desires to borrow may
tend to bring about either larger or smaller changes in
bank reserves than are desirable from the viewpoint of
public policy, especially in periods when banks’ willingness
to borrow is changing rapidly in response to market forces.
The relation between reserve banking initiative and member
bank initiative in changing the volume of Federal Reserve
credit was discussed in Chapter III.
These additional aspects of bank credit expansion are
significant because they indicate that in practice we cannot
expect bank credit and money to expand or contract by
any simple multiple of changes in bank reserves. Expansion
or contraction takes place under given market conditions,
and these have an influence on the public’s preferences
or desires for money and on the banks’ preferences for
loans and investments. Market conditions are modified
in the course of credit expansion or contraction, but the
reactions of the public and of the banks will influence
the extent and nature of the changes in money and credit
that are attained.
Management o f Reserve Balances
In managing its reserve balances, an individual commer
cial bank constantly watches offsetting inflows and out
flows of deposits that result from activities of depositors
and borrowers. It estimates their net impact on its depos
its and its reserve position. Its day-to-day management
78
FUNCTION OF BANK RESERVES
problem is to make sure that, after all transactions, its
reserves are sufficient to comply with legal requirements.
M EM B ER B A N K R ES ER V ES
B illio n s o f d o lla r s
1930
'35
’40
’45
’50
’55
’60
While a member bank must watch its reserves to make
sure that they are large enough, this does not mean that
reserves remain unused. Actually, a member bank uses
its reserves, most of which are held with the Federal Re
serve Bank, in much the same way that a depositor uses
his checking account.
79
THE FEDERAL RESERVE SYSTEM
Under Federal Reserve rules, reserve requirements apply
to reserves maintained on the average over a period (a week
for reserve city banks and two weeks for other member
banks). While maintaining these reserves at or above the
required minimum, a bank may make constant use of them.
Through its reserve account at its Federal Reserve Bank
the bank settles adverse clearing balances with other
banks and also transfers funds to other cities. The bank
must be careful, however, to see that over the reserve
period the average amount of its reserves equals or exceeds
the amount required in relation to its deposits. The occa
sion for borrowing from a Federal Reserve Bank usually
arises when reserves have fallen below the required level
and banks must replenish them.
At the beginning of this chapter it was stated that banks,
as business organizations, endeavor to use all their avail
able funds in profitable ways and keep as reserves only the
minimum required by law. During the greater part of the
life of the Federal Reserve System, member banks have
put practically all their funds to use and have had prac
tically no excess reserves. During the middle and late
1930’s and the early part of World War II, however, this
was not true as is brought out in the chart on page 79.
After the early 1930’s there was a large movement of
gold into the country. This gold greatly increased the
reserves of member banks. At the same time there was
only a limited demand for loans acceptable to banks at
current interest rates and a limited supply of investment
securities that bankers wanted to acquire at interest rates
prevailing in the market. Consequently, the banks had an
excessive volume of unused reserves. During and after
World War II the greater part of these excess reserves were
80
FUNCTION OF BANK RESERVES
absorbed into required reserves as credit expanded, demand
for currency increased, and increases were made in their
reserve requirements, as permitted by law. In recent years
excess reserves have once again constituted a relatively
small proportion of total reserves, although a larger pro
portion than in the 1920’s.
81
CHAPTER V
THE CREDIT MARKET. Commercial banks are part o j the
national credit market, which is made up o j many interrelated
markets. Developments in all parts o j the market interact on other
parts. Neither the banking sector nor the nonbanking sectors
o j the market can be understood by themselves.
HE activities of commercial banks — and also the
monetary policy actions of the Federal Reserve Sys
tem — are among the many influences that condition, and
are also conditioned by, developments in the national
credit market. Through this market the current flow of
money saving and of other available funds in the economy
is mobilized and invested in loans and securities. These
instruments are a representation of, and a means for
transferring, the economy’s real wealth.
The credit market has many segments, which are
differentiated in several ways. Characteristic of the credit
transaction — such as the purpose of borrowing and
degree of risk involved — is one, and geographic coverage
is another. In addition, a variety of financial institutions,
T
83
THE FEDERAL RESERVE SYSTEM
businesses, individuals, and governments participate in the
market. The commercial banking system plays an impor
tant, but in terms of dollar volume by no means the
dominant, role in the market, as the chart shows.
The various parts of the credit market are closely linked.
Because of this, developments originating in or affecting
the commercial banking system, for example, are soon
transmitted to other market institutions and participants.
Similarly, market developments appearing initially in
other sectors are likely to react soon on banks. Thus, the
84
THE CREDIT MARKET
functions and activities of commercial banks, the Federal
Reserve, and other sectors or market participants cannot
be understood in isolation.
Nature o f the Market
A financial market brings together borrowers and lend
ers or investors, and it establishes and communicates Ithe
prices at which they are willing to make transactions.
Some financial markets, such as the stock exchange, are
formally organized and have a specific place of business,
but most credit markets have no formal organization or
designated place of business. Nevertheless, through highly
developed mechanisms of communication, they bring to
gether a large number of transactors willing to bid for
or offer funds at a price. The price of credit is an in
terest rate.
Sectors of the credit market differ in several ways. For
one, they deal in different kinds of instruments. There are
markets for U.S. Government obligations, State and local
government obligations, corporate bonds, stocks, bank
loans, mortgages on real estate, and so on. Also, the instru
ments in which they deal vary in maturity, risk, and liquid
ity; and there are submarkets specializing in securities
delineated by these features.
For example, what is commonly known as the “money
market” specializes in short-term U.S. Government securi
ties and prime short-term commercial or financial paper.
This kind of paper is low in risk and highly liquid, and it
typically offers the lowest interest yields. Money market
instruments are close substitutes for cash and for each
other and are a principal medium for temporary invest
ment by banks, other financial institutions, and business
85
THE FEDERAL RESERVE SYSTEM
corporations. The term “money market” is often con
trasted with the term “capital market,” the latter being
used to refer to the market for longer-term governmental
and private securities.
In practice, however, sharp distinctions between kinds
of credit markets are blurred, since markets are all closely
R A TE S O N B A N K L O A N S T O B U S IN ES S
„............
7 NORTHERN AND
E A S T E R N CITIES
\
NEW
11 S O U T H E R N A N D
W E S T E R N CITIES
YORK
CITY
linked through the activities of borrowers, lenders, and
investors. As these groups seek the most favorable oppor
tunities for borrowing or for investment of available funds,
they find it advantageous to move from one market to
another.
The national credit market, geographically, is made up
86
THE CREDIT MARKET
of a large number of local and regional credit markets. The
rates of interest charged and other conditions in these
markets may vary, but these rates and markets are none
theless closely related.
Local and regional credit markets maintain contact with
one another in a variety of ways: through the correspond
ent relations of local banks with banks in other markets;
through local contacts with large savings and financing
institutions, whose operations may be either regional or
national; through arrangements between local dealers in
investment securities and either the underwriting houses or
members of stock exchanges in the financial centers; and
through the facilities of the Federal Reserve System.
Local markets handle for the most part the demand for
relatively small loans arising from local needs and based
on local conditions. Concerns that are well known — either
within a region or throughout the nation — and whose
borrowings involve large sums obtain most of their credit
in a broader market, either regional or nationwide.
Such business concerns can and do adjust their demand for
loan funds, region by region, in response to changing con
ditions in financial markets.
In such ways local markets are linked into regional
markets and in turn into a broad national market, with
interest rates in various regions kept in fairly close align
ment. If lendable funds are scarce and costly in one center,
the local supply will tend to be augmented by an inflow
from centers where funds are more abundant and cost less,
or the demand for funds will shift to centers where the
supply of funds is larger. As a result, well established
borrowers — small as well as large — with a high credit
rating can obtain loans from banks or other lenders on
87
THE FEDERAL RESERVE SYSTEM
much the same conditions in one city as in another. There
are many regional credit centers, but a large share of
the nation’s credit and money market business is trans
acted in or through New York City.
Market for U.S. Government Securities
The national credit market tends to pivot on the market
for U.S. Government securities, which cuts across money
and capital markets. If both new financing and refunding
are included, the U.S. Treasury is the largest single bor
rower in the credit market.
Treasury securities furnish a default-free outlet for
short- and long-term investments; they are actively traded;
and all of them — especially the short-term issues — are an
efficient medium for making marginal portfolio adjust
ments, such as shifts into or out of cash as needs for work
ing funds by businesses and institutions change. In view of
the character of the instrument, Treasury obligations are
widely held by institutional and other investors, and their
yields have a strong influence on investor decisions in
other markets.
Size. At the end of 1962, Treasury debt outstanding
amounted to approximately $300 billion. Of this total
about $200 billion was in the form of marketable issues,
that is, issues that may be bought or sold in the market
prior to maturity. For the year 1962 as a whole the volume
of trading in marketable issues — including transactions
among dealers — amounted to well over $400 billion.
Most of this amount, about 80 per cent, occurred in issues
that were due within one year. As the time to maturity
lengthened, the volume of trading became smaller. And
the volume in the long end of the market, where issues
88
THE CREDIT MARKET
maturing in, say, more than ten years are traded, accounted
for only about 2 per cent of the total.
The short end of the U.S. Government securities market
is very active for a number of reasons. Foremost is the fact
that commercial banks — as well as other financial institu-
N o t e .— Based on data from Treasury Survey of Ownership, and also on
Federal Reserve estimates.
tions, such as savings banks, insurance companies, and
savings and loan associations — invest a large part of
their operating or secondary reserves in short-term Gov
ernment securities. Also, many businesses, State and local
89
THE FEDERAL RESERVE SYSTEM
governments, and foreign governments invest in such
securities any excess cash or funds being accumulated for
large payments or kept as contingency reserves. In general,
the short-term end of the Government securities market
provides an interest-earning lodgement for liquid funds
until they are needed for operating purposes. The daily
sales and purchases by thousands of institutional investors
and businesses make for a steady stream of trading in
these securities.
Commercial banks also hold substantial amounts of
longer-term U.S. Government securities, especially securi
ties maturing in from one to ten years. Other financial
institutions too invest in such obligations and also in very
long-term issues.
Activity. Practically all of the trading in marketable
Treasury securities is conducted over the counter instead
of on an organized security exchange. About twenty
primary dealers in Treasury obligations handle most of it,
largely on orders executed by telephone or telegraph. Most
of these dealers, which include six large money market
banks, have their main trading offices in New York City.
Government security dealers carry a sizable inventory
of securities, and they generally buy for or sell out of their
own accounts. Orders come into them directly from large
customers or are channeled to them through commercial
banks or stock brokerage firms. The dealers operate in a
very competitive market and stand ready to quote bid and
asked prices for very sizable blocks of securities. Typical
transactions in Treasury bills are carried out in blocks of
$1 million or more, whereas trading in long-term bonds
tends to be in somewhat smaller units. Odd-lot transactions
involving a few thousand dollars of securities are generally
90
THE CREDIT MARKET
handled by commercial banks as a customer service. These
banks may carry small trading positions for this purpose,
or they may go through the primary dealers to execute
the transaction.
Services. The Government securities market performs a
very useful and important service for investors. Under
normal circumstances, even the largest institutions can
make portfolio adjustments at current market prices and
can secure rapid execution of their orders. This is particu
larly true of transactions in shorter-term Treasury securi
ties. Transactions in longer-term securities too can usually
be consummated with a minimum of delay and price
adjustment. However, discontinuities — stemming from
the inability of buyers and sellers to agree on terms within a
reasonably short period of time — are more prevalent in
the market for long-term issues, especially if very large
amounts are involved.
Because of its size, its continuing activity, and the defaultfree nature of obligations traded, the market for U.S.
Government securities is highly sensitive to changes in
general credit conditions. For all these reasons, it provides
a touchstone by which to assess prices and yields in other
parts of the credit market. Moreover, since the U.S.
Government securities market is the focal point for supply
and demand pressures in the money and capital markets,
interest rate movements in this market are a help to the
Federal Reserve in its task of evaluating general credit
developments.
The market does more than indicate developments,
however. It conveys the impact of the Treasury’s financing
programs and of Federal Reserve monetary policy to the
credit market generally. The first impact of monetary
91
THE FEDERAL RESERVE SYSTEM
policy is generally on the Government securities market
because these are the securities that the Federal Reserve
purchases and sells in the open market, as the next chapter
describes, and because it is for the most part in these
securities that commercial banks make portfolio adjust
ments as their reserve positions change.
All these functions of the market are most effectively
performed if the market is free to register the changing
choices and expectations of its many business, institu
tional, and individual participants, whether they be buyers
or sellers. With active and continuing participation by
diverse economic groups, the market can reflect, in the
financial area, the economy’s choices in the use of resources
over time; it can provide a basis for rational calculation
of credit conditions by the business and financial com
munity; and it can readily accommodate Treasury and
Federal Reserve financial and monetary activities.
Market Role o f Economic Groups
In the over-all credit market no one group plays a sin
gle market role — that is, as lender only or as borrower
only — although an individual group may tend to be more
one than another. For example, groups that are primarily
savers, such as individuals or consumers, are also ultimate
borrowers. Similarly, groups that are primarily borrowers,
such as businesses, also advance funds to markets. The
net position of each group in relation to the credit market
reflects both supplier and user roles. While the net position
of any one group varies with the course and pattern of
economic activity, some groups have consistent and
typical roles.
Consumers as a group generally advance more funds to
92
THE CREDIT MARKET
the market than they borrow; most of their funds are
advanced through financial institutions as intermediaries.
Businesses, on the other hand, generally raise more funds
than they advance. Thus, funds flow in large part from
consumers to financial institutions to businesses.
Like businesses, State and local governments in the
aggregate generally borrow more funds than they advance.
The Federal Government’s role fluctuates with its budget
ary position; it is a net source of funds when tax and other
receipts exceed cash outlays and a net borrower when
outlays are running ahead of receipts. Foreign transactors,
too, lend and borrow in our credit market; the impor
93
THE FEDERAL RESERVE SYSTEM
tance of these borrowers increased in the latter part of the
1950’s and during the early 1960’s.
Supply o f Credit
Ultimately, the main source of funds to the credit
market is the saving of consumers and businesses. Con
sumers save more than any other sector of the economy,
as shown in the chart, and their saving makes up the bulk
of funds coming into the market.
Consumers. During the past decade consumers have on
the average provided about three-fifths of the economy’s
gross saving. Gross saving of consumers is the amount
of current income not spent for current consumption on
GROSS N A T I O N A L S A Y IN G
Billions of d o ll a r s
150
94
BY SECTOR!
THE CREDIT MARKET
such items as food and clothing. Part of such saving goes
directly for purchases of consumer capital goods — auto
mobiles, other durable goods, and homes; part flows into
financial assets; and part is used to repay debts incurred
earlier. Of course consumers — like other groups in the
economy — may finance their purchases of capital goods
or their acquisitions of financial assets by incurring new
debt or by drawing upon existing holdings of assets. The
amount that consumers save and the portion going into
the credit market are affected by many factors, such
as incomes, interest rates, capital values, and forward
expectations.
When consumers acquire financial assets or repay debt,
they make funds available to the credit market. When they
purchase bonds, stocks, and other credit instruments, they
supply funds directly. When they put their saving in savings
deposits, saving and loan shares, premiums on insurance
policies, and contributions toward pensions, their funds
still flow into the market — not directly, but through
savings institutions as intermediaries. Consumers may also
use some of their saving to increase their checking account
balances at commercial banks.
Since the end of World War II there has been a com
paratively rapid expansion of financial institutions engaging
in an intermediary function. Consumer saving that flows
into these institutions reaches ultimate borrowers when the
financial institutions advance funds by buying market
instruments such as corporate or government bonds, real
estate mortgages, and short- or intermediate-term paper
of varying negotiability.
During the first three years of the 1960’s the amount
of consumer saving reaching the credit market indirectly
95
THE FEDERAL RESERVE SYSTEM
through financial institutions averaged $31 billion a year.
In contrast, the amount flowing directly from consumers
into credit market instruments averaged only about $2
billion, as shown in the following table. In earlier years,
when interest rates available from financial institutions
were lower relative to market rates, a somewhat higher
proportion of consumer funds flowed directly into credit
market instruments.
Businesses. Businesses in the aggregate are primarily
borrowers rather than lenders in the credit market, but
at the same time they regularly generate a large flow of
internal saving in the form of retained earnings and depre
ciation allowances. They use the largest part of this internal
saving to finance replacement of capital goods or to expand
working and fixed capital. Nevertheless, they do make
some funds available to the credit market.
Business investment in financial assets is in large part
temporary, however. When businesses plan to expand,
they often accumulate internally generated funds for a
period, and they hold these funds in some liquid asset
pending their expenditure for plant and equipment. Or
they may have liabilities accruing over time — as, for
example, taxes — and accumulate holdings of liquid assets
in anticipation of a large payment on some particular date.
Sometimes — if market conditions are favorable — they
borrow funds ahead of projected capital expansion and
invest the proceeds in highly marketable short-term paper.
Ordinarily, businesses keep the amounts in their demand
deposit accounts close to the minimum needed for working
purposes, but when market rates of interest on prime
short-term paper are low, they may keep more of their
liquid funds in these accounts.
96
THE CREDIT MARKET
Supply of and D emand for F unds , 1960-62
(Annual averages, in billions of dollars)
Instrument and sector
Amount
S u pply qu an tities
Flows into financial assets, total1.......................................
100.9
2................................................
5 1 .8
C red it m a rk e t instrum en ts
Consumers................................................................................
Nonfinancial businesses..........................................................
Financial institutions..............................................................
Governments............................................................................
Rest-of-world............................................................................
2.3
.2
42.4
5.7
1.2
3......................
3 5 .8
F ixed-value claim s on fin an cial in stitu tion s
Consumers................................................................................
Others........................................................................................
31.3
4.5
Other assets 4.......................................................................
13.2
D em an d qu an tities
Incurrence of debt and other liabilities, total1....................
96.7
2................................................
51.0
Consumers.......................................................................
Nonfinancial business......................................................
Financial institutions .......................................................
Governments............................................................................
Rest-of-world ...................................................................
18.0
18.0
4.1
8.5
2.4
Fixed-value obligations of financial institutions 3...............
Other liabilities 4..................................................................
35.6
10.1
C red it m a rk e t instrum en ts
1 Net flows. For example, purchases of credit market instruments are
net of sales, and increases in debt represent extensions net of repayments.
2 Consists of Federal, State, and local government securities, corporate
bonds and stocks, mortgages, consumer credit, and bank and other loans.
3 Consists of currency and demand deposits, savings deposits and shares,
and saving through private life insurance and pension funds. Excludes
funds raised in credit markets by financial institutions.
4 Consists of security credit, trade credit, proprietors’ net investment in
noncorporate business, saving through government life insurance and
pension funds, and miscellaneous items.
N o t e .— Federal Reserve flow-of-funds data. Differences between
supply and demand quantities (including paired subtotals) reflect statistical
discrepancies. Details may not add to totals because of rounding.
97
THE FEDERAL RESERVE SYSTEM
Businesses also supply credit directly to their customers,
either individuals or other businesses. Such credit may
represent a use of funds generated by the activity of the
particular business, or it may represent funds borrowed
from such sources as banks, other businesses, or even the
capital market.
Governments. Like businesses, governmental units are
usually net borrowers as a group, but they do supply funds
to markets, often for special purposes. A large part of the
funds advanced by governments, however, particularly
those out of retirement funds, represent the reinvestment
of a net inflow of saving from consumers. Such funds are
usually invested in long-term obligations.
Special governmental programs affect the volume of
funds in specific markets. This is illustrated by home
mortgage programs of the Federal Government. The
Government provides funds when a Federal agency pur
chases mortgages from lenders in the secondary market.
Such operations enable lenders to make additional mort
gage credit available.
Repayment of debt by governments supplies funds to
credit markets. When governments repay obligations held
by market institutions, funds become available to those
institutions for relending. Funds repaid to individuals and
nonfinancial business may also enter the credit market.
If the individuals use such funds to finance expendi
tures that would otherwise have been financed by borrow
ing, the repayments affect credit markets through a reduc
tion in individual demands for credit.
Savings institutions. Savings institutions advance funds
to credit markets mainly by relending or investing the
current saving of others. The availability of new saving
98
THE CREDIT MARKET
to particular types of financial institutions reflects on the
one hand the aggregate flow of income, the level of interest
rates, and other factors that affect the amount of saving in
financial form in the economy and on the other hand the
preferences of individuals, businesses, and governments for
different types of financial assets. Some funds flow into
financial institutions under contractual arrangements such
as insurance contracts and retirement funds, and the flow
of such funds is little affected by economic fluctuations
or variations in interest rates.
Savings institutions also make funds available to credit
markets from their retained earnings, from capital stock
issues, and from borrowings, but these are all relatively
small sources of funds for them.
Commercial banks. The amount that commercial banks
may lend depends on the availability to them of reserve
funds. The amount of reserves in turn is influenced by
the credit and monetary policy of the Federal Reserve
System. But the amount of commercial bank lending is
also influenced by the extent to which the public chooses to
place its savings funds in the banks’ time and savings
accounts. Banks are required to hold smaller reserves
against these accounts than against their demand deposits.
Hence for any given total of reserves, the larger the pro
portion of a bank’s time deposits, the more credit the bank
can extend. In providing reserves to member banks, the
Federal Reserve must take into account the growth rates
of the two types of deposits.
Credit Supplies from Financial Intermediaries
In the aggregate, financial institutions advance directly
to the credit market more funds than any other sector in
99
THE FEDERAL RESERVE SYSTEM
the economy. These funds are advanced mostly by banks
and other institutions that obtain deposits or deposit-type
claims from individuals and others and invest the funds in
market instruments. These investments take the form of
bonds, real estate mortgages, stocks, and other loans.
The different types of intermediary institutions, how
ever, participate in differing degrees in the short-term and
long-term sectors of the market. To an important extent,
these institutions are influenced in the kinds of loans and
investments they make by the nature and source of their
funds — that is to say, by the character of their liabilities.
Legal restrictions and administrative regulations may also
affect the kind of lending and investing activity.
Commercial banks have the shortest-term liabilities of
all financial institutions. At the end of 1962, demand de
posits made up about three-fifths of their liabilities to
depositors, and time and savings deposits two-fifths. Bank
capital amounted to less than 10 per cent on average of
their total resources. Because demand deposits show wide
seasonal or other temporary variations, banks must be
prepared to meet large drains on their deposits and conse
quently on their reserves.
For this reason banks in general tend to lend on shortor intermediate-term maturities, although they do make
some long-term loans. At the longer end of their lending
are real estate mortgage loans. Instalment loans to busi
nesses may also be of fairly long maturity. But most
lending — including loans to businesses, consumers,
brokers and dealers, and nonbank financial institutions —
is under comparatively short-term arrangements.
The security portfolio of a commercial bank is also
weighted in the direction of shorter- and medium-term
100
THE CREDIT MARKET
instruments. These are for the most part issues of Federal
or other governmental units. Commercial banks have also
stressed investments in longer-term securities in periods
when their time and savings deposits have grown rapidly
in importance.
Liabilities of mutual savings banks and of savings and
loan associations are savings deposits and savings shares,
held mainly by individuals. The rates of withdrawal from
such accounts are much lower than those from checking
accounts and somewhat lower than from savings and time
deposit accounts at commercial banks. Consequently these
institutions hold longer-term assets to a greater extent than
commercial banks. They invest principally in mortgages
and hold any liquid funds mainly in U.S. Government
obligations. Mutual savings banks also invest moderate
amounts in other marketable securities.
The obligations of life insurance companies to their
policy holders and of pension plans to their participants
are largely long-term and relatively predictable in char
acter. These institutions, accordingly, invest most of the
funds they receive in long-term capital market instruments.
All of these intermediary financial institutions add
breadth and flexibility to the credit market. As a result of
their development, individuals can hold liquid assets such
as savings and loan shares or can safeguard the future
through life insurance policies and pension plans, and at
the same time ultimate borrowers can have access to a
wide range of sources for short- and long-term credit.
Demand in the Credit Market
Variations in the amount and composition of credit
demand have an influence on the supply of funds in the
101
THE FEDERAL RESERVE SYSTEM
market because businesses, individuals, and financial insti
tutions have the flexibility, within limits, to alter both the
aggregate amount and the kinds of credit they make avail
able. As lenders, they respond to changes in the level and
structure of interest rates, which are influenced in part by
emerging credit demands from the various sectors of the
economy.
On balance, consumers and businesses borrow the larg
est amounts from the market. In the first three years of the
1960’s, each of these two groups raised an average of about
$18 billion a year through the medium of credit market
instruments. Governments — Federal and State and local
combined — borrowed an average of $9 billion a year, and
financial institutions $4 billion.
Consumers obtain funds chiefly through long-term home
mortgages and short- and intermediate-term consumer
credit instruments. They use short- and intermediate-term
loans to finance outlays not only for such durable goods
as autos and household equipment, but also for household
repairs, education, and travel and for meeting personal
emergencies of various kinds. They may obtain such credit
from banks, sales and other finance companies, and
credit unions, or from retail stores.
Mortgage debt of consumers originates primarily in
connection with their purchases of homes. Like all forms
of debt, however, it may also finance other expenditures.
Or it may enable the borrower to retain financial assets
that he might otherwise have had to dispose of, or even
to add to such assets.
Nonfinancial businesses raise funds in the capital mar
ket — mainly to help finance expansion of plant and
equipment — by issuing bonds, preferred and common
102
THE CREDIT MARKET
stocks, and mortgages. Those that need funds to carry
inventories or to meet other short-term requirements rely
heavily on bank loans with short- and intermediate-term
maturities. Borrowing for these purposes is often under a
line of credit. Such an arrangement enables a regular
business borrower to obtain funds up to a certain amount
for short periods of time without further negotiation. Some
businesses also raise short-term funds through sales in the
open market of their own commercial paper or of bankers’
acceptances, which bear the endorsement of a bank. Busi
nesses sometimes borrow at banks for longer-term capital
expenditure programs as well as for short-term needs.
Governments raise funds mainly by issuing securities.
The specific kinds of marketable securities issued by the
U.S. Government include Treasury bills, which are sold
on a discount basis and have maturities up to a year;
certificates, usually having maturities of one year; notes,
with maturities of one to five years; and bonds, with
maturities of more than five years. The U.S. Government
also issues nonmarketable securities, of which the principal
types are savings bonds sold to the public and special
issues to Government trust funds.
State and local governments issue mainly long-term
bonds, but they also borrow on short-term securities or
loans and tax-anticipation notes. State and local govern
ment obligations are distinguished by the fact that interest
received from them is exempt from Federal income taxes.
There are a number of specialized financial institutions
that obtain almost all of their funds from the credit
market. These include sales and consumer finance com
panies, mortgage companies, and security dealers, which
borrow heavily from banks. Such institutions, in turn,
103
THE FEDERAL RESERVE SYSTEM
make credit available to their customers, so that on balance
their role as lender tends to offset their role as borrower
insofar as the net impact on the credit market is con
cerned. But because they are active on both sides of the
credit market, they are distinguished from intermediary
financial institutions such as banks and savings and loan
associations, which obtain only a relatively small amount
of their lendable funds in the credit market.
Competitive Relationships in the Market
Demand and supply pressures in the credit market tend
to arise from the activities of particular sectors of the
economy — consumers, businesses, and governments —
and may first be focused on a part of the credit market.
Enlarged borrowing by businesses or consumers tends to
be reflected in developments in the particular markets most
closely related to their changing financial needs, such as
markets for long-term securities or for short- and inter
mediate-term credit, including bank loans.
For example, greater demand by businesses for credit
may first be reflected in a rise in interest rates on corporate
bonds. Or if there is an easing of market conditions because
of reduced demand or increased saving by consumers, this
may be reflected in lower rates or more liberal terms for
instalment credit and mortgages. Because of the inter
relationship of markets, however, such developments are
soon felt to some degree throughout the whole credit
market structure.
All borrowers compete to some degree for available
funds, but competition is most apparent for similar kinds
of credit. For example, U.S. Government demands for
both short- and long-term funds compete directly with
104
THE CREDIT MARKET
demands from private business for credit with similar
maturities.
Competition also arises from the fact that a borrower
can raise funds for a particular purpose in a variety of
ways. For example, within limits a corporation has the
option of raising funds through a bank loan or a bond
issue. If it obtains the funds from a bank loan, the bank
has less funds for financing short- and intermediate-term
consumer borrowing. Similarly, if it sells a bond issue, this
competes with the financing needs of governments and
with the needs of consumers for mortgage funds.
More broadly, any one group of borrowers competes
to some degree with all other groups of borrowers, regard
less of whether such groups actually are, or have the
option of, engaging in similar types of financing. This
stems from the fact that the composition of funds flowing
into credit markets is noticeably responsive to the changing
composition of demand.
Funds supplied to markets shift among alternative uses
in response to differential movements in interest rates or
to changes in other conditions, such as the economic out
look, which in turn may affect interest rate movements.
Nevertheless, flexibility of supply is neither immediate nor
complete, in part because supplies respond to changing
conditions only after a lag and in part because of legal,
institutional, and other restrictions.
Markets are also linked through the ability of lenders to
obtain funds in one market and make them available in
another. This can be illustrated by the behavior of banks.
As demand for credit expands, commercial banks may
sell securities out of their investment portfolio to obtain
funds to lend to, say, nonfinancial businesses. This in
105
THE FEDERAL RESERVE SYSTEM
creased supply of securities competes with other securities
coming into the market and tends to drive up interest rates
in the market.
Interest rates in the securities market thus are affected
by the demand for bank loans and, in turn, they have an
effect on the terms and conditions on which such loans are
made. As the effect of an increase in demand for bank loans
spreads through credit markets in this way, it influences
the terms on which the Government can obtain new funds
in the securities market.
With sectors of the credit market closely related and
with enlargement in the size and scope of the market,
partly because of the growth of financial intermediaries,
sources of credit available to borrowers have become ex
tensive, competition on the side of supply has become
more intense, and the potentiality for accelerated credit
expansion has increased. The emerging patterns of sup
plies and demands in credit markets provide important
information that helps the Federal Reserve in its efforts
to adapt credit and monetary policies to the current
situation.
Because market sectors are related in the ways described,
the effect of reserve banking policy on bank reserve posi
tions, and hence on the possibilities for expansion in
commercial bank credit and in money, is transmitted
throughout the national credit market. Monetary policy,
therefore, has an influence on borrowing and lending
throughout the entire economy.
106
CHAPTER VI
INTEREST RATES. Interest rates are the prices paid fo r
borrowed money. They are established in credit markets as supplies
o f and demands for loanable funds seek balance. Movements o f
interest rates are infuenced by the nation’s saving and investment,
by market expectations, and by th e fo w o f bank credit and money.
NTEREST rates are the prices paid for use of credit.
The instruments of monetary policy have an influence
on the economy in part through their impact on these
prices. But in a market economy many factors go into the
formulation of interest rates. They are established in the
credit market by the interplay of the many forces of de
mand and supply, including the impact on credit supply
associated with the use of monetary policy instruments.
The pricing function of interest rates is to bring the supply
of and demand for funds into balance. In this process
interest rates influence the volume and composition of
available loan funds and their allocation among com
peting economic activities.
Variations in interest rates exert incentive and disin-
I
107
THE FEDERAL RESERVE SYSTEM
centive effects on individual seekers and suppliers of
funds. These effects derive directly from the pricing role
of interest rates and indirectly from their role as capitaliza
tion rates by means of which future streams of income may
be translated into present-day capital values.
This chapter describes briefly the relationship of contract
(coupon) rates to market interest rates, considers fluctua
tions in the interest yields on different types of loans and
investments, discusses the underlying economic processes
that affect interest rate formation, and describes how
actions of the banking system influence movements in
interest rates.
Contract Interest Rates and Market Yields
Most obligations traded in the market bear a specified
contractual rate of interest to maturity. This rate is stated
ordinarily in interest coupons attached to a bond and
hence is known as the coupon rate. The coupon rate is to
be distinguished, however, from the market rate of interest
or yield to maturity, which is the rate as of today that the
market is prepared to pay or accept in exchanging present
for future purchasing power.
The extent to which the market rate departs from the
coupon rate depends on the changing demand for an
obligation in relation to its supply. As demand rises rel
ative to supply, the market price of an obligation rises
and the market yield declines because market participants
pay a higher price to obtain the same fixed interest return.
The opposite occurs when demand falls relative to supply;
market interest rates then rise as a lower price is estab
lished in the market for the same interest income.
The amount of variation in market price that is asso
108
INTEREST RATES
ciated with a divergence between market yield and coupon
rate is affected by the length of time an obligation has to
run until it matures. As an example, assume that an obli
gation with a coupon rate of 2l/ 2 per cent per annum and
a current market rate of 3l/ 2 per cent per annum will
mature in only six months. A market price of about 99y2
for the obligation would make the coupon rate, the market
rate, and the maturity consistent with each other.
If, as a contrast, we assume a ten-year maturity on an
obligation of similar coupon rate and similar market rate,
then the market price would bz9\y2. The current market
price for the longer-term security has to be lower than that
109
THE FEDERAL RESERVE SYSTEM
of the short-term obligation in order to provide the
investor with an equal percentage return, that is, for the
two maturities to be equally attractive from the stand
point of yield. That is to say, for the long-term issue to
yield an average of 31/2 per cent over the ten-year period,
the current market price must be low enough that the gain
in capital value over the period, together with annual
payments, will make the market yield 1 per cent higher
than the coupon rate.
Some short-term negotiable securities, notably Treasury
bills and bankers’ acceptances, do not have a contractual
rate of interest specified for the investor. The yield on a
new issue is determined entirely by the discount from par
at which the obligation is sold. Its subsequent market price
depends, as with coupon bonds, on the yield at which
market participants engage in transactions and on the
effect on this yield of changes in period to maturity.
When we speak of fluctuations in market rates of inter
est, we usually refer to changes in the yields at which
existing obligations are traded in the market. We assume
that new borrowers in the market will have to pay at
least this rate. In general, coupon rates and actual market
yields on new securities will be a little higher than this as
a special inducement to investors to make purchases.
Differences Among Interest Rates
Reflecting the many purposes and situations that give
rise to borrowing and lending, there is a wide variety of
loans and investments in credit markets, each bearing an
interest rate. Some interest rates are relatively high, and
some relatively low. The particular level for each security
reflects the distinctive characteristics of the obligation, the
110
INTEREST RATES
particular class of borrowers using it, and the preferences
that lenders and investors may show for it.
Observable differences in market interest rates are
affected by a wide variety of factors. Among the most
important are the maturity structure of market instru
ments, that is, whether short- or long-term; the market’s
evaluation of differences in factors related to risk, including
the business experience of borrowers and the kinds of
assets or guarantees that back up their obligations; whether
the loan is large, readily negotiable in form, and often
traded in the market, or whether it is relatively small, less
negotiable, and seldom traded; tax exemption features;
and the varying supplies that lenders make available in
given circumstances for different uses.
Ill
THE FEDERAL RESERVE SYSTEM
During the postwar period interest rates on securities
having a short maturity have generally been below long
term rates, but this was not always true in earlier periods.
There have been prolonged periods when short-term rates
were above long-term rates. In addition, the relationship
between the two has varied with business cycles.
In general, tendencies for short-term securities to bear
lower interest rates than other obligations are related in
part to the fact that market prospects are always uncertain
and that many types of investors prefer to commit their
funds in prime, readily negotiable paper of shorter term
rather than in longer-term, less readily marketable securi
ties. The extent to which market rates reflect these features
of term, risk, and negotiability changes over time. Shifting
needs of borrowers and evaluations of investors naturally
exert an important influence in altering the maturity
structure of rates.
How Interest Rates Move Over Time
Both borrowers and lenders have considerable flexibility
in substituting one type of instrument for another. As a
result, interest rates on various kinds of market instru
ments tend to fluctuate together. Movements in these
rates differ, however, in both degree and timing. This has
been true in both recent and earlier times.
Market experience shows that whether the interest rate
of a particular instrument responds continuously to a
changing market situation — that is, rises or falls by small
increments from day to day, or even from hour to hour —
depends on the character of the instrument as well as on
the nature of market demand and supply. Interest rates
on obligations designed for and traded in central credit
112
INTEREST RATES
and security markets respond quite sensitively to changes
in either demand or supply.
Some interest rates, however, respond only slowly to
shifting market conditions. Examples include rates on
smaller business loans, on consumer loans, and on mort
gage loans.
For still another group, rates are adjusted administra
tively in steps as conditions warrant. Examples include the
rate charged by commercial banks to prime customers,
the rate charged member banks by Federal Reserve Banks,
and rates paid bank customers on their savings and time
deposits. These rates are influenced by institutional,
113
THE FEDERAL RESERVE SYSTEM
administrative, or legal factors in addition to the interplay
of market supply and demand forces.
Changes in credit conditions accompanying changes in
business activity are felt in both short- and long-term
markets as a rule. Rates in these markets generally rise
and fall together, but fluctuations are normally greater in
short-term rates than in long-term rates. There are a
number of reasons for this.
For one, movements in short-term interest rates reflect
to a considerable extent the shifting ease or tightness of
bank reserve positions. As described earlier, banks often
make their initial asset adjustments to changing reserve
availability by buying or selling short-term securities of
prime quality.
In addition, fluctuations in short-term rates reflect the
highly variable expectations of investors about their cash
positions and needs for liquidity and about the near-term
economic and credit situation. These movements in rates
are influenced especially by the shifting attitudes toward
liquidity of large investors, such as business corporations
and financial institutions. These investors, in managing
their changing requirements for funds, tend to look upon
short-term paper as an interest-earning store of value that
is a close substitute for non-interest-earning cash. Hence,
they sell or buy short-term paper when their cash funds
temporarily fall below or exceed levels desired for trans
actions needs.
The less extreme fluctuations in long-term interest rates,
as compared with short-term rates, reflect in part the
tendency for owners of long-term securities to regard such
issues as investments that they expect to retain for extended
periods. Therefore, any decisions they make to buy, sell,
114
INTEREST RATES
or hold such securities are based for the most part on
longer-run economic prospects. Under these circum
stances, near-term and temporary factors influence the
market demand for and supply of long-term securities
much less than they do shorter-term obligations.
YIELDS A N D PRICES O N U .S . G O V ER N M EN T SECURITIES
Per cent per annum
6
A'Y
9-12 M O N TH ISSU ES
Market yields on longer-term securities reflect evalua
tions of market conditions that may prevail in the more
distant future as well as current and near-term market
conditions. Estimates of yields for the near-term will
necessarily be more variable than for more distant years,
115
THE FEDERAL RESERVE SYSTEM
in part because possible instabilities in the more distant
future cannot be projected with any confidence, and in
part because cyclical movements in credit conditions tend
to even out over a span of years. The greater stability of
yield estimates for the more distant future will counteract
the greater variability of yield projections for the near
future. Accordingly, long-term interest yields, which are
in some sense weighted averages of yields expected over
both the short- and longer-run future, will usually show
smaller upswings and downswings than will short-term
rates.
While short-term interest rates fluctuate more than long
term rates, prices of long-term securities fluctuate more
than prices of short-term securities for reasons indicated
earlier in this chapter. This is illustrated in the chart on
page 115, which shows yields and prices of short- and long
term Government securities in recent years.
Factors in Interest Rate Changes
Variations in the supply of and demand for loanable
funds of enough strength to change the level and maturity
structure of market interest rates are usually the joint
product of a number of underlying economic forces. Inso
far as the maturity structure of interest rates is concerned,
it is influenced by the comparative liquidity of credit mar
ket instruments; by the degree to which liabilities and
functions of different financial institutions influence their
preferences for short- and long-term securities; by expecta
tions of active market participants about future rates; and
by the relative supply of securities outstanding in different
maturity categories.
All of these forces, which have been individually dis
116
INTEREST RATES
cussed in this and earlier chapters, are continuously work
ing on the maturity composition of market interest rates.
Sometimes they tend to reinforce each other, but at other
times they may be offsetting.
For instance, an increase in the outstanding amount of
short-term U.S. Government securities available to the
nonbank public and a decrease in the outstanding amount
of long-term securities would tend — if no other forces
were at work — to raise short-term and lower long-term
interest rates. This tendency might be reinforced by market
expectations. On the other hand, offsetting changes in the
market’s demand for securities may well occur over time
as a result of changing institutional preferences or the
persistence of countervailing expectations. In a well
organized and flexible credit market, dynamic adjustments
are constantly under way as temporary market factors
give way to more lasting influences.
In fact, because of competitive relations in the credit
market, the various market interest rates generally respond
together to changes in fundamental economic forces,
though some rates move more readily, more rapidly, and
more extensively than others. Basic influences on the central
tendency shown by all rates — that is, on the average level
of interest rates — include changes in the nation’s saving
and investment propensities, changes in market expecta
tions as to the future course of economic activity and of
prices, and changes in the flow of bank credit and money.
Saving-investment process. From a saver’s point of view
the rate of interest can be viewed as a price that trans
lates present saving into future buying power. For example,
at a 5 per cent annual interest rate, $100 saved from present
income will exchange for $105 after a year. Meanwhile,
117
THE FEDERAL RESERVE SYSTEM
since the saver has not spent his $100 — that is, has
refrained from current consumption to this extent — his
saving permits resources to be used to an equivalent dollar
amount for the nation’s investment in plant and equip
ment, durable goods, and housing (or in net foreign
investment).
A nation’s saving represents the amount by which its
members have refrained from using income to buy goods
and services to be consumed currently. The investment of
this saving, which represents expenditures for tangible
wealth (plus or minus the net change in claims on foreign
ers), increases the economy’s capacity to produce goods
and services in the future. This increase, when realized,
takes the form of added output of goods and services from
which borrowers are able to pay the interest earned by the
nation’s saving.
Interest is, on the one hand, an earning on saving and,
on the other, a cost of investment in buildings, equipment,
or other capital goods. Movements of interest rates, there
fore, can be said to reflect the balancing of saving and
investment tendencies at given levels of output and prices.
But the demand for investment in relation to the economy’s
willingness to save also affects a nation’s real output as
well as the market prices of the goods and services that
have been produced. The extent of influence depends on
the economic and financial organization of a country, on
the phase of its economic cycle, and on specific economic
conditions at the time.
In recession periods the plant facilities of a country
turn out a volume of goods and services below their
capacity. In these circumstances an increase in investment
demand relative to the supply of saving is likely to lead
118
INTEREST RATES
to the financing of a larger volume of real investment, and
thus to increased output and rising real income. The rise
in real income from the expanded investment demand will
generally be accompanied by an increase in saving. This
will limit any tendency for interest rates to rise, and saving
and investment may be brought into balance at little net
advance in either interest rates or in the level of prices for
goods and services.
In times of economic boom, however, when plant
capacity is fully or almost fully utilized, investment demand
in excess of available saving works progressively to in
tensify upward pressures on interest rates and price levels.
Under these conditions the extent to which saving may
be increased out of a rise in output and real income is
necessarily limited.
Role o f expectations. Shifts in expectations of businesses
and consumers as to the future course of prices, produc
tion, and income affect saving, investment, and interest
rates. Two kinds of effects can be distinguished. First,
there are the very short-run effects, felt mainly in short
term markets and not closely related to basic tendencies
in saving and investment. Second, there are the longer-term
effects on saving and investment, which have a more per
vasive and sustained impact on interest rates.
How shifts in business expectations may affect interest
rates in the short run is illustrated by what typically happens
in credit markets in the early stages of a cyclical recovery.
Under these conditions interest rates — particularly short
term rates — usually rise faster than basic demand-supply
developments warrant. This rise is influenced by pros
pects of rapid expansion in economic activity, high
and rising demands for credit, and a possible shift in
119
THE FEDERAL RESERVE SYSTEM
Federal Reserve System operations from being appreciably
stimulative to being less stimulative and eventually
restraining.
Conversely, market expectations that the near-term
economic outlook is unfavorable may precipitate a sharp
decline in short-term rates. At such times prospects will
loom large for a significant reduction in borrowing
demands and for an increase in the supply of funds as a
result of more active bank credit expansion under the
stimulus of monetary policy. Interest rate movements of
this short-term type may slow down markedly, or even be
reversed, if it becomes evident that the market’s expecta
tions are not to be realized.
Longer-run effects of expectations may include disloca
tions in the saving-investment process and may thereby
have more enduring effects on conditions in credit markets.
For example, upward pressures on interest rates and com
modity prices become and remain intensified during periods
when high capacity utilization is accompanied by widely
prevalent expectations of inflation. In such periods poten
tial borrowers are stimulated to obtain immediate financing
in order to beat the expected higher costs of business plant
and equipment in the future. Investors also take steps to
protect themselves against the expected inflation. For
instance, they purchase inflation hedges such as equities
and land rather than debt obligations, and they also bor
row to finance these purchases.
When inflationary expectations are modified, the process
is reversed. Investors’ preferences for debt obligations
relative to equities become stronger; yields on equities
tend to rise; and upward pressures on interest rates are
displaced by declining tendencies.
120
INTEREST RATES
Money and bank credit. Fluctuations in market rates of
interest are affected not only by changes in the savinginvestment process and in the economy’s expectations but
also by changes in the supply of bank credit and money.
When bank credit expands, banks buy securities and make
loans for financing economic activity, and this adds
directly to the supply of funds available. Thus interest
rates may fall in response to this expansion in supply.
When bank credit expands, the supply of money typi
cally rises. Increases in the supply of money not matched
by increases in the public’s desire to hold cash have one
of two effects or some combination of them. As one alter
native, the supply of funds in credit markets may rise
further as the public attempts to substitute other financial
assets for cash; if so, downward pressures on market rates
of interest may be accentuated. As another, consumers and
businesses may spend larger amounts on goods and serv
ices as they try to reduce the amount of cash they hold.
Interactions. The factors influencing the supply of and de
mand for loanable funds and the levels of interest rates —
that is, the money supply, saving and investment, and ex
pectations — are not independent of each other. The be
havior of one is influenced by and impinges on the move
ments of the others. Changes in interest rates, output, and
prices are a product of their joint effects.
When economic activity declines and investment demand
falls relative to saving, interest rates tend to fall. At such
times reserve banking actions to increase the availability
of credit and the supply of money will make for easier
credit market conditions, declining interest rates, and a
financial environment and expectations favorable to a
revival in economic activity.
121
THE FEDERAL RESERVE SYSTEM
When the economy is at a high level of capacity utiliza
tion, when demands for goods and services tend to exceed
the capacity to produce them at current prices, and when
investment demand is outrunning the propensity to save,
prices and interest rates tend to rise. Under these circum
stances reserve banking actions will generally be designed
to keep credit and monetary expansion in line with the
economy’s growing capacity to produce and thereby to
contain inflationary pressures.
Unlimited expansion of bank credit and money in these
conditions, in order to satisfy all demands for credit at
pre-existing interest rates, would enlarge the dollar amount
of both saving and spending without relieving the short
age of real resources. It would thus result mainly in rising
prices and expectations of further rises. It would not check,
except perhaps temporarily, a pronounced tendency for
interest rates to rise. Thus for monetary policy to be an
effective influence toward stable prices and sustained eco
nomic growth, interest rates need to fluctuate in response
to variations in economic activity, the supply of saving,
and investment demands.
Interest Rate Inflexibilities
Some market rates of interest, as was mentioned earlier,
do not reflect immediately changes in the supply of credit
relative to demand but respond to such changes after a lag.
In some instances a stated interest rate may not change,
but the effective rate may be varied through other changes
such as the amount that banks require borrowers to leave
on deposit or the extent to which investors require com
pensation for purchasing securities having a maximum
interest rate, such as Government-insured mortgages.
122
INTEREST RATES
As credit demands press actively against the supply of
funds in market sectors where interest rates tend to be less
flexible, lenders allocate funds among borrowers on a basis
other than price. Lenders, who always tend to be selective
to some degree in satisfying borrowers, adhere to stricter
lending standards and screen creditworthiness of borrow
ers more carefully when credit conditions are tight. Bor
rowers then become obliged to shop more intensively to
find lenders whose loan standards and terms they can
meet, and some borrowers fail to find accommodation.
Thus, an increase in demand for funds relative to supply
not only causes interest rates to rise but also has a direct
effect on the ease with which borrowers can obtain funds
and the amount they can obtain. Similarly, developments
that limit the supply of funds relative to demand, including
those that limit bank credit expansion, are accompanied
by both rising interest rates and increased nonprice alloca
tion of funds as standards for lending become more strict.
Federal Reserve Actions and Interest Rates
Federal Reserve policy, which has its immediate impact
on the availability of bank reserves, affects market interest
rates in several ways. The main influence of monetary
policy on interest rates is exerted by the increase or de
crease in the supply of funds in the market that results
from multiple expansion or contraction of bank credit
based on fractional reserve requirements. On the average,
however, only a small share of aggregate credit demand is
satisfied through the bank credit expansion that is associ
ated with growth in money supply. Available estimates
indicate that the share so satisfied averaged about 6 per
cent annually during the decade ending in 1962.
123
THE FEDERAL RESERVE SYSTEM
The Federal Reserve can initiate a change in bank
reserves through its open market operations or, when
appropriate and feasible, by changes in reserve requirement
percentages. Federal Reserve purchases and sales of
Government securities in the open market, of course, have
some immediate impact on interest rates. By conducting
most of its operations in short-term securities, the market
for which is much broader than markets for longer issues,
the System tends to minimize this immediate impact. Pur
chases have been made, however, in the intermediate- and
long-term area in an effort to reduce even further the down
ward pressures on short-term rates at times when this has
appeared to be desirable, such as in periods when short
term capital outflows have been intensifying a balance of
payments problem.
Since open market operations in securities of either short
or long maturity bring about larger changes in the supply
of funds — through multiple expansion or contraction of
bank credit — their basic impact is on rates in all sectors
of the market, which come to be affected in some degree.
Flexible adjustment between short- and longer-term inter
est rates is an essential aspect of a responsive credit market.
Such a market continuously reflects evolving borrower and
lender preferences in the commitment of financial resources
into the future. Continuous market adjustments enable the
nation’s financial institutions to function effectively in the
public interest, as they mobilize the saving of numerous
individuals and others and channel the funds into invest
ments.
The Federal Reserve discount rate is related to and inter
acts with interest rates in the market. As was explained
earlier, the Federal Reserve discount rate is kept in close
124
INTEREST RATES
alignment with short-term interest rates in order to avoid
giving member banks either too much or too little incentive
for using a facility that is intended to meet banking con
tingencies and temporary needs for reserve funds. While
the discount rate is administered in relation to the level
and structure of market interest rates, market rates them
selves are primarily the product of the forces of demand
for and supply of credit, including of course the effect of
other Federal Reserve actions affecting bank reserves.
Because of psychological factors in the market, bank
credit and monetary policy may have some effect on inter
est rates in addition to, and even prior to, those resulting
from changes in bank reserve positions. However, interest
rate movements prompted by expectations of prospective
reserve banking action are not likely to be long sustained
unless accompanied by changes in basic supply and demand
conditions.
The course of interest rates is necessarily affected by
reserve banking action, as monetary policy influences the
availability of bank reserves and the flow of bank credit
and money in response to developments in domestic
economic activity and in the balance of payments. Reserve
banking operations, however, attempt to interfere as little
as possible with investor, lender, and borrower decisions
as to the specific commitment of financial resources
over time.
125
CHAPTER VII
INFLUENCE OF RESERVE BANKING O N ECONOM IC
STABILITY. Federal Reserve influence on the flow o f bank credit
and money affects decisions to lend, spend, and save throughout
the economy. Reserve banking policy thus contributes to stable
economic progress.
ARLIER chapters have described the mechanism of
Federal Reserve influence on the flow of bank credit
and money, explained the structure of credit markets, and
discussed important factors affecting movements in in
terest rates. This chapter clarifies the relation of reserve
banking measures to domestic economic stability and
growth, while the next relates reserve banking to the
balance of international payments.
Reserve banking policy attempts to provide a financial
climate conducive to sustainable growth in output, employ
ment, and consumption under conditions of relative
stability in the average level of prices and of long-run
balance in our international payments. However, these
objectives cannot be attained through reliance on monetary
E
127
THE FEDERAL RESERVE SYSTEM
policy alone. Their accomplishment also depends on fiscal
and other governmental policies and on policies of private
institutions and organizations.
The posture of Federal Reserve monetary policy at any
moment — whether restrictive or expansive — is a reaction
to prevailing economic conditions. Monetary policy func
tions restrictively when inflationary tendencies are present.
In other circumstances it functions expansively or assumes
a posture somewhere between stimulation and restraint.
To help avoid the dangers of economic downturn, reserve
banking works to prevent speculative or otherwise unsus
tainable expansion of bank credit.
The diagram on the opposite page shows in a simplified
way how actions taken by the Federal Reserve System
influence total spending and thereby contribute to the
ultimate objectives of high employment, maximum pro
duction, and stable prices.
The Federal Reserve carries out its responsibility for the
public interest by influencing the reserves of member banks.
As the diagram shows, that is where the initial impact of
reserve banking policy falls. As banks respond to changes
in the availability of reserve funds by altering their lending
and investment policies, reserve banking comes to influence
the supply of money, the availability of credit, and the
cost of money in various credit markets.
Some observers stress the influence of reserve banking
in terms of its effects on the money supply, others empha
size the impact of changes in the availability and cost of
credit, and still others stress its effects on over-all liquidity.
In the functioning of the economy each of these modes of
influence has a role, and in the discussion that follows each
is taken into account.
128
INFLUENCE ON ECONOMIC STABILITY
FLO W OF FEDERAL RESERVE INFLUENCE
F E D E R A L R E S E R V E A U T H O R IT IE S
i
regulate
1
V O LU M E OF M EM BER B A N K RESERVES
r
1
w h ich
strongly
influence
BAN K DEPOSITS
(A N D MONEY SUPPLY)
BAN K LOANS AND
INVESTMENTS
l
w h ich
w h ich
a r e a f a c t o r in
+
/
are
a f a c t o r in
4
CREDIT A V A IL A B IL IT Y
AN D IN TEREST CO ST
G E N E R A L LIQ U ID IT Y
w h ich
influe nce
i
P R IV A T E SP E N D IN G FOR C O N SU M P T IO N A N D IN V ESTM EN T
( A N D S A V IN G )
1
w hich
la rge ly
determ ine
l
P R O D U C T IO N , E M P L O Y M E N T , A N D P R IC E S
129
THE FEDERAL RESERVE SYSTEM
R eactions of Commercial B anks
What is the reaction of commercial banks to changes
in the supply of reserves? For example, what is their
reaction to limitations on reserves in a period of strongly
expanding demand for bank loans? When they are in this
situation and therefore under reserve pressure, banks are
more reluctant to make new loans and interest rates on
the loans they do make tend to rise, as compared with
periods when their reserves are rising rapidly as the result
of reserve banking policy.
In a period in which policy is limiting bank credit
expansion, a bank that seeks to expand its loans rapidly
may have to obtain funds by selling Government or other
securities (mainly short-term) in the market, by permitting
its holdings of maturing issues to run off, or by drawing
down balances with, or borrowing from, other banks.
Discounting at Reserve Banks, as emphasized before, is
primarily for meeting passing contingencies and is not, in
the U.S. banking system, a source of funds to individual
banks for financing permanent loan expansion.
If a bank sells securities, lets maturing issues run off, or
draws down its balance with another bank, its action will
necessarily affect other banks. In the case of security sales,
for example, the buyer is likely to draw down his account
at another bank to make payment. Consequently, banks
as a group cannot expand their total loans and investments
in this way.
If many banks try to obtain additional reserves by selling
securities, the amount of short-term paper or securities
in the market will be increased significantly. This increased
supply tends to lower prices and to raise yields on all such
paper. Similar market pressures may result if banks, in
130
INFLUENCE ON ECONOMIC STABILITY
order to build up their reserves, allow maturing issues to
run off or draw upon balances with correspondents.
At the lower prices and higher yields, Government and
other short-term securities will be more attractive. In
order to buy them, nonbank investors may use temporarily
idle deposits or they may even be induced to economize
on cash balances held for current payments. When banks
sell short-term paper to other investors and use the pro
ceeds to make loans, ownership of deposits may shift from
holders of idle balances to borrowers who are spenders
and will shortly disburse the proceeds. To the extent that
this occurs, the velocity of existing deposits will increase.
In this process, the volume of money transactions increases
as the existing supply of money is used more actively.
As banks see their short-term securities or secondary
reserves declining, however, they become increasingly
reluctant to reduce these securities or reserves further in
order to make additional loans. This leads banks to raise
interest rates on loans and to adopt more selective loan
standards.
In addition, as market interest rates rise — a develop
ment that is reinforced by bank sales of securities —
security prices decline and sales of securities may involve
book losses. Banks are influenced to some extent by
potential capital losses on the securities in their portfolios,
and they hesitate to sell securities at a loss. Income tax
considerations and strict earnings calculations, however,
may moderate or even negate the deterrent effect of such
losses on continued sales of securities.
At times when monetary policy aims at stimulating
bank credit expansion to help counteract recessionary
tendencies in the economy, banks will find their reserve
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THE FEDERAL RESERVE SYSTEM
funds increasing quite rapidly. In using these funds, they
are likely first to repay any outstanding indebtedness to
the Reserve Banks, particularly if loan demands are weak
or declining as might be expected under the conditions
assumed. After they have reduced their borrowings, banks
will begin to purchase short-term securities, thereby rebuild
ing their secondary reserve positions and reinforcing any
tendency already existing in the market toward declining
interest rates. They will also begin to relax their loan
policies and this, together with reduced interest rates, may
actively encourage the extension of bank loans that were
postponed or that were not encouraged by lenders under
the earlier conditions of credit restraint.
Effects of C hanges in the M oney Supply
Changes in bank reserve availability influence changes
in the money supply. What is the response of the economy
to changes in the rate at which the supply of money is
growing, under the influence of monetary policy?
At each level of income and interest rates, there will be
an amount of money that the public wishes to hold for
transactions, or for precautionary or speculative purposes.
Suppose that actions taken by the Federal Reserve fail to
provide the desired amount of money. In that event some
reaction is likely to be registered both in spending and in
interest rates.
In an attempt to reestablish its desired level of balances,
the public may spend less, or it may sell off financial assets
(or purchase fewer of them), with a consequent rise in
interest rates. As interest rates rise in this situation they
too influence decisions to spend and to save. Also, the
rise in interest rates affects the demand for money balances,
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INFLUENCE ON ECONOMIC STABILITY
as it leads people to accommodate themselves to smaller
cash balances.
On the other hand, a volume of money in excess of what
the public wishes to hold leads to increased spending and
lending and to reductions in interest rates.
Demand for Cash
In assessing the effect on economic activity of changes
in the money supply, it is important to recognize that
there is no simple automatic measure of the appropriate
relationship between the amount of money outstanding
and the level of economic activity. A given volume of
money, for example, can be associated with either higher
or lower levels of total spending — that is, can finance
more or fewer transactions — depending on how often
it is used. The rate of turnover, or velocity, of money
indicates how much work each unit of money does in
financing transactions.
Cash balances are held by private sectors of the economy
for a variety of reasons. A large part of their total repre
sents working balances, that is, amounts of demand
deposits and currency held for financing regular trans
actions. The size of such balances varies in part with the
time lag between receipts and expenditures. For example,
the time that elapses between pay dates is one factor
affecting the size of cash balances. People who are paid
every week have smaller cash balances, on the average,
than those who are paid monthly. The size of the cash
balance also varies with income. The higher a person’s
income and expenditures, the larger his cash balance for
transactions is likely to be.
Cash balances are held for other reasons too. They may
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THE FEDERAL RESERVE SYSTEM
represent saving out of income, as a store of value for pre
cautionary reasons — to gain flexibility in choice and timing
of purchases, to provide against a rainy day, or to antici
pate future expenditures or investments. In other instances
they may be held as a store of value for speculative reasons,
with the expectation of buying in case of a sharp decline
in security, real estate, or commodity prices.
The size of the cash balances that businesses and indi
viduals find it desirable to hold depends in part on the
level of interest rates. When interest rates are low, the
holder sacrifices relatively little in holding cash rather
than an asset that earns interest. The higher the level of
interest rates, the greater the sacrifice in holding idle cash
instead of an interest-bearing financial asset. The form
in which contingency or speculative balances are held —
whether it be in demand deposits that bear no interest
or in interest-earning assets — is highly sensitive to the
rate of interest paid.
Several types of assets are close substitutes for cash in
its store-of-value function, as explained in Chapter I.
These include savings and time deposits at commercial
banks, deposits at mutual savings banks, shares in sav
ings and loan associations, and U.S. Government savings
bonds. Short-term market instruments, especially obliga
tions of the U.S. Government, such as Treasury bills, are
also close substitutes for cash because they are generally
convertible into cash with relatively small risk of capital
loss. Such assets possess high, though varying, degrees of
liquidity. A backlog of these “near money” assets, to
gether with some holdings of cash, gives the individual
consumer or enterprise greater discretion in making its
decisions to spend.
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INFLUENCE ON ECONOMIC STABILITY
Use o f Cash in Relation to Monetary Policy
Changing attitudes of people toward their cash balances
and liquid asset holdings get reflected in changes in the use
or velocity of money. Changes in the amounts of cash and
other liquid assets that individuals wish to hold are influ
enced by many factors. Among important influences are
changes in the amount of transactions to be financed;
expectations as to future levels of economic activity, interest
rates, and prices; and other motives and circumstances
that determine decisions to spend or save. In addition,
changes in bank credit and money themselves may set in
motion forces, such as changes in interest rates, that lead
to changes in the turnover of money for a period of time.
Changes in the public’s willingness to hold cash assets, it
is evident, are related broadly to movements in economic
activity and, hence, are one indicator of underlying condi
tions making for expansion or contraction of the economy.
Efforts of reserve banking policy to curb inflationary
spending by limiting expansion of the money supply are
generally accompanied by more active use of cash balances
by the public. Some individuals and businesses may in
crease their spending by drawing upon their own existing
cash balances or by converting financial assets into cash.
As interest rates rise in this situation, others will be induced
to put their idle balances to work in interest-earning assets.
Such an addition to the flow of available credit tends to
offset somewhat the credit-restraining effects of antiinflationary monetary policy.
As incomes rise in an expansionary period, however,
people will feel a growing need for transactions cash, and
it will become increasingly inconvenient for them to
economize on existing holdings. For this reason many
135
THE FEDERAL RESERVE SYSTEM
economists believe that a rise in velocity in this situation
will approach a definable limit. Another reason is that
there are limits to the increases in interest rates that non
bank financial institutions can offer to induce the public
to economize on cash holdings. Institutions are limited in
bidding for funds because when they pay higher interest
rates this affects the cost of their lending, and as lending
costs rise borrowing becomes less attractive to businesses
and individuals. Therefore, the ability of institutions to
attract funds and to use them profitably is reduced.
When economic activity is declining, efforts to stimulate
spending by encouraging expansion of the money supply
may be accompanied by a less active use of cash balances.
The expansionary effects of additions to bank reserves and
the supply of money may be weakened, in other words, by a
rise, however activated, in the public’s desire to hold cash
and by an accompanying decline in the velocity of money.
As a result, countercyclical monetary action, even though
aggressive, may not be accompanied by a commensurate
rise in spending.
With the changing use of cash balances a potential
countervailing force to monetary policy, it is necessarily
incumbent on the monetary authorities to pay close at
tention to money velocity and to weigh its strength care
fully in determining possible actions.
E ffect of C hanges in C redit C onditions
Changes in interest rates and other credit conditions
associated with countercyclical variations in the supply
of money and credit influence economic developments
through their effect on decisions to borrow and spend or to
save and lend.
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INFLUENCE ON ECONOMIC STABILITY
How Lenders and Savers Are Affected
Commercial banks’ willingness to lend and the terms
they offer are strongly influenced by monetary policy be
cause it has a direct impact on their reserve positions.
Other lenders, such as finance companies and mortgage
companies, obtain part of their funds by borrowing from
commercial banks. At times when credit expansion is under
restraint, these lenders find that funds are less readily
available and more expensive than in times of credit ease.
As the volume of their borrowing is restricted and its cost
rises, nonbank lenders may find it necessary to curtail their
lending. They will also tend to charge customers higher
rates of interest on loans.
In periods of rising interest rates, all financial institu
tions find that the value of their existing portfolio of assets
declines, sometimes sharply. In these circumstances, par
ticularly when the potential capital loss (after tax) is
large relative to the increment to income from new
loans, financial institutions are reluctant to sell assets in
order to make loans.
The flow of lendable funds in the over-all credit market
depends to a large extent, however, on the saving of con
sumers, who make funds available to the market directly
or through intermediary financial institutions. Whenever
the supply of saving falls short of the prevailing demand
for it, interest rates rise. The rise in interest rates tends to
be limited, however, by the extent to which it brings forth
saving that would not otherwise have been made. Motives
to save are complex, and the rate of interest return is only
one of a number of incentives.
How much total consumer saving will respond in given
circumstances to changes in interest rates is a matter of
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THE FEDERAL RESERVE SYSTEM
some uncertainty. Nevertheless, changes in interest rates
do have discernible effects on the distribution of the flow
of consumer saving among various financial investments
and also, to a degree, on the distribution of total consumer
saving between financial investments and investments in
capital goods.
How Borrowing and Spending Respond
The effect on borrowing and on spending of changes in
credit conditions and costs will not be uniform among
businesses and individuals. The effect will vary with—
among other things — the reliance that is placed on credit
by the potential borrower, with the borrower’s financial
position and credit standing, and with his income and
profit expectations.
Business. In periods of restraint on the pace of monetary
expansion, potential business borrowers will be dis
couraged in a number of ways. The pressure on banks to
restrict the growth of their loan portfolios will lead them
to ask some borrowers to accept smaller loans and some to
accept shorter maturities. In other instances banks may ask
customers to postpone their borrowing altogether. And
any rise in bank lending rates may also discourage some
potential borrowers from seeking loans. Customers who
want to borrow are likely to seek accommodation else
where, but these sources — nonbank financial institutions
and the credit market generally — will also be under pres
sure as a result of the general excess of demand at current
levels of interest rates.
The net effect of receding ease and eventual tightening
of credit markets is likely to be some curtailment of spend
ing by business. Forward inventory commitments, and
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INFLUENCE ON ECONOMIC STABILITY
later the actual purchases, may be curbed; and there may
also be a slowing down in planned spending for plant and
equipment.
These curtailments in spending may not affect the
majority of businesses or the full amount of many loans,
but they will affect some borrowers and the amounts
involved in some loans. In other words, marginal borrow
ing will be restrained. The result usually is a smaller
increase in spending than transactors would have wanted
under more favorable credit conditions, rather than an
actual contraction in spending. For this reason, the brake
on business spending is difficult to observe.
The sensitivity of business spending and borrowing to
changes in interest rates and other credit terms varies
widely. The ability and willingness to accumulate inven
tories, for example, may be significantly affected for some
enterprises by a rise in bank lending rates, while for others,
whose inventory costs are smaller or whose financial
position is stronger, such a rise may have little deterrent
impact. In certain fields such as industrial and commercial
construction, public utilities, and railroads, where there
are large fixed investments, long-term interest rates are a
particularly significant cost factor. In such fields com
paratively small increases in interest rates can result in
postponement of borrowing to finance capital outlays.
Even in fields where interest costs incurred for financing
fixed investment may be less important, as in retail and
wholesale trade, some business units may be induced to
cut back on their reliance on longer-term borrowing when
interest rates rise, and other borrowers may be deterred
from adding to such debt. The more long-term rates rise
under conditions that seem temporary, the more long-term
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THE FEDERAL RESERVE SYSTEM
borrowers tend to postpone investment outlays because
they expect to borrow later at lower interest costs.
Businesses borrow in the expectation that the return
from the use of borrowed funds will exceed interest costs
by a significant margin. When the margin is large and
when it is fairly well assured, moderate increases in in
terest rates may have little effect on the willingness of
a business to borrow. But when the margin is smaller or
when the return is less certain, a rise in interest rates
discourages borrowers.
A rise in interest rates increases the cost of long-term
borrowing and influences the utilization of productive
resources through changes in the relationship between
prices of existing capital assets and the cost of producing
new assets. These changes direct some activity away from
production of long-lived, slowly depreciating capital goods
and thereby free resources for an immediate increase in
output of consumer goods or of producers’ equipment to
make consumer goods. In the fixed capital area these
changes, together with changes in the outlook for profits
and risks due to the altered credit and monetary situation,
shift the balance of business decisions toward holding or
buying old assets, and adapting such assets to new uses,
as compared with producing new ones.
The relationship between capitalized values of existing
assets and costs of producing new ones is indicated on the
following page. The illustration pertains to an office build
ing with a net income from rent of $100,000 a year.
If the current interest rate for such investment, with
allowance for risk, were 6 per cent, the capitalized value
of the existing property would be more than the cost of
constructing a new building with the same earning pros
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INFLUENCE ON ECONOMIC STABILITY
pects. An investor in this type of real estate would build
a new structure instead of buying an existing building,
other things being equal.
Estimated cost of constructing a new
building....................................................
$1,500,000
Capitalized market value of an existing
building with earnings from rent (net
of all current costs and depreciation)
of $100,000:
If current interest rate, with allow
ance for risk, is 6 per cent............
If current interest rate, with allow
ance for risk, is 7 per cent............
1,666,667
1,428,571
On the other hand, if the relevant interest rate were 7
per cent, it would not pay to build a new structure and the
decision would go the other way. The economic resources
that would have gone into constructing the new building
would then be available for other uses.
Consumer. Consumers make use of both short- and long
term credit. They use short- and intermediate-term credit
to finance purchases of durable goods, home improve
ments, and a variety of services. Most of their long-term
borrowing takes the form of residential mortgages.
Various types of institutions extend short- and inter
mediate-term credit to consumers on fairly standardized
terms and charge rates that are relatively inflexible and
high in relation to open market rates of interest. The
interest rate that a consumer financing institution pays for
the funds it borrows is only one of the cost elements
in the finance charge to consumers, but it does have
an influence on the institution’s willingness to lend.
General credit tightness or ease will be transmitted to
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THE FEDERAL RESERVE SYSTEM
consumer credit through changes in the strictness or leni
ency of credit standards applied by institutions granting
such credit. The variation of credit standards affects the
volume of new credit extended, and this in turn affects
the volume of consumer credit that is outstanding.
Even though the mortgage market is less highly organ
ized than are markets for government and corporate obli
gations, and interest rates on mortgages are less sensitive
to shifts in supply or demand pressures than are rates on
other securities, the financing available for home pur
chases is considerably affected by credit conditions and
interest rates.
Some lending institutions increase or decrease sharply
the proportion of lendable funds they are willing to place
in mortgages when interest rates on competing investment
media fall or rise significantly. This tendency may be
especially pronounced for Government-underwritten mort
gages— FHA-insured or VA-guaranteed — because ad
ministrative ceilings on their contract rates make their
actual market rates less flexible than those on other media.
As the availability of residential mortgage funds fluctu
ates, potential borrowers may encounter more or less diffi
culty in qualifying for mortgage loans. Borrowing to buy
houses is typically long-term and repayable in monthly
instalments. The ability of a potential borrower to qualify
for a mortgage usually depends on the relationship of the
monthly payment to his income. The standards that
lenders apply in this respect depend in large measure on
the availability of mortgage funds, and these standards be
come more stringent as the amount of funds available
for lending declines.
In addition, any increase in interest rates on mortgages
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INFLUENCE ON ECONOMIC STABILITY
adds to the monthly payment. Thus marginal borrowers
are no longer able to qualify on the basis of existing loan
standards regarding the relation of the monthly mortgage
payment to monthly income. In periods when over-all
demand for goods and services is tending to be excessive,
limitations on the pace of monetary expansion and on
the availability of credit, together with increases in interest
costs, tend to discourage house building or to encourage
preferences for lower priced houses. In periods of economic
slack and credit ease, increases in loanable funds and
lower interest rates encourage residential construction.
T ime Sequence of E ffects on Spending
The effect on the economy of changes in the flow of bank
credit and money work themselves out over time. For
example, when productive resources are intensively util
ized, limitations on bank credit expansion will generally
mean that income payments to individuals do not increase
as they might have. This restraint on income will be
gradual and will be accompanied by abatement of the
pressure of demand against the supply of goods.
Both consumers and businesses will spend less, and the
spending of each group will influence the spending of
the other. That is, curtailed spending for consumer goods
and other finished products will have a dampening effect
on producers’ demands for machinery and other equip
ment required to make such goods, while curtailed busi
ness spending in its turn will restrain consumer income
and spending. Consumers and investors may anticipate
these secondary effects and, through their attitudes and
actions, may bring them about more promptly and in
greater degree.
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THE FEDERAL RESERVE SYSTEM
In a period of inflationary pressures such developments
work to restore stability in the economy. In this process,
any increased tendency to restrain spending and cor
respondingly to enlarge the flow of financial saving out
of current income helps to correct forces making for in
flationary tendencies. This enables a larger proportion of
borrowing demands to be met out of increased financial
saving, which reduces pressures leading to expansion of
bank credit and money.
On the other hand, in a period when the total demand
for goods and services tends to be slack in relation to cur
rent output, the stimulation to spending that arises from
easier credit conditions will be multiplied over time. In
creased activity arising from credit ease will add to the
volume of money income available for subsequent spend
ing, thereby expanding the demands of consumers for
goods and services and strengthening business incentives
to improve and add to production facilities.
As the flows of spending, investing, and saving in the
economy change in response to monetary policy and also
to other circumstances, the reserve banking authorities
are in a position to adapt current policies to these develop
ments. If spending is tending to react too strongly or too
weakly to policy shifts, the stance of policy can be altered.
The gradualness with which policy has its effect, together
with the inherent flexibility of monetary instruments,
enables the reserve banking authorities to adapt to chang
ing circumstances. At the same time, policy needs to be
sensitive to, and also to anticipate, current economic
tendencies and what they are likely to mean for the nearterm future. Through these efforts the timing of policy is
made consonant with the evolving course of the economy.
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INFLUENCE ON ECONOMIC STABILITY
M onetary P olicy and G rowth
This chapter has described how the economy responds
to reserve banking efforts to maintain economic stability.
It has dealt primarily with responses to countercyclical
monetary policies — that is, with responses to a restrained
expansion in bank credit and money during inflationary
periods and to an encouraged expansion in recessions.
In contributing to economic stability at high levels of
employment, monetary policy helps to create a favorable
environment for sustainable long-term growth with a
reasonably stable value for money. The rate of growth of
the economy over time depends in large part on the extent
to which resources are devoted to expansion of industrial
plant and equipment, to agricultural improvements, to
education and the development of technical skills, to
research, and other similar items. Thus it hinges on the
saving-investment process, described in Chapter VI.
The willingness and need of a country to invest for long
term growth depends on a whole complex of economic,
social, and political elements. Among important factors
are the rate of technological innovation, the need to use
existing technology to catch up with more advanced
countries, and a country’s growth and development over
the years. For instance, a country such as the United
States, which has grown rapidly in the past, is more in a
position to use its existing resources to produce consump
tion goods and services than are other less advanced
countries. Less advanced countries, on the other hand,
need to stress investment in plant, equipment, and agri
culture strongly — through use of new technology or the
more intensive application of existing technology — in
order to realize growth potentials.
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THE FEDERAL RESERVE SYSTEM
In our free society, choice in the use of resources is made
in part through public decisions as to taxation and govern
mental spending, but it depends for the most part on
decisions of a multitude of individuals and businesses
expressed in competitive bidding in the market for goods,
services, and the financial assets that serve as a medium
for savings. Efforts by the reserve banking authorities
to minimize cyclical fluctuations in economic activity while
encouraging relative stability in average prices and balance
in our international payments help to create an environ
ment in which the economy will be able to grow at a pace
consistent with the aspirations and energies of the people.
Still, it is clear that bank credit and money need to
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INFLUENCE ON ECONOMIC STABILITY
expand sufficiently over the longer run to facilitate what
ever rate of economic growth is consistent with the way
the public wants to allocate economic resources between
production for present and production for future con
sumption, at high levels of employment and with reason
able stability in the average level of prices. The appropriate
rate of expansion in bank credit and money will be influ
enced by the share of bank credit in total credit and by
changing habits of the public with respect to the kinds of
assets in which they hold liquidity. Thus, while monetary
authorities adapt their policies to continuing short-run
changes in economic conditions, they must also keep in
mind the public’s long-run needs for cash balances.
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CHAPTER VIII
THE BALANCE OF PAYMENTS. Our economy is part o f the
world economy. Prices and interest rates here interact with prices
and interest rates abroad, and the interrelationships affect our
international balance o j payments. In its decisions on monetary
policy the Federal Reserve has to take the U.S. balance o f pay
ments into account. Operations by the System in foreign exchange
markets help to cushion unusual supply or demand pressures in
these markets.
HE presentation in preceding chapters has been
deliberately simplified by keeping to a minimum all
discussion of international economic relationships. This
chapter shows how these relationships affect the balance
of payments between the United States and the rest of
the world, and it explains why and how Federal Reserve
policy is modified to help deal with international payments
problems. When the aims of monetary policy are broad
ened to include exerting some influence on the balance of
payments, decisions about policy become much more
complicated.
T
149
THE FEDERAL RESERVE SYSTEM
With one exception, the actions of the Federal Reserve
that can influence the balance of payments are, broadly
speaking, no different from the actions it takes to influence
domestic monetary conditions. The exception, the one
special type of action that is taken in relation to external
affairs only, is intervention in the foreign exchange markets.
The concluding section of this chapter discusses the foreign
exchange operations of the System.
What Is the Balance o f Payments ?
The term “balance of payments” is used in two main
senses. It sometimes refers to the whole complex of inter
national business and financial transactions involving pay
ments between one country and the rest of the world. In its
other sense the term refers to the difference between re
ceipts and payments resulting from certain transactions —
such as in goods, services, and long-term capital — between
one country and other countries during some specified
period; in this second sense the term is often abbreviated
to simply the “balance.”
When people speak of the balance on current account,
they mean the surplus (excess of receipts over payments)
or the deficit (excess of payments over receipts) resulting
from all current transactions. By the phrase current trans
actions they mean all sales and purchases of goods and
services, together with gifts and grants.
Examples of current transactions that give rise to receipts
by the United States from the rest of the world are U.S.
exports of goods, foreigners’ expenditures for travel in the
United States, payments of dividends and interest by
foreigners to U.S. residents, and so forth. Similarly,
various sorts of current transactions give rise to payments
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THE BALANCE OF PAYMENTS
from the United States to the rest of the world. Special
mention may be made here of Government grants. In
many instances there are no monetary payments to for
eign countries in connection with these grants, but never
theless the grants are counted as “payments” offsetting
the “receipts” nominally accruing from the exports cov
ered by grants.
But current transactions are not the only kind of inter
national transactions. There are also capital transactions.
Examples of these are loans, investments, changes in
holdings of bank deposits, and shifts in the ownership of
gold reserves.
Because there are different ways in which international
transactions of these two broad kinds can be classified,
terms such as balance, surplus, and deficit have different
meanings depending on the particular classification being
employed.
For many purposes of analysis the most useful and
important classification is one that combines all current
transactions and many capital transactions that relate to
nonliquid assets — particularly, but not exclusively, long
term investments and loans. In such a classification, the
resulting surplus (or deficit) is equal to the increase (or
decrease) in the country’s net liquid asset position in rela
tion to the rest of the world.
From an international point of view, a country’s liquid
assets include its gold reserves and in addition, depending
on the precise details of the classification being used,
various other official and private assets abroad. Against
these liquid assets there are various liabilities, which may
also be viewed as foreigners’ liquid assets held in this
country. This type of classification is used in the official
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THE FEDERAL RESERVE SYSTEM
U.S. balance of payments statistics, which are compiled
and published by the Department of Commerce.
These statistics help to show the causes of gold move
ments between the United States and other countries and
to explain changes in foreign holdings of liquid assets in the
United States, such as deposits in U.S. banks and invest
ments in U.S. Treasury bills or other liquid assets.
When there is a surplus in the U.S. balance of payments
accounts — that is, an excess of receipts over payments on
current transactions and certain kinds of capital trans
actions — it is often called a “favorable” balance for the
United States, because it adds to U.S. gold reserves or
other U.S. liquid assets abroad or decreases foreign liquid
assets in the United States.
The terms “favorable” or “unfavorable” applied to the
balance of payments in this sense do not refer to the total
asset and liability position of the country in relation to
the rest of the world. It is possible that the net international
assets of the United States can increase in total, while the
net liquid asset portion of the total decreases. For example,
U.S. nonliquid assets abroad — chiefly long-term invest
ments— may rise sharply relative to the corresponding
foreign loans and investments here, but foreigners may
increase their holdings of liquid assets here more than
we increase our holdings of such assets abroad. Indeed,
that is what has happened in recent years.
In the postwar period the U.S. balance of payments has
been “unfavorable” in this limited sense, as the accom
panying chart shows. The deficit in the accounts has been
especially large in the years beginning with 1958. This
deficit has been settled by large movements of gold from
U.S. reserves to foreign countries and by large additions
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THE BALANCE OF PAYMENTS
to foreign holdings of liquid assets in the United States.
These foreign dollar assets belong mostly to commercial
banks and foreign and international monetary authorities
(mainly central banks and the International Monetary
Fund). But some are also held by individuals and busi
nesses in other countries as well as by international
development lending institutions.
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THE FEDERAL RESERVE SYSTEM
Use o f the Dollar in International Payments
U.S. dollars are widely held and used by other countries
for settling international transactions. And they are prac
tically the only means of immediate payment used by other
countries in their transactions with the United States.
Whenever the payments from the United States to for
eigners on current transactions, long-term capital trans
actions, and various other capital transactions exceed the
corresponding payments from abroad to the residents of
the United States and to the U.S. Government, there is
almost sure to be, in the first instance, an increase in
foreign dollar holdings in the United States.
If this amount is greater than foreign individuals, busi
nesses, and commercial banks wish to retain, they sell
dollars in the exchange markets for other currencies. To
prevent the rates of exchange for their currencies from
rising above specified levels — usually in accordance with
the Articles of Agreement of the International Monetary
Fund — foreign central banks have to buy dollars in the
exchange markets. Then at their discretion, the foreign
central banks may convert some part of their increased
dollar holdings into gold.
Whether and to what extent a foreign monetary author
ity decides to let its balance of international payments
affect its dollar holdings or its gold holdings depends
largely on its established practice with regard to the form
of its reserves. Some countries, such as the United King
dom and some continental European countries, have made
a practice of holding all of their reserves in gold except for
working balances. Any substantial short-run change in
their official dollar account, therefore, has been reflected
promptly in purchases or sales of gold.
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THE BALANCE OF PAYMENTS
Some other countries have held part of their reserves in
gold and part in dollars. Others have considered it advan
tageous to hold nearly all of their reserves in dollars. And
some hold their reserves in pounds sterling, which are
liabilities of the United Kingdom. When these countries
convert dollars into sterling or vice versa, their operations
may affect British and American gold reserves in opposite
directions.
Because of the wide use of dollars both as a means of
commercial payment and as a monetary reserve, variations
in the dollar holdings of central banks reflect their use for
settling payments balances with other foreign countries as
well as payments to, and receipts from, the United States.
The widespread use of the dollar as an international re
serve currency makes the stability of the dollar important
to other countries as well as to the United States.
Significance o f the Balance o f Payments
Maintaining a stable international value for the dollar
is an important policy objective of the United States for
both international and national reasons. If international
confidence in the dollar were destroyed, the environment
for sustainable long-run growth of the domestic economy
would be impaired.
A healthy balance of payments is essential, in the long
run, for maintaining stability of the dollar and the world’s
trust in its soundness. It is easy to see why this is so. Longcontinued deficits in the U.S. balance of payments would
put more dollars into the hands of foreign private persons
and central banks than they would wish to hold. The
central banks would convert these dollars into gold.
But these conversions could go on only as long as the
155
THE FEDERAL RESERVE SYSTEM
United States had enough gold to meet the demands.1
If U.S. gold reserves were ever to become so small that
substantial doubts about the ability of the United States
to convert dollars into gold would arise, the dollar would
cease to be an unquestioned international means of pay
ment and reserve asset. Loss of confidence in the dollar
might even be generated through a build-up of speculative
fears far in advance of real dangers, if people did not see
progress toward elimination of the deficit.
It is therefore important to bring about adjustments in
the U.S. balance of payments. Fortunately, the possession
of large gold reserves provides time for doing this in ways
that will avoid disturbance of confidence. Governmental
measures of various kinds can encourage an increase in
exports and in other ways stimulate increases in U.S.
receipts from the rest of the world and decreases in pay
ments from this country. While these measures are grad
ually having their beneficial effects on the balance of
payments, gold is available in ample amount to meet the
demands of foreign central banks and official institutions.
Factors Influencing the Balance o f Payments
The farther the world has moved from the highly
restrictive framework of barriers and controls on inter
national trade and investment that grew up in the years
of the great depression and that persisted through the
war and early postwar years, the more closely interrelated
the economies of different countries have become. Under
1 See Chapter IX regarding the measures that can be taken to make U.S.
gold holdings available for international use in case the gold stock falls
below the amount required for the gold certificate reserves of the Federal
Reserve Banks.
156
THE BALANCE OF PAYMENTS
these circumstances economic events within each of the
national economies have come to be influenced more and
more by events in the broader world economy.
Within the domestic economy, production and trade
and borrowing and investment are guided by price and
cost relationships, by profit-making possibilities, and by
interest rates and credit availabilities. Exactly the same
kinds of influences are at work in the broader world
economy. It is true, of course, that the international in
fluences of cost-price relationships or of differences in
interest rates are less pervasive than similar influences
within the domestic economy: many products and services
cannot, in the nature of things, enter into international
trade, and many who lend or borrow in domestic markets
cannot easily shift to international markets despite the
steady removal of obstacles to international capital move
ments. Nevertheless, international cost-price relation
ships, differences in profit expectations, and differences in
interest rates and credit availabilities are powerful in de
termining the shape of a country’s balance of payments
with the rest of the world.
The emergence in recent years of large and continuous
deficits in the U.S. balance of payments reflects in part
the improved competitive position of foreign industrial
countries in world trade. Large investment outlays and
rapid technological advances have enabled many of these
countries to offset the advantages the United States held
in the early postwar years. Moreover, in 1949, the par
values of many major foreign currencies were reduced, so
that these currencies became cheaper in terms of the dollar.
At that time these adjustments in exchange rates had little
immediate impact on the balance of payments. Later, as
157
THE FEDERAL RESERVE SYSTEM
European output of exportable goods increased and con
trols on international trade and payments were relaxed, it
became evident that the 1949 devaluations had been helpful
in making European exports attractive to foreign buyers.
Also, investments in Europe have become attractive to
American companies.
During the period 1960 through mid-1963 the general
level of wholesale prices in the United States was remark
ably stable. In contrast, in many important European
countries there was a rising trend of production costs and,
in lesser degree, of the selling prices of goods, particularly
those consumed domestically. However, international com
petition was intense and was a factor inhibiting price ad
vances for internationally traded goods abroad as well as
in this country.
Monetary Policy and the Balance o f Payments
During most of the time since the Federal Reserve Sys
tem was established, balance of payments considerations
have entered little into the making of monetary policy.
But beginning in 1958, there emerged a large and persistent
deficit in the payments balance. In such a situation the
Federal Reserve has to take closely into account the
effects of monetary policy on the balance of payments.
Monetary policy affects the balance of payments in
two major ways. First, it can help to improve the inter
national competitive position of the United States through
continued encouragement of domestic price stability.
Therefore, the Federal Reserve aimed at avoiding so great
an expansion of bank credit and money as might under
mine the stability actually achieved in the average price
level from 1958 to 1963. In other words, it sought to pro
158
THE BALANCE OF PAYMENTS
vide enough bank reserves to facilitate the financing of a
growing output of goods and a fuller utilization of availa
ble productive resources while avoiding upward price
pressures domestically that would reduce the trade balance
and accentuate the international payments deficit.
Secondly, monetary policy affects the balance of pay
ments because it influences capital flows between the
United States and foreign countries through its effect on
interest rates and credit availability. In providing re
serves to the banks in sufficient volume to facilitate a
strengthening of forces of domestic expansion, the Fed
eral Reserve endeavored to do so in ways that would
minimize the resultant downward pressures on short-term
interest rates. Here the aim was to keep short-term interest
rates as nearly as possible in a suitable alignment with
short-term rates in major foreign money markets.
Experience in 1959-61 demonstrated that sizable shifts
in relative levels of short-term rates here and abroad can
quickly generate sizable international flows of some types
of liquid funds. During 1959, relatively high rates in the
United States, by attracting foreign commercial bank
funds into U.S. dollar liquid assets, helped to hold down
the drain on the U.S. gold stock caused by the deficit in
current and long-term capital transactions. In 1960, busi
ness cycle forces here and abroad helped to improve our
balance of payments on current account, but short-term
capital outflows — which were partly in response to rela
tively high interest rates abroad — made the gold drain
larger than it had been in 1959. In 1961, the outflows of
those types of short-term capital that are most strongly
affected by international differences in interest rates were
smaller again.
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THE FEDERAL RESERVE SYSTEM
In endeavoring to minimize the downward pressures on
short-term interest rates associated with an expansionary
monetary policy, the Federal Reserve regularly conducted
part of its open market operations, beginning in 1961, in
medium-term and long-term securities, as explained in
Chapter III. And at times it reduced the supply of bank
reserves in order to keep short-term rates firm. Without
these and other actions — such as those taken by the
Treasury in its management of the public debt — outflows
of some sorts of liquid funds to other countries would
have been larger, increasing the amount of gold sales
needed to finance the deficit in the balance of payments.
Operations in the Foreign Exchange Market
Partly to help deal with problems created by the deficit
in the balance of payments, the Federal Reserve System
began in early 1962 to buy and sell foreign currencies in
the exchange markets and in direct transactions with
foreign monetary authorities. The aims laid down for its
operations have included the smoothing out of abrupt
changes in exchange rates and also the prevention of
fluctuations in U.S. gold reserves or dollar liabilities due
to temporary forces acting in the markets. In addition,
two broader aims were set forth. One is to supplement
the international exchange arrangements made through the
International Monetary Fund. The other is to lay a basis
for new solutions for the long-run problem of inadequacy
of gold for meeting countries’ international reserve needs.
In the nature of things, these operations cannot have
any far-reaching influence on the factors ultimately re
sponsible for the balance of payments deficit. Federal Re
serve policy-makers recognized that adjustment of the
160
THE BALANCE OF PAYMENTS
balance of payments requires gradual changes in interna
tional cost-price relationships and in demand-supply
relationships in international capital and credit markets.
And they recognized that adjustment of the balance of
payments may require a considerable period of time.
Whatever contribution the Federal Reserve could make
to this long-run adjustment would flow from the effects
of monetary policies in influencing interest rates and
credit availabilities and in helping to maintain price
stability, rather than from exchange market operations.
But meanwhile, in connection with the need to sustain
world confidence in the dollar, it was necessary that shortrun disturbances of exchange markets by economic or
political events in one country or another be kept from
snowballing. With the U.S. balance of payments in deficit,
it was very important to set up bulwarks against cumula
tive speculative movements that might start a flight from
the dollar.
During 1961 the Federal Reserve Bank of New York,
acting as agent for the U.S. Treasury’s Exchange Stabiliza
tion Fund, had gained useful experience in operations in
the foreign exchange market. This experience demon
strated that official operations in foreign currencies could
help to moderate speculative movements of funds inter
nationally. Then in February 1962 the Federal Open
Market Committee decided that the Federal Reserve
Bank of New York should begin to undertake foreign
exchange operations on behalf of the System itself.
In actual practice Federal Reserve operations through
late 1963 were of quite limited size, but arrangements
had been made whereby large operations could be under
taken in case of need. The existence of these arrangements
161
THE FEDERAL RESERVE SYSTEM
was in itself a deterrent to speculative disturbances.
By December 1963, reciprocal currency agreements had
been negotiated with the central banks of eleven nations
and with the Bank for International Settlements. By these
arrangements, the Federal Reserve System put itself in a
position to obtain, on call, about $2 billion of foreign
currencies.
Under each arrangement, the System can obtain a
stated amount of foreign currency in exchange for a cor
responding amount of dollars. In the event of a drawing —
which may be requested by either party — the balances
acquired have to be repaid by the time agreed at the same
exchange rate. This protects each party from loss should
the other’s currency be depreciated. The balances ac
quired may be invested at a pre-agreed rate of interest
(the same for both parties) or they may be sold in the
exchange markets or to the other party to the swap. If
both parties concur, the agreements may be renewed any
number of times.
The swap arrangements are available for use by foreign
countries in case of need. In 1962 Canada drew U.S.
dollars, under its swap arrangement with the Federal
Reserve, in exchange for Canadian dollars, as part of a
series of measures it took to establish confidence in the new
par value of the Canadian dollar.
The Federal Reserve has used foreign currencies ac
quired under some other swap arrangements to buy
“excess” dollars from foreign central banks that the
latter had accumulated through intervention in the ex
change markets. As noted earlier, for reasons of law,
custom, or policy, some foreign central banks ordinarily
refrain from holding more than a certain amount or pro
162
THE BALANCE OF PAYMENTS
portion of their external reserves in dollars. At times when
dollar accruals to the official reserves of one or another
of these central banks have temporarily become very
large, perhaps because of seasonal influences or perhaps
because of short-run speculation, the Federal Reserve has
been able to forestall temporary gold movements. In
effect, foreign excess holdings of dollars are replaced —
through the swap drawing and the subsequent purchase
operation — by dollar assets that are protected against
exchange rate risk.
The foreign currencies drawn and used under the various
swap arrangements are ordinarily repaid to the foreign
institution concerned within a period of months, by making
use of foreign currency bought after the initial disturbance
has ended. The swap arrangement is then maintained on
a standby basis until a new occasion for making a drawing
arises. Thus, operations under swap agreements are de
signed primarily as a defense against speculative capital
flows and against temporarily accentuated gold drains.
163
CHAPTER IX
RELATION OF RESERVE BANKING T O G O LD . Cold
flows, which generally reflect balance o f payments conditions, are
an important influence on member bank reserves. Inflows o f gold
reduce the reliance o f banks on Federal Reserve credit, and outfows
o f gold increase it. Changes in the country's monetary gold stock
are refected in Federal Reserve Bank holdings o f gold certif cates.
HE previous chapter showed how the balance of pay
ments relates to reserve banking policy. Changes in
the U.S. gold stock generally reflect our balance of pay
ments position and thus must be taken into account, along
with the underlying causes of the changes, in the formula
tion of the over-all stance of monetary policy, whether it
be stimulative, restraining, or something in between.
In addition to its special relationship to the balance of
payments and its use as an international reserve, gold influ
ences Federal Reserve policies and operations in two ways.
First, reserves in gold constitute a statutory base for
Reserve Bank power to create Federal Reserve credit.
Second, changes in the U.S. gold stock affect the volume
T
165
THE FEDERAL RESERVE SYSTEM
of member bank reserves and the use of Federal Reserve
credit. This chapter explains the statutory role of gold
and the technical aspects of relationships between changes
in gold holdings and in the volume of member bank re
serves and Federal Reserve credit.
Gold as Reserve Money
In the U.S. monetary structure the standard unit of
value — the dollar — is defined by statute as a weight of
gold. Gold, however, is not coined into money, and cur
rency based dollar for dollar on gold — represented by
gold certificates — does not enter into public circulation
or into member bank reserves. Under the Gold Reserve
Act of 1934, private persons subject to U.S. jurisdiction
are not permitted to hold any gold for monetary pur
poses. Gold nevertheless functions as reserve money of
the Federal Reserve Banks. It also functions as a means
of settling international balances. These are the elements of
our modified gold standard.
The Treasury is custodian of all U.S. monetary reserves
held in the form of gold. Reserves of the Federal Reserve
Banks take the form of certificates representing the gold,
or of credits with the Treasurer of the United States pay
able in these gold certificates. As a technical matter, there
fore, Reserve Bank holdings of gold certificates are the
statutory base for its power to expand or extinguish
Federal Reserve credit.
Under existing law the Reserve Banks must hold a stipu
lated proportion of gold certificates as reserve against
their liabilities for notes and deposits, respectively. The
legal minimum for the gold reserve ratio is 25 per cent for
each category of liabilities. On September 30, 1963, the
166
RELATION TO GOLD
actual ratio was 31 per cent. This was above the statutory
minimum but was down sharply from earlier levels.
When the Treasury buys gold, it pays for this gold at
the established rate of $35 per fine troy ounce (exclusive
of handling charges) by drawing on its deposit account at
the Reserve Banks. Against the gold acquired, the Treas
ury credits an equivalent amount to the gold certifi
cate account, thus providing the basis for restoring its
deposit account at the Federal Reserve Banks. The new
gold certificates then provide the basis for additional
Federal Reserve credit.
The Treasury must hold gold at the rate of $35 an ounce
for all the gold certificates that it issues or credits to the
gold certificate account.1 Consequently, while the title
to the gold is in the Government, the greater part of it is
held as cover for gold certificates issued to the Federal
Reserve Banks or credited to their account. Only the Re
serve Banks may by law own gold certificates, and these
may not circulate outside the Reserve Banks.2
At the end of September 1963 the Treasury held $15.6
billion of gold, of which $15.3 billion was held as cover
for a corresponding amount of gold certificates or gold
certificate credits issued to the Federal Reserve Banks.
Of the remainder, $156 million was held as a reserve
against United States notes. In addition to the gold held
1 The amount of gold that the Treasury must hold as cover for each
dollar of gold certificates can be changed only by an Act of Congress.
2 However, about $20 million of gold certificates issued before the Gold
Reserve Act of 1934, and not turned in to the Treasury when gold and gold
certificates were withdrawn from circulation, were still regarded as out
standing in the official statistics on currency in circulation at the end of
1963. But according to an Act of Congress, approved June 30, 1961, the
Treasury is no longer required to hold gold as cover for the certificates
that were not returned from circulation as required by law.
167
THE FEDERAL RESERVE SYSTEM
by the Treasury, $53 million of gold was in the working
balance of the Exchange Stabilization Fund.
In addition to its responsibility as a buyer and holder
of monetary gold, the Treasury sells gold to foreign mon
etary authorities for settlement of international balances
or for other legitimate monetary purposes at the estab
lished price. Through these transactions foreign monetary
authorities may convert their dollars into gold to increase
their own gold reserves or to use in making international
payments. Similarly, foreign monetary authorities can
always acquire dollars, if they so desire, by selling gold to
the Treasury. The Treasury conducts its gold transactions
with foreign authorities through the Exchange Stabiliza
tion Fund.
168
RELATION TO GOLD
Until 1961 the United States used only one method to
limit fluctuations in exchange rates for the dollar in terms
of other currencies to the narrow range permitted under
the Articles of Agreement of the International Monetary
Fund. This method was for the U.S. Treasury to buy or
sell gold. Since then, however, both the Treasury and the
Federal Reserve have intervened from time to time in the
exchange market by buying and selling foreign curren
cies, as was discussed in Chapter VIII.
How Gold Is Monetized
The process by which gold produced in the United
States or sold by foreign holders reaches the Treasury and
is reflected in additions to the reserves of member banks
and Federal Reserve Banks is described below.
The gold is taken to a U.S. assay office or to a U.S. mint.
If the seller is a domestic producer, the Treasury pays for
the gold by check. The seller will deposit this check with
his bank, usually a member bank, which in turn deposits
it with a Reserve Bank, where the amount of the check is
added to the member bank’s reserve balance and charged
to the account of the Treasury. The Treasury will replenish
its account by crediting an equivalent amount to the Sys
tem’s gold certificate account, and this is credited to the
appropriate Reserve Bank. Assume that the gold is worth
$10 million. Then the gold stock of the Treasury, the gold
certificate account of the Reserve Bank, the reserve balance
of the member bank, and the bank deposit of the seller of
the gold will each increase by $10 million.
For many years movements of gold into and out of this
country’s monetary reserves have reflected almost exclu
sively transactions with foreign central banks, govern-
169
THE FEDERAL RESERVE SYSTEM
ments, and international institutions. When a foreign
official authority sells gold, the payment is made on the
books of the Federal Reserve Bank of New York by trans
fer from the account of the Treasury to the account of the
foreign authority, and there is no immediate increase in
member bank reserve balances and deposits. Such increases
will occur, however, when the foreign official authority
draws on its deposit account at the New York Bank to
provide funds for goods and services bought in American
markets, to invest in money market assets, or to transfer
funds to commercial banks for other reasons.3 The owner
ship of the newly gained gold certificate reserves becomes
distributed among the Reserve Banks as a result of these
various transactions.
On the other hand, when a foreign monetary authority
wants to acquire, say, $10 million of gold, it instructs the
Federal Reserve Bank of New York to charge that amount
to its deposit account and to pay the Treasury. Acting
as fiscal agent of the Treasury, the Reserve Bank then
obtains the gold from the assay office for transfer to the
foreign authority. In payment for the gold the Reserve
Bank withdraws the equivalent amount from its gold
certificate fund and charges the account of the Treasury
for the gold certificate credits surrendered. As a result of
these transactions, the gold certificate account of the
Reserve Bank and the gold holdings of the Treasury each
decline by $10 million.
Prior to actual purchase of the gold, the foreign authority
usually increases its account with the Reserve Bank by
3 Foreign deposits with Federal Reserve Banks are relatively small and
generally kept at a minimum needed for working purposes. Most of the
deposits of foreigners are at commercial banks.
170
RELATION TO GOLD
transferring the needed amount from the market, either
from existing deposits with member banks, generally
acquired through its own exchange market operations, or
from funds acquired through the sale of Treasury bills or
other investments it had been holding. In either case both
the deposits of member banks and their reserve balances
will be reduced by an equal amount.
For use in balancing their international accounts, foreign
central banks and governments hold large amounts of
dollar assets in various forms, mainly short-term U.S.
Government securities. As already indicated, they hold
relatively small demand deposits with the Federal Reserve
Bank of New York.
Gold transactions with foreign countries take place
regularly without a physical movement of gold into or
out of this country. A foreign monetary authority may
purchase gold from the United States and have it “ear
m arked,” or segregated, for its accou n t at the Federal
Reserve Bank of New York. Under such an arrangement
the gold is physically held in that Reserve Bank. Con
versely, a foreign authority may sell some of its earmarked
gold to the U.S. Treasury.
Earmarked gold belongs to foreign authorities. It is not
a part of the U.S. monetary gold stock. Foreign purchases
of gold to go into, and sales of gold to come out of, ear
marked accounts have the same effect on our banking
system as foreign purchases of gold for export and foreign
sales of newly imported gold. Transactions involving ear
marked accounts are spoken of as gold movements.
The process of monetizing gold described above is
essentially the same as when the Reserve Banks actually
held gold. The only difference is that the title to the gold
171
THE FEDERAL RESERVE SYSTEM
owned by the United States is in the Treasury and that
the Reserve Banks hold claims on it in the form of gold
certificates or a credit in the gold certificate account on the
books of the Treasury. The altered procedure has not
changed in any significant respect the ultimate effects of
gold flows on the reserves of Reserve Banks and member
banks and on bank credit and the total money supply.
Gold and Federal Reserve Operations
k
It has been shown that gold purchases or sales by the
United States increase or decrease the reserves of Reserve
Banks. It has also been shown that, disregarding transitory
lead-and-lag effects associated with the use by foreign
official authorities of deposit accounts at Reserve Banks,
gold purchases or sales by the Treasury affect the reserve
position of member banks and hence their ability to make
loans and investments and expand their deposits.
The ultimate effect on member bank reserves of gold
movements is thus the same as that of Federal Reserve
open market or discount operations. When gold flows in,
it increases member bank reserves in the same way as
would an equivalent amount of open market purchases or
discounts by the Reserve Banks; when gold flows out,
it reduces member bank reserves in the same way as
would the repayment of a discount by a member bank or
the sale of a security by a Reserve Bank. This is why
demand for Reserve Bank credit tends to diminish when
gold comes in and to increase when gold goes out.
Sometimes the Federal Reserve makes loans on gold to
foreign central banks. When the proceeds of such loans
are disbursed, this has the same effect on credit conditions
in this country as any other advance by a Reserve Bank.
172
RELATION TO GOLD
Federal Reserve operations can be used to offset the
effect of gold flows on member bank reserves. But if the
Federal Reserve cushion of “free” gold certificate hold
ings — that is, the excess of gold certificates over the
statutory minimum required as reserves against note and
deposit liabilities of the Federal Reserve Banks—were to
approach and then fall below the statutory minimum, to
what extent would this interfere with a stabilizing reserve
banking policy? During most of its existence, as the ac
companying chart shows, the Federal Reserve System has
had a sizable margin of “free” gold reserves, and the
reserve ratio has been in excess of the required ratio.
Thus, when expansion of Federal Reserve credit has been
173
THE FEDERAL RESERVE SYSTEM
needed, it has ordinarily not been hampered by a gold
reserve limitation. Nevertheless, questions about the rela
tion between the gold reserve requirement and reserve
banking policy are often asked, especially in periods of
decline in the U.S. gold stock, even though the answer is
clearly set forth in the Federal Reserve Act.
In effect the Act states that, if the ratio were to fall
below the statutory minimum, the Board of Governors
would have authority to suspend the reserve requirements,
initially for a period not exceeding thirty days and then
on renewal for successive periods not exceeding fifteen
days. In suspending the requirements, the Board of Gov
ernors must impose on the Reserve Banks a tax that varies
with the amount of the deficiencies. The tax could be
nominal as long as the deficiencies were confined to
reserves against deposits and the first 5 percentage points
of deficiency in the reserve against Federal Reserve notes.
For larger deficiencies, in the reserves against notes, the
tax would have to be increased rather steeply. Moreover,
the tax imposed because of deficiencies in reserves against
notes would have to be added to discount rates charged
by the Reserve Banks.
While the foregoing authority would provide adequate
leeway for the Federal Reserve to continue to be unham
pered by reserve limitations in its pursuit of policies
directed to orderly economic progress, the possibility that
such limitations might arise has in the past been a source
of public concern. For example, the decline in the Reserve
Banks’ ratio of reserves to combined note and deposit
liabilities during World War II threatened the Federal
Reserve’s freedom of policy action. In this situation the
Congress in 1945 deemed it wise to reduce the reserve
174
RELATION TO GOLD
requirements of the Reserve Banks from 40 per cent for
Federal Reserve notes and 35 per cent for deposits to 25
per cent for each kind of liability.
It should be pointed out here that as long as reserve
requirements against deposits at member banks are above
the statutory minima, the Federal Reserve System may
increase the margin of “free” gold certificates by lowering
these requirements. As member bank reserves declined in
consequence of such a lowering of requirements, the
amount of gold certificates that the Federal Reserve Banks
would be required to hold as reserves would be auto
matically reduced.
Unless offset by Federal Reserve action, changes in the
nation’s gold reserve position have a direct bearing on
the supply of bank credit. In deciding on particular ac
tions to carry out its policies, the Federal Reserve takes
into account the effect of gold flows on member bank
reserves.
175
CHAPTER X
RELATION OF RESERVE BANKING TO CURRENCY.
The Federal Reserve System is responsible fo r providing an elastic
supply o f currency. In thisfunction it pays out currency in response
to the public’s demand and absorbs redundant currency.
A N important purpose of the Federal Reserve Act was
to provide an elastic supply of currency — one that
would expand and contract in accordance with the needs
of the public. Until 1914 the currency consisted principally
of notes issued by the Treasury that were secured by gold
or silver and of national bank notes secured by specified
kinds of U.S. Government obligations, along with gold
and silver coin. These forms of currency were so limited
in amount that additional paper money could not easily
be supplied when the nation’s business needed it. As a
result, currency would become hard to get and at times
command a premium. Currency shortages, together with
other related developments, caused several financial crises
or panics, such as the crisis of 1907.
One of the tasks of the Federal Reserve System is to
177
THE FEDERAL RESERVE SYSTEM
prevent such crises by providing a kind of currency that
responds in volume to the needs of the country. The
Federal Reserve note is such a currency.
The currency mechanism provided under the Federal
Reserve Act has worked satisfactorily: currency moves
into and out of circulation automatically in response to an
increase or decrease in the public demand. The Treasury,
the Federal Reserve Banks, and the thousands of local
banks throughout the country form a system that dis
tributes currency promptly wherever it is needed and
retires surplus currency when the public demand subsides.
How Federal Reserve Notes Are Paid Out
Federal Reserve notes are paid out by a Federal Reserve
Bank to a member bank on request, and the amount so
paid out is charged to the member bank’s reserve account.
Any Federal Reserve Bank, in turn, can obtain the needed
notes from its Federal Reserve Agent, a representative of
the Board of Governors of the Federal Reserve System,
who is located at the Federal Reserve Bank and has
custody of its unissued notes.
The Reserve Bank obtaining notes must pledge with the
Federal Reserve Agent an amount of collateral at least
equal to the amount of notes issued. This collateral may
consist of gold certificates, U.S. Government securities,
and eligible short-term paper discounted or purchased
by the Reserve Bank. The amount of notes that may be
issued is subject to an outside limit in that a Reserve Bank
must have gold certificate reserves of not less than 25
per cent of its Federal Reserve notes in circulation (and
also of its deposit liabilities). Gold certificates pledged as
collateral with the Federal Reserve Agent and gold certifi
178
RELATION TO CURRENCY
cates deposited by the Reserve Bank with the Treasury
of the United States as a redemption fund for Federal
Reserve notes both are counted as a reserve against notes.
As our monetary system works, currency in circulation
increases when the public satisfies its larger needs by
withdrawing cash from banks. When these needs decline
and member banks receive excess currency from their
depositors, the banks redeposit it with the Federal Re
serve Banks, where they receive credit in their reserve
accounts. The Reserve Banks can then return excess notes
179
THE FEDERAL RESERVE SYSTEM
to the Federal Reserve Agents and redeem the assets they
had pledged as collateral for the notes.
As of mid-1963 the total amount of currency in circula
tion outside the Treasury and the Federal Reserve was
$35.5 billion, of which $30.3 billion — or six-sevenths —
was Federal Reserve notes. All of the other kinds of cur
rency in circulation are Treasury currency. Such currency
includes United States notes (a remnant of Civil War
financing), various issues of paper money in process of
retirement, silver certificates, silver coin, nickels, and cents.
Until 1963, Federal Reserve notes were not authorized
for issue in denominations of less than $5. Hence, all of
the $1 and $2 bills, as well as some bills of larger denomi
nations, were in other forms of paper money, chiefly silver
certificates and United States notes. A law passed in 1963
permits the Federal Reserve to issue notes in denom
inations as low as $1, and silver certificates will eventually
be retired.
All kinds of currency in circulation in the United States
are legal tender, and the public makes no distinction
among them. It may be said that the Federal Reserve has
endowed all forms of currency with elasticity since they
are all receivable at the Federal Reserve Banks whenever
the public has more currency than it needs and since they
may all be paid out by the Reserve Banks when demand
for currency increases. In the subsequent discussion
reference will be made to the total of currency in circula
tion rather than to any particular kind.
Demand for Currency
It has already been stated that the amount of currency
in circulation changes in response to changes in the pub180
RELATION TO CURRENCY
lie’s needs for pocket cash as against checking-account
balances at banks. These changes are substantial and fre
quent. The demand varies for different days of the week,
for different days of the month, and for different seasons.
In agricultural regions the need for currency is heavy at
times when crops are being harvested. Throughout the
country the need increases before holidays such as Inde
pendence Day, Labor Day, and Thanksgiving, when many
people take trips and need more pocket cash. There is an
extraordinary increase before Christmas, when cash is
used for Christmas shopping and as gifts. After the holi
days excess currency is deposited in the banks by the mer
chants, hotel keepers, and others with whom it has been
spent, and the banks in turn send it to the Reserve Banks.
181
THE FEDERAL RESERVE SYSTEM
In addition to seasonal changes in the demand for
currency, there are changes that reflect variations in busi
ness conditions. When business activity is rising, the need
for currency to make payments increases, and when busi
ness activity declines, the need for currency also declines.
Checks are used for most payments in this country, but
many payments are made in currency, especially those in
connection with retail trade and payrolls. Statistical
studies show that the amount of currency in circulation
fluctuates in response to changes in the volume of these
two kinds of payments.
During World War II the amount of currency in circu
lation increased greatly in response to a variety of influ
ences: the growth of payrolls, retail trade, and travel;
many and widespread changes in places of residence; pay
ments to members of the armed forces; larger incomes of
people not in the habit of using banks; and no doubt
hoarding of currency for various reasons. The demand for
additional currency subsided after the war, but during the
war in Korea in the early 1950’s, it strengthened again.
Over the ensuing years the amount of currency and coin
in circulation has continued to expand gradually as eco
nomic activity and the volume of transactions have grown
and as coin-operated machines have come into wide
spread use.
Effect o f Note Circulation on Banking System
From the point of view of the Federal Reserve and mem
ber banks, changes in currency in circulation have a special
significance that arises out of the system of reserve require
ments. As has been explained, reserve requirements are
expressed as percentages of bank deposits. If someone
182
RELATION TO CURRENCY
borrows, say, $1,000 from a bank and leaves it on deposit
to be transferred from bank to bank by check, the amount
of reserves that the banking system must hold increases
by only a fraction of this amount — for example, $200
if reserve requirements are assumed to be 20 per cent. If,
C U R R E N C Y A N D F ED E R A L R ESERVE CREDIT
1962
1963
on the other hand, the borrower withdraws the proceeds
of the loan in currency, the reserves of the bank — as
well as those of the banking system as a whole — decline
by the full $1,000.
If the banking system had no excess reserves, it would
have to obtain additional reserves whether the loan were
left on deposit or were withdrawn as currency. The addi
tional amount of reserves needed, however, would differ.
The increase would be only $200 in the case of the demand
183
THE FEDERAL RESERVE SYSTEM
for $1,000 of checking deposits, while it would be $1,000
in the case of demand for an equal amount of currency.
The Federal Reserve could supply the required reserves
needed by the banks by buying Government securities in
the open market, if this were considered desirable, or it
could lend the needed funds to member banks. Whichever
procedure were followed, Federal Reserve credit — that is,
Reserve Bank holdings of discounts and securities —
would increase.
When the demand for currency abates, currency flows
back to member banks and their reserves increase. Under
these circumstances the Federal Reserve can absorb re
dundant reserves by selling U.S. Government securities.
In general, the Federal Reserve System adjusts its open
market operations so that the outflow and return flow of
currency may take place with minimum tightening or
easing effects on the general credit situation.
Changes in the public’s demand for currency affect not
only the reserves of member banks but also the reserve
position of Federal Reserve Banks. When the public
elects to hold money in the form of currency rather than
as demand deposits at banks, this ties up more of the
Reserve Banks’ own reserves. For example, when the
public’s demand is for $1,000 in currency, the Federal
Reserve Banks pay out that amount of Federal Reserve
notes — and their reserve requirements increase by $250
(25 per cent of $1,000). If, however, the public’s demand is
for $1,000 in checking deposits, member bank reserves,
which are the deposits against which the Reserve Banks
must hold reserves, are required to increase by only $200,
and the reserves needed by the Reserve Banks increase by
only $50 (25 per cent of $200). Under the circumstances
184
RELATION TO CURRENCY
assumed, an increase in currency would tie up five times
as much of the Reserve Banks’ reserves as would an
identical increase in bank deposits.
While the Federal Reserve pays out currency in response
to the demand of the public and absorbs any currency the
public does not need, it should not be concluded that the
volume of currency in circulation is free of influence by
the Federal Reserve. The policies pursued by the Federal
Reserve affect the total volume of money in the econ
omy — that is, the amount of currency in circulation plus
the amount of checking deposits. Thus, in providing the
economy with an elastic currency, the Federal Reserve
must endeavor to see that the two forms of money together
are appropriately related to the volume of production and
trade. This means that their combined total should be
neither so large as to foster an excessive demand for goods
nor so small as to cause a deficiency in aggregate demand.
185
CHAPTER XI
BALANCE SHEET OF THE FEDERAL RESERVE BANKS.
Federal Reserve Junctions are rejected in the consolidated balance
sheet ojth e Reserve Banks, known as the weekly condition statement.
This statement shows how much Federal Reserve credit is being used
and the key items that account fo r its use.
AJOR reserve banking functions are reflected in the
consolidated balance sheet of the twelve Federal
Reserve Banks. The balance sheet, one of the most com
plete statements of its kind, is released every Thursday
and shows the condition of the Reserve Banks at the end
of the preceding day. The statement, known generally as
the weekly condition statement, appears in the Friday
issue of the principal daily newspapers of the country and
is usually accompanied by explanatory comment.
The condition statement of the Federal Reserve Banks
is necessarily complex because its purpose is to provide
an accounting summary of all phases of Federal Reserve
operations and to show, in some detail, the use of Federal
Reserve credit. The nation’s demand for money converges
M
187
THE FEDERAL RESERVE SYSTEM
on commercial banks, especially the member banks, and
through them on the Reserve Banks. Accordingly, much
can be learned about current banking and financial trends
by following changes in the principal items of the statement
from week to week.
The balance- sheet of the Federal Reserve Banks for
July 3, 1963, in condensed form, is presented on the
opposite page. In order to include some items that are
eliminated in the consolidation process, the balance sheet
used here is the combined one. The major items on it are
printed in capital letters. Explanation of its items pro
vides both a review of many important points made in
earlier chapters and an opportunity to mention some
technical aspects of Federal Reserve operations not hereto
fore dealt with.
Explanation o f Asset Accounts
1. G old C ertificate R eserves. Although the law does
not permit the Federal Reserve Banks to own gold and
does not permit gold certificates to circulate, it does
authorize the Treasury to issue gold certificates to the
Reserve Banks. Gold certificate reserves consist of these
gold certificates, of credits on the books of the Treasury
payable in gold certificates, and of the redemption funds
for Federal Reserve notes, which the Reserve Banks are
required by law to maintain on deposit with the Treasury.
2. Federal Reserve notes of other Reserve Banks. When
one Reserve Bank receives notes of another Reserve Bank,
it may pay them into circulation if they are fit. If they are
not fit for further circulation, it forwards them to the U.S.
Treasury for retirement. This item represents notes held
temporarily or in transit to Washington for retirement.
188
BALANCE SHEET OF RESERVE BANKS
Combined B alance Sheet of the R eserve B anks
July 3, 1963
Millions
of dollars
ASSETS
1.
2.
3.
4.
5.
6.
G old C ertificate R eserves.............................................
15,457
246
338
565
Federal Reserve notes of other Reserve Banks..................
Other cash...........................................................................
D iscounts for M ember Banks ..........................................
Other discounts and advances............................................
Acceptances........................................................................
7. U.S. G overnment Securities:
(a) Bought outright........................................................
(b) Held under repurchase agreement...........................
8. C ash I tems in P rocess of C ollection .............................
9. Other assets.........................................................................
32,289
394
6,779
501
T otal A ssets..................................................................
56,613
44
LIABILITIES
10. F ederal R eserve N otes...........................................................
11. D eposits:
(a) Member bank reserves....................................................
(b) U.S. Treasurer — general account..............................
(c) Foreign.............................................................................
(d) Other.................................................................................
12. D eferred A vailability C ash I tems.......................................
13. Other liabilities............................................................................
30,976
T otal L iabilities.....................................................
55,091
17,538
884
167
192
5,257
77
CAPITAL ACCOUNTS
14. Capital paid in....................................................................
15. Surplus................................................................................
16. Other capital accounts........................................................
481
934
107
T otal L iabilities and C apital A ccounts .............
56,613
17. T he R eserve R atio (per cent)............................................
31.1
In a consolidated balance sheet of the Reserve Banks, this
item would disappear, since the asset of one Bank is a
liability of another.
3. Other cash is coin and paper money (other than gold
189
THE FEDERAL RESERVE SYSTEM
certificates and Federal Reserve notes) in the Reserve
Bank vaults.
4. D iscounts for M ember B a n k s , an item of great
interest to the money and financial markets, represent the
amount of Federal Reserve credit that member banks
obtain at their own initiative through borrowing and for
which they have a direct repayment responsibility. Most
member bank borrowings from Federal Reserve Banks, as
explained in Chapter III, represent short-term advances
secured by Government securities. This reflects in part
the key role of U.S. Government securities among bank
assets and in part the greater convenience of using them
as collateral. Borrowing against Government securities or
other eligible paper is done at the established discount
rate; borrowing secured by other collateral satisfactory
to Reserve Banks is charged a rate not less than one-half
of a percentage point higher.
5. Other discounts and advances include, first, loans
secured by gold made to foreign monetary authorities and,
second, advances to individuals, partnerships, and corpora
tions on the security of direct obligations of the United
States. It is under the authority for this second type of
advance that the Reserve Banks may lend to nonmember
banks as well as other institutions against Government
securities as collateral, subject to such regulations as the
Board of Governors may prescribe. Rates on such loans
are higher than the rates charged member banks. Loans
to foreign monetary authorities secured by gold are made
at the prevailing discount rate. As of July 3,1963, no credits
of either type were outstanding.
6. Acceptances are prime bankers’ acceptances pur
chased by the Federal Reserve Banks in the open market
190
BALANCE SHEET OF RESERVE BANKS
from acceptance dealers at prevailing interest rates. Some
times such purchases are made under repurchase agree
ment whereby the seller agrees to buy them back within
fifteen days or less.
7. U .S . G overnment S ecurities comprise Treasury
bills, certificates of indebtedness, Treasury notes, and
Treasury bonds. Since Reserve Bank purchases of Govern
ment securities are the principal means by which the
Federal Reserve can create Reserve Bank credit on its own
initiative, changes in Reserve Bank holdings of these
securities are watched closely by observers in the credit
market. A breakdown of holdings, by type of security, is
shown each week in the published statement.
Reserve Bank holdings sometimes include Government
securities purchased from nonbank dealers with the agree
ment that dealers will repurchase them within a specified
period of fifteen days or less. The Federal Reserve System
makes repurchase arrangements available in periods of
temporary credit stringency to help meet market needs
for reserve funds and for credit when dealer inventories of
Government securities are unusually large. Use of the
facilities, when made available by the System, is at the
initiative of the dealers. On July 3, 1963, the Reserve Banks
held $394 million of Government securities under repur
chase agreements with dealers.
The law authorizes the Reserve Banks to hold at any
one time as much as $5 billion of Government obligations
acquired directly from the Treasury. These direct borrow
ings by the Treasury are infrequent and of very short
duration. They grow out of temporary imbalances between
the inflow and outflow of Treasury funds. The Treasury
draws checks for current payments on deposit accounts
191
THE FEDERAL RESERVE SYSTEM
held with the Reserve Banks. Just before tax collection
dates, these accounts sometimes fall below desirable work
ing levels. Because Treasury accounts at commercial banks
through which tax payments are received may also be low
at these times, the Treasury may be without adequate funds
for a few days to replenish its Reserve Bank balances.
When its balances fall below working levels, the Treas
ury may sell special short-term certificates of indebtedness
to Federal Reserve Banks to forestall a temporary over
draft in the Treasury’s checking accounts. When such obli
gations are outstanding on the Wednesday statement date,
they are reported separately in the condition statement.
8. C ash I tems in P rocess of C ollection are checks and
other cash items deposited with the Federal Reserve Banks
and in process of collection on the date of the statement.
The item has a counterpart in a technical account on the
liability side of the statement, described as D eferred
A vailability C ash I tems. The relationship of these two
accounts yields a measure of a type of Federal Reserve
credit, called “float,” generated by the Reserve Banks
in rendering collection services to member banks; float
is further explained on page 194 under liabilities.
9. Other assets for this condensed statement consist of
accrued interest and other accounts receivable, premium
on securities owned, balances due from foreign central
banks (including convertible foreign currencies acquired
under “swap” agreements), bank premises, and various
items of lesser significance.
Explanation o f Liability Accounts
10. F ederal R eserve N otes, which are the principal
type of currency in circulation, are liabilities of the Federal
192
BALANCE SHEET OF RESERVE BANKS
Reserve Banks secured by specific collateral, as explained
in Chapter X. They are a first lien on all the assets of the
issuing Reserve Bank. Changes in the amount of Federal
Reserve notes in circulation occur in accordance with
changing demands of the public for currency and with
member bank holdings of vault cash.
11. D eposits consist for the most part of the reserve
accounts of member banks. The aggregate of the member
banks’ balances in these accounts, along with their vault
cash, constitutes the operating base of the banking system.
The Federal Reserve influences the total flow of bank loans
and investments by conducting its own operations in such
a way as to regulate the volume of its deposit liabilities
to member banks, while at the same time supplying to
banks the amount of Federal Reserve notes needed for
their own vault cash and for the public’s hand-to-hand
circulation.
The checking accounts of the U.S. Treasury, which it
uses to make payments for Government purchases of
goods and services, make up the second category of deposit
liabilities. Weekly changes in the Treasury’s deposit account
are often fairly sizable. Although directly related on
occasion to accompanying changes in other balance sheet
accounts, these week-to-week changes are most often
reflected in opposite changes in the reserve accounts of
the member banks.
The Treasury also maintains deposit accounts with
approved commercial banks for receiving taxes and the
proceeds of securities sold to the public. These accounts
are commonly known as tax and loan accounts. The
Treasury’s established practice is to maintain large enough
balances in its checking accounts at the Reserve Banks to
193
THE FEDERAL RESERVE SYSTEM
meet its current payments. It transfers funds from its
commercial bank accounts into its checking accounts in
accordance with its schedule of payments. Whenever the
Treasury account at the Reserve Banks exceeds desired
working levels, the excess may be redeposited with com
mercial banks. By carrying the bulk of its deposits in tax
and loan accounts, the Treasury moderates the effect on
bank reserves of fluctuations in its receipts and payments.
Deposits of foreign central banks and governments are
the third category. These deposits are maintained with the
Reserve Banks for international settlement and foreign
monetary reserve purposes. Changes in the total of these
deposits likewise affect member bank reserves. Such
changes may also be immediately associated with changes
in other accounts, particularly in gold certificate reserves,
when the Treasury buys or sells gold.
Nonmember banks that pay at par checks submitted to
them by Reserve Banks may keep check-clearing accounts
with the Reserve Bank of their district as a matter of
convenience. These accounts are part of the fourth main
category, “other” deposit liabilities. Other depositors whose
balances are reflected here include certain Government
agencies and international organizations.
12. D eferred A vailability C ash I tems was men
tioned on page 192 as the counterpart of C ash Items in
P rocess of C ollection , an asset account. The former
arises from the fact that Reserve Banks do not give
immediate credit for all checks deposited with them for
collection. The credit is deferred according to a schedule
that allows time for out-of-town checks to go through the
mail or by other transfer media to the banks on which
they are drawn. The maximum period for credit to be
194
BALANCE SHEET OF RESERVE BANKS
deferred is now two business days. After that, the member
bank’s reserve account is automatically credited.
Since the time actually taken to collect checks is often
longer than that allowed in the schedules, this crediting
frequently occurs before the account of the bank on which
the check is drawn is debited. The difference between the
asset account (cash items in process of collection) and the
liability account (deferred availability cash items) repre
sents checks that, although not yet collected by the Reserve
Banks, have already been credited, in accordance with a
specified time schedule, to the reserve accounts of the banks
that deposited them. This difference, which is sometimes
sizable, measures the amount of Federal Reserve credit or
float generated by the national check collection process
and available to the member banks.
13. Other liabilities consist principally of unearned dis
count on notes and securities, miscellaneous accounts
payable, and dividends accrued between the semiannual
dividend payment dates.
Explanation o f Capital Accounts
14. Capital paid in. When a bank is admitted to mem
bership in the Federal Reserve System, it is required to
pay for capital stock of the Reserve Bank of its district
an amount equal to 3 per cent of its own capital stock and
surplus. The shares do not carry the power through voting
to control the management of the Reserve Bank as does
ordinary stock in private banks or corporations. The mem
ber banks are entitled by statute to a cumulative divi
dend of 6 per cent per annum on the paid-in value of their
stock. Ownership of Reserve Bank stock may not be trans
ferred, nor may the owning bank hypothecate its shares.
195
THE FEDERAL RESERVE SYSTEM
15.
Surplus represents retained net earnings of the
Reserve Banks. The Reserve Banks may draw on their
surplus to meet deficits and to pay dividends in years when
operations result in loss, but they may not distribute it
otherwise to the stockholding member banks.
DISPOSITION OF FEDERA L RESERVE BANK E A R N IN G S
1914-62
While the Federal Reserve Banks earn an income, their
operations are not carried on for this purpose but are
determined by Federal Reserve credit and monetary
policies. Over the years most of their income above
amounts needed to cover expenses, including expenses of
the Board of Governors in Washington and the 6 per cent
statutory dividend to members, has been paid to the
Treasury. Since the surplus account has come to be
196
BALANCE SHEET OF RESERVE BANKS
approximately double the paid-in capital stock account,
no further additions are being made to it, except when
necessary to maintain this relationship with capital. The
law provides that, if the Reserve Banks are dissolved, any
surplus is to be paid to the U.S. Government.
16.
Other capital accounts comprise unallocated net
earnings for the year to the date of the statement.
The Reserve Ratio
As explained in Chapter IX, Reserve Bank holdings of
gold certificates constitute their legal reserves and provide
the statutory limit to the expansion of Federal Reserve
credit. In recognition of the reserve function of gold, the
reserve ratio of the Reserve Banks is published regularly as
a memorandum item on their condition statement (item 17
in the statement on page 189).
Use o f Federal Reserve Credit
The Federal Reserve Banks are not operated to make a
profit, and they do not extend additional credit simply
because they have enough reserves to do so. The use of
Federal Reserve credit is determined principally by the
policy pursued in the public interest by the Federal Re
serve authorities to encourage or discourage the expansion
of bank credit and money.
The degree to which Federal Reserve credit is extended
depends on movements in other factors that affect com
mercial bank reserves and hence the ability of banks to
lend or invest and expand the money supply. How the
use of Federal Reserve credit varies with changes in these
other factors affecting bank reserves is discussed in
the next two chapters.
197
CHAPTER XII
THE BANK RESERVE E Q U A T IO N . Federal Reserve credit,
gold, and currency in circulation are the principal factors that
influence the volume o f member bank reserves— the basis o f bank
credit and the money supply. The relationship among thesefactors,
together with other more technical ones, is sometimes called the
bank reserve equation.
EMBER bank reserves and all of the factors that
affect their volume can be combined into a bank
reserve equation. In this equation, simplified in presenta
tion on page 200, factors supplying member bank reserve
funds are set opposite factors absorbing such funds. The
various factors come partly from the combined balance
sheet of the Federal Reserve Banks and partly from the
Treasury’s accounts. Together they reflect the numerous
forces in the country’s economic life that affect the activi
ties of the banking system.
Over the longer run, the major factors affecting member
bank reserves are Federal Reserve credit, the monetary
gold stock, and currency in circulation. Other factors,
M
199
THE FEDERAL RESERVE SYSTEM
which are less important in the long run, include Treasury
currency; Treasury cash accounts; and nonmember bank,
foreign, and other accounts at the Federal Reserve.
Any of the factors in the bank reserve equation can
increase or decrease member bank reserves. On the one
hand, inflows of gold, decreases in currency in circulation,
F actors in the B ank R eserve E quation, M arch
(Averages of daily figures. In billions of dollars)
1963
Factors supplying reserve funds:
Monetary gold stock..................................................
Federal Reserve credit...............................................
Treasury currency......................................................
15.9
32.5
5.6
Total...................................................................
54.0
Factors absorbing reserve funds:
Currency in circulation1........... ................................ 31.6
Treasury cash accounts..............................................
1.3
Nonmember bank, foreign, and other accounts at the
Federal Reserve..............................................
1.4
Total...................................................................
34.3
Member bank reserves..............................................
19.5
Total...................................................................
54.0
1 Currency in circulation outside the Treasury, Federal Reserve, and
member banks. See also notes to table on p. 211.
N ote. — Details may not add to totals because of rounding.
and increases in Federal Reserve credit add to these re
serves; on the other hand, outflows of gold, increases in
currency in circulation, and contraction of Federal Reserve
credit decrease them. Each of these factors, and indeed
other more technical ones, may be highly variable over
short periods. The interaction of short-run variations is
considered in the chapter that follows. This chapter dis200
BANK RESERVE EQUATION
cusses the longer-run interplay of the major factors in
order to put the role and function of Federal Reserve
credit in clear perspective.
As shown in the table, gold and Federal Reserve credit
account for most of the supply of reserve funds. In addition
to member bank reserves, currency in circulation accounts
for most of the use of reserve funds.
The relative importance of these major factors changed
from time to time over the 1934-62 period, as shown in the
chart on page 203. Through 1941 the dominant factor was
growth in the gold stock, whereas during the war the pre
dominant influences were increases in currency in circula
tion and in Federal Reserve credit. Between 1945 and 1958,
changes in these factors were smaller and more varied than
in other periods. Beginning in 1958 the principal factors
were an increase in Federal Reserve credit and a decrease
in the gold stock.
Interplay o f Bank Reserve Factors
Gold flows are greatly affected by forces outside Federal
Reserve regulation. They necessarily depend on inter
national economic, financial, and political forces as well
as on forces of domestic origin. Currency movements are
influenced primarily by the level of business activity and
by the habits and preferences of the public for currency.
Federal Reserve credit is the balance wheel between these
two more or less independent factors and member bank
reserves. The extent to which the Federal Reserve System
uses its credit powers depends on current Federal Reserve
policy and on changes in bank reserves caused by gold or
currency movements.
If the effect of gold and currency movements on bank
201
THE FEDERAL RESERVE SYSTEM
reserves is in harmony with current credit and monetary
policy, Federal Reserve action to offset these movements
will not be necessary. If the effect of the two independent
factors is not in harmony with current policy, the System
will take offsetting action. Thus, the kind of policy being
pursued by the Federal Reserve — whether one of ease or
one of restraint — may be associated with either increases
or decreases in Federal Reserve credit, depending on the
movements in other factors in the reserve equation.
Suppose the Federal Reserve is attempting to ease mar
ket conditions and to increase the reserves of commercial
banks. If other factors are not adding to bank reserves, the
Federal Reserve will buy Government securities, thus in
creasing reserve funds by the amount of the purchase. A
policy of ease will then be associated with a rise in Federal
Reserve credit.
Suppose, on the other hand, that large foreign sales of
gold to this country and large inflows of currency to banks
occur at a time of ease in current reserve banking policy.
This reduces the need for Federal Reserve credit. These
gold and currency movements may even be so large as to
create reserve conditions that are too easy in view of
domestic economic developments. Under these circum
stances the Federal Reserve will temper the excessive easing
of credit conditions by selling securities. A policy of ease
will then be associated with some decline in Federal Re
serve credit, because other factors will have contributed
more than enough to an appropriate easing of member
bank reserve positions.
Member bank reserves, although affected by the three
other principal factors in the bank reserve equation, are
not an entirely passive element. They respond to economic
202
BANK RESERVE EQUATION
BANK RESERVE E Q UA TI O N
B illio n s of d o llars
M A J O R F A C T O R S S U P P L Y IN G R E S E R V E FU N D S
F ED E R A L R ESER V E
C R ED IT
/-
--- ----------
M A JO R F A C T O R S U S IN G R E S E R V E F U N D S
C U R R E N C Y IN
C IR C U LA T IO N
M EM BER B A N K
R ES ER V E B A L A N C E S
W O R LD
W AR
P O S T -A C C O R D
n
1935
1940
1945
1950
1955
1960
203
THE FEDERAL RESERVE SYSTEM
forces that are not necessarily reflected in gold or currency
movements, and their independent impulses may be re
flected in member bank borrowing from the Reserve Banks.
For instance, at times of vigorous demand for credit and
consequent growth in bank loans and deposits, member
banks need more reserves. This need, if not being met by
other factors, expresses itself in a demand at the discount
window for more Federal Reserve credit.
The type of Federal Reserve action taken in response to
all these influences depends in general upon economic con
ditions and the desirability at the time of enlarging the
flow of credit and money. The Federal Reserve ordinarily
supplies its credit through some combination of open mar
ket purchases and additional discounts, but it may also
meet the demand by reducing the reserve requirements of
member banks.
Prewar Changes in Member Bank Reserves
A brief account of the interplay of the major factors in
the bank reserve equation over the past three decades will
illustrate the usefulness of the equation approach. How
these factors affected member bank reserves from mid1934, which was shortly after adjustment of the monetary
system to gold revaluation, until the United States entered
World War II is shown in the following table.
It will be seen that the principal factor supplying re
serve funds was a huge increase in the gold stock and that
the principal factor absorbing reserve funds, aside from
member bank reserves, was the growth in currency in
circulation. This was a period of world depression and of
unsettled political conditions abroad. As the nation’s man
power and other resources were continuously underem
204
BANK RESERVE EQUATION
ployed, the Federal Reserve pursued a policy of monetary
ease to encourage their fuller utilization. With gold in
flows adding to reserve funds, this policy was effectuated
with little net change in Federal Reserve credit.
M ajor F actors in B ank R eserve E quation
C hange, June 1934 - D ecember 1941
(Monthly averages of daily figures. In billions of dollars)
Factors supplying reserve funds :
Increase in gold stock................................................
14.9
Factors absorbing reserve funds:
Increase in currency in circulation1...........................
Reduction in Federal Reserve credit.........................
Other factors (net).....................................................
5.6
0.1
0.2
Total.......................................................................
5.9
Increase in member bank reserves.............................
9.0
Total.......................................................................
14.9
1 Currency in circulation outside the Treasury and Federal Reserve. See
also notes to table on p. 211.
The effect of the gold movement on member bank re
serves was substantial, and excess reserves became large.
And they remained large even though the Federal Reserve
authorities raised the reserve requirements of member
banks as economic recovery progressed. Over this entire
period, banks made almost no use of Reserve Bank dis
count facilities.
War and Postwar Adjustment Periods
After the United States entered the war and began to
provide exports under lend-lease, foreign sales of gold to
205
THE FEDERAL RESERVE SYSTEM
this country stopped. After the war there was some further
rise in gold reserves, but taking the war period and the
postwar adjustment period as a whole, gold movements
were a factor operating on balance to absorb member bank
reserves as the following table shows.
M ajor F actors in B ank R eserve E quation
C hange, D ecember 1941 - M arch 1951
(Monthly averages of daily figures. In billions of dollars)
Factors supplying reserve funds:
Increase in Federal Reserve credit.............................
Other factors (net).....................................................
21.3
2.2
Total.......................................................................
23.5
Factors absorbing reserve funds:
Increase in currency in circulation1...........................
Decrease in gold stock..............................................
16.2
0.9
Total.......................................................................
17.1
Increase in member bank reserves.............................
6.4
Total.......................................................................
23.5
1 Currency in circulation outside the Treasury and Federal Reserve. See
also notes to table on p. 211.
The major factors affecting member bank reserves over
these abnormal years were the increases in Federal Reserve
credit and in currency in circulation, most of which
occurred during the war. During that period the Federal
Reserve System, in support of war finance, undertook to
supply enough Federal Reserve credit to enable the bank
ing system to purchase Government security offerings not
taken up by nonbank investors, to counteract the drain on
member bank reserves from the increase in currency in
circulation, and to support the more than doubling of
206
BANK RESERVE EQUATION
commercial bank deposits. Another objective of Federal
Reserve operations during the war period was to maintain
a stable credit market so that Government and essential
industry could obtain credit promptly and cheaply. To
accomplish these purposes the Federal Reserve supplied
credit freely through open market operations.
The Federal Reserve authorities carried over into the
postwar period a policy of supporting prices of Govern
ment securities at close to par, thus maintaining a high
degree of yield stability in this and other sectors of the
credit market and continuing a policy of credit and
monetary ease. In this situation Federal Reserve credit was
freely available at the call of the market, and banks and
other holders of Government securities were able readily
to adjust their operating positions by selling these securi
ties. Member banks had little need for borrowing at Re
serve Banks.
There was a growing recognition in this period that
Federal Reserve support of Government securities prices
and yields at arbitrary levels was incompatible with effec
tive Federal Reserve regulation of the volume of bank
reserves. In March 1951 the Treasury and the Federal
Reserve agreed on discontinuance of the policy. The major
objective of the accord was to minimize the creation of
reserve funds at the initiative of banks and other investors
who might sell Government securities to the Federal Re
serve at pegged prices and yields.
Post-Accord Period
Beginning in 1951, Federal Reserve operations were re
adapted to the flexible use of its general methods of influ
encing bank reserve positions in accordance with the sea
207
THE FEDERAL RESERVE SYSTEM
sonal, cyclical, and growth needs of the economy for bank
credit and money. Over the next seven years, changes in
Federal Reserve credit reflected a combination of open
market operations, discount operations, and changes in
reserve requirements. The net changes affecting bank re
serve positions were relatively small, with a moderate
growth of currency in circulation approximately offset by
other factors, as shown in the following table. Nevertheless,
M ajor F actors in Bank R eserve E quation
C hange , M arch 1951 - M arch 1958
(Monthly averages of daily figures. In billions of dollars)
Factors supplying reserve funds:
Increase in Federal Reserve credit.............................
Increase in gold stock................................................
Other factors (net).....................................................
0.9
0.6
1.4
Total.......................................................................
2.9
Factors absorbing reserve funds:
Increase in currency in circulation1...........................
3.4
Decrease in member bank reserves..............
Total......................................................................
0.5
2.9
1 Currency in circulation outside the Treasury and Federal Reserve. See
also notes to table on p. 211.
over this period bank credit and money continued to grow
as reductions in legal reserve requirements enabled banks
to use existing reserves for credit expansion; as increased
public preferences for time deposits, which have low re
serve requirements as compared with demand deposits,
also freed some existing reserves; and as banks economized
somewhat further on excess reserve balances.
During this interval there were two periods of cyclical
economic expansion — from mid-1952 to mid-1953 and
208
BANK RESERVE EQUATION
from late 1954 to the early fall of 1957. And there were two
short periods of economic recession — from mid-1953 to
late 1954 and from the fall of 1957 to the spring of 1958.
These cyclical movements, shown by the fluctuations in
total output of factories and mines in the chart, called for
changes in Federal Reserve policy.
P R O D U C T IO N A N D PRICES
IN D USTRIAL PROD UCTIO N
'
WHOLESALE
C O M M O D I T Y PRICES
In the expansion periods Federal Reserve policy first
encouraged increases in bank credit and money; then after
expansion gained momentum and inflationary tendencies
developed, it restrained such increases. Restraint was
effected by limiting the provision of bank reserves through
open market operations. Under these circumstances, with
demand for bank credit strong, member banks borrowed
209
THE FEDERAL RESERVE SYSTEM
more at the discount windows of Reserve Banks. In both
the 1952-53 and 1955-57 periods their borrowings rose to
more than $1 billion. While discount rates were raised only
once during the 1952-53 expansion, they were raised seven
times during the 1955-57 expansion — from U/ 2 per cent
to 31 / 2 per cent.
As expansions tapered off and during the recession
periods, the Federal Reserve used open market purchases,
and also reductions in reserve requirements, to provide
member banks with reserves and thus to ease credit availa
bility and stimulate expansion of bank credit. Member
banks paid off much of their borrowing at Reserve Banks
in the recession periods, and the Reserve Banks lowered
their discount rates along with declines in market rates.
Emerging Balance o f Payments Problem
During the years from 1958 to 1963, there was a sub
stantial outflow of U.S. gold. Meanwhile currency in
circulation continued to expand. These two factors ab
sorbing reserves were counteracted by an increase in
Federal Reserve credit, as the table indicates, and by the
increased availability of reserves in 1959-60 when regula
tions were amended to permit member banks to count
vault cash in meeting their reserve requirements.
In the spring of 1958 monetary policy was designed to
stimulate credit expansion because the U.S. economy was
in a recession. Between the summer of 1958 and the autumn
of 1959, as economic recovery progressed, a policy of ease
turned gradually to one of restraint. Member banks in
creased their borrowings from the Reserve Banks to about
$1 billion, and there was a series of increases in Federal
Reserve Bank discount rates.
210
BANK RESERVE EQUATION
Monetary policy in the United States came to be in
fluenced more and more by the large and persistent deficit
in the balance of payments that began in 1958 and by the
objective of minimizing the related outflow of gold, as well
as by the needs of the domestic economy. During and after
1960 in particular, outflows of short-term funds from the
M ajor F actors in B ank R eserve E quation
C hange, M arch 1958 - M arch 1963
(Monthly averages of daily figures. In billions of dollars)
Factors supplying reserve funds:
Increase in Federal Reserve credit.............................
Vault cash amendments (amounts added to reserves
on effective dates)1.............................................
Other factors (net).....................................................
2.2
0.5
Total.......................................................................
10.6
Factors absorbing reserve funds:
Decrease in gold stock..............................................
Increase in currency in circulation2...........................
6.6
3.2
Total.......................................................................
9.8
Increase in member bank reserves.............................
0.8
Total.......................................................................
10.6
7.9
1 In three stages, between November 1959 and November 1960, member
banks were gradually permitted to count all of their vault cash in meeting
reserve requirements.
2 As a result of the changes described in note 1, after November 1960 the
“currency in circulation” figure that affected reserves became currency
outside of the Treasury and Federal Reserve Banks and currency other
than vault cash held by member banks. Before November 1959, all cur
rency outside of the Treasury and Federal Reserve Banks affected reserves.
The figure here is a construct that reflects the gradual effect of the vault
cash changes on the relevant currency measure.
United States to foreign countries added to the payments
deficit, and monetary policy began to make efforts to keep
short-term interest rates in the United States from falling
so low that outflows would be further encouraged.
211
THE FEDERAL RESERVE SYSTEM
In 1960 and early 1961 there was a mild recession, but
short-term interest rates did not decline so much as they
had in earlier recessions. This was due in part to the mild
ness of the recession but also in part to official policy,
which was influenced by the relation of interest rates to the
balance of payments deficit. The discount rate was reduced,
but only from 4 to 3 per cent. There were no changes in
reserve requirements during the recession, but within this
period member banks were permitted to count all their
currency holdings in meeting reserve requirements.
The economy began to recover in 1961, and the expan
sion continued into 1963. While the volume of industrial
production increased considerably, the output of the econ
omy remained below its capacity and in mid-1963 unem
ployment was still substantial. In contrast with previous
periods of increased output, therefore, the Federal Reserve
followed a policy of monetary ease for a much longer time.
Bank credit expanded rapidly; member bank borrowings
from the Reserve Banks remained comparatively low; and
market rates of interest showed little change as compared
with other periods of cyclical expansion.
In supplying reserves for domestic economic expansion,
the Federal Reserve also took account of the persistent
deficit during the period in the balance of payments, which
was reflected in a large gold outflow. To offset the reserve
absorbing effects of this outflow, the Federal Reserve pro
vided some credit through market purchases of inter
mediate- and long-term securities, as explained in earlier
chapters. This helped to minimize the downward pressures
on short-term interest rates from such operations. In the
fall of 1962 it also supplied reserves by reducing reserve
requirements on time deposits.
212
BANK RESERVE EQUATION
Concluding Comment
The foregoing analysis indicates how the major long-run
factors in the bank reserve equation are related, and how
ups and downs in any one of them may be offset by changes
in the others or may be reflected in changes in member
bank reserves. The discussion has also brought out how
Federal Reserve operations may be adjusted to changes in
the various factors affecting bank reserves.
Students of monetary and banking developments can
gain considerable insight into the developments of any
particular period by arranging and analyzing the monetary
factors in terms of the bank reserve equation. The data for
these factors are published each month in the Federal Re
serve Bulletin.
213
CHAPTER XIII
SHORT-TERM CHANGES IN BANK RESERVES. Reserve
banking policy responds to all o j the elements that affect mem
ber bank reserve positions. Af u ll accounting o j bank reservefactors
is published each week in a table accompanying the Reserve Bank
condition statement.
ISCUSSION of the bank reserve equation in Chapter
XII dealt with the factors—gold, currency in circu
lation, and Federal Reserve credit—that have been central
in longer-run changes in the general level of member bank
reserves. Significant short-run or week-to-week changes in
the reserve position can be caused by still other elements,
such as changes in Treasury checking accounts, in foreign
deposits with the Reserve Banks, and in Federal Reserve
float; the latter is an element of Federal Reserve credit that
shows substantial week-to-week variation but changes little
over the longer run. Operations of the Federal Reserve
System must be as responsive to transient as to more
lasting reserve changes.
From the standpoint of an observer of day-to-day credit
D
215
THE FEDERAL RESERVE SYSTEM
market conditions or a participant in the market, the fact
that member bank reserves have changed is of paramount
interest. But how the change came about — that is, what
specific factors caused it — is of only slightly less interest to
him. Since he is trying to judge the current course of
Federal Reserve policy, it is important to him whether a
given short-run change is the result of a positive banking
action, or reserve banking tolerance of the play of market
forces, or of a chance interplay of factors without policy
significance.
From the standpoint of its own operations, the Federal
Reserve must have detailed knowledge of the performance
characteristics and potentialities for fluctuation of each
reserve factor, and for this purpose it must maintain a full
statistical record of each reserve element. Such background
information makes it possible for the System to identify,
within a fairly narrow margin of error, the nature and
likely amount of prospective changes in the various re
serve factors and to decide whether resulting changes in
member bank reserves should be permitted or should be
offset by System action. As is true of any dynamic process,
the administration of policy with regard to the level of
member bank reserves must work with a margin of toler
ance for the unpredictable, because innumerable economic
forces are influencing all of the reserve factors.
Interplay o f Elements
The weekly statement includes a table showing all of the
elements of the reserve equation. Balance sheet data for
the Reserve Banks are consolidated with data from certain
accounts of the Treasury that relate to its cash holdings and
to its currency outstanding, and with data from member
216
SHORT-TERM CHANGES IN RESERVES
banks on their reserve holdings. Thus, the figures reflect
the effects of the country’s gold and currency flows upon
member bank reserve positions.
D etailed B ank R eserve E quation
(Weekly averages of daily figures. In millions of dollars)12
Factor or element
Week ended Change from
July 3,
week ended
1963
June 26, 1963
Supplying reserve funds:
Federal Reserve credit:
U.S. Government securities...............
Acceptances.......................................
Member bank borrowings.................
Float..................................................
32,249
44
329
1,651
+666
+1
+95
-203
Total Federal Reserve credit___
34,273
+559
Gold stock............................................
Treasury currency outstanding.............
15,733
5,587
-4 6
+5
Total...........................................
55,593
+518
132,589
390
+363
-1 2
863
173
235
1,101
-2 9
-1 2
+ 18
+2
Total...........................................
35,352
+331
Total reserves held................................
220,241
+ 188
Required.....................................
Excess.........................................
19,811
430
+ 136
+52
Absorbing reserve funds:
Currency in circulation..........................
Treasury cash holdings..........................
Deposits with Reserve Banks:
Treasury.............................................
Foreign..............................................
Other..................................................
Other Federal Reserve accounts (net)..
1 Consists of $35,574 million o f currency outside the Treasury and
Federal Reserve, minus $2,985 million vault cash at member banks.
2 Of this amount, $17,257 million was held with Reserve Banks and
$2,985 million as vault cash at member banks.
N o t e .— Details may not add to totals because of rounding.
217
THE FEDERAL RESERVE SYSTEM
The weekly reserve equation focuses on how much the
member banks have in their reserve accounts. Since it is
an average rather than the level on any single day that is
significant, the figures for member bank reserves used in
the weekly reserve equation are averages of daily figures.
The figures for the week ending July 3, 1963, are given in
the table on the preceding page.
The information is grouped under two headings—
factors supplying reserve funds and factors absorbing re
serve funds, with details concerning member bank reserve
positions under the latter. For elements supplying reserve
funds, increases add to member bank reserves and de
creases reduce such reserves. For elements absorbing re
serves, increases reduce member bank reserves, and de
creases increase them. To highlight the role of particular
elements and groups of elements in that week and to
facilitate discussion of them, the factors have been re
arranged as shown in the following table.
Identifying the Factors in Reserve Changes
At the outset, it should be noted that no great signifi
cance can be attached to the changes occurring in a single
week, except as they may seem to be part of some longerterm movement. Any week’s figures may be affected by
fairly wide fluctuations of an unpredictable and short-run
nature in such monetary factors as those discussed here.
The most important factors increasing member bank
reserves during the week chosen for illustration were in
creases in some components of Federal Reserve credit,
chiefly an increase in U.S. Government securities held by
the Federal Reserve. But, setting these particular factors
aside for the moment, other factors increasing reserves in
218
SHORT-TERM CHANGES IN RESERVES
eluded decreases in Treasury and foreign deposits at the
Reserve Banks.
The changes in Treasury deposits with Federal Reserve
Banks reflected Treasury payments for Government exR earrangement of
D etailed Bank R eserve E quation
(Averages o f daily figures. In millions o f dollars)
Factor or element
Change,
June 26 to
July 3, 19631
A. Changes accounting for increases in bank reserves:
In creases in:
U.S. Government securities held by Reserve Banks.
Acceptances held by the Reserve Banks................
Member bank borrowings at Reserve Banks.........
Treasury currency outstanding...............................
D ecrea ses in:
666
1
95
5
Treasury cash holdings..........................................
Treasury deposits with Reserve Banks........... .
Foreign deposits with Reserve Banks....................
12
29
12
Total................................................................
820
B. Changes accounting for decreases in bank reserves:
D ecreases in:
Float.......................................................................
Gold stock..............................................................
203
46
Increases in:
Currency in circulation12........................................
Other deposits with Reserve Banks........................
Other Federal Reserve accounts (net)....................
363
18
2
Total................................................................
632
C. Increase in total reserves held (A — B)....................
188
1 Changes based on averages for the weeks ending on these dates.
2 Outside the Treasury, Federal Reserve, and member banks.
219
THE FEDERAL RESERVE SYSTEM
penditures made by drawing checks against Treasury ac
counts with the Federal Reserve Banks. Treasury trans
actions run into billions of dollars each month. Despite
careful supervision of its accounts, Treasury balances at
the Reserve Banks often fluctuate abruptly, with corre
sponding effects (in the opposite direction) on member
bank reserves. Over the illustrative week, however, changes
in these balances were quite moderate, adding $29 million
to reserve funds.
When payments are made out of foreign accounts at
the Reserve Banks, the recipients of the payments usually
deposit them with member banks, which then add them
to reserve accounts at the Reserve Banks. Conversely,
when foreign deposits are being built up, there is a corre
sponding drain on member bank reserves. The decrease in
foreign deposits supplied $12 million of reserves in the
week under review.
The major factors absorbing reserves in the illustrative
week were an increase in currency in circulation and a re
duction in Federal Reserve float. There was also a small
change in the gold stock.
The public’s holdings of currency fluctuate sharply with
seasonal spending patterns. The public obtains currency
by withdrawing funds from banks, and this reduces bank
reserves. When customers return currency to banks, this
builds up reserves. During the week under discussion, the
public obtained $363 million of currency from banks,
thereby reducing bank reserves to that extent.
Federal Reserve float, as explained in Chapter XI, repre
sents Federal Reserve credit extended to member banks
through the check collection process, when checks not yet
collected by the Federal Reserve are credited to member
220
SHORT-TERM CHANGES IN RESERVES
bank reserve accounts in accordance with an established
schedule. The amount of float fluctuates from day to day,
primarily in consequence of variations in the volume of
check transactions but also as a result of weather and other
factors affecting the speed of collection. In our reference
week a reduction in float absorbed $203 million of re
serve funds.
The U.S. gold stock tends to fluctuate in line with con
ditions in our international balance of payments. As ex
plained in Chapter VIII, inflows of gold from foreign
countries are generally associated with a balance favorable
to the United States, while outflows of gold are associated
with a balance favorable to foreign countries. During the
illustrative week, the gold stock of the United States de
clined by $46 million.
These factors absorbing reserves were much stronger
than factors supplying reserves, other than Federal Re
serve credit. Therefore, the Federal Reserve purchased a
large amount of U.S. Government securities—$666 million
—to keep bank reserves from declining. In addition, mem
ber banks on their own increased their reserves another
$95 million by borrowing that much from the Federal
Reserve Banks.
As a result of all the changes in the various factors—
those outside the control of the Federal Reserve System
or of member banks and those that reflect Federal Re
serve or member bank initiative—total reserves of member
banks increased by $188 million.
Total reserves of member banks are divided between re
quired and excess reserves. For the week here reviewed
required reserves increased by $136 million, and excess re
serves by $52 million.
221
THE FEDERAL RESERVE SYSTEM
Meaning o f Net Reserve Position
One of the things that the credit market observes in
gauging the emphasis of current monetary policy—that is,
whether it is tending to be stimulative, neutral, or restrain
ing in its effects upon the volume of credit and money—
is the trend of changes in the net reserve position of mem
ber banks. The net reserve position is defined as the dif
222
SHORT-TERM CHANGES IN RESERVES
ference between the excess reserves of member banks and
member bank borrowing; excess reserves, of course, repre
sent the difference between total and required reserves.
The term “net free reserves” is used by the market to
refer to a position in which excess reserves are larger than
borrowings, while the term “net borrowed reserves” refers
to a position in which borrowings are larger than excess
reserves. As monetary policy moves from a restraining to
a stimulative posture, a net borrowed reserve position will
gradually give way to a net free position. These swings in
the reserve position usually reflect changes in member bank
borrowings more than changes in excess reserves. The
reason for this is that banks universally seek to avoid un
employed funds, thus keeping to minimal levels their com
bined excess reserves and the fluctuations in these reserves.
Referring again to the principal elements in the bank
reserve equation for the week ending July 3, 1963, member
banks showed net free reserves of $101 million, the amount
by which their excess reserves of $430 million exceeded
their borrowing of $329 million. Free reserves declined by
$43 million from the preceding week (since borrowings
were increased by $95 million while excess reserves in
creased by only $52 million). The member banks’ net re
serve position over that period appears to have moved in
the direction of less monetary ease.
While monetary policy necessarily influences the net re
serve position of banks, this position is also much affected
by bank responses to the many cross currents that stem
from the interplay of diverse market forces and by unfore
seen developments. Considering the complexity of the
forces affecting the net reserve position in the short run—a
fact reflected in the many sizable and irregular fluctuations
223
THE FEDERAL RESERVE SYSTEM
in this measure from week to week—little or no signifi
cance can be attached to the shift during a single week.
However, the downward trend in net free reserves over a
period of several months preceding this particular week
confirmed that Federal Reserve policy had been tending to
become somewhat less stimulative with regard to the
growth of credit and money than it had been earlier.
In general, the net reserve position of member banks is
an important gauge of pressures on bank reserves. When
net free reserves rise, the result is an increased marginal
availability of reserves, which the banking system can
readily use to expand credit. But when member bank
borrowings grow relative to excess reserves, credit ex
pansion comes under restraint. In this process individual
banks find extra reserves m ore difficult and expensive to
obtain, and they come under increasing pressure to repay
advances from the Federal Reserve. As this continues over
time, a net borrowed reserve position emerges for the
banking system as a whole.
Of course, the net reserve position of banks is only one
index of credit and monetary tendencies and of the di
rection of reserve banking policy, and in this respect it has
to be considered in relation to banks’ desires to hold free
reserves and to other fundamental indicators of credit con
ditions. The central task of monetary policy is to regulate
expansion in bank reserves, bank credit, and money so that
growth in real output is accomplished with a minimum of
either inflationary or deflationary pressures. Changes in
bank credit and money, along with other changes in credit,
the flow of savings, and interest rates, are among key
indices of the credit situation in the short as well as in the
longer run.
224
CHAPTER XIV
ORGANIZATION FOR M ONETARY POLICY. The Board
o f Governors has a central role in achieving coordinated use of
all o f the instruments o f monetary policy, and it maintains close
relations with other policy-making agencies in the Government.
Federal Reserve Banks ploy an important part in System policy
through representation on the Federal Open Market Committee
and through their responsibilities fo r discount operations.
ECISIONS affecting the availability and cost of mem
ber bank reserves are made by the Federal Reserve
System in light of the many factors—economic, financial,
balance of payments, and technical—that have been dis
cussed in earlier chapters. These decisions are the essence
of monetary policy. The Federal Reserve System is or
ganized in such a way that monetary policy reflects the
considered judgment of the Board of Governors in Wash
ington and the twelve Federal Reserve Banks.
The Board of Governors is a public regulatory body
that has a central responsibility for the coordinated use
of the various instruments of monetary policy. Its members
D
225
THE FEDERAL RESERVE SYSTEM
are appointed by the President with the advice and consent
of the Senate. The Federal Reserve Banks, distributed as
they are throughout the United States, help to increase the
System’s responsiveness to local and regional business and
credit conditions. Views of the Board and the Banks are
exchanged regularly through meetings of the Federal Open
Market Committee, at which policy for open market oper
ations is decided. Such operations are the focal point of the
day-to-day policy process.
This chapter discusses how the Federal Reserve System
is organized to make decisions for monetary policy, while
the following chapter goes into considerable detail on the
open market policy process, from policy formulation to
execution.
Distribution o f Federal Reserve Authority
A graphic view of the organization of the Federal Re
serve System can be helpful to an understanding of its
structure in relation to its primary functions. The chart on
page 22 of Chapter II shows in broad outline the statutory
organization of the System. The chart on the facing page
completes the story on structure by showing the relation
ship of the organizational parts of the System to the several
instruments of credit policy. The four squares at the bottom
of the chart represent these instruments; each is joined by a
line to the unit or units within the System that make policy
decisions with reference to that instrument.
Board o f Governors
The Board participates in all of the principal monetary
actions of the Federal Reserve System. It has full authority
over changes in reserve requirements within the limits
226
THE FEDERAL RESERVE SYSTEM : RELATION TO INSTRUMENTS OF CREDIT POLICY
BOARD
OF
GOVERNORS
F EDE RAL R ES E R V E
BANKS
M EM B E R B AN K S
ORGANIZATION FOR MONETARY POLICY
K>
:ercises g e n e r a l su per vision
THE FEDERAL RESERVE SYSTEM
prescribed by Congress; it “reviews and determines” dis
count rates proposed in the first instance by the directors of
the Reserve Banks; and its members constitute a majority
of the Federal Open Market Committee. In addition it is
responsible for the regulation of stock market credit, and
it has the authority to establish the maximum rates of
interest that member banks may pay on savings and other
time deposits.
The central position of the Board of Governors derives
in part from its role as a public policy agency located in the
nation’s capital, where it has continuous contact with both
executive and legislative branches of the Government. The
Board of Governors maintains contact with a number of
Government agencies, whose policies affect the total supply
and structure of credit in the economy and thereby in
evitably interact with the credit and monetary policies of
the Federal Reserve.
Relations with Other Government Agencies
To facilitate coordination of monetary and other eco
nomic policies at the national level, the Chairman of the
Board of Governors in recent years has met regularly with
the President of the United States, members of the Coun
cil of Economic Advisers, the Director of the Bureau of
the Budget, and the Secretary of the Treasury. At the same
time regular contact has also been maintained at staff levels
of responsibility between the Board of Governors and other
economic and credit agencies of the Government. In this
respect there is continuous exchange of relevant informa
tion between the Board’s staff and staffs of the Council of
Economic Advisers and of the Treasury.
The debt management activities of the U.S. Treasury are
228
ORGANIZATION FOR MONETARY POLICY
most closely related to monetary policy on a day-to-day
basis. Informal contact with Treasury officials at the staff
level is fairly continuous. In addition, officials of the two
agencies get together for luncheons twice each week to
discuss developments and plans. A Monday luncheon, held
at the Treasury, is attended by the Secretary of the Treas
ury, the Chairman or Vice Chairman of the Board of
Governors, and Treasury staff advisers. A Wednesday
luncheon, held at the Federal Reserve, is attended by the
Chairman and Vice Chairman of the Board of Governors,
the Under Secretary of the Treasury in charge of debt
management and international monetary affairs together
with his principal staff assistants, and staff economists of
the Board. These points of contact keep the officials of
each agency informed of developments that might affect
their operations.
In its refunding and borrowing operations the Treasury
goes repeatedly to the credit market, where conditions
reflect in part the credit and monetary policy of the Federal
Reserve. It is important to the Treasury to have a well
functioning and resilient market for Government securities,
and it is important for the implementation of monetary
policy that Treasury financing operations interfere as little
as possible with Federal Reserve actions regarding the flow
of credit and money.
Certain conditions in the credit market can at times be
encouraged through complementary Treasury and Federal
Reserve operations. For instance, Treasury management
of the debt in the early 1960’s helped to keep domestic
short-term interest rates from falling to levels that would
add to the continuing balance of payments deficit by
encouraging further outflows of liquid capital. The Treas
229
THE FEDERAL RESERVE SYSTEM
ury’s efforts to this end, in addition, made it easier for the
Federal Reserve to maintain a stimulative, easy money
policy to foster domestic economic expansion.
With both the Treasury and the Federal Reserve now
operating in foreign exchange markets, and with both
agencies participating regularly with their counterparts in
other countries in international discussions that involve
policy proposals, the need for close coordination of
Federal Reserve and Treasury operations in the inter
national sphere too has increased greatly. This involves
continuous exchange of information among principals at
the Treasury, the Board of Governors, and the Federal
Reserve Bank of New York, and this information is also
made available to other Reserve Banks.
With regard to international financial problems in
general, the Chairman of the Board of Governors is a
member of the National Advisory Council on International
Monetary and Financial Problems, which includes in its
membership the heads of all agencies that make foreign
loans or engage in foreign financial transactions.
Federal Reserve Banks
In the administration of monetary policy, Federal Re
serve Banks play a principal role in discount operations of
the System. In fact, the setting of discount rates and the
administration of discounting operations provide an excel
lent illustration of the ways in which decision-making
responsibilities are shared in the decentralized Federal
Reserve System.
Establishment of the discount rate is one of the main re
sponsibilities of the directors of the Federal Reserve Banks.
Every fourteen days the directors of each Bank must
230
ORGANIZATION FOR MONETARY POLICY
establish a discount rate subject to review and determina
tion by the Board of Governors in Washington. This pro
cedure assures that regional conditions and credit needs as
well as national and international conditions are taken into
account in setting the rate.
These broader national and international considerations
are sometimes reflected differently or have different de
grees of importance in the various regions of the country.
Hence, at times there are diverse views as to the proper
movement of discount rates. In general, however, economic
tendencies and credit conditions tend to be more or less
national in character, and opinions as to desirable changes
in discount rates usually are quite similar.
The Reserve Banks have full responsibility for deciding
what loans and discounts to individual member banks are
consistent with the Federal Reserve Act. The objectives of
the Act, however, are interpreted by the Board of Gov
ernors in its Regulation A, quoted on page 43. Regulation
A, as explained in Chapter III, sets the general conditions
under which discount accommodation will be granted to
member banks. Within these guidelines, there are a few
differences in practice from one Reserve Bank to another
that stem from the different traditions, customs, and basic
economic structures of various regions of the country. But
the general standards governing discounting are the same
for all Reserve districts.
The total volume of loans and advances made to member
banks varies over the economic cycle as the pressure of
credit demand on the available supply of member bank
reserves changes. However, the guiding principles of Regu
lation A, which govern the granting of credit to individual
member banks, do not so change. Thus, in discount ad
231
THE FEDERAL RESERVE SYSTEM
ministration the only element that is adjusted as policy
objectives change is the discount rate.
In addition to their role in discount administration, Re
serve Banks participate in the formulation and execution of
policy for open market operations as discussed in following
paragraphs.
Federal Open Market Committee
As pointed out in an earlier chapter, the Federal Open
Market Committee consists of the seven members of the
Board of Governors together with the presidents of five
of the Reserve Banks. The Chairman of the Board of
Governors serves as Chairman of the Committee, and the
President of the Federal Reserve Bank of New York serves
as Vice Chairman. The President of the New York Bank
is a permanent member of the Committee. Presidents of
the other Banks rotate as members, with four being elected
by the Reserve Banks voting in groups prescribed by law.
Membership of these four is for one year.
The presidents of all the Reserve Banks participate in
discussions at the meetings, although only those who are
currently members vote on proposed Committee actions.
In this way the knowledge and information of the entire
Federal Reserve System is available to the Committee. At
the same time it helps to keep all Reserve Bank officials
informed about present thinking on general monetary
policy and about developments in the domestic and world
economies.
The Open Market Committee meets often — generally
every three weeks. This permits a continual interchange of
ideas and evaluation of the latest economic and financial
developments. At each meeting the Committee, with the
232
ORGANIZATION FOR MONETARY POLICY
help of its staff, reviews the national and international busi
ness and credit situation.
Decisions about open market policy and the coordina
tion of open market operations with other instruments of
monetary policy are thus made in the light of a full and
continuing discussion of regional, national, and inter
national conditions. In this sense, the Federal Open Market
Committee is the focal point for formulation of Federal
Reserve monetary policy.
Operations in Government securities and in foreign cur
rencies that are authorized by the Federal Open Market
Committee are undertaken by the Federal Reserve Bank of
New York for the System Open Market Account. The
Manager of the Account supervises all domestic security
transactions, and the Special Manager supervises all oper
ations in foreign currencies. Both the Manager and the
Special Manager, in addition to being officials of the Fed
eral Open Market Committee, are officers of the Federal
Reserve Bank of New York. All transactions executed by
them are in accordance with the Committee’s instructions.
Each Reserve Bank participates in holdings and earnings
of the System Account.
To facilitate the execution of operations in Government
securities and foreign currencies, the System Account Man
agement maintains trading rooms at the Federal Reserve
Bank of New York. These are linked by telephone to the
major dealers in the Government securities and foreign
exchange markets. In addition to being used for transacting
System business, the trading rooms serve as listening posts,
which permit both the Manager and the Special Manager
to keep in close touch with changes in market conditions
and market psychology.
233
THE FEDERAL RESERVE SYSTEM
Against this organizational background, the next chap
ter explains the role and workings of the Open Market
Committee and the System Open Market Account Man
agement in the formulation and execution of monetary
policy—in particular open market operations, for which
they have direct responsibility.
234
CHAPTER XV
THE OPEN MARKET POLICY PROCESS. In deciding on
reserve banking policy, account must be taken o f all the economic
forces at work in the domestic economy as well as o f those affecting
relations with the rest o f the world. Complexities o f the economic
situation require that reserve banking instruments be used flexibly,
with the nature o f the banking process making fo r central reliance
on open market operations. As a result, the formulation o f open
market policy and the conduct o f operations in the market are at
the heart o f the policy process.
HE process by which reserve banking policy influences
the economy begins with changes in the availability
and cost of member bank reserves. The Federal Reserve
can initiate such changes through its open market oper
ations, through changes in the rate at which it discounts
paper for banks, and—within limits—through changes in
the reserve requirements of member banks.
Changes in the availability and cost of reserves are re
flected immediately in money market conditions. Their
influence spreads to bank credit and money, to interest
T
235
THE FEDERAL RESERVE SYSTEM
rates in markets for longer-term debt, and to the entire
range of spending financed by borrowed funds. In the end
the ultimate targets of policy actions—total income and
spending, total output and employment, the general level
of prices, and international trade and capital flows—come
to be influenced.
At all times, however, financial conditions, domestic
economic activity, and the balance of international pay
ments are influenced by many underlying forces that make
themselves felt independently of monetary actions. Thus,
while the Federal Reserve undertakes to direct its policy
toward attainment of orderly economic progress and a
stable dollar, these objectives cannot be reached through
monetary policy alone.
Complexities o f Policy-Making
The policy process in reserve banking involves a con
tinuing assessment of changing economic developments
and takes full account of the interaction of monetary meas
ures and forces outside the monetary sphere. For instance,
when the performance of the economy or of the balance of
international payments has been falling short of longerrange objectives, Federal Reserve authorities must decide
whether and to what extent changes in the financial vari
ables more directly affected by monetary action—namely,
the pace of bank credit and monetary growth, and levels of
interest rates—can help to improve the situation. They
must also decide whether changes in other forces—includ
ing other public policies—are working or may work to
remedy the shortfall. If it seems appropriate to change the
pace at which bank credit and the money supply are grow
ing or to change prevailing interest rates, then the policy236
OPEN MARKET POLICY PROCESS
makers must decide by how much and with what timing
to adjust the reserve base of member banks so that mone
tary action will encourage the change desired.
Judgments of this kind call for full analysis of all relevant
information about the domestic economic and credit
situation, the flows being generated in international pay
ments, and the major forces affecting the world economy
generally. Hence in arriving at policy decisions the Federal
Reserve considers a spectrum of guides. These range from
ultimate goals for output, employment, average prices,
and the balance of payments to the more immediate ob
jectives, such as bank reserve availability, which transmit
System policy to money market conditions and interest
rates, bank credit, and the money supply.
It would be easier for the System to make decisions on
policy if there were a simple statistical norm—such as a
particular rate of growth in the money supply or particular
levels of interest rates—which, if it could be attained,
might insure continuous realization of optimum conditions
in output, employment, and the balance of payments.
Neither experience nor a consensus of economic theory,
however, has indicated any single norm for policy guid
ance. Rather, the Federal Reserve System must consider
changes in all indicators, financial and nonfinancial, that
help to explain recent economic tendencies, that shed light
on likely future developments, and that reflect the stance of
monetary policy in relation to other influences on the
economy.
Policy-makers thus place a high priority on compre
hensive, dependable, and timely economic intelligence. A
wide range of information, both statistical and qualitative,
is available for use in making such judgments, and methods
237
THE FEDERAL RESERVE SYSTEM
of economic analysis are much advanced over those used
in earlier periods.
Even so, opinions differ on how the available informa
tion should be interpreted. These differences arise because
there are still important gaps in the data and because the
information that is available currently does not fully re
veal emerging economic developments in the domestic and
international spheres. In addition, different participants in
the decision-making process may attach different weights
to the various elements in an evolving situation—not only
among domestic factors but as between domestic and in
ternational.
In this complex economic world—in which data tend to
run somewhat behind events and in which the effects of
changes in Federal Reserve policy work themselves out
over time—adaptations in policy tend to be taken step by
step. In that way, they can be readily modified or reversed,
if necessary, as the future unfolds. This is especially im
portant at times when the strength of perceivable trends is
not clear or when there is strong interaction between
domestic and international economic developments.
Nevertheless, situations may arise that clearly call for
rapid and forceful policy measures. In these circumstances,
too, the continuous nature of the policy process permits
prompt response.
Role o f the Open Market Committee
In view of the way in which the U.S. banking system is
structured and the way in which banking processes have
evolved, open market operations are the instrument best
suited to step-by-step adaptation of monetary policy. They
can be used to initiate small policy actions or aggressively
238
OPEN MARKET POLICY PROCESS
to carry out large changes in reserves over relatively
short periods. They are continuous in nature, can be un
dertaken quickly, and are well adapted to ready modifica
tion and reversal, if necessary. In practice, therefore,
open market operations normally take the lead in general
monetary policy implementation, with changes in the dis
count rate and in required reserve ratios being used more
often to supplement and reinforce this initiative.
All of the System’s open market operations—in both do
mestic securities and foreign currencies—are carried out
under policy directives of the Federal Open Market Com
mittee. The Committee’s procedures and practices have
varied over the years along with the changing focus of the
issues and problems faced. The practices described in fol
lowing paragraphs are those that have evolved out of past
experience to meet present needs. As needs change in the
future and as knowledge increases further, current prac
tices are likely to be modified.
To keep open market policy constantly in touch with
the monetary and credit needs of the economy and with the
international economic position of the country, the Com
mittee has found it essential to meet often, usually every
three weeks. The primary purpose of these meetings is to
develop a policy consensus that can be formulated into
operating directives to the Manager of the System Open
Market Account and the Special Manager for foreign
currency operations. The meetings are also a forum for dis
cussion of the use of all instruments of monetary policy
against the background of over-all monetary objectives.
Decisions on changes in the use of policy instruments
other than open market operations—discount rates and
reserve requirements—are not made by the Federal Open
239
THE FEDERAL RESERVE SYSTEM
Market Committee as such. But since all policy instru
ments are closely related, views developed in Committee
deliberations are carried over into meetings of the Board
of Governors and of the Reserve Bank presidents with
their directors, where actions on these other instruments
are decided. In this way Committee discussions have a
bearing on the coordinated use of all instruments.
Committee Procedures
Meetings of the Federal Open Market Committee are
organized to facilitate wide discussion and careful assess
ment of available information as part of the process of
coming to decisions on open market policy. To this end,
all twelve of the Reserve Bank presidents attend the meet
ings and participate in the discussion, although only the
five who are members vote on proposed Committee
actions. This arrangement makes the knowledge and in
formation of the entire Federal Reserve System available
to the Committee.
Background preparation. Between meetings, members of
the Committee are kept informed about late developments
in the nation’s economy, in regional economies, and in the
balance of payments by the research staffs at the Board of
Governors and at each of the Reserve Banks. Regular
briefings are provided in both oral and written form. Some
of these staff reports stress only the facts of recent
changes. Others assess and interpret them in relation to past
trends and in terms of the key factors in economic cycles
and growth suggested by various economic theories.
Such analyses are helpful in the assessment of possible
future trends.
In addition, Committee members receive regular reports
240
OPEN MARKET POLICY PROCESS
from the Manager of the System Open Market Account
and the Special Manager for foreign currency operations.
These reports—provided daily, weekly, and in advance of
each meeting—analyze developments in the domestic
money and securities markets, in bank reserve positions,
and in foreign exchange markets. They also provide a full
review of System operations against the background of
Committee objectives.
Before each meeting members of the Committee receive
special staff reports that place developments since the pre
ceding meeting in clear perspective. One of these is a re
view of the key phases of the current economic situation,
domestic and international, prepared by the research staff
of the Board of Governors. It sets forth recent information
on the broad economic aggregates that represent the
ultimate targets of domestic policy—output, employment,
income, and prices—and reviews changes in such im
portant factors as business investment, housing, consumer
outlays, and Government finance that underlie movements
in these broad aggregates. In addition, it reviews develop
ments in key financial variables such as bank credit, money,
and interest rates, which are the proximate targets of
policy, and reports changes in the money market and bank
reserve statistics that respond most immediately to mone
tary policy actions. Finally, it sets forth summary infor
mation on output and credit conditions abroad and the
state of the U.S. balance of payments. When special
problems or proposals relating to policy are under con
sideration, Committee members usually receive supple
mentary background papers.
Organization. Meetings of the Federal Open Market
Committee are held at the Board of Governors building in
241
THE FEDERAL RESERVE SYSTEM
Washington. The agenda for each meeting is typically
divided into two parts. One focuses on foreign currency
operations; the other on broader questions of general open
market policy.
The discussion of foreign currency operations begins
with an oral report by the Special Manager of the Account.
He reviews the highlights of recent foreign exchange
market experience and identifies situations likely to re
quire Committee attention or action before the next meet
ing. After discussion of questions raised by his comments
and recommendations, the Committee takes whatever ac
tions may be needed to direct foreign currency operations
until the next meeting.
The meeting then proceeds to a consideration of general
open market policy. Discussion begins with an oral report
by the Account Manager. In this he outlines recent and
prospective System actions in the market and reviews
money and securities market developments expected to be
of special significance to the Committee in the period
ahead. If Committee members have questions or reserva
tions about the conduct of open market operations in
the interval since the last meeting, they raise them at
this point.
The Committee then receives oral briefings from its staff
economists. These are analytical and interpretive state
ments that draw out the significance and implications of
the more detailed written reports distributed in advance
of the meeting. One statement covers key developments in
domestic business; another, recent changes in domestic
financial markets; and a third, recent developments in the
U.S. balance of payments.
After the staff reports, each Board member and Bank
242
OPEN MARKET POLICY PROCESS
president—nonvoting as well as voting—speaks in turn.
Each presents his judgments on current economic and
financial conditions, and the Reserve Bank presidents re
port any significant recent developments in the economies
of their districts.
These summaries of regional conditions are useful in
interpreting over-all economic tendencies because they
often help to spot developments not yet reflected in
statistical series for the nation as a whole. Also, reports by
the Bank presidents reflect a special knowledge of banking
developments obtained from supervision of member banks,
administration of the discount window, and other regular
contacts with bankers and business leaders, including their
Bank’s directors.
Each speaker states his view with regard to policy,
usually by indicating whether he believes that money
market conditions and the volume of reserves available to
member banks should be kept about the same or be
changed. Recommendations to shift toward more or less
ease or restraint in open market operations may include an
expression of opinion as to the desirability of a near-term
change in the discount rate. In addition, speakers typically
relate any proposals they may have concerning money
market conditions and bank reserves to broader financial
variables such as interest rates, the pace of bank credit and
monetary growth, or other liquid assets. They also assess
these financial variables against trends in domestic eco
nomic activity and employment, the level of prices, and
the balance of international payments. When all members
of the Committee have spoken, the Chairman summarizes
the points of view expressed and the consensus that seems
to have developed on open market policy.
243
THE FEDERAL RESERVE SYSTEM
Following such further comments as may help to clarify
differing points of view, attention turns to the current
policy directive, which expresses the Committee’s judg
ment as to the appropriate posture of monetary policy for
the period until the next meeting. If the policy judgment
that is reached calls for a change in the directive, alterna
tive formulations are considered. Then a vote of the Com
mittee members is taken on that policy formulation which
seems to express most satisfactorily the majority view. On
occasion the wording of the directive will be revised to
acknowledge the short-run significance of some unexpected
event or condition such as the Suez crisis in late 1956,
the stock market break in May 1962, the Cuban crisis
in October 1962, or President Kennedy’s assassination in
November 1963. Developments of this type maybe deemed
to require specific recognition in the policy directive, even
though basic policy remains unchanged.
The directives of the Federal Open Market Committee
to the System Account Managers provide the central
basis for the record of Committee policy actions published
in the Annual Reports of the Board of Governors. But more
fundamentally they establish formal lines of policy direc
tion from the 12-member policy-forming Committee to the
Account Managers, who execute day-to-day market opera
tions. Thus, the directives, discussed in the next section, are
the basis for policy execution, although the Managers’
understanding of the instructions is enhanced by their
presence at the Committee’s discussions.
Execution o f Policy
Over its history the Committee has changed the form of
its directives from time to time. At present, instructions
244
OPEN MARKET POLICY PROCESS
for open market operations in domestic securities are con
tained in two directives. One is a “continuing authority
directive,” which is reviewed at least once a year. It sets
the technical limits on operations—indicating such things
as the types of securities that may be bought or sold, the
procedures to be followed in transactions, and the con
ditions under which repurchase agreements may be made
with dealers. The other is the current policy directive voted
at each meeting. This states the present objectives of open
market policy and gives guidance, in light of the Com
mittee’s discussions, to the Account Manager in imple
menting Committee policy until the next meeting.
The current policy directive is revised rather often. Re
visions take account of recent and prospective changes in
the domestic economy and the balance of payments, which
may require alterations in open market policy.
With regard to foreign currency operations, the policy
aims of the Committee relate to the international position
of the dollar as mirrored in the technical performance of
foreign exchange markets and to the way in which the
deficit or surplus in the U.S. balance of payments is
financed. When the Open Market Committee authorized
operations in foreign currencies in 1962, it defined the
goals and character of this program in a detailed state
ment. The statement, published by the Board in its Annual
Report for 1962, explained the purposes of foreign cur
rency operations, the types of currencies in which transac
tions could be conducted, the nature of institutional ar
rangements with central banks in other countries, and the
administrative structure and procedures to be used for
executing transactions.
At the same time the Committee adopted a set of guide
245
THE FEDERAL RESERVE SYSTEM
lines for foreign currency operations. These define the
circumstances in which the System may acquire and hold
foreign currencies and specify the purposes for which it
may engage in spot and forward exchange transactions.
These rules guide the Special Manager in his day-to-day
operations in foreign currencies. A continuing authority
directive, subject to change when appropriate, lists the
particular foreign currencies in which he may operate,
along with the quantitative limits on various types of
transactions.
At least once a year—at its annual organization meeting
in early March—the Federal Open Market Committee
reviews all of its continuing directives and operating
procedures to make sure they are consistent with the
present needs and objectives of effective monetary policy.
The balance of this article discusses the factors taken
into account in the wording of the current policy directive
and in the execution of day-to-day open market operations
in domestic securities.
The operating problem. The main function of the current
policy directive is to set forth guidelines as to the avail
ability of member bank reserves and the degree of ease or
firmness in the money market for the Account Manager
to follow until the next meeting. These objectives have to
be expressed in a manner that will give the Account
Manager adequate guidance while at the same time allow
ing him sufficient latitude—in view of continuously
evolving market conditions and expectations—to carry out
basic Committee aims in relation to domestic economic
activity and the balance of payments.
It might seem at first glance as if the Committee could
achieve its objectives by simply stating the dollar volume
246
OPEN MARKET POLICY PROCESS
of securities that the Account Manager should buy or sell
in the market before the next meeting. In practice, how
ever, this is not feasible, for the supply of reserves
available to member banks is affected by changes in a num
ber of factors that in the short run are independent of
Federal Reserve monetary action. Among these are changes
in the level of monetary gold, currency in circulation, and
float—the last arising mainly from fluctuations in the vol
ume of checks in process of collection. As a result the System
can bring about a desired change in the general avail
ability of reserves to banks only if reserve changes arising
from these other factors have been fully allowed for.
The task of taking into account changes in these factors,
together with normal seasonal movements in required re
serves, is essentially an operating problem rather than a
policy problem. It is a part of the Account Manager’s job—
with the help of the staff's at the Federal Reserve Bank of
New York and the Board of Governors—to detect such
variations and to make prompt adjustments to them. In
other words, the execution of open market policy requires
a continuous and sensitive appraisal of day-to-day market
conditions.
Looking ahead to the interval between meetings, the
Committee itself cannot easily predict the amount of re
serves that open market operations will have to supply or
absorb to take account of changes in other factors affect
ing reserves. But as the period unfolds, the Account
Manager can usually accommodate his operations to such
changes. He may observe the changes through statistical
measures developed by the staff, or they may become
evident to him in the process of day-to-day operations in
the money market. Most open market transactions are
247
THE FEDERAL RESERVE SYSTEM
undertaken simply to respond to seasonal and other short
term reserve changes of these kinds.
For policy purposes the Federal Open Market Com
mittee is less interested in the gross volume of open market
transactions likely to be needed in the period ahead than
it is in the supply of reserves that will be available to sup
port further growth of bank credit at member banks.
Several measures help to indicate the extent of reserve
availability at member banks. For measuring the results of
policy actions over a period of weeks or months, trends in
total, required, and nonborrowed reserves are particularly
useful, because they reveal changes in the reserve base that
supports bank deposit and credit expansion. But these
measures have only limited usefulness as very short-run
operating guides for the System Account Manager—and
it is in the short run that day-to-day operations must be
planned and executed. To be used effectively on a day-today basis, these measures would have to be adjusted to
allow for immediate seasonal pressures on reserves as well
as for other short-run forces that may unexpectedly pro
duce a sudden bulging or slackening of reserve needs. Such
adjustments are difficult at best, and for current operations
in such a complex and dynamic economy as that of the
United States where it is hard to find recurring patterns,
they have to be viewed as tentative or approximate.
In the very short run various marginal measures of bank
reserve positions are useful indicators of the interaction
between monetary policy and market forces. These indi
cators include the amounts of excess reserves that member
banks hold and the amounts of their borrowings from the
Federal Reserve. Subtraction of total member bank bor
rowings from their total excess reserves provides a net
248
OPEN MARKET POLICY PROCESS
measure of reserve positions for all member banks. As ex
plained in Chapter XIII, when this difference is positive,
it is popularly referred to as net free reserves; when it is
negative, it is called net borrowed reserves.
The technical advantage of marginal reserve guides is
that they help the Account Manager to accommodate
seasonal and other short-run credit demands readily as
they develop. For example, when net reserves are tending
to fall because of a seasonal or random rise in the public’s
need for bank credit, the Account Manager will supply the
reserves required to back the deposits created in credit
expansion. Similarly, when net reserves are tending to rise
because of a seasonal decline in the demand for bank
credit—taking the form, for example, of seasonal repay
ment of bank debt by business—he will absorb the
required reserves released by the associated decline in de
posits. With smaller deposits, banks would need less re
quired reserves and their excess reserves would rise unless
absorbed by System operations.
Taken by itself, however, the net free (or net borrowed)
reserve position also has limitations as a guide. For one
thing, it may not show what is happening to total bank
credit over time. A given level of net reserves at one
point may be associated with a faster or slower rate of
growth in total bank credit than the same level of net re
serves at another time because of differences in the strength
of credit demand, the level and structure of interest rates,
and market expectations — all of which affect bank pref
erences for free reserves.
The danger in adhering to net reserves alone as a guide
is that the System might be misled into reinforcing chang
ing demands for bank credit generated by forces of cycli-
249
RELA T IO N S H IPS
B i l l i o n s of d o l l a r s
20.0
AMONG
RESERVE
MEASURES
B i l l i o n s of d o l l a r s
20.0
1 9 .5
1 9 .0
1 8 .5
1 8 .0 °
1 7 .5
r
1 7 .0
1 6 .5
1 6 .0
15.5
1 5 .0
N o t e . —Nonborrowed reserves are total reserves less member bank borrowings.
The difference between
nonborrowed reserves and required reserves is the net reserve position of the banking system. Thus, when non
borrowed reserves exceed required reserves, member banks as a group have net free reserves, but when
nonborrowed fall below required, member banks as a group have a net borrowed reserve position.
THE FEDERAL RESERVE SYSTEM
K)
O
OPEN MARKET POLICY PROCESS
cal expansion and contraction when this was undesirable.
For example, in periods of vigorous credit demands and
rising bank needs for reserves, free reserves tend to decline
as banks use reserves that formerly had been excess or
increase their borrowings from Federal Reserve Banks. If
in such circumstances there were additions to the total
supply of bank reserves through open market operations
in order to keep free reserves from falling, this would en
courage a rapid expansion of bank credit—perhaps more
rapid than desired to accommodate the seasonal, cyclical,
and growth needs at the time.
Under conditions of slack credit demands and declining
interest rates, on the other hand, the opposite may occur.
In such periods member banks typically try to repay debt
at the Federal Reserve and add to their excess reserves in
an effort to build up their free reserves. If, in these circum
stances, free reserves within the banking system were not
permitted to grow enough to meet the changed preferences,
open market operations would tend to encourage further
contraction rather than the credit expansion that would
help stimulate economic recovery. In short, although the
net reserve measure is a useful and sensitive short-run guide
to open market operations, it is not used inflexibly as a
policy target. Rather, it is continuously interpreted in the
light of other evidence on credit and economic develop
ments and in the light of changes in various fundamental
measures of the bank reserve base—total, required, and
nonborrowed reserves.
Moreover, even in the short run the significance of any
given net reserve figure must be assessed alongside a broad
assortment of other information that bears on what is
typically alluded to as the “tone” or “feel” of the money
251
THE FEDERAL RESERVE SYSTEM
market. Indicators such as the intensity of demand for
and the depth of supply of Federal funds, the amount of
new money needed by Government securities dealers and
their sources and costs of financing, and day-to-day trends
in market prices and yields for Treasury securities all pro
vide important insights into the immediate state of reserve
availability and the strength of demands pressing upon
that availability. In executing policy it is essential to have
these immediate indicators of money market atmosphere,
because daily estimates of reserve availability may be wide
of the mark and because such estimates are for the banking
system as a whole and do not allow for the differing market
impact of possible variations in reserve distribution.
In summary, although at first glance it might seem to be
most efficient for the Federal Open Market Committee to
express its instructions to the System Account Manager in
simple and explicit terms—either as some dollar amount of
net purchases or net sales to be accomplished before the
next meeting, or as some given target of net reserve avail
ability or reserve growth—this quantitative approach has
not proved feasible. Experience has shown that the Com
mittee cannot forecast the size of technical adjustments that
will be needed between meetings to allow for changes in
other reserve factors. Nor can it predict the precise extent
to which bank credit, money, and interest rates will re
spond to given target levels of, or changes in, reserve
availability.
Nature o f operating instructions. In practice, therefore,
the Committee finds it desirable to express its operating
instructions in broader terms, which allow the Account
Manager sufficient latitude to evaluate and interpret
changing technical relationships among all of the relevant
252
OPEN MARKET POLICY PROCESS
money market indicators. For this reason Committee in
structions have typically directed the Account Manager to
seek more, less, or about the same amount of reserve
availability and money market ease or tightness as has
been prevailing. Decisions as to the precise size, timing,
and direction (purchase or sale) of any market operations
needed to implement these instructions are left to the
Manager’s discretion, for he has day-to-day contact with
the market and with the daily figures bearing on bank re
serves and money market conditions and he is therefore in
a position to make the necessary and continuing day-today adaptations of operations to basic policy aims.
To illustrate the form of operating instructions, the cur
rent economic policy directive adopted at the meeting of
September 11, 1962, follows:
It is the current policy of the Federal Open Market Committee to per
mit the supply of bank credit and money to increase further, but at the
same time to avoid redundant bank reserves that would encourage capital
outflows internationally. This policy takes into account, on the one hand,
the gradualness of recent advance in economic activity and the availability
of resources to permit further advance in activity. On the other hand, it
gives recognition to the bank credit expansion over the past year and to
the role of capital flows in the country’s adverse balance of payments.
To implement this policy, operations for the System Open Market
Account during the next three weeks shall be conducted with a view to
providing moderate reserve expansion in the banking system and to foster
ing a moderately firm tone in money markets.
In making day-to-day decisions, the Account Manager
adheres to the guidelines of the current directive. As the
example shows, the first paragraph contains a statement of
the Committee’s broad goals, and the second its operating
instructions.
If changes in banking and money market conditions in
the period between meetings should begin to deviate
sharply from the general pattern assumed in the policy
253
THE FEDERAL RESERVE SYSTEM
deliberations at the latest meeting, the Account Manager
would call this to the Committee’s attention. If the change
were very rapid, he might ask for a special meeting (per
haps by telephone conference) to review alternative means
of coping with the changed situation and to determine
whether the Committee wished to issue new operating in
structions. Any Committee member who was similarly
concerned by the unexpected course of developments
could, of course, also request a special meeting. In fact,
Committee members may at any time make comments to
the System Account Manager about actual operations
of the System Account and market developments in rela
tion to Committee intentions.
Basis for day-to-day operations. In his day-to-day evalu
ation of money market developments the Account Manager
considers both statistical and qualitative measures of
financial activity. One key element in this continuous
evaluation process is a daily projection of changes in
factors affecting bank reserves. The reserve projection con
tains estimates for several weeks ahead of daily and weekly
average changes in all of the key elements that affect the
bank reserve equation—float, currency, gold and foreign
accounts, and so forth—as well as in the various reserve
measures—total, required, nonborrowed, and free re
serves. These projections show the direction and general
order of magnitude of the open market operations likely
to be needed in the period immediately ahead.
Every morning the daily and weekly estimates for factors
affecting reserves are revised on the basis of actual reserve
figures collected for the preceding business day from the
System’s statistical reporting network. Since the money
market is especially sensitive to the current and expected
254
OPEN MARKET POLICY PROCESS
reserve position of large city banks, figures on the dis
tribution of reserves among banks are also assembled from
the reported data and carefully evaluated.
Data on reserves are supplemented by other types of
statistical information. For example, statistics on trans
actions in Federal funds are collected daily from a sample
of large money market banks. These shed light on the de
mand for and supply of excess reserves by banks and are a
sensitive indicator of changes in current bank reserve avail
ability relative to the demand for bank credit. In addition,
the Account Manager receives from the Market Statistics
Department of the Federal Reserve Bank of New York
aggregate data collected from Government securities
dealers that show their current inventories, volume of
trading, and sources of financing.
Apart from these various types of current and retro
spective statistics, the Account Manager obtains through
a network of telephone contacts maintained by the Trading
Desk a wide assortment of information from Government
securities dealers and other money market professionals
on current rate and price quotations in money markets as
well as estimates of customer offerings and demands in
markets for Federal funds and U.S. Government securities.
This information, which reflects the interaction of the
volume of reserves actually available and the demand
pressing upon these reserves, is needed for meaningful
interpretation and evaluation of the preliminary statistical
estimates on bank reserve positions. It also helps the
Account Manager to come to a better understanding of
market expectations and of the likely response to Federal
Reserve operations.
This brief review of the guides and information that
255
THE FEDERAL RESERVE SYSTEM
shape day-to-day activities of the Account Manager
illustrates the wide range of information he takes into
account in the execution of policy. The Manager, in turn,
keeps members of the Committee continuously informed
of the particular money market and bank reserve develop
ments that underlie each day’s actions. Insights gained
from these reports of current developments, in combina
tion with analyses of the broader but less timely indicators
of general changes in the domestic economy and the
balance of payments, provide the background information
on which Committee members must base their new policy
judgment at the succeeding meeting.
256
CHAPTER XVI
SUPERVISORY FUNCTIONS OF THE FEDERAL RESERVE. By keeping individual banks strong and by maintain
ing competition among banks, bank supervision helps to main
tain an adequate and responsive banking system. This contributes
to the effective functioning o f monetary policy and o f economic
processes generally.
OR the general instruments of monetary policy to
work effectively, the nation must have a responsive
banking system in which the public has full confidence.
The orderly functioning of such a system depends on the
effective operation of each bank in the system.
The current financial needs of commerce, industry, and
agriculture are met in part through loans and investments
made by individual banks, and the bulk of the nation’s
payments are made through the checking accounts in
these banks. As a factor of instability, failure of banks to
meet their liabilities can reach far beyond depositors and
borrowers and the immediate territory that the banks
serve. The business of banking, therefore, is vested with a
F
257
THE FEDERAL RESERVE SYSTEM
public interest and is subject to supervision by govern
mental authorities.
Bank supervision, which began in this country more than
a century ago, is rooted in two characteristics peculiar
to the American banking system: first, a large number of
commercial banks differing greatly in size and in the type
of banking service offered; and second, the wide vari
ety of detailed State and national banking laws and of reg
ulations issued under these laws.
Fundamentally, bank supervision is directed to safe
guarding and serving the community’s interest. In rela
tion to individual banks, the objective is to foster the
maintenance of each in sound and solvent condition and
under good management, in order to protect depositors
and to assure uninterrupted provision of essential banking
services. With respect to all banks, a further objective is
to help maintain a banking system which will adapt con
tinuously and responsively to the financial needs of a
growing economy and in which individual units will com
pete actively in rendering banking services.
Compass o f Bank Supervision
As a governmental activity, bank supervision encom
passes a wide variety of technical functions relating to
the operations of banks. These concern the issuance
and enforcement of supervisory and other regulations;
the organization and chartering of banks; the periodic
examination of banks and the requiring of steps by bank
management to correct unsatisfactory or unsound condi
tions found through such examination; the review and
analysis of periodic reports of condition and of income
and dividends; and the rendering of counsel and advice
258
SUPERVISORY FUNCTIONS
on bank operating problems when requested, particularly
in the case of smaller banks.
In addition, bank supervision deals with approval of
proposed changes in the scope of corporate functions
exercised by individual banks and of proposed changes in
their capital structures; authorization of branches; ap
proval of bank mergers and consolidations; and regula
tion of bank holding companies.
Bank supervision is concerned primarily with banks as
going concerns. Therefore, its principal objective is to
protect the banking structure against weakness of the
component banks and whenever possible to assist them
in becoming stronger units. Another important aim is
to prevent undue concentration of banking ownership
and power, which could inhibit competition and the avail
ability of adequate alternative banking facilities.
Given these aims, the major responsibility of supervisory
authorities is to keep informed of the condition, opera
tions, and management of the banks subject to their review
and to contribute to the prevention or correction of situa
tions that, through inadequacy of either banking capability
or banking competition, might adversely affect the econ
omy or the general public interest.
Role o f Bank Examination
Bank examination is the best known form of super
visory activity. Its purpose is to develop information that
will disclose the current financial condition of the in
dividual bank, ascertain whether the bank is complying
with applicable laws and regulations, and indicate the
bank’s future operating prospects. A bank examination
is not an audit since as a general practice it does not in-
259
THE FEDERAL RESERVE SYSTEM
elude detailed checking of entries relating to transactions
or direct verification of individual loan and deposit bal
ances. Banks are encouraged to provide such audit fa
cilities through internal audit departments of their own
or the services of public accountants.
The bank examiner in the field, therefore, is primarily
a fact finder and an appraiser. Examination steps include
analysis and appraisal of a bank’s assets; analysis of its
liabilities; review and appraisal of its management; review
of the administration of its trust department activities;
determination of its capital and liquidity position and
operating trends; study of the bank’s position, expecta
tions, and plans in relation to business conditions in the
community as well as generally; and consideration of the
bank’s performance in the light of various statutory and
regulatory provisions affecting the conduct of its business.
In the light of examiners’ findings, the supervisory au
thority formulates and expresses the appropriate super
visory policy and prescribes such steps as may need to be
taken to correct criticized phases of a bank’s affairs. The
supervisory policy expressed and the corrective measures
prescribed for a particular bank necessarily reflect the
composite experience of the supervisory authority in ex
amining and supervising many banks over a period of
many years.
Uses of the examination information are fourfold. In
the first place the directors and officers of examined banks
use it as the basis of action to strengthen their banks as
well as to prevent future difficulties. Second, the bank
ing authorities make it the basis of supervisory policy
and action with respect to particular institutions, includ
ing decisions whether to approve branches, mergers, or
260
SUPERVISORY FUNCTIONS
competing bank charters. Third, information accumulated
from many examinations guides the authorities in framing
or revising regulations, in shaping or reshaping supervisory
policies, and in recommending necessary or desirable
changes in banking laws. Fourth, the intimate knowledge
of banking conditions developed in the Federal Reserve
System as a result of bank examination and supervision
gives monetary policy-makers a greater feeling for pro
spective shifts in attitudes and expectations of bankers
and businessmen. Both the data and the nonstatistical
knowledge that are obtained in the examination and super
visory process are an essential part of the nation’s eco
nomic intelligence.
Governmental Agencies Concerned with Supervision
The complex nature of this country’s banking system
is reflected in, and is in part the product of, the govern
mental structure of bank supervision. State banks are
chartered by and operate under the laws of any one of the
fifty States. National banks in all States and the District
of Columbia operate under Federal banking law, with
membership in the Federal Reserve System mandatory.
System membership is also available to State banks that
meet membership qualifications. A system of Federal in
surance of deposits is applicable to all member banks and
to others that desire and qualify for insurance.
In such a structure of bank supervision there are neces
sarily cases of overlapping responsibilities and functions.
All of the supervisory authorities have similar basic ob
jectives, however, and by cooperating with each other in
developing effective working arrangements, they have been
able to avoid much of the seeming duplication in activities.
261
THE FEDERAL RESERVE SYSTEM
Federal Government legislation to deal with banking
problems at different times has given rise to three Federal
agencies actively and directly engaged in bank supervisory
functions:
The Office of the Comptroller of the Currency, a bureau
of the Treasury Department established in 1863, has
charter and supervisory authority with respect to the
national banks of the country.
The Federal Reserve System, established in 1913 to
provide, among other purposes, a “more effective super
vision of banking in the United States,” has supervisory
authority with respect to all its members and also with
respect to all bank holding companies. In practice, the
System confines its field examinations to State member
banks and, whenever practicable, it makes such examina
tions jointly with State supervisory authorities.
The Federal Deposit Insurance Corporation, estab
lished in 1933, has supervisory authority in connection
with its responsibility to insure deposits of Federal Re
serve member banks and of other banks that voluntarily
become insured by the Corporation. The Corporation in
practice examines only those insured banks that are not
subject to examination by another Federal supervisory
agency.
Scope o f System Supervisory Functions
The supervisory functions of the Federal Reserve are
varied. Its responsibilities in this area are concerned par
ticularly with admission of State banks to membership
in the System; the field examination of State member
banks and review of operations of all member banks; the
correction of unsatisfactory conditions in State member
262
SUPERVISORY FUNCTIONS
banks or of violation of banking law by them, including, if
necessary, disciplinary action to remove officers and di
rectors for unsafe or unsound banking practices or for con
tinued violation of banking law; and the issuance and
enforcement of regulations pertaining to member banks.
Other Federal Reserve supervisory functions include
approval of the establishment of branches or absorption
of other banks by State member banks; permission to
holding companies to acquire stock of banks and to vote
stock in member banks; chartering of foreign banking and
financing corporations; granting permission to mem
ber banks to engage in banking in foreign countries; and
supervision related to regulation of loans by banks,
brokers, and dealers in securities for the purpose of
purchasing or carrying of stocks registered on national
securities exchanges.
In carrying out these functions the Federal Reserve
authorities deal with complex and highly technical bank
ing questions. For example, in passing upon an applica
tion for approval of a proposed acquisition of bank shares
under the Bank Holding Company Act, the Board is
required to consider the financial history, condition, and
prospects of the institutions concerned; the character of
their respective managements; the convenience, needs, and
welfare of the communities and area served; and whether
or not the effect of the acquisition would be to expand the
size or extent of the particular bank holding company
system beyond limits that are consistent with adequate
and sound banking, the public interest, and the preserva
tion of competition in the field of banking.
Under a policy of decentralization, the Board of Gover
nors has delegated to the Federal Reserve Banks some
263
THE FEDERAL RESERVE SYSTEM
phases of the field work involved in Federal Reserve
supervisory activities, notably the bank examination func
tion. The Board of Governors, however, directs and
coordinates the supervisory work of the Reserve Banks,
reviews the results of their examination activities, and
determines broad supervisory policies.
The Reserve Banks do not examine national banks since
the Comptroller of the Currency is directly charged with
that responsibility under the law. In this way the two
agencies avoid duplicating examinations. Also, inasmuch
as State member banks are subject to examination by
State authorities, the Reserve Banks and these authorities
cooperate, whenever feasible, in joint or alternate ex
aminations. The established policy is for a Reserve Bank
to conduct one regular examination of each State member
bank every calendar year and to furnish a copy of the
report and any related correspondence to the Board of
Governors. Each Federal Reserve Bank obtains from the
Comptroller’s Regional Chief Examiners copies of re
ports of examination of national banks and exchanges
reports with the Board of Governors, the Comptroller of
the Currency, and the Federal Deposit Insurance Corpora
tion in Washington.
Bank Supervision and Monetary Policy
It is sometimes suggested that bank supervisory stand
ards be adjusted flexibly to help in counteracting cyclical
instabilities in the economy. This suggestion would call for
a firming of examination and other supervisory standards
in periods of inflationary or speculative boom and a
relaxation in periods of recession.
In considering this suggestion, one should bear in mind
264
SUPERVISORY FUNCTIONS
that bank supervision involves recurrent, and not con
tinuous, inspection of individual banks and by its nature
entails a complex set of procedures evolved over many
years. Such a process scarcely accommodates itself to a
raising or a lowering of examination standards in response
to changing economic conditions.
At the same time bank supervisory authorities are fully
aware that banking difficulties have at times in the past
intensified economic instability and that such risks should
be reduced. Accordingly, modern supervisory appraisal of
bank assets emphasizes sustainable banking values rather
than current market values. In this way, bank supervisory
authorities and examiners try to exclude from bank-asset
valuation the transitory influences associated with eco
nomic fluctuations. All of the governmental agencies con
cerned now use this approach to bank supervision and
examination.
While the general instruments of reserve banking are
the appropriate means for influencing economic stability
through credit and monetary policy, bank supervision
contributes to an intimate, current understanding of bank
ing conditions. In this respect, various questions that
supervisory agencies ask in their examination of banks
and their frequent communications with banks through
out the year supply information on bankers’ activities and
expectations that throw light on the developing bank
credit situation. In effect, examination reports provide a
continuous sampling of banking data. Some of the in
formation derived from them—such as that suggestive of
tendencies in the quality of bank credit advanced—would
not easily be obtained otherwise. Such information is a
valuable by-product of the bank supervision process.
265
THE FEDERAL RESERVE SYSTEM
Fundamentally, supervision contributes to the main
tenance of economic stability through its effects on the
internal strength of banks. To the extent that bank super
vision fosters competition and helps individual banks
under competent management to remain strong, it makes
for an effective and responsive system of banks and en
ables banks to weather adverse conditions and serve their
communities constructively in bad times as well as good.
266
CHAPTER XVII
SERVICE FUNCTIONS. The Federal Reserve Banks handle the
legal reserve accounts o f member banks, furnish currencyfo r circu
lation, facilitate the collection and clearance o f checks, and act as
fiscal agents o f the U.S. Government.
HE Federal Reserve System, in addition to being re
sponsible for regulating the flow of credit and money
and for bank supervision, performs a variety of regular
services for member banks, the U.S. Government, and the
public. This chapter describes the principal service func
tions of the Federal Reserve Banks.
The volume of service operations performed by the
Reserve Banks for the banking system and the Treasury
runs into huge figures, as the table on the next page shows.
In 1962 these Banks transferred three trillion dollars of
funds and handled more than one trillion dollars in checks.
Both the composition and the volume of service operations
vary considerably with short-term fluctuations in the levels
of production, trade, and prices. Over the half century of
the Federal Reserve System’s existence, these operations
T
267
THE FEDERAL RESERVE SYSTEM
have grown rapidly as the financial resources of the nation
have expanded.
V olume of Selected F ederal R eserve Bank O perations
1962
Type of operation
Number
of pieces
handled
(thousands)1
Amounts
handled
(thousands
of dollars)
Discounts and advances....................
7
19,685,050
Currency received and counted:
Paper currency...............................
Coin...............................................
4,734,419
10,213,309
31,621,061
1,140,009
Checks handled:
Postal money orders......................
U.S. Government checks...............
All other2......................................
247,400
443,271
3,873,341
4,701,516
125,431,359
1,283,430,670
Transfers of funds.............................
3,318
3,168,359,313
Issues, redemptions, and exchanges
of U.S. Government securities___
198,123
639,755,488
1 Packaged items handled as a single item are counted as one piece.
2 Exclusive of checks drawn on the Federal Reserve Banks.
Handling Member Bank Reserve Accounts
A substantial part of the daily work of the Reserve
Banks relates to member bank reserve accounts. Member
banks use their reserve accounts much as individuals use
their checking accounts in day-to-day transactions, draw
ing on them for making payments and replenishing them
with funds that are received. For example, entries are made
in these accounts as member banks obtain currency (paper
money and coin) to pay out to their customers or as they
redeposit currency in excess of the amount needed for
268
SERVICE FUNCTIONS
circulation, and as checks are collected and cleared. Other
entries arise as Treasury deposits are transferred from
member banks to the Federal Reserve Banks, or as funds
(member bank reserve deposits) are transferred by tele
graph from one Reserve Bank to another for various pur
poses, or as a bank borrows from, or makes repayment to,
a Reserve Bank. Various types of transactions are de
scribed in subsequent paragraphs. The Reserve Banks
must record all transactions and strike a daily balance for
the reserve account of each member bank.
Distributing Currency
There are two principal ways by which any individual
gets paper money and coin. He may draw it out of his
bank and have it charged to his account, or he may re
ceive it as payment for his services or his merchandise.
In the latter event, the currency received has usually been
drawn out of a bank by someone else.
There are times when banks are called on to pay out
more currency than they receive, and there are times when
they receive more than they pay out. Moreover, the de
mand varies for different kinds of currency. Some com
munities use more coin and less paper money than others;
and some use more of certain denominations.
The ready availability of currency at Federal Reserve
Banks enables member banks to provide the amounts and
kinds of currency that people in their communities want.
When member banks need to replenish their currency
supply, they order currency from their Reserve Bank and
have it charged to their reserve accounts. Nonmember
banks generally get their supplies from member banks.
To meet the varying demands for currency, the Reserve
269
THE FEDERAL RESERVE SYSTEM
Banks keep a large stock of paper money and coin on
hand. This includes both Federal Reserve notes, which are
Reserve Bank liabilities, and Treasury currency — silver
certificates, United States notes, and coin. A Reserve
Bank pays for Treasury currency by crediting the Treas
ury’s deposit account for the amount obtained.
Collecting, Clearing, and Transferring Funds
Currency is indispensable, yet it is used mainly for the
smaller transactions of present-day economic life. A cen
tury ago it was used far more generally. Since then the use
of bank deposits has increased to such an extent that pay
ments made by check are now many times larger than those
made with paper money and coin. The use of checking
deposits by business and the general public is facilitated
by the service of the Federal Reserve Banks in clearing
and collecting checks and in providing the mechanism
through which commercial banks settle for the checks
they clear and collect.
For example, suppose that a manufacturer in Hartford,
Connecticut, sells $1,000 worth of electrical equipment to
a dealer in Sacramento, California, and receives in pay
ment a check that is drawn on a bank in Sacramento.
The Hartford manufacturer deposits the check in a bank
in Hartford.
The Hartford bank sends the check (together with other
checks) to the Federal Reserve Bank of Boston for credit
in its reserve account. The Boston Reserve Bank sends the
check to the Federal Reserve Bank of San Francisco,
which in turn sends it to the Sacramento bank. The
Sacramento bank charges the check to the account of
the depositor who wrote it and has the amount charged to
270
SERVICE FUNCTIONS
its own reserve account at the San Francisco Reserve Bank.
The Federal Reserve Bank of San Francisco remits the
amount to the Federal Reserve Bank of Boston through
the Interdistrict Settlement Fund.
Because promptness in collecting checks is important,
the Federal Reserve Banks extend to member banks having
a substantial volume of checks payable in other Federal
Reserve districts the privilege of sending such checks
directly to other Federal Reserve Banks for collection.
The Hartford bank, therefore, might have forwarded the
$1,000 check directly to the Federal Reserve Bank of
San Francisco for collection, at the same time informing
the Federal Reserve Bank of Boston of its action. On the
basis of this information the Federal Reserve Bank of
Boston would then have credited the Hartford bank’s
reserve account just as if the check had been sent through
the Boston Bank.
The volume of checks handled by the Federal Reserve
Banks has grown rapidly over the years, as the follow
ing chart shows. Many other checks are collected by
large city banks for their correspondents and are not
handled by the Reserve Banks. Banks collect checks pay
able locally through clearing houses or by presenting the
checks directly to the banks on which they are drawn. The
settlement or payment for most checks drawn on member
banks, however, is made, directly or indirectly, through
their reserve balances with the Federal Reserve Banks.
Thus, the facilities of the Reserve Banks aid in clearing
and collecting checks, whether they originate locally or
across the country.
All checks collected and cleared through the Federal
Reserve Banks must be paid in full by the banks on which
271
THE FEDERAL RESERVE SYSTEM
they are drawn, without deduction of a fee or charge.
That is, they must be payable at par; otherwise the Re
serve Banks will not receive them for collection. Banks on
the par list comprise all member banks and those non
member banks that have agreed to remit at par for checks
forwarded to them by the Federal Reserve Banks for pay
ment. As of the end of 1962, about 93 per cent of all
CHECKS H A N D L E D BY RESERVE BANKS
Billion s of d o ll a r s
1500
1250
1 0 00
750
500
250
commercial banks and branches, accounting for about
98 per cent of all commercial bank deposits, were on the
Federal Reserve par list.
Over the years the process of clearing and collecting
checks has been greatly shortened and simplified. Both
commercial banks and the Federal Reserve Banks have
272
SERVICE FUNCTIONS
participated in this development. By doing so, they have
improved the means of paying for goods and services and
of settling monetary obligations; they have also reduced
the cost to the public of making payments and transferring
funds. Ways to achieve further improvements are under
continuous consideration. For example, much of the man
ual burden of processing checks has been relieved by
conversion of this work to electronic equipment.
In addition to checks, the Federal Reserve Banks handle
other items for collection. These include such items as
drafts, promissory notes, and bond coupons.
In order to make transfers and payments as promptly
and efficiently as possible, the twelve Federal Reserve
Banks maintain a gold certificate fund in Washington
called the Interdistrict Settlement Fund. Each Reserve
Bank has a share in it. This fund represents a substantial
part of the gold certificate reserves of the Federal Reserve
Banks. Through it money is constantly being transferred
by telegraphic order from the account of one Reserve
Bank to that of another.
On an average business day more than $7 billion of
transfers and payments are made through the Interdistrict
Settlement Fund. These are for the most part settlements
for checks collected, transfers of balances for account of
member banks and their customers, and transfers for the
U.S. Treasury.
The cost of clearing and collecting checks and of supply
ing currency and coin is a major part of Federal Reserve
Bank expenses. The Reserve Banks provide these services
for member banks free of charge. This practice is consistent
with the ideal of a money that circulates at par in all
regions of the country.
273
THE FEDERAL RESERVE SYSTEM
Fiscal Agency Functions
The twelve Federal Reserve Banks carry the principal
checking accounts of the U.S. Treasury, handle much of
the work entailed in issuing and redeeming Government
obligations, and perform numerous other important fiscal
duties for the U.S. Government.
The Government is continuously receiving and spending
funds in all parts of the United States. Its receipts come
mainly from taxpayers and purchasers of Government
securities and are deposited eventually in the Federal
Reserve Banks to the credit of the Treasury. Its funds are
disbursed mostly by check, and the checks are charged
to Treasury accounts by the Reserve Banks.
When the Treasury offers a new issue of Government
securities, the Reserve Banks receive the applications of
banks, dealers, and others who wish to buy; make allot
ments of securities in accordance with instructions from
the Treasury; deliver the securities to the purchasers;
receive payment for them; and credit the amounts re
ceived to Treasury accounts. As brought out below, most
of these payments are made initially to member and non
member banks and are kept in Treasury tax and loan
accounts at these banks.
Each Federal Reserve Bank administers for the Treasury
the tax and loan deposit accounts of the banks in its dis
trict. Both member and nonmember banks, by complying
with the Treasury’s requirements, may become “special
depositaries” of the Treasury and carry tax and loan
deposit accounts. The principal requirement is the pledge
with a Federal Reserve Bank, as fiscal agent of the Treas
ury, of enough Government securities or other acceptable
collateral to secure fully the balance in the account.
274
SERVICE FUNCTIONS
For the convenience of the Treasury and also for the
convenience of investors in Government securities, it is
necessary to have facilities in various parts of the country
to handle public debt transactions. The Federal Reserve
Banks furnish these facilities. They redeem Government
securities as they mature, make exchanges of denomina
tions or kinds, pay interest coupons, and do a number of
other things involved in servicing the Government debt.
In addition they issue and redeem U.S. savings bonds and
service the banks and other financial institutions desig
nated as issuing and paying agents for such bonds.
Another part of the fiscal agency activities of the Federal
Reserve Banks is their work in connection with the socalled “V-loan program.” This program, authorized by
the Defense Production Act of 1950 and implemented by
Regulation V of the Board of Governors, is an arrange
ment to assist competent contractors and subcontractors
who lack sufficient working capital to undertake defense
contracts for the production of essential goods and ma
terials. For this purpose the Departments of the Army,
Navy, Air Force, Commerce, Interior, and Agriculture,
the Defense Supply Agency of the Department of De
fense, the General Services Administration, the National
Aeronautics and Space Administration, and the Atomic
Energy Commission are authorized to guarantee loans
made by commercial banks and other private financing
institutions. The Reserve Banks act as fiscal agents for the
guaranteeing agencies in connection with such loans.
The Federal Reserve Banks may also perform fiscal
agency services in connection with the financial activities
of various Government lending agencies. They are reim
bursed by the U.S. Treasury and other Government
275
THE FEDERAL RESERVE SYSTEM
agencies for much of the expense incurred in the per
formance of fiscal agency functions other than depositary
functions.
Because of its location in one of the principal financial
centers of the world, the Federal Reserve Bank of New
York acts as the agent of the U.S. Treasury in gold and
foreign exchange transactions. It acts as depositary for
the International Monetary Fund, the International Bank
for Reconstruction and Development, and other interna
tional organizations. It also receives deposits of foreign
monetary authorities and performs certain incidental serv
ices as their correspondent. These services include han
dling short-term investments and holding earmarked gold.
All the Federal Reserve Banks participate in foreign
accounts carried on the books of the Federal Reserve
Bank of New York. In these matters the New York Re
serve Bank acts as agent for the other Federal Reserve
Banks. The Board of Governors in Washington exercises
special supervision over all relationships and transac
tions of Federal Reserve Banks with foreign monetary au
thorities and with international organizations.
Preparedness for National Defense
The Board of Governors is responsible for the develop
ment of national security preparedness measures relating
to bank credit and monetary policies. In cooperation with
the Department of the Treasury (including the Comp
troller of the Currency), the Federal Deposit Insurance
Corporation, and others, it is also responsible for pre
paredness programs relating to the operation of the
banking system. The Federal Reserve Banks are responsi
ble for providing commercial banks with instructions on
276
SERVICE FUNCTIONS
the distribution of currency, the collection of checks,
and the availability of credit for essential purposes in an
emergency. These preparedness responsibilities of the
Board of Governors and the Federal Reserve Banks are
a part of the over-all defense program of the Government
to assure the nation’s readiness to meet economic and
financial needs related to any wartime emergency.
277
SELECTED FEDERAL RESERVE PUBLICATIONS
(List appears on following pages)
279
PUBLICATIONS
B oard of G overnors
A n n u a l R eport. (N o charge.)
F ederal R eserve B ulletin . Monthly. (Subscription price, $6.00 a
year or 60 cents a copy; foreign mailing, $7.00 a year or 70 cents
a copy. Group subscriptions in the United States for 10 or more
copies to one address, 50 cents per copy per month, or $5.00 for
12 months. Reprints of selected articles are available free of charge
upon request.)
F ederal R eserve C hart B o ok : financial a n d business statistics.
Monthly. Annual subscription includes one issue of Historical
Chart Book. (Subscription price, $6.00 a year or 60 cents a copy;
in quantities of 10 or more copies of the same issue for single
shipment, 50 cents each; foreign mailing, $7.00 a year or 70 cents
a copy.)
F ederal R eserve H istorical C hart B ook . Issued annually in
September. Subscription to monthly chart book includes one
issue of the Historical. (60 cents a copy; in quantities of 10 or
more for single shipment, 50 cents each; foreign mailing, 70
cents each.)
A ll-B ank S tatistics, 1896-1955. April 1959. 1,229 pages ($4.00
a copy.)
F ederal F un ds M arket . A study by a Federal Reserve System
Committee. May 1959. I l l pages. ($1.00 a copy; in quantities
of 10 or more for single shipment, 85 cents each.)
T he F ederal R eserve A ct , as amended through October 1, 1961,
with an appendix containing provisions of certain other statutes
affecting the Reserve System. 386 pages. ($1.25 a copy.)
F low of F un ds in the U nited S tates, 1939-53. December 1955.
390 pages. ($2.75 a copy.)
Industrial P roduction — 1957-59 Base. 1962. 172 pages. ($1.00 a
copy; in quantities of 10 or more for single shipment, 85 cents
each.)
M onetary Policy a n d M anagement of the P ublic D ebt : A
S elected B ibliography . This list (mimeographed) is revised or
supplemented annually. (No charge.)
281
PUBLICATIONS
T reasury -F ederal R eserve Stu dy of the G overnment S ecurities
M arket . Part I. 1959. 108 pages. Part II. 1960. 159 pages. Part
III. 1960. 112 pages. (Individual books, $1.00 each; set of 3 books,
$2.50.)
Copies of this book, T he F ederal R eserve System : P urposes
F unctions , may be obtained without charge, either individ
ually or in quantities for classroom and other use.
and
In addition to the publications listed, the Board issues periodic
releases, other special studies, and reprints. Lists of available
material may be obtained upon request. Inquiries regarding publica
tions should be directed to the Division of Administrative Services,
Board of Governors of the Federal Reserve System, Washington,
D.C. 20551.
282
PUBLICATIONS
F ederal R eserve B anks
BOSTON
T ime D eposits in N ew E n g l a n d . A survey of the historical develop
ment of time and savings deposits, with special emphasis on con
ditions in New England. (Federal Reserve Bank of Boston, 1962
Annual Report, pages 3-61.) (No charge.)
CHICAGO
M odern M oney M echanics : A W orkbook on D eposits, C u r
rency , a n d B an k R eserves. Text and “T account” description of
the money-creation process and the factors affecting member
bank reserves. 1961. 32 pages. (No charge.)
T he T wo F aces of D ebt. A description of the economic role of
debt and the amounts owed by various sectors. 1963. 20 pages.
(No charge.)
CLEVELAND
M oney M arket I nstruments . 1962. 32 pages. (No charge.)
KANSAS CITY
E ssays on C ommercial B an k in g , by D . A. Cawthorne, Sam B.
Chase, Jr., and Lyle E. Gramley. Nine essays on various aspects
of commercial bank policies and operations. August 1962. 98
pages. (No charge.)
A Study of Scale E conomies in B an kin g , by Lyle E. Gramley. A
study of costs and earnings of commercial banks as related to
their size. November 1962. 60 pages. (No charge.)
MINNEAPOLIS
Y our M oney a n d the F ederal R eserve S ystem (rev. ed.). An
illustrated elementary discussion of the work of the Federal
Reserve System. 1957. 20 pages. (No charge.)
283
PUBLICATIONS
NEW YORK
D eposit V elocity a n d I ts S ignificance , by George Garvy. N o
vember 1959. 88 pages. (60 cents a copy; 30 cents a copy on
orders from educational institutions.)
F ederal R eserve O perations in the M oney a n d G overnment
S ecurities M arket , by Robert V. Roosa. July 1956. 105 pages.
(No charge.)
M o ney : M aster or S ervant ? An explanation in nontechnical
language of the role of money in our economy. 2nd edition, April
1960. 48 pages. (No charge.)
T he M oney S ide of “ T he S treet,” by Carl H. Madden. An account
of the workings of the New York money market. September 1959.
104 pages. (70 cents a copy; 35 cents a copy on orders from
educational institutions.)
O pen M arket O perations . An explanation in nontechnical terms
of the translation of broad monetary objectives into day-to-day
operations. January 1963. 43 pages. (No charge.)
PHILADELPHIA
D efending the D ollar , by Clay J. Anderson. A discussion of the
balance of payments, the foreign exchange market, and the
defense of the dollar against outflows of funds. November 1962.
27 pages. (No charge.)
How to I nterpret F ederal R eserve R eports. January 1962. 48
pages. (No charge.)
M onetary P olicy— decision -making , tools, a n d objectives. This
collection of articles deals with some of the problems encountered
in implementing monetary policy. April 1961. 52 pages. (No
charge.)
T he Q uest for S tability . Five essays describing efforts to achieve
an efficient monetary system in the United States. 1954. 54 pages.
(No charge.)
284
PUBLICATIONS
RICHMOND
T he F ederal R eserve at W ork , by B. U. Ratchford and Robert P.
Black. A discussion in layman’s terms of the structure, objectives,
and functions of the Federal Reserve System. 2nd edition, 1962.
30 pages. (No charge.)
F ederal R eserve B ank D irectors, by Welford S. Farmer. A
description of the role of the head office and branch directors in the
operation of the Federal Reserve Banks and their contribution to
the functioning of the economy. 19 pages. (No charge.)
N otes on C entral B anks , by B. U. Ratchford and Jimmie R.
Monhollon. A booklet dealing with the nature, characteristics,
and functions of central banks, with special reference to the
Federal Reserve System. March 1963. 33 pages. (No charge.)
R eadings on M oney . A discussion of the nature of money and the
processes of its creation and circulation. 3rd edition, 1963. 58
pages. (No charge.)
Each Federal Reserve Bank also publishes a monthly review of
credit and business conditions which will be sent regularly to anyone
requesting it. Some of the Banks issue booklets on special subjects,
such as agricultural credit and economic indicators.
Requests for the reviews and other Bank publications, and
inquiries about quantity orders, should be sent to the Federal
Reserve Banks at the following addresses:
Federal Reserve Bank of Atlanta
Atlanta, Georgia 30303
Federal Reserve Bank of Boston
Boston, Massachusetts 02106
Federal Reserve Bank of Chicago
Chicago, Illinois 60690
Federal Reserve Bank of Cleveland
Cleveland, Ohio 44101
285
PUBLICATIONS
Federal Reserve Bank of Dallas
Dallas, Texas 75222
Federal Reserve Bank of Kansas City
Kansas City, Missouri 64106
Federal Reserve Bank of Minneapolis
Minneapolis, Minnesota 55440
Federal Reserve Bank of New York
New York, New York 10045
Federal Reserve Bank of Philadelphia
Philadelphia, Pennsylvania 19101
Federal Reserve Bank of Richmond
Richmond, Virginia 23213
Federal Reserve Bank of St. Louis
St. Louis, Missouri 63166
Federal Reserve Bank of San Francisco
San Francisco, California 94120
286
IN D E X
Acceptances, bankers’..............................................................31, 110, 190
Annual R ep o rts, Board of Governors........................................... 244, 245
Balance of international payments:
Accounts....................................................................................... 150-53
Chart.............................................................................................. 153
Definition.......................................................................................150-52
Factors influencing........................................................................ 156-58
Federal Reserve policy and........................................................... 149-63
Foreign currency operations (S e e Federal
Open Market Committee)
Gold conversions and.................................................................... 155
Monetary policy and..................................................................... 158-60
Open Market Committee operations and......................................33,36
Problem of.....................................................................................210-12
Relationship to domestic economic activity..................................
12
Significance.................................................................................... 155
Swap arrangements................................................................... 162, 192
Balance sheet of the Federal Reserve Banks.................................... 187-89
Bank:
Credit.............................................................. 4, 10, 30, 76-78, 165, 265
Examinations......................................................................4, 21, 259-66
Examiners...................................................................................... 260
Reserve equations....................................................... 199-213, 217, 219
Reserve factors....................................................................199-213, 215
Reserves (S ee Reserves)
Supervision:
Federal Reserve functions......................................................... 257-66
Government agencies and.......................................................... 261
Monetary policy and................................................................. 264-66
Scope............................................................................... 258, 262-64
Bank for International Settlements..............................................—
162
Bank Holding Company Act............................................................. 263
Bankers’ acceptances.............................................................. 31, 110, 190
Banking Act of 1 9 3 5 .........................................................................
50
Banking system, operation of reserves in...........................................66-69
Board of Governors............................................... 20-23, 225-28, 247, 276
Businesses:
Demands for credit........................................................................102-04
Nonfinancial, in credit markets..................................................... 102
Sources of credit..............................................................................96-98
287
INDEX
Capital accounts................................................................................
Capital assets, costs of producing new assets...................................
Capital markets.................................................................................
Cash:
Demands for..................................................................................
Monetary policy and......................................................................
Central banks.................................................................................... 4,
Central reserve cities.........................................................................
Charts:
Bank Reserve Equation..................................................................
Change in Financial Position.........................................................
Checks Handled by Reserve Banks...............................................
Coupon Rate, Market Yield, and Price.........................................
Credit Expansion...........................................................................
Currency and Federal Reserve Credit...........................................
Currency in Circulation.................................................................
Deposits and Bank Lending...........................................................
Discount and Bill Rates.................................................................
Disposition of Federal Reserve Bank Earnings.............................
Federal Reserve Credit..................................................................
Flow of Federal Reserve Influence................................................
Government Security Transactions, 1 9 6 2 ......................................
Gross National Product and Money Supply.................................
Gross National Saving...................................................................
Kinds of Currency..........................................................................
Long- and Short-Term Interest Rates..........................
Member Bank Reserves.................................................................
Money and Near-Moneys..............................................................
Organization of the Federal Reserve System.................................
Process of Deposit Expansion.......................................................
Production and Prices....................................................................
Rates on Bank Loans to Business.................................................
Relation of Parts of the Federal Reserve System
to Instruments of Credit Policy..................................................
Relationships Among Reserve Measures.......................................
Reserves and Borrowings..............................................................
Reserves of Federal Reserve Banks...............................................
Selected Interest Rates...................................................................
Total U.S. Gold Stock...................................................................
U.S. Balance of Payments.............................................................
288
195
140
86
133
135
194
3
203
93
272
109
84
183
181
76
48
196
59
129
36
146
94
179
Ill
79
7
22
72
209
86
227
250
222
173
113
168
153
INDEX
Charts—Continued
U.S. Government Marketable Debt..............................................
89
Yields and Prices on U.S.Government Securities.......................... 115
Check clearing and collection.................................................. 194, 270-73
Commercial banks....................2, 25, 40, 63, 70, 84, 89, 99, 100, 272, 276
Comptroller of the Currency...................................................26, 262, 264
Condition statements of the Reserve Banks, weekly.............187, 215, 216
Conferences of Chairmen of the Reserve Banks...............................
24
Conferences of Presidents of the Reserve Banks..............................
24
Contract interest rates....................................................................... 108
Coupon rates..................................................................................... 108-10
Credit:
Bank................................................................4, 10, 30, 76-78, 165, 265
Demands for..................................................................................101-04
Expansion (chart)...........................................................................
84
Federal Reserve............................................................59, 165, 201, 204
Funds, supply and demand........................................................... 94-104
Markets:
Competition for funds............................................................... 104-06
Definition...................................................................................
83
Geographical distribution........................................................... 86-88
Interest rates............................................................................... 107
Nature of..................................................................................... 85-88
Net reserve positions and........................................................... 222
Role of economic groups............................................................ 92-94
U.S. Government securities (S ee Government
securities market)
Mortgages...................................................................................... 142
Policy:
Effect on borrowers................................................................... 138-43
Federal Reserve.................................................................197, 206-10
Relation of parts to instruments of (chart)............................... 227
Regulation o f.................................................................................
9
Short- and intermediate-term......................................................... 141
Sources.......................................................................................... 94-101
Stock market, regulation of..............................................55-57, 61, 228
Credit and money:
Bank................................................................ .....................4, 5, 10, 30
Effect of changes in.........................................................................10-13
Forces affecting flow of.................................................................
9
Regulation o f.................................................................................4, 59
289
INDEX
Currency:
Before 1 9 1 4 ...................................
Circulation....................................
Demands for.................................
Distribution o f.............................
Dollars as an international reserve
Elasticity of....................................
Federal Reserve credit and (chart)
Federal Reserve notes....................
Kinds (chart)................................
Relation to reserve banking..........
Treasury........................................
....................................... 177
180-82, 201, 204, 206, 208, 210
.............................. 180-82, 269
....................................... 269
....................................... 155
........................................1, 177
....................................... 183
...............166, 178-80, 188, 192
...................................
179
......................................177-85
....................................177, 180
Deposits:
Bank lending and......................................................................73, 74-76
Demand, as money........................................................................
6
Demand, ratios of reserves to......................................................... 66-69
Expansion (chart)...........................................................................
72
Foreign central banks.................................................................... 194
Liabilities....................................................................................... 192-95
Savings and other time................................................................ 70, 228
Treasury accounts.......................................................................... 193
Treasury tax and loan accounts................................................ 194, 274
U.S. banks, June 30, 1 9 6 3 ..............................................................
25
Directors:
Federal Reserve Banks...................................................................
19
Member banks.............................................................................. 262-63
Discount:
Administration........................................................................42, 230-32
Bill rates and (chart)......................................................................
48
Operations........................................................................ 29, 40-50, 230
Rates.......................... 40, 45-49, 59, 124, 210, 212, 228, 230-32, 239-40
Discounting.......................................................................................40, 57
Discounts:
Effect on reserves...........................................................................
41
Member banks..................................................................43-45, 58, 190
Earnings, Reserve Bank.................................................................... 196
Economic stability............................................................................. 127
Examinations, bank................................................................4, 21, 259-66
Exchange Stabilization Fund.........................................................161, 168
290
INDEX
Federal Advisory Council..................................................................
23
Federal Deposit Insurance Corporation.......................................262, 264
Federal funds market....................................................................49, 255
Federal Open Market Account................................................. 31, 39, 233
Federal Open Market Account Manager
and Special Manager.......................... 31, 233, 239, 241, 244-49, 252-56
Federal Open Market Committee
(S ee also Open market operations):
Directives.......................................................................................246-56
Foreign currency operations............................. 29, 39, 160-63, 242, 245
Function........................................................................................
23
Meetings:
Agenda....................................................................................... 242
Frequency.................................................................................. 232
Organization of..........................................................................241-44
Preparation for........................................................................... 240
Monetary policy role..................................................................... 238
Operation of...................................................................................
31
Organization................................................................................... 232
Policy:
Directives.................................................................. 239, 244, 246-56
Execution................................................................................... 245-56
Procedures............................................................................ 33, 239-44
Federal Reserve Act............................................................1, 4, 17, 24, 26
Federal Reserve Agents................................................... 19, 178, 179-80
Federal Reserve Banks:
Balance sheets of........................................................................... 187-89
Branches........................................................................................
17
Capital stock................................................................................ 26, 195
Credit policy................................................................................... 197
Directors........................................................................................
19
Districts..........................................................................................
17
Earnings......................................................................................... 196
Examinations............................................................................... 21, 264
Fiscal agency functions................................................................. 274-76
Foreign accounts............................................................................... 194,276
Gold certificate accounts................................................... 167, 169, 170
New York Bank.................. 161, 170, 171, 230, 232, 233, 247, 255, 276
Obligations and privileges..............................................................
26
Officers...........................................................................................
20
Representation at Federal Open Market
Committee meetings..........................................................240, 242-43
291
INDEX
Federal Reserve Banks—Continued
Role in decision-making............................................................... 230-33
Service functions............................................................................267-77
Surpluses........................................................................................ 196
Volume of service operations......................................................... 267
F ederal R eserve B u lletin s ...................................................................
213
Federal Reserve notes............................... 166, 178-80, 184, 188, 192, 270
Federal Reserve System:
Authority, distribution of.............................................................. 226
Decentralization.............................................................................
18
Establishment.................................................................................
1
Functions................................................. 1, 4, 257, 262-64, 267, 268-77
Influence, flow of (chart)............................................................... 129
Influence on credit and money....................................................... 8-10
Map...............................................................................................
16
Membership...................................................................................
24
Monetary policy, organization for................................................ 225-34
Open market policy process..........................................................235-56
Organization chart.........................................................................
22
Policy-making:
Complexities.............................................................................. 236-38
Federal Open Market Committee role....................................... 238
Guides in.................................................................................... 237
Publications, selected.................................................................... 279
Relation of parts to instruments of credit policy (chart)............... 227
Relations with other Government agencies............................37, 228-30
Structure.......................................................................................... 15-24
Treasury accord with..................................................................... 207
“Feel of the market”......................................................................... 251
Financial institutions, in credit markets......................................... 99, 103
Financial position changes (chart).....................................................
93
Fiscal agency functions.....................................................................274-76
Float....................................................................................... 192, 195, 220
Foreign banks.........................................................................194, 220, 263
Foreign currency operations
{S ee Federal Open Market Committee)
Gold:
Balance of international payments (S ee Balance of
international payments)
Bank reserve factors and................................................................ 201
Certificate accounts............................................................. 167, 169, 170
292
INDEX
Gold—Continued
Certificate reserves.................................166, 173-75, 178, 188, 197, 273
Certificates, Treasury issued.......................................................... 188
“Earmarked” ................................................................................. 171
International transactions.............................................................. 168
Monetization of............................................................................. 169-72
Movements......................................................................... 171, 172, 206
Price............................................................................................... 167
Reserve banking and..................................................................... 165-75
Reserve money.............................................................................. 166-69
Reserves, basis of Federal Reserve credit...................................... 165
Stock, total U.S. (chart)................................................................ 168
Title to....................................................................................... 167, 171
Treasury holdings..........................
167
Gold Reserve Act of 1 9 3 4 ................................................................. 166
Government marketable debt (chart)................................................
89
Government securities:
Definition....................................................................................... 191
Federal Reserve Banks’ processing of........................................... 274
Market:
Activity......................................................................................
90
Federal Reserve support o f........................................................ 207
Open market operations and..................................... 34, 37, 233, 255
Services......................................................................................
91
Size.............................................................................................
88
Transactions, 1962 (chart).........................................................
36
Yields and prices........................................................................... 115
Governments, in credit markets............................................ 98, 102, 103
Gross National Product and Money Supply (chart)....................
146
Gross National Saving (chart)...........................................................
94
Interdistrict Settlement Fund........................................................ 271, 273
Interest, definition............................................................................. 118
Interest rates:
Bank loans to business (chart).......................................................
86
Changes.........................................................................116, 136-38, 139
Contract......................................................................................... 108
Definition....................................................................................... 107
Differences.....................................................................................110-12
Expectations and........................................................................... 119
Federal Reserve actions and...................................................30, 123-25
Fluctuations................................................................................... 110
293
INDEX
Interest rates—Continued
Inflexibilities................................................................................... 122
Long- and short-term....................................................I ll, 114-17, 159
Monetary policy and..................................................................... 123-25
Money and bank credit and........................................................... 121
Movements.....................................................................................112-16
Selected (chart)............................................................................... 113
International Bank for Reconstructionand Development................. 276
International Monetary Fund............................................................ 276
International payments:
Dollars........................................................................................ 154, 168
Gold........................................................................................... 154, 168
International reserves, dollar holdings as........................................ 155
Lending agencies, Federal................................................................. 275
Loans and investments............................................................ 66-69, 74-76
Margin requirements....................................................................55-57, 61
Member banks:
Borrowing............................................................................43-45, 57, 58
Classes............................................................................................
24
Deposits..........................................................................................
25
Examinations............................................................................262, 264
Number.........................
24
Obligations and privileges..............................................................
26
Officers and directors...................................................................... 263
Reserve requirements (S ee Reserve requirements)
Reserves (S e e Reserves)
Supervision....................................................................................262-64
Monetary instruments, coordination...................................................57-62
Monetary policy:
Aims................................................................................................ 127
Balance of international payments and......................................... 158-60
Bank supervision and.....................................................................264-66
Economic growth and....................................................................145-47
Effects on:
Borrowing and spending............................................................. 138
Commercial banks..................................................................... 130-32
Lenders and savers...................................................................... 137
Nonbank lenders........................................................................ 137
Spending..................................................................................... 143
“Even keel”....................................................................................
38
294
INDEX
Monetary policy—Continued
Influences....................................................................................... 128
Interest rates and................................................................. 107, 123-25
Net reserve positions and.....................................................222, 248-51
Open market policy process..........................................................235-56
Organization of Federal Reserve System for................................225-34
Treasury coordination.................................................................... 229
Monetary regulation, instruments.....................................................
29
Money (S ee also Credit and money):
Creation of....................................................................................
75
Definition.......................................................................................
5
Gold as reserve money.................................................................. 166-69
“High-powered” ........................................................................... 69, 77
Markets..........................................................................................
86
Near-moneys and........................................................................... 7, 8
Supply, effect of changes in........................................................... 132
Mutual savings banks:
Number and deposits....................................................................
25
Sources of credit funds.................................................................. 101
National Advisory Council on International Monetary
and Financial Problems................................................................. 230
National Bank Act............................................................................
26
National banks:
Charters.........................................................................................
26
Examinations................................................................................. 264
Number and deposits.....................................................................24-25
Reserves.........................................................................................
3
System membership.......................................................................
24
National defense................................................................................ 276
National Monetary Commission.......................................................
4
Near-moneys...................................................................................... 7, 8
Net reserve positions................................................................223, 248-51
Nonbank lenders............................................................................... 137
Nonmember banks......................................................................... 25, 194
Open Market Account............................................................. 31, 39, 233
Open Market Committee (S ee Federal
Open Market Committee)
Open market operations..........................29-39, 57, 58-60, 61, 208-10, 238
Par lists.................................
Production and prices (chart)
272
209
295
INDEX
Regulations, Board of Governors:
A (discount process)....................................................................42, 231
V (defense production loans)......................................................... 275
Repurchase agreements...................................................................31, 191
Reserve:
Balances.........................................................................................
80
Banking (S ee also Monetary policy).............................................. 127
Banks, foreign................................................................................
4
Measures, relationships among (chart).......................................... 250
Money, multiplying capacity.........................................................
73
Ratios............................................................................... 66-68, 197, 239
Reserve requirements:
Changes in...................................... 29, 50-55, 57, 174, 212, 226, 239-40
Federal Reserve Banks.....................................................178-80, 182-84
Member banks...................................................................51, 65, 70, 80
Suspension o f................................................................................. 174
Reserves:
Borrowings and (chart).................................................................. 222
Changes, short-term...................................................................... 215-24
Currency circulation and............................................................... 182-85
Federal Reserve Bank (chart)........................................................ 173
Free......................................................................................223, 224, 249
Function o f..................................................................................... 64-81
Gold certificate.............................................. 173-75, 178, 188, 197, 273
Member banks:
Balances...............................................................80, 248-51, 267, 268
Bank reserve equations............................................................ 199-213
Changes............................................................................. 29, 204, 235
Chart..........................................................................................
79
Excesses......................................................................................
80
Gold purchases or sales, effect................................................... 172
Measure o f.............................................................................248, 255
Ratios...........................................................................................66-68
Supplies...................................................................................... 248
Treasury payments, effect........................................................... 220
Multiplying power.......................................................................... 71-74
Open market operations and.....................................................247, 255
Operation in banking system.........................................................
66
Wartime and postwar....................................................................205-07
Saving, gross national (chart)...........................................................
94
Saving-investment process.................................................................117-19
296
INDEX
Savings and loan associations.........................................................89, 101
Savings institutions, in credit markets..............................................95, 98
Securities, purchases or sales o f................................................... 3, 31, 35
Service functions, Federal Reserve Banks........................................ 267-77
State member banks:
Examinations................................................................................ 4, 264
Number and deposits....................................................................
25
Obligations and privileges..............................................................
26
Stock market credit, regulation............................................55-57, 61, 228
Supervisory functions, Federal Reserve............................... 4, 257, 262-64
Surplus............................................................................................... 196
Swap agreements............................................................................... 162
Tax and loan accounts..................................................................193, 274
Transfer of funds..............................................................................270-73
Treasury, U.S.:
Currency........................................................................................ 180
Federal Reserve accord..............................................................33, 207
Fiscal agency services for..............................................................274-76
Gold certificate accounts............................................................... 167
Gold holdings................................................................................ 167
Notes.'........................................................................................... 177
Payments........................................................................................ 219
Relation of Federal Reserve with.......................................... 37, 228-30
Tax and loan deposit accounts..................................................193, 274
United States notes................................................................167, 180, 270
V-loan program.................................................................................
275
Weekly condition statements of the Federal Reserve Banks............
187
297
@FedFRASER