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THE FEDERAL
RESERVE
TODAY
by Robert P. Black

Federal Reserve
Bank of Richmond
\

Reprinted

with

permission with slight changes

from the May 1964 issue of @!_llyers 'Jitle News.

First Edition
Second Edition
Third Edition
Fourth Edition
Fifth Edition ..

.... 1964
..... 1966
... 1967
...... 1968
.... 1971

Library of Congress Catalog Card No.: 70-182567
Additional

copies of this booklet are available

without charge from the Federal Reserve Bank of
Richmond, Richmond, Virginia 23261.

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Federal Reserve Bank of St. Louis

THE FEDERAL
RESERVE
TODAY
The - Federal Reserve System
opened its doors for business
nearly 60 years ago. During the
intervening years, it has undergone
many changes as its role has expanded from one of limited scope
to one that affects the Iives of
every American. This is the story
of the System today-its objectives, its structure, and its actions.

The System has two basic functions: (1)

SYSTEM
FUNCTIONS

AND
OBJECTIVES

providing the Treasury and the public with
several basic services and (2) regulating
the flow of money and credit in order to
' contribute to economic growth and stability. Of the two, its monetary policy actions-the steps it takes to influence economic conditions-are the more important.
System policy actions have several major
objectives: to contribute to high levels of
employment,

encourage

economic

growth, to foster price stability, and to help
maintain a sound international balance of
payments position. System policy alone
cannot achieve these objectives since many
other factors play important roles. It can,
however, do a great deal to create a monetary and credit climate conducive to the
attainment of these goals.
These objectives are mutually interdependent over the long run. Without ful I employment, the country cannot realize its
growth and prosperity potentials. If there
is continuing inflation, speculative activity
is apt to replace productive efforts, inventory and other excesses leading to recession may develop, and balance of payments
problems will probably arise. Serious balance of payments problems in turn may
make it impossible to pursue as expansionary monetary and fiscal policies as may
be needed domestically. A sound balance
of payments position, high levels of employment, and stable prices, however, produce the best possible environment for
sustainable economic growth. Because of
these interrelationships, the System considers all its goals to be equally important.

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STRUCTURE
OF THE
SYSTEM

The structure of the System closely resembles that of a triangle. At the apex is
the Board of Governors, farther down are
the 12 Federal Reserve Banks and their
24 branches. Forming the base of this
triangle are the nearly 6,000 commercial
banks that are "members" of the System.
There are also several committees that
play important roles in System operations.
The Member Banks. Federal Reserve
member banks hold about 80 percent of all
commercial bank deposits, although only
about 40 percent of all commercial banks
belong to the System. National banks must
be members, and state-chartered banks
may join if they meet certain requirements.
The member banks of each district are the
stockholders of the Reserve Bank serving
their district.
The Reserve Banks. The Reserve Banks

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constitute the next level of the pyramid.
Each of the 12 Reserve Banks serves a
certain district of the country, and all but
two Reserve Banks have branches that
cover particular parts of their districts.
Cities with head offices of Reserve Banks
are Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St.
Louis, Minneapolis, Kansas City, Dallas,
and San Francisco.
The corporate structure of the Reserve
Banks resembles that of commercial banks,
but there are important differences. First,
the Banks are not profit-motivated. Instead,
policy is based purely upon the System's
estimates of the needs of the economy.
Since the System acquires large quantities
of income-producing Government securities
in the process of implementing monetary
policy, Reserve Banks do earn substantial

THE FEDERAL RESERVE SYSTEM
.OUNDARIES OF FEDERAL RESERVE DISTRICTS ANO THEIR BRANCH TERRITORIES

HAWAII

Legend
-

Boundaries of Federal Reserve Districts -Boundaries of Federal Reserve Branch Territories

0 Board of Governors of the Federal Reserve System
® Federal Reserve Bank Cities

• Federal Reserve Br.anch Cities

~
:::-:----_

____ "";:--

I II II~~• _

1111111r
The office of the Board of Governors in Washington.

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profits. During 1970, for example, their
combined earnings totaled $3.9 billion.
Second, the member bank stockholders do
not have all the rights of ordinary stockholders. For example, their dividends are
limited by law to six percent, they elect
only six of the nine directors of each Bank,
and they would share in the assets of the
Banks only to the extent of the par value
of their stock if the Reserve Banks were
ever liquidated. Third, "investment" decisions are under the control of the Federal Open Market Committee rather than
the boards of directors of the Banks. Finally, the Board of Governors exercises over
the Reserve Banks many of the supervisory
powers customarily held by directors of
private corporations.
Reserve Bank directors have several
monetary policy duties, however, in addition to their regular responsibilities in
overseeing Bank operations. First, they
establish, subject to the approval of the
Board of Governors, the discount rates the
Reserve Banks charge on loans to member
banks. Second, they elect five of the Reserve Bank presidents to serve as members
of the Federal Open Market Committee.
Third, they provide System officials with
considerable "grass roots" information 6n
business conditions.
Board of Governors. The Board of Governors in Washington is composed of seven
members appointed for 14-year terms by
the President of the United States with
the advice and consent of the Senate.
Board members may not be reappointed if
they have served a full term, and each
must come from a different Federal Reserve District. The chairman and vice chairman of the Board are appointed from
among the members by the President for

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four-year terms and may be reappointed.
The Board's duties include supervising
state member banks, overseeing the operations of Reserve Banks, approving changes
in the discount rate, setting reserve requirements for member banks, establishing margin requirements on specified
stocks and bonds, setting maximum interest rates payable on time and savings deposits of member banks, and serving as
members of the Federal Open Market
Committee.
The Federal Open Market Committee.
The Federal Open Market Committee is the
System's most important policymaking
body since it determines the extent to
which the System buys and sells Government securities and bankers' acceptances.
It also has charge of the System's operations in foreign exchange markets. Members include not only the seven members
of the Board of Governors but also five
Reserve Bank presidents, one of whom is
the President of the New York Reserve
Bank. The other presidents serve one-year
terms on a rotating basis. Both domestic
and foreign operations are conducted by
the New York Reserve Bank as agent for
the Committee.
Other Committees. Other important committees include the Conference of Presidents, the Conference of Chairmen, the
Conference of First Vice Presidents, and
the Federal Advisory Council. The first
three-as their names imply-meet periodically to discuss problems of mutual
interest to the Reserve Banks. The Federal Advisory Council is a 12-man committee of bankers, which meets several
times a year to advise the Board of Governors on matters of current interest.

SERVICE
FUNCTIONS

Like the central banks of most other
countries, the System provides a number
of important services to the Treasury and
the public.
Fiscal Agency Functions. One of the
most important of these is acting as fiscal
agent for the U. S. Treasury. The Reserve
Banks service the Treasury's checking accounts; assist in the sale, transfer, and
redemption of Government securities; pay
interest coupons; and assist the Treasury
and other Government agencies in many
other ways. Reserve Banks receive no compensation for redeeming coupons and handling the Treasury's checking accounts,
but they are reimbursed for most other

Coupons being clipped on municipal securities held in safekeeping for a member
bank.

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fiscal agency functions.
Collection of Checks and Noncash Items.
The System also operates a nationwide
"clearinghouse" for checks, drafts, and
similar items. Member banks route these
items to Reserve Banks, which in turn send
them to the proper places for collection.
Settlement is accomplished by means of
entries to the accounts member banks
maintain with the Reserve Banks.
Wire Transfer of Funds. The System
maintains a communications center at Culpeper, Virginia that is staffed and operated
by the Federal Reserve Bank of Richmond
for transferring funds by wire from one
part of the country to another. The communications system is actually composed
of several computers designed to transmit
messages in a very rapid fashion over
special telephone lines. For example, if a
national concern headquartered in New
York wishes to transfer funds to its Chicago office, it can have its bank request
the transfer through the System communications faci I ities. The New York Reserve
Bank will deduct the funds from the bal-

With machines such as these, the Federal Reserve Banks
can quickly transfer funds from one part of the country
to another.

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The Federal Reserve Banks use machines like these in
collecting more than eight bi II ion checks every year.

Coins being counted at the
Federal Reserve Bank of
Richmond.

ance •of the New York commercial bank,
and the Chicago Reserve Bank will add the
funds to the reserve balance of the firm's
bank in Chicago, which will credit the account of the firm. The Reserve Banks will
then settle by means of an entry on the
books of the lnterdistrict Settlement Fund
-a System clearing agency in Washington.
Supplying Coin and Currency. The Federal Reserve Banks provide a vital part of
the machinery through which most coin
and currency moves into and out of circulation. As the public demands more cash
from commercial banks, the banks draw
10

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A truckload of new currency being transferred to a vault at the Federal Reserve
Bank of Richmond.

down their balances at the Federal Reserve in exchange for additional cash.
Similarly, when cash flows in from the public, the banks deposit the funds in their
accounts with the Reserve Banks.
Note Issue. Look in your billfold and
chances are that you will find a bill bearing a green seal. This is a Federal Reserve
note-the most common type of currency
in circulation today. These notes, which
are issued by the 12 Reserve Banks, must
be backed 100 percent by collateral consisting of Government securities, gold certificates, or other special types of assets.

System policy affects the economy primarily through influencing interest rates,

INFLUENCE

the availability of credit, and the money
supply (cash

plus private demand de-

posits) and, through them, the volume of
spending. The initial impact of policy is
usually felt by the commercial banking

ON ECONOMIC
ACTIVITY

system, but it spreads quickly throughout
the entire financial structure of the nation

and, often,

throughout the

inter-

national economy as well.

Key Role of Commercial Banks. Commercial banks play a vital role in this
whole process because they are the only
private institutions that can "create"
money. Other private financial institutions
act merely as intermediaries in channeling on to borrowers or others money entrusted to them by depositors, stockholders,
and others. It is not so with commercial
banks, whose actions can actually increase or decrease the volume of money
in existence.
Here is how the process works. Suppose
that the System purchases some Government securities from a New York bond
house and credits the proceeds to the "reserve account" that the dealer's bank
maintains with the Reserve Bank. The
dealer's bank will then have excess reserve
funds and will normally put the funds to
work by making loans or investments. If
it makes loans, it will simply credit the
checking accounts of the borrowers. If it
purchases investments, deposits will also
rise when the funds used in payment are
deposited by the seller. In both cases new
money, in the form of additional demand
deposits (checking accounts), will be
"created."

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But the process does not stop here. As

Commercial banks play a unique role in
the American economy.

money can result in shifts in spending that

these deposit holders spend their newly

have tremendous impacts upon prices and

acquired funds, the deposits will move to

the overall level of economic activity.

other banks. These banks will have to set

How Reserves Fit into the Picture. To a

aside part of their new funds as "reserves"

large extent, changes in the volume of

to back their new deposits but will be able

member

to lend approximately the remainder. These

amount of money banks can

bank

reserves

determine

the

"create."

loans will create additional new deposits,

Several

which will move at least in part to other

which time deposits rise, the behavior

banks that in turn can expand loans and

of Government deposits at

deposits in the same manner. The process

banks, the amount of cash withdrawn from

can go on until deposits become so large

banks, and so on-play important roles,

that all the funds injected into the bank-

but reserves usually play the most im-

ing system are used as reserves to support

portant single part.

other

factors-the

amount

commercial

the new deposits. By the time the process

Consequently, by increasing or decreas-

stops, demand deposits will usually have

ing the volume of reserves the System can

risen by several times the amount of the

influence the money supply, the avail-

reserves created by the System's original

ability of credit, interest rates, and, through

action. Conversely, a decline in member

these, the level of economic activity and

bank reserves can bring about a multiple

prices. By stepping up the rate of increase
in member bank reserves, the System can

contraction in the money supply.

stimulate the domestic economy, and by

The Importance of Money in the Economy.

slowing down the rate of increase or by

Money plays a unique role in the

actually letting reserves fall, the System

economy in that nothing else is generally

can reduce the rate of increase in total

acceptable in payment for goods and ser-

domestic spending.

vices. Other assets such as time deposits,

In the process of affecting reserves, it

savings and loan shares, and short-term

also can influence both directly and in-

Treasury securities possess many of the

directly international

attributes of money, but they cannot be
spent until they have been converted into

employment, the System can make a major

The volume of expenditures determines
level

economic

capital

while encouraging healthy growth and high

cash or demand deposits.
the

trade and

movements. By helping prevent inflation

activity.

contribution to a successful foreign trade

Rising

position. By helping to keep interest rates

expenditures require either more money or

in reasonable alignment with foreign rates

a pickup in velocity-the rate at which

and by taking certain other actions, Sys-

money is spent. Since the average dollar is
spent many times in the course of a year,
increases or decreases in the supply of

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Rising business activity requires more
money or a more intensive use of existing
money.

tem policy can also ease balance of payments problems arising from international
capital movements.
13

MONETARY
POLICY
TOOLS

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The System utilizes several important
policy tools to affect the level of economic
activity. Basically, controls fall into two
categories: general and selective. General
controls-the discount rate, reserve requirements, and open market operationsare aimed at the overall availability of
money and credit and the general level of
interest rates. Selective controls regulate
particular types of credit. At the present
the System's only strictly selective control
is the changing of margin requirements on
certain stocks and bonds. In addition to
these tools, the System has two others that
are partly general and partly selective. One
is the setting of maximum interest rates
payable on time and savings deposits of
member banks. The other is the buying
and selling of foreign currencies in the
foreign exchange market.
The Discount Rate. Probably no other
policy tool is as well known or as poorly
understood as the discount rate-the rate
charged member banks on their loans from
the Reserve Banks. Changes in the discount rate are initiated by the boards of
directors of the individual Reserve Banks,
but the Board of Governors must approve
all changes. This coordination, plus the
fact that the boards of directors of all
the Reserve Banks have much the same
information available to them, generally
results in roughly simultaneous changes at
all Reserve Banks. Small differences in
timing do occur, but the first change is
the important one since "the market" assumes that other Reserve Banks wi 11 soon
come into line. Changes in the discount
rate have several important effects on
credit conditions and hence on the economy. A hike in the rate, for example, makes
it more costly for banks to borrow at the

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A group of System economists and statisticians discussing monetary policy.

The President and the Board of Directors
of the Federal Reserve Bank of Richmond.

Reserve Banks. The higher cost may encourage them to sell short-term securities
rather than use the discount privilege.
Such sales lower the prices of short-term
securities and raise short-term interest
rates. In addition, the higher cost of
funds may force banks to screen loan
applications more carefully and to slow
the growth in their loan portfolios. Conversely, a reduction in the rate reduces
bankers' incentives to sell short-term
securities as a substitute for borrowing at
the discount window. As a result prices of
short-term securities tend to be higher,
and interest rates on these securities correspondingly lower, than would otherwise
be the case.
But apart from this, changes in the discount rate can have important psychological effects on the attitudes of both
lenders and borrowers. These psychological
effects react on market expectations patterns and often influence both the timing
of borrowers' demands for funds and the
willingness of lenders to lend. If, for ex-

ample, the market interprets an increase
in the rate as the beginning of a sustained
program to tighten credit, the tightening
effects can be quite dramatic. Lenders
will tend to cut back commitments, waiting for more attractive rates, and some
borrowers will try to complete their borrowing before the expected higher rates
materialize. A reduction in the rate, on the
other hand, may produce precisely the
opposite effect.
These expectational effects sometimes
occur before an actual change in the discount rate takes place. This is _the case
when the market develops a strong feeling
that general credit conditions will soon
dictate a change in the discount rate. As
a rule, the discount rate is kept "in line"
with the market, and when substantial
differentials develop between the discount
rate and market rates market participants
may anticipate a change in the discount
rate. When the change is fully anticipated
-or in market parlance, "discounted"the announcement of the actual change

System purchases and sales in the open
market are made by telephone from this
"trading desk" at the New York Federal
Reserve Bank.

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System regulations specify the cash down
payments that must be made in purchasing or carrying specified stocks and bonds.

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The room where foreign exchange operations are conducted at the New York
Reserve Bank.

may have little or no perceptible effect on
credit markets.
Open Market Operations. Open market
operations are the most useful of the System's policy tools. Each purchase or sale
directly affects the volume of member
bank reserves and, in the process, the
economy as a whole. Purchases increase
reserves and "ease" credit since the System pays for the securities by crediting
the reserve account of the seller's bank.
Conversely, sales reduce reserves and
"tighten" credit since the System collects

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by charging the reserve account of the
seller's bank.
Operations are either "dynamic" or "defensive." Dynamic operations are those
taken actually to increase or decrease the
volume of reserves in order to ease or
tighten credit. Defensive operations are
those taken merely to offset the effects of
other factors influencing reserves. For example, the System sometimes sells securities to offset increases in reserves resulting
from an inflow of cash into commercial
banks. On the surface, such sales appear

to be tightening moves, but actually they
may be part of an easier money package
if the System does not sell enough securities to offset the entire increase in reserves resulting from the cash inflow.
Consequently, it is impossible to know
the significance of a purchase or a sale
unless one knows how other factors are
affecting reserves.
Reserve Requirements. The System's
most powerful tool is the Board's power
to change reserve requirements-th e percentage of reserves that banks must hold
back of deposits. Changes in requirements
either increase or decrease the volume of
excess reserves by changing the volume
of reserves required against existing deposits. A reduction, for example, increases
excess reserves and stimulates the economy while an increase has roughly opposite
effects.
Margin Requirements. Changes in margin requirements are the changes in the
percentages of cash down payments the
Board requires purchasers of securities
to make when they borrow to buy specified
securities. There are three separate regulations-Regulatio n T, which covers credit
extended by brokers and dealers; Regulation U, which governs loans made by commercial banks; and Regulation G, which applies to credit granted by others. An increase in margin requirements tends to
discourage speculation on borrowed credit,
and a decrease tends to encourage security
purchases.
Regulation Q. The Board can also use
its ability to set interest rate ceilings on
member bank time and savings deposits
as a means of influencing economic activity. Such ceilings must be set in consultation with the Federal Deposit Insurance Corporation and the Federal Home
Loan Bank Board. The ceilings are set
forth in the Board's Regulation Q.

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There are various ways in which Regulation Q can be used. If the Board wishes to
slow down the rate of expansion in bank
credit, for example, it can leave the ceilings unchanged while other interest rates
are rising. Conversely, it can speed up
bank credit expansion by raising the ceilings. In the process it will probably also
affect the relative levels of short- and
long-term interest rates.
Foreign Exchange Operations. As a
means of fostering improved international
liquidity and offsetting temporary disruptive international capital flows, the System
also engages fairly frequently in the purchase and sale of foreign currenciesBritish pounds, German marks, Swiss
francs, and the like. Foreign balances are
generally acquired either in the market or
through "swaps" with foreign central banks
that credit the account of the System on
their books in exchange for a like dollar
credit on the books of the Federal Reserve.

The System can use such foreign exchange to acquire surplus dollars held by
foreigners before they are converted into
gold, to prevent speculation against the
dollar, and to assist foreigners in fighting
inflationary inflows of capital funds. Such
actions, of course, yield no permanent
solution to balance of payments deficits,
but they do provide a convenient respite
during which a permanent solution can be
sought.
Since foreign exchange operations have
important effects upon foreign currencies
as well as upon our own, they naturally
must be undertaken in close cooperation
with foreign monetary authorities. Because
of similar Treasury responsibilities in this
area, they are also closely coordinated
with Treasury actions, most of which are actually conducted by the New York Federal
Reserve Bank as agent for the Treasury.

THE

POLICYMAKING
PROCESS

Coordination among the several policy
- tools is maintained largely through the
Federal Open Market Committee-the most
important System policy forum. There both
Board and Bank representatives meet
regularly about every four weeks, or more
often if necessary, to establish policy. In
attendance are not only the Board members and the five presidents currently on
the Committee but also the other seven
presidents, the managers of the System's
open market and foreign accounts and one

The Federal Open Market Committee and
some of its staff.

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of their assistants, some senior Board staff
members, and one of the senior economists
from each Bank. Thus, not only the policymakers but also their chief advisers and
those who implement policy for the Committee are always apprised currently as to
System policy objectives.
Committee meetings fall into three parts
-a discussion of recent pol icy actions by
the managers of the accounts, a rundown
on current economic developments by the
Committee staff, and finally a discussion

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and a vote by members of the Committee.
Discussion is quite free, and there is often
considerable diversity of opinion. In addition to discussing open market policy,
presidents typically state their views concerning discount rate policy so that the
Board-which must ultimately approve
such moves-and the other presidents wi 11
know in advance what actions the presidents plan to recommend to their boards.
Between meetings, Board members and
presidents keep in daily touch with the
New York Bank by means of phone calls,
wires, and memoranda. If necessary, telephone meetings of the entire Committee
may be cal led on very short notice, and
any member is free to object at any time
to the manner in which the instructions of
the Committee are being followed. In addition to these daily contacts, numerous
memoranda are exchanged at less frequent
intervals to provide maximum information
to the various policymakers.

System policymakers keep in daily contact
with each other by means of telephone
calls, wires, and memoranda.

MONETARY
POLICY:
LIMITATIONS,
ADVANTAGES

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Limitations. Formulating monetary policy
is a very difficult task, and there are definite limitations as to what policy can do.
Real economic stability requires not only
wise monetary policy but also (1) sound
fiscal actions-the manner in which the
Government taxes, spends, and manages
its debt-and (2) sufficient competition
throughout the economy so that individual
prices are free to move down as well as up.
Obviously, trouble can develop in all three
areas, so it is difficult to achieve perfect
stability for any sustained period of time.
But even if fiscal policy were always
perfectly prudent and competition strong
enough to prevent monopolistic price increases, there would still be limitations to
what monetary policy could do. First, the
problem of forecasting would still exist
since wise monetary policy-and, indeed,
sound discretionary stabilizing policy of
any type-requires good forecasts. Errors
of judgment can be minimized through
experience and careful analysis, but they
can never be eliminated completely. Second, even under the best conditions, there
are important "slippages" in the financial
mechanism. For example, commercial
banks may not readily contract or expand
earning assets in response to System
nudging, thus negating some of the action.
In addition, even if they do respond
promptly, shifts in the velocity of money
may partly offset changes in the money
supply. Both kinds of slippage complicate
the task of the money authorities, but their
importance can easily be overrated.
Advantages. Despite its imperfections,
monetary policy has several advantages
over the two alternative types of stabilizers
-fiscal policy and direct controls such as
price controls and rationing.

First, it is highly impersonal. Monetary
policy itself interferes very little with the
freedom of the market, although market imperfections sometimes intensify the effects
of policy upon particular sectors of the
economy. A tight monetary policy cuts down
the rate at which total spending can rise,
but it does not dictate which particular
expenditures must be slowed down or reduced. The expenditures cut are the ones
to which spenders attach the lowest priorities. Similarly, a policy of "ease" stimulates total outlays, but the market directs
which form the added expenditures will
take. Even the policy actions themselves
are impersonal. For example, no Government security dealer is told that he must
buy or sell Government securities when
the "Fed" is in the market. He does so because the System "buys at the market."
Direct controls obviously dictate what can
and cannot be done, and even fiscal policy
stimulates or restricts particular sectors of
the economy. In so doing, both give a different "mix" of goods and services than
would the free market of its own accord.
Second, monetary policy is more flexible
than most stabilizers. It is not completely
flexible, of course, since it-like virtually
all stabilizers-involves some lags. But it
is unusually flexible. The Open Market
Committee meets at least every four weeks,
reaches a decision that day, and begins to
implement its decision immediately. In
contrast, discretionary fiscal policy actions
necessarily involve considerable delays

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since any large moves must be debated
by Congress. And certainly few would want
to eliminate that debate. The so-called
automatic stabilizers- primarily Federal
income taxes and unemployment compensation payments-that tend to create budget surpluses during booms and deficits
in recessions may, however, act more
quickly than monetary policy.
Finally, and perhaps most important,
Congress has carefully insulated the Federal Reserve against day-to-day political
pressures so that it is free to act in the
best interests of the country's economy.
Congress wisely spread the policymaking
machinery throughout the System to avoid
undue concentration of power; it made the
System responsible to Congress rather
than to the Executive Branch; it provided
for 14-year terms for Board members and
made them ineligible for reappointment
after they have served a full term; and
it staggered their terms of office. The System has, of course, only such powers as
Congress has given it and can lose those
powers if it does not exercise good stewardship. Its powers are broad, however,
and Congress has so far chosen to permit
the System to base its policy actions almost entirely upon economic considerations. Such can never be the case with
fiscal policy or direct controls, which, in
our sort of democracy, must necessarily
be pa rt I y influenced by noneconomic
factors.

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PHOTO CREDITS
Board of Governors of the Federal Reserve
System; Colonial Studios, Richmond, Virginia;
Alan's Photography Studio, Culpeper, Virginia;
First and Merchants National Bank, Richmond,
Virginia; Miller & Rhoads, Richmond, Virginia;
Federal Reserve Bank of New York; New York
Stock Exchange.

Full text of The Federal Reserve Today

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