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THE FEDERAL RESERVE SYSTEM

PURPOSES & FUNCTIONS

THE FEDERAL RESERVE SYSTEM

PURPOSES & . FUNCTIONS

THE FEDERAL RESERVE SYSTEM

PURPOSES & FUNCTIONS

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BOARD OF G O V E R N C fc B (5 § fi& 8 € fH .

Federal Reserve Bank
of St. Louis

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WASHINGTON, D.C. 1984

First Edition □ May 1939
Second Edition □ November 1947
Third Edition □ April 1954
Fourth Edition □ February 1961
Fifth Edition □ December 1963
Sixth Edition □ September 1974
Seventh Edition □ December 1984

Library of Congress Card Number 39-26719

Copies of this book may be obtained from Publications Services, Division of Support
Services, Board of Governors of the Federal Reserve System, Washington, D.C. 20551.

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Contents
- !

A cknow ledgm ents

Chapter 1

The Federal Reserve:
Central Bank of the United States
Role o f the Federal Reserve in Governm ent
Structure o f the Federal Reserve System
Board of Governors

Federal Open Market Committee
Federal Reserve Banks
Member Banks

Advisory Committees

10
Chapter 2

Monetary Policy and the Economy

How M onetary Policy W orks: A Schematic Overview
Guides for M onetary Policy

Inform ation on M onetary Policy and Its Relation
to the Econom y

M easures o f M onetary and Credit Aggregates

Purposes & Functions
Chapter 3

The Implementation of Monetary Policy:
Open Market Operations
Establishing Reserve Objectives for Operations
Security Transactions o f the Central B an k

Factors O ther than O pen M arket Operations Influencing Reserves
T he M anager’s Open M arket Techniques
Outright Purchases and Sales
Repurchase Agreements

Sale—Purchase Transactions

43
Appendix

The Federal Reserve Balance Sheet
and the Reserve Equation
Consolidated Balance Sheet o f the Reserve Banks
Major Asset Accounts

Major Liability Accounts
Capital Accounts

T he Reserve Equation

Sources of Reserve Funds
Uses of Reserve Funds
Total Reserves

45
45

v ii
Contents

___________________________________________________________ Chapter 4

Implementation of Monetary Policy:
Other Instruments
T he Reserve B an k D iscount Window
Mechanics of Borrowing
Adjustment Credit

Extended Credit for Seasonal Purposes
Other Extended Credit
T he D iscount Rate

Reserve Requirem ents

Structure of Reserve Requirements

Reserve Requirements and Monetary Policy
O ther Policy Tools

71
Chapter 5

The Federal Reserve in the International Sphere
M onetary Policy and International Economic Developments
Foreign Currency Operations
“ Swap” Network

Other U .S. Foreign Currency Resources
Internationalization o f Banking

The Anatomy of Internationalization

Eurobanking, U .S. Monetary Aggregates,
and U .S. Reserve Requirements

International Banking Facilities

75
75

v iii

Purposes & Functions

Chapter 6

Supervisory and Regulatory Functions
Federal Supervisory Structure

Scope o f Federal Reserve Supervisory Functions

Domestic Operations of U .S. Banking Organizations

International Operations of U .S. Banking Organizations
U .S. Activities of Foreign Banking Organizations
T he Regulation o f Banking Structure

Bank Flolding Company Expansion

Bank Acquisitions

Other Changes in Bank Control

Regulatory Responsibilities for Consum er Laws
Consumer Laws

Nonbanking Acquisitions
Bank Mergers

100

Community Reinvestment and Development

101
Chapter 7

Federal Reserve Bank Services

103

Federal Reserve B an k Services and Pricing

103

T he Federal Reserve and the Paym ents System
Currency and Coin

105

Check-Processing Services

106

Electronic Fund Transfers

108

Net Settlement

105

110

O ther Federal Reserve B an k Services

110

Fiscal-Agency Functions o f the Federal Reserve System

111

ix
Concents

_________________

Tables

2.1

Measures of the Money Stock and Liquid Assets, March 1984

2.2

Derivation of Domestic Nonfinancial Debt Outstanding,
March 1984

3.1

Transactions of the System Open Market Account,
1982 and 1983

3.A.1

Consolidated Statement of Condition of All Federal Reserve Banks,
March 28, 1984

3.A.2

Reserve Equation

46
52

4.1

Discount Window Borrowing, by Type, 1975—83

4.2

Reserve Ratios, September 1984

6.1

Number and Deposits of Registered Bank Holding Companies,
Selected Years, 1957-83

7.1

Currency and Coin in Circulation, Selected Years, 1935-83

7.2

Number of Checks, Total and Collected by the Federal Reserve,
Selected Years, 1920—83

108

106

Purposes & Functions

Charts
1.1

Organization of the Federal Reserve System

2.1

Velocity of M l, 1959-84

3.1

Measures of Reserves and Interest Rates, 1973—84

3.A.1

Federal Reserve Float

3.A.2

Currency in Circulation

5.1

17
32

54
55

Total Assets at Foreign Offices and IBFs of U.S.-Chartered Banks,
Dollar Volume and Percentage of Worldwide Assets of
U.S.-Chartered Banks, December 1973 and December 1983

5.2

Total Assets at U .S. Offices of Foreign Banks, Dollar Volume
and Percentage of Total Assets of Banking Institutions
in the United States, December 1973 and December 1983

7.1

Elements of the Check-Clearing System

107
Other Illustrations

Map

The Federal Reserve System

Box

Reserve Concepts

Photograph

Index

113

The New York Trading Desk at Work

Acknowledgments

Ohis edition of The Federal Reserve System: Purposes & Functions, its seventh,
has been completely rewritten by members of the staff of the Board of Governors
of the Federal Reserve System to reflect the evolution over the past decade of
Federal Reserve policies and practices in the monetary, regulatory, and other
areas, given changes in the legislative framework and in the structure of the
financial system. Stephen H. Axilrod, Staff Director for Monetary and Financial
Policy, had principal responsibility for preparation of the book. Major contri
butions were made by Edward C. Ettin, Deputy Director, Division of Research
and Statistics; Dale W. Henderson, Associate Director, Division of International
Finance; Donald L. Kohn, Deputy Staff Director for Monetary and Financial
Policy; David E. Lindsey, Deputy Associate Director, Division of Research and
Statistics; Brian Madigan, Senior Economist, Division of Research and Statistics;
Lorin S. Meeder, formerly Associate Director, Division of Federal Reserve Bank
Operations; Samuel Pizer, Staff Adviser, Division of International Finance;
Naomi P. Salus, Special Assistant to the Board, Office of Board Members; and
Richard Spillenkothen, Assistant Director, Division of Banking Supervision and
Regulation. Mendelle T. Berenson, Chief of the Economic Editing Section,
Division of Research and Statistics, edited the manuscript; Nancy Steele, Econ
omist, Office of Staff Director for Monetary and Financial Policy, verified the
text; and Barry E. Huber, Design Manager, Graphic Communications Section,
Division of Data Processing, was responsible for graphic design.

Chapter 1

The Federal Reserve:
Central Bank of the United States
Uhe Federal Reserve System was created by the Federal Reserve Act,
passed by the Congress in 1913 in order to provide for a safer and more
flexible banking and monetary system. For about a hundred years before
the creation of the Federal Reserve, periodic financial panics had led to
failures of a large number of banks, with associated business bankruptcies
and general economic contractions. Following the studies of the National
Monetary Commission, established by the Congress a year after the
particularly severe panic of 1907, several proposals were put forward for
the creation of an institution designed to counter such financial disrup
tions. After considerable debate, the Federal Reserve System was estab
lished. Its original purposes were to give the country an elastic currency,
provide facilities for discounting commercial credits, and improve the
supervision of the banking system.
From the inception of the Federal Reserve System, it was clear that
these original purposes were aspects of broader national economic and
financial objectives. Over the years, stability and growth of the economy,
a high level of employment, stability in the purchasing power of the
dollar, and reasonable balance in transactions with foreign countries have
come to be recognized as primary objectives of governmental economic
policy. Such objectives have been articulated by the Congress in the
Employment A ct of 1946, and more recently in the Full Employment and
Balanced Growth Act of 1978. The Federal Reserve Act has also been
amended over the years to enable the System to function more effectively
in helping to attain the nation’s economic goals, with key amendments
set forth in the Banking Act of 1935, the 1970 amendments to the Bank
Holding Company Act, the International Banking Act of 1978, the Full
Employment and Balanced Growth Act of 1978, and the Depository
Institutions Deregulation and Monetary Control Act of 1980.
The Federal Reserve contributes to the attainment of the nation’s
economic and financial goals through its ability to influence money and
credit in the economy. As the nation’s central bank, it attempts to ensure
that growth in money and credit over the long run is sufficient to encour
age growth in the economy in line with its potential and with reasonable
price stability. In the short run the Federal Reserve seeks to adapt its

2
Purposes & Functions

policies to combat deflationary or inflationary pressures as they may arise.
And as a lender of last resort, it has the responsibility for utilizing the
policy instruments available to it in an attempt to forestall national
liquidity crises and financial panics.
Because a sound financial structure is an essential ingredient of an
effective monetary policy and a growing and prosperous economy, the
Federal Reserve has also been entrusted with many supervisory and reg
ulatory functions. Among other things, it is responsible for the amount
of credit that may be used for purchasing or carrying equity securities; it
regulates the foreign activities of all U .S. banks and the U .S. activities
of foreign banks; it administers the laws that regulate bank holding
companies; it supervises state-chartered member banks; and it establishes
rules to ensure that consumers are adequately informed and treated fairly
in certain credit transactions.
Most countries today have a central bank whose functions are broadly
similar to those of the Federal Reserve. The Bank of England, for example,
has been in existence since the end of the seventeenth century; the Bank
of France was established in 1800 by Napoleon I; the Bank of Canada
began operations in 1935. Each of these banks conducts its nation’s
monetary policy, although, depending on the historical, economic, and
political circumstances surrounding its establishment and subsequent
development, its specific responsibilities differ from the others’, as do its
role and its degree of independence within the government.

Role of the Federal Reserve in Government
It is often said that the United States has an independent central bank.
This is true in the sense that decisions of the Federal Reserve do not have
to be ratified by the President or by one of his appointees in the executive
branch of the government. But the Federal Reserve must report to the
Congress, and thereby to the people as a whole, on its policies. All
appointments to the Board that governs the Federal Reserve System,
including the designation of the Chairman and Vice Chairman from
among the members, are made by the President by and with the consent
of the Senate. In view of these circumstances and because the Federal
Reserve works within the framework of the overall objectives of economic
and financial policy established by the government, it is more accurate
to characterize the System as “ independent within government.”
As it carries out its responsibilities, the Federal Reserve is in continual
contact with other policymaking groups within the government. The

3
Central Bank of the United States

Chairman of the Board of Governors generally represents the Federal
Reserve in such policy discussions. He appears before the relevant com
mittees of the Congress to report on Federal Reserve policies, the System’s
views about the state of the economy, financial developments, and other
matters. Under the Full Employment and Balanced Growth A ct of 1978,
twice a year he presents to the Senate Committee on Banking, Housing,
and Urban Affairs and the House Committee on Banking, Finance and
Urban Affairs the System’s monetary policy objectives, expectations about
the performance of the economy, and the relationships of monetary
objectives to the economic goals and policies of the administration and
the Congress. The Chairman meets from time to time with the President
of the United States and regularly confers with the Secretary of the
Treasury and the Chairman of the Council of Economic Advisers. The
Chairman is frequently asked to serve on government-wide policy bodies,
such as the Depository Institutions Deregulation Committee.
In addition to serving in areas related primarily to domestic operations,
the Chairman of the Board of Governors is a member of the National
Advisory Council on International Monetary and Financial Problems of
the U .S . government, which includes the heads of other relevant U .S.
agencies, and he is also the alternate U .S. governor of the International
Monetary Fund. As a member of the U .S. delegation to key international
conferences, the Chairman also presents the central bank’s views on
matters of international financial and economic policy.
Other members of the Board of Governors also participate in govern
mental discussions of various domestic and international issues, ranging
from the formulation of U .S. positions on such matters as reform of the
international monetary system to proposals for restructuring U .S. finan
cial regulations. Board members frequently testify before the Congress on
a variety of issues of concern to the Federal Reserve. A member of the
Board selected by the Chairman serves on the Federal Financial Institu
tions Examination Council, which also has representatives from the
Federal Deposit Insurance Corporation, the Federal Home Loan Bank
Board, the Office of the Comptroller of the Currency, and the National
Credit Union Administration. This group is charged by the Congress
with establishing more uniform examination standards for depository
institutions. At scheduled intervals, the Board members meet with the
members of the Council of Economic Advisers. A luncheon meeting with
Treasury officials is generally held each week, attended, as availability
permits, by the Chairman or Vice Chairman of the Board of Governors
and perhaps another Board member, and by the Deputy Secretary of the
Treasury or the Under Secretary of the Treasury for Monetary Affairs, as
well as by senior staff of both institutions.

4
Purposes &. Functions

Members of the Board’s staff are in close touch with their counterparts
throughout the government. They have frequent, informal contacts with
the staffs of such agencies as the Council of Economic Advisers, the
Treasury, and the Office of Management and Budget on economic mat
ters, and with those of the Treasury, the Comptroller of the Currency,
the Federal Deposit Insurance Corporation, the Federal Home Loan Bank
Board, and the National Credit Union Administration on regulatory and
legal matters.

Structure of the Federal Reserve System
Our nation’s central bank is a complex organization, whose principal
components are the Board of Governors of the Federal Reserve System,
the Federal Open Market Committee, and the Federal Reserve Banks.
The organization of the System is depicted in chart 1.1.

B oard of G overnors

The apex of the Federal Reserve’s organization is the Board of Governors
in Washington. The Board’s prime function is the formulation of mone
tary policy. In addition, the Board has broad supervisory and regulatory
responsibilities over the activities of various banking institutions and the
operations of the Federal Reserve Banks. The Board also has responsibil
ities in the area of the nation’s payments mechanism and for federal
consumer credit regulations.
The Board is an agency of the federal government. It consists of seven
members appointed by the President of the United States and confirmed
by the Senate. The full term of a Board member is fourteen years, and
the seven terms are arranged so that one expires in every even-numbered
year. A member may not be reappointed after having served a full term.
The Chairman and the Vice Chairman of the Board are named for fouryear terms by the President from among the Board members, and they
may be redesignated as long as their terms as Board members have not
expired. These designations are also subject to confirmation by the Sen
ate.
The members of the Board constitute a majority of the Federal Open
Market Committee (FOM C), which directs the System’s open market
operations and thereby the general course of monetary policy. In addition
to its FOM C functions, the Board reviews and approves discount rate

5
Central Bank of the United States

actions of the Federal Reserve Banks and issues regulations governing the
administration of the discount window at those Banks. The Board also
may use reserve requirements as a monetary policy instrument by exer
cising its authority to vary certain reserve ratios of depository institutions
within ranges prescribed by law.

Chart 1.1

Organization of the Federal Reserve System

6
Purposes & Functions

The Board exercises broad supervisory authority over the operations of
the twelve Federal Reserve Banks. This authority includes oversight of
their activities in providing services to depository institutions and of their
examination and supervision of certain banking institutions. Each of the
Banks must submit its budget to the Board for approval. Certain expen
ditures— such as those for construction or major alterations of Bank
buildings and for the salaries of the Banks’ presidents and first vice
presidents— are subject to the Board’s specific approval. The Board also
approves the appointments of the president and the first vice president
of each Federal Reserve Bank.
The Board has supervisory and regulatory responsibilities over banks
that are members of the Federal Reserve System, bank holding companies,
bank mergers, international banking facilities in the United States, Edge
act and agreement corporations, foreign activities of member banks, and
activities of the U .S . branches and agencies of foreign banks. The Board
also sets margin requirements, which limit the use of credit for purchasing
or carrying securities. In addition, the Board plays a key role in assuring
the smooth functioning and continued development of the nation’s vast
payments system. Another area of Board responsibility involves the imple
mentation by regulation of major federal laws governing consumer credit
such as the Truth in Lending Act, the Equal Credit Opportunity Act,
and the Home Mortgage Disclosure Act.
The Board is required to submit a number of reports to the Congress,
including an annual report on its operations and special reports twice
each year on the state of the economy and the System’s objectives for the
growth of money and credit. The Board also makes available detailed
statistics and other information about the System’s activities through a
variety of publications such as the monthly Federal Reserve Bulletin. Mate
rials relating to the Board’s regulatory functions are presented in another
publication, the Federal Reserve Regulatory Service. The Board pays the
expenses of carrying out its duties not out of funds appropriated by the
Congress but out of assessments upon the Federal Reserve Banks. Each
year a public accounting firm audits the Board’s financial accounts. Those
accounts are also subject to audit by the General Accounting Office.

Federal Open Market Committee
Open market operations are the principal instrument used by the Federal
Reserve to implement national monetary policy. According to statute
the Federal Open Market Committee is responsible for determining what

7
Central Bank of the United States

transactions the Federal Reserve will conduct in the open market. These
transactions, conducted in government and federal agency securities,
provide or absorb reserves of depository institutions. In addition to oper
ations in the domestic securities market, the FOMC authorizes and directs
operations in foreign exchange markets for major currencies.
The FOM C comprises the seven members of the Board of Governors
and five Reserve Bank presidents, one of whom is the president of the
Federal Reserve Bank of New York. The other Bank presidents serve oneyear terms on a rotating basis. By statute the Committee determines its
own organization, and by tradition it elects the Chairman of the Board
of Governors as its Chairman and the president of the Federal Reserve
Bank of New York as its Vice Chairman. The Committee annually
determines its schedule of meetings and most recently has adopted a
regular schedule of eight meetings per year in the Board’s offices in
Washington; in addition, telephone consultations or other meetings may
be held as needed.

Federal Reserve Banks
Other functions of the Federal Reserve System— including operation of
the payments mechanism, distribution of coin and currency, examination
of banks, and fiscal-agency functions for the Treasury— are implemented
through a network of twelve Federal Reserve Banks located in Boston,
New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St.
Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Branches of
Reserve Banks have been established in twenty-five other cities. The
Board’s offices in Washington are a headquarters-type facility. The bound
aries of the twelve Federal Reserve Districts and the locations of the
various Reserve Banks and their Branches are shown on the accompanying
map.
Each Reserve Bank has its own board, consisting of nine outside direc
tors. As provided by law, three Class A directors, who represent member
banks, and three Class B directors, who represent the public, are elected
by the member banks in each Federal Reserve District. The Board of
Governors appoints three Class C directors, who also represent the public,
and it designates one of these three as chairman and another as deputy
chairman of the Bank’s board. No Class B or Class C director may be an
officer, director, or employee of a bank, nor may Class C directors be
stockholders of a bank. Each Branch of a Reserve Bank has its own board
of directors, comprising five or seven members. The majority (three or

______

____

___

Purposes & Functions

four, as the case may be) are appointed by the head-office directors, and
the others by the Board of Governors.
The Federal Reserve System

Legend
—

Boundaries of Federal Reserve Districts

Federal Reserve Bank cities

------ Boundaries of Federal Reserve Branch territories

Federal Reserve Branch cities

■

Federal Reserve Bank facility

Board of Governors of the Federal Reserve System

9
Central Bank of the United States

The directors of each Reserve Bank oversee the operations of their
Bank subject to the overall supervision of the Board of Governors; and,
subject to approval by the Board, they establish the discount rates that
their Bank charges on collateralized loans to depository institutions. The
directors appoint, and recommend the salaries of, the Bank’s president
and first vice president, subject to final approval by the Board of Gover
nors.
The Federal Reserve Banks derive their earnings primarily from interest
on their proportionate share of the System’s holdings of securities acquired
through open market operations and, to a much lesser extent, from
interest on System holdings of foreign currencies and on their loans to
depository institutions. In addition, since 1981, earnings of the Federal
Reserve Banks have included fees for various services that they provide
to depository institutions; pricing of Federal Reserve services was man
dated by the Depository Institutions Deregulation and Monetary Control
Act of 1980.
Earnings of Federal Reserve Banks are allocated first to the payment of
expenses (including assessments by the Board of Governors to defray its
expenses), the statutory 6 percent dividend on Federal Reserve stock that
member institutions are legally required to purchase, and any additions
to surplus necessary to maintain each Reserve Bank’s surplus equal to its
paid-in capital stock. Remaining earnings are then paid into the U .S.
Treasury. About 95 percent of the Reserve Banks’ net earnings have been
paid into the Treasury since the Federal Reserve System was established.
In 1983, net System earnings totaled $15.0 billion, and payments to the
U .S. Treasury amounted to $14.2 billion. Should a Reserve Bank be
liquidated, its surplus— after all obligations had been met— would become
the property of the U .S. government.

Member Banks
A t the end of 1983, about 5,700 commercial banks— out of a total of
nearly 15,000 in the country— were members of the Federal Reserve
System. These member banks accounted for 70 percent of all commercial
bank deposits and about 40 percent of the deposits at all depository
institutions (commercial banks, savings banks, savings and loan associa
tions, and credit unions). National banks, which are chartered by the
Comptroller of the Currency, are required by law to be members of the
System. Commercial banks chartered by any of the fifty states may elect
to become members if they meet the requirements established by the

10
Purposes & Functions

Board of Governors. The member banks own all the stock of the Reserve
Banks and may vote for the three Class A and three Class B directors.
However, ownership of stock does not carry with it the usual attributes
of control and financial interest.
The Depository Institutions Deregulation and Monetary Control Act
of 1980 subjects all depository institutions to the reserve requirements of
the Federal Reserve System. Reserves must be maintained against trans
action-type accounts, nonpersonal time deposits, and borrowings from
banking offices abroad. A t the end of 1983, in addition to the 5,700
member commercial banks, about 33,300 nonmember institutions were
subject to System reserve requirements, including about 9,100 nonmember commercial banks, 400 foreign-related banking institutions, 150 Edge
act and agreement corporations, and 23,700 thrift institutions— savings
banks, savings and loan associations, and credit unions. Many smaller
institutions whose reservable liabilities do not exceed an exempted amount
have, by statute, zero reserve requirements. Depository institutions with
deposit liabilities that are subject to reserve requirements, whether mem
bers or nonmembers, have access to the discount window. All depository
institutions that are eligible for federal deposit insurance may use System
services.

Advisory Committees
To help it deal with its complex and varied responsibilities, the System
makes use of advisory and working committees. The Federal Reserve Act
provides for a Federal Advisory Council consisting of one member from
each Federal Reserve District. The board of directors of each Reserve
Bank annually selects one council member, usually a prominent banker
in the District. The council is required by law to meet in Washington at
least four times a year. It confers with the Board of Governors on economic
and banking developments and makes recommendations regarding the
activities of the Federal Reserve System.
Another statutory advisory group is the Consumer Advisory Council,
which usually meets with the Board of Governors four times each year.
The council has thirty members. Some represent the interests of the
financial industry and consumers, and some are academic and legal spe
cialists in consumer matters.
After passage of the Depository Institutions Deregulation and Monetary
Control A ct of 1980, the Board of Governors established the Thrift
Institutions Advisory Council, whose purpose is to provide information

11
Central Bank of the United States

and views on the special needs and problems of thrift institutions. This
advisory group comprises representatives of savings banks, savings and
loan associations, and credit unions.

Chapter 2

Monetary Policy
and the Economy
Dhe basic goal of monetary policy, as noted in chapter 1, is to ensure
that, over time, expansion in money and credit will be adequate for the
long-run needs of a growing economy at reasonably stable prices. Over
the shorter run, monetary policy is also conducted so as to combat cyclical
inflationary or deflationary pressures.
Monetary policy is far from the only influence on the economy. Fiscal
policy— that is, the policy of the federal government with respect to
taxation and spending— has an important impact on demands for goods
and services and on credit market conditions. In the private sector, the
wage and price policies of business and labor affect the degree of infla
tionary pressures. Exogenous price shocks, such as the huge rises in oil
prices of the 1970s or sharp increases in agricultural prices because of
droughts, affect the overall price level. And policies of foreign countries,
through their impact on demands for goods produced in the United States,
on world commodity prices, or on international credit conditions, also
influence our economy. Finally, expectations— for example, of inflation
or of budget deficits— may also influence the economy and credit condi
tions by affecting the willingness to spend of businesses and consumers
and the attitudes of borrowers and lenders.

How Monetary Policy Works:
A Schematic Overview
Monetary policy encompasses actions taken by the Federal Reserve that
affect the availability and cost of depository institutions’ reserves and
thereby influence overall monetary and credit conditions. These institu
tions are required to hold reserves in the form of cash in their vaults or
of deposits at a Federal Reserve Bank equal to certain fractions of their
various types of deposits; under current law, the bulk of required reserves
is held against transaction deposits— that is, deposits that have unlimited
checking privileges. The depository system as a whole can obtain reserves
to support deposits as a consequence either of changes in the Federal
Reserve’s security portfolio brought about through open market operations

14
Purposes & Functions

(described in chapter 3) or of borrowing by depository institutions at the
Federal Reserve’s discount window (described in chapter 4). The Federal
Reserve influences the amount of reserves mainly by open market oper
ations, the primary tool of monetary policy, but it also acts through
adjustments to the discount rate (which affect the cost of borrowing) and
on occasion changes in reserve requirement ratios.
How the effects of monetary policy actions are diffused through finan
cial markets and the economy may be understood by envisioning a change
in the demand for reserves (as influenced by actions of the public and
depository institutions) relative to their supply (as influenced by the
Federal Reserve). Suppose that there were a strong increase in the public’s
demand for money and credit generated by an economy that was starting
to overheat. This would be reflected in an increase in the demand by
depository institutions for reserves required to support the additional
deposits, particularly transaction accounts, that businesses and consumers
would need to finance the expansion in spending.
As these demands for reserves pressed against the supply of reserves,
interest rates would tend to rise, at first especially in short-term markets,
as institutions sought additional funds. Depository institutions, forced to
compete more aggressively for the existing supply of reserves, would bid
up interest rates in the federal funds market (the market in which insti
tutions lend excess reserve balances to other institutions, mainly on an
overnight basis); they would also sell off securities from their portfolios
and offer higher yields on such managed liabilities as large negotiable
time deposits. Depository institutions might also borrow more reserves
from the Federal Reserve discount window in the process of making an
orderly adjustment to the given supply of reserves that the Federal Reserve
was providing at its own initiative through open market operations. As
market interest rates rose, the Federal Reserve might also increase the
discount rate so as to reduce the incentive for institutions to borrow the
reserves at the discount window.
The rise in interest rates would work, over time, to hold the demand
for reserves in line with supply. It would do so as the higher interest rates
associated with the portfolio adjustments by depository institutions,
including a stiffening of loan terms, reduced the public’s demand for
money and credit. The adjustment process would also affect financial and
product markets more generally. For instance, longer-term interest rates
would tend to rise, thereby restraining demand for investment goods,
such as housing and plant and equipment. A rise in shorter-term consumer
finance rates would work to restrain demand for consumer durable goods.
The dollar would also tend to appreciate on exchange markets, thereby

15
Monetary Policy and the Economy

inducing both U .S. and foreign residents to shift their spending away
from U .S . goods and toward foreign goods. These adjustments would all
take place with varying time lags, depending in part on expectations of
various borrowers, lenders, and spenders; but in the end, restraint on
reserves and money in the face of an inflationary upsurge in aggregate
demand would act to keep the economy from overheating and would
thereby limit upward pressures on interest rates.
If, in contrast to the process described above, the increased demand
for money, credit, and reserves were accommodated by the Federal Reserve—
by increasing reserves supplied through open market operations in line
with demand— the initial upward pressure on interest rates might be
relieved. But this relief would be only temporary. The ensuing rapid
expansion in money would finance a surge in spending and raise expec
tations of inflation. The change in expectations, and the subsequent
emergence of actual inflation, would sooner or later be reflected in higher
market interest rates. Lenders would demand an inflation premium to
protect the real value of their capital, and borrowers would become willing
to pay it out of expected inflation-enlarged earnings. Under these con
ditions the rise in interest rates would, because of inflation, be greater
than in the first example, in which money and reserves were restrained
relative to emerging excessive demands.
The preceding examples illustrate the impact of an increase in the
demand for reserves relative to supply if an economy began overheating.
Opposite effects on interest rates would be felt should the economy
weaken rather than overheat. As credit and money demands began to
fall relative to the amount of reserves being supplied, interest rates would
decline as depository institutions acquired financial assets with the surplus
funds. Institutions would also take the opportunity to reduce borrowed
reserves at the discount window. With a lag, these rate reductions and
the associated depreciation of the dollar on exchange markets would, as
reserve growth was maintained over time, tend to stimulate spending and
demands for money and credit— which would in turn limit the declines
of interest rates.

Guides for Monetary Policy
The interaction of the demand for and supply of reserves affects conditions
in a wide range of financial markets. The impacts are transmitted to the
reserve positions of depository institutions, to the money supply, to a
variety of interest rates, to exchange rates, and to credit flows. Federal

16
Purposes & Functions

Reserve actions affecting reserves influence all these financial variables
in one degree or another; thus the issue arises as to which variables may
best serve as guides to the Federal Reserve in implementing monetary
policy— because they most consistently indicate whether policy is attuned
to ultimate economic objectives.
Money-supply guides work most effectively when the ways the public
holds cash and liquid balances are not being substantially affected by
institutional and structural changes in financial markets. The example in
the last section assumes the absence of such structural distortions so that
the demand for money moves in close correspondence with changes in
the aggregate demand for goods and services. Maintenance over time of
reserve growth consistent with a money-supply guide helps to stabilize
the economy at large and to keep inflationary, or deflationary, pressures
in check in the face of changes in demands for money and credit.
However, when institutional changes are under way, or when for other
reasons substantial changes occur in the public’s propensity to hold money
relative to income— such as the emergence of precautionary cash demands
in periods of economic disturbance— money-supply guides may become
less effective. Institutional and other changes that substantially alter the
demand for money relative to income are reflected in changes in the
velocity or turnover of money (that is, in the ratio of nominal gross
national product to the money stock) that are out of keeping with his
torical patterns. For instance, over a period of time after the introduction
on a nationwide basis of interest-bearing savings accounts against which
checks could be written (termed negotiable order of withdrawal, or NOW
accounts) at the beginning of 1981, the public shifted a very large amount
of funds out of demand deposits into the new accounts. As a result, the
velocity of a transaction-money measure including essentially only cur
rency and demand deposits rose very rapidly as a lower volume of demand
deposits was being held in relation to given levels of income (see chart
2 . 1 ).
Because NOW accounts serve a transaction purpose, the measure of
transaction money— M l— needed to be redefined to include such accounts.
However, NOW accounts are also a repository for the public’s longer-run
savings, and to that extent they respond, in ways that may be quite
different from the response of a purely transaction deposit, to such factors
as changes in wealth, interest rate differentials among financial assets,
and the overall propensity to save. Thus the behavioral characteristics of
M l were affected by the inclusion of assets that served broader functions
for the public, beyond transaction needs. Such a structural change nec
essarily increases uncertainty in interpretation of a monetary aggregate,

17
Monetary Policy and the Economy

at least until new patterns of behavior have had time to be established
and recognized.
Uncertainties were particularly great in the latter part of 1982 and in
1983, when the velocity of M l first declined much more than it usually
does in the contractionary phase of an economic cycle and then rebounded
less than is usual in the early quarters of an expansion. This change in
the pattern may have reflected strong precautionary demands for cash in
a period of particular economic uncertainty as well as the sharp decline
in short-term market interest rates that occurred as the rate of inflation
dropped off substantially; this decline in rates greatly lowered the cost—
in terms of earnings forgone— of holding liquid balances, and also longerterm savings, in NOW accounts that were subject to a 5 lA percent interest
ceiling. The introduction around the end of 1982 of two highly liquid

Chart 2.1

Velocity of M l, 1959-84

Ratio scale

18
Purposes & Functions

deposit accounts bearing a market interest rate also contributed to uncer
tainties in interpretation. The new Super NOW account had unlimited
transfers and was included with other transaction accounts in narrow
money; a new money market deposit account offered limited transaction
features and was appropriately included only in broad money, though it
was competitive in some degree with transaction accounts in M l.
When institutional changes substantially affect money demand relative
to income, rigid adherence to money targets will produce undesirable
economic results. For example, restraint on reserves in the face of an
upward shift in money demand relative to income generated by institu
tional changes would tighten money market and credit conditions inap
propriately since no associated increase would have occurred in the pub
lic’s demands for goods, services, and credit. Thus the associated rise in
interest rates, and in the foreign exchange value of the dollar, would
weaken economic activity instead of serving as a stabilizing force.
Under those circumstances, economic results would be more satisfac
tory if the Federal Reserve provided the reserves needed to support greater
money growth rather than resisting the rise in money demand. As the
supply of money was adjusted to a shift in demand occasioned by insti
tutional change, interest rates, and also exchange rates, would tend to
remain relatively stable, and such disturbances in money demand would
not adversely affect spending behavior.
By contrast, when the demand for goods and services shifts— that is,
when the public or the government changes its spending propensities at
any given level of interest rates— the money supply is more effective as a
target. A n example of such a shift is an intended expansion in the federal
government’s budgetary deficit, generated either by a tax cut or by pro
grams to increase governmental spending. Changes in demand for goods
and services at given levels of interest rates may also be initiated in the
private sector— by, for example, technological innovations or changes in
attitudes related to inflationary or other expectations. When such shifts
occur, holding interest rates stable by allowing money and credit aggre
gates to move in tandem with spending will offer no resistance to infla
tionary or contractionary forces in the economy.
The problems with interest rates as a guide to policy are seen most
clearly under inflationary conditions. Inflation and the uncertainties asso
ciated with it distort the relationship between nominal interest rates and
spending behavior. By and large, spending decisions are influenced more
by real interest rates than by the nominal interest rates that can be
influenced temporarily and at the margin by Federal Reserve policy. The
real interest rate a borrower expects to pay on a particular loan is the

19
Monetary Policy and the Economy

difference between the nominal rate charged and the rate of inflation the
borrower expects over the life of the loan. But since expected rates of
inflation are subjective and extremely difficult to measure, in an infla
tionary environment it is harder to discern the real interest rate that is
associated with a given nominal interest rate and thus harder to predict
the borrowing and spending behavior that will result from any particular
level of nominal interest rates. Moreover, these relationships may be
complicated further by the effects of taxes. Even without the distortions
of inflation, the relationship between nominal interest rates and spending
is extremely difficult to predict, so that a policy that aims at a particular
nominal interest rate runs the risk of inadvertently contributing to the
inflation or deflation that it is aimed at countering.
Even in periods of evident disturbances in money demand, when money
market conditions or interest rates more broadly may seem to be desirable
guides to policy, disturbances or shifts in the demands for goods and
services are also likely to develop. As a result, despite uncertainties in
money demand, the money supply will still be a relevant guide to monetary
policy, though flexibility will be needed in setting and attaining monetary
growth targets.
Because they perceive difficulties with both the money supply and
interest rates as targets for monetary policy, some observers have suggested
that the Federal Reserve aim at a particular nominal level of economic
activity, presumably one consistent with attainment of reasonable price
stability over time. The ultimate objectives of monetary and other public
policies are, of course, economic growth, high and rising levels of employ
ment, and reasonable price stability. But these objectives are influenced
not only by monetary policy but also by fiscal policies, by wage, price,
and spending policies in the private sector, and by economic develop
ments abroad. In any event, monetary policy has only an indirect influ
ence on the achievement of economic goals. Moreover, it is not adaptable
to year-by-year targeting of the nation’s income because lags between
changes in the financial variables that are most directly influenced by
policy and changes in economic activity are often relatively long and vary
with economic conditions and expectations. The contribution of mone
tary policy itself to the nation’s ultimate economic goals is best indicated
by the behavior of those financial aggregates, such as monetary aggregates,
that are reasonably subject to control or at least to strong influence via
the availability and cost of reserves to the depository system; but that
behavior must be assessed in light of structural changes in the financial
system that affect the public’s preferences for and use of various forms of
money and credit.

20
Purposes &. Functions

Information on Monetary Policy and Its Relation
to the Economy
While the formulation and implementation of policy necessarily entail
evaluation of all aspects of the financial system, the real economy, and
international economic and financial conditions, since the mid-1970s
the Federal Reserve has also been announcing annual objectives for the
growth rates of the monetary and credit aggregates. The current provisions
of the Federal Reserve Act, as amended by the Full Employment and
Balanced Growth Act of 1978, require the Board of Governors of the
Federal Reserve System to report to the Congress twice each year as to
. . objectives and plans of the Board of Governors and the Federal
Open Market Committee with respect to the ranges of growth or dimi
nution of the monetary and credit aggregates. . . . ” This section of the
act also states that “Nothing in this Act shall be interpreted to require
that the objectives and plans. . . [for] the monetary and credit aggregates
. . . . be achieved if the Board of Governors and the Federal Open Market
Committee determine that they cannot or should not be achieved because
of changing conditions: [provided [t]hat . . . the Board of Governors
shall include an explanation of the reason for any revisions to or deviations
from such objectives and plans.”
The reports to the Congress are made in February and July. They
contain an extended discussion of the economic factors— such as wage
and price trends, consumer and business spending, economic develop
ments abroad, governmental tax and spending policies, credit market
flows, and institutional change— that interact with monetary policy to
influence the course of economic activity. They also review the behavior
of the money and credit aggregates in the period just past in relation to
previously announced objectives and to the changing economic and
financial conditions that influenced attainment of these objectives and
their appropriateness.
In providing a basis for evaluating the newly announced monetary and
credit objectives in relation to the nation’s ultimate economic goals, the
reports also show the range and a measure of the central tendency of
projections by FOMC members of rates of growth in nominal GNP, real
GNP, and prices, and of the unemployment rate one to two years ahead.
These projections are conditioned on the objectives and plans for mon
etary and credit aggregates and prospects for the stance of fiscal policy.
The plans for the monetary and credit aggregates are also related, as
required by law, to the short-term goals for the nation contained in the

21
Monetary Policy and the Economy

most recent Economic Report of the President and to any short-term
goals that may be approved by the Congress. In these ways, the twiceyearly reports by the Federal Reserve to the Congress also contribute to
an evaluation of the interaction and coordination of monetary and fiscal
policies.

Measures of Monetary and Credit Aggregates
The Federal Reserve has developed a number of money and credit mea
sures that are useful in the interpretation of monetary conditions, some
of which have also served, in one degree or another, as targets or guides
for monetary policy. These measures unavoidably represent a compromise
among various alternative concepts that takes into account the avail
ability of the necessary raw data and the not always clear empirical
evidence from statistical tests relating various money and credit measures
to other economic variables.
The definitions of money published by the Federal Reserve are shown
in table 2.1. They attempt to distinguish between money that is oriented
to transactions and money that includes other highly liquid balances that
serve a variety of purposes. Distinctions between transaction and other
balances, or among near-money assets generally, based, say, on differences
in liquidity, have always been somewhat arbitrary. Individual financial
assets have characteristics that cause them to shade into one another over
a wide spectrum rather than to differ sharply from one another. In recent
years these distinctions have become even more blurred as regulatory
changes and market innovations have led to a proliferation of new deposit
instruments and liquid assets, some usable directly as a means of payment
and others convertible readily and inexpensively into a transaction bal
ance.
Definitions of the money supply were fundamentally altered in 1980
following a period of rapid financial innovation and regulatory change
that eroded the meaningfulness of the previous measures. The new defi
nitions reflected particularly the growing importance in the monetary
system of depository institutions other than commercial banks and the
increasing importance of all depository institutions and certain other
intermediaries as issuers of claims held by the public in lieu of deposits.
Relatively minor adjustments have been made on occasion since that
time, largely to reflect evolving financial practices, further regulatory
changes, and new sources of information. But because financial innova-

22
Purposes & Functions

Table 2.1

Measures of the Money Stock and Liquid Assets,
March 1984
Billions of dollars, seasonally adjusted except as noted
Aggregate and component

Ml
Currency
Travelers checks of nonbank issuers
Demand deposits
Other checkable deposits at all depository institutions
M21
Ml
Overnight RPs issued by commercial banks2
Overnight Eurodollars held by U.S. residents at overseas branches of U.S. banks2
Money market mutual fund shares (general-purpose and broker/dealer, taxable
and nontaxable)2
Savings deposits at all depository institutions
Money market deposit accounts at all depository institutions2
Small-denomination time deposits at all depository institutions3

Amount

535.3
150.9
5.0
244.0
135.4
2,230.0
535.3
47.0
11.3
144.8
305.5
392.5
803.4

tion is an ongoing process, at some point it may be necessary to modify
these definitions further, or even to adopt substantially new ones.
The narrowest measure of money— M l— is designed to include bah
ances that are commonly used in payment for purchases of goods and
services— that is, assets thought to be held primarily to carry out trans
actions. Thus M l consists of currency, travelers checks, demand deposits,
and interest-bearing accounts with unlimited checking authority. It and
the broader measures of money exclude balances held by the U .S . gov
ernment as well as foreign governments and official institutions on the
ground that the amount of their balances is not related to the size of
spending and transactions in the United States.
The broader measure of money— M2— encompasses, besides M l,
financial assets that are extremely liquid, that can be converted into
transaction balances with relative ease or to a limited degree can be used
directly for transactions, or whose nominal values are for the most part
fixed. This measure thus includes a variety of accounts and instruments
such as money market deposit accounts offered by depository institutions,

23
Monetary Policy and the Economy

Table 2.1, continued

Aggregate and component

Amount

M3‘

2,767.8

M2
Large time deposits at all depository institutions12345
Money market mutual funds (institution-only)2
Term RPs at all depository institutions2,5
Term Eurodollars held by U.S. residents2

3,273.6
M3
Bankers acceptances
Commercial paper
Savings bonds
Short-term Treasury obligations

2.
3.
4.
5.

2,230.0
347.9
45.0
55.9
93.9

2,767.8
42.4
145.4
72.2
245.8

M2 and M3 both differ from the sums of their components because of consolidation adjustments and the
seasonal adjustment technique. The consolidation adjustment for M2 represents the amount of demand deposits
and vault cash at commercial banks owned by thrift institutions that is estimated to be used in servicing their
time and savings deposits. The consolidation adjustment for M3 is the estimated amount of overnight repurchase
agreements and overnight Eurodollars held by institution-only money market mutual funds. The nontransaction
component in M2 and the nontransaction component in M3 alone are seasonally adjusted only as aggregates.
The individual seasonally adjusted series included in these nontransaction components in the table are not
used in calculating seasonally adjusted M2 or M3.
Not seasonally adjusted.
Time deposits in amounts of less than $100,000; includes retail repurchase agreements.
Time deposits in amounts of $100,000 or more.
Excludes retail repurchase agreements.

other time and savings deposits in these institutions, overnight Eurodollar
accounts held by U .S . residents, overnight repurchase agreements issued
by banks, and shares in certain money market funds. On the other hand,
the measure does not include balances that are clearly held for long-term
purposes (such as individual retirement and Keogh accounts). Also excluded
are certain important liquid assets, such as Treasury bills and commercial
paper, whose nominal values are subject to market risk.
The broadest measure of the money stock— M3— adds to M2 certain
other liquid assets that are held mostly by large asset holders, such as time
deposits and certain other instruments through which funds are loaned
in large denominations ($100,000 or more) to depository institutions at

24
Purposes &. Functions

Table 2.2

Derivation of Domestic Nonfmancial Debt Outstanding,
March 1984
Billions of dollars, seasonally adjusted, except as noted
Item in calculation

Amount

Total credit market debt

6,464.1

L ess :

a. Debt of foreigners
b. Debt of financial sectors

243.6
805.7

Equals :

Debt of domestic nonfmancial sectors

5,414.8

B orrow in g sector

a.
b.
c.
d.

U.S. government
State and local governments
Nonfinancial business
Households

1,224.0
378.0
1,871.6
1,941.2

a term longer than overnight, term Eurodollars held by U .S. residents,
and shares in money market funds that are generally restricted to insti
tutions. Borrowings by depository institutions in these forms represent
funds that can be readily managed and varied in line with changes in
funding needs, given credit demands and other deposit flows.
In addition to these measures of the money stock, which have served
as annual targets for monetary policy, the Federal Reserve also publishes
a broader measure of liquid assets, L. This measure includes a variety of
short-term market instruments such as bankers acceptances, commercial
paper, and marketable Treasury and agency obligations with original
maturities of less than twelve months. It has not served as a target for
monetary policy partly because data on it are not available as promptly
as are those on the money measures and partly because, compared with
the money measures, its components are less influenced by Federal Reserve
policy and more by decisions of borrowers about the sectors of the market
in which they wish to raise funds.
All of the monetary and liquid-asset aggregates focus on the asset side
of the public’s balance sheet. Debt measures, on the other hand, focus
on credit advanced to the public. In 1983, the Federal Open Market
Committee indicated that it would monitor, along with the monetary

25
Monetary Policy and the Economy

Table 2.2, continued

Item in calculation

Amount

M emoranda

Bank credit (loans and investments of commercial banks)

1,641.5

L ess :

a. Bank credit to financial sectors
b. Bank credit to foreigners
c. Regulated security credit

101.1
33.2
32.5

Equals :

Bank holdings of domestic nonfinancial debt
Credit extended by other depository institutions1

1,474.7

995.7

L ess :

Credit extended by other depository institutions to financial business2

141.1

Equals :

Holdings of other depository institutions of domestic nonfinancial debt
Share of domestic nonfinancial debt held directly by selected institutions (percent)
a. Commercial banks
b. Other depository institutions
c. All others
1.
2.

854.6

27.2
15.8
57.0

Savings and loan associations, savings banks, and credit unions.
Securities of federally sponsored credit agencies and mortgage pools.

aggregates, a broad measure of debt, encompassing the borrowing of all
domestic nonfinancial sectors: federal and state and local governments,
nonfinancial businesses, and households. This series, whose derivation is
shown in table 2.2, is especially valuable as a source of information about
financial markets and about monetary policy pressures at times when the
monetary aggregates are being distorted by regulatory changes or inno
vations or by changes in the public’s preferences for financial assets.
The debt of domestic nonfinancial sectors reflects demands for goods
and services in the United States better than does a measure of total debt.
The latter includes borrowing by foreigners in this market that may finance
activity abroad, as well as borrowing by domestic financial institutions

26
Purposes & Functions

that represents financial intermediation rather than underlying credit
demands. On the other hand, narrower credit measures, such as credit
advanced by banks or all depository institutions, also shown in table 2.2,
have relevance for particular markets, but do not reveal overall credit
demands in view of the ease with which many borrowers can shift between
institutional and market sources of funds.

Chapter 3

The Implementation
of Monetary Policy:
Open Market Operations
§3pen market operations, carried out under the general direction of the
Federal Open Market Committee, are the most powerful and flexible
monetary policy tool of the Federal Reserve. They determine the amount
of nonborrowed reserves available to the depository system. The oper
ations are coordinated with discount window and reserve requirement
policies to the end of attaining the monetary policy objectives of the
Committee and the Board of Governors. A detailed description of open
market operations, which involve the purchase and sale in the open
market principally of U .S. government securities, is the subject of this
chapter.
After each of its meetings, the Federal Open Market Committee (FOMC)
issues a directive to the Federal Reserve Bank of New York to guide open
market operations in the period before the next meeting. The FOMC has
designated the Federal Reserve Bank of New York as its agent in executing
open market transactions and has selected a Manager for Domestic Oper
ations, who is also a senior officer of the New York Bank, to conduct the
operations. Over the years, the directive has emphasized varying approaches
to the implementation of policy, depending in part on the economic and
financial conditions of the period and the degree of emphasis being placed
on money and credit aggregates, reserves, and money market conditions
as guides to the stance of monetary policy and as tools in the day-to-day
implementation of policy. But whatever basic policy approach is reflected
in the Committee’s decision, the directive needs to, and does, provide
operating instructions to guide the Manager’s decisions about the day-today purchase and sale of securities.
The directive adopted by the FOMC at a given meeting is made public
shortly after the next meeting of the Committee. It is released along with
the policy record summarizing the Committee’s assessment of the coun
try’s economic and financial position at the time of the meeting and the
discussion by the members of the appropriate course for policy during the
period ahead. The votes of individual members are recorded; if any
member dissents, a statement of the reasons for that dissent is also included.
Publication of the record of Committee discussion and of policy decisions

28
Purposes & Functions

keeps the public and the financial community informed on a continuing
basis about considerations influencing the implementation of policy.

Establishing Reserve Objectives for Operations
Because open market operations have their initial impact on the reserve
base of the depository system— and directly on nonborrowed reserves—
the objectives for monetary policy are translated into reserve guidelines
to form a basis for the Manager’s day-to-day decisions. (The various
measures of reserves are explained in the box that follows.) Before
October 1979, the daily provision of reserves was guided in large part by
efforts to produce a certain degree of ease or tautness in bank reserve
positions and in money market conditions thought to be consistent with
objectives specified for, say, the money supply or credit (in those years
expressed in terms of bank credit). The degree of ease or tautness in
money market and reserve conditions was signified by the behavior of the
federal funds rate— the interest rate that banks and other depository
institutions charge for surplus reserves that they lend to one another—
and by the extent to which the depository system found itself “short” of
reserves and thus had to borrow them from the discount window or run
down excess reserves. If the money supply grew more than was desired,
the Manager was typically instructed to seek some degree of increased
tautness in money market conditions and reserve positions; if it expanded
less than was desired, he was usually instructed to seek more ease.
Changes in the pressure on the money market and short-term interest
rates were attained by varying the extent to which the demand for reserves
to support deposits was accommodated through the provision of nonbor
rowed reserves. When additional ease was sought, the Manager purchased
more securities than he otherwise would have done. This action raised
nonborrowed reserves and thereby lowered the amount of reserves that
banks needed to borrow at the discount window and simultaneously
decreased the pressure to borrow in the federal funds market. As a result,
interest rates in that market, and in short-term markets generally, tended
to fall. When additional tightness was needed, securities were sold, or
fewer securities were bought; these actions lowered nonborrowed reserves,
raised the need to borrow at the discount window, increased demands in
the federal funds market, and tended to cause short-term interest rates to
rise.
Control of the money supply under this type of operating procedure
relied on the ability to estimate the relationship between the money

29
Open Market Operations

market conditions that guided provision of nonborrowed reserves and the
amount of money the public was willing to hold at the associated levels
of interest rates. Because uncertainties in this relationship appeared to be
worsening as the inflationary environment of the late 1970s altered behav
ioral patterns, the Committee adopted a change in procedure for imple
menting open market operations in October 1979. That was a time of
ebbing confidence in the dollar both at home and abroad, and the pro
cedural change, which entailed a shift to aggregate reserves as the focus
for operations, was designed to provide greater assurance that growth in
the nation’s money supply would be restrained to combat inflation.
The new operating procedure involved setting a predetermined target
path for nonborrowed reserves based on the FOM C’s objectives for the
money supply over the period. Provision of reserves consistent with this
path was expected to offer more effective control over the money supply
than provision of reserves guided in the first instance by efforts to maintain
a particular set of money market conditions. The relationship between
the money supply and a reserve path (the multiplier relationship) was
expected to be more reliable under the conditions of the time than the
relation between money demand and interest rates.
This procedure implied greater freedom for interest rates to vary in the
short run as needed to keep money growth on target over time. Changes
in the demand for reserves, given predetermined nonborrowed reserves,
were more or less automatically reflected in the amount of reserves that
had to be borrowed at the discount window by depository institutions and
in pressures on money market interest rates, particularly the federal funds
rate. These changes set in motion an adjustment process on the part of
the public and depository institutions that, as indicated in chapter 2,
worked to bring money growth back toward target. Also, the path of
nonborrowed reserves could be, and was, raised or lowered to further ease
or restrain the supply of reserves relative to demand if that seemed
necessary to keep the money supply, and in the process the total of
reserves (borrowed and nonborrowed) that support it, on target over the
longer run.
In that context, it is important to understand the role played by various
reserve measures— total reserves and the monetary base as well as non
borrowed reserves— in the implementation of monetary policy. While
attainment of objectives for the monetary and credit aggregates over time
entails consistent growth of total reserves, as well as of the total monetary
base, there are practical difficulties in attempting to control such reserve
aggregates through open market operations, particularly in the short run.
Only the nonborrowed component of reserves is determined through the

30
Purposes &. Functions

Reserve Concepts
RESERVE ASSETS are those that, by statute, can be used to satisfy

reserve requirements. The Federal Reserve Act specifies only two
such assets: VAULT CASH — the currency and coin held by depository
institutions in their cash drawers and vaults; and RESERVE BALANCES
w it h F e d e r a l R e s e r v e B a n k s — accounts of depository institutions
with their Reserve Banks (other than the required clearing balances
institutions hold that are related to services provided by the Federal
Reserve). No other asset may count as reserves. Reserves must be
posted over a fourteen-day MAINTENANCE PERIOD (which runs from
a Thursday to the second Wednesday). TO TA L RESERVES are mea
sured as the sum of reserve balances with Reserve Banks plus the
part of vault cash holdings actually used to meet reserve require
ments. (The vault cash that can be so used in a current maintenance
period is not determined by current vault cash holdings but is equal
to actual vault cash held in a two-week period approximately four
weeks earlier.)
Total reserves also can be apportioned into two components: The
first, REQUIRED RESERVES, is the minimum amount of total reserves
that a depository institution must hold. This minimum amount is
determined by the application of RESERVE RATIOS, specified per
centages of certain liabilities of depository institutions called
RESERVABLE LIABILITIES (see chapter 4). To determine required
reserves, reservable liabilities are averaged over a fourteen-day inter
val called a COMPUTATION PERIOD (which runs from a Tuesday to
the second Monday). The fourteen-day COMPUTATION PERIOD for
transaction deposits ends two days before the end of the associated
reserve maintenance period, while the fourteen-day computation
period for other reservable liabilities ends thirty days before the end
of the associated reserve maintenance period. The second compo-

initiative of the Federal Reserve in open market operations. In carrying
out operations, the System Account Manager supplies reserves through
the purchase or sale of securities in the open market that are effectively
paid for by adding to or subtracting from a depository institution’s reserve
balance at the Federal Reserve. The remaining component of total reserves—
borrowed reserves— depends on the initiative of depository institutions.
(The movements of total reserves and its key components are illustrated
in chart 3.1, along with several interest rates.)

31
Open Market Operations

nent of total reserves is EXCESS RESERVES, the amount by which
total reserves exceed required reserves. If required reserves exceed
total reserves, the difference is called DEFICIENT RESERVES. Deftciencies not offset by surpluses in surrounding maintenance periods
(within allowable limits) are subject to a penalty.
Total reserves are provided in two forms. The first is NONBORROWED RESERVES— reserves that the depository system can obtain
only from the Federal Reserve System through open market oper
ations (or through a variety of “ technical” factors affecting the
Federal Reserve’s balance sheet— discussed in the appendix— which
the Federal Reserve takes into account in conducting open market
operations). The second form is BORROWED RESERVES— loans to
depository institutions by Federal Reserve Banks credited to the
institutions’ reserve balances with the Reserve Banks. These loans
are sometimes called DISCOUNTS AND ADVANCES (see chapter 4),
or borrowings from the “discount window. ”
Another reserve-related measure is the MONETARY BASE. The
monetary base may be measured as the sum of reserve balances with
Federal Reserve Banks plus service-related balances plus CURRENCY
IN CIRCULATION — that is, currency circulating outside the Federal
Reserve and the Treasury. The monetary base also may be viewed
as total reserves plus service-related balances plus the surplus of vault
cash holdings over required reserves of institutions satisfying require
ments wholly through vault cash plus currency in the hands of the
nonbank public (the currency component of the money supply).
These two measures of the monetary base are not exactly equal,
owing to a generally small difference between the amount of vault
cash currently held by institutions that have required reserve bal
ances at Federal Reserve Banks and their lagged vault cash used to
satisfy current reserve requirements. The NONBORROWED MONE
TARY BASE is the monetary base less borrowed reserves.

The amount of total reserves depends on the interaction between open
market operations and the borrowing of reserves from the discount window
at the initiative of depository institutions. Given the administrative reg
ulations governing access to the discount window (explained in chapter
4), the demand for such borrowing varies with the relation of short-term
market interest rates to the discount rate and with a variety of special,
temporary influences on the reserve position of individual institutions.
While variations in borrowing at the discount window may at times need

32
Purposes & Functions

Chart 3.1

Measures of Reserves and Interest Rates, 1973-84
Billions of dollars

1973

1975

Quarterly data. Data on reserves are seasonally adjusted.

1980

1984

33
Open Market Operations

to be offset through open market operations if money growth is to remain
on track over the longer run, at other times such borrowing helps assure
the appropriate provision of reserves. For example, additional reserves
provided through the discount window may satisfy a need for more reserves
related not to excessive growth in money but to, say, unexpected shifts
among deposits subject to varying reserve requirements that increase the
amount of reserves needed to support a given money supply. In addition,
changes in borrowing also usefully cushion markets from sharp and poten
tially destabilizing volatility in face of transitory variations in money
demand or longer-run shifts in demand that are appropriate to accom
modate.
The monetary base is a broader concept than total reserves and essen
tially comprises the Federal Reserve’s liability for currency in circulation
and its liability for reserve balances. Currency in circulation, which
accounts for nine-tenths of the base, is appropriately provided at the
demand of the public and of depository institutions (which hold currency
as vault cash). For that reason the base, even the nonborrowed base, has
not been a suitable objective for day-to-day control through open market
operations. Efforts to control the base risk undesired movements in the
money supply as well as sharp variations in money market conditions. For
example, if an unexpected rise in currency in circulation were offset by
an equivalent decline in reserves— as would be entailed by a target for
the total monetary base— the money supply would contract by a large
multiple of the drop in reserves (because the fractional reserve system
permits a given amount of reserves to support a much larger amount of
deposits).
Emphasis on reserve aggregates, and in practice a nonborrowed reserves
path, as the guide for day-to-day open market operations is most useful
when the monetary aggregate to be controlled is closely related to reserves
(as is M l because transaction deposits are subject to reserve requirements)
and the significance of emerging trends in that aggregate for overall
economic performance is not subject to unusual uncertainty. However,
when institutional and structural changes are altering the demand for
money relative to income or are increasing uncertainties in interpreting
the movements in money, a more flexible day-to-day approach to the
provision of reserves will be needed than is implied by adherence to a
reserve path. Such factors were particularly pronounced in late 1982 and
early 1983, and uncertainties have persisted, though to a lesser degree,
in association with the continuing process of adaptation to the deregu
lation of deposit interest rate ceilings and with experience with the
public’s attitudes toward new deposit instruments under varying economic

34
Purposes & Functions

and financial conditions. Thus, beginning in late 1982, a more judgmental
approach was adopted to the implementation of monetary policy through
open market operations.
Under such circumstances, emerging evidence about the outlook for
economic activity and prices and conditions in financial markets neces
sarily has to be taken more into account in assessing the significance to
be attached to movements in the various aggregates for the implemen
tation of monetary policy. In the process, relatively more weight in policy
implementation may be given to the broader money and credit aggregates,
which are less directly connected to the reserve base than is M l, but
which may at times be less affected by institutional change. With more
flexible management of nonborrowed reserves, an expansion or contrac
tion of M l relative to target, for example, may not be permitted to lead
automatically to offsetting increases or decreases in pressure on reserve
positions (as would be the case if a predetermined path for nonborrowed
reserves were maintained). This approach may be appropriate because
the broader aggregates are on track, because analysis suggests that a
fundamental shift in the velocity of money is under way, or because more
time is required to evaluate the significance of money movements in the
context of current economic and financial conditions.
In general, no one approach to the implementation of open market
operations is likely to be satisfactory under all of the economic and
financial circumstances that monetary policy may face. In decades past,
the approach to policy implementation has been adapted in light of such
factors as the need to combat inflation, efforts to encourage sustainable
economic growth, uncertainties related to institutional change, and evi
dent shifts in the public’s attitudes toward, and use of, money. The more
that economic and financial conditions warrant emphasis on a monetary
aggregate objective that is closely related to the reserve base, such as M l,
the greater is the emphasis that may be placed on guiding open market
operations by relatively strict targeting of reserve aggregates. In other
circumstances, a more flexible approach to reserve management is required.

Security Transactions of the Central Bank
A Federal Reserve security transaction changes the reserve base of the
banking or depository system: a purchase adds to nonborrowed reserves,
and a sale reduces them. In contrast, the same transaction between
financial institutions, business firms, or individuals simply redistributes
reserves within the depository system without changing the reserve base.

35
Open Market Operations

When the Federal Reserve purchases securities from any seller, it pays,
in effect, by issuing a check on itself. The seller’s bank, on receipt of the
check, presents the check to the Federal Reserve for payment; and the
Federal Reserve, in turn, honors the check by increasing the reserve
account at the Federal Reserve Bank of the seller’s bank. The reserves of
the seller’s bank rise with no offsetting decline in reserves elsewhere;
consequently, the total volume of reserves increases. Just the opposite
occurs when the Federal Reserve sells securities: the payment results in a
reduction in the reserve account of the buyer’s bank at the Federal Reserve
Bank with no offsetting increase in the reserve accounts of any other
bank. The total reserves of the banking system decline in this case.
It is this characteristic of Federal Reserve purchases and sales of assets—
the dollar-for-dollar change in the reserves of the banking system— that
makes open market operations so important. Through these operations
the Federal Reserve can change the amount of reserves available to
depository institutions and thus influence the rate of growth of money
and, at the margin, conditions in credit markets.
A central bank conceivably could provide or absorb bank reserves
through market transactions in any type of asset. In practice, however,
most types of assets cannot be traded readily enough to accommodate
open market operations. For open market operations to work effectively,
the central bank must be able both to buy and to sell on a timely basis,
at its own convenience, in whatever volume may be needed to keep the
supply of reserves in line with prevailing policy objectives. These condi
tions require that the instrument it buys or sells be traded in a broad,
highly active market that can accommodate the transactions without
distortions or disruptions to the market itself.
The market for U .S . government securities satisfies these conditions,
and the Federal Reserve carries out by far the greatest part of its open
market operations in that market. Operations are also undertaken from
time to time in federal agency securities and, until recently, in bankers
acceptances.1The U .S . government securities market, in which aggregate
trading averages many billions of dollars a day, is the broadest and most
1.

There are statutory limitations on the types of securities that the Federal Reserve
may buy or sell. These essentially confine transactions to U .S. government securities,
to obligations issued or guaranteed by agencies of the United States, and to a limited
number of short-term instruments. Effective July 2, 1984, the Federal Reserve dis
continued repurchase agreements on bankers acceptances, recognizing that the mar
ket for these private instruments had reached a scale of activity that no longer
required or justified continuing Federal Reserve support. In 1977, the Federal Reserve
had ceased buying these instruments on an outright basis.

36
Purposes &. Functions

active of U .S . financial markets. Transactions are handled “over the
counter,” with the great bulk of orders placed with specialized dealers
(both bank and nonbank) that make markets in Treasury securities.
Although most dealer firms are located physically in New York City, a
network of telephone and wire services links dealers and customers—
regardless of their location— to form a nationwide market.
The large volume of secondary trading in government securities reflects
in part the sheer size of the outstanding marketable federal debt— over
one trillion dollars at the end of 1983. But it also reflects the widespread
use of these securities, which are free from the risk of default, to provide
liquidity in the portfolios of investors: financial and nonfinancial busi
nesses, state and local governments, foreign official institutions, and
individuals. This use is encouraged by the heavy concentration of Treasury
issues in relatively short maturities: almost half of these issues mature
within one year and over three-fourths within five years.
The outstanding amount of federal agency securities and the volume
of trading in these issues have also grown substantially.2 Inasmuch as such
issues are considered fairly close substitutes for Treasury issues, govern
ment securities dealers have generally extended their market-making to
the federal agency sector. These developments have enabled the Federal
Reserve to execute some open market transactions in federal agency issues,
although such activity represents a relatively small share of the System’s
total market transactions.

Factors Other than Open Market Operations
Influencing Reserves
The Manager’s purchases and sales are not the only factors that affect
nonborrowed reserves. Other influences beyond the immediate control
of the Federal Reserve cause reserves to rise and fall, and they must be
taken into account by the Manager in his implementation of the Com
mittee’s Directive. These technical factors are discussed in detail in the
appendix to this chapter, but their implications for open market oper
ations should be noted.
2.

Federal and federally sponsored agency debt totaled around $240 billion at the end
of 1983. The bulk of the latter consists of securities of federally sponsored housing
and farm credit agencies. These entities, while privately owned, were organized by
acts of Congress and operate in close collaboration with the federal government. The
Federal Home Loan Banks, the Federal National Mortgage Association, and the
various agencies of the Farm Credit System fall in this category.

37
Open Market Operations

The movement of the technical factors that affect reserves— principally
currency in circulation, Federal Reserve float, and Treasury and foreign
official balances at Federal Reserve Banks— must be forecast in order to
determine what would happen to reserves if the Manager engaged in no
operations. Fluctuations in some of these technical factors, such as cur
rency in circulation, are attributable mainly to pronounced seasonal
influences— for example, the tendency for individuals to hold more cur
rency during the holiday shopping season late in the year— and thus their
impact on nonborrowed reserves is fairly predictable. A rise of currency
in circulation drains reserves from the depository system, while a decline
provides them; for example, a depositor brings currency to his bank,
which in turn credits the amount to the customer’s deposit account and
to the bank’s reserves.
Other factors affecting reserves, such as Federal Reserve float, are more
affected by random occurrences— for instance, transportation difficulties
due to winter storms— and thus are more difficult to predict. A rise in
float, which represents the difference between checks credited to banks’
reserve accounts and those not yet collected, adds to reserves, while a
decline reduces reserves.
Two staffs, one at the Federal Reserve Bank of New York and one at
the Board of Governors in Washington, prepare independent projections
of these technical factors and their effect on the level of nonborrowed
reserves for the next few days and for several weeks to come. These
projections are revised each day in light of new information. The Manager
uses the projections and estimates in formulating his plan for open market
operations. Although the Manager is not “ in the market” every day, he
usually engages in operations several times each week.
Because technical factors can provide or absorb a sizable amount of
reserves over an operating period, observers cannot determine the stance
of policy simply by observing the volume of transactions by the Manager
or even whether they are purchases or sales. If technical factors are, on
balance, adding to or drawing down reserves in amounts consistent with
the Committee’s objectives, the Manager will take no action at all, being
content with the levels of nonborrowed reserves that will come about
without his intervention. More likely, he will have to undertake a large
volume of operations to neutralize technical factors and to obtain desired
levels of nonborrowed reserves. Indeed, most of the Manager’s operations
are “defensive” in the sense that they offset the various market forces that
are pushing the level of nonborrowed reserves in a direction inconsistent
with the attainment of the Committee’s objectives.

38
Purposes & Functions

Table 3.1

Transactions of the System Open Market Account, 1982 and 1983
Millions of dollars
Type of security and type of transaction

1982

1983

17,067
8,369
3,000

18,888
3,420
2,400

312
0
3,131

484
0
2,421

1,797
0
-2,720

1,896
0
-3,892

388
0
-4 4

890
0
500

307
0
-367

383
0
1,058

19,870
8,369
3,000

22,540
3,420
2,487

U .S . govern m en t securities

Outright transactions
Treasury bills
Gross purchases
Gross sales
Redemptions
Coupon issues maturing within 1 year
Gross purchases
Gross sales
Exchanges, maturity shifts, or redemptions
Coupon issues maturing within 1 to 5 years
Gross purchases
Gross sales
Exchanges or maturity shifts
Coupon issues maturing within 5 to 10 years
Gross purchases
Gross sales
Exchanges or maturity shifts
Coupon issues maturing beyond 10 years
Gross purchases
Gross sales
Exchanges or maturity shifts
Total outright transactions
Gross purchases
Gross sales
Redemptions

The Manager’s Open Market Techniques
The Manager presents his operating plan for the day in a telephone
conference call each morning with a Reserve Bank president who is
currently a member of the Federal Open Market Committee and with

39
Open Market Operations

Table 3.1, continued

1982

1983

Matched transactions
Gross sales
Gross purchases

543,804
543,173

578,591
576,908

Repurchase agreements
Gross purchases
Gross sales

130,774
130,286

105,971
108,291

0
0
189

0
0
292

18,957
18,638

8,833
9,213

1,285

-1,062

9 ,7 7 3

1 0 ,8 9 7

Type of security and type of transaction

F ed eral agen cy obligations

Outright transactions
Gross purchases
Gross sales
Redemptions
Repurchase agreements
Gross purchases
Gross sales
B an k ers accep tan ces

Repurchase agreements, net
N e t ch an ge in to tal S y ste m holdings

senior staff at the Board of Governors. After this call, all Committee
members are promptly informed of the actions the Manager expects to
take during the day in light of Committee objectives and developing
financial conditions. The operations of the System Open Market Account
in 1982 and 1983 are shown in table 3.1.
The Manager uses two general approaches to the execution of oper
ations. The approach selected depends on the particular reserve situation.
When projections of reserve factors indicate that a need to supply reserves
to, or withdraw them from, the depository system seems likely to persist,
the Manager may make outright purchases or sales of securities. If the
need is to withdraw reserves, maturing securities held in the System’s
portfolio also may be allowed to mature without replacement.
When the need to alter reserves appears to be only temporary— either
because the projections suggest that reserves provided today will soon

40
Purposes &. Functions

need to be withdrawn to offset expected seasonal movements in technical
reserve factors, or because the near-term outlook for reserves is subject to
marked uncertainty— the Manager typically will employ special methods
that have only a temporary effect on the aggregate supply of reserves.
Thus, as explained later in this chapter, when the need is for temporary
provision of reserves, “repurchase agreements” are employed; when it is
for temporary withdrawal, “matched sale-purchase transactions” are used.
When the Manager has decided to undertake a particular operation,
staff members at the Trading Desk of the Federal Reserve Bank of New
York contact the primary dealers making markets in Treasury and federal
agency securities. In fulfilling their obligation to make regular markets,
the dealers stand ready to quote firm bid and offer prices on such securities
and to do business at those prices on whichever side of the market the
customer wishes. Because approximately three dozen dealers that make
active markets in U .S. government and federal agency securities have
trading relationships with the Trading Desk, the Desk normally encoun
ters no difficulty in completing its large orders promptly.*3

Outright Purchases and Sales
System transactions on an outright basis typically occur through an auc
tion process in which dealers are requested to submit bids or offers for
securities of the type and maturity that the Manager has elected to sell
or buy that day. Once dealer tenders have been received, they are arrayed
according to price. The Manager then accepts amounts bid or offered in
sequence, taking the highest prices bid for sales and the lowest prices
offered for purchases, until the desired size of the whole transaction is
reached.
Not all outright transactions occur through the dealer market. The
Federal Reserve acts as agent for a number of official agencies, such as
foreign central banks, in making dollar investments. If orders from such
3.

Of the firms that were active as primary government securities dealers in 1983, about
one-third were special departments of major money market banks. Among the
nonbank dealers, several were large, integrated brokerage houses that operate as
investment bankers and traders in a number of different sectors of the securities
markets, including equity as well as fixed-income securities. Other firms specialize
mainly in the Treasury and federal agency markets, perhaps along with involvement
in related money market instruments. But most dealer houses participate in more
than one market sector, and their willingness to respond promptly through arbitraging
transactions when yield relationships are changing the total structure of market rates
helps to link developments in the various sectors of the market.

41
Open Market Operations

an agency coincide with the System’s need to supply or absorb reserves,
the Manager may simply execute the customer order directly with the
System Account. Because the staff of the Desk keeps a continuous record
of bid and offer prices being quoted by dealers for the full list of Treasury
securities, customer orders can be readily executed directly with the
System’s portfolio at the midpoint of “going” prices.
Most of the System’s outright transactions, whether in the dealer
market or directly with foreign official accounts, take place in Treasury
bills. From time to time the System extends its purchases beyond Treasury
bills to include intermediate- and long-term U .S. government securities
and federal agency issues, but in recent years it has not had occasion to
sell such issues.

The New York Trading Desk at Work

Purposes & Functions

Repurchase Agreements
In situations that call only for temporary additions to bank reserves, the
Manager engages in short-term repurchase agreements (RPs) with dealers;
that is, the System buys securities from the dealers, who agree to repur
chase them by a specified date at a specified price. Because the added
reserves will automatically be extinguished when the RPs mature, this
arrangement is a way of injecting reserves on a short-term basis.
Repurchase agreements for the System Account may be dated to ter
minate in one to fifteen business days. However, most mature within
seven days, and dealers usually have the option to terminate agreements
before maturity.4 The absorption of reserves from premature withdrawals
of dealer RPs may also suit the needs of the System. Such withdrawals
often occur when there is a greater than anticipated availability of reserves
to depository institutions, which tends to reduce the borrowing costs
dealers face elsewhere.
Whenever the Manager arranges RPs with dealers, the distribution
among dealers is determined by auction. To help ensure enough offers
from dealers to enable the System to meet its reserve objectives, dealers
are also encouraged to seek securities for RPs from customer sources (that
is, nondealer holders of U .S . government securities) in addition to what
ever amounts the dealers may have in their own inventories. Individual
dealers may enter several offers at various interest rates. The Manager
arrays all the offers in descending order and then accepts those offers with
the highest rates up to the dollar amount needed to meet the reserve
objectives.
The “foreign RP pool” makes possible a related technique often used
by the Desk. The foreign pool consists of the RP orders that foreign
central banks and other official correspondents place with the System as
a means of investing dollar balances overnight. If, in accommodating
these orders, the Manager sold securities out of the System Account
(which would be done with an agreement that they will be resold to the
System), reserves would be drained because the inflow of dollars to the
foreign accounts would not be returned to the market. However, the
Manager may also pass all or some of these orders through to the market,
arranging the foreign RPs with dealers instead of with the System Account
and thus avoiding the potential reserve-draining effect of the transactions
4.

On occasion, the Desk has arranged “fixed-term” RPs, which have no option for
early withdrawal.

43
Open Market Operations

(that is, the dollar balances would be returned to the market but to
different owners). Dealers compete for foreign-customer RPs in a manner
similar to that used for System RPs.

Sale—Purchase Transactions
When the Manager for Domestic Operations faces a temporary need to
absorb rather than provide bank reserves, matched sale-purchase trans
actions with dealers are employed. These transactions involve a contract
for immediate sale to, and a matching contract for subsequent purchase
from, each participating dealer; the maturities of such arrangements usu
ally do not exceed seven days. The initial sale causes surplus reserves to
be drained from the banking system; later, when the System purchase is
implemented, the flow of reserves is reversed.
Matched sale-purchase transactions are typically arranged in Treasury
bills. The Desk selects a bill in which the System has a substantial holding
and invites dealers to state an interest rate at which they are willing to
purchase the bills for same-day delivery and sell them back for delivery
on a subsequent day. The Desk then accepts the most advantageous bids,
up to the point that sufficient reserves are withdrawn. In many cases,
dealers serve as intermediaries between their customers (perhaps banks
with excess funds) and the Federal Reserve when the Desk arranges
matched sale-purchase transactions.

Appendix

The Federal Reserve
Balance Sheet
and the Reserve Equation
Dhis appendix examines the individual factors that affect reserve aggre
gates. Most factors, such as changes in Treasury deposits at Federal
Reserve Banks or in currency in circulation, respond to decisions made
outside the Federal Reserve. However, the Federal Reserve by and large
can offset the impact of such factors on the overall availability of reserves
by altering the System’s holdings of securities, which are under its direct
control. The first section of this appendix explains the consolidated
balance sheet of the Federal Reserve Banks. The second section derives
a tool called the “reserve equation,” which incorporates both the Federal
Reserve’s consolidated balance sheet and the Treasury’s monetary accounts,
and specifies all of the factors that affect reserves.

Consolidated Balance Sheet of the Reserve Banks
The consolidated balance sheet of the Federal Reserve Banks provides an
accounting summary of all phases of Federal Reserve Bank operations.
This balance sheet, also known as the statement of condition of the
Federal Reserve Banks, is published every Thursday to show the condition
of the Reserve Banks as of the preceding Wednesday. The statement
appears the next day (Friday) in many daily newspapers around the
country. The balance sheet in table 3. A. 1 is a condensed form of the
statement for March 28, 1984.

Major Asset Accounts
The GOLD CERTIFICATE A CCO U N T (item 1 in the table) represents, in
effect, warehouse receipts issued to the Reserve Banks by the Treasury
against its gold holdings. In return the Reserve Banks issue an equal value
of credits to the Treasury deposit account (item 9b), computed at the
statutory price of $42.22 per fine troy ounce. Because all gold held by the
Treasury as of the date of table 3. A. 1 has been monetized in this fashion,

46
Purposes & Functions

Table 3.A.1

Consolidated Statement of Condition of All Federal Reserve Banks,
March 28, 1984
Millions of dollars
Account

Amount

Assets
1.
2.
3.
4.
5.

6.
7.

Gold certificate account
Special drawing rights certificate account
Coin
Loans
Securities
a. Bought outright
b. Held under repurchase agreement
Cash items in process of collection
Other assets
T o ta l a sse ts

11,114
4,618
515
718
154,228
154,228
0
8,181
9,076
1 8 8 ,4 5 0

Liabilities

Federal Reserve notes

D ep osits

10.
11.

a. Depository institutions
b. U.S. Treasury, general account
c. Foreign official accounts
d. Other
Deferred availability cash items
Other liabilities and accrued dividends
T o ta l liabilities

153,617
22,297
17,766
3,838
187
506
6,941
2,301
1 8 5 ,1 5 6

C a p ita l accou n ts

12.
13.
14.

Capital paid in
Surplus
Other capital accounts
T o t a l liabilities an d cap ital ac c o u n ts

1,498
1,465
331
1 8 8 ,4 5 0

the Federal Reserve Banks’ gold certificate account of $11.1 billion rep
resents the nation’s entire official gold stock. New gold certificate credits
may be issued only if the Treasury acquires additional gold or if the
statutory price of gold is increased. If the gold stock is reduced, the
Treasury must redeem an equal value of gold certificates from the Federal
Reserve in exchange for a reduced Treasury deposit at the Federal Reserve.

47
The Federal Reserve Balance Sheet

A Federal Reserve asset item closely related to the gold certificate
account is the SPECIAL DRAWING RIGHTS CERTIFICATE A CCO U N T (item
2). Special drawing rights (SDRs) are created by the International Mon
etary Fund (IMF), after agreement by a large majority of the members of
the IMF, to serve as a supplement to the international monetary reserves
of the members of the Fund; SDRs are allocated to the members in
accordance with the size of the members’ quotas, but without any pay
ment. SDRs received by the U .S. government are, by law, held by the
Secretary of the Treasury for the account of the Exchange Stabilization
Fund (ESF). From time to time the ESF monetizes SDRs by issuing SDR
certificate credits to the Reserve Banks. These credits are added to the
SDR certificate account, and the dollar value of the new SDR certificate
credits is added to a special Treasury deposit account (part of item 9d).5
C O IN (item 3) represents only the amount of coins issued by the
Treasury that the Reserve Banks hold. When the Treasury issues addi
tional coin, the Federal Reserve credits the Treasury deposit account
(item 9b) and increases its own holdings of coin (item 3). The public
obtains coin, as needed, from depository institutions, which in turn
generally acquire it from the Reserve Banks. When depository institutions
withdraw coin from the Reserve Banks, their deposits with the Banks
(item 9a) are debited.
LOANS (item 4) represent the amount of discount window credit extended
by Federal Reserve Banks to depository institutions. The proceeds of such
loans are credited to the accounts of depository institutions at the Federal
Reserve (item 9a), and the accounts are debited when the loan is repaid.
The System’s portfolio of SECURITIES (item 5) comprises mainly U .S.
government securities (Treasury bills, notes, and bonds) and obligations
of federal agencies, acquired originally through open market operations.
C A SH ITEMS IN PROCESS OF COLLECTION (CIPC) (item 6) are checks
and other cash items (such as interest coupons from municipal securities)
that have been deposited with the Reserve Banks for collection on behalf
of an institution having an account. This item has a counterpart on the
liability side of the statement— item 10, deferred availability cash items.
Items 6 and 10 are both “suspense items”— accounts that reflect a trans5.

Since 1974, the International Monetary Fund has calculated the daily value of the
SDR using a weighted average of the exchange rates of the currencies of certain
member countries. The Exchange Stabilization Fund values its SDR holdings on this
basis and, when monetizing SDRs, determines accordingly the dollar value of the
SDR certificate credits issued. As of March 28, 1984— the date of table 3. A. 1— the
ESF held $0.7 billion of nonmonetized SDRs, while the Federal Reserve held $4.6
billion of monetized SDRs.

48
Purposes & Functions

action in process. When a Federal Reserve Bank receives a check for
collection, CIPC is raised. Unless the depository institution receives
reserves the same day, the volume of deferred availability cash items also
rises.6 When the institution that brought the check for collection receives
credit, its reserve account, in item 9a, is increased, and item 10 is reduced.
When the check is actually collected, item 6 and the reserve account of
the institution on which the check is drawn, in item 9a, are both reduced.
OTH ER ASSETS (item 7) consist of the value of Federal Reserve Bank
premises, interest accrued, Federal Reserve holdings of foreign currency,
and various other items generally of minor importance.

Major Liability Accounts
FEDERAL RESERVE NOTES (item 8) are the principal type of U .S. currency

in circulation. These notes represented a little more than 80 percent of
total Reserve Bank liabilities at the end of March 1984.7
DEPOSITS of all kinds at Reserve Banks are reported in item 9.
- DEPOSITS OF DEPOSITORY INSTITUTIONS (item 9a) take the form
of reserve balances and service-related balances. Certain service-related
balances are required for clearing checks and other instruments of insti
tutions whose reserve balances by themselves are not large enough to
handle clearings. Other service-related balances are required to compen
sate the Reserve Bank for Federal Reserve float. Reserve balances are
much larger in volume than service-related balances and, together with
certain holdings of vault cash, constitute the reserves available to the
depository system for satisfying reserve requirements.
■ The second largest category of Reserve Bank deposit liabilities is
the DEPOSITS OF THE U .S . TREASURY (item 9b). The Treasury draws on
these accounts to make payments by check or direct deposit for all major
types of federal spending. When these payments clear, depository reserve
balances rise and Treasury deposits fall. The Treasury’s accounts at Reserve
Banks are replenished primarily by transfers of funds from accounts held
6.

Intraterritory checks (that is, checks involving a payor and a payee depository served
by the same Federal Reserve office) generally are credited the same day the check is
received by the Federal Reserve. Such payment is effected by directly debiting and
crediting the depositories’ accounts at the Federal Reserve Bank, and there need be
no entry in the two suspense accounts discussed above.
Although each Reserve Bank may hold as assets Federal Reserve notes issued by other
Reserve Banks, such notes cancel out in a consolidated statement of condition for
the System as a whole and thus do not appear in the table.

49
The Federal Reserve Balance Sheet

at depository institutions, in which the Treasury initially deposits its
receipts from taxes and from the sale of securities. When such transfers
occur, reserve balances are debited and Treasury deposits are credited.
■ D e p o s i t s o f f o r e i g n c e n t r a l b a n k s a n d g o v e r n m e n t s (item
9c) are the third category of deposit liabilities at the Reserve Banks. Such
deposits are maintained with the Federal Reserve Bank of New York, but
all the Reserve Banks share in the deposit liability. These deposits represent working balances held by foreign authorities for purposes of inter
national settlement.
■ The fourth category, OTHER DEPOSIT LIABILITIES (item 9d), includes
deposits of some U .S . government agencies and of international organi
zations of which the United States is a member, as well as miscellaneous
deposits.
As mentioned above, DEFERRED AVAILABILITY CASH ITEMS (item 10)
arise because Reserve Banks do not give immediate credit to the account
of a depositing institution for all checks presented to the Reserve Banks
for collection. The credit is deferred according to schedules that allow
some time for out-of-town checks to be transferred to the institutions on
which they are drawn. After this interval, the institution’s reserve balance
is automatically credited and the total of deferred availability cash items
is reduced. Since the time actually taken to collect a check may be longer
than that allowed in the schedule, the depositing institution’s reserve
balance often is credited before the reserve balance of the institution 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) is
called Federal Reserve “float” and represents checks and other items that,
although not yet collected by the Reserve Banks, have already been
credited to the reserve balances of the institutions that deposited them.
Float measures the amount of Federal Reserve credit granted to the
deposits of depository institutions (item 9a) that is generated by the
Federal Reserve’s involvement in the national process of check collection.
OTH ER LIABILITIES AND ACCRUED DIVIDENDS (item 11) consist of
unearned discounts, discounts on securities, and miscellaneous accounts
payable.

Capital Accounts
A bank that is a member of the Federal Reserve System must, under the
Federal Reserve Act, subscribe to the capital stock of the Reserve Bank

50
Purposes & Functions

of its District. The total amount of the subscription is equal to 6 percent
of the bank’s current capital stock and surplus. O f this amount 3 percent
is CAPITAL PAID IN (item 12), and 3 percent is subject to call by the Board
of Governors. These shares, unlike ordinary stock in private banks or
corporations, do not carry voting power to control the policies of the
Reserve Banks. Member institutions are entitled by statute to a cumulative
dividend of 6 percent per annum on the value of their paid-in stock.
Ownership of Reserve Bank stock may not be transferred, nor may the
owning institution use its shares as collateral for loans.
The SURPLUS A CCO U N T (item 13) represents retained net earnings of
the Reserve Banks, while the OTHER CAPITAL ACCOUNTS (item 14)
reflect the unallocated net earnings for the current year up to the date of
the statement. 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 otherwise distribute it to the stockholding member banks.
As previously noted, virtually all net earnings of Federal Reserve Banks
over the years have been paid to the U .S. Treasury.

The Reserve Equation
The “ reserve equation,” shown in table 3.A .2, provides a useful frame
work for analyzing how reserves are determined. This equation specifies
all the factors that can influence the supply of reserves. Items 1 through
7 in the equation are the factors that determine reserve balances of
depository institutions held at Reserve Banks in the current reserve main
tenance period. Items 1 through 3 are the sources supplying funds that
potentially could end up as reserve balances with Federal Reserve Banks.
Items 4 through 7 are the uses other than reserve balances that absorb
potential reserve funds. Item 8, reserve balances, is, of course, the remain
ing factor using such reserve funds. Indeed, the amount of reserve balances
is determined in the reserve equation as the difference between total
sources supplying such reserve funds and total uses, other than reserve
balances, absorbing such reserve funds.
Most of the factors in the equation appear on the consolidated balance
sheet of the Federal Reserve Banks, reviewed earlier in the appendix. In
the reserve equation, reserve balances are, of course, separated from
service-related balances and adjustments (item 6 c), rather than combined
in deposits of depository institutions (item 9a on the Federal Reserve’s
balance sheet). Deferred availability cash items (item 10 in the Federal
Reserve’s balance sheet) are subtracted from cash items in process of

51
The Federal Reserve Balance Sheet

collection (item 6) to measure directly the asset Federal Reserve float
(item lc in the reserve equation). A convenient rule of thumb is that
items from the asset side of the Reserve Bank balance sheet enter the
equation as sources (which supply potential reserve funds), and that
liabilities enter as uses (which absorb potential reserve funds).
The equation determining reserve balances also incorporates the Treasury monetary accounts, which reflect the Treasury holdings of gold and
currency and coin, as well as its issuance of currency and coin. The first
steps in incorporating these accounts into the reserve equation are to add
unmonetized gold and Treasury currency outstanding (including coin) to
both sides of the Federal Reserve balance sheet, and to subtract coin held
by the Federal Reserve from both sides of this balance sheet. Certain
items on the resulting balance sheet are then combined to give the
remaining sources and uses of reserve balances.
Gold stock (a source, item 2a) consists of the gold certificate account
plus any unmonetized gold. Currency in circulation (a use, item 4) consists
of Federal Reserve notes and Treasury currency outstanding less coin and
currency held by the Treasury and coin held by Federal Reserve Banks.
(Federal Reserve notes held by Reserve Banks are already netted out in
the consolidated balance sheet of the Reserve Banks.) Another use,
Treasury cash holdings (item 5), comprises unmonetized gold plus coin
and currency held by the Treasury. (Because coin and currency held by
the Treasury are netted out of currency in circulation, they must be
included in this use of reserv e fu n d s.)

Sources of Reserve Funds
When the source items increase, they provide reserve funds. For example,
an increase in the first item, Reserve Bank credit— composed of the
System’s holdings of securities, discount window loans, Federal Reserve
float, and other assets— would augment reserve balances if all other items
in the reserve equation stayed the same. A decrease in Reserve Bank
credit (or any other source item) would reduce reserve balances, other
things unchanged.
Reserve Bank credit is the largest factor on the sources side of the bank
reserve equation, as table 3. A .2 shows. By far the most important com
ponent of Reserve Bank credit is the System’s portfolio of securities (item
la), which accounted for 94 percent of Reserve Bank credit as of March
1984. Securities holdings are the only item in the reserve equation over
which the Federal Reserve has direct control. Borrowing at the discount

52
Purposes &. Functions

Table 3.A.2

Reserve Equation
Monthly averages, in millions of dollars
March 1984

Change from
March 1983

200,302

13,483

168,704
158,164
905
961
8,674

12,821
14,025
55
-987
-272

2. Monetary reserves
a. Gold stock
b. Special drawing rights certificate account

11,115
4,618

-2 3

3. Treasury currency outstanding

15,865

685

180,954

16,304

4. Currency in circulation

168,318

13,738

5. Treasury cash holdings

489

6,442
4,012
229
1,622
579

1,712
651
-1 5
1,044
32

Factor

Sources (factors supplying reserve funds)
1. Reserve Bank credit
a. Security holdings
b. Loans
c. Float
d. Other assets

L ess :

Uses other than reserve balances
(factors absorbing reserve funds)

6. Deposits, other than reserve balances, with Federal
Reserve Banks
a. Treasury deposits
b. Foreign deposits
c. Service-related balances and adjustments1
d. Other deposits

window— another component of Reserve Bank credit— takes place at the
initiative of depository institutions.
The significance of the float component (item lc) hinges not so much
on the total amount of potential reserve funds it provides, which is
relatively small compared with other components of Reserve Bank credit,
as on the size and frequency of changes in its level. Sometimes, float
varies erratically from one week to the next, especially in winter, when
bad weather may hinder the shipment of checks. Float is one of the most

S3
The Federal Reserve Balance Sheet

Table 3.A .2, continued

Factor

7. Miscellaneous accounts, liabilities, and capital

March 1984

5,705

Change from
March 1983

847

Eq u a l s :

8. Reserve balances with Federal Reserve Banks2,3

19,348

—2,8214

Pl u s :

9. Vault cash used to satisfy reserve requirements5

16,794

923

36,142
35,190
952

-1,898
-2,058
160

Eq u a l s :

10. Total reserves
a. Nonborrowed reserves
b. Borrowed reserves

1.
2.

3.
4.

Consists of required clearing balances and adjustments to compensate for float, both of which are included in
item 9a in table 3. A. 1 but excluded from item 8 in this table.
Components do not exactly add to this total because the factors affecting reserves are monthly averages of
daily data, while reserve balances, as well as the remaining items in the table, are prorated monthly averages
of data from fourteen-day reserve maintenance periods. This explains the discrepancy between lines lb and
10b, which represent the same concept.
Includes excess clearing balances but excludes service-related balances and adjustments— required clearing
balances and adjustments to compensate for float— which make up item 6c.
The declines in reserve balances with Federal Reserve Banks and total reserves since March 1983 reflect the
net change in the level and deposit coverage of reserve ratios under the terms of the Depository Institutions
Deregulation and Monetary Control Act of 1980 (see chapter 4); for member banks the reserve ratios for
transaction deposits were generally phased down and coverage of time deposits reduced, and for nonmember
institutions the reserve ratios were generally phased up.
Data on vault cash used to satisfy reserve requirements are on a lagged basis because vault cash held in a
previous computation period is eligible to satisfy reserve requirements in the current reserve maintenance
period (see chapter 4).

difficult items in the reserve equation to predict because of its volatility
(see chart 3 .A. 1).

Uses of Reserve Funds
An increase in any of the use items, other than reserve balances, absorbs
funds that otherwise could be held as reserve balances. For example, if
other items were unchanged, a rise in currency in circulation (item 4)
would be accompanied by a decline in reserve balances, as depository

54
Purposes &. Functions

institutions drew down such accounts to pay the Federal Reserve for
currency received from the System.
Currency in circulation is the largest single factor absorbing potential
reserve funds. The public’s demands for currency depend principally on
the volume of spending, responding to both long-run growth and cyclical
movements of the economy. However, there also are sizable seasonal
swings in demands for currency, especially around major holidays (see
chart 3. A .2). In the last two months of a year, the increase in currency
in circulation absorbs several billion dollars of reserves. In the following
two months much of this bulge returns from circulation. One of the
original reasons for creating the Federal Reserve System was to provide a
means of accommodating such seasonal increases in the public’s currency
holdings (by supplying reserve funds) and to avoid the often undesirable
contraction of bank reserves and deposits that would otherwise occur.
Both Treasury deposits (item 6a) and service-related balances and
Chart 3.A.1

Federal Reserve Float

B illion s o f dollars

55
The Federal Reserve Balance Sheet

adjustments of depository institutions (item 6c) also absorb potential
reserve funds. Week-to-week changes in these items can be sizable, even
though their levels are relativey low.

Total Reserves
Reserve balances with Federal Reserve Banks (item 8) form only one
component of the total reserves available to depository institutions; vault
cash (item 9) must be added to reserve balances to derive total reserves
(item 10). Vault cash held during an earlier computation period is eligible
to satisfy reserve requirements in the current reserve maintenance period.
However, not all such vault cash is actually counted as reserves. Some
smaller institutions hold vault cash in excess of their reserve requirements;
such surplus holdings in the lagged computation period are not included
Chart 3.A.2

Currency in Circulation

B illion s o f dollars

56
Purposes &. Functions

in the vault cash component of total reserves (item 9), which consists
only of that portion of vault cash held two computation periods earlier
that is used to satisfy reserve requirements in the current maintenance
period. Total reserves decreased $1,898 million from March 1983 to
March 1984; nonborrowed reserves decreased by $2,058 million, while
borrowing from the Federal Reserve by depository institutions increased
by $160 million.

Chapter 4

Implementation of
Monetary Policy:
Other Instruments
D his chapter focuses on operations of the Federal Reserve discount win
dow, including establishment of the discount rate, and on reserve require
ments against deposits at banks and thrift institutions. Changes in the
discount rate and in reserve requirements are the monetary instruments
that the Federal Reserve can employ, along with open market operations,
to implement national monetary policy.

The Reserve Bank Discount Window
Lending reserve funds through the discount window was originally con
ceived to be the principal instrument of central banking operations, but,
on an ongoing basis, open market operations have long since displaced
the window in this role. For some time, the window has served mainly
to complement open market operations in the day-to-day implementation
of monetary policy. However, the availability of credit at the discount
window— particularly as such credit can help relieve liquidity strains
when the country’s banking and financial system may be under stress—
performs the vital function of helping to assure the basic stability of our
banking and financial system.
Before passage of the Monetary Control Act of 1980 (M CA), only
banks that were members of the Federal Reserve System had regular access
to the discount window.1 The M CA extended reserve requirements to
nonmember institutions and at the same time provided that any such
institution having deposits reservable under the act (transaction accounts
and nonpersonal time deposits) would have access to the discount window
on the same basis as member institutions. These institutions include
domestic nonmember commercial banks, U .S. branches and agencies of
foreign banks, savings banks, savings and loan associations, and credit
unions. Individuals, partnerships, and corporations other than depository
1.

The MCA is title I of the Depository Institutions Deregulation and Monetary Control
Act of 1980 (P.L. 96-221).

58
Purposes &. Functions

institutions may be granted access to the discount window “ in unusual
and exigent circumstances;” no direct lending to such borrowers has been
undertaken since the 1930s. If these loans to nondepositories are not
collateralized by U .S. government securities, the law requires an affir
mative vote of at least five Board members.
A very large number of depository institutions are member banks or
hold reservable deposits— about 15,000 banks and about 24,000 thrift
institutions (including credit unions) with total deposits of %2Vi trillion
at the end of 1983— and thus have regular access to the discount window
at their initiative. The Federal Reserve System serves as lender of last
resort, and depository institutions are expected to draw on reasonably
available alternative sources of funds before coming to the discount win
dow. It is apparent that the volume of borrowed reserves could vary widely
if each institution were free to tap the Federal Reserve Banks’ discount
windows without restriction. A pattern of large and volatile borrowing
by depository institutions would run the risk of eroding the System’s
ability to control the reserve base of depository institutions and to achieve
national monetary and credit objectives.
Credit at the discount window is subject to administrative constraints
set forth in Regulation A of the Board of Governors of the Federal Reserve
System. The uniform framework for lending established under this regu
lation is implemented by the individual Reserve Banks through their
discount, or lending, officers and credit committees. The policy guidelines
are general, in recognition of the wide range of circumstances that may
give rise to borrowing needs. They are designed to enable discount officers
to exercise judgment in the administration of lending and to respond
flexibly to the needs of individual institutions. Implementation of dis
count window policy is coordinated by Reserve Bank lending officers and
by members of the Board’s senior staff. This coordination helps to mini
mize regional differences of interpretation. Lending guidelines and the
way they are applied do not change, regardless of the monetary policy
stance of the Federal Reserve.
The availability of borrowed reserves at the discount window permits
individual depository institutions, as well as the depository system as a
whole, to adjust in an orderly fashion to sizable fluctuations in deposits
and loan demand. Most borrowing at the window is for very short periods,
often just overnight, because institutions are expected to adapt to eco
nomic and financial circumstances without relying on Federal Reserve
credit on a regular basis. Such very short-term borrowing is called adjust
ment credit. Institutions also have access to more extended credit from
the Federal Reserve under special conditions— such as the seasonal need

59
Other Instruments of Monetary Policy

of a smaller institution without ready access to the national money market,
emergency needs that may be related to the particular circumstances of
an individual institution, or a prolonged need caused by liquidity strains
at an institution whose portfolio is largely in longer-term assets. The
various lending programs of the Federal Reserve are reviewed in detail
below, following a brief description of certain mechanics of borrowing.

Mechanics of Borrowing
Technically, a depository institution has two ways of borrowing funds
from its Reserve Bank: by means of a discount or by means of an advance.
Although the two methods are different, it has become customary to refer
to both as “discounting,” and, by extension, to refer to the interest rate
set on such borrowing as the “discount rate.”
A discount, in a technical sense, entails a sale to a Reserve Bank by a
depository institution of loans and similar assets that carry that institu
tion’s endorsement. An advance is a loan by a Reserve Bank to the
borrowing institution on its note secured by adequate collateral. A t one
time discounts were by far the more important means of access to Federal
Reserve credit, but today, because of the ease of operation, virtually all
funds flowing through the discount window do so by means of advances.
All advances must be secured to the satisfaction of the Reserve Bank
providing the credit. Satisfactory collateral generally includes securities
of the U .S . government and of federal agencies, and, if of acceptable
quality, mortgage notes covering one- to four-family residences, state and
local government securities, and business, consumer, and other customer
notes. Although collateral is generally held in safekeeping at the Federal
Reserve Banks or by acceptable third-party custodians, borrowers in good
financial condition who seek short-term adjustment credit may be per
mitted to hold their own collateral appropriately earmarked.

Adjustment Credit
Funds obtained at the discount window as short-term adjustment credit
historically have accounted for the great bulk of borrowing from the
Reserve Banks. The average level of such borrowings since 1975, along
with seasonal and other extended credit, is given in table 4.1. Adjustment
borrowing tends to be heaviest and most widespread during periods of
tight credit. Even then, since institutions turn to the discount window

60
Purposes & Functions

Table 4.1

Discount Window Borrowing, by Type, 1975-83
Annual average in millions of dollars

1.
*

Year

Adjustment
credit

Seasonal
credit

Other extended
credit

1975
1976
1977
1978
1979

144
64
405
750
1,187

24
18
56
121
151

28
2
0
0
*

195
84
461
871
1,339

1980
1981
1982
1983

1,153
1,073
746
554

72
183
136
112

191
105
170
373

1,416
1,361
1,052
1,039

Total1

Details may not add to totals because of rounding.
Less than $500,000.

only after tapping other reasonably available sources of funds, the average
level of aggregate borrowing from the Federal Reserve naturally amounts
to only a very small fraction of the total loans and investments of eligible
depository institutions— generally less than one-tenth of one percent.
Appropriate reasons for adjustment borrowing include the coverage of
sudden, unforeseen deposit outflows, the need to counter temporary and
unexpected difficulties in obtaining funds from other sources, and, in
some circumstances, the accommodation of unexpected increases in loan
demand. Adjustment borrowing therefore tends to be used mainly by
institutions that have volatile checking account liabilities or that are
heavily involved in relatively short-term lending. Adjustment credit would
not be considered appropriate for such purposes as financing speculative
loans and investments, substituting Federal Reserve credit for the borrow
ing institution’s capital, financing lending in the federal funds market,
acquiring securities or other money market paper at a profit, refinancing
existing indebtedness to private lenders at a lower rate, or avoiding
relatively expensive money market funding.
In judging whether a user is relying unduly on adjustment borrowing,
the Reserve Bank discount officer takes into account the institution’s
indebtedness in relation to its total deposits, the frequency and duration
of its past borrowing, any special circumstances affecting its current
position, and efforts it has made to obtain funds from other reasonably

61
Other Instruments of Monetary Policy

available sources. In addition to private market sources, savings and loan
associations and savings banks that are members of the Federal Home
Loan Bank System can look to this special industry lender for liquidity
assistance, and many credit unions also have the option of borrowing
from a special industry lender. Institutions that have access to such sources
are expected to turn to them for funds before seeking assistance from the
Federal Reserve.
Large institutions in particular have many options for obtaining funds
on a daily basis, including international markets. When such institutions
make use of adjustment credit, they generally repay their loans on the
next business day. Borrowing by smaller institutions, which have fewer
alternative sources of funds, can extend over several days, or at times a
bit longer. Very frequent requests for loans and requests for renewals of
loans are closely scrutinized and may be discouraged, particularly if the
institution has a pattern of borrowing frequently or for extended periods.

Extended Credit for Seasonal Purposes
Seasonal credit from the discount window is designed primarily to assist
small institutions that lack effective access to national money markets.
Such an institution must also demonstrate a seasonal need that arises
from a recurring pattern of movement in deposits or loans; it must meet
a part of its seasonal needs from its own resources (the part required for
larger institutions represents a greater share of average deposits than does
that for small institutions); and, if it is not a bank, it must also make use
of seasonal credit assistance available from a special industry lender. In
practice, seasonal credit has been limited essentially to institutions with
deposits of $250 million or less.
Without an assured source of seasonal credit, these smaller institutions
typically would accumulate short-term securities as a pool of liquidity on
which they could draw to meet peak seasonal needs for funds. To the
extent that resources were tied up in this way during the off-peak season,
some needs for credit for desirable projects might not be accommodated.
O f the institutions that have used the seasonal borrowing privilege,
most are lenders that do a substantial volume of business in farm or resort
areas. For some users, seasonal credit lines may be available for periods
extending over a number of months. Whenever possible, institutions are
expected to arrange with their Reserve Banks for seasonal credit in advance
of their actual need for funds.

Purposes &. Functions

Other Extended Credit
Extended credit advanced for other than seasonal purposes is designed to
meet two general types of needs. The first involves a depository institution
that is experiencing liquidity strains owing largely to exceptional circum
stances or practices that are affecting that institution alone. Such strains
may arise from a number of causes. They may be triggered, for example,
by developments over which the management of the affected institution
has no control— such as the closing of a key industrial plant in a small
town or a natural disaster. Or they may result from a series of bad
management decisions. The nature of the Federal Reserve response to
requests for credit from institutions facing these types of problems will
depend importantly on whether the problems appear to be correctable,
whether the borrowing is likely to be repaid on a timely basis, and whether
failure of the institution would risk serious damage to the public interest
in the market the lender serves.
Depending on the circumstances, the Federal Reserve may elect to
provide extended credit either to help support an explicit program of
management and financial reform (with a view to returning the depository
institution to a sound basis over a period of time) or to make available
bridge financing while arrangements are being completed for a merger
with a stronger institution or an orderly closing of the institution. In such
cases, the Federal Reserve works closely with the appropriate federal and
state supervisory agencies. While the cases involving large banks have
perhaps received the greatest publicity, most cases of extended credit in
this general category involve small institutions.
A depository institution experiencing problems of the type described
above that has access to a special industry lender is expected to seek
extended credit assistance from that lender before turning to the Federal
Reserve. This expectation reflects the view that the special industry lender
will be thoroughly familiar with the evolution of the institution’s problem.
In appropriate circumstances, however, the Federal Reserve is prepared
to supplement the efforts of the special industry lender in helping to meet
the liquidity problems of the troubled institution.
Extended credit is also provided to meet protracted liquidity problems
that arise when money market conditions cause special difficulties for
depository institutions whose portfolios are largely invested in long-term
assets. Although some commercial banks have such portfolios, they are
most common to savings and loan associations and savings banks, which

63
Other Instruments of Monetary Policy

invest a large proportion of their funds in long-term residential mortgages.
These institutions have in the past often been under liquidity pressure in
periods of rising short-term market interest rates, when savers have shifted
funds out of deposits into market instruments. However, the deregulation
of rates that may be paid on deposits has given these institutions more
flexibility in managing liquidity by enabling them to offer market rates
and thus to retain deposits.
Extended credit was provided under this program to a number of thrift
institutions in late 1981 and the first half of 1982 to help mitigate liquidity
strains. Before providing extended credit, the Reserve Banks consult with
the agency that supervises the affected institution— in the case of savings
and loan associations, the appropriate Federal Home Loan Bank— to
determine, among other things, whether funds are available from other
sources, including a special industry lender. As with extended credit to
meet the exceptional liquidity problems of a particular institution, this
type of extended credit from the discount window is made available on
condition that the borrower adopt an appropriate plan to restore liquidity
and to repay the loan within a reasonable period.

The Discount Rate
The interest rate charged by each Reserve Bank on its loans is established
by its Board of Directors, subject to review and determination by the
Board of Governors. The Federal Reserve Act originally envisioned that
the discount rate of each Reserve Bank would be set to reflect the banking
and credit conditions in its District. Over the years, however, the pro
gressive integration of regional credit markets into a fluid national market
has gradually produced a national perspective for discount rate determi
nation. As a result, the twelve Reserve Banks now post a uniform structure
of discount rates except during the short periods when some Reserve
Banks already have changed their rate, but the boards of other Reserve
Banks have not yet met to take such action.
The basic discount rate applies to all loans made under the programs
of adjustment and seasonal credit. This rate also applies to other extended
credit for an initial period, currently sixty days. However, the rate on
extended borrowing is raised above the basic rate according to a schedule
if the credit is outstanding over a longer period; an alternative flexible
rate that takes into account rates on market sources of funds may be
established at a certain point in the rate schedule. When extended credit

Purposes & Functions

provided to a particular institution is expected to be outstanding for an
unusually long time in relatively large amounts, the period for which each
rate in the extended credit rate structure applies may be shortened. The
discount rate that would be applicable to loans made to individuals,
partnerships, and corporations in unusual and exigent circumstances would
be established at the time of the loan.
Surcharges above the basic discount rate have been applied at times to
adjustment borrowing by larger institutions that were making frequent
use of such credit. In 1980 and 1981, the Federal Reserve applied a
surcharge (varying between 2 and 4 percent) to adjustment borrowing by
institutions with deposits of $500 million or more that had borrowed in
successive weeks or that had borrowed more than four times in a thirteenweek period. The purpose was to encourage prompter portfolio adjust
ments by these institutions.
The basic discount rate and related rates are adjusted from time to time
in light of changing market conditions and to complement open market
operations and the thrust of monetary policy generally. Although insti
tutions may borrow from the Federal Reserve only temporarily and under
restricted conditions, and they are reluctant to borrow frequently, a
discount rate that is low relative to market rates makes it more likely that
institutions will come to the window. Thus depository institutions will
tend to increase their borrowing when market interest rates rise relative
to the discount rate, and to curtail borrowing when market rates fall.
As market interest rates and the level of borrowing change, the discount
rate is generally adjusted to help control the volume and profitability of
borrowing by depository institutions. Changes in the discount rate are
made judgmentally rather than automatically and may lag changes in
market rates to a degree.
A t times, changes in the level of borrowing may simply reflect tem
porary responses of the depository system to transitory demands for money
and credit. Or such changes may help to keep money and credit from
deviating substantially from policy objectives by providing or absorbing
reserves when the demand for excess reserves or the amount of required
reserves needed to support a given level of deposits has changed unex
pectedly and therefore could not be fully taken into account in open
market operations. Under all those circumstances, an adjustment in the
discount rate would needlessly exacerbate money market pressures, and
indeed might be counterproductive.
A t other times, however, an adjustment in the discount rate may be
desirable to reinforce open market operations. This might be the case
when a rising (or falling) level of borrowing was contributing to sustained

65
Other Instruments of Monetary Policy

strength (or weakness) in money and credit growth relative to policy
objectives. In a period of excessive money growth, for instance, a rise in
the discount rate would reduce incentives to borrow from the Federal
Reserve and help accelerate institutions’ portfolio adjustments that work
to reduce expansion in credit and money. In that way a rise in the discount
rate would complement the restraining effect of open market operations
on nonborrowed reserves.
The immediate response of market interest rates to a change in the
discount rate— the “ announcement effect”— will depend in part on the
extent to which the change has been anticipated. To the degree that
short-term rates have moved in anticipation of an adjustment in the
discount rate, the actual change may have relatively little impact on
market conditions, given the amount of reserves being supplied through
open market operations. The response of market rates generally to a
discount rate change will be largest when the market views the adjustment
as signaling a shift in the Federal Reserve’s evaluation of the underlying
condition of the economy and of money and credit demands. In general,
changes in the discount rate must be interpreted in the context of sur
rounding economic and financial conditions and in light of the way they
complement other policy actions.

Reserve Requirements
Since 1980, all depository institutions in the United States— commercial
and savings banks, savings and loan associations, credit unions, U .S.
agencies and branches of foreign banks, and Edge act and agreement
corporations— must meet reserve requirements set by the Federal Reserve
and hold the reserves in the form of vault cash or deposits at Federal
Reserve Banks. Reserves are held against transaction accounts and nonpersonal time deposits, as well as against funds raised abroad through
foreign affiliates or other foreign banks for domestic use. Before 1980,
reserves were required only of member banks (and were held against all
deposits at those banks). But from the mid-1970s on, the old structure of
reserve requirements was rapidly becoming outdated. Regulatory change
and competitive pressures during a period of high interest rates were
fostering the growth of deposits, especially the newly introduced interestbearing transaction deposits, at institutions other than member banks.
Thus reserve requirements needed to be applied to a broad group of
institutions for more effective monetary control— to make it more likely

Purposes &. Functions

that the amount of reserves supplied by the Federal Reserve would be
reasonably closely related to the supply of money in the economy.

Structure of Reserve Requirements
Under the Monetary Control Act of 1980, the Federal Reserve Board
may impose reserve requirements on transaction deposits and on nonpersonal time deposits solely for the purpose of implementing monetary
policy. These requirements must be applied uniformly to all similar accounts
at all depository institutions. The Board may also set reserve requirements
on the net liabilities of depository institutions in the United States to
their foreign affiliates or to other foreign banks. Reserve requirements on
nonpersonal time deposits may be differentiated by maturity, subject to
the overall limits of zero to 9 percent on the ratio of required reserves to
nonpersonal time deposits given in the act. There are no overall limits
on reserves against net foreign borrowing by depository institutions.
The range of reserve ratios permitted under the M CA and the initial
levels of those ratios established by the Board are shown in table 4.2. The
highest reserve requirements authorized and imposed are those on trans
action accounts, which include demand deposits and interest-bearing
accounts with unlimited checking privileges. The Board may modify the
reserve ratio on transaction accounts within a range of 8 to 14 percent.
Relatively low reserve requirements have been placed on nonpersonal
time deposits and net foreign borrowings. Under the act, the Federal
Reserve has no authority, except in extraordinary circumstances, to impose
reserves against personal time deposits.
Reserve requirements have been structured to bear less heavily on
smaller institutions than on larger ones. At every institution a small
amount of reservable liabilities is exempt from any reserve requirement,
and transaction accounts up to a certain level are subject to relatively
low reserve requirements. These levels are adjusted annually to reflect
the growth in deposits, and in 1984, the first $2.2 million of reservable
liabilities was exempt from any requirements, and transaction deposits up
to $28.9 million had a reserve ratio of only 3 percent.2
Under extraordinary circumstances, the Board is also empowered by
the M CA to establish reserve requirement ratios beyond the ranges shown
in the table. Specifically, with the concurrence of no fewer than five
2.

The Congress originally set these reserve requirement break points at $2 million and
$25 million, and required the annual adjustment.

67
Other Instruments of Monetary Policy

Table 4.2

Reserve Ratios, September 1984
Percent
Type of liability

All reservable liabilities
$0-2.2 million3
Transaction accounts4
$0-28.9 million5
More than $28.9 million
Time and savings deposits
Personal
Nonpersonal, by maturity6
Less than IV2 years
1V i years or more
Net liabilities to foreign
banking offices7

2.
3.

6.
7.

Initial ratios after
phase-in of Monetary
Control Act1

Permissible
range12

0
3
12

3
8-14

0
0-9

3
0
3

At the discretion
of the Board

The schedule of phase-in of the reserve requirement ratios in this column is as follows: U .S. agencies and
branches of foreign banks— August 1982; member banks and Edge and agreement corporations— February
1984; former member banks that withdrew from the Federal Reserve System between July 1, 1979, and March
31, 1980— October 1985; nonmember commercial banks, savings and loan associations, savings banks, and
credit unions— September 1987 (except for institutions in Hawaii— January 1993).
Except under certain conditions; see text.
The G a m -S t Germain Depository Institutions Act of 1982 (P.L. 97-320) provided that $2 million of reservable
liabilities (transaction accounts, nonpersonal time deposits, and Eurocurrency liabilities) of each depository
institution was subject to a zero percent reserve requirement. The act also instructed the Board to adjust the
amount of reservable liabilities subject to this zero percent requirement each year for the next succeeding
calendar year by 80 percent of the percentage increase in the total reservable liabilities of all depository
institutions, measured on an annual basis as of June 30. No corresponding adjustment is to be made in the
event of a decrease. Effective January 12, 1984, the amount of the exemption was established at $2.2 million.
Reservable transaction accounts are demand deposits, NOW accounts, automatic transfer accounts, share
draft accounts, and any other account at a depository institution on which the account holder is permitted to
make withdrawals by negotiable or transferable instruments, payment orders of withdrawal, and telephone and
preauthorized transfers (in excess of three per month) for the purpose of making payments to third persons or
others. Reserves are required on net transaction accounts. These amounts are derived by deducting from total
transaction accounts the sum of cash items in process of collection and demand deposits due from domestic
depository institutions. Money market deposit accounts, and other similar accounts, that permit up to six
preauthorized, automatic, or other transfers per month (no more than three of which may be checks) are
classified as time deposits and are subject to reserves as such.
The Monetary Control A ct of 1980 requires that the amount of transaction accounts against which the 3
percent reserve requirement applies be modified annually by 80 percent of the percentage change in transaction
accounts held by all depository institutions determined as of June 30 each year. Effective December 29, 1983,
the amount was established at $28.9 million.
Nonpersonal deposits are those nontransaction accounts that are transferable or in which the beneficial interest
is held by a depositor that is not a natural person.
Net liabilities to foreign banking offices include net borrowings from related foreign offices, gross borrowings
from unrelated foreign depository institutions, loans to U .S. residents by foreign offices of U .S. depository
institutions, and sales of assets by U .S. depository institutions and U .S. offices of foreign banks to their foreign
offices.

Purposes & Functions
Board members, and after consultation with the other agencies that
supervise depository institutions, the Board may impose a supplemental
reserve requirement of up to 4 percentage points on transaction accounts
if such an action is essential for the conduct of monetary policy. Unlike
reserves required under the regular schedule, such reserve balances would
earn interest from the Federal Reserve. Furthermore, with an affirmative
vote of no fewer than five members, and after consultation with the
appropriate committees of the Congress, the Board may, for periods of
up to 180 days, impose ratios outside the bounds shown in the table and
apply requirements to other classes of liabilities.
Since February 1984, depository institutions have been required to
maintain a given level of reserves on average over a fourteen-day period
ending every other Wednesday. The reserve requirement against trans
action deposits is essentially contemporaneous while that against other
reservable liabilities is lagged;3 the average level of reserves that must be
held during a reserve maintenance period is computed by applying the
appropriate reserve ratios to the level of transaction accounts held on
average over the fourteen days ending two days before the end of the
reserve maintenance period and to the average level of other reservable
liabilities over a two-week period ending about two weeks before the
reserve maintenance period begins. Different reserve maintenance periods
were set for transaction and other liabilities so that current changes in
most non-M 1 liabilities would not affect the relationship between current
reserve availability and the current level of deposits in M l, the measure
of money that encompasses deposits on which unlimited transactions are
permitted.
To provide flexibility for depository institutions in case of sudden,
unexpected changes in reserve positions that may occur late in a reserve
maintenance period, the Federal Reserve offers reserve carry-forward
options within certain limits. Excess reserves of up to 2 percent of reserve
and clearing-balance requirements over a fourteen-day maintenance period
may be carried forward into the next fourteen-day maintenance period to
help satisfy that period’s reserve requirements;4 any deficiency in reserves
up to 2 percentage points of an institution’s reserve and clearing-balance
requirements during a maintenance period similarly may be carried for
ward to be made up by the holding of additional reserves in the next
3.
4.

From 1968 to early 1984, all reserve requirements were lagged, and reserves were
held on a weekly basis against deposits two weeks earlier.
Clearing balances are required of institutions to gain access to Federal Reserve
services, and the level of required clearing balances is related to usage of these
services. See chapter 7.

69
Other Instruments of Monetary Policy

maintenance period.5 A penalty equal to the discount rate plus 2 per
centage points is levied against reserve deficiencies beyond the carry
forward amount. Such deficiencies occur rarely, of course, because depos
itory institutions must by law meet their reserve requirements.

Reserve Requirements and Monetary Policy
Reserve requirements are important for the conduct of monetary policy
because they form the link between Federal Reserve open market oper
ations on the one hand and the supply of money and the cost and
availability of credit on the other. Open market operations, supplemented
by borrowing at the discount window, determine the total volume of
reserves available to depository institutions, while reserve requirement
ratios dictate the maximum quantity of reservable deposits that the reserve
base can support.
The reserve requirement structure of the M CA is oriented particularly
toward control of M 1. Certain other accounts with transaction features—
such as accounts with money market mutual funds— by law are not subject
to reserve requirements and are not included in M l; but they are included,
along with time and savings deposits generally, in broader measures of
money. The structure of reserve requirements is oriented less to the
control of these broad measures because the bulk of those deposits included
do not bear reserve requirements set by the Federal Reserve. Thus the
reserve base is most useful as a fulcrum for monetary control when policy
can focus relatively more on M l than on other monetary and credit
aggregates. Because nonpersonal time deposits and funds raised abroad,
which banks can readily manage to accommodate to changing bank credit
demands, are subject to reserve requirements, the Federal Reserve can—
by changing reserve requirements— influence their cost and can alter the
cost of raising funds in domestic markets as compared with that in foreign
markets.
The linkage between reserves and deposits or money tends to be more
predictable when reserve requirements are “binding”— that is, when the
required reserves are in excess of cash balances that depository institutions
would have held voluntarily— and when reserves in excess of require
ments are at frictional levels. As a result of low or nonexistent reserve
5.

To help smooth the transition from the lagged reserve structure in effect before
February 1984 to the present contemporaneous structure, the maximum carry-forward
was established as the larger of $25,000 or 3 percent until August 1984, 2Vz percent
until January 1985, and 2 percent thereafter.

70
Purposes &. Functions

requirements for smaller institutions, the vast majority of depository
institutions can meet their obligations with vault cash that they would
hold in any case for daily operating needs. However, most transaction
accounts are held at institutions that cannot meet all of their reserve
requirements through vault cash but also must hold reserve balances at
Federal Reserve Banks, and are therefore “bound.” Excess reserves are
usually kept at frictional levels because institutions want to minimize their
holdings of reserves, which are noneaming assets.
The predictability of the linkage between reserves and money also
improves when the various components of the money concept to be
controlled are subject to the same reserve ratios, so that shifts between
different types of deposits in that money measure or among institutions
of varying size or type do not alter the relationship between reserves and
those deposits. The M CA introduced a reserve requirement structure that
moved in that direction for M l, but legislative exemptions for institutions
holding small amounts of reservable liabilities and lower reserve require
ments on transaction deposits under a certain level leave room for deposit
shifts to affect the average relationship between required reserves and
transaction deposits in the aggregate.
Reserve requirement ratios can be changed to help implement monetary
policy. A rise in reserve requirements reduces the volume of deposits that
can be supported by a given level of reserves and, in the absence of other
actions, tends to reduce the money supply and raise the cost of credit. A
decline in reserve requirements leaves depository institutions initially
with excess reserves, which can induce an expansion of bank credit and
deposit levels and a decline in interest rates.
Adjustments to reserve requirements are not, however, well suited to
the day-to-day implementation of monetary policy. Changes were infre
quent before the M CA was passed. And up to September 1984, there
had been no discretionary changes since the phase-in of reserve require
ments for all institutions under the M CA began in November 1980,
except for a minor change affecting the maturity of nonpersonal time
deposits subject to reserve requirements. Even small adjustments to reserve
ratios have substantial effects on required reserves. To avoid large, sudden
impacts on deposits and credit, changes in reserve ratios have been at
least partially offset by open market operations at the time of implemen
tation or have tended to be made when large seasonal changes were taking
place in the demand for reserves. More generally, reserve requirements
are an important variable in banks’ business calculations, and frequent
changes in them would unnecessarily complicate financial planning by
these institutions.

71
Other Instruments of Monetary Policy

As a result, the tendency has been to use changes in reserve require
ments mainly for their “announcement” effect— to underline a particular
policy direction and to influence the public’s perception of the thrust of
monetary policy. In addition, reserve requirements on large certificates
of deposit or net Eurodollar borrowing have been adjusted to affect the
cost and availability of credit extended by banks or to influence the
relative cost of domestic and foreign sources of funds. On occasion, higher
reserve requirements have been applied only to the increment in these
managed liabilities as a means of slowing the expansion of bank credit.

Other Policy Tools
In addition to the general monetary instruments that affect the availability
and cost of the reserves of depository institutions, the Federal Reserve in
the past has had authority to establish ceilings for interest rates on time
and savings deposits and to implement selective credit controls. Before
passage of the Depository Institutions Deregulation Act of 1980 (DIDA),
ceiling rates on time and savings deposits had been administered on a
coordinated basis by the Board of Governors for member banks, by the
Federal Home Loan Bank Board for insured savings and loan associations,
and by the Federal Deposit Insurance Corporation for insured nonmember
commercial and savings banks.6The structure of ceiling rates was designed
to contribute to equitable competition for interest-bearing deposits as the
institutions adapted to changing economic and financial circumstances.
To administer the phase-out of ceiling rates in an orderly fashion by no
later than 1986, the Depository Institutions Deregulation Committee—
comprising the Secretary of the Treasury, the Chairman of the Board of
Governors, and the heads of the other agencies that regulate depository
institutions— was established by the DIDA; the authority of individual
regulatory agencies to set ceiling rates was transferred to this committee.
There is no legislative authority at present for selective credit controls
(apart from margin requirements on stocks, discussed below). The Credit
Control Act, which expired in June 1982, provided that “ [w]henever the
President determines that such action is necessary or appropriate for the
purpose of preventing or controlling inflation generated by the extension
of credit in an excessive volume, the President may authorize the Board
[of Governors] to regulate and control any and all extensions of credit.”
6.

The DIDA is title II of the Depository Institutions and Monetary Control Act of
1980 (P.L. 96-221).

Purposes & Functions
The Board, in response to a request from the President, administered
certain control programs under this authority in the spring of 1980.
Previously, the Federal Reserve had been given the responsibility for
administering consumer credit regulations during the World War II and
Korean war periods; in the latter period, selective regulation was extended
to real estate credit.
The Securities Exchange Act of 1934 and its amendments authorize
the Board of Governors to regulate the use of credit for purchasing or
carrying securities. In exercising its responsibility, the Board imposes
limits on the amount of such credit that may be provided by brokers and
dealers (Regulation T ), banks (Regulation U ), and other lenders (Reg
ulation G ). To prevent borrowers from obtaining more credit abroad than
lenders are permitted to supply in this country, as well as to improve
compliance generally, all U .S. persons who use securities credit are required
to comply with the Board’s margin regulations (Regulation X). Margin
regulations apply to transactions in stock and in related instruments such
as options, warrants, and bonds convertible to stock.
The main purpose of margin requirements is to inhibit undue fluctua
tions in stock prices that might be fostered by the excessive use of credit
in the purchase of securities or by highly leveraged short sales or trans
actions in options. Although sharp changes in stock prices are always
possible, restrictions on the use of credit may limit cumulative price
increases and decreases and reduce the risk that fluctuations in the stock
market will have destructive effects on financial markets and the economy
generally, as well as on the individual investor.
The regulations on securities credit set forth the maximum amount of
credit that a lender may advance against most stock pledged as collateral,
when the purpose of the loan is to purchase stock.7 For example, if the
Federal Reserve margin requirement were 60 percent, an investor who
wanted to buy $10,000 worth of stock would have to put up $6,000 in
cash. In effect, the regulations would allow the investor to borrow no
more than $4,000 to finance the purchase. Similar margin is required if
securities are sold short— that is, when someone sells securities that he
does not own. In the case of options, the “writer”— that is, the original
seller— is also subject to a margin that is based on the value of the
underlying securities if he does not already have an offsetting position in
those securities.
7.

The regulations apply to “ margin stocks, ” which are corporate equity securities traded
on a national exchange such as the New York Stock Exchange, or included in the
Federal Reserve’s “List of O TC Margin Stocks. ”

73
Other Instruments of Monetary Policy

The Federal Reserve’s regulations establish margin requirements that
apply only at the time a security is bought or sold. Therefore, if stock is
bought on margin and its price subsequently falls, the regulations do not
require the investor to put up additional collateral or to pay off part of
his loan in order to restore the original relationship between the loan and
the now lower value of the underlying collateral. Similarly, any increase
in the Federal Reserve’s margin requirement applies only to future trans
actions, so that an investor does not have to post additional collateral or
pay off loans associated with margin transactions made under the earlier,
lower requirement. However, most broker/dealers have maintenance
requirements, and may require additional collateral or cash at any time.
For example, the New York Stock Exchange requires its members to issue
a margin call— that is, to call for more money— whenever a customer’s
net equity falls below 25 percent of the market value of stocks held in a
margin account; and many individual brokerage firms use maintenance
margins that are somewhat higher.

Chapter 5

The Federal Reserve
in the International Sphere
Dhe U .S. economy is an important, interdependent part of the world
economy. Public policies and economic developments in this country
have a major influence beyond our borders. At the same time, policies
and economic developments abroad have significant effects on our econ
omy. The U .S . dollar continues to play a leading role in international
monetary arrangements: it is the currency most used in international
transactions and most widely held in official reserves.
These international relationships affect the operations and activities
of the Federal Reserve in various ways. In deciding on the monetary policy
that is appropriate for achieving basic domestic economic goals, the Board
of Governors and the Federal Open Market Committee consider the
information conveyed by the record of U .S. international transactions,
movements in exchange rates, and other international economic devel
opments. In addition, the Federal Reserve has specialized instruments
and powers that have direct influence on international financial variables
and the activities of international banks. The Federal Reserve also can
undertake foreign exchange transactions, in cooperation and consultation
with the U .S . Treasury. These transactions, and similar ones by foreign
central banks involving dollars, may be facilitated by foreign currency
“swap” arrangements between the Federal Reserve and certain other
central banks. In the regulatory area, the ongoing internationalization of
banking has led to new responsibilities for the Federal Reserve, as well as
to changes in existing regulations. Finally, the Federal Reserve works
with other agencies of the U .S. government in the conduct of interna
tional financial policy, supports those agencies in this country’s partici
pation in various international organizations, and maintains relations
with other central banks on subjects of mutual concern.

Monetary Policy and
International Economic Developments
The general instruments of monetary policy— open market operations,
the discount rate, and reserve requirements— are employed essentially to

76
Purposes & Functions

attain basic domestic economic objectives. A monetary policy that
encourages economic growth, high levels of employment, and reasonable
price stability at home will also contribute most effectively to stable
international conditions. A t the margin and for short periods, when it is
consistent with the achievement of domestic objectives, the use of general
monetary instruments may be adapted in light of external factors; for
instance, the timing of a discount rate action may be affected.
In formulating monetary policy the Board of Governors and the FOMC
use information on international factors. Changes in public policies or
economic conditions abroad that may affect the U .S. economy are eval
uated in assessing the stance of U .S . monetary policy, as are movements
in international variables like the exchange rate.
Movements in dollar exchange rates can be helpful in distinguishing
among interpretations of the same economic event— for example, assess
ing whether a tendency for interest rates to rise reflects inflationary
expectations or an increase in the demand for bank reserves. If inflationary
expectations worsened, a decline in the nominal exchange rate of the
dollar could be expected to accompany a rise in interest rates. On the
other hand, if the demand for reserves rose relative to supply, an appre
ciation of the dollar would be the likely accompaniment of rising interest
rates.
On some occasions a change in the exchange rate would reinforce other
signals that suggested the need for a change in monetary policy. For
example, in late 1979 a marked deterioration of the dollar on exchange
markets was one of the important signs that increases in expected inflation
were affecting U .S. financial and goods markets. This development con
tributed to the adoption of the new reserves operating procedure designed
to assure closer control over money growth.
On other occasions a change in the exchange rate would not signal a
need to alter monetary policy. Suppose there were a surge in public or
private spending at a time when the economy was approaching capacity.
Given an unchanged path of bank reserves, the associated increase in
demand for money and credit would cause a rise in interest rates, with an
accompanying tendency for the dollar to appreciate on exchange markets.
These changes in interest rates and the exchange rate would work to
restrain inflationary pressures. As the dollar appreciated, home and for
eign demand would be shifted away from U .S . goods, and prices of
imported goods would be held down. Resisting the appreciation of the
dollar by adopting a more expansionary path for bank reserves and the
money supply would simply magnify the inflationary effect of the original
surge in demand.

77
The Federal Reserve in the International Sphere

Foreign Currency Operations
The Federal Reserve has engaged in foreign currency operations since
1962, in addition to the transactions that it has executed for customers
since the 1950s. The foreign currency operations of the Federal Reserve
are directed by the FOMC, acting in close cooperation with the Treasury,
which has overall responsibility for the management of U .S. international
reserves. The Manager for Foreign Operations at the New York Federal
Reserve Bank acts as the agent for both the Committee and the Treasury
in carrying out U .S. foreign currency operations. The policy of the FOMC
with regard to foreign currency operations is embodied in its Authorization
for Foreign Currency Operations and its Foreign Currency Directive.
The nature and scope of foreign currency operations have evolved in
response to changes in the international monetary system, the most
important of which was the transition in the early 1970s from the Bretton
Woods system of fixed exchange rates to a system of flexible exchange
rates. In the period of flexible exchange rates, the main aim of Federal
Reserve foreign currency operations (as provided for in the Foreign Cur
rency Directive) has been to counter disorderly conditions in exchange
markets through intervention operations, carried out primarily in the
New York foreign exchange market. During some periods of downward
pressure on the dollar, the Federal Reserve has purchased dollars (sold
foreign currency), thereby absorbing some of the selling pressure on the
market value of the dollar. Similarly, sales of dollars (purchases of foreign
currency) have at times been undertaken to counter upward pressure on
the dollar’s foreign exchange value. The Federal Reserve Bank of New
York may also carry out transactions in the U .S. foreign exchange market
as an agent for the accounts of foreign monetary authorities.
Intervention operations involving dollars, whether initiated by the
Federal Reserve or by a foreign authority, do not alter the supply of
reserves available to U .S . depository institutions. In other words, the
intervention is “sterilized” in that it does not lead to a change in the
domestic reserve base different from any that would have taken place in
the absence of the intervention.
Suppose the Federal Reserve wants to counter downward pressure on
the dollar. It draws down, say, its deutsche mark balances (an asset on
the Federal Reserve balance sheet) at the Bundesbank— the German
central bank— and sells deutsche marks for dollars, temporarily reducing
the supply of dollar bank reserves. However, unless an explicit decision
has been made to lower dollar bank reserves, the Federal Reserve routinely

78
Purposes & Functions

uses the dollars it has acquired to purchase a dollar security, thereby
restoring the supply of dollar bank reserves to its former level.
The Bundesbank may or may not allow the Federal Reserve’s interven
tion operation to affect deutsche mark bank reserves. In order to avoid
an increase in deutsche mark bank reserves, the Bundesbank must sterilize
by selling a deutsche mark security in the open market. The net effect of
a Federal Reserve intervention operation that is sterilized by both the
Federal Reserve and the Bundesbank is to reduce the supply of dollar
securities and increase the supply of deutsche mark securities available to
the private sector.
Dollar interventions initiated by foreign central banks also leave the
U .S. domestic reserve base unaffected either because they do not entail
changes in the Federal Reserve’s balance sheet or because any such
changes are routinely offset. Most dollar sales by foreign central banks
are implemented by drawing down holdings of dollar securities or by
borrowing dollars in the market, and thus have no impact on bank
reserves. If a foreign central bank sold dollars from its holdings at the
Federal Reserve or sold dollars borrowed from the Federal Reserve through
the “swap” network described below, those transactions would, in and of
themselves, affect bank reserves. However, in either case the impact
would be offset as a matter of course by Federal Reserve sales of domestic
securities.

“ Swap” Network
A major feature of the foreign currency operations of both the Federal
Reserve and foreign central banks has been the “swap” network, which
consists of reciprocal short-term credit arrangements between the Federal
Reserve and certain foreign central banks. These arrangements enable
the Federal Reserve to borrow the foreign currencies it needs for inter
vention operations to support the dollar and enable the partner foreign
central banks to borrow the dollars they need to support their own
currencies. Swap transactions are implemented through the New York
Federal Reserve Bank, acting as an agent for the Federal Reserve System.
A swap transaction involves both a spot (immediate delivery) trans
action, in which the Federal Reserve exchanges dollars for foreign cur
rency, and a simultaneous forward (future delivery) transaction, in which
the two central banks agree to an exchange of currencies in the opposite
direction three months in the future. The Federal Reserve might initiate
a swap transaction (make a swap drawing) at times when it needs the

79
The Federal Reserve in the International Sphere

foreign currency obtained (borrowed) in the spot half of the swap transaction to finance intervention sales of foreign currency in support of the
dollar. In order to repay the drawings at maturity, the Federal Reserve
would need to reacquire the foreign currency. Such acquisitions have
usually been accomplished by subsequently purchasing foreign currency
in the market, thereby reversing the original intervention in support of
the dollar. When a foreign central bank initiates the swap drawing, it
uses the dollars obtained in the spot half of the swap transaction to finance
sales of dollars to support its own currency, and subsequently meets its
obligation to deliver dollars to the Federal Reserve by reacquiring dollars
in the market.
The first swap line was established with the Bank of France in March
1962. Similar agreements were subsequently made with other central
banks, and the size of existing credit lines has been increased from time
to time. A t the end of 1983, the Federal Reserve had swap agreements
with fourteen foreign central banks and the Bank for International Set
tlements (BIS) totaling $30.1 billion. Eleven foreign central banks and
the BIS have made swap drawings since the establishment of the network.
Foreign drawings were relatively more frequent and on a larger scale in
the 1960s than in the 1970s; there were no foreign central bank swap
drawings in the years 1971-72 and 1977-80 and only a small drawing
early in 1981, but large drawings were made in 1982 in connection with
the liquidity crisis in Mexico. The Federal Reserve has made swap draw
ings on nine foreign central banks and the BIS at various times.
The purpose and scope of the exchange market operations by the
Federal Reserve and the use of the swap network have changed in response
to changes in the character of the international monetary system. Under
the regime of managed flexible exchange rates that emerged after the
suspension of gold convertibility in 1971, the United States began to
intervene in exchange markets. Federal Reserve swap drawings were used
to finance much of this intervention. The size of U .S. intervention
operations and Federal Reserve swap drawings increased sharply after
November 1, 1978, when U .S. authorities announced a program designed
to correct an excessive depreciation of the dollar through large-scale
intervention and other measures. Federal Reserve swap drawings peaked
in October 1979, when drawings totaled $3.8 billion. After the middle
of 1980, the dollar tended to strengthen in exchange markets, and together
with the Treasury, the Federal Reserve sold dollars against foreign cur
rencies. In part, these currencies were acquired to cover outstanding
issues of securities by the Treasury denominated in foreign currencies.
Early in 1981, the United States curtailed its official exchange market

80
Purposes & Functions

operations, though remaining ready to enter the market when needed to
counter disorderly conditions.

Other U .S. Foreign Currency Resources
In the early years of floating exchange rates, U .S. support for the dollar
was financed almost exclusively by Federal Reserve swap drawings. How
ever, in the period of sizable U .S . interventions from November 1978
through early 1981, Treasury resources financed about half of total U .S.
support for the dollar, with the remainder financed through swap drawings
by the Federal Reserve. The Treasury acquired foreign currency resources
in part through its own swap arrangement with the Bundesbank, but
mainly through drawings on the International Monetary Fund (IMF),
sales of special drawing rights (SDRs), and issuance of securities denom
inated in foreign currencies.1 Over the period 1979-80, the Treasury
issued a total of $5.2 billion equivalent of securities denominated in marks
and $1.2 billion equivalent of securities denominated in Swiss francs with
maturities ranging between two-and-one-half years and four years; these
securities have since been retired.
As of the end of 1983, the United States held foreign currency reserves
totaling $6.3 billion equivalent: the Federal Reserve held foreign currency
balances of $3.7 billion, and the Exchange Stabilization Fund of the
Treasury held the remaining $2.6 billion.

Internationalization of Banking
International banking has grown vigorously over the past two decades.
During this period, international trade and investment have expanded
more rapidly than world economic activity. In addition, the oil price
increases of the middle and late 1970s generated surplus funds for some
countries and the desire to borrow on the part of others. In response to
these and other conditions, U .S . and foreign banks not only continued
traditional business with nonresidents at their own domestic offices, but

Special drawing rights in the International Monetary Fund are unconditional credit
lines created on occasion by agreement of the members of the Fund to supplement
their international reserve assets. SDRs are allocated to members in accordance with
an accepted formula.

81
The Federal Reserve in the International Sphere

also rapidly expanded activity in each other’s national markets and in the
Eurocurrency markets. The location of foreign banking business depended
on such factors as the business needs of customers, the scope of operations
permitted by the legal and regulatory framework, and tax considerations.

The Anatomy of Internationalization
Part of the international activity of U.S.-chartered banks consists of
lending to and accepting deposits from foreign customers at the banks’
domestic offices (including their international banking facilities, which
are discussed below); however, the bulk of the international business of
these banks takes place at their foreign offices. Total assets of the foreign
branches, net of claims on related offices, increased by 200 percent from
the end of 1973 to December 1983, reaching a level of more than $300
billion (chart 5.1). Some operations of the branches involve transactions
with U .S . residents, particularly with their own head offices, but most
branch activity is with foreign customers.
In addition to branches located offshore, U .S . banks have used foreignincorporated subsidiaries, either wholly owned or jointly owned with
other banks, to expand their activities. The foreign subsidiaries of U .S.
banks have grown rapidly in recent years: total assets of foreign subsid
iaries, net of claims on related offices, increased from less than $20 billion
in December 1973 to an estimated $68 billion in December 1983.
Most of the activity at foreign branches and subsidiaries is Eurocurrency
business— that is, taking deposits and lending in currencies other than
that of the country in which the banking office is located. Eurobanking
is usually free of reserve requirements and some other constraints, although,
as explained below, the Federal Reserve imposes reserve requirements on
certain Eurobanking activities of banks with offices in the United States.
The U .S . dollar is the most widely used Eurocurrency, both generally
and at foreign branches and subsidiaries of U .S. banks. At the end of
1983, foreign branches of U .S . banks had dollar liabilities to unrelated
entities of about $237 billion, or some three-quarters of their total liabil
ities to such entities.
Multinational banks borrow and lend in the interbank market both to
adjust the maturity structure of their portfolios and to free themselves
from the need to balance exactly their liabilities to and claims on non
banks. A substantial portion of both the liabilities and assets of the foreign
branches of U .S . banks consists of deposits placed with, or accepted from,
the offices of other banks.

82
Purposes & Functions

The expansion of U .S. banks abroad beginning in the 1960s had a
counterpart in the rapid growth of foreign bank operations in the United
States in the 1970s. A t the end of 1983, about 225 foreign banks from
52 countries operated more than 500 agencies, branches, and subsidiary
commercial banks in the United States. The growth of the assets of U .S.
offices of foreign banks is shown in chart 5.2. These offices actively
participate in domestic money markets and in the market for loans to
large businesses.

Chart 5.1

Total Assets at Foreign Offices and IBFs of U.S.-Chartered Banks,
Dollar Volume and Percentage of Worldwide Assets of U.S.-Chartered
Banks, December 1973 and December 19831

1973

1983

1973

1983

1. Total assets at foreign offices and IBFs exclude claims on related offices— that is, claims on the parent bank
and its foreign branches and subsidiaries.

83
The Federal Reserve in the International Sphere

In recent years foreign bank and nonbank investors have gained access
to the U .S . banking market by acquiring controlling interests in U .S.chartered banks. As of December 1983, foreign investors of all types were
the majority owners of about 135 U .S. banks, including several large
banks, with total assets of $125 billion in their U .S. offices.
The responsibilities of the Federal Reserve for the supervision and
regulation of the international activities of U .S. banks, and for the U .S.
activities of foreign banks, are discussed in chapter 6.

Chart 5.2

Total Assets at U .S. Offices of Foreign Banks, Dollar Volume and
Percentage of Total Assets of Banking Institutions in the United States,
December 1973 and December 1983'
Billions of dollars

Percent

1. Banking institutions include U.S.-chartered banks (including U .S. subsidiaries of foreign banks) and U .S.
agencies and branches of foreign banks.

84
Purposes <St Functions

Eurobanking, U .S. Monetary Aggregates,
and U .S. Reserve Requirements
The network of foreign affiliates developed by U .S. banks has facilitated
the holding of Eurodollar deposits by nonbank U .S. residents. Such
deposits (held not only at foreign branches of U .S. banks but also at
foreign banks abroad) have increased rapidly, especially in recent years,
reaching $125 billion by the end of 1983. Because they are close substi
tutes for deposits at domestic banks, Eurodollar deposits of nonbank U .S.
residents at foreign branches of U .S. banks are included in the U .S.
monetary aggregate M3, and those having very short (one-day) maturities
are also included in M 2.2
Similarly, foreign borrowings used by banks as part of their managed
liabilities in their U .S. operations have been integrated into data on
banks’ sources of funds, and credit obtained abroad by U .S. nonbanks
can be regarded as one of the sources of credit for the U .S. economy. In
general, the Eurodollar market has become an important source of funds
for many U .S . banks and for some U .S. corporations with direct access
to Euromarket financing. However, Eurodollar funding frequently substi
tutes for other types of funding rather than adding to the total.
To facilitate monetary control and maintain competitive balance between
Eurodollar and domestic funding, the Board of Governors imposed a
reserve requirement on Eurodollars in 1969. The structure and level of
the Eurodollar reserve requirement were altered on several occasions in
the 1970s, and again in November 1980, as a step in the implementation
of the Monetary Control A ct of 1980. As explained in chapter 4, at
present net Eurodollar borrowings by banking offices in the United States
and direct lending to U .S . borrowers from foreign offices of U .S . banks
are subject to reserve requirements comparable to those on nonpersonal
time deposits.
The Board of Governors has broad authority to establish reserve require
ments on liabilities of foreign offices of U .S. banks and other U .S.
depository institutions. However, the close integration of world financial
markets, the active competition among financial institutions based in
different countries, and the high degree of substitutability among various
types of financial instruments would limit the effectiveness of reserve
requirements imposed on the liabilities of foreign offices of U. S. depository
institutions alone.
2.

See chapter 2.

85
The Federal Reserve in the International Sphere

International Banking Facilities
Since December 1981, the Board has permitted U.S.-chartered depository
institutions, U .S. agencies and branches of foreign banks, an dU .S. offices
of Edge act or agreement corporations to establish international banking
facilities (IBFs) in the United States. The regulatory environment of IBFs
has much in common with that of foreign branches of U.S.-chartered
banks.3 IBFs conduct a loan and deposit business with foreign residents,
including foreign banks, and with other IBFs without being subject to
reserve requirements or to interest rate ceilings. Funds advanced to a
U .S. banking office from its IBF are subject to the Eurodollar reserve
requirement in the same manner as funds advanced from its foreign offices.
However, IBFs have been subjected to a number of restrictions that do
not apply to foreign branches of U .S . banks. Most of these restrictions
were imposed to keep IBF activity from complicating the conduct of
domestic monetary policy. A n IBF may not accept deposits from or make
loans to any U .S. resident except another IBF and the entity establishing
the IBF. IBFs are not permitted to issue negotiable instruments because
such instruments might be purchased by U .S. residents in the secondary
market. In addition, accounts of IBF foreign nonbank customers are
required to have a minimum maturity of two days so that they will not
be close substitutes for demand deposits at domestic banking offices.
3.

IBFs are exempted by statute from insurance requirements of the Federal Deposit
Insurance Corporation. A number of states— New York, California, Illinois, and
Florida, among them— have encouraged banking institutions to establish IBFs by
granting favorable tax treatment under state or local law to IBF operations.

Chapter 6

Supervisory and
Regulatory Functions
Secognizing the importance of a sound banking system to the health of
the economy and financial markets, the Federal Reserve Act cited as one
of its purposes “ to establish a more effective supervision of banking.” The
Federal Reserve System shares this responsibility with other federal bank
ing agencies but is unique in its combination of monetary policy and
regulatory roles.
In its role as the central bank and as lender of last resort the Federal
Reserve has a basic responsibility for the financial stability of the economy.
Intrinsic to this responsibility is a concern for the strength and stability
of the banking system and for the consistency of the banking structure
with the needs of monetary policy. The Federal Reserve brings to its
decisions on supervisory and regulatory matters a wide perspective on the
financial markets and an awareness of the general effects that actions
affecting depository institutions may have on other sectors of the econ
omy. Experience gained in the process of supervision and regulation also
enables monetary policy decisions to be made against the background of
a more practical and knowledgeable assessment of how such decisions
will flow through and interact with the banking and depository system
and financial markets generally.
The Federal Reserve’s responsibilities for supervising and regulating
the activities of depository institutions in the United States include
(1) supervision and regulation of state-chartered banks that are members
of the Federal Reserve System, all Edge act and agreement corporations,
and all bank holding companies;1 (2) supervision and regulation of the
U .S. activities of foreign banking organizations under the International
Banking Act of 1978; (3) regulation of the U .S. commercial banking
structure through administration of the Bank Holding Company Act of
1956 as amended and, along with other federal agencies, the Bank Merger
Act of 1960 and the Change in Bank Control Act of 1978; and
(4) regulation of the foreign activities of all U .S. commercial banking
organizations that are members of the Federal Reserve System or that
conduct their foreign activities through an Edge corporation.
1. Edge act and agreement corporations are discussed below.

88
Purposes & Functions

The Congress has also assigned to the Federal Reserve regulatory
responsibilities for a number of consumer protection statutes, whose cov
erage oftens extends well beyond banks to other financial institutions and
creditors. Generally, the purpose of these statutes— such as the Truth in
Lending Act, the Fair Credit Billing Act, and the Equal Credit Oppor
tunity A ct— is to ensure that consumers, including bank customers, are
adequately informed and are treated in a fair and nondiscriminatory
manner when they engage in financial transactions.
Although the terms “bank regulation” and “bank supervision” are often
used interchangeably, they actually refer to distinct, but complementary
activities. Bank regulation is the formulation and issuance by authorized
agencies of specific rules or regulations, under governing law, for the
structure and conduct of banking. These laws and regulations establish a
framework for bank behavior that fosters the maintenance of a safe and
sound banking system and the fair and efficient delivery of services to
bank customers. Bank supervision is concerned primarily with the safety
and soundness of individual banks, and involves general and continuous
oversight to ensure that banks are operated prudently and in accordance
with applicable statutes and regulations.

Federal Supervisory Structure
Several governmental bodies share the responsibility for supervising and
regulating depository institutions. This supervisory structure has evolved
in part out of the complexity of the U .S. financial system, with its many
kinds of depository institutions and numerous chartering authorities. It is
also the product of the wide variety of federal and state laws and regula
tions designed to remedy a succession of problems that U .S. commercial
banks and nonbank depository institutions have faced over the past
century. Three federal bodies— the Federal Reserve, the Office of the
Comptroller of the Currency (O C C ), and the Federal Deposit Insurance
Corporation (FDIC)— with related but somewhat different bank regula
tory functions now share authority with bank supervisors of the fifty states
in a so-called dual banking system that allows for the chartering, super
vision, and regulation of commercial banking organizations at both the
federal and the state levels.
This structure involves some overlap of responsibilities. For example,
the O C C grants charters to national banks and also has the principal

89
Supervisory and Regulatory Functions

responsibility for their regulation and supervision, but by statute the
Federal Reserve has a general regulatory and supervisory responsibility for
the operations of all banks that are members of the Federal Reserve
System— including national banks because they are required by law to be
members. Similarly, the FDIC has authority over both member and
insured nonmember banks because by statute the deposits of national
banks and of state-chartered member banks must be federally insured. In
practice, however, the several state and the three federal supervisory
agencies have established arrangements that substantially reduce the effects
of overlaps associated with joint regulatory responsibility. For instance,
the FDIC has principal supervisory responsibility for insured nonmember
commercial banks and insured state-chartered savings banks; the O C C,
for national banks; and the Federal Reserve, for state-chartered banks
that are members of the Federal Reserve System and for all bank holding
companies.
In addition to the three federal banking supervisory agencies, two
federal agencies have primary responsibility for regulating and supervising
nonbank depository institutions: the Federal Home Loan Bank Board
(FHLBB) and the National Credit Union Administration (N C U A ). The
FHLBB supervises the Federal Home Loan Bank System and the Federal
Savings and Loan Insurance Corporation (FSLIC) and, through them,
regulates federally chartered savings and loan associations and federally
chartered savings banks, supervises savings and loan holding companies,
and shares with the states the supervision of FSLIC-insured, state-char
tered savings and loan associations. The N C U A charters, supervises,
examines, and provides share insurance for all federally chartered credit
unions and has the authority to examine and supervise those state-char
tered credit unions that apply and are accepted for N C U A insurance.
The Federal Financial Institutions Examination Council, an inter
agency body, was established by statute in 1978. Its purpose is to prescribe
uniform principles, standards, and report forms for the federal examina
tion of depository institutions— whether banks or thrift institutions—
and to promote coordination in other areas of supervision, including
coordination among state and federal supervisors. The council is com
posed by law of the chairmen of the Federal Home Loan Bank Board, the
National Credit Union Administration, and the Federal Deposit Insur
ance Corporation, as well as the Comptroller of the Currency and a
Governor of the Federal Reserve Board appointed by the Chairman of
that Board.

Purposes & Functions

Scope of Federal Reserve Supervisory Functions
The Federal Reserve has supervisory responsibility over domestic and
international operations of all member banks, Edge act and agreement
corporations, and U .S . bank holding companies, and over many of the
U .S . activities of foreign banking organizations.

Domestic Operations of U .S. Banking Organizations
The Federal Reserve has statutory authority to conduct on-site exami
nations of all member banks, Edge act and agreement corporations, and
bank holding companies. The Comptroller of the Currency has primary
responsibility for supervising and examining member banks that are
nationally chartered, and the Federal Reserve fulfills its responsibilities
for these banks chiefly through reviewing financial reports from the banks
and from the O C C. The Federal Reserve System exercises primary super
visory responsibility for and examines only those member banks that are
chartered by the states. This supervisory role derives from the Federal
Reserve’s statutory responsibility for admission of state-chartered banks
to membership in the Federal Reserve System. The Federal Reserve and
the various state supervisory agencies share authority to examine statechartered member banks and must approve applications for new branches.
However, the Federal Reserve conducts joint examinations with state
agencies, or alternates annual examinations with those agencies, and
cooperates with the states in other areas to reduce duplication and overlap
in the examination and supervision of state-chartered banks.
The examination of a depository institution generally entails (1) an
appraisal of the soundness of the institution’s assets; (2) an evaluation of
internal operations, policies, and management; (3) an analysis of key
financial factors such as capital, earnings, liquidity, and interest rate
sensitivity; (4) a review for compliance with all banking laws and regu
lations; and (5) an overall determination of the institution’s solvency. In
addition to these examinations for the general safety and soundness of
state member banks and bank holding companies, the Federal Reserve
conducts special examinations of state member banks in certain areas
such as consumer affairs; activities of trust departments, stock transfer
agents, and municipal securities dealers; and electronic data processing.
The Federal Reserve also is the primary supervisor for bank holding
companies under the Bank Holding Company Act of 1956, as amended.

91
Supervisory and Regulatory Functions

Because most large commercial banks are owned by bank holding com
panies, this statutory authority accords the Federal Reserve supervisory
responsibility for banking organizations that at the end of 1983 controlled
about 84 percent of the total deposits of U .S. commercial banks. To
ensure the safety and soundness of these institutions, the Federal Reserve
conducts on-site inspections of parent bank holding companies and their
significant nonbank subsidiaries. These inspections include a review of
nonbank assets and funding activities, an evaluation of policies and
procedures for managing the holding company and its subsidiaries, and a
review for compliance with the Bank Holding Company Act and other
relevant banking statutes.
If in the process of an examination, or by any other means, the Federal
Reserve determines that the condition of a bank or a bank holding
company is not satisfactory, the Federal Reserve is responsible for requir
ing that the organization take steps to correct the situation. In most cases,
when the condition is not too serious, the Federal Reserve will enter into
an informal agreement or memorandum of understanding with the bank
and its directors concerning the appropriate actions to be taken; in more
serious instances a written agreement or cease-and-desist order is issued
to direct the bank to take the necessary corrective measures.
When the weaknesses of an individual bank reach a critical level, the
Federal Reserve may play a significant role in the design of a plan to
provide financial and managerial assistance. Under the emergency pro
visions of the Bank Holding Company Act and the Bank Merger Act,
the Board of Governors can approve the immediate acquisition of a failed
or problem bank by a bank holding company or a state member bank.
The Federal Reserve works closely with the Federal Deposit Insurance
Corporation, the Office of the Comptroller of the Currency, and state
banking agencies to facilitate these transactions. Occasionally, liquidity
assistance may need to be provided through the discount window to
problem institutions before their acquisition by another depository insti
tution or liquidation by the insurance authority.

International Operations of U .S. Banking Organizations
The international operations of U .S. banks have undergone significant
growth in the past decade, as described in chapter 5. The Federal Reserve
has four principal statutory responsibilities with respect to the supervision
and regulation of the international operations of U .S. banking organi
zations that are members of the Federal Reserve System. These respon-

92
Purposes & Functions

sibilities are (1) authorizing the establishment of foreign branches of
member banks and regulating the scope of their activities; (2) chartering
and regulating the activities of Edge act corporations; (3) authorizing
overseas investments by member banks, Edge act and agreement corpo
rations, and bank holding companies, and regulating the activities of
foreign firms acquired by such investments; and (4) establishing supervi
sory policies with respect to foreign lending of member banks.
The Congress has provided scope for U .S. banks to conduct a wider
range of activities abroad than they have usually been permitted in this
country. The Board was given broad discretionary powers to regulate the
overseas activities of member banks and bank holding companies with
the aim of allowing U .S . banks to be fully competitive with institutions
of the host country in financing U .S. trade and investment overseas. In
addition, through Edge act and agreement corporations, banks may con
duct a deposit and loan business in U .S. markets outside their home
states, provided that the operations of these corporations are related to
international transactions. The statutes and regulations relating to these
corporations ensure that the foreign operations of member banks do not
undermine the restrictions on the interstate banking activities of domestic
banking organizations.
Primarily through their branches and subsidiaries, U .S. banks have
become heavily involved in lending to developing countries. The accu
mulation of unprecedented indebtedness by some of these countries became
a special concern to banking authorities and other officials in the early
1980s, when several large borrowers were unable to maintain debt service.
To meet the problem, the International Monetary Fund, commercial
banks, and official authorities in the United States and other countries
cooperated in helping to arrange interim financing agreements and
restructuring of debts in conjunction with adjustment programs developed
by debtor countries in consultation with the IMF. Concern over the debt
of developing countries also led to enactment of the International Lending
Supervision Act of 1983, which significantly increased the oversight
responsibilities of the Federal Reserve and other banking agencies.
The International Lending Supervision Act directs the Federal Reserve
and other banking agencies to consult with supervisory authorities of
other countries to reach understandings aimed at achieving the adoption
of effective and consistent supervisory policies and practices with respect
to international lending. It also directs them to take a number of steps to
strengthen the international lending procedures of U .S. banks. The act
provides for the maintenance of special reserves when the quality of an
institution’s assets has been impaired by a protracted inability of public

93
Supervisory and Regulatory Functions

or private borrowers in a foreign country to make payments on their
external indebtedness or when no definite prospect exists for the orderly
restoration of debt service. The act also requires federal banking agencies
to establish minimum capital levels for banking institutions, which will
strengthen both their domestic and international activities, and to establish regulations for accounting for fees on international loans and for the
collection and disclosure of certain international lending data.

U .S. Activities of Foreign Banking Organizations
The International Banking Act of 1978 (IBA) provided for federal regulation of the U .S. operations of foreign banks and granted important
new responsibilities to the Federal Reserve for the supervision and regulation of such operations. Enactment of this legislation followed rapid
growth in the activities of foreign banks in the United States and an
increase in their competitive impact upon domestic markets.
The IBA created a federal regulatory and supervisory structure for the
U .S . branches and agencies of foreign banks similar to that applicable to
U .S . banks. This policy of “national treatment” promotes competitive
equality between domestic and foreign banking institutions in the United
States by giving foreign banks operating in this country the same powers
and subjecting them to the same restrictions and obligations that apply
to U .S . banks. As part of the implementation of national treatment, the
IBA limited expansion of interstate deposit-taking and domestic non
banking activities of foreign banks, provided the option of federal licens
ing for agencies and branches of foreign banks, and required FDIC insur
ance for branches that engage in retail deposit-taking.
A t the federal level, the IBA apportioned primary supervisory respon
sibility for U .S . branches and agencies of foreign banks among the three
federal banking agencies, according to the type of license and whether
the banking office has deposit insurance. In addition, the Federal Reserve
was given broad residual and oversight authority for the supervision of all
federal and state-licensed branches and agencies of foreign banks oper
ating in the United States. In fulfilling this responsibility, the Federal
Reserve must assess the impact and condition of foreign banks operating
across state lines. To carry out its responsibilities, the Federal Reserve
has statutory authority to examine on site the assets and liabilities of all
branches and agencies, but it generally relies upon examinations that
state and other federal banking authorities conduct. Under the Bank
Holding Company A ct and the International Banking Act, the Federal

Purposes & Functions
Reserve also has responsibility to approve, review, and monitor the U .S.
nonbanking activities of foreign banking organizations.

The Regulation of Banking Structure
The Federal Reserve System has statutory responsibility for the adminis
tration of the Bank Holding Company Act of 1956 as amended, the Bank
Merger A ct of 1960, and the Change in Bank Control Act of 1978.
Under these acts the Board approves or denies the acquisition of banks
and closely related nonbanking activities by bank holding companies and
permits or rejects certain other changes of control and mergers of banks
and bank holding companies.

Bank Holding Company Expansion
The Bank Holding Company Act of 1956 gave to the Federal Reserve
the primary responsibility for supervising and regulating the activities of
bank holding companies. This act, as amended in 1966 and 1970, was
designed to achieve two basic objectives. The first was to control the
expansion of bank holding companies to avoid the creation of monopoly
or restraint of trade in banking. The second was to limit the expansion
of bank holding companies to those nonbanking activities that are closely
related to banking, thus maintaining a separation between banking and
commerce. This second objective reflects a long-accepted policy of the
Congress that the public interest requires a clear separation of banking
from unrelated activities.
Table 6.1 shows the growth in bank holding companies and the total
deposits of their subsidiary banks. Before 1971, the Congress exempted
from regulation companies that owned only one bank because such com
panies generally owned or controlled very small banks. During the late
1960s, however, many larger banks converted to the one-bank holding
company form of organization to take advantage of this exemption and
thus to be able to conduct nonbanking activities in the holding company
that were illegal for their bank subsidiaries. To preserve the traditional
separation of banking and commerce, the Congress amended the Bank
Holding Company A ct in December 1970 to embrace all one-bank hold
ing companies. Primarily as a result of this new legislation, the number
of bank holding companies covered by the statute increased from 121 at
the end of 1970 to 1,567 at the end of 1971, while the proportion of

95
Supervisory and Regulatory Functions

Table 6.1

Number and Deposits of Registered Bank Holding Companies,
Selected Years, 1957-83

End
of
year

Number
of
holding
companies

Domestic deposits of subsidiary banks
Amount
(billions of dollars)

Percentage of
all deposits
ofU .S. banks

1957
1960
1965

501
471
531

15.1
18.3
27.6

7.5
7.9
8.3

1970
1971
1975

1211
1,567
1,821

78.1
297.0
527.5

16.2
55.3
67.1

1980
1981
1982
1983

3,056
3,702
4,559
5,409

840.7
937.8
1,107.7
1,279.4

71.0
74.1
79.4
83.8

1. Includes only bank holding companies that control two or more banks.

commercial bank deposits controlled by these companies increased from
16.2 percent to 55.3 percent. The number of bank holding companies
has continued to increase steadily and totaled 5,409 at the end of 1983,
when 83.8 percent of all deposits of domestic banking organizations was
held by bank subsidiaries of holding companies.

Bank Acquisitions
Under the Bank Holding Company Act as amended in 1970, a bank
holding company is defined as any company that (1) directly or indirectly
owns, controls, or has power to vote 25 percent or more of any class of
the voting shares of a bank; (2) controls in any manner the election of a
majority of the directors or trustees of a bank; or (3) exercises a controlling
influence over the management or policies of a bank. A company that
seeks to become a bank holding company must obtain the prior approval
of the Federal Reserve. Any company that qualifies as a bank holding
company must register with the Federal Reserve System and file reports
with the System. A n existing bank holding company must obtain the
approval of the Board before acquiring more than 5 percent of the shares

96
Purposes &. Functions

either of additional banks or of permissible nonbanking companies. To
limit interstate banking operations by bank bolding companies, the
Douglas amendment to the act, passed in 1966, provided that a bank
holding company operating in one state may not acquire a bank in a
second state unless that state authorizes the acquisition expressly by
statute. In recent years, some states have done so, generally on a reciprocal
basis and only with states in their own regions. Bank holding companies
can engage in nonbanking activities that are closely related to banking
without geographic restrictions.
In considering applications to acquire a bank or a bank holding com
pany, the Board must take into account the likely effects of the acquisition
on banking competition, the convenience and needs for banking services
of the community to be served, and the financial and managerial resources
and prospects of the holding company and the bank. The Board may not
approve any acquisition that would result in a monopoly or that would
substantially lessen competition, unless the acquisition’s favorable impact
on the convenience and needs of the community clearly outweighs its
anticompetitive effects.
In assessing the competitive impact of a proposed acquisition by a bank
holding company, the Board focuses first on the local banking markets,
where customers usually obtain their bank services. If a holding company
already has one or more banking offices in the market in which it seeks
to acquire a bank, the Board determines the extent to which existing
competition would be adversely affected by the acquisition. The Board
examines several aspects of market structure other than the combined
market shares of the firms involved— for example, the size of the market,
in terms of both geographic expanse and the number and sizes of com
peting firms. The Board also takes into account the degree of competition
from thrift institutions in the markets involved. In some cases the absolute
size of the deposits of the acquiring organization and of the bank to be
acquired is important. The Board may also examine indexes of rivalry
such as market concentration ratios (which measure the percentage of
the market controlled by the largest banks) and the distribution of market
shares, and the way both have changed over time.
If the holding company is not already represented in the markets in
which the bank to be acquired operates, the Board examines the likely
effects of the acquisition on probable future, or potential, competition.
In such an examination, the Board considers factors like the absolute and
relative size of the bank to be acquired (as indicated by its rank in these
markets and its market share); market concentration; the number of other
potential entrants into the markets; and the likelihood that, if the appli-

97
Supervisory and Regulatory Functions

cation were denied, the would-be acquiring holding company would enter
these markets some other way, such as by establishing a newly chartered
bank subsidiary.
In addition to competitive considerations, the Board assesses how a
proposed acquisition will serve the convenience and the banking needs
of the public. Specifically, the Board is interested in whether the acqui
sition will result in the provision of new or better services, such as the
introduction of trust services or longer banking hours, or whether it may
mean lower prices for bank services. In this evaluation, the Board also
considers the applicant’s record in meeting the credit needs of the com
munities it already serves, including low- and moderate-income areas.
To ensure that the holding company will remain a source of strength
to its subsidiaries, the Board also considers carefully the likely effects of
a proposed bank acquisition on the financial and managerial resources of
both the bank to be acquired and the holding company. Important factors
bearing on its final decision are (1) the present capital position of the
holding company, the bank, and existing bank subsidiaries, and, if those
positions are deficient, the plans the holding company has to augment
them; (2) the asset quality, earnings, and liquidity of the bank and of the
holding company; (3) the quality of the management of the bank and of
the holding company, and any plan the holding company may have for
improving the management; (4) the way the holding company intends
to finance the acquisition; and (5) the holding company’s debt and its
ability to service it.

Nonbanking Acquisitions
In enacting the Bank Holding Company Act of 1956, the Congress
indicated its intent that, with few exceptions, holding companies be
prevented from engaging in nonbanking activities or from acquiring non
banking companies. A t the same time, the Congress recognized that a
complete prohibition of holding company involvement in nonbanking
activities might not be in the public interest. Over the years, banking
organizations had developed considerable expertise in certain bank-related
areas, and allowing holding companies to enter these areas could both
stimulate competition and improve the financial services available to the
public.
Consequently, the Congress provided some exceptions to the prohi
bition against bank holding companies engaging in nonbanking activities,
and the 1970 amendments to the act broadened the exceptions somewhat.

98
Purposes &. Functions

The most important exception is that holding companies may undertake
certain activities that the Board determines to be so closely related to
banking, or to managing or controlling banks, as to be a proper incident
to banking and that would result in benefits to the public. In making its
determinations, the Board considers such factors as the risks of the activity, its effects on competition, the potential for an undue concentration
of resources, and possible conflicts of interest.
As of early 1984, the Board had ruled that, subject to approval of
individual proposals and with certain qualifications, a bank holding com
pany might engage in nineteen activities closely related to banking:
1. Making and servicing loans and other extensions of credit.
2. Operating as an industrial bank.
3. Performing trust activities.
4. Acting as an investment or financial adviser.
5. Leasing real or personal property on a full-payout basis.
6. Making equity and debt investments in corporations or projects
designed primarily to promote community welfare.
7. Providing financially related bookkeeping and data processing ser
vices.
8. Acting as an agent or broker for credit-related insurance and
certain other limited forms of insurance.
9. Acting as an underwriter for credit life insurance and for credit
accident and health insurance directly related to extensions of
consumer credit by the bank holding company system.
10. Providing financially related courier services.
11. Providing management consulting advice to nonaffiliated bank
and nonbank depository institutions.
12. Acting as an agent or broker for the sale at retail of money orders
having a face value of not more than $10,000, the sale of U .S.
savings bonds, and the issuance and sale of travelers checks.
13. Performing real estate appraisals.
14. Arranging equity financing for commercial real estate.
15. Underwriting and dealing in government obligations.
16. Providing foreign exchange advisory and transaction services.
17. Acting as a futures commission merchant.
18. Providing discount securities brokerage services.
19. Investing in export trading companies (specifically authorized by
the Congress in 1982).
In addition, the Board of Governors has approved a limited number of
other nonbanking activities for individual bank holding companies because
these organizations demonstrated that their unique circumstances afforded

99
Supervisory and Regulatory Functions

net benefits to the public. Such approvals have included the acquisition
of distressed thrift institutions.

Bank Mergers
Another major responsibility of the Federal Reserve is to act on proposed
bank mergers when the resulting institution is to be a state member bank.
During the 1950s, there was a sharp rise in the number of bank mergers,
several of which involved large banks located in the same metropolitan
area. Fearing that a continuation of this trend could seriously impair
competition in banking and could lead to an excessive concentration of
financial power, the Congress passed the Bank Merger Act of 1960.
That act requires that all proposed bank mergers between insured banks
receive prior approval from the federal bank regulatory agency under
whose jurisdiction the surviving bank will have legal status. In other
words, if the surviving bank is to be a national bank, the Comptroller of
the Currency has jurisdiction; if a state-chartered member bank, the Board
of Governors of the Federal Reserve System; and if a nonmember insured
bank, the Federal Deposit Insurance Corporation. To foster uniform
standards among the three agencies in assessing bank mergers, the act
also requires the responsible authority to request reports on competitive
factors from the two other banking agencies, and from the Department
of Justice as well. Mergers of two bank holding companies come under
the jurisdiction of the Federal Reserve, according to provisions of the
Bank Holding Company Act.
The Bank Merger Act, as amended in 1966, requires the responsible
agency to take into consideration in every case the financial and managerial resources and prospects of the existing and proposed institutions,
and the convenience and banking needs of the community to be served.
The responsible agency may not approve any merger that could substan
tially lessen competition, or tend to create a monopoly, unless the agency
finds that the probable beneficial effect on the convenience and needs of
the community clearly outweighs the anticompetitive effects.

Other Changes in Bank Control
The Change in Bank Control Act of 1978 (Title VI of the Financial
Institutions Regulatory and Interest Rate Control Act of 1978) gives the
federal bank supervisory agencies the authority to disapprove changes in

100

Purposes &. Functions
control of insured banks and bank holding companies. The Federal Reserve
Board is the responsible federal banking agency for changes in control of
bank holding companies and state member banks, and the Federal Deposit
Insurance Corporation and the Comptroller of the Currency are respon
sible for insured state nonmember and national banks respectively. The
act specifically exempts holding company acquisitions of banks and bank
mergers because these transactions are already covered by the statutory
and regulatory procedures for approval discussed above.
The act requires that the federal banking agency consider such factors
as the financial condition, competence, experience, and integrity of the
acquiring person or group of persons, and the effect of the transaction on
competition. The Federal Reserve’s objectives in its administration of the
act are to enhance and maintain public confidence in the banking system
by preventing serious adverse effects from anticompetitive combinations
of interests, inadequate financial support, and unsuitable management.

Regulatory Responsibilities for Consumer Laws
In recent years, the Federal Reserve has been authorized by the Congress
to implement a number of statutes designed to ensure that consumers,
including bank customers, have sufficient information and are treated
fairly in credit and other financial transactions. To help carry out its
responsibilities for consumer protection, the Board is advised by a C on
sumer Advisory Council, which meets three times a year and is composed
of representatives of consumers, creditors, and others concerned with
these issues.
The Federal Reserve is responsible for writing and implementing reg
ulations to carry out many of the major statutes protecting consumers in
financial transactions. Its responsibilities for enforcement of these laws
generally extend only to state-chartered banks that are members of the
Federal Reserve System. However, the Board or the Federal Reserve Banks
will accept complaints about the policies or practices of any bank and
refer them to the appropriate bank regulators.

Consumer Laws
The Federal Reserve has responsibilities for writing rules or enforcing a
number of major laws that offer consumers protection in their financial
dealings.

101
Supervisory and Regulatory Functions

The Truth in Lending Act requires disclosure of the “finance charge”
and the “ annual percentage rate”— and certain other costs and terms of
credit— so that consumers can compare the prices of credit from different
sources. This act also limits liability on lost or stolen credit cards.
The Fair Credit Billing Act sets up a procedure for the prompt correc
tion of errors on a revolving credit account and prevents damage to credit
ratings while a dispute is being settled.
The Equal Credit Opportunity Act prohibits discrimination in the
granting of credit on the basis of sex, marital status, race, color, religion,
national origin, age, receipt of public assistance, or the exercise of rights
under the Consumer Credit Protection Act. The Federal Reserve regu
lation provides for notice to applicants who have been denied credit of
the reason for the denial. It also gives married individuals with jointly
held credit accounts the right to have credit histories maintained in the
names of both spouses.
The Fair Credit Reporting Act sets up a procedure for correcting
mistakes on credit records and requires that the records be used only for
legitimate business purposes.
The Consumer Leasing Act requires disclosure of information to help
consumers compare the cost and terms of one lease of consumer goods
with another, and the cost of leasing with that of buying on credit or for
cash.
The Real Estate Settlement Procedures A ct requires disclosure of infor
mation about the services and costs involved at “settlement,” when real
property is transferred from seller to buyer.
The Electronic Fund Transfer Act provides a basic framework regarding
the rights, liabilities, and responsibilities of consumers who use electronic
transfer services and of the financial institutions that offer the services.
The Federal Trade Commission Improvement Act authorizes the Board
to identify unfair or deceptive acts or practices on the part of banks and
to issue regulations to prohibit them.

Community Reinvestment and Development
Several laws address the issue of lending for housing-related purposes and
for the development of communities served by financial institutions.
The Home Mortgage Disclosure Act requires depository institutions to
disclose the geographic distribution of their mortgage and home improve
ment loans. The purpose of the act is to provide to depositors and others
information that will enable them to make informed decisions about

Purposes & Functions

whether institutions in metropolitan areas are meeting the housing credit
needs of their communities.
The Community Reinvestment Act encourages banks to help meet the
credit needs of their communities for housing and other purposes, partic
ularly in neighborhoods of families with low or moderate incomes, while
maintaining safe and sound operations. An institution’s performance
under the act is assessed during the course of bank examinations and is
taken into account, along with other factors, when the Federal Reserve
considers certain applications for bank mergers and bank holding company
formations, mergers, and acquisitions.

Chapter 7

Federal Reserve Bank Services

flh e Federal Reserve Banks, as the operating arms of the nation’s central
bank, provide a variety of services to depository institutions and to the
government of the United States and its agencies. Most of these services
relate to the nation’s payments system, while others involve safekeeping
of securities and fiscal-agency functions, such as holding U .S. Treasury
deposits and issuing, servicing, and redeeming U .S. government obliga
tions.

Federal Reserve Bank Services and Pricing
Since its inception, the Federal Reserve System has played an important
role in the payments mechanism and in providing certain other services
to the nation’s depository institutions. A major reason for creating the
Federal Reserve was to ensure that the nation had a safe and efficient
means for transferring funds within the banking system that was readily
available to small banks as well as large ones, and to banks in remote
areas of the country as well as those in money centers. As recently as
1980, the Congress, in the Monetary Control Act, reaffirmed the need
for Federal Reserve participation in the payments system.
The payments mechanism is at the heart of our highly interdependent
financial system, in which billions of dollars are transferred each day.
The effects of any disruption of this mechanism could spread quickly,
affecting depository institutions, financial markets, and, in the extreme,
the economy generally. The Congress has recognized that active partic
ipation by the Federal Reserve in the payments system protects against
disruption and works to maintain public confidence in the safety and
integrity of the financial system as a whole. Through its participation,
the Federal Reserve has also improved the efficiency of the payments
mechanism by, for example, encouraging technological advances, such
as electronic transfers, that have the potential for lowering costs and
speeding the flow of funds. The Federal Reserve is especially well posi
tioned to foster such advances when they require widespread cooperation
among depository institutions or the participation of a neutral and trusted

Purposes <St Functions

intermediary. In addition, it has acted to ensure that all depository
institutions have access to adequate payments services.
The Monetary Control Act of 1980, which extended reserve require
ments and access to the discount window to nonmember depository
institutions, also extended access to Federal Reserve services to all depos
itory institutions. Before that, Federal Reserve Bank services had been
available only to member banks. In addition, the act required the Federal
Reserve to charge fees to depository institutions for many of these services,
which had previously been free to member banks.1 As the act specified,
the Federal Reserve has set fees in such a way that over the long run the
revenues from these services will recover the costs of providing them. So
that it will be competing on a fairer basis with private providers of these
services, the Federal Reserve is required to include in its costs not only
its actual operating expenditures, but also estimates of the taxes and cost
of capital it would incur if it were a private firm— the so-called private
sector adjustment factor. By specifying that the Federal Reserve charge
for services in this way, the Congress intended to encourage economic
use of payments services through the explicit pricing of such services and
to promote competition among public and private providers of services,
and thus to enhance the efficiency of the payments mechanism. During
1984, revenues of the Federal Reserve for all priced services exceeded the
costs— including those imputed for taxes and capital— of such services.
The Federal Reserve Board reviews all major issues involving the pricing
and level of services and often submits proposals for public comment
before putting them into effect. Decisions concerning priced services are
made independently of those related to the Federal Reserve’s role as
regulator, supervisor, and lender of last resort. Pricing procedures estab
lished by the Board are aimed at assuring that the Federal Reserve com
petes in ways that are fair to users of Federal Reserve services and to other
providers of similar services, and that are in keeping with the responsi
bilities of a public agency to promote the public interest.
Depository institutions may pay for Federal Reserve services directly,
or by applying credits that are earned on clearing balances held at the
Federal Reserve.12 Clearing balances are deposits of banks and thrift insti1.
2.

The Federal Reserve is not required to charge depository institutions for certain
services associated with the issuance of currency and coin and with its fiscal-agency
functions.
So-called earnings credits are calculated by multiplying the clearing balance up to a
certain maximum by a rate based on the federal funds rate.

105
Federal Reserve Bank Services

tutions at the Federal Reserve in addition to any reserve balances they
may be required to maintain. Institutions hold clearing balances if their
required reserve balances are not large enough to cover the dollar volume
of their check clearings and other transfers of funds through the Federal
Reserve, or to accumulate earnings credits.

The Federal Reserve and the Payments System
In carrying out its responsibilities, the Federal Reserve is involved in
many facets of the payments system, including provision of currency and
coin, processing and clearing of checks, providing for the settlement of
checks and other types of payments, and wire transfers of funds.

Currency and Coin
A n important function of the Federal Reserve System is to ensure that
the economy has enough currency and coin to meet the public’s demand.
Currency and coin are put into or retired from circulation by the Federal
Reserve Banks, which use depository institutions as the channel of dis
tribution. When banks and other depository institutions need to replenish
their supply of currency and coin— for example, when the public’s need
for cash rises around holiday shopping periods— they order the cash from
the Federal Reserve Bank or Branch in their area, and the face value of
that cash is charged to their accounts at the Federal Reserve. When the
public’s need for currency and coin declines, and depository institutions
return excess cash to a Federal Reserve Bank, its value is credited to the
account of the depository institution.
Virtually all currency in circulation is in the form of Federal Reserve
notes, which are printed by the Bureau of Engraving and Printing of the
U .S. Treasury. Before being issued to the public, notes must be secured
by legally authorized collateral, most of which is in the form of U .S.
government and federal agency securities held by the Federal Reserve
Banks. Coins are produced by the Treasury’s Bureau of the Mint.
Currency and coin are used primarily for small transactions. In the
aggregate, such transactions probably account for only a small proportion
of the total value of all transfers of funds. As table 7.1 shows, at the end
of 1983, the total amount of currency and coin in circulation was around
$172 billion.

106
Purposes &. Functions

Table 7.1

Currency and Coin in Circulation, Selected Years, 1935-83
Millions of dollars
Year

Amount

1935
1945
1955
1965
1975

5,882
28,515
31,158
42,056
86,547

1981
1982
1983

145,566
156,158
171,935

Check'Processing Services
About 25 percent of the checks written in the United States are deposited
in the same institution on which they are drawn. Dealing with the
remaining checks requires a mechanism for exchanging (“clearing” ) them
and providing for the related movement of funds (“settlement” ) among
the depository institutions that are involved. When a depository insti
tution receives checks drawn on other institutions, it may send them for
collection to those institutions directly, or indirectly through a local
clearinghouse, a correspondent institution, or a Federal Reserve office.
Chart 7.1 illustrates the process.
A t the end of 1983, the Federal Reserve maintained forty-eight check
clearing centers, which were collecting some 57 million items each busi
ness day. These facilities are located at the twelve Federal Reserve Banks,
at twenty-five Branches of these Banks, and at eleven other offices around
the country called regional check-processing centers. The Federal Reserve
credits the accounts of receiving institutions for the value of deposited
checks in accordance with the “ availability schedule” of the Reserve
Banks. This schedule reflects the length of time it normally takes for the
Federal Reserve to receive payment from the institutions on which the
checks are drawn; credit is usually given on the day of deposit or the next
business day, and rarely later than the second business day following
deposit.
Although the accounts of payee institutions (those that send checks
to the Federal Reserve for collection) are credited according to the avail
ability schedule noted above, the accounts of payor institutions (those

107
Federal Reserve Bank Services

on which the checks are drawn) are not debited for the value of checks
until the day the checks are actually delivered to those institutions by
the Federal Reserve. When a check deposited with the Federal Reserve
is not collected until after the credit is given, the same deposit may be
on the books of two different institutions at the same time for a brief
period. This phenomenon is called Federal Reserve float.
To minimize float while making speedy payments, the System utilizes
air charter services, commercial airlines, and other courier services to
accomplish the rapid delivery of checks among Federal Reserve offices.
(About 40 percent of all checks that clear through the Federal Reserve
are payable through an office outside the area in which they are deposited.)
In the early 1980s, the Federal Reserve made substantial improvements
in these and other procedures in order to speed the movement of checks
back to the payor institutions. By the second quarter of 1984, Federal

Chart 7.1

Elements of the Check-Clearing System

a d eb it

a credit

Transactions are settled at the Federal Reserve or a correspon
dent institution by crediting the deposit account of the payee’s
depository institution and debiting the deposit account of the
payor’s depository institution.

108
Purposes &. Functions

Reserve check float, which had been $4 billion per day three years earlier,
had fallen to about $500 million. For the most part, this reduction in
float has occurred, in effect, at the immediate expense of the payor
institutions through more prompt debiting of their Federal Reserve accounts.
The Federal Reserve recovers the cost of the remaining check float, as
required by the Monetary Control Act (M CA ), by charging the payee
institution directly or by adjusting its balances held at the Federal Reserve.
The estimated total number of checks written has risen dramatically
since the early 1950s (table 7.2). The proportion of total checks cleared
by the Federal Reserve began increasing in the mid-1960s and by 1981
had reached 45 percent. The trend then reversed as private clearing
arrangements expanded in response to the imposition of fees by the Federal
Reserve for check-collection services.

Electronic Fund Transfers
Electronic fund transfer (EFT) systems have been evolving throughout
the world over recent decades as a faster, more secure, and less costly way
of transferring money. In contrast to transfers authorized by check, those
made electronically may be initiated through computers, magnetic tape,
plastic cards, or telephones.
Table 7.2

Number of Checks, Total and Collected by the Federal Reserve,
Selected Years, 1920-83
Billions of checks

Year

Total
checks written

Number

Percent of total

1920
1930
1940
1952
1967
1973

n.a.
n.a.
n.a.
7.0
17.9
22.5

.5
.9
1.1
2.3
5.4
10.0

n.a.
n.a.
n.a.
33
30
44

1981
1982
1983

35.5
36.9
38.4

15.9
13.9
14.3

45
38
37

n.a. Not available.

Collected by the Federal Reserve

109
Federal Reserve Bank Services

The Federal Reserve Banks are directly involved in two types of EFT
services: transfers of funds by wire and through automated clearinghouses.
Wire transfers of funds may be executed through the so-called FedWire,
which connects Federal Reserve offices, depository institutions, the U .S.
Treasury, and other government agencies. FedWire is typically used to
transfer large dollar payments. All such transfers are completed on the
same day, usually in a matter of minutes, and are guaranteed final when
the receiving institution is notified of the credit to its account. FedWire
may be used by depository institutions to transfer funds for their own
account that result from purchases or sales of federal funds, to move
balances at correspondent banks, and to send funds to another institution
on behalf of customers. Transfers on behalf of customers include flows of
funds associated with the purchase or sale of securities, the replenishment
of business demand deposits, and other time-sensitive payments. The
Treasury Department and other federal agencies use FedWire extensively
to disburse and collect funds.
Wire transfers grew rapidly from the mid-1970s into the early 1980s,
but growth has moderated in recent years, in part because of the natural
maturing of this service. During 1983, FedWire handled about 38 million
transfers of funds valued at $84 trillion.
First established in the early 1970s, automated clearinghouses (ACHs)
have evolved into a nationwide clearing and settlement mechanism that
provides processing for electronically originated credits and debits. The
Federal Reserve operates a number of ACH s, which provide clearing
services to all depository institutions for automated entries. Several pri
vately operated ACH s offer similar services to their members. Since 1978,
the Federal Reserve has transmitted A CH payments through a nationwide
network, and it provides interregional services to privately operated ACHs.
ACH s offer such benefits as more timely payments, increased conve
nience, and greater security for certain types of payments.
Automated clearinghouses transfer funds by electronic means instead
of paper checks. In an A C H operation, depository institutions, acting on
a customer’s instructions, transmit debits and credits via delivery of mag
netic tapes or telecommunications links to the local A C H facility, much
as they would physically deliver checks to a check-clearing facility. For
example, with the authorization of the payees, businesses and govern
ments can make many of their recurring payments for salaries, wages,
commissions, interest, dividends, annuities, social security, welfare, pen
sions, and the like through ACH s, with the proceeds credited directly to
the payee’s account at his or her depository institution without the prior
issue of a paper check. Consumers may also authorize their depository

110
Purposes &. Functions

institutions to make regular, recurring payments through ACH s for such
obligations as mortgages or utility and insurance bills. A CH volume has
grown in recent years, but in 1984, ACH s still accounted for only about
400 million transactions, a relatively small proportion of total payments.
Currently, the U .S. government initiates over half the number of A CH
payments.

Net Settlement
The Federal Reserve Banks provide a service commonly called net settle
ment for such private participants in the payments mechanism as check
clearinghouses, automated clearinghouse associations, and wire transfer
systems, that normally process a large number of transactions among their
member institutions. Net settlement involves posting net debit and net
credit entries generated by such organizations to the accounts of the
individual institutions on the books of the Federal Reserve. At the end
of each business day, the organization sums all transactions for each
institution and delivers or transmits to the Federal Reserve the net
accounting entries to effect settlement among the participating institu
tions.

Other Federal Reserve Bank Services
The Federal Reserve Banks provide a variety of other services to depository
institutions, most of which fall into the broad categories of securities
safekeeping and transfer, and noncash-collection services.
Federal Reserve safekeeping services have important advantages for
depository institutions in terms of security and convenience. A depository
institution may request its Federal Reserve Bank to maintain custody of
securities that are issued by the U .S . government and its agencies and by
state and local governments. These securities may be deposited with a
Reserve Bank or Branch for purely custodial purposes, or to be available
to collateralize borrowings from the Federal Reserve or deposits of public
funds held by the institution. A large portion of the securities held for
depository institutions is pledged as collateral. On instructions, the Reserve
Banks will accept deposits of securities, transfer securities between depos
itors’ custodial and collateral accounts, effect deliveries of securities, and
process associated payments.

Ill
Federal Reserve Bank Services

The noncash-collection service is similar to the check-collection ser
vice. Federal Reserve offices accept the following items for collection:
maturing or matured municipal coupons; called, maturing, or matured
municipal securities; bankers acceptances; bills of lading; and drafts,
checks with documents attached, and other checks that cannot be han
dled as cash items through the normal check-processing operation.

Fiscal-Agency Functions of the Federal Reserve System
As fiscal agents of the United States, the Federal Reserve Banks and their
Branches function as the federal government’s banker. They maintain
the Treasury’s “checking account,” clear Treasury checks drawn on that
account, issue and redeem government securities, and perform other
services as directed by the Treasury. The Federal Reserve Banks also
perform fiscal-agency services in connection with the financial activities
of various federal and federally sponsored agencies. The Reserve Banks
are reimbursed by the Treasury and the federal agencies for much of the
expense incurred in the performance of fiscal-agency functions.
The Treasury maintains special interest-earning accounts (called Trea
sury tax and loan accounts) at more than 15,000 depository institutions
throughout the country. These Treasury depositories accept tax receipts
directly from individuals and corporations and report the amount of those
receipts to a Federal Reserve office and to the Internal Revenue Service.
When the Treasury wishes to use these funds, they are transferred to a
Federal Reserve Bank.
The federal government makes most of its disbursements to the public
from its funds on deposit at the Federal Reserve Banks. Such payments,
resulting in a debit to the Treasury’s account at the Reserve Banks, are
made mainly by check; but in the case of certain repetitive payments,
such as those for social security and employees’ salaries, an increasing
share is being processed through A CH facilities and deposited directly to
the accounts of the recipients at depository institutions.
As fiscal agents for the United States, the Federal Reserve Banks also
handle the operations involved in selling new Treasury securities, servic
ing outstanding issues, and redeeming maturing issues. When the Treasury
offers new issues of marketable securities to the public, the Federal Reserve
Banks disseminate information regarding the issues, accept tenders from
customers, collect payments, credit the Treasury’s account for the pro
ceeds, and effect delivery of the securities. Most marketable Treasury

112
Purposes & Functions

securities are not delivered to and retained by investors as certificates
(“definitive” form), but rather are recorded and stored for the account of
depository institutions (often acting on behalf of the ultimate investors)
on the books of the Federal Reserve (“book entry” form). Securities then
are generally transferred from one book-entry account to another, using
the Federal Reserve’s communication network, and principal and interest
are paid automatically on the due dates by crediting the accounts of the
depository institutions.
The Reserve Banks and Branches also issue, service, and redeem U .S.
savings bonds. In addition, Federal Reserve Banks and Branches are
authorized to qualify depository institutions and corporations as issuing
agents and payment agents for savings bonds.
The Federal Reserve also acts as fiscal agent for foreign central banks
and international organizations such as the International Monetary Fund.
Services of this kind are provided primarily by the Federal Reserve Bank
of New York. The most important services rendered on a day-to-day basis
for foreign official accounts are the receipt and payment of funds in U .S.
dollars, and investment and custody transactions. Foreign official insti
tutions channel a significant portion of their U .S. dollar receipts and
payments through their accounts at the New York Federal Reserve Bank.
The New York Federal Reserve Bank also buys and sells foreign exchange
for these official institutions with corresponding debits and credits to their
dollar balances at the Bank. The Bank imposes a charge for most of its
investment and custodial services. As of December 1983, the New York
Bank held, as custodian for these foreign accounts, around $125 billion
in marketable and nonmarketable U .S. Treasury and agency securities,
primarily Treasury bills. It also held for foreign central banks 341 million
fine troy ounces of gold valued at $132 billion at the free market price of
$388 an ounce prevailing at the time.

Index

Acceptances, bankers (See Bankers acceptances)
Adjustment credit ........................................................................................... 5 8 ,5 9 -6 1 ,6 4
Annual report to Congress.......................................................................................................6
Automated clearinghouses........................................................................ 106, 109-10, 111
Balance of international payments (See U .S. balance of payments)
Balance sheet of Federal Reserve Banks ....................................................................... 45-56
Bank control, changes in .............................................................................. 87, 94, 99-100
Bank examination ................................................................................................7 ,8 8 -9 1 ,9 3
Bank for International Settlements ..................................................................................... 79
Bank holding companies................................................. 2, 6, 87, 89, 90, 91, 92, 94-100
Bank Holding Company Act of 1956 ........................... 1, 87, 90, 91, 93, 94, 95, 97, 99
Bank Merger Act of 1960 ................................................................................ 87, 91, 94, 99
Bank m ergers......................................................................................................................6, 99
Bankers acceptances ..................................................................................... 24, 35, 39, 111
Banking Act of 1935 .............................................................................................................. 1
Board of Governors (See also Federal Reserve System)
Audit of accounts.................................................................................................................. 6
Contacts with other officials and organizations (See Federal Reserve System)
Expenses, assessments on Federal Reserve B anks...........................................................69
Members and s t a f f ................................................................................................................ 4
Regulations (See Regulations, Board of Governors)
Reports to Congress........................................................................................... 3, 6, 20-21
Structure and functions .................................................................................................. 4-6
Supervision and regulation (See Supervision and regulation)
Capital accounts of Federal Reserve B a n k s ...............................................................46, 49
Capital stock of Federal Reserve Banks.................................................................. 9, 10, 49
Central banks, foreign........................................................... 2, 40, 42, 49, 75, 77-79, 112
Certificates of deposit ............................................................................................................ 71
Change in Bank Control Act of 1978 (See Bank control)
Check clearing and collection................................................................ 47, 48, 49, 106-10
Clearing b alan ces................................................................................................. 104-05, 108
Commercial banks
Access to discount window ...............................................................................................57
Lending by, international .................................................................................................92
Member and nonmember ban k s..........................................................................9-10, 57
Supervision and regulation of (See Supervision and regulation)

114

Purposes &. Functions
Community reinvestment and development ..............................................................101-02
Comptroller of the Currency..............................................3, 4, 9, 88, 89, 90, 91, 99, 100
Condition statement of Federal Reserve B anks...........................................................45-56
Consumer Advisory C o u n c il...................................................................................... 10, 100
Consumer credit, regulations and financial transactions ........... 2, 4, 6, 72, 88, 100-01
Consumer Credit Protection A c t ........................................................................................101
Consumer Leasing Act .........................................................................................................101
Council of Economic Advisers .......................................................................................... 3 ,4
Credit (See also Money and credit and Discount operations)
Consumer, regulations and financial transactions ................... 2, 4, 6, 72, 88, 100-01
Federal Reserve.....................................................................................................51, 57-73
Seasonal and emergency.............................................................................. 58-59, 61, 62
Securities ..................................................................................................................2, 6, 72
Credit Control Act ................................................................................................................ 71
Credit unions (See Thrift institutions)
Currency and coin
Circulation ..................................................... 33, 37, 45, 47, 48, 51, 53-55, 104, 106
Demand for ................................................................................................. 17, 54, 105-06
Federal Reserve notes ................................................................................ 46, 48, 51, 105
Treasury accounts .............................................................................................................. 51

Dealers in U.S. government securities ................................................. 36, 40-43, 72, 73
Debt, domestic nonfinancial debt outstanding...........................................................24-25
Depository institutions (See also specific types)
Borrowings.....................................................................................................................59-65
Examination ................................................................................................................. 88-91
Reserve requirements (See Reserve requirements)
Depository Institutions Deregulation and Monetary Control Act
of 1980 ................................ 1, 9, 10, 53, 57, 66, 67, 69, 70, 71, 84, 103, 104, 108
Depository Institutions Deregulation Com m ittee.........................................................3, 71
Deposits
Negotiable order of withdrawal accounts (NOWs) ................................ 16, 17, 18,67
Time and sav in gs................................................................................................................ 71
Transaction accounts ........................... 10, 13, 14, 16, 18, 21, 33, 57, 65, 66-68, 70
Treasury tax and loan and other accounts................... 45, 46, 47, 48-49, 54, 55, 111
Directives (See Federal Open Market Committee)
Directors, Federal Reserve B a n k s.......................................................................................7-9
Discount operations
Adm inistration...................................................................................................4-5, 58, 59
Instrument of monetary policy .................................................................. 14, 27,57-65
Mechanics ............................................................................................................................59
Seasonal and emergency borrowing privilege .......................................... 58-59, 61, 62
Discount rates ........................................................................ 4-5, 9, 14, 59, 63-65, 75-76
Discount window ............................................ 10, 14, 29, 31, 33, 47, 51, 57-63, 91, 104

115
Index

Earnings and expenses of Federal Reserve Banks ..................................................... 9, 50
Edge act and agreement corporations ............................................... 6, 10, 65, 67, 85, 92
Electronic Fund Transfer Act ............................................................................................. 101
Electronic fund transfers..................................................................................... 103, 108-10
Employment Act of 1946 ....................................................................................................... 1
Equal Credit Opportunity Act ..............................................................................6, 88, 101
Eurodollars and Eurocurrency ..................................................... 23-24, 67, 71, 81, 84, 85
Examination of banks .......................................................................................... 7 ,8 8 -9 1 ,9 3
Exchange Stabilization F u n d ......................................................................................... 47, 80
Fair Credit Billing A c t .................................................................................................88, 101
Fair Credit Reporting Act ...................................................................................................101
Farm Credit S y stem ................................................................................................................ 36
Federal Advisory C ouncil..................................................................................................... 10
Federal agency obligations ............................. 7, 24, 35, 36, 39, 40, 41, 47, 59, 105, 112
Federal Deposit Insurance Corporation................... 3, 4, 71, 85, 88, 89, 91, 93, 99, 100
Federal Financial Institutions Examination C o u n cil................................................... 3, 89
Federal funds ............................................................................................. 14, 28, 29, 60, 104
Federal Home Loan Banks and Federal Home Loan Bank
Board ......................................................................................... 3, 4, 36, 61, 63, 71, 89
Federal National Mortgage Association ..............................................................................36
Federal Open Market Committee (See also Monetary policy and Open market
operations)
Directives.............................................................................................................. 27, 36, 77
Foreign currency operations ..................................................................................7, 77-80
Functions..........................................................................................................................4, 6
International economic and financial matters, effects
on policymaking .................................................................................................. 75-77
Manager for Domestic Operations and Manager
for Foreign Operations............................................. 27, 28, 30, 36-41, 42, 43, 77
M eetings...........................................................................................................................7, 27
Membership and organization........................................................................................... 7
“Swap” arrangements (reciprocal currency arrangements).............................. 75, 78-80
Trading Desk, photograph.................................................................................................41
Federal Reserve A c t ........................................................................ 1, 10, 20, 30, 49, 63, 87
Federal Reserve Banks
Assessments for Board of Governors............................................................................ 6, 9
Balance sheet ............................................................................................................... 45-56
Borrowing at ................................................................................................................. 59-65
Branches............................................................................................................................... 7
Capital accounts.......................................................................................................... 46, 49
Capital sto c k .................................................
9, 10, 49
Checks handled by (tab le)............................................................................................... 108
Consumer credit complaints .............................................................................
100

116
Purposes & Functions
Federal Reserve Banks— Continued
Decisionmaking responsibilities ..................................................................................9, 10
Deposits a t ........................................................................ 45, 46, 47, 48-49, 54, 55, 111
Directors............................................................................................................................7-9
Discount rates (See Discount rates)
Districts .................................................................................................................... 7, 8, 63
Earnings and expenses ................................................................................................. 9, 50
Fiscal agency functions....................................................................................... 7, 111-12
Foreign accounts .............................................................................................................. 49
New York Bank ......................................................... 7, 27, 37, 40, 41, 49, 77, 78, 112
Organization ....................................................................................................................... 7
Representation on Federal Open Market Com m ittee..............................................7, 27
Services ................................................................................................................ 9, 103-12
Supervision and regulation o f ....................................................................................... 4, 6
Surplus ............................................................................................................................9, 50
Federal Reserve Bulletin...............................................................................................................6
Federal Reserve notes .................................................................................... 46, 48, 51, 105
Federal Reserve Regulatory Service ........................................................................................... 6
Federal Reserve System (See also Board of Governors)
Advisory councils and committees ...........................................................3, 10, 89, 100
Contacts with other officials and organizations ............................. 2-4, 75, 79, 91, 92
Establishment ...................................................................................................................... 1
Functions............................................................................................. 1, 2, 7, 54, 87-102
International sphere, operations andactivities..........................................................75-85
M a p ......................................................................................................................................... 8
Membership............................................................................................... 9-10, 49-50, 90
Monetary policy
Guides for ................................................................................................. 15-19, 21, 27
Instruments.............................................................................................................. 27-43, 57-73
Organization (chart) .............................................................................................................5
Role in government.......................................................................................................... 2-4
Securities, portfolio...................................................................................... 13, 14, 47, 51
Structure ........................................................................................................................... 4-9
Supervision and regulation (See Supervision and regulation)
“Swap” drawings, use b y ................................................................................................... 75,78-80
Federal Savings and Loan Insurance Corporation (FSLIC) ..............................................89
Federal supervisory structure ............................................................. 3, 71, 88, 93, 99-100
Federal Trade Commission Improvement Act .................................................................101
Financial Institutions Regulatory and Interest Rate Control Act of 1978
(See Bank control)
Fiscal agency functions of Federal Reserve Banks...................................... 7, 104, 111-12
Fiscal p o lic y ................................................................................................. 13, 18, 19, 20, 21
F loat................................................................................ 37, 48, 49, 51, 52-53, 54, 107-08
Foreign banks (See also Central b an k s)........2, 6, 57, 65, 67, 80-81, 82-83, 84, 90, 93
Foreign currency operations.................................................................................................... 7,77-80

117

Index
Foreign exchange rates ...................................................................................................76, 79
Foreign operations of U .S. b an k s.............................. 2, 6, 80-81, 84, 85, 87, 90, 91-93
Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins
Act) ......................................................................................................................1, 3, 20

Gam—St Germain Depository Institutions Act of 1982 ......................................... 67
General Accounting Office ...................................................................................................6
Gold
Certificate account .................................................................................................... 45-46
Held for foreign central banks ..................................................................................... 112
S to c k ............................................................................................................................. 46, 51

Home Mortgage Disclosure Act ..................................................................................6, 101
Humphrey-Hawkins Act ........................................................................................... 1, 3, 20

Interest rates
Ceilings ................................................................................................................ 17, 33, 71
Discount rates (See Discount rates)
Expectational factors...................................................................................................15, 65
Measures of (chart) .......................................................................................................... 32
Monetary policy a n d ..................................................................................... 13-19, 28-34
International Banking Act of 1978 .................................................................. 1, 87, 93-94
International banking facilities..................................................................................... 6, 85
International Lending Supervision Act of 1983 ............................................................... 92
International Monetary Fund ...................................................................... 47, 80, 92, 112
International operations of U .S. banks (See Foreign operations of U .S. banks)
International sphere, Federal Reserve operations and activities.............................. 75-85
Lender of last resort ..................................................................................2, 58, 62, 87, 104
Lending, international ........................................................................................................ 92
Liquid assets (L) ......................................................................................... 16, 21, 22-23, 24

Margin requirements ................................................................................. 2, 6, 72, 73
Matched sale-purchase transactions ............................................................................40, 43
Member banks (See also Depository institutions and State member banks)
Borrowing .....................................................................................................................57-59
Examination .......................................................................................................... 7, 88-91
Number ..................................................................................................................................9
Reserve requirements (See Reserve requirements)
Reserves (See Reserves)
Supervision and regulation o f ..................................................... 2, 6, 87, 89, 90, 91-93
System membership, obligations and benefits...................................... 9-10, 49-50, 90
Monetary and credit aggregates....................... 16-17, 18, 19, 20, 21-26, 27, 29, 34, 84
Monetary b a s e ...................................................................................................................31,33
Monetary Control Act (See Depository Institutions Deregulation and Monetary Control
Act of 1980)

118
Purposes & Functions
Monetary policy
G o a ls................................................................................................................................... 13
Guides for ..................................................................................................... 1 5 -1 9 ,2 1 ,2 7
How it w orks..................................................................................................................13-15
Instruments .....................................................................................................27-43, 57-73
International economic developments, effectson policymaking ......................... 75-76
Reports to Congress........................................................................................... 3, 6, 20-21
Money and credit
Definitions of M l, M2, and M 3 .................................................................................21-24
Demand for ......................................................................................14, 15, 16, 18, 33, 54
Measures of (See also Monetary and credit aggregates)...........................................21-24
Regulation............................................................................................................................27
Velocity o f M l ..............................................................................................................16,17
Money market deposit accounts and money market fu n d s........... 18, 22, 23, 24, 67, 69
M ortgages.....................................................................................................6, 59, 62-63, 101

National banks...................................................
National Credit Union Administration ...............
National Monetary Commission.............................
Negotiable order of withdrawal accounts (NOWs)
Nonmember ban k s....................................................

............... 9, 88-89, 90, 99, 100
........................................ 3, 4, 89

...........................................

............................ 16, 17, 18, 67
10, 57, 67, 71, 89, 99, 100, 104

Open Market Account (See System Open Market Account)
Open market operations (See also Federal Open Market Committee)
C o n d u c t.........................................................................................................................38-43
Impact on reserves....................................................................................... 14, 15, 28-36
Instrument of monetary policy ................................................................. 4, 6, 27-43, 57
Purpose..................................................................................................................................27
Reserve objectives f o r .................................................................................................. 28-34
Securities (See U .S. government securities)
Transactions .............................................................................................................. 34-43

Payments mechanism...........................................................................4, 6, 7, 103-10
Private sector adjustment fa c to r....................................................................................... 104
Publications........................................................................................................................6, 72

Real Estate Settlement Procedures A ct.
Regulations, Board of Governors ...........
Reports to C ongress..................................
Repurchase agreements............................
Reserve ratios ............................................
Reserve requirements (See also Reserves)
A pplicability........................................
Instrument of monetary p o lic y ..........
Maintenance period ...........................

................................. 101
.................................... 58, 72
...........................3, 6, 20-21
........ 22-23, 35, 39, 40, 42
..........................................67
. 10, 57, 65-66, 81, 85, 104
5, 13-16, 27, 57, 66-71, 84

......................................... 68

119
Index

Reserve requirements— Continued
Structure .............................................................................................................. 66-69, 84
Reserves
Borrowed ...................................................................................................... 28-34, 37, 56
Excess ....................................................................................................................30-31, 70
Factors influencing........................................................................................ 34-37, 45-56
Measures o f ..................................................................................................................29-33
Monetary policy a n d .....................................................................................13-19, 28-34
Nonborrowed .................................................................................. 27, 28-34, 36, 37, 56
Open market operations a n d ................................................................ 28-34, 39, 42, 43
Sources and uses, reserve equation .......................................................................... 50-56
T o t a l.............................................................................................................. 31, 35, 55-56
Sale—purchase transactions ......................................................................................... 40, 43
Savings and loan associations (See Thrift institutions)
Savings banks (See Thrift institutions)
Securities (See specific types)
Securities Exchange Act of 1934 ....................................................................................... 72
Securities credit .......................................................................................................... 2, 6, 72
Securities transactions of the Federal Reserve.............................................................34-43
Settlement (See Check clearing and collection)
Special Drawing R ights........................................................................................... 46, 47, 80
State member banks (See also Member banks)
Examination ................................................................................................................7, 90
Supervision and regulation o f ..................................................... 2, 6, 87, 89, 90, 91-93
System membership, obligations and benefits...................................... 9-10, 49-50, 90
Supervision and regulation
Bank control, changes i n .......................................................................... 87, 94, 99-100
Bank holding companies and bank mergers............................................ 87, 90, 94-100
Consumer credit regulations and financial transactions..........2, 4, 6, 72, 88, 100-01
Distinction between ........................................................................................................ 88
Federal Reserve Banks .................................................................................................. 4, 6
Foreign bank operations in the United States ...................................... 2, 6, 87, 93-94
Foreign operations of U .S. banks............................................... 2, 6, 84, 87, 90, 91-93
Member banks (See Member banks)
Securities credit ...................................................................................................... 2, 6, 72
Surplus of Federal Reserve B a n k s................................................................................... 9, 50
“Swap” arrangements (reciprocal currency arrangements).................................. 75, 78-80
System Open Market Account ...................................................................... 38, 40, 41, 42
Thrift in stitution s................. 9, 10, 11, 57, 58, 61, 62-63, 65, 67, 71, 89, 96, 104-05
Thrift Institutions Advisory C ouncil............................................................................10-11
Transaction accounts................................ 10, 13, 14, 16, 18, 21, 33, 57, 65, 66-68, 70
Treasury, U .S.
Contacts of Federal Reserve with
3, 4, 75, 79

120
Purposes & Functions

Treasury, U .S .— Continued
Currency accounts........................................
Deposit accounts with Federal Reserve___
Exchange Stabilization F un d .......................
Fiscal agency services for .............................
Payments from Federal Reserve B a n k s___
Securities (See U .S. government securities)
Tax and loan accounts ................................
Truth in Lending Act ......................................

................................................51
45, 46, 47, 48-49, 54-55, 111
..........................................47, 80
.................................. 7, 111-12
............................................9, 50
................................ 48-49, 111

6 88, 101

............................................. ,

U.S. balance of payments
Foreign currency operations ................................................................................7, 77-80
Monetary policy and international economic development.................................. 75-76
U .S. government agencies, contacts of Federal Reserve w ith ........... 2-4, 75, 79-80, 91
U .S. government securities
Dealers .....................................................................................................36, 40-43, 72, 73
Federal agency obligations......................... 7, 24, 35, 36, 39, 40, 41, 47, 59, 105, 112
Federal Reserve Bank services...................................................................... 103, 110, 111
Federal Reserve holdings .................................................................................................47
Foreign currency operations and ................................................................................7, 80
Open market operations in ................................................ 7, 27, 28, 35-36, 38, 40, 47
Repurchase agreements (See Repurchase agreements)

Treasury securities .................................................. 24, 36, 40,, 41, 47, 59, 79-80, 112

Vault cash .......................................................... 13, 30, 31, 33, 48, 53, 55-56, 65, 70
Wire transfers of funds

F R B l-3 5 0 ,000-1284 C

109, no

Full text of The Federal Reserve System : Purposes & Functions, (1984)

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