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Board of Governors
of the Federal Reserve System
and the United States Treasury Department

THE FEDERAL RESERVE
AND THE TREASURY:
ANSWERS TO QUESTIONS
FROM THE
COMMISSION ON MONEY AND CREDIT

PREPARED FOR TH E

Commission on Money and Credit

Prentice-Hall, Inc.
Englewood Cliffs, N J.

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@ 1 9 6 3 by Prentice-Hall, Inc., Englewood Cliffs, N.J.
All rights reserved. No part of this book may be reproduced in
any form, by mimeograph or any other means, without permission
in writing from the publishers.
Library of Congress Catalog No.: 63-12487
Printed in the United States of America

CMC Supporting Papers

The Committee for Economic Development is publishing for the
Commission on Money and Credit
THE FEDERAL RESERVE AND THE TREASURY: ANSWERS TO
QUESTIONS FROM THE COMMISSION ON MONEY AND CREDIT
and fifty-eight individual essays organized into nine separate vol
umes, each centered around a particular aspect of monetary and fis
cal policy. Their titles and the contributing authors are as follows:
IMPACTS OF MONETARY POLICY
Daniel B. Suits; Robert Eisner and Robert H. Strotz, with a bibliog
raphy by G. R. Post; Edwin Kuh and John R. Meyer; Leo Grebler and
Sherman J. Maisel; Charlotte DeMonte Phelps; Irwin Friend
STABILIZATION POLICIES
E. Cary Brown, Robert M. Solow, Albert Ando, and John Kareken;
Milton Friedman and David Meiselman; Lawrence E. Thompson;
Arthur M. Okun; Merton H. Miller; Allan H. Meltzer; Oswald
Brownlee and Alfred Conrad
MONETARY MANAGEMENT
Frank M. Tamagna; Warren L. Smith; Clark Warburton; Michael D.
Reagan; C. P. Kindleberger; Robert Z. Aliber
FISCAL AND DEBT MANAGEMENT POLICIES
William Fellner; Richard A. Musgrave; James Tobin; James R.
Schlesinger; Paul H. Cootner; Irving Auerbach; Ralph K. Huitt;
John Lindeman
FEDERAL CREDIT AGENCIES
George F. Break; Jack Guttentag; Ernest Bloch; D. Gale Johnson;
Dale E. Hathaway; George S. Tolley; Jack McCroskey
FEDERAL CREDIT PROGRAMS
Stewart Johnson; Warren A. Law; James W. McKie; D. Gale Johnson;
James Gillies; Robert C. Turner and Ross Robertson; J. Fred Weston
PRIVATE CAPITAL MARKETS
Irwin Friend; Hyman P. Minsky; Victor L. Andrews
PRIVATE FINANCIAL INSTITUTIONS
Paul M. fiorvitz; Deane Carson and Paul Cootner; Thomas G. Gies,
Thomas Mayer, and Edward C. Ettin; Lawrence L. Werboff and
Marvin E. Rozen; Fred H. Klopstock; E. Gordon Keith
INFLATION, GROWTH, AND EMPLOYMENT
Joseph W. Conard; Jesse W. Markham; Franklyn D. Holzman; John
W. Kendrick; Daniel Creamer; Stanley Lebergott; Lawrence R. Klein
and Ronald G. Bodkin; Tibor and Anne Scitovsky

TRADE ASSOCIATIONS MONOGRAPHS

THE COMMERCIAL, BANKING INDUSTRY
The Am erican Bankers A ssociation
THE CONSUMER FINANCE INDUSTRY
National Consumer Finance A ssociation
LIFE INSURANCE COMPANIES AS
FINANCIAL INSTITUTIONS
Life Insurance A ssociation of A m erica
MANAGEMENT INVESTMENT COMPANIES
Investment Company Institute
MORTGAGE COMPANIES: THEIR PLACE
IN THE FINANCIAL STRUCTURE
M iles L. Colean, fo r the
Mortgage Bankers A ssociation of A m erica
MUTUAL SAVINGS BANKING: BASIC CHARACTERISTICS
AND ROLE IN THE NATIONAL ECONOMY
National A ssociation of Mutual Savings Banks
PROPERTY AND CASUALTY INSURANCE COMPANIES:
THEIR ROLE AS FINANCIAL INTERMEDIARIES
A m erican Mutual Insurance Alliance
A ssociation of Casualty and Surety Companies
National Board of F ire U nderw riters
THE SAVINGS AND LOAN BUSINESS: ITS PURPOSES,
FUNCTIONS, AND ECONOMIC JUSTIFICATION
Leon T. Kendall, fo r the
United States Savings and Loan League

The Commission on Money and Credit was established in 1957
as an independent organization by the unanimous vote of the Board
of Trustees of the Committee for Economic Development. The
bylaws governing the Commission on Money and Credit state that
“ It shall be the responsibility of the Commission to initiate studies
into the United States monetary and financial system. *
This volume was especially prepared for the Commission on
Money and Credit as part of its research program leading to the
publication in June 1961 of its final report: Money and Credit: Their
Influence on Jobs, P rices, and Growth. It is published by direction
of the Commission according to its bylaws, as a contribution to
the understanding of the monetary and financial system of the United
States. It is one of more than 100 research studies prepared for
the Commission by trade organizations, individual scholars, the
Federal Reserve System, and the Treasury of the United States.
A selected group of these papers including those of this volume,
is being published for the Commission by the Information Division
of the Committee for Economic Development in accordance with
commitments to The Ford Foundation and the Merrill Foundation,
which provided main financial support for the Commission.
Publication of this volume does not necessarily constitute en
dorsement of such study by the Commission, its Advisory Board,
its Research Staff, or any member of any board or committee, or
any officer of the Committee for Economic Development, The Ford
Foundation, the Merrill Foundation, or any other organization
participating in the work of the Commission.

COMMISSION ON MONEY AND CREDIT

Members
F r a z a r B . W ild e, CHAIRM AN
C h airm an , C on n ecticu t G en era l
L ife In su ra n ce C om pany
H. C h ristia n Sonne,
VICE CHAIRM AN
N ew Y o rk , New Y ork
A d o lf A . B e r le , J r.
New Y ork , New Y ork
(W ithdrew to s e r v e as C hairm an
o f the U.S. State D epartm ent
Latin A m e rica n T a sk F o r c e .)
J am es B. B la ck
C hairm an o f the B oard , P a c ific
G as & E le c tr ic Com pany
Joseph M. Dodge
Chairm an of the B oard, The
D etroit Bank and T ru st C om
pany
(R esigned O ctob er 7, 1960.)
M a rrin er S. E c c le s
Chairm an of the B oard, F irs t
S ecu rity C orp oration
Lam ar F lem ing, Jr.
C hairm an of the B oard, A n d er
son, Clayton & Co.
Henry H. F ow ler
F ow ler, Leva, Hawes & Sym ing
ton
(Resigned F ebru ary 3, 1961, on
his appointment as Under
S ecreta ry of the T reasu ry.)
G aylord A. Freem an, Jr.
V ice Chairman, The F irst Na
tional Bank of Chicago
(Appointed A p ril 29, 1960.)
F red T. Greene
P residen t, F ederal Home Loan
Bank of Indianapolis
(Died M arch 17,1961.)

P h ilip M. K lu tznick
P a rk F o r e s t, Illin o is
(R esign ed F e b ru a ry 8, 1961, on
h is appointm ent a s United
States R e p re se n ta tiv e to the
E co n o m ic and S o cia l C ou n cil
o f the United N ation s.)
F re d L a za ru s, J r.
C hairm an o f the B o a rd , F e d e r
ated D epartm ent S to r e s, Inc.
Isad or Lubin
A rthur T . V an derbilt P r o fe s s o r
o f P u b lic A ffa ir s , R u tg e rs
U n iversity
J. Irwin M ille r
C hairm an o f the B oard, C um
m ins Engine C om pany
R ob ert R. Nathan
P resid en t, R ob ert
A s s o c ia te s , Inc.

Nathan

E m il R ieve
P resid en t E m eritu s, T e x tile
W ork ers o f A m e r ic a , A F L CIO
(Appointed M ay 19, 1960.)
David R o c k e fe lle r
P resid en t, The C hase Manhattan
Bank
B e a rd s le y Ruml
New Y ork, New Y ork
(Died A p ril 18, 1960.)
Stanley H. R uttenberg
D irector, Departm ent o f R e
sea rch , A F L -C IO
C harles Sawyer
Taft, Stettinius & H o llister
W illiam F. Schnitzler
S e cre ta ry -T r e a s u re r , A F L -C IO
(Resigned A pril 28, 1960.)

COMMISSION ON MONEY AND CREDIT
Earl B. Schwulst
President and Chairman of the
Board, The Bowery Savings
Bank

J. Cameron Thomson
Retired Chairman of the Board,
Northwest Bancorporation

Charles B. Shuman
President,
American
Bureau Federation

Willard L. Thorp
Director, Merrill Center for
Economics, Amherst College

Farm

Jesse W. Tapp
Chairman of the Board,
Bank of America, N.T. &S.A.

Theodore O. Yntema
Chairman, Finance Committee,
Ford Motor Company

Advisory Board
Lester V. Chandler
P rofessor of Economics,
Princeton University
Gerhard Colm
Chief Economist, National Plan
ning Association

Richard A. Musgrave
Woodrow Wilson School of Pub
lic and International Affairs,
Princeton University
Richard E. Neustadt
Professor of Public Law and
Government, Columbia Uni
versity

Gaylord A. Freeman, Jr.
Vice Chairman, The First Na
tional Bank of Chicago
(Resigned April 29, 1960, on his
appointment to the Commis
sion.)

Paul A. Samuelson
P rofessor of Economics, Massa
chusetts Institute of
Technology

Leo Grebler
Professor of Business Admin
istration, University of Cali
fornia (Los Angeles)

Sumner H. Slichter
Lamont University Professor,
Harvard University
(Died September 27, 1959.) ■

Raymond W. Goldsmith
Professor of Economics, Yale
University
Neil H. Jacoby
Dean, School of Business Ad
ministration, University of
California (Los Angeles)

Edward S. Shaw
Professor of Economics, Stan
ford University
Alan H. Temple
New York, New York

Jacob Viner
Professor of Economics,
Emeritus, Princeton University
Staff
Bertrand Fox
Research Director

Eli Shapiro
Deputy Research Director

FOREWORD

Shortly after its organization the Commission on Money and
Credit met with the then Secretary of the Treasury, Mr, Robert B,
Anderson, and his staff, and soon thereafter with the Board of
Governors of the Federal Reserve System and their staff. The
meetings enabled the Commission to explore with the aforemen
tioned officials their thoughts as to the nature, range and details
of problems and issues which might appropriately be studied by
the Commission.
Both the Treasury and the Federal Reserve had set forth their
views in detail on many matters of concern to the Commission in
testimony before and submissions to, various committees of Con
gress during the preceding decade. Each was also preparing to
testify further before the Joint Economic Committee in the course
of its study on Employment, Growth and Price Levels, All these
materials were used extensively during the work of the Commission.
Nevertheless, there were additional issues and problems on which
the Commission wanted to obtain the views of the Treasury and
the Federal Reserve or on which it wanted more up-to-date state
ments.
Consequently, the Commission took advantage of the cooperation
promised at the initial meetings and addressed formal inquiries
to both the Treasury and the Board of Governors of the Federal
Reserve System. These inquiries had been developed in informal
discussion sessions between the staff of the Commission and of the
Federal Reserve and Treasury respectively. In both instances
there was an explicit understanding that the replies were “to become
part of the public record of materials submitted to the Commis
sion.” Pursuant to this understanding, the replies were released
for publication by the Treasury and Federal Reserve.
The replies of the Treasury were prepared and released for
publication by the Department of the Eisenhower Administration;
they should not be attributed to the Treasury Department of the
Kennedy Administration,

Both sets of replies and the questions to which they responded
are reproduced in full in this volume in the belief that they will
contribute to public understanding of official views on monetary,
fiscal and debt management operations and policies. The Commission
and its staff are indebted to both the Treasury and the Federal
Reserve for their willing and valuable contributions.

December, 1961.

Bertrand Fox
Director of Research

Eli Shapiro
Deputy Director of Research

CONTENTS
Part One

THE FEDERAL RESERVE ANSWERS

I, Processes and Procedures Involved in the Formula
tion and Execution of Monetary P olicy..........................

n. Appropriateness of Monetary Policies under “ Cost
Push,” “Demand Shift,” and “Demand Pull” Inflation .

III. Possible Contributions of Monetary Policy to Growth.

IV. The Validity of Claims that the Corporate Income Tax
Rate and Volume of Internal Financing Reduces the
Responsiveness of Business Firms to Monetary Policy

V. The Effectiveness of Small Changes in Interest Rates
in Stemming Inflationary P re ss u re s .............................

VI. Ways in Which the National Debt Assists or Hampers
the Effectiveness of Monetary Policy.............................

VII. The Importance of Changes in the Velocity of Money
to the Effectiveness of Monetary P olicy........................

VIII. The Effect on the Rise in Volume of Near-Money As
sets......................................................................................

IX. The Effect of Shifts of Funds by Depositors and So
Forth between Financial Institutions on Monetary
P o licy ............................................................■...................

X. The Management of Portfolios by Financial Institu
tions and Its Effect on Monetary Policy in the PostAccord Period....................................................................

100

XL How Changes in Liquidity Positions, Loan-Deposit
Ratios, Supervisory Standards, and So Forth, Affect
Credit Availability............................................................

106

XII. The Extent of the Federal Reserve’s Concern with the
Level of Bank Earnings and the Adequacy of Bank
C^pitEl, ................ ...................................... ( , , ,

111

XIII. Criteria to Be Used in Determining the Instrument
Mix Needed to Achieve Policy Objectives under Vary
ing Circumstances...............................................................

116

XIV, Criteria Used in Determining When and by How
Much to Alter Discount Rates.........................................

121

XV. Criteria Employed in Determining Amounts which
the Banking System and Individual Banks May Bor
row from Reserve Banks................................................

126

XVL Problems Involved in Policing the Discount Window.

132

XVII, How Rises in the Discount Rate Increase Demands
for Credit by Business F i r m s ......................................

147

XVIII. Accommodating Monetary Policies to Differences in
Regional Economic Conditions, Particularly in Re
gard to Discount Policy...................................................

153

XIX, Pros and Cons of Reserve Requirements Based on
the Turnover of Deposits and on Bank A s s e ts ...........

160

XX, How the Existence of Nonmember Banks May Lead
to Unhealthy Competition.................................................

168

XXI. The Influence of Foreign Interest Rates, U.S. Bal
ance of Payments, Long-Term International Lending,
and So Forth on Monetary P o lic ie s ..............................

172

XXII. The Effect of Interest Rate Regulation on Time De
posits on the Competitive Position of Financial In
termediaries, Flows of Domestic Funds, and Foreign
Holdings of Dollar A s s e ts ..............................................

183

XXIII, The Relation of Bank Examination Standards to Gen
eral Monetary P o licie s....................................................

192

XXIV, The Influence of Bank Supervisory Policies on the
Portfolio Policies of Commercial B a n k s...................

195

XXV, The Pros and Cons of Dividing Administrative R e
sponsibilities for Bank Examination and Supervision
Among Different A u th orities.........................................

199

Part Two

THE TREASURY ANSWERS

I, National Economic Objectives and Their Reliance on
Fiscal P o l ic y ....................................................................

207

n. Reliance upon Changes in the Tax Structure to In
crease the Effectiveness of the Financial System, . .

212

III, The Relationship of the Federal Debt to the Attain
ment of National O
b
j e
c t i v
e
s

220

IV. The Relationship of Debt Management Policy to
the Attainment of National Objectives...................
V. What Debt Structure Should the Treasury Have as
a Target?,....................................................................
VI. Minimizing the Interest Cost of the Debt..............

VIL Reducing or Expanding the Treasury’ s Authority
to Manage the Public Debtand Market New Issues

231

vm . Changes Needed to Permit the Treasury to Mar
ket Its New Issues on a More Satisfactory B asis.

233

IX. Possible Changes in the Treasury’ s Securities
Market Needed to Make Outstanding Securities
More Readily Transferable.....................................

235

X. Speculation in the Treasury’ s Securities M arket.

240

XI. Insulating the Treasury’ s Securities Marketfrom
the Capital Market.....................................................

242

XII. How Fiscal and Debt Management Policies are
Influenced by International Considerations...........

243

XIII. Changes in the Management of Treasury Cash
Balances....................................................................

245

XIV. How Fiscal and Debt Management Policy Can
Contribute to Growth Beyond Stabilizing Employ
ment and the Price L evel........................................

248

XV-XVII. Independence of the Federal Reserve System;
Responsibility for Debt Management and Mone
tary Policy; and Coordination between Congress,
the Federal Reserve System, the Treasury, and
Other Departments and A gencies...........................

249

APPENDIX;

253

Debt Management and Advance Refunding . . .

Part One

THE FEDERAL RESERVE ANSWERS

QUESTION I

What are the processes and procedures that are in
volved in the formulation and the execution of monetary
policy? That is, given the customary credit control
instruments and the ultimate objectives of price stability,
high level employment, and economic growth, how is
monetary policy formulated in the short run? For in
stance, what sort of factors are weighed in determining
current policy, what guides are utilized, and what are the
immediate objectives of policy?
Among the points of interest within this context are such
factors as the meaning and importance attached to the
general notion of liquidity inthisdecision-makingprocess; what specific considerations are looked at in evalu
ating the current adequacy or inadequacy of the money
supply; and whether influence on the level and structure
of interest rates is ever an objective of policy?

THE FEDERAL RESERVE ANSWERS

ANSWER I

Summary
Formulation and execution of monetary policy is a continuous
process. The ultimate objectives are, as the question states, price
stability, high level employment, and sustained economic growth.
The processes and procedures through which policy is executed
in the short run are necessarily more specific than these broad
goals, but they can never be dissociated from them.
The first section of this answer considers the nature of mone
tary policy decisions made by the Federal Reserve, with specific
reference not only to the liquidity and reserve position of banks and
the expansion of bank credit and money, but also to the relationships
between the money supply, the use of money, the over-all liquidity
of the economy, and interest rates. The second section discusses
briefly the principal elements of economic developments in general—
demand, employment, prices, and financial flows—that are con
sidered by the Federal Reserve authorities in determining monetary
policies. The third section deals primarily with more specific
operating guides and procedures that determine day-to-day and other
short-run operations by the System in the open market.1
Continuous review of economic and financial developments is a
prime essential for policy formulation and execution. Implicitly in
volved in the consideration of policy are three interrelated ques
tions: In what respects is the whole constellation of past and
prospective events, as seen at a given moment, contributing to or
detracting from price stability, high level employment, and economic
growth? In what respects does it lie within the power of the Federal
1Further more detailed discussions of most of these points are
given in answers to other questions.
Many aspects of these various matters are discussed—in some
cases more fully—in statements presented by the Chairman of the
Board of Governors of the Federal Reserve System to the Joint Eco
nomic Committee of Congress in 1959. See particularly Study of
Employment, Growth, and Price Levels. Hearings, Part 6A, pp.
1233-35, and Part 6C,pp. 1765-77,1785-87, and 1800-04. A thought
ful analysis of much the same problems is given in the Memorandum
^E vidence presented by Winfield W. Riefler to the Radcliffe Committee; see “ Committee on the Working of the Monetary System*
g m sip a l Memoranda of Evidence (T^nHrm- Her Majesty’ s Stationery

QUESTION I

Reserve to set forces in motion, either to foster the attainment of
these goals or to counter any threats to that achievement? What
specific action should the Federal Reserve take?
Whatever broad influences may flow from their actions, the
Board of Governors and the Federal Open Market Committee are
fully aware that the particular economic or financial variable over
which they have anything approaching full and direct control is the
total of commercial bank reserves. Through this control, they exert
a strong influence directly on total loans and investments and total
deposits of banks and indirectly some influence on spending, in
vestment, and saving by the public in general, At any given moment,
therefore, the choice for Federal Reserve policy lies between vari
ous degrees of restraint upon or encouragement to expansion of
bank credit through altered reserve availability.
Decisions on the degree of restraint or encouragement to be
imposed on bank credit expansion are translated into action prin
cipally through Federal Reserve open market and discount oper
ations, with occasional use of changes in reserve requirements and
other instruments of policy. Open market operations affect the re
serve position of the commercial banks. The bulk of such operations
are fo r the purpose of offsetting the effects of other factors that
affect the availability of reserves, most of which are of a temporary
or special nature. The net effect of System operations and these
other factors determines the availability of reserves for credit
expansion.
Federal Reserve open market operations also have other direct
and immediate effects upon interest rates in money markets, the
money supply, and the general liquidity of money holders. Since
these effects are intertwined with other market forces, they are not
predictable or measurable. Much greater ultimate effects arise
from the action of banks in adjusting their loans and investments to
their changed reserve positions and then in turn from the actions
of borrow ers and depositors in adjusting their uses of funds to the
changed availability of bank credit. The over-all magnitude of these
adjustments with respect to total volume of loans and investments
and of deposits at banks is roughly controllable by Federal Reserve
policies. Flows of other funds, however—evolved over time from
accumulated savings and outside the control of the banking system—
are of much greater magnitude and generally of greater influence
in determining the course of the economy than are those deriving
from changes in the volume of bank credit. The ultimate flows of
all these funds into particular uses are beyond the direct control of
the Federal Reserve. Nevertheless, changes in the availability of
bank credit have a marginal influence upon money flows and upon
interest rates that, if not properly controlled, can affect economic
stability adversely.

THE FEDERAL RESERVE ANSWERS

Monetary policy exerts its influence largely through the quan
titative vehicles of control over the volume of bank credit and
money. Through this channel monetary policy affects the over-all
liquidity of the economy and interest rates, which in turn influence
saving and spending. In determining particular policy actions, con
sideration must be given not alone to the volume of money but also
to the rate and manner of use of the funds-as reflected in interest
rates, in the over-all liquidity of the economy, and in the total vol
ume of monetary transactions. Efforts must be directed toward
adjusting the volume of bank reserves so as to influence, or to
correct for, these forces in ways most conducive to the mainte
nance of price stability, high level employment, and economic
growth. It must always be recognized, however, that monetary
policies alone should not be expected to assure the attainment of
these objectives. Monetary policies cannot be relied upon to correct
for imperfections in the economic structure or for imbalances
resulting from actions by others—whether in the public or the pri
vate sector.
The Nature of the Monetary Policy Decisions Made by the Federal
Reserve
Authority for making monetary policy decisions is shared by
the Board of Governors, the Federal Open Market Committee, and
the' directors and officers of the twelve Federal Reserve banks.
Decision as to the current posture of monetary policy is usually
evolved at periodic meetings of the Federal Open Market Committee.
These meetings, which generally are attended by the members of
the Board of Governors and all Federal Reserve bank presidents,
since May 1955 have been ordinarily held at intervals of three weeks.
Although this Committee has specific responsibility for directing
the conduct of open market operations, other related policy actions
are often discussed at meetings of the Committee, and such actions
are determined in the light of the general policy position determined
by the Committee.
At each meeting, the Committee makes a decision as to the de
gree of restraint or encouragement that should be imposed on bank
credit expansion. Because of the complexity both of the forces at
work in the money market and of the interrelations between devel
opments in the money market and the course of economic and fi
nancial events in the economy as a whole, the decisions of the
Federal Open Market Committee with respect to the current em
phasis of policy are necessarily expressed in general terms.
The formal record of their decisions is embodied in the policy
directive given to the Federal Reserve Bank of New York, which
executes transactions for the Federal Open Market Account, These
directives, together with a record of the reasons for their adoption

QUESTION I

and of somewhat more specific views as to their current application,
are published for each year in the Board’ s Annual Report, The
Account Management is guided by this record, as well as by the
formal directive, in conducting specific operations to effectuate
policies.
Bank credit and the money supply. In operational terms, the
principal immediate effect of Federal Reserve actions is to control
the supply of reserve funds available to the commercial banking
system. On the basis of these reserve funds, the banks make loans
and investments, which result in the creation of the bulk of the cash
balances that the public holds. Changes in commercial bank credit
comprise only a fraction of the total flow of saving and credit in
the economy, and changes in the amount of Federal Reserve credit
are only a fraction of the changes in commercial bank credit.
Federal Reserve and commercial bank credit operations, however,
through their indirect effects play a distinctive role in the savinginvestment process and in the shaping of the flow of income, ex
penditure, and output in the economy as a whole.
The banking system as a whole differs from other financial
institutions in that commercial banks as a group by expanding or
contracting credit largely determine the total supply of money avail
able to be held in cash—currency or bank deposits. This is true
because the money made available by the extension of bank credit—
however used—must at every moment find lodgement in some bank
either as a deposit or in retirement of bank credit (unless held in
currency or taken in gold). The amount of money that can be created
is a multiple of the reserves made available by the Federal Reserve
and is limited by the amount of such reserves that are available.
No single financial institution, however—bank or nonbank—can
lend or invest more money than is left with it, and no individual
can invest more than he saves or borrow s. When expansion of bank
credit exceeds the amounts the public wishes to retain in the form
of money balances, the excess balances are likely to result in an
expansion of spending. Restriction on bank credit expansion to a
rate less rapid than that at which the public wishes to increase its
money balances will likely lead the public to reduce spending and
increase saving in an effort to establish the desired level of money
balances.
Since the impact of monetary policy on the economy is trans
mitted through changes in bank credit and the money supply, it is
essential for policy formulation that there be continuous assessment
of the adequacy of these magnitudes. This is not an easy task, but
it is one that the Federal Reserve, with its power to control the
creation of credit and money, must endeavor to perform .

THE FEDERAL RESERVE ANSWERS

Since the Federal Reserve cannot control the uses that are made
of money at the initiative of banks or other holders, monetary policy
decisions must be based upon judgment as to the total amount of
bank credit and money that is appropriate at any time. Policy can
not be directed toward enabling banks to meet all demands for
credit, or any particular demand, that might develop under any
conditions* This could result in an undue stimulus to spending and
investing, which would derive, first, from increased spending grow
ing out of bank credit expansion and, second, from the creation of
a redundant money supply, i.e., excessive liquidity. Special prob
lems arise when some particular type of credit tends to expand at
an unsustainable pace or for other reasons threatens the mainte
nance of economic stability. Such instances raise a question as to
whether restraints on total credit expansion should be exercised
or whether more selective controls can and should be imposed.
Bank liquidity. The Federal Reserve exerts its influence upon
the availability of bank credit, upon the money supply, and upon
interest rates, almost wholly by influencing bank liquidity— in
contrast to using other types of measures such as direct control
of bank lending and investment or direct control of interest rates.
In the United States, therefore, bank liquidity—to be distinguished
from liquidity of the economy in general—plays a special role in
financial and economic processes.
Bank liquidity consists of various elements which maybe divided
into two broad groups—primary and secondary. Primary bank
liquidity relates to the net reserve position of commercial banks.
The secondary liquidity of banks resides in their holdings of certain
liquid assets, often called secondary reserves, which can be readily
liquidated by a bank in order to meet deposit drains or adjust pri
mary reserve positions. These liquid assets include short- and
medium-term Government securities, loans to securities dealers,
bankers* acceptances, other short-term open market paper, and
balances with other banks. Before the 1930’ s call loans, bankers*
acceptances, and interbank balances were the principal secondary
reserves; today short-term Government securities are predominant.
The over-all liquidity of a bank is determined by the distribution
of its loans and securities between liquid and nonliquid or less
liquid components, by the volume of its borrowings, by its capital
position, and by the nature of its deposits. Accurate measures of
liquidity call for complex and variable formulas .Secondary liquidity
of banks is not subject to direct influence by the Federal Reserve,
but the Federal Reserve may exert an indirect effect through its
°*®r Primary liquidity and over total expansion of bank
credit, although the effect would depend on actions by the banks
themselves with respect to the illiquid portion of their assets. For
example, an increase in member bank reserves wouldpermit banks

QUESTION I

to improve liquidity by expanding secondary liquid assets, while
also increasing their illiquid assets by a smaller proportion. A de
crease in reserves, necessitating a reduction in total assets, would
mean a decrease in liquidity to the extent that the reduction was
effected in liquid assets.
Measurement of the primary liquidity position of banks requires
consideration of both positive and negative elements. Positive pri
mary liquid assets consist of balances held by banks with Federal
Reserve banks. For liquidity purposes, i.e., for meeting drains on
deposits and reserves, reserve balances held in excess of require
ments are generally a more significant and useful measure than
total reserves. Banks’ holdings of coin and currency may also be
considered as a part of primary liquidity, but as a rule these hold
ings are kept at the minimum needed for operating purposes.
Beginning in 1960, all of these holdings could be counted as required
reserves.
The negative element of primary liquidity for banks arises from
member bank borrowings from the Federal Reserve. These provide
a vital element of elasticity in the process by which bank credit ex
pansion is restrained or encouraged. Such borrowings, which are
obtained at the initiative of the member banks, serve to cushion,
where necessary, the impacts on total bank reserves either of
Federal Reserve operations or of other factors.
By tradition and by Federal Reserve administration, the cushion
provided by member bank borrowing is an elastic one, in the strict
sense of the word “elastic,” meaning that the greater the use of the
cushion, the greater the reverse pressure set up on the borrowing
banks to adjust their investment and loan policies and so get out of
debt to the Reserve Banks. It is for this reason that member bank
borrowing can be regarded as a negative element of bank liquidity
that should be deducted from excess reserves to measure the net
liquidity position of an individual bank or of the banking system.
The degree of restraint exerted by member bank borrowing may be
varied by raising or lowering the discount rate charged on such
borrowing, relative to rates of interest that banks may receive,
particularly on secondary liquid assets.
The Federal Reserve restrains (or encourages) bank credit ex
pansion by reducing (or increasing) the banks* primary liquidity.
This is ordinarily accomplished through open market operations.
At times changes in reserve requirements may be employed to re
lease or absorb reserves. The effect of these actions, after allow
ance for the various other factors that influence the availability and
use of reserves, may be reflected either in excess reserves or in
member bank borrowings at the Reserve Banks, The over-all result
for bank liquidity is commonly measured by the figure of “free

THE FEDERAL RESERVE ANSWERS

reserves* or “net borrowed reserves,8 which is d e r iv e d by sub
tracting borrowings of all m e m b e r banks at the Reserve Banks from
excess reserves of member banks.
For individual banks, interbank borrowing for reserve adjust
ments has roughly the same effect on the borrowing bank as borrow
ing from the Federal Reserve. It differs, however, in its effect on
the credit system as a whole in that no additional new reserves are
made available to the banking system as a whole and no debt is in
curred to the Federal Reserve. In our system of thousands of unit
banks, interbank operations—such as interbank balances, borrowing,
and the buying and selling of “Federal funds*—provide mobility to
funds that might otherwise be temporarily immobilized. The lending
bank gives up primary liquidity for the secondary liquidity repre
sented by the asset it acquires, while the borrowing bank obtains
the reserves it needs and incurs a debt, not to the Reserve Bank
but to another member bank.
The effectiveness of the deterrent to bank credit expansion that
is inherent in a reduction in the aggregate net primary liquidity of
the banking system as a result of open market operations is enhanced
by the repercussions through the banking system of actions that in
dividual banks take to adjust their reserve positions, whenever these
actions take a form that involves depositors of other banks. For
example, pressures are transmitted from bank A to bank B, when
ever a depositor of bank B purchases securities sold by bank A.
Similarly, in expansionary phases, additions to bank liquidity by
Federal Reserve actions are transmitted through the financial struc
ture and act as an encouragement to monetary expansion.
The existence of an extensive and efficient nonbank market for
Treasury bills and other short-term Government securities con
tributes greatly to the effectiveness of Federal Reserve restraint
on or encouragement to bank credit expansion. Among bank deposi
tors, there are always ready buyers, at a price, for the securities
sold by the Federal Reserve in its open market operations and for
the securities sold by member banks endeavoring to adjust their
reserve positions. Thus the supply of funds available for other uses
may be reduced. Likewise, when banks have excess reserves but no
present loan demand, they can bid short-term Government securi
ties from nonbank holders and thus add to the supply of money. This
addition to the money supply is likely to seek other uses.
Federal Reserve open market operations that effect cyclical or
I01™ rn I ™ * ? i n bank reserve positions are ordinarily only
* Federal Reserve transactions in the market
S S h w c° urse °f a ye.a r- The bulk of these transactions are d i,
ar counteracting the effect of various largely temporary
factors that influence the availability of or need for reserves.

QUESTION I

These transactions are essential to prevent such temporary factors
from causing wide money market shifts that would unduly interfere
with the attainment of broad objectives. Ordinarily policy shifts are
effected over time through relatively small adjustments in the large
operations conducted for short-term purposes.
Generally it can be assumed that additions to the supply of re
serves will provide the basis for an expansion of bank credit and
bank deposits by a fairly constant multiple. Small variations in the
multiple expansion ratio may occur, however, as a result of shifts
in the relative proportions of deposits subject to different reserve
requirement ratios, the relative preference of the public as between
currency and deposits, and fluctuations in the amount of excess re
serves that banks choose to hold. On the basis of the present dis
tribution of deposits, the multiple expansion ratio averages nearly
seven to one for demand deposits at member banks.
Long experience has shown that any departure from a relatively
steady ratio between bank credit expansion and the reserves supplied
at Federal Reserve initiative sets forces into operation that tend to
encourage bank credit expansion when free reserves exist and to
restrain bank credit expansion when net borrowed reserves exist.
In a period of vigorous credit demands, for example, the Federal
Reserve may increase the restraint on bank credit expansion by not
providing through open market operations all of the reserves de
sired. A s a consequence banks would be forced either to increase
their borrowings at the discount window or to limit their credit
expansion. Conversely, in a period of contraction, the accompanying
decrease in required reserves brings about an increase in excess
reserves or permits banks to reduce borrowing, thereby encourag
ing credit expansion or relaxing restraint without Federal Re
serve action.
The significance at any given time of net borrowed reserves
(or free reserves) as a factor tending to restrain (or encourage)
bank credit expansion depends on at least five things: (1) the mag
nitude of the free reserves (or net borrowed reserves); (2) the level
of short-term money rates relative to Federal Reserve discount
rates; (3) the vigor of actual current demands for bank credit; (4)
the existing level of total bank liquidity; and (5) the variations among
different classes and groups of banks with respect to the conditions
just named.
Federal Reserve decisions to impose a certain degree of re
straint or encouragement on expansion of bank credit and money are
something very different from a precise determination of the actual
expansion of bank credit or of the money supply. Rather, these de
cisions relate to the setting into operation of forces to resist or
accentuate other forces that affect the course of bank credit. The

THE FEDERAL RESERVE ANSWERS

state of bank liquidity at any given moment and the changes in
liquidity that are constantly occurring influence the level and
structure of interest rates. This effect is reflected primarily on
short-term money market rates and secondarily, sometimes with a
considerable lag, on bank lending rates. Ultimately, because of the
fluidity of financial markets, the whole structure of interest rates
is affected, although, as elsewhere explained, the particular pattern
of rates is largely determined by other forces in the credit markets.
The use or velocity of money. Changes in the volume of bank
credit and the money supply are not determined by the banking sys
tem alone but also depend upon decisions of borrowers as to credit
demands. Changes in the use of money grow principally from the
decisions of borrowers, of holders of money, of spenders, and of
nonbank lenders. From the standpoint of performance of the econ
omy, it is not the holding of money but the use of money that counts.
Amounts held, to be sure, may influence decisions as to the use of
money. If new money created keeps moving to holders who do not
want to hold more cash, the flow and the turnover of money can ex
pand rapidly. Experience shows that the rate of use or velocity of
money varies significantly over short periods of time, as well as
over long periods.
Even though Federal Reserve operations exercise their influence
primarily through the quantity of bank credit and the money supply,
policy decisions cannot be made exclusively in terms of the level
or rate of change of the money supply. Monetary policy must take
into consideration variations in money turnover, which have an im
portant influence on the course of economic events. Variations in
money turnover need not be considered as a bar to the effectiveness
of monetary policy if policy formulation takes them into consider
ation, although they may at times complicate its task,
ffeneral liquidity, A related reason why Federal Reserve policy
ecisions cannot be made solely in terms of money supply goals
is that.economic decisions are influenced by all elements of liquidity,
other assets as well as of money balances.
The concept of general liquidity used here refers to liquid asset
i f ” onbankin& sectors of the community. Decisions of
n™ i
*B are likely t0 be affected by the degree of their

q S t ^ v e ? t ! m l.

POint ln time “ d by variations ln their 11-

abiu£Ito tS ! 8« ? rta8f etS P0SSf SS W i t t e s of liquidity, namely the
little or no risk n /v ,
?°?vert ^ means
payment at will, with
limp deDosits at hnnfcSS m/ aoe yalue. Some types of assets, such as
redeemable at fixed v S u e s ^ T h f
1° anassociation shares, are
position to assure liquidity f i r

QUESTION I

of assets, liquidity depends upon shiftability among holders, or
marketability, whereby holders of such assets wanting spendable
funds may exchange these assets for the idle cash balances of others
without the creation of new money. Short-termpaper of high credit
worthiness offers such liquidity. In addition, assets, such as long
term bonds, which otherwise would not be classified as liquid, might
be given liquidity by Federal Reserve action. If the Federal Reserve
should follow a policy of purchasing any particular assets at prices
that would not penalize offerings, then such assets in effect become
as liquid as money.
Particular actions available to the Federal Reserve to restrict
general liquidity outside the banking system are limited. Regulation
of margin requirements, which reduced trading on brokers* credit
to minimal amounts, has effectively limited the volume of stock
market call loans, which before the I930*s provided an important
type of liquid asset. Liquidity of time deposits at commercial banks
can be restricted to some extent by rules as to conditions of with
drawal, which are incorporated in regulations relating to reserve
requirements and to payment of interest on such deposits. The
Federal Reserve, however, has no similar power with respect to
deposits at mutual savings banks or to shares of savings and loan
associations.
Because of the predominant position of short-term Government
securities in the holdings of noncash liquid assets—and also because
of their importance in money market adjustments—debt manage
ment policies of the federal government may exert highly important
influences on the use of money and on general liquidity. This in
fluence may be exerted through shifts in the maturity structure of
the public debt available to others than the Federal Reserve and
federal government funds. The practice of some governmentally
chartered agencies of selling short-term obligations in order to
make long-term loans may also have an influence.
The Federal Reserve can, to some degree, affect the maturity
distribution of the public debt held by the public—bank and nonbank—
by changes in System holdings of particular securities. Operations
for such purposes, however, are restricted, in part because of the
need to maintain a high degree of liquidity in the System portfolio
to make possible its large short-term variations, and in part be
cause of the uncertain effects on the functioning of the Government
securities market. For these reasons Federal Reserve operations
in Government securities are conducted principally with a view to
affecting the volume of bank reserves and are usually confined to
the short-term sector of the market, which is broader and more
flexible than other sectors.
For the month-to-month decision-making of the Federal Open
Market Committee, the changes in noncash components of general

THE FEDERAL RESERVE ANSWERS

liquidity that are most directly relevant are those that are most
closely related to current changes in the money supply. If an
crease in the money supply occurs through bank acquisitions of
Treasury bills from nonbank holders, the degree of general (nonbank) liquidity rises, although aggregate nonbank holdings of all
types of liquid assets do not. Conversely, if the banks to expand
loans sell short-term Government securities to nonbank holders,
general liquidity may rise even without an increase in the money
supply. Shifts between demand and time deposits have a similar
sig n ifica n ce , although the impact on s e c u r it ie s markets and interest
rates may be somewhat different.
Transfers of security holdings between banks and nonbank hold
ers, or among nonbank holders in exchange for deposits, it may
be noted, provide some of the characteristic processes by which
monetary velocity may increase during a period of economic ex
pansion and rising interest rates or decrease when interest rates
decline. An increase in noncash liquidity outside the banking system
is not necessarily a hindrance to or a limitation on the effectiveness
of monetary policies. It may imply merely that the public wishes
to hold such assets rather than idle cash balances. Or it may, under
some conditions, imply that more restraint is required than would
otherwise be necessary upon the creation of additional money through
bank credit expansion. To the extent that credit demands are being
met through the borrowing of savings other than through the banking
system there is less need for bank credit expansion. Such expansion
might add excessively to the volume of cash balances.
If nonbank holders desire to shift from other liquid assets to
money, monetary policy should be designed to discourage or fa cili
tate such shifts, according to the prevailing state of economic a c
tivity, If there are pressures on resources, the creation of additional
money is restrained and holders of assets desiring to obtain cash
have to find buyers other than banks. In periods of slack in economic
activity, on the other hand, monetary policy attempts to increase
general liquidity by making reserves more readily available to
banks, and through this to encourage expansion in bank credit and
the money supply. In essence, it may be said that Federal Reserve
policies influence general liquidity by influencing the availability of
money, rather than by attempting any direct regulation of nonbank
holdings of other types of liquid assets.
Financial developments in the United States in 1959 and 1960
provide an example of a situation in which monetary policies were
adapted first to large increases in credit demands, in nonbank lend
ing, in general liquidity, and in monetary velocity, and then to a
shift m these tendencies. In 1959, exceptionally large amounts of
credit demands—both government and private—were met with little
or no expansion in the money supply. Banks provided substantial

QUESTION I

amounts of short-term loans to businesses and individuals, but
obtained the funds to meet these demands by selling Government
securities to nonbank buyers. Nonbank lenders absorbed not only
these sales of securities by banks but also large net additions to the
outstanding public debt, and they increased their holdings of other
assets as well. The funds for these purposes came in part from
current savings and in part from activation of already existing cash
balances, which had been built up during 1958, when monetary policy
was directed toward encouraging monetary expansion. In 1959 funds
were attracted into uses other than cash holdings by the higher in
terest rates that resulted from the pressures of the large credit
demands along with restraint on bank credit expansion.
Under these circumstances, adequate credit was available to
maintain a high degree of economic activity without creation of ad
ditional money that could have exerted undue pressures on available
resources. This experience is an example of how monetary policy
can be effectively applied in limiting unnecessary expansion of bank
credit and creation of money when credit and liquidity needs are
being otherwise met.
During i960, in contrast, credit demands declined considerably
from the record level of 1959, reflecting not only a shift from a
large federal government deficit to a moderate surplus, but also a
decrease in private credit demands. Monetary policy shifted grad
ually from restraint to encouragement of bank credit expansion.
Interest rates declined. Banks met a moderate, though reduced,
loan demand and added to their holdings of Government securities,
while reducing their borrowings from the Reserve Banks. The money
supply declined somewhat in the first half of the year but increased
in the last half; the public’ s holdings of time deposits and savings
association shares increased considerably; but nonbank holdings of
U.S. Government securities declined. Monetary velocity, however,
was maintained at a higher level during 1960 than in previous years.
General liquidity of the nonbank public, as measured by holdings of
liquid assets, which had been built up greatly in 1958 and 1959,
showed a much smaller growth in 1960, but indebtedness also in
creased less.
Interest rates. Interest rates serve as an essential allocator of
resources in the whole process of saving and investment, and in the
day-to-day functioning of the money and credit system. Changes in
interest rates and concomitant changes inbondprices have pervasive
influences on incentives to invest and save.Individuals, businesses,
and financial institutions, as borrowers or investors, are all likely
to be affected in some degree by changes in the cost of borrowing
money or in the capital value of their financial assets. Since the
impact of changes in interest rates on borrowing costs and capital

THE FEDERAL RESERVE ANSWERS

values ultimately influences spending and saving decisions, mone
tary policy by influencing interest rates can have an effect on these
decisions.
The level and structure of interest rates prevailing in credit and
capital markets at any given time reflect a complex interplay of
demand and supply forces. Creditandmonetarypolicy, which affects
primarily the quantity of bank reserves and in turn the volume of
bank credit and the money supply, functions as only one supply fa c
tor in interest rate determination. The great bulk of the supply of
funds available for lending arises from the savings of the p u b lic past and current; bank credit usually comprises only a small portion
of the total. It is often a marginal factor, the importance of which
may vary according to the state and composition of economic activ
ity and expectations.
Monetary policy, it seems clear, can never be the sole determin
ant of the credit supply and therefore of the supply forces that
influence interest rate levels. In other words, it cannot at will
determine the level and pattern of interest rates through its influ
ence on supply. Monetary operations necessarily have to permit the
interplay of total demand and total supply forces to be reflected in
interest rate changes. As is described below in the discussion of
Federal Reserve operating guides and procedures, rate changes
often provide monetary authorities sensitive clues to the direction
and intensity of pressures in the credit markets.
Federal Reserve actions to implement monetary policy are
generally focused on the volume and availability of bank reserves
rather than on any particular level or pattern of interest rates.
Federal Reserve actions designed to impose or maintain a desired
degree of restraint or encouragement on bank credit expansion con
sist principally of market operations in short-term Government
securities. Operations in short-term securities have minimal di
rect effects upon the structure of securities prices and interest
rates, although the indirect impact on the level of interest rates
arising from the effects of System operations on bank credit expan
sion may be substantial. The nature of these indirect effects is
determined by the market itself.
Under some circumstances, however, monetary policies may for
a short period be purposefully directed toward cushioning supply or
demand changes tending to have temporarily disturbing effects on
market patterns of interest rates. This may occur, for example,
during a period of Treasury financing or when some seasonal or
similar temporary influence is affecting rates to an excessive de
gree. International movements of funds that can be attributed to
interest rates differentials may call for policies aimed particularly
at influencing interest rates. There may also be cyclical develop

QUESTION I

ments in which operations directed toward affecting the structure
of interest rates may appear to be appropriate.
As a matter of general practice, however, Federal Reserve
policies are administered so that basic changes in the saving/in
vestment relationship and variations in demand and supply among
different segments of the market can be reflected in changing levels
and structures of interest rates.
Principal Factors Influencing Policy Decisions
Decisions made by the Federal Open Market Committee as to
the degree of restraint or encouragement that should be imposed on
bank credit expansion cannot be interpreted or illustrated by any
precise mathematical formula. The process of decision-making
proceeds by successive approximations. That is to say, the Com
mittee reviews at each meeting information covering a wide range
of economic and financial developments, and form s a judgment as
to whether its previous decision regarding the degree of restraint
or encouragement of bank credit expansion was in fact appropriate
or not, and whether it is still appropriate. If it is not, the Committee
then considers what changes should now be made in direction or in
degree of encouragement or restraint on bank credit expansion.
Information required for the broad and continuing analysis of
economic forces pertinent to policy decisions is almost unlimited
in scope. Information available at any time is limited and judgments
must often be based on incomplete facts. Even more important than
the information itself are the judgments that must be made in in
terpreting the data: for example, judgments as to the stage of the
business cycle the economy has reached, involving views as to
whether consumption, saving, and investment are in balance or are
showing signs of disequilibrium; judgments as to the climate of
expectations about price movements, equity values, and interest
rates; and judgments as to the trend of the international balance of
payments. It is in the light of judgments such as these that decisions
must be reached as to the appropriate degree of restraint or en
couragement to be imposed on expansion of bank credit.
Price stability and economic growth. Basic to the formulation
of monetary policy are the national objectives of price stability,
high level employment, and economic growth. Satisfactory achieve
ment of these objectives depends on actions of the Congress and the
Executive and on actions of people in all walks of life. Disturbances
to economic stability and growth may arise in many ways. Gener
ally, the roots of the trouble develop long before overt signs are
clearly seen. In an industrial economy, growth tends to proceed
irregularly through cycles of advance and recession or pause. Some
cyclical variation may be the unavoidable result of the self-correcting

THE FEDERAL RESERVE ANSWERS

forces of the market system. A flexible price system is essential
for maintaining balance between production and consumption of
particular goods and services. At times structural imbalances de
velop that cannot be corrected by general public policies.

The task of public policies is to endeavor to detect forces of
disturbance and to temper excessive movements in one direction or
another so far as
Federal Reserve powers contribute most
p o s s i b l e .

to the achievement of the national objectives of price stability, high
level employment and economic growth when they are so exerted
as to minimize price inflation or deflation, to damp down expecta
tions of sudden and violent changes in commodity prices or in equity
values, and to prevent unsustainable expansion o r discourage harm
ful contraction in bank credit. The immediate task of Federal Re
serve policy is to decide upon the degree of restraint or encour
agement to be imposed on bank credit expansion consistent with
achievement of national objectives. This may mean helping to check
unstabilizing developments in the economy influenced by credit
factors when they become apparent. It also means helping to prevent
such disturbances from occurring.
Federal Reserve policies, it needs to be kept in mind, are ex
erted through influencing the total volume of bank credit and money.
It lies beyond the powers of the Federal Reserve to promote growth
of particular segments of the economy without affecting other seg
ments in ways that may or may not be desirable. It is likewise dif
ficult or impossible to restrain particular activities without exerting
general restraint.
Clearly actions by the Federal Reserve alone cannot assure the
attainment of the broad national objectives. Attempts to assure con
tinuous stimulation of over-all growth through bank credit expansion,
regardless of other developments, might incur the risk of inflation
ary or speculative developments that would be unsustainable and
thus create instability and unemployment or they may merely r e
sult in the accumulation of idle cash balances with little perceptible
effect in the economy. Monetary policies cannot be expected to pre
vent or correct imbalances that might develop as a result of par
ticular governmental actions, of structural imperfections in the
economy, or of mistakes of judgment made by private businesses
or individuals with respect to the amounts and prices of goods and
services they offer. It may at times be unwise to endeavor through
monetary policies to prevent the adjustments in the economy that
such imbalances may inevitably entail, although Federal Reserve
actions might help to ease the adjustment process. Any such im
balances and their causes must at all times be taken into consider
ation m determining policies. Their existence may call for more
restrictive, or justify less restrictive, policies.

QUESTION I

It follows that in formulating policies the Federal Reserve
authorities must be cognizant of developments with respect to
production, employment, and prices, as well as the financial vari
ables more directly affected by monetary policies. They must ap
praise the course of developments and make judgments as to any
emerging imbalances and their causes. These analyses require
the assembly and interpretation of a large amount of information
in many aspects of the economic situation—foreign as well as
domestic.
The flow of funds. Broad influences of monetary policy, reaching
beyond the money market to affect economic and financial develop
ments in the economy at large, can be traced through two sets of
channels of cause and effect: on the one hand, those connected with
bank lending and investment, and on the other hand, those connected
with changes in the liquidity of the economy. It is never possible
to trace these two sets of influences in complete detail. They are,
moreover, an integral part of the broader complex of the flow of
funds that reflects changes in income and consumption, saving and
investment, and portfolio management.
Monetary policy is more or less limited in the scope of its direct
influence. It operates through the channel of bank credit, which con
stitutes a relatively small portion of total credit and the total flow
of funds. Over the past ten years since the Treasury-Federal Re
serve Accord, the net increase in the total of credit and equity
market instruments has generally been between $30 billion and $60
billion a year, while the amount supplied by the com mercial banking
system has averaged about $6 billion. Of total bank credit only about
half is reflected in a growth of the money supply, as narrowly de
fined to include demand deposits and currency; the remainder rep
resents savings held in the form of time deposits and bank capital.
The bulk of funds for investment or other borrowing comes from
savings other than those created by or channeled through the bank
ing system.
In exerting a direct influence over the total of com mercial bank
loans and investments, however, monetary policy may play a m ar
ginal role in the flow of funds and in the saving/investment rela
tionship, Maintenance of equality between total investment outlays
and the amount of voluntary saving that corresponds with a high
employment level of income at stable prices is an essential for
sustainable economic growth. Monetary policy, by restricting the
creation of additional bank credit and permitting interest rates to
rise at times of relatively full utilization of resources when invest
ment outlays are tending to press unduly against the flow of volun
tary saving, aims both to restrain investment outlays and to encourage
saving. In periods of recession or slack, monetary policy helps to
encourage investment and other spending by making bank credit

THE FEDERAL RESERVE ANSWERS

more readily available to supplement the flow of loanable funds
emanating from savers. Any other policies under the circumstances

would contribute to instability.
An important analytical device for summarizing the flow of sav-

ing into investment and for placing the various elements of this flow
in perspective, both in relation one to another and in relation to
flows of current income and expenditure, is the Board’ s compilation
of flow-of-funds accounts for the economy as a w h ole/ The flowof-funds accounts are a convenient vehicle for analyzing the
mutual impact of the various financial and nonfinancial groups in
the economy and of the adjustment process among the various finan
cial markets.
Operating Guides and Procedures
Open market operations necessary to effectuate the policies
adopted by the Federal Open Market Committee are carried out
by the Manager of the Federal Open Market Account at the Federal
Reserve Bank of New York. The Management is guided by the broad
directive that has been formally adopted by the Committee, by the
discussion of the current economic situation, and by such specific
instructions as may be expressed at the Committee’ s meetings.
The instructions given and the essential points of the discussion,
including a summary of the factors and reasons upon which the de
cisions were based, are incorporated in the Record of Policy Actions
published each year in the Board’ s Annual Report. The Manager of
the Account is expected to use his special and expert knowledge of
market conditions, along with a great amount of statistical material
on market trends in judging the specific actions needed to maintain
or bring about the conditions indicated by the Committee’ s directive.
Operations are conducted within the limits imposed by various op
erating procedures that have been adopted by the Committee.
The principal specific factors considered by the Management
in determining short-term operations may be summarized as
follows:
^This compilation is available in its present form by years since
1946 and by quarters since 1952. Figures are published quarterly
*n the Federal Reserve Bulletin. An example of its use for current
analysis is found in the text of the Board’ s Annual Report for 1959.
Availability of the flow-of-funds accounts has improved the ability
to analyze each type of credit flow to each major sector simultane*
ously in terms of (l) the total credit flow of that type, (2) the whole
pattern of capital market flows, (3) the other sources of financing
utilized by the sector, and (4) the sector’ s need for funds in rela
tion both to its income and its expenditures.

QUESTION I

(a)
Bank reserves. The particular immediate purpose of open
market operations is to keep banks supplied with a volume of re
serves adequate to support the volume of bank credit and money
considered appropriate. As previously pointed out, the bulk of
Federal Reserve operations are directed toward counteracting the
effect of various largely temporary factors that influence the
availability of or need for reserves. In the course of a year the
gross volume of System open market operations may exceed $10
billion; net changes in total holdings in any one week may equal
several hundred million dollars; and the net change from the
seasonal low point of the year in the spring to the high point in
December customarily averages about $1,5 billion.
These repetitive variations in the Federal Reserve portfolio
are almost wholly for the purpose of covering normal seasonal
movements in required reserves (resulting from similar movement
in deposits) and in currency. Large, sometimes erratic, fluctuations
in Federal Reserve float also call for some offsetting action, al
though precise offsets are generally not possible or necessary.
Fairly large day-to-day or week-to-week operations are needed
to cover these and various other temporary or occasional factors
that influence the availability of reserves. Other large changes in
System holdings over extended periods have been made to counter
act the effect of gold movements. The task of meeting these tem
porary and special needs is in essence not a policy matter, but a
technical operating problem of measuring or otherwise detecting
such variations and making prompt adjustments to them. As ex
plained later, the net amount of Federal Reserve operations
designed to cover cyclical variations and growth in credit and
monetary needs seldom exceeds $1 billion in the course of a year.
For short-term operating purposes, the essential immediate
guide is the volume of total bank reserves that is adequate to meet
the current needs of member banks for required reserves against
their deposits plus some volume of excess reserves. The volume of
reserves supplied relative to minimum needs or desires of banks
represents the degree of restraint on or encouragement to credit
expansion. The figure of "free reserves” or its negative counter
part “net borrowed reserves” provides a convenient and significant
working measure of the posture of policy at the time. This figure,
which is the difference between member bank excess reserves and
member bank borrowings at the Reserve banks at any one time, is
readily and promptly obtainable on a daily basis with a reasonable
degree of accuracy. It is also a device that is better adapted than
its components taken separately for estimating and projecting the
net impact of regular variations in factors affecting reserves.
The general level of free reserves prevailing over a period of
time may be viewed as an indicator of the degree of restraint or

THE FEDERAL RESERVE ANSWERS

ease that exists in the money market. Although figures for free or
net borrowed reserves are useful for current operational purposes,
and serve as a general indicator of policy, they must be considered
in the context of changes in the total reserve position of member
banks. The particular level of free reserves that may be needed to
achieve the objective of policy may vary from time to time depend
ing on changing economic conditions* To maintain free reserves at
some particular level might under circumstances of vigorous credit
demands mean providing reserves to meet all demands. Under con
ditions of slackening credit demands, maintenance of the same
level might mean an actual reduction in the supply of reserves or
an increase in borrowings, with pressure for credit liquidation
rather than encouragement to expansion.
(b)
Bank credit and money supply. Broader guides to policy
operations are provided by the consequences of changes in reserve
availability on the amount of total loans and investments of banks
and on the money supply. Assumptions or estimates as to these
elements underlie the current and projected figures for total re
serves and free reserves. The Open Market Committee in its de
liberations has in mind what conditions with respect to the availability of bank credit and growth in the money supply would be an
appropriate end of policy at the time.
In conducting its operations to carry out the Committee’ s de
cisions as to reserve availability, the Account Management must
adjust its operations to cover seasonal and other temporary vari
ations in monetary and credit needs, as well as in other factors
that affect reserves. Average seasonal swings in currency in c ir
culation cover a range of more than $1 billion in the course of a
year, and there are fairly wide temporary movements around holi
days; seasonal swings in required reserves ordinarily amount to
somewhat less than $1 billion (reflecting seasonal variations in the
volume of bank deposits of about $5 billion). There are also sig
nificant temporary variations in required reserves incident to
Treasury financing operations and to periodic large tax and divi
dend payments.
Growth in reserve needs resulting from monetary expansion
might average $1 billion a year, or only $20 million a week. Cyclical
movements generally amount to less than $ l billion in the course
o any 12-month period. Because of wide, purely temporary,
partly unpredictable variations in the money supply, as well as in
other factors affecting reserve needs, it is difficult to relate dayto-day Federal Reserve operations precisely to a particular level
0
® money supply. Cyclical and growth changes in reserve avail
ability are usually the net result of relatively large, partly off
setting short-term operations.

QUESTION I

(c)
Money rates. The role of interest rates both as an objective
of and as a guide to Federal Reserve policy has already been noted.
As pointed out, the Federal Reserve policies generally are directed
toward providing an appropriate volume of reserves and not toward
establishing or maintaining anyparticular level or pattern of interest
rates. Such rates are determined by the forces of the market, one
of which is the supply of bank credit. At times, however, when
special circumstances are affecting the market, the Federal Re
serve may act directly to influence prices and yields of securities.
The level of market rates is also to some extent influenced by the
Reserve Bank discount rates.
In operations to effectuate policies adopted by the Committee,
interest rate movements perform a distinctive and important function
as an index of the course of marketforces. Alterations in sensitive
money market rates, such as those on Treasury bills, may furnish
the Account Management a delicately attuned signal of market forces
and guide for the timing of operations.
Federal Reserve operations are generally so conducted as to
minimize their influence on the structure or pattern of rates. In
order to avoid unnecessary System interference with the functioning
of the market and to inform market participants of the usual nature
and scope of Federal Reserve intervention in the market, the Open
Market Committee has adopted a number of operating procedures
to be observed by the Account Management in conducting open mar
ket operations. In brief, these working rules, which may be changed
at any time by action of the Committee to meet special situations,
relate to the maturities of Government securities in which trans
actions can be conducted, to operations in securities involved in a
concurrent Treasury financing, and to operations directed toward
changing the structure of the System portfolio.

Conclusion
Federal Reserve policies, directed toward the broad ultimate
objectives of fostering price stability, high level employment, and
sustained economic growth, are determined by the policy-making
authorities of the System on the basis of a great many consider
ations. They are put into effect operationally through control over
bank reserves. It is principally through the channel of bank re
serves that Federal Reserve policies influence the volume of bank
credit, the money supply, and interest rates.
In determining the volume of operations needed at any time in
order to provide reserves adequate for changes in bank credit and
the money supply that would best contribute to the broad objectives
of policy, allowance must be made for seasonal and other temporary

THE FEDERAL RESERVE ANSWERS

variations in factors that affect the supply of or demand for re
serves. In dollar amounts these temporary variations are much
greater than cyclical or growth needs.
Decision as to the appropriate amount of bank credit and money
at any time is made in the light of a great number of variables:
supply and demand conditions in markets for goods and services,
the volume of employment and production relative to available re
sources, movement of the general level of prices, the general li
quidity of the economy, the availability of credit from nonbank
sources, the strength of prevailing credit demands, and the rate
at which the existing money supply is being used. It must be re c
ognized that bank credit supplies only a relatively small portion of
the total credit needs of the economy, but the maintenance of this
portion at an appropriate amount is of considerable marginal im
portance in helping to make possible sustainable economic growth.
Movements of interest rates are determined by the interaction
of borrowing demands of all kinds upon the available supply of
lendable funds. Bank credit is only aportionof this supply. Federal
Reserve policies and operations do not aim at long-term control of
the level or structure of interest rates. Normally the free inter
play of supply and demand forces on the course of interest rates
enables such rates to perform essential allocative functions. Interest
rate changes are an essential part of the mechanism through which
monetary policies ultimately influence the decisions of borrowers
and lenders. They serve as a significant indicator of market de
velopments that are relevant to the determination of such policies.

QUESTION II
Is monetary policy less appropriate or less effective
under conditions of “ cost-push* or “demand-shift” in
flationary pressures than under conditions of demandpull inflation? Is it possible to differentiate in practice
as to when one or the other of these situations is dom
inant?
ANSWER II
Summary
? us^ s s . flu° tuations in the United States since World War II,
while differing from one another in many ways, have had features

QUESTION II

in common with respect to the interactions of demands, output,
costs, prices, and profits. The description of these relationships
provided below indicates that the problems of inflationary pressures
arise during the expansion phase of the business fluctuations char
acteristic of industrial economies, when demands are expanding.
In the early stages of a business expansion, production and employ
ment are likely to increase without generating widespread upward
pressures on prices and costs. Continued expansion in demands
eventually generates upward pressures on prices and costs as out
put in some industries reaches high levels in relation to capacity
and unemployment is reduced. If the pace of expansion is moderate
and competitive conditions are maintained, increases in prices and
costs are likely to be confined to a relatively few markets. On the
other hand, if demands expand rapidly and expectations are ebullient,
increases in prices and costs are likely to become widespread.
With respect to the second of the two questions raised, once the
process of inflation is under way, it is usually not possible to deter
mine whether the dominant influence on prices stems from “ cost
push” or “demand shift.” Since prices of goods and services rep
resent costs to someone, increases in costs are one of the ways by
which inflationary pressures are transmitted through the economy.
At the same time, increases in some costs are promptly reflected
in income payments and thus exert an influence on demands. Through
this interaction of demands, prices, and costs, the inflationary
process is initiated, and once in operation, the demand and cost
elements interact in such a manner that they cannot be disentangled
as separate and distinct forces.
In the chain-reaction process of demands, prices, and costs,
the most direct influence that monetary policy can exert is on de
mands for goods and services. Through its influence on credit
availability and on liquidity, monetary policy endeavors to maintain
a climate of demands and expectations during business upswings
that is conducive to a high rate of utilization of available resources
without widespread upward pressures on prices and costs. Should
upward pressures nevertheless develop, monetary policy can help
to restrain them. Appropriate monetary policy can limit the funds
that may be made available through bank credit to finance the ex
pansion in demands stimulated by the income effects of price and
cost increases, by expectations, and by other forces.
When business activity is high, prices generally are advancing,
and the community expects continuing advances in prices, a mone
tary policy that restrains the use of bank credit is an appropriate
and necessary tool. Whatever the causes or the means of propagating
inflation, expansion of bank credit would influence both spending
and expectations and so would provide additional impetus to the
p rice-cost spiral. Under these conditions, individual and group

THE FEDERAL RESERVE ANSWERS

efforts to hedge against inflation or to protect against it by tying
contractual arrangements to price indexes would tend to aggravate
inflationary forces.
In appraising the effectiveness of monetary policy, a number of
factors must be considered. The formation of policy, first of all,
depends on current assessments of developing business and finan
cial conditions and, despite improvements in economic intelligence
over the years, it is not possible always to judge accurately the
strength of the forces developing. Other activities of the federal
government, furthermore, have an impact on levels of production,
employment, and income, and thus they influence needs for greater
or lesser degrees of monetary ease or restraint. These policies,
consequently, may complicate or simplify the task and they may
inhibit or enhance the performance of monetary policy. Government
policies that affect the functioning of markets and those that directly
affect prices—such as import duties and quotas and antitrust poli
cies—also bear on the effectiveness and results of monetary policy.
The degree of market power exercised by private groups also may
affect the sensitivity of markets to cur rent and prospective demands.
If monopoly power were widespread, it could have an influence on
the effectiveness of both monetary and fiscal policies in pursuing
their goals.
Nature of Cost-Push and Demand-Shift Explanations
Controversy over causes of postwar inflation has focused mainly
on developments since 1954, On the causes and nature of the epi
sodes of inflation in the earlier postwar years, there appears to be
widespread agreement. World War II left a legacy of accumulated
demands for goods of all kinds, and methods employed in financing
the war resulted in highly liquid financial positions. When wartime
price controls were removed, effective demands at current prices
were considerably in excess of supplies in virtually every market.
When the Korean War began in mid-1950, memories of warinduced shortages and price increases provoked protective buying
by consumers and businesses, here and abroad. In both periods of
inflation, costs as well as prices rose and there were large shifts
in the composition of demands, but the influence of strong demands
in originating and sustaining price advances was by far the pre
dominant one.
In the 1954-57 inflation, demands were not strong in all markets
simultaneously, and the advance in prices was moderate in com pari
son with the war-related experiences. In view of these circum
stances, several interpretations of the period since 1954 have em
phasized the independent nature of costs. Another interpretation
stressed rapid changes in the composition of demands. What is
Digitized forhas
FRASER

QUESTION II

common to these interpretations is that they have attributed primary
importance to rigidities or to autonomous elements in markets for
goods and services and have given little or no weight to the role of
aggregate demands. From these theses, further interpretation is
drawn that use of general instruments of restraint on aggregate
demands in order to check such price increases would be ineffective
or would incur unacceptable social costs in terms of unemployment
of human and material resources.
The “ cost-push* approach to the explanation of price inflation
seems fundamentally to assume that costs are more or less in
dependently determined by market power and, therefore, little can
be done about them. Prices are set by administrative decisions to
cover all costs, including a satisfactory margin of profit, without
regard to current or prospective demand conditions. Production is
scheduled to conform to sales at these prices.
In such circumstances, it is said, government policies—mone
tary and/or fisca l—must operate to provide demand sufficient to
assure maximum output and full employment at the wages that are
the result of labor-management agreements and at the prices
businessmen—and, sometimes, public agencies—deem necessary.
Otherwise, output and employment will be held or reduced below
attainable levels, but there will be no appreciable restraint on ad
vances in price levels and labor or other costs.
In practice, however, the extent to which the price of a product
can be raised is limited by actual or potential competition from
other products or from imports; these checks are strengthened by
government policies that operate to restrain demands and prevent
ebullient expectations from developing. Competitive constraints on
prices strengthen resistance to increases in costs and at times
may exert downward pressures as businessmen attempt to maintain
or increase profit margins. The influence on costs may take such
form s as programs to raise productivity, various efforts to econ
omize on the use of materials, control of administrative and other
types of salaried employment, or resistance to increases in wage
rates and fringe benefits.
The “demand-shift* explanation of the type of inflation experi
enced in the 1954-57 business expansion rests on a combination of
factors. Inflation, it is said, originates in the general excess de
mands which temporarily emerge as the economy passes from
recession to full employment, and from the excess demands in spe
cific sectors that often remain after the aggregate excess has been
eliminated. Inflation is perpetuated and spread throughout the
economy, the argument proceeds, by the influence of costs in wage
and price determination and by the relative insensitivity of prices
and costs to decreases in demands.

THE FEDERAL RESERVE ANSWERS

In this view, particularly as it relates to the 1954-57 business
expansion, demands increase and full employment is reached with
out generating upward price and cost pressures. Then, a rapid shift
in the composition of demands is reflected in excess demands in
some sectors and insufficient demands in others. Because prices
are more sensitive to increases than to contractions in demands, a
general rise results as prices advance in those sectors where demands are increasing rapidly and decline by smaller amounts or
not at all in those sectors where demands are decreasing. General
monetary and fiscal policies appropriate to combat an inflation
arising out of excess aggregate demand are not suitable, it is con
tended, to combat an inflation arising out of excess demands in
particular sectors of the economy.
The composition of demands relative to the composition of
available resources has an important bearing on developments in
business expansions. The problems of inflationary pressures, how
ever, are likely to arise well before demands and output reach the
limits of capacity, partly because the use of marginal production
facilities raises costs. Problems of inflation certainly arise before
output reaches capacity in all major sectors because resources
are not highly mobile. In 1955 and 1956, for example, output was
well below capacity in the basic textile industries but very close to
capacity in the basic metals industries. As E. A, Goldenweiser wrote
in 1941:
It should be mentioned., .that there is no clear-cut
line at which an increasing number of bottleneck ad
vances in prices passes over into a general inflation.
The development of a number of bottlenecks in many
leading commodities may be the introductory phase of
a general inflation. It can occur long before the entire
country is operating at full capacity, because neither
plant capacity nor labor supply is completely mobile.
The existence of unused capacity in some industries
may not prevent great shortages of capacity in others,
and the presence of large numbers of unskilled workers
without jobs may not prevent grave shortages in many
skilled lines. So long as these instances of shortages are
scattered and relatively few the situation is not properly
described as inflation and can be handled by nonmonetary
remedies. But it may become general long before full
capacity is achieved. It should be kept in mind that it is
the available supply of goods and not the theoretically
possible supply that must meet a growing demand in o r
der to prevent inflation.!
Goldenweiser, “Inflation,** Federal Reserve Bulletin, (April
1941), p, 292,

QUESTION II

The demand-shift approach treats the milder, peacetime infla
tions of the sort experienced in 1954-57 as something different
in kind from the type often associated with wars, whereas the dif
ference appears rather to be one of degree. The immobility of
resources is more obvious in the form er cases, but it is not con
fined to them. In the more severe inflations, immobility of resources
also limits shifts to areas of strongest demands, but its existence
and influence are concealed by the general excess of demands.
In an economy with high and rising standards of living and many
other features fostering change, demands are not likely to expand
in such a way that their composition is always in balance with the
location and types of existing plant and other resources. In business
expansions, imbalances are likely to exist, and they are not likely
to be precisely the same from one expansion to the next. Such im
balances operate to attract the newly available resources (and
savings) into the sectors of strongest demand pressures.
Patterns of Price and Cost Changes in Business Fluctuations
P rices are determined by the interaction of a number of factors
functioning continuously in many different types of markets, and
there is an unending process of market adaptation to changes in
the various factors. While business fluctuations differ from one
another in important respects, they all have features in common
with regard to the interactions of demands, output, costs, prices,
and profits. Reviewing the process of change during postwar busi
ness expansions and contractions in this country, certain relation
ships and patterns of behavior are discernible.
Periods of expansion. Early in expansions of business activity,
prices usually are rising in markets for “ sensitive” industrial
materials—that is, the materials whose prices are most responsive
to short-run changes in demand. For rubber, hides, and some other
sensitive materials, world production cannot be increased much
(if at all) in the short run in response to rising demands. As a re
sult, increases in demands are rather promptly reflected in price
advances and may alter the international flows of commodities.
Production or supply can be increased in the short run for other
sensitive materials, such as scrap metals, wastepaper, copper,
lead, zinc, and lumber. Because increases in output are accom
panied by rising costs per unit of output or because of other con
ditions of supply, expansion in demands is reflected in price rises
which provoke increases in supply. P rice trends for a group of
these sensitive materials often suggest the direction and strength
of demands before other types of data for the same time period
become available.

THE FEDERAL RESERVE ANSWERS

Many foods and foodstuffs—including livestock, poultry, and
some crops—also conform to the type of market behavior described
for sensitive industrial materials. For these, however, the response
of domestic demands to cyclical and secular income changes is
slight (the income elasticity of demand is low). Substantial changes
in output may occur, however, mainly because of variations in
weather, swings in the hog and cattle cycles, or rising productivity.
Consequently, price fluctuations for these commodities usually r e
flect changes in supplies to a greater extent than they reflect shifts
in demands.
Agricultural commodities subject to federal support programs
are largely protected from the price-depressing influence of large
increases in production. At the same time, the existence of stocks
previously accumulated in the process of supporting prices has
limited in recent years the response of prices to a crop failure
or other events that reduce production and supply.
For most industrial materials other than those described as
sensitive, supply is expansible in the short run until some relatively
high rate of capacity utilization is reached. This is true for steel
mill products, paper products, many chemicals, cement, brick, and
other materials. In the early stages of expansion, variable costs
per unit of output are not likely to rise as increases in output are
accompanied by gains in productivity and wage rates do not rise
much. Fixed costs per unit and average costs per unit decline, and
profit margins as well as total profits rise. Expansion in demands
for these materials is accompanied for a time by rising output and
supply without widespread advances in list prices. Absorption of
freight and other concessions from list prices which had developed
during the previous recession tend to be reduced during the early
stages of expansion. These changes in actual prices are not re
flected in the established price indexes, which are based mainly on
manufacturers* published price lists.
The behavior of wholesale or manufacturers* prices of most
finished industrial products in the early stages of expansion is much
like that described for the second group of industrial materials—
for similar reasons. Therefore, increases in their prices early
in expansions are likely to be restricted in scope.
Continued expansion of demands eventually generates upward
pressures of costs on prices of industrial materials in the second
or nonsensitive group and on prices of finished products. The up
turn in costs is primarily a consequence of higher levels of output
in relation to available manpower and material resources.
Contrary to the suggestion sometimes made that pressures of
demand against resources available to produce specific products

QUESTION II

cannot possibly contribute to increases in their prices and costs
until operations are at 100 percent of capacity, costs of production
often begin to rise before output approaches such high levels. The
plant and equipment existing in an industry at any time is of vary
ing age and efficiency. As demands expand, less efficient facilities
must be used if output is to be increased to fill the rising volume
of orders. Partly because these marginal facilities have to be ac
tivated, over-all productivity advance slows and may actually cease
or be reversed. This contributes, along with increasing wage rates,
premium payments for overtime, and advances in prices of some
materials consumed in the industry, to rising costs per unit of output.
P rice - and cost-raising pressures of demands in specific indus
tries, furthermore, may become widespread enough to constitute
a general problem before output reaches high rates in relation to
capacity in all major industries. Usually, some industries are grow
ing while others are not, and some regions are gaining while others
are losing business. A number of important bottlenecks may develop
even while unused capacity exists elsewhere. These developments
also contribute to a higher level of frictional unemployment of labor
than might exist otherwise, A judgment that output in the whole
economy is at a high rate relative to plant capacity does not require
that there be no margins of unused capacity, any more than “full
employment” means that there are no persons looking for jobs.
Given variations in the timing and intensity of demand and cost
pressures among industries, governmental policies to further ex
pand aggregate demands in order to raise demands and output in
those industries where capacity is not being intensively utilized
would intensify demand pressures on those industries where output
is already close enough to capacity to result in rising costs and
higher prices. Consequently, while a higher level of aggregate de
mand might increase total output somewhat, it would also accentuate
upward pressures of demand on prices.
An additional and important aspect of these developments and
relationships is that an expansion of capital outlays is likely to be
stimulated well in advance of full utilization of plant capacity.
Business enterprises always have some capital replacement needs,
and additional capital expenditures in most cases reduce costs or
increase sales potentials. Incentives to undertake new commitments
for expansion as well as for replacement are intensified if business
managers expect higher levels of demand for their products from
both secular growth and cyclical expansion. Since it ordinarily
takes many months before new facilities can be acquired and effi
ciently integrated into the production process, business managers
must plan expenditures to increase capacity well before output
reaches the limits of their ability to produce.

THE FEDERAL RESERVE ANSWERS

Among the elements of cost, attention in recent years has been
focused on changes in labor costs, partly because wage rates have
risen persistently and labor costs are an important part of total
variable costs. In major industries, where changes in wage rates
tend to be industry-wide, such changes occur at a particular m o
ment in time and they usually are widely publicized. On the other
hand, changes in productivity, which operate in the direction of off
setting the effect of wage rate increases on labor costs per unit
of output, occur over a period of time. Also, the advances are likely
to vary considerably from plant to plant and from one producer to
another.
For many industries, average measures of productivity show
more cyclical variability than wage rates, rising in the early stages
of expansion, leveling off as output approaches capacity, and de
clining in the early stages of recession. This pattern of change is
probably accentuated by the short duration of the business fluctu
ations of postwar e^erience, Many new facilities are put in place
late in expansion—or in the early months of recession—and there
is some time lag between installation and their efficient operation.
When there is such a lag, the resulting productivity gains may ap
pear late in recession and early in expansion.
Partly for this reason, unit labor costs tend to decline in the
early stages of expansion when productivity gains generally exceed
increases in wages. As expansion develops, unit costs turn up be
cause productivity advance slows and the rise in wages continues
and possibly accelerates. In recession also, unit labor costs typ
ically rise in certain industries as output per manhour declines.
Meanwhile, capital consumption and other relatively fixed costs—
by definition—do not vary with the level of output. On a per unit
of output basis, therefore, they show an inverse correlation with
output, decreasing when output is rising and increasing when output
is falling.
Cyclical variations in costs per unit of output, which result in
considerable part from swings in production, are not accompanied
by similar variations in prices. Consequently, profit margins fluc
tuate more widely than labor and other costs per unit of output,
generally moving in the opposite direction. In the early stages of
e*Pansi°n> profit margins rise sharply; in later stages, they level
off or decline; in recession, they decline decidedly.
The preceding review of price and cost influences indicates that
m early stages of economic expansion, production and employment
are likely to advance without generating widespread price and cost
pressures. While wage rates and prices of certain materials in
crease, margins of profits over costs widen and are likely to ap

QUESTION II

proach their cyclical peaks. After expansion has progressed for a
time, however, upward price and costpressuresbuildup, primarily
because output in some industries has reached high levels in rela
tion to capacity and unemployment has been reduced. As described
earlier, less efficient plant facilities must be used and productivity
advance slows or is reversed. At the same time, reduced unem
ployment and enlarged profit margins intensify pressures for in
creases in employee compensation.
With demands strong and output in some industries already at
high levels in relation to capacity, the subsequent behavior of
prices and costs is strongly influenced by the rate at which over-all
activity has been expanding and by expectations. If the pace of ex
pansion has been moderate, competitive conditions are maintained
within most industries, between industries serving common markets,
and between domestic goods and goods produced abroad. In these
circumstances, increases in prices and costs are likely to be con
fined to a relatively few markets and are unlikely to be very large.
On the other hand, if demands have been expanding rapidly and
assessments of prospects are highly optimistic, increases in wage
rates and fringe benefits are likely to be large and price advances
extensive. Increases in wages will be propagated throughout industry
and may directly cause further expansion in demands for goods and
services. Price advances may indirectly contribute to expanding
demands by generating expectations of additional advances.
Increases in the price indexes will further contribute to cost
increases through escalator provisions of labor, rent, and other
contracts. Some state and local taxes and fees may be raised to
cover the rising costs of current services and higher costs of
school, highway and other construction. These taxes are also re
flected in the consumer price index used for escalation purposes.
And thus an interacting inflationary process of demands, prices,
and costs can get in full operation.
Implicit in this description of price behavior for industrial
commodities is the fact that relatively few markets conform to an
ideal competitive model. In the competitive model, prices are de
termined by the interaction of buyers’ bids and sellers’ asking
prices in the market; the individual seller has no significant in
fluence on total supply and therefore has no discretion except with
regard to his acceptance or rejection of the going price or how much
he will supply at that price. This type of market behavior is ap
proached most closely in markets for livestock, some other agri
cultural commodities, and the industrial materials earlier described
as sensitive.
Markets for industrial commodities, on the contrary, are gen
erally characterized by “im perfect” or “monopolistic*’ competition.

THE FEDERAL RESERVE ANSWERS

Prices in these markets often are described as “administered,"
In such industries, a producer must make decisions regarding the
pricing of the product—including all the price-related decisions
associated with quality, design, and selling techniques. These p ric
ing decisions are based on judgments of what sales would be at
different levels of prices, on calculations of what costs per unit
would be at various levels of production, and on the behavior of
competing producers and products. Thus pricing decisions take
into account, in addition to demand, the range of forces affecting
production and costs, just as sales, production, and costs are in
fluenced by pricing decisions. Producers must attempt to find a
price that is in harmony with all the relevant short- and long-term
demand and cost considerations, but without knowing precisely what
will most effectively accomplish this aim.
The fact that prices are set by the decisions of producers im
plies a degree of market power—stemming from the nature of the
product and the nature of the production process—but it does not
connote full monopoly power. On the contrary, market fo rce s—
including competition within the industry and from other domestic
or foreign products or alternative sources of satisfaction—are
constantly working to alter past price decisions.
Rates for utilities, freight, public transportation, insurance, and
postage are also administered prices, as are rates for many other
business and consumer services. Both the cost and demand condi
tions encountered in the service industries vary widely. Some ser
vices are produced under conditions affording opportunities for
basic technological improvement and productivity advance while
for others such opportunities are limited. Some are primarily labor
while others have a higher commodity content. Prices of some se r
vices are very responsive to local labor market and related e co
nomic conditions while others are subject more to nationwide forces.
Some are regulated by public commissions and still others are
stipulated fees for public services. In particular instances, service
prices follow trends in wage rates fairly closely.
The result of most of these influences is that inflationary p res
sures in the economy are transmitted to services via increases
in costs. For the regulated prices, advances may lag considerably
behind the initiating causes and may occur in many instances even
after business expansion has given way to recession.
Periods of recession. During contractions in demands and a c
tivity, changes in prices and costs and in the relationship between
them are determined mainly by the duration of the contraction and
by developments in the preceding expansion. In a prolonged and
severe depression, accompanied by distress sales and substantial
decreases in prices of existing assets, strong downward pressures

QUESTION II

develop on prices of currently produced goods and on wage rates
and other elements of production costs. Since a contraction of this
severity has not occurred since World War II, attention may be
confined to the milder recessions experienced since then.
In recession, prices of sensitive industrial materials generally
decline. Contraction in domestic demands and decreases in prices
may reduce domestic supply by altering international commodity
flows and/or by making marginal operations unprofitable. For the
nonsensitive materials, analysis is complicated by the tendency of
producers to change prices by varying concessions and discounts
from unchanged list prices. While it is known that net or actual
prices fluctuate more widely than list prices, little information is
available to show the degree of change in actual prices.
List prices tend to be maintained in the early stages of con
traction and if the recession proves to be brief, recovery in activ
ity begins before many list-price cuts have been made. When it
becomes clear that demands are reviving, the list price for a
product on occasion is lowered to conform to actual transactions
p rices—because the operation of new facilities or some other
development causes demand-cost relationships to be fundamen
tally different from those on which producers had been basing
their decisions.
In describing the behavior of nonsensitive materials during
business expansion, it was emphasized that producers’ price de
cisions are based largely on calculations of costs at various possible
levels of output as well as on judgments about demand. When de
mands contract and production is reduced, many elements of costs
do not decline. Wage rates, for example, are maintained—or may
actually increase in some lines owing to the terms of long-run labor
agreements. The tendency of wage rates to be maintained was char
acteristic also of the mild recessions of prewar years.
Even in an administered price market, individual producers,
faced with declining demands, have an incentive to reduce prices
in order to increase sales, if they think competing producers will
not also reduce prices. This goes far to explain the preference of
producers for unpublicized price cuts—for price cuts brought about
through concessions rather than through reductions in list prices.
In certain situations, however, there may be incentives to publicize
price reductions by cutting list prices: a cyclical contraction in
demand for a particular material may be accompanied by competi
tion from a new and lower cost source of supply or a new substitute
material, or it may be accompanied by a change in the methods of
production that appreciably reduces costs.
The recession behavior of manufactures’ prices of most finished
products is similar to that of the nonsensitive materials.
industrial

THE FEDERAL RESERVE ANSWERS

To the extent that prices of materials decline, however, downward
pressures on prices of finished goods are intensified. Prices of
services tend to resist forces of decline in recession. In many
cases, they rise further because of the increases authorized by
regulatory agencies on the basis of earlier increases in costs, but
the rate of rise in average prices of services slows down.
To summarize, prices of many sensitive materials typically
decline in recession. These commodities have little weight in broad
price indexes, however, and their influence currently is much less
than in the indexes available for prewar years. Declines in prices
of some other commodities are likely to be concealed in concessions
from stable list prices. Still other prices, however, may resist
any downward adjustment to declines in aggregate demand in mod
erate recessions.
If the previous expansion was accompanied by inflationary de
velopments and appreciable increases in levels of prices, the in
creases are not likely to be fully erased during mild business
recessions, giving rise to what has been called the “ratchet effect,**
If, however, price increases in the previous expansion were small,
they may be subsequently offset as the competitive pressures that
develop during recession, domestic and foreign, strengthen incen
tives to cut costs and to reflect these reductions in the form of
lower prices. This emphasizes the importance of containing growth
in credit and in demands for goods and services during periods of
economic expansion and of preventing a climate of expectations
conducive to large and widespread advances in prices and costs.
Developments Since 1954
The interpretations of the functioning Qf the market system
which have led to skepticism about the efficacy of general meas
ures of public policy have been supported almost exclusively by
analyses of the 1954-57 business expansion, A comparison of de
velopments in the period with the process described above will
tend to show that the originating causes of inflation in the 1954-57
expansion—as in other periods of expansion characterized by in
flation—were strong demands and overly optimistic appraisals of
prospects. Once begun, the inflation was sustained by persistence
of strong demands, by demand-price-cost-demartd interaction, and
by generation of widespread expectations of continuing inflation.
The business expansion that began in the spring of 1958 had not,
through the spring of i960, led to large and widespread increases
in prices, as producers endeavored to hold down and reduce costs.
Comparison of this period with both the process described p re
viously and with the 1954-57 experience shows that the growth in
final demands, while substantial, was reasonably well balanced and
moderate in relation to available resources.

QUESTION II

The 1954-57 expansion. Recovery from recession began in the
second quarter of 1954, Expansion of consumer buying and resi
dential construction activity was followed shortly by a shift from
liquidation to accumulation of inventory. This was aperiod of rapid
industrial expansion abroad, and foreign demands were contributing
strength to domestic markets.
Prices of sensitive industrial materials began to rise in the
spring of 1954, as shown in Chart II-l, and were back to the pre
recession level by the spring of 1955. By that time, prices of some
other materials and producers* equipment also had been raised.
Changes in wholesale prices of industrial commodities from June
1954 to June 1955, and over succeeding 12-monthperiods, are shown
in Table II -l.
TABLE H-1
W holesale P r ic e s
(P ercen t In crease)
June 1954
to
June 1955
Industrial com m odities
M aterials
Sensitive
Other
Finished goods
C onsum er
Durable
Nondurable
P r o d u c e r s ' equipment

1.8
2.4
5.42
1.3
.9
.3
.5
.2
2.1

June 1955
to
June 19561

June 1956
to
June 1957

June 1954
to
June 1957

4.9
5.4
5.4
5.4
4.2
2.6
3.5
2.1
7.9

3.2
2.9
-2.6
4.9
3.7
2.5
3.0
2.1
6.1

10.2
11.0
8.1
11.9
9.0
5.5
7.2
4.5
16.9

!W ell over half of the increases in this period occurred during
the second half of 1955, The rate of increase in prices in that period
was faster than after the end of 1955 when the rapid shift in the
composition of demands is said to have become a major influence.
2The rise in this group began in March 1954, and from that time
to June 1955 amounted to 7 percent.
Source—Based on Bureau of Labor Statistics data.
Industrial production reached a new high in the spring of 1955
and continued to expand, while the labor market tightened. Sales
and output of autos far exceeded previous records, under the in
fluence of price concessions, radical changes in design, and a shift
in credit terms to considerably longer maturities and lower down
payments. The volume of residential building was exceptionally

THE FEDERAL RESERVE ANSWERS

CHART II-l

QUESTION II

large, and production of other consumer durable goods and business
plant and equipment all advanced. Even though steel production
reached capacity levels and output of other primary metals was at
peak rates, metals were in short supply, and capacity was under
mounting strain in many other important industries. Business profits
after taxes increased considerably. This intensified incentives to
expand capital investment and also provided some of the needed
funds, with the result that business investment plans rose sharply.
These were the conditions and expectations in mid-1955, when
some important labor contracts were negotiated. Demands for large
increases in wage rates and fringe benefits were strong, and re
sistance to them was weak. In the auto, steel, and certain other
major industries, large increases were agreed upon, and these lib
eral contract terms were negotiated for the most part without work
stoppages.
Given the demand conditions and prospects of the time, prices
could be and were raised to cover not only the increases in wage
rates but also advances in other costs such as those resulting from
the sharp increase in hiring of nonproduction or salaried workers.
Costs of materials and supplies were also advancing. Partly be
cause of the lagged effects of the World War II and Korean War
inflations on the book values of the stock of real capital, depreci
ation charges were higher in relation to sales than in earlier postwar
periods of rising economic activity. A widespread rise in prices of
industrial commodities erupted in mid-1955 and a price-cost spiral
was set in motion.
By the spring of 1956, the rise in business capital expenditures—
which had been stimulated partly by the surge of consumer buying
in 1954-55—reached boom proportions. Total spending by govern
ment was also rising. Economic activity abroad continued to increase
and foreign demands for United States products gained further in
strength. Meanwhile, some categories of demand were increasing
less rapidly than earlier and still others, such as demands for
autos and new houses, declined.
Curtailments in output in some of these lines in 1956 released
resources and thus permitted expansion elsewhere. Unemployment
remained low. For the most part, pressure of demands against
capacity in basic industries was maintained. The capital goods in
dustries depend on many of the same materials and types of labor
as are required in the auto industry. Similarly, industrial and com
m ercial construction use essentially the same labor and some of
the same materials consumed in residential construction.
In the industries producing basic metals, for example, the op
erating rate was about 93 percent of capacity in mid-1955, when

the f e d e r a l r e se r v e a n sw er s

the advance in prices became widespread among industrial com
modities. By the end of 1955, the rate was up to 97 percent. New
capacity was being installed in these industries during 1956, and at
least some of it became fully available for production during that
year. While rated capacity increased 4 percent from the end of
1955 to the end of 1956, output rose 3 percent, so that the year-end
operating rate was 96 percent. Some other industries producing
basic materials also maintained very high operating rates.
Expectations of continuing prosperity remained strong in 1956,
despite decreases in sales of autos and housing. The decrease in
automobile sales came to be regarded as a normal falling-off from
the extraordinarily high levels of 1955, and expectations in the
industry and elsewhere were for a renewed rise after introduction
of new models toward the year-end. The capital goods boom that
began in 1955 continued through 1956 and into 1957.
Price and wage developments in 1956, then, were dominated
by strong demands, by shifts in the composition of demands for
finished durable goods, and by ebullient expectations. P rices of a
few sensitive materials declined: prices of lumber declined after
February 1956 in response mainly to the decrease in residential
construction; and in the spring of that year, copper prices began
to decline—from very high levels associated with strikes—as sup
plies caught up with demand. Prices of most industrial commodities,
however, continued to increase.
In lagged response to the inflationary developments begun in
1955, moreover, the Consumer Price Index began to rise in early
1956. This rise resulted in wage increases based on escalation
clauses in existing contracts and intensified demands for other
large wage increases. In the summer, long-term contracts nego
tiated in the steel, aluminum, and some other industries, provided
for liberal annual increases in wages and fringe benefits and auto
matic cost-of-living adjustments.
In early 1957, prices of industrial commodities rose further—
reflecting partly a working through of earlier increases in prices
of materials and other costs and partly the fact that the expectations
of inflation continued to be widespread. Concurrently, rising prices
were limiting sales, and inventories were increasing. After nearly
three years of expansion, the seeds of recession—invariably sown
in a boom—were beginning to germinate.
By the autumn of 1957, wholesale prices of industrial commodi
ties had risen about 10 percent from the early 1954 level, the total
wholesale index 7 percent, and the Consumer Price Index 6 percent.
Given the strength of demands and the optimistic nature of expec
tations, increases of these magnitudes over a three- to four-year

QUESTION II

period are perhaps not extraordinarily large. Nevertheless, the
rise in prices would have been larger had monetary policies not
been restrictive. Developments through the period emphasize the
need for vigorous efforts to contain the growth in demands for
credit and for goods and services during periods of economic ex
pansion and to prevent the generation of a climate of expectations
conducive to widespread advances in prices and costs.
The 1957-58 recession. In the early autumn of 1957, more than
three years after the upturn in business, expansion gave way to
recession. A capital equipment boom by its very nature cannot be
indefinitely prolonged. Exceptionally high rates of capacity expan
sion, rapid rise in equipment prices, and reduction in business
liquidity eventually weaken incentives to make additional outlays,
A decline in business capital spending will usually entail a period
of inventory liquidation for capital goods industries, with reduced
employment in these industries. Secondary effects of these develop
ments are reductions in business inventory holdings, employment,
incomes, and demands generally. The recession that began in the
autumn of 1957 was of this type—although other elements were
present, including cutbacks in defense ordering and contraction in
foreign demands for U.S. exports.
Recession was not accompanied by widespread liquidation of
credit and distress sales, however, and the basis was soon formed
for recovery and renewed expansion, in part because of the in
creased availability and reduced cost of credit. Policy actions had
operated to restrain the use of bankcreditfor speculative purposes
during the expansion, and then operated in recession to encourage
expansion in bank credit and increase the liquidity of the economy.
During the recession, prices of sensitive industrial materials
declined, as the chart shows, with the average returning to the
early 1954 low. While it is likely that various form s of concessions
from list prices developed for other industrial commodities, list
prices generally were maintained and, in fact, were raised further
for some commodities. The failure of list prices to decline may be
attributed in part to continuance of expectations of rising prices,
to additional increases in costs arising out of commitments made
during the preceding boom, and to the brevity of the recession.
Expansion since early 1958. When recovery in business activity
began in the spring of 1958, average levels of prices were appre
ciably higher than in early 1954—when the previous recovery began.
Expectations of continuing upward creep in prices remained wide
spread. The reality of expectations of inflation became obvious not
so much in the behavior of commodity markets but in a further
advance in common stock prices to new highs and a continued in
crease in land values. Moreover, interest rates turned up promptly

THE FEDERAL RESERVE ANSWERS

and long-term rates which had declined only moderately in the re
cession, quickly approached or reattained prerecession highs.
The pattern of demands, production, productivity, prices, and
profits through the first year of expansion was similar in many
important respects to the comparable period of recovery from the
1954 low. Consumer buying expanded rapidly, housing starts closely
paralleled the rise of 1954-55, and liquidation of inventories slowed
down and then gave way to accumulation toward the end of 1958,
Constant dollar Gross National Product reached a new high in the
fourth quarter of 1958 and industrial production exceeded the 1957
prerecession peak by March 1959. Prices of sensitive industrial
materials responded to expanding demands, rising about as much
in the first year of economic expansion as in the comparable period of 1954-55.
However, growth in final demands was less rapid than in the
comparable period of 1954-56. Consumer buying of autos rose less
sharply—for a variety of reasons, including higher prices and no
important further easing in credit terms in contrast to the marked
liberalizing of terms in 1955. Moreover, merchandise imports rose
substantially while exports changed little. In recent years, there
has been a considerable improvement in the ability of other indus
trial nations to satisfy their own requirements and also, partly
because of price advances in this country, to compete with Am eri
can manufacturers of many materials and finished products in
domestic markets as well as in markets abroad.
Consequently, while consumption of materials in manufacturing
reached a new high in the spring of 1959 and inventories were being
accumulated at a rapid rate (stimulated in part by the expectation
of interruptions of supply by strikes), the margins of capacity over
output for most major materials were somewhat greater than in
mid-1955, and greater than during any other period of high-level
activity since World War II. The margins were not large, but their
importance was magnified by the fact that they existed simultane
ously in several industries whose markets overlap. Government
policy actions and policy pronouncements, furthermore, lessened
the expectation of rising prices. Altogether, there was more un
certainty in the outlook, and prospects were for more intensive
competition.
From the spring of 1959 to the spring of 1960, therefore, develop
ments were quite different from those in the comparable period
after the spring of 1955. One of the most obvious differences was
the development of strong resistance to cost increases as manu
facturers were less confident of their ability to pass them on in
the form of higher prices. Specifically, strong resistance to de
mands for increases in wages and fringe benefits in the steel and

QUESTION IH

other industries, as reflected in prolonged work stoppages, resulted
in generally smaller increases. Gains in productivity, meanwhile,
were as large as or larger than in the earlier period. Salaried em
ployment, which had declined more in the 1957-58 recession than
in previous recessions, increased less rapidly than in the 1954-57
expansion. Advances in prices were limited, and wholesale prices
of the various groups of industrial commodities were nearly stable.

QUESTION III
Granted that stability of employment and prices are
conducive to economic growth, are there any ways in
which the monetary authorities can contribute directly
to growth in addition to aiming at stabilizing employment
and price levels?
ANSWER m
Summary
The monetary authorities can and do contribute directly to
growth in ways over and beyond the pursuit of stabilization poli
cies. An expanding population requires expanding employment
opportunities, and stability can be maintained in a growing economy
only when demand grows sufficiently, year by year, to provide the
increase in job openings needed to keep pace with labor force growth.
The monetary authority recognizes and accommodates this need
for employment growth in the course of its stabilization activities,
in which the objective is long-run expansion of money supply and
bank credit consonant with maximum sustainable growth in output
and employment*
High levels of total demand e^anding at sustainable rates p ro
vide an optimum climate for investment leading to further growth
in the economy, and the monetary authority contributes to growth
in so far as it contributes to such a climate. Within the capacity
limits set by labor force growth, however, expansion of total output
can be accelerated onlybyspeedingtherateof productivity advance,
mainly through research, development of new products, and mod
ernization of capital. Hence a direct contribution to growth by the
monetary authority ain addition to aiming at stabilizing employment
and p ric e s ” would take the form of an influence toward higher rates
of productivity increase. To achieve faster productivity increase

THE FEDERAL RESERVE ANSWERS

without inflation, such an influence must act to shift the composition
of total demand and production, within the output capacity limits of
the economy, toward activities that are most effective in stimulating
productivity.
The forms of monetary policy instruments now in use are illsuited to an objective of altering the structure of demand. These
instruments are intended to provide for appropriate growth in total
money supply and bank credit with minimum direct influence on
individual credit markets or areas of production. Composition of
output is determined by structure of private and government de
mands in competitive markets in relation to output capacities. If
monetary policy actions were to be used as a direct instrument in
aid of faster productivity growth, therefore, they would have to be
modified to include some form of control or pressure on credit
markets tending to shift demands into the types desired. While
measures to exert such pressure might be devised, they would
probably be seriously destabilizing to total demand if effective, and
if held to limits that would not be destabilizing might be ineffective
in shifting demand.
Monetary policy has an important contribution to make toward
faster growth, but only as one part of a broader public program for
growth that would include tax measures, expenditures, and debt
management as well as monetary measures. Adjustments of prices
and costs in the private economy so as to obtain optimum demand
conditions are also essential for maximum growth. In almost any
form of public program, the monetary contribution would be to exert
a stabilizing influence on demand and prices; the initiating force
in shifting output structure is most appropriately sought in other
public agencies and in the private economy.
Introduction
In considering the contribution that monetary policy can make
to economic growth, it is useful to distinguish sheer expansion of
activity—growth in labor force, employment, and productive facili
ties—from rising productivity—growth in output per person or per
worker or per hour worked. Growth in the sense of rising activity
is closely related to population growth: When population is increas
ing the economy must expand merely to provide the new job oppor
tunities needed for a growing labor force, to generate the output
needed to maintain existing standards of consumption, and to provide
the schools, housing, roads, and other facilities that should increase
together with population. Growth in productivity, on the other hand,
makes possible that combination of rising living standards, increased
leisure, and more effective national strength that we have come to
expect from growth.

QUESTION III

Growth in total activity and growth in productivity proceed to
gether, of course, and are interrelated with one another, since
investment to accommodate population growth usually raises pro
ductivity at the same time. The distinction between activity and
productivity is nevertheless significant in this discussion, since
monetary policy stands in markedly different relationship to these
two elements of growth.
Growth in total activity. Growth in aggregate employment and
production is a direct concern of the Federal Reserve under existing
legislation, in particular the Employment Act of 1946. One of the
aims of monetary policy is, in the language of the Employment Act,
to provide “ useful employment opportunities. . .for those able,
willing, and seeking to w ork. , . * With labor supply continually
expanding, employment opportunities must also increase continually
at any fixed level of employment but along a growth trend that
parallels the growth in labor supply and that keeps unemployment
as low as possible.
An important area of Federal Reserve efforts toward adequate
employment growth lies in the work of the twelve Federal Reserve
banks in analyzing business opportunities and in encouraging im
provement in financial facilities in their districts. To the extent that
industry can be attracted to areas where available workers live,
frictional and structural unemployment in the economy can be sub
stantially restrained.
If employment, for any reason, does not grow rapidly enough to
absorb net additions to the labor force, the resulting rise in un
employment may be merely cyclical or it may also reflect a longerrun tendency toward stagnation. Short-run and longer-run develop
ments are always difficult to distinguish in current affairs, but for
economic policy the distinction is important and should be attempted
to the extent possible. Policy measures to stimulate demand, such
as tax changes and credit programs, can take many form s, some
flexibly adapted to short fluctuations in business, and others neces
sarily more permanent in form . The measures used should suit the
developments taking place, and some appraisal of those develop
ments is essential in choosing form s of policy measures.
The scope of choice in monetary policy, however, is limited
within the present framework of powers of the monetary authorities.
Broadly speaking, the actions available to the Federal Reserve to
foster long-run expansion of employment take the same form as
actions to offset cyclical tendencies toward recession. For both
purposes measures are taken to stimulate demand generally and
investment demand in particular through expansion of bank credit
availability and the money supply. Expansion to offset recession
tendencies is needed only sporadically, of course. Expansion to

THE FEDERAL RESERVE ANSWERS

provide for growth proceeds continuously, on the other hand; it
constitutes a basic p o l i c y objective underlying all others, and stabil
ization actions are in effect temporary departures from this objec
tive to counter short-run imbalances between demand and capacity.
While the growth objective can be viewed as separate from and
underlying stabilization goals, however, there are no specific or
separate monetary actions to provide for growth. In current opera
tions, credit policy becomes restrictive when total demand expands
too fast in relation to growth in labor force and plant capacity or is
of such a nature as to threaten stability, and policy leans toward
ease when demand is not expanding fast enough to keep pace with
labor force growth. In the process money supply, liquidity, aiid
credit availability expand over the long run at rates consonant with
maximum sustainable economic growth. But the actions leading to
this expansion are fully integrated with stabilization actions and are
indistinguishable from them.
In following the directive of the Employment Act, then, monetary
policy accommodates employment growth directly in the course of
stabilization activities. There is not a contribution to growth here
“in addition to,” in the words of Question HI, “aiming at stabilizing
employment and price levels,* Provision for adequate sustainable
growth in money supply, credit availability, and financial facilities
are essential if employment and activity are to be maintained at
high and expanding levels. Question HI, however, focuses on other
forms of contribution to growth that the monetary authority might
make. In terms of the distinction mentioned earlier between growth
in total activity and productivity growth, such other contributions
would take the form of aids to faster productivity growth. The fo l
lowing discussion follows this focus and is concerned primarily
with contributions that monetary policy might make toward higher
productivity.
Growth in productivity. Monetary policy has a far more diffuse
relation to productivity growth than to employment growth. Higher
production per capita can originate in manyways.lt can come from
increases in the proportion of the population in the labor force,
from lengthening of the work week, from shifts of demand away
from low-productivity industries toward high-productivity indus
tries, and from deepening of the uses of capital relative to labor
in production.
The fundamental source of rising productivity, however, lies in
innovation and development of new products, new services, and new
methods of production. An economy can deliberately undertake, in
a war or other emergency, to expand output by working longer
hours, bringing marginal workers into the labor force, and oper
ating more equipment on a multiple-shift basis, but there are

QUESTION m

inevitable limits to growth by such routes. Growth in living stand
ards and economic strength can be continuous only if it is based
on creative ability to see and exploit new opportunities for doing
things better. Both elements are essential—the new ideas them
selves and the application of those ideas to economic activity.
Without new ideas an economy must continually borrow from abroad
in order to maintain its international competitive position. And new
ideas fall on sterile ground unless there are both willingness and
resources to put the ideas to work.
Historically, the direct sources of productivity growth have
interacted continuously with one another. Competitive pressures
to reduce costs in individual industries result in rising productivity
that releases resources for other uses. New products and product
improvements are introduced that create new demand to absorb
these resources as well as capture demand from existing products.
In the process the new industries demonstrate to existing ones new
materials and new ways to produce that raise productivity further
in older industries. Growth in demand for individual products may
increase productivity through new possibilities for large-scale
production. Materials shortages stimulate research that results in
new materials more useful than the vanishing ones. Wars and threats
of wars, although absorbing resources wastefully, also result in
development of new processes and products. And the innovations
that make up this process occur in all areas of economic activity—
production, marketing, consumption, government—with continuous
cross-fertilization.
The following discussion considers ways in which this complex
p rocess—the creating, developing, and exploiting of new ideas
wherever they occur in the economy—might be stimulated or speeded
by monetary policy. More specifically, the questions considered are
(1) the relation of existing form s of monetary influence to produc
tivity growth, (2) the possibilities for larger investment spending as
a route to faster productivity growth, and (3) the contribution that
additional powers, such as selective credit controls, might make'to
productivity,
A s a goal of monetary policy, high rates of productivity growth
must be coordinated with other monetary objectives—high employ
ment and price stability. There is no inevitable conflict between
these two sets of goals, but from time to time a need arises to
emphasize one aim more than another. The discussion below sug
gests that with appropriate use of public powers outside the realm
of monetary policy, such temporary conflicts can be largely avoided.
Existing Forms of Monetary Influence
Federal Reserve policy actions ordinarily take form s intended
to have the least possible specific effect on particular markets.

THE FEDERAL RESERVE ANSWERS

The aim of monetary policy is to provide for a volume of bank
credit and money supply consistent with general price stability and
with high and expanding total demand. The composition of that de
mand—in terms of consumption goods and services, capital forma
tion, and government operations—is allowed to reflect the interaction
of millions of individual decisions in the market as to what to buy
and what not to buy.
These demands are continually changing with shifts in the ca
pacities and desires of the nation, and it is the function of com
petitive markets to respond sensitively to these shifts in order to
meet demands as they arise. With the structure of demand largely
determined by market forces, the function of monetary policy is to
promote, in so far as bank credit and money supply are factors, an
aggregate of such demands that grows continuously and consistently
with expansion of the labor force and productive capacity in the
economy.
In this role, monetary policy exerts a permissive rather than
initiating influence on productivity growth, Prosperity with price
stability provides an optimum climate for growth through ventures
into new ways of doing things that involve risk and uncertainty. Such
conditions help to minimize both the fear of unemployment, which
inhibits willingness to compete and to make mistakes, and the fear
of inflation, which generates drives to buy too much of existing
forms of capital rather than to explore new form s. Both of these
fears inhibit economic development, and when they are minimized
by high levels of activity and stable growth rates, the economy is
given the greatest freedom to e^qpandproductivity through discovery
and experiment.
In its general form, however, monetary policy is not in a posi
tion to aim at stability in the economy as a whole and at the same
time to discriminate in favor of specific forms of demand that
speed growth, A policy of credit ease adopted in order to aid spe
cific investment in growth would stimulate other form s of spending
as well, and if total demand were high could lead to an inflationary
condition in the economy. And an opposite policy of credit tightness
to raise saving and to suppress nongrowth demands for credit would
restrain growth investment as well and tend toward underemploy
ment and inadequate total demand.
The relative competitive positions of growth and nongrowth
demands for credit are virtually impossible to assess, since credit
demands arising from growth are as various in form as the sources
of growth that create them. This can be seen by considering the
different sources of credit used to finance innovation in such forms
as railroad dieselization, modernization on farms, research and
development for defense goods, construction of toll highways, and

QUESTION m

development and marketing of new industrial equipment .While many
others might be mentioned, these are enough to indicate that credit
to finance productivity growth has come from established security
market channels, from banks, from government aid, from equity
investments by individuals in small firm s, and from internal saving
by business. Where capital cost has been a dominant consideration,
as in toll highways, the demand for funds has been sensitive to mar
ket conditions. In many form s of new product development, on the
other hand, market prospects tend to override other considerations.
With this diversity in growth financing, it is apparent that mone
tary stabilization policy has no distinctive effect on growth demands
for credit. These demands compete directly with other borrowing
in all parts of the credit market. By operating in the credit market
at as general a level as possible, the Federal Reserve minimizes
its specific influence on individual segments of the market. The
effects of stabilization activities on growth demands for credit are
thus as diffused and various as effects on other form s of credit de
mand, and growth investment is neither hindered nor helped differ
entially by credit conditions of restriction or ease that may occur
with varying levels of business activity, A climate of economic
stability is, nevertheless, important to technical progress and
development over a broad range of activities.lt constitutes a major
contribution of monetary policy to growth under existing conditions.
Policies for Higher Investment and Saving
The question remains whether alternative forms of monetary
policy might be adopted that could contribute to productivity growth
as well as to employment growth by favoring credit demands lead
ing to growth as against other forms of demand.
Most proposals for stimulating growth in the U.S. economy in
clude measures to increase the rate of business investment spending.
These measures are advocated on the basis of both long-run and
short-run considerations. In the long run, higher capital outlays
would contribute to growth primarily by modernizing plant and
equipment more rapidly and raising the trend of growth in labor
productivity as a result. For the immediate period increased in
vestment would also serve to expand total demand and to halt the
gradual rise in unemployment rates that has been occurring in
recent years.
In so far as total demand is slack in the economy, monetary
measures to stimulate capital spending through credit ease are
generally consistent with, and indeed part of, stabilization policy.
The rising unemployment rate reflects an excessive tendency
toward saving in the economy relative to investment demand, and
expansion of capital spending will help to correct the imbalance.

THE FEDERAL RESERVE ANSWERS

As a route to more adequate e m p l o y m e n t growth, therefore, raising
investment outlays does not present new problems to monetary
authorities specific to the policy goal of a higher rate of growth
in the economy.
When total demand and employment are already at high levels,
however, the problem of expanding investment spending is broader
and more complex. An increase in capital outlays in these circum
stances requires a parallel increase in saving if inflation is to be
avoided. There are thus two sides to the problem, and the policy
steps needed to raise investment maybe separate from those needed
to raise rates of saving. Whether separate or combined, however,
influences on saving and on in vestm en t must be coordinated reason
ably well if stability is to be maintained.
General monetary measures to tighten or to ease financial
markets, however, tend to have opposite influences on saving and
investment. This is an essential characteristic of monetary policy
as a stabilizing force in the economy. To raise saving and invest
ment together requires a different and broader form of policy action
in which the existing instruments of monetary policy can play only
one part.
The requirement for expanding investment and saving together
is, in general, some form of structural change in economic relation
ships among groups or types of income. Tax benefits in favor of
investment are of this type, since they would shift tax burden away
from investors in new capital goods and toward noninvestors. Other
tax measures, such as small business investment company pro
visions, and various forms of government lending programs or
credit guarantees alter structure to increase credit availability to
certain types of capital outlays independently of monetary actions,
The extent of structural shifts needed to increase productivity
a p p r e c ia b ly is d i ffi c u l t to p r e d i c t . I t d e p e n d s on the r e s p o n s i v e n e s s

of business in expanding outlays as a result of the shift, on the ef
fectiveness of higher investment in raising output per manhour, and
on the measures needed to expand saving. Applied as a b r o a d - s c a l e
incentive, the required shift may not be feasible and a more narrowly
focused device may be necessary, combining direct subsidies and
increased government saving. Whatever the form, however, the
effect i s to shift income and demand in ways that give i n v e s t m e n t
goods a more favorable position than they presently have.
Structural shifts such as these are based either directly or im
plicitly on governmental tax and borrowing powers and on use of
these powers to divert income and resources from one area to
another in the economy. The monetary authority has no comparable
command over flows of funds and hence no comparable ability to

QUESTION IE

shift the basic structure of income and spending relationships.
Monetary policy must act within the existing structure when it op
erates through general controls on bank reserves and money supply.
Monetary policy unquestionably has a role in a broader public
program of higher private capital formation, however. While tax
and other legislation can be devised that would tend to raise both
saving and investment rates, the effect in practice would be, in
general, a greater upward influence on one than on the other. Such
programs, that is, might be destabilizing in some degree—inflation
ary if investment demand responds more and depressive if saving
shows the greater response. Imbalance should of course be avoided
within the program to the extent possible, but monetary policy will
inevitably play a part in countering both the short-run and long-run
residual pressures that emanate from the program.
Stability is important to growth under existing conditions, with
investment determined mainly by market factors. A stabilizing
influence is even more essential when public policy measures are
expressly shifting economic structure in order to accelerate growth.
While the economy has shown great resilience in the postwar period,
a program to alter structure might produce shocks potentially dan
gerous to over-all balance. Measures to preserve balance—mone
tary, fiscal, and other—would then have to assume a correspondingly
enlarged role in public policy in order to avert those dangers.
Selective Credit Controls
The preceding discussion has indicated that general and nondiscriminatory form s of policy actions now available to the mone
tary authority contribute to growth as a stabilizing force in an
expanding economy. While stability is essential to sustaining growth,
general form s of policy action can only accommodate growth rates
determined elsewhere in the economy, whether in competitive
markets alone or with specific assistance from government. Gen
eral form s of policy instruments, that is, have not the scope in
themselves to accelerate growth directly by altering the structure
of demand and income.
There remains the possibility that selective credit controls in
some form can make a direct contribution separate from stabiliza
tion. Direct controls on specific types of credit can in fact have
some of the ability to affect economic structure that is found in
taxing powers. Regulations that prohibit lending on terms mutually
acceptable to sellers and buyers have a number of influences on
income, spending, and credit market flows that shift demand struc
ture away from that of a free market. If suitably constructed, there
fore, a system of direct controls might contribute to a shift of credit
from nongrowth to growth demands and to a higher economy-wide
rate of saving.

THE FEDERAL RESERVE ANSWERS

Many forms of regulation can be designed to divert credit flows
to or from specific uses. In the U.S., direct controls have been
limited largely to terms of lending for consumer credit, home
mortgages, and stock market credit. Bank examination procedures
have an element of direct control, but the focus in examinations has
been on soundness of individual banks* positions rather than eco
nomic policy. Securities regulation, control of nonbank financial
institutions, and limits on savings deposit interest rates have sim
ilarly had objectives other than influence on the level and structure
of demand. If it appeared appropriate, however, controls of these
types could be reoriented toward influencing demand structure and
could be integrated into larger programs of economic policy to ex
pedite growth.
The first function of such controls as aids to growth would prob
ably be to restrain consumer demands for credit. With consumers
forced to accumulate savings to a greater degree before buying
houses and durables, production resources would be freed to expand
output of business capital goods, while credit markets could be
eased without threat of inflation. Such controls could of course be
extended with parallel effects so as to discriminate among indus
tries, among regions, or among types of firms if the need for such
extreme measures appeared to exist.
Direct controls could very probably be used only in conjunction
with specific government inducements to higher business spending,
since by themselves the credit controls would undoubtedly be de
flationary, Their effect in depressing consumer demand, that is,
would be stronger than the influence of credit ease toward expanding
business investment, particularly since the restraint on consumers
would in itself depress investment demand. Such controls would
thus be used not as a direct aid to growth but rather as a catalyst
to government-induced business investment.
Before undertaking a system of direct controls as part of a
growth program, however, the very substantial problems asso
ciated with them should be understood and balanced against poten
tial benefits. Selective credit controls are a common instrument of
policy in a number of countries, but the U.S. economy has charac
teristics that make this form of control distinctively difficult to
administer. With a large and diversified geographic area, with
thousands of individual commercial banks, finance companies and
mortgage lenders, and with a generally impersonal relationship
between government and the financial community, selective controls
are awkward, costly, and onerous to enforce effectively. When
continued over extended periods, moreover, such controls tend to
be subverted by changes in credit market relationships, and the
form of control must be continually adapted to follow these market
shifts. Selective controls should thus be undertaken only if they can

QUESTION IE

produce the desired result—greater growth—reliably and efficiently
on a permanent basis and if no more palatable alternative device
exists.
Historically, consumer credit and mortgage controls have been
used only on temporary bases, for the specific purpose of holding
down inflationary pressures during a massive shift of resources
into and out of national defense activities. In each situation the need
was specific, urgent, and short run, and the types of influence ex
erted by the controls discernible.
In applying direct controls on financial markets in aid of a na
tional growth program, the first question is whether there is a need
that is as specific. It is important that the need be specific as to
types of output desired and that it be recognized by all major sectors
of the economy. Regardless of the importance or urgency of the
need, no policing of direct controls can be effective unless it relies
primarily on the cooperation and good faith of the public,
The concept of growth is poorly suited to a national program
requiring this degree of public cooperation. Productivity growth is
a complex and broadly based process in the U.S. economy, and
successful innovation springs from interaction of many different
forms of demand and competitive responses to demand shifts. Fi
nancing of new techniques makes use, as mentioned earlier, of all
form s of credit channels, both in development and in application to
production. In a subject as far ranging and diffuse as growth, there
fore, it is not surprising to find broad differences of opinion among
groups as to the purposes, nature, and sources of growth. And with
out a reasonable concurrence on the value of a credit control program
will become increasingly diluted with time, particularly if used
aggressively.
Selective controls also have a more specifically economic diffi
culty. While the aims visualized for a program to speed growth are
many, there is clearly a need to preserve balance in the economy
as it expands. Balance is difficult to define in this context, but
broadly it refers to capacity to produce at all times the kinds of
goods and services that the public wants and in the proportions de
sired. A program for growth should ideally shift resources into
investment, education, research, and so forth for the purpose of
expanding—sooner or later—a structure of output that meets the
public’ s demands as they would appear in free markets.
If this is the goal of growth, selective controls are an inappro
priate and even dangerous tool of policy. The purpose of direct
controls is always to shift demand structure away from fre e market form . As part of a program to increase total research,
development, and modernization outlays, controls would inevitably

THE FEDERAL RESERVE ANSWERS

restrain investment and research in the industries where final de
mand was restricted and thus warp the capacity of the economy to
meet the structure of demand that will be most satisfactory to the
public. Thus a monetary instrument that is effective in wartime,
when private consumption preferences must be subordinated, can
be quite out of place in a different setting of economic policy.
Distortion of demand structure is part of the underlying and
fundamental objection to selective controls in the United States,
that is, that such controls contravene the decision of competitive
markets in determining output structure. Maximum freedom of
private choice in use of resources remains a major tenet of eco
nomic policy and should be qualified only when critical national
needs can be met in no other way. To suppress this freedom in
order to improve the general public welfare would very probably
be self-defeating. With the broad objective of encouraging innova
tion and modernization wherever they are most fruitful in the econ
omy, selective controls would be in contradiction to the goal and a
hindrance to achieving it.
Government Programs for Growth
The potential for promoting balanced growth at higher rates
through monetary policy appears small when compared with possi
bilities for specific government programs in growth expenditures
financed through taxation. On the investment side the government is
in a position to present explicit capital demands to the economy,
whether in the form of research or in physical facilities that the
government deems strategic to growth. In so far as policy looks to
growth for defense purposes, these demands would presumably be
most immediately for military equipment and technical education,
but they need not be restricted to such areas. Government research
in agriculture has, for example, had striking consequences for farm
productivity. On the saving side, the taxing power can be used just
as explicitly to generate saving by the government that is needed
to finance the extra investment spending.
As in the case of a government effort to stimulate private in
vestment, a direct public investment program can create insta
bilities in the economy in so far as private responses result in
differences between demands for investment and saving. Counter
acting these disturbances would be part of general stabilization
policy, both fiscal and monetary, and is not a direct part of a growth
program.
Conclusion
The concept of economic growth is one of the least specific in
public affairs. The meaning of growth, the objective of a public

QUESTION IV

policy on growth, and the urgency of the need are all subjects on
which there are wide differences of opinion. The processes of eco
nomic growth are complex interactions among many types of forces
in the community and in spite of intensive study remain little under
stood. It is still not possible to state in operating terms the extent
to which individual activities are sources of growth and the extent
to which they are only uses of growth.
To be effective, therefore, public policy to stimulate growth
should have specific objectives as to types of growth and should
work toward those objectives by direct means. Attempts to stim
ulate growth at a very general level, with diffuse goals and indirect
channels of influence, may be misdirected if the forces at work are
not well understood. The result can be no more than unwanted dis
tortion of economic structure. The role that monetary policy can
have in promoting growth is affected by these considerations.
It is in the problem of adjusting continuously to many forms of
growth pressures that monetary policy has its most immediate
relation to growth policy. The first function of any monetary au
thority is to provide the means of payment and associated bank
credit needed by an operating economy. As the economy grows
these needs also grow, and the monetary authority must stand pre
pared to meet them.
Monetary policy should in particular be closely coordinated as
a stabilizing element in any government program for direct partici
pation in growth investment and saving, serving here to offset
inadvertent or even intentional imbalances of receipts and outlays
related to such a program. Irrespective of growth considerations,
monetary policy must always take government expenditures and
receipts into consideration, since these are major factors affecting
current economic conditions. The stabilizing functions of monetary
policy in relation to a growth program, therefore, are not likely to
be markedly different from the normal functions served by mone
tary policy.

QUESTION IV

It is frequently claimed that both (a) the existing high
corporate income tax rate, and (b) the volume of in
ternal financing now undertaken by business firms,
reduce the responsiveness of business firms to mone
tary policies. What is your view regarding the validity
of these claims? What is their significance with respect

THE FEDERAL RESERVE ANSWERS

to the effectiveness of monetary policy and the rela
tive impact of monetary policy upon various sectors
of the economy?
ANSWER IV
Summary
The answer to the first part of this question is limited to the
specific point raised with respect to corporate responsiveness to
monetary policy under conditions of high income tax rates. It does
not attempt to assess other economic effects of such tax rates,
which may indirectly affect adversely the economic climate in which
monetary policy operates.
The first allegation, that high corporate income tax rates re
duce the responsiveness of business corporations to monetary
policy, may be questioned on two grounds:
1, The relative reduction in rate of return with a given increase
in interest cost is the same when taxes are high as when they are
low. This is so because income taxes reduce all items of deductible
expense and most taxable income by the same proportion.
2. High income tax rates may influence corporate investment
policies and corporate external financing practices in certain ways
that might increase rather than reduce corporate responsiveness
to monetary policy.
With respect to the second claim that heavy reliance on internal
funds by businesses as a group blunts their responsiveness to mone
tary policy, three considerations may be noted:
1. Many businesses rely much more heavily on borrowed funds
than is suggested by aggregate statistics for the business sector.
2. Cost of credit is only one factor influencing business borrow
ing decisions. Responsiveness to changes in the cost of credit will
depend in large part on the relative importance of noncredit factors,
e.g „ the urgency of the project to be financed.
3. The customary proportions of internal vs, borrowed funds
in a company’ s total financing may have little effect on its decision
as to whether to undertake a particular investment that requires
outside financing.
It seems doubtful that the impact of monetary policy on other
sectors of the economy is directly and significantly affected by

QUESTION IV

either the existing high corporate income tax rate or by the heavy
reliance on internal funds by the corporate sector as a whole.
The claims referred to relate to the responsiveness of business
firm s to monetary policy, by which is apparently meant responsive
ness to changes in the cost and availability of loanable funds. The
reasoning proceeds that, because of high tax rates and heavy in
ternal financing, firm s are more or less insensitive to the rising
cost and reduced availability of funds during periods of excessive
credit demand and accompanying policies of monetary restraint.
In examining these claims, one should keep in mind that monetary
policy influences but does not determine interest rates and credit
availability.
Effect of Existing High Corporate Income Tax Rate
It is important to note at the outset that this part of the question
relates to the differential effect of historically high vs. historically
low income tax rates on corporate responsiveness to changes in
monetary policy. It does not relate to what effect the mere existence
of a corporate income tax may have on the attitudes of corporate
managements. Nor does it relate to the general question of corporate
responsiveness to changes in the cost of money, independent of the
tax factor.
High corporate income tax rates, such as those presently in
effect, undoubtedly influence the form that corporate financing takes.
They may have some effect on the general level of interest rates
and of corporate investment, though the effect would tend to diminish
the longer tax rates remained at the same high level. Many ob
servers feel that high tax rates also reduce corporate responsive
ness to cost increases, and therefore to monetary policy as it
affects the cost of money. While there are no recent empirical
studies on this point, the logic of the situation suggests that the
level of income tax rates as such should not significantly affect
corporate responsiveness to monetary policy.
The claim that monetary policy is less effective under conditions
of high tax rates usually focuses on the effect of credit restraint on
the cost of credit rather than on credit availability, i.e., on co r
porate responsiveness to interest rate increases. The argument as
frequently advanced is that much greater increases in interest rates
are acceptable when tax rates are as high as they are at present, than
would be the case if they were lower. This is because, with interest
payments deductible for tax purposes and with the federal income
tax rate on most corporate income at 52 percent, the Treasury in
effect pays more than half of a corporation’ s interest costs.

THE FEDERAL RESERVE ANSWERS

Thus, it is said, the restraining influence on corporate borrow
ing of a given increase in interest rates is greatly reduced. Or, put
another way, much larger increases in interest rates are required
to produce the same response that a much smaller increase would
produce if tax rates were lower.
In focusing on interest rates, however, it should be noted that
interest cost is only one element in the profit and loss statement.
The claim that corporations are less responsive to interest rate
increases when tax rates are high could be, and frequently is, made
about other deductible costs. Moreover, if an income tax rate of 52
percent is viewed as offsetting more than half of a corporation’ s
interest cost, it must also be viewed as offsetting the same propor
tion of every other deductible cost, and as absorbing more than half
of a corporation’s receipts.1 This is, of course, not the way income
taxes are computed, but applying a rate of 52 percent to the net of
receipts and deductible expenses is equivalent to applying that rate
to each of the separate items. In effect, income taxes reduce all
items of income and expense by the same proportion, and this means
that the relative importance of interest as a cost is the same what
ever tax rate is currently in effect.
At any level of tax rates, the worth of an expenditure of funds
will be gauged in light of the net return it will provide. Because
income taxes reduce both receipts and deductible expenses by the
same proportion, a rise in interest cost produces the same relative
reduction in after-tax return (assuming gross return is unchanged)
regardless of the level of the tax rate, so long as the tax rate is
the same at both levels of interest cost. This relationship can be
illustrated most conveniently by use of a simple arithmetic example.
Chart IV -1 shows, for a $10,000,000 plant earning $1,500,000
per annum before interest and taxes, the return after interest and
taxes that would be earned under different combinations of tax rate,
interest rate, and financing method. If the investment is financed
entirely by borrowing, as in the left-hand section of the chart, an
increase in the interest rate from 3 percent to 5 percent reduces
the net return by one-sixth, whatever the tax rate may be# That is,
at a 25 percent tax rate, the return is reduced from 9 percent to
7 1/2 percent, at a 50 percent tax rate, from 6 to 5 percent and, at
a 75 percent tax rate, from 3 to 2 1/2 percent.
Thus, the absolute reduction in return with a given increase in
interest rate is smaller the higher the level of tax rates, but the
— f o 1?? reduction is the same at all tax rate levels. Since this

^Dividend income and capital gains are exceptions, of course, since
they are taxed at less than 52 percent.

QUESTION IV

CHART IV-1

THE FEDERAL RESERVE ANSWERS

relative effect is independent of the level of income tax rates, the
fact that the federal tax rate on most corporate income is currently
52 percent, rather than, say, 25 percent, seems unlikely to have
much direct influence on corporate responsiveness to interest rate
increases.
While the claim that income taxes reduce corporate responsive
ness to cost increases is usually made with respect to high tax
- rates, it seems less likely to obtain under conditions of high but
fairly constant rates than under conditions of risingtax rates, and/or
of strong anticipation of a change in tax rates. When tax rates are
rising rapidly, with the new high level expected to be temporary, a
small net addition to current costs may promise substantial future
income benefits.
A certain laxness with respect to cost control reportedly was
fairly common in the early years of World War II, In this period,
effective tax rates, which had ranged between 10 and 14 percent
throughout the l920,s and 1930’ s, rose to 40 percent by 1941 and to
56 percent by 1943.2 But effective income tax rates, though now
below their wartime peak, which included the excess profits tax
with its high marginal rates, have remained at historically high
levels for nearly twenty years.
After so extended a period of high federal income tax rates, it
does not seem logical to assume that there are many corporate
managements today who consider the effect of income taxes on costs
alone. They must be mainly concerned with the combined effect of
rising costs and high taxes on net earnings. It seems reasonable to
assume that, in a competitive industry where rates of return are
not regulated or protected, most companies faced with an increase
in any cost will consider alternative actions. These alternatives
may include economizing on other costs, avoiding the cost increase
in whole or in part, accepting lower profits, or accepting a lower
profit margin.
Interest is like any other deductible cost in this respect. Even
though, for most companies, it is a small cost relative to total
sales, it may be relatively large for an individual project. In gen
eral, the longer run the project (i.e., the slower the pay-out period
and/or the longer the maturity of the debt incurred to finance the
project), the greater the relative importance of interest cost.
The analysis thus far has taken no account of what may be an
important indirect effect of high taxes on corporate i n v e s t m e n t
^E ffective rates are measured here by the ratio of federal income
and excess profits taxes to the earnings of corporations reporting
a net income.

QUESTION IV

policy. The figures plotted on Chart IV -i assume the same gross
rate of return, and the same range of interest rates, under each
assumed tax rate. It may be that both borrowers and lenders have
such fixed goals with respect to after-tax returns that funds will
not be supplied by lenders, nor demanded by borrowers, unless the
pre-tax return is greater when tax rates are high.
The expected profitability of a proposed investment is, of course,
greatly affected by the current and expected levels of tax rates.
Under the assumptions with respect to gross return and financing
method used in the left-hand section of Chart IV -l, the after-tax
return with interest cost at 3 percent would amount to 9 percent if
taxes were levied at a 25 percent tax rate, but amounts to only 6
percent at a 50 percent tax rate. In order to obtain a 9 percent return
at the present higher tax level, the gross return, as may be seen
from Chart IV-2, must be 21 percent rather than 15 percent. That
is, the investment must “pay out” in five years rather than in
seven years.
If a corporation has sought to maintain its after-tax return at
approximately the same level regardless of the level of tax rates,
projects that would have been undertaken when taxes were low may
not be undertaken when taxes are high. This would, however, have
more effect on the general level of corporate investment under dif
ferent tax rates than on the responsiveness of corporate borrowers
to changes in interest costs under conditions of constant tax rates.
If, on the other hand, in a period of high tax rates, a company has
reluctantly lowered its profitability requirements with respect to
new investments, any further reduction resulting from a rise in
interest cost may induce the corporation to postpone or cancel a
proposed investment. In other words, a reduction in after-tax re
turn from 6 to 5 percent may be less acceptable than the same ab
solute reduction from 9 to 8 percent, or even than the same rela
tive reduction from 9 to 7 1/2 percent.
There are no reliable studies of the minimum net return that
corporations consider acceptable under particular circumstances.
It probably varies with the nature of the project, with the pressure
of competitive factors, with long-run expectations as to markets,
costs and prices, and perhaps, as suggested above, with the level of
tax rates.
There probably is such a minimum, however, and it greatly
affects a corporation’ s response to rising interest rates.Referring
again to Chart IV -l, suppose a company will go ahead with a ce r
tain proposed expansion that is expected to yield a gross return of
15 percent, if it is reasonably sure of a net return of at least 6 p er
cent. At present tax rates, it can obtain this return and finance the

THE FEDERAL RESERVE ANSWERS

T A X RATES AND REQUIRED RETURN ON INVESTM ENT 1 /
P ercen t

1 / Return (b e fo r e in te re st and ta x e s) re q u ire d to y ie ld 9 p e r c e n t
return (a fter in terest and ta x e s ) under d iffe re n t in co m e tax
ra te s , in terest rates and financing arran gem en ts.

CHART IV-2

QUESTION IV

project entirely with borrowed funds, only so long as it can borrow
at 3 percent or less. At half present tax rates, it could pay as much
as 7 percent interest.
If an increase in borrowing costs occurs, the company can still
obtain the minimum yield it has set by reducing the proportion of
borrowed funds used and financing a part of the project with internal
funds. Such a response is the desired objective, of course, of a pol
icy of restraint that is expected to encourage corporations to rely
more heavily on internal funds and to economize on borrowed cash.
Suppose the company is able to finance one-fourth of the cost of the
project with internal funds. Then the expected net return from the
investment will remain at 6 percent or above until the interest rate
reaches 4 percent, as the right-hand section of the chart shows .3
With different assumptions as to expected gross return on the
proposed investment and/or as to minimum net return required, the
point at which the company’ s investment and borrowing decisions
are significantly affected by rising interest costs will be different.
Under any reasonable set of assumptions, however, there comes a
point at which the rise in interest rates reduces the after-tax re
turn to a level that is not acceptable. There seems no logical reason
for assuming that this point comes more slowly when tax rates are
high. It may, in fact, come faster for the company that has not been
able to offset historically high tax rates with historically high pre
tax rates of return.
Moreover, high taxes have one very important influence on cor
porate financing that may indirectly increase corporate responsive
ness to monetary policy. This is their influence on the form which
corporate external financing takes. With interest payments, but not
dividend payments, deductible in computing taxable income there is
a strong incentive, for those corporations that are in a position to
make a free choice, to favor debt rather than stock financing. The
higher the income tax rate the stronger the incentive, other things
being equal, and the higher must be the level of interest rates rela
tive to stock yields before equity financing has a net cost advantage.^

~^For simplification, the calculations underlying the chart make no
allowance for the cost to the company of foregoing alternative in
vestment income from internal funds used to finance the company’ s
own expansion.
4We ignore here the inherent cost advantage of equity financing
that derives from the fact that dividend costs may be lowered or
eliminated at the discretion of the company, while interest costs
are fixed. Many large companies, however, feel committedto main
tain their dividend rates and are extremely reluctant to reduce or
omit payments.

THE FEDERAL RESERVE ANSWERS

At a 50 percent tax r a te , the interest cost of debt must be double
the dividend cost of stock in order to eliminate the cost advantage
of debt and make equity financing an economical alternative to
borrowing* At a 25 percent tax rate, the debt cost need be only onethird greater. This means that avoidance of rising interest rates
by shifting to stock financing is likely to be less feasible when tax
rates are high than when they are low—a factor tending to make
corporate outlays more sensitive to credit restraint under condi
tions of high income tax rates.
Effect of Heavy Reliance on Internal Funds
The bulk of business investment during the postwar period has
been accomplished without recourse to outside financing. Over fiveeighths of the funds used by nonfinancial corporations, as a group,
to expand their fixed and working assets in recent years has come
from internal sources. As may be seen from Table IV -1, the com position of these internal funds has changed markedly since the early
postwar years. The relative importance of other major sources of
corporate funds has not changed significantly during the postwar
period, though their dollar magnitude has increased substantially.
TABLE IV-1
Gross Sources of Corporate Funds
(Percentage Distribution)
1956-59

1947-50

1951-55

Internal sources
Retained earnings
Depreciation allowances

62
39
23

61
25
36

64
19
45

New security issues
Increase in bank loans
Other sources

17
6
15

21
8
11

21
6
10

100

Source

Total

Note: Percentages shown are derivedfrom Department of Commerce
estimates of sources and uses of funds by corporations (other than
banks and insurance companies), as published in the Economic Re
port of the President. Gross sources were computed separately for
each year, and in general are equal to the sum of all positive changes
in net worth and liability accounts and all negative changes in asset
accounts; thus, “other sources” comprises increases in accrued
federal income taxes, other current liabilities or miscellaneous
noncurrent liabilities, and any decreases in cash balances, U.S.
Government security holdings, accounts receivable or any other
asset. Percentages for each period shown above represent the
average of percentages for each year of the period.

QUESTION IV

Reflecting primarily the record plant and equipment programs
undertaken by business since the end of World War n, the bulk of
all corporate internal funds now represent allowances for depreci
ation of existing facilities, and the more volatile component—re
tained earnings—accounts on the average for a greatly reduced
proportion of corporate internal funds. In dollar terms, depreciation
allowances have risen steadily from $5 billion in 1947 to about
$21.5 billion in 1959, while retained earnings, which averaged about
$11.5 billion in the 1947-50 period, have been lower ever since and
averaged less than $9 billion in the 1956-59 period.
Even though, as a group, corporations finance most of their
asset expansion out of their own savings, it does not appear entirely
valid to characterize business firm s as being relatively unaffected
by monetary policy. In the first place, dependence on internal funds
varies considerably from company to company, and even from in
dustry to industry, as the following table indicates.
Some companies finance exclusively with internal funds, just as
some consumers purchase their automobiles for cash. Among large
corporations, extremely high dependence on internal funds appears
to be characteristic only of railroads and most manufacturing in
dustries. In the case of electric and gas utilities, large retail trade
companies, and the largest communications company, internal funds
supply only three-eighths to one-half of total funds used, and among
sales and consumer finance companies practically all asset expan
sion is financed with credit. Thus, if the impact of monetary policy
on businesses is a function of the degree of dependence on external
funds, then a significant share of the business sector is consider
ably affected by the availability of credit.
Second, cost of credit is only one of several factors affecting
business decisions to borrow. Other factors, related to the urgency
of a proposed outlay that would require outside financing, include
expectations as to sales and earnings, estimates of present vs.
future costs, prices, and availability of materials, and the need to
improve margins by modernizing or diversifying. Standards of what
constitutes “urgency” may be influenced by the relative availability
of credit and its cost, but it is probably safe to say that the less
urgent the outlay the more crucial becomes the credit factor. In
fact, public statements of corporate officials confirm that it is the
less urgent, or less immediately profitable, projects that are most
likely to be postponed when credit is restricted.
Third, the weighing of credit cost and availability against non
credit factors affects the decision as to whether to borrow on a
particular occasion, and the customary importance of internal funds
a company’ s total financing may be largely irrelevant. Thus, if
a railroad feels under much less pressure to expand than does an

THE FEDERAL RESERVE ANSWERS

TABLE IV-2
Importance of Internal Funds to Corporations In Selected Industries.
(Percent of gross sources)
Total internal funds
1956
1955

Retained earnings Depreciation
1955
1956
1955 1956

69
68
53
49
80
65

58
61
57
63
66
63

35
35
43
27
46
29

27
31
46
32
36
25

33
33
9
22
34
36

31
30
11
31
30
38

Iron and steel
Nonferrous metals
Machinery
Automobiles
Other transporta
tion equipment

63
70
57
53

66
70
37
47

30
48
25
23

30
47
16
11

32
22
32
30

36
23
22
36

Railroads

Electric power

Communications

Retail trade

Consumer finance

All corporations
Large corporations:
Manufacturing
Food
Tobacco
Rubber
Petroleum
Chemicals

Sales finance

1. Negligible.
Note: Source of data for all corporations, as well as definition of
gross sources, is as noted in Table IV -1. Figures for large cor
porations in selected industries are based on Federal Reserve
compilations for about 300 nonfinancial corporations and about 110
finance companies; data are available for the 300-company sample
only through 1956.

QUESTION IV

electric utility, a restrictive monetary policy may have much more
impact on the former’s credit demand than on the latter’ s, despite
the fact that railroads typically rely much more heavily on internal
funds than do electric utilities (70 percent vs. 40 percent, as may
be seen in Table IV-2).
A final consideration is that monetary policy has indirect effects
that may impinge strongly on companies that make only moderate
use of credit. For example, an individual manufacturing firm that
relies very largely on internal funds for financing its own outlays
may nevertheless find its current and prospective sales, and there
fore its incentives to expand, greatly influenced by credit conditions
if its ultimate customers tend to finance their purchases of the
company’ s products largely with credit.

Effects on Other Sectors
It seems doubtful that the present high corporate tax rate sig
nificantly affects the impact of monetary policy on noncorporate
borrowers. While it might influence the attitudes and goals of lend
ers who are subject to the corporate income tax, the over-all effect
of this influence would appear to be quite small.
Less than one-fourth of all public and long-term private debt
is held by lenders who are subject to the corporate income tax. More
than one-half is held by institutional investors that are largely or
entirely exempt from the tax. The remainder is held by individuals
and miscellaneous investors. This composition of debt ownership,
together with other nontax factors that influence the cost and avail
ability of funds to different classes of borrowers, would seem to
minimize the influence of corporate tax rates on the responsiveness
of lenders to monetary policy.
It also seems unlikely that the heavy reliance on internal funds
by businesses as a group has much direct influence on the impact
of monetary policy on other sectors of the economy, except in cer
tain stages of a cyclical upturn or downturn. Particularly in the
early stages of an economic expansion, the volume of funds generated
by rising sales may increase faster than outlays, and businesses
may be able to provide funds to other sectors, thus moderating the
impact of a restrictive monetary policy. Similarly, in early stages
of economic contraction, businesses may find their earnings de
clining while their outlays are still rising, and may need to restrict
the credit they make available to their consumer and business cus
tomers. It should be noted, however, that the major component
of internal funds— depreciation allowances— shows little cyclical
variation.

THE FEDERAL RESERVE ANSWERS

QUESTION V
One frequently stated objection to an anti-inflationary
monetary policy is that it is not very effective unless
the brakes are applied so vigorously as to make it “too
effective” and precipitate a sharp decline in the securi
ties markets and thereby in business activity. Are small
changes in interest rates likely to be effective in stem
ming inflationary pressures? If not, what is your evalu
ation of the alleged danger that, to be effective, interest
rates might have to rise so far (or bond prices fall so
far) as to disrupt the securities market?
ANSWER V
Summary
Relationships between interest rates, monetary policy, and the
functioning of securities markets are highly complicated. Accord
ingly, this question cannot be answered satisfactorily without taking
into account many economic forces, including changes in bank credit
and the money supply, which affect changes in interest rates and
security market movements and which, in turn, are influenced by
them.l Moreover, it should be emphasized that monetary policy
works not only through the effects of interest rates on spending but
also through the effects on spending of changes in cash balances
and of nonprice rationing of credit. In this frame of reference, the
question may be answered in summary as follows:
(a) In a developing inflationary situation, increases in interest
rates will largely depend on the extent to which private and public
demands for funds are outrunning the supply of funds at pre-existing
rates. The pressure on interest rates will tend to be greater when
inflationary psychology is pervasive and rising interest rates as
well as rising prices are expected. Nonprice rationing of funds in
the market, which usually occurs to some extent, may be expected
to substitute in part for increases in rates.
(b) In the short run, monetary policy affects both the course of
interest rates and general credit availability. In arriving at judg
ments as to action, monetary policy focuses primarily on the volume
and availability of bank reserves rather than on any particular level
I'The answer to the first part of this question can be considered as
an elaboration and translation to a specific context of some of the
general points made in the answer to Question I.

QUESTION V

or pattern of interest rates. Thus, anti-inflationarymonetarypolicy
functions by restraining the supply of bank reserves. In this way,
it limits the demands that can be satisfied through bank credit.
Under conditions of strong credit demand, interest rates will then
tend to rise, though unevenly in different sectors of the market,
and the tendency toward rising interest rates will be accentuated
as monetary policy endeavors to compress the total supply of credit
towards the amount generated by the current savings decisions of
the public. The rise in rates may come sooner and perhaps be
sharper, of course, if market participants generally expect rising
interest rates.
When credit demands are slack relative to the supply of savings,
interest rates will tend to decline. In these circumstances, monetary
actions to increase the availability of bank credit will accentuate
the downward trend of interest rates.
On a recent occasion, an international balance-of-payments de
ficit was made larger by a credit outflow in response to higher
short-term interest rates in major foreign markets than prevailed
in this country. These conditions made it necessary to pay greaterthan-usual attention to the level and structure of interest rates in
the shaping of monetary policy. They also resulted in an experi
mental extension of open market operations from short-term
Government securities to those of longer maturity, thus modifying
the direct market impact of System transactions.
(c) When rising interest rates appear to be the result of inflation
generated expansion in credit demands, with tendencies toward an
unsustainable volume of business transactions, monetary restraint
will be called fo r. Rising rates will themselves help to discourage
some credit demand and enhance the volume of credit available to
other users. In exerting this influence, the extent to which rates
will rise depends on the effects of higher interest rates in restrain
ing marginal investment outlays, in stimulating the flow of marginal
saving into lendable form s, and in inducing conservative portfolio
policies on the part of financial institutions.
(d) Over the past decade of flexible monetary operations, marked
advances occurred in interest rates from cyclical lows to cyclical
highs in expansion periods. Variations in short-term rates were
especially wide—reflecting the typically high sensitiveness of such
rates to changes in money market conditions—but were not greater
than in many earlier cycles. While continuing to vary within a nar
rower range than short rates, long-term rates adjusted more
promptly to turns in the economic cycle, and showed a greater
amplitude of fluctuation, than did long rates in earlier periods.
Variations in both short and long rates in the past decade helped to

THE FEDERAL RESERVE ANSWERS

limit and correct developing imbalances in saving and investment.
In restraining inflationary credit developments, the rate increases
that have occurred were supplemented by nonprice rationing of
available credit among different borrowers, including increased
use by lenders of required compensatory balances and loan repayment provisions less attractive to borrowers.
It is difficult to determine what the consequences would have
been of attempts by monetary action to keep rate changes smaller
than they were, but in view of the strength of inflationary pressures
during the expansive periods of economic cycles over the past
decade, it seems likely that, assuming the same fiscal policy,
smaller rises in interest rates would have been at the cost of a
less effective monetary policy. In other words, the over-all result
of efforts to dampen cyclical rate advances might well have been a
greater increase in price levels, some progressive impairment of
the saving-in vestment process, and still wider cyclical fluctuations
in economic activity,
(e) The alleged danger that a rise in interest rates to be effec
tive will disrupt the securities markets assumes that the distance
which interest rates will ultimately have to move in a period of
inflationary economic expansion uniquely determines that danger.
A detailed examination of the relationship between interest rate
changes and functioning of securities markets makes it evident that
comparatively large cyclical changes in interest rates per se need
not disrupt the functioning of the securities markets, at least as
long as these changes do not occur too abruptly. On the other hand,
failure of the fiscal and monetary authorities to pursue adequate
anti-inflation policies when these are needed would pose a real dan
ger of disrupting the economy, including its financial mechanism.
Actually, sharp changes in market rates are neither a necessary
aim of monetary actions nor a requisite for their effectiveness*
Indeed, most Federal Reserve operations are undertaken to prevent
disruptive effects of strong seasonal and other transient influences
on either supply or demand, and thereby on interest rates, in credit
markets.
(f) There is, of course, no present basis for judging whether
inflationary pressures in years to come are likely to be "sm all” or
“large,” in whatever way these terms may be defined* Nor is there
any present basis for predicting how “ small** or how “large* will be
the interest rate changes accompanying a monetary policy restrictive
enough to prevent inflation. So long, however, as monetary and fis
cal policies of the federal government provide a framework con
ducive to economic stability and sustainable growth, movements of
securities markets and interest rates should tend to be self-limiting
and unlikely to interact in any disruptive way.

QUESTION V

Formation and Functioning of Interest Rates
Interest rates are formed in credit markets as the supply and
demand for funds seek a balance, and the resulting interest rate
levels and movements serve to allocate funds among alternative
and competing uses, Changes in the willingness to lend and in bor
rowing demands are the result of a number of forces at work in
the economy, but three important and interrelated influences are
the nation’ s saving and investment tendencies at given levels of
income and interest rates, changing expectations related to future
economic activity and financial market conditions, and the actions
of monetary authorities in regulating bank credit and money.
Imbalances between the nation's willingness to save and its
investment demand— that is, between its willingness to refrain from
current consumption and its desire to use domestic resources for
the production of capital goods or to invest abroad—are reflected
in interest rate movements to a greater or lesser extent depending
on a number of circumstances. At times when the use of productive
capacity is declining, for example, investment demands are likely
to fall relative to savings, tending to reduce interest rates. Rising
real investment in such conditions will lead to greater output and to
additional saving out of the resulting higher real incomes.
When the economy moves toward full resource utilization, and
particularly if inflationary tendencies are present, interest rates
are likely to rise to a greater extent. Inflationary pressures are
often generated as the economy moves toward near-capacity utili
zation of its plant and equipment. At those times, investment demand
is likely to exceed what the public wishes to save, with resulting
pressure on interest rates (and prices), since the extent to which
saving might be increased out of a rise in real income is limited.
These pressures become intensified during periods when expecta
tions of continued inflationary conditions are widely prevalent. In
such periods, savers attempt to hedge against the expected inflation
by, among other things, purchasing equities rather than debt obli
gations; as a result, stockprices typically rise rapidly, stock yields
decline, and interest rates rise further. Borrowers, on the other
hand, make further demands on credit markets since they expect
cost and price conditions to be less favorable at a later point or
because the cost of borrowing may seem small relative to possible
speculative profits.
While the main outlines of interest rate movements are deter
mined by continuing changes in the balance between investment
demands and the public’ s willingness to save, the Federal Reserve,
through the effect of its actions on bank reserve positions, has an
important marginal influence on the timing and size of changes in
the supply of loanable funds. Furthermore, expectations as to Sys-

THE FEDERAL RESERVE ANSWERS

tem policy may have a strong short-run and temporary impact on
the money and capital markets.
When there are inflationary pressures, the Federal Reserve
limits the availability of bank credit in an effort to keep growth
in spending in line with the resources available to satisfy demands
without inflation. Limitations on the extent of bank credit expansion
combined with strong credit demands will tend to cause market
interest rates to rise.
A general rise of interest rates under these conditions might be
dampened for a time if the Federal Reserve supplied more bank
reserves. Expansion of bank credit in order to permit satisfaction
of credit demands at pre-existing interest rates would, under con
ditions of near-full employment of resources, result mainly in
rising prices and would force the monetary value of both saving
and investment to rise without relieving a shortage of real re
sources. In this process incomes would be redistributed and re
sources reallocated, reflecting differences in the ability of economic
groups and sectors to participate in the general advance in prices
of commodities, services, wealth, and equities.
Pronounced tendencies for interest rates to rise, furthermore,
would be checked only temporarily if inflationary expectations were
pervasive. Indeed, if such expectations were not alreadypervasive,
they would clearly become so if the Federal Reserve followed poli
cies of tolerating, rather than resisting, inflationary trends. Thus,
in the absence of a comprehensive system of official resource ra
tioning and price controls, the Federal Reserve cannot establish
rates contrary to market forces; any attempt to do so would be
self-defeating.
The changing degrees of restraint on or stimulus to monetary
expansion over time are attempts at successive approximations
to the needs of a constantly evolving economic situation. The chain
of events set in course by monetary policy in turn influences the
character of future policy. For example, a situation of strong credit
demands and restraint on monetary expansion is typically accom
panied by rising interest rates, and in turn the rate increases help
to modify economic activity and the continued need for restraint.
Thus, the degree of monetary restraint that needs to be applied is
affected by the extent to which interest rate rises limit spending,
especially that financed by borrowing, and encourage saving. It is
also affected by the extent to which rising interest rates and the
accompanying decline in portfolio values may discourage lending
by reducing the liquidity of lending institutions.
The interest rate sensitivity of the demand for and supply of
funds has been the subject of extensive consideration in the liter

QUESTION V

ature of econom ics. While there is disagreement as to the precise
degree of sensitivity, it is agreed that changes in interest rates
and in associated changes in terms of borrowing affect marginal
borrowers who undertake investments in which borrowing costs
are fairly significant—including certain inventories as well as
housing, public service facilities, and many types of commercial
and industrial construction. Changes in the level and structure of
interest rates also seem to have an influence on the supply of funds
through their effect on marginal saving-spending decisions and on
the portfolio preferences of savers. These and other effects were
all reflected, in varying degree, in changes in the flow of credit and
in economic activity during the past decade, when interest rates
moved flexibly in response to varying conditions in credit markets
and thus served as an essential aid in the effort to maintain eco
nomic stability.
Credit Availability and Interest Rates
The interest rates prevailing in credit markets are not uni
formly responsive to changes in credit availability relative to de
mand. Some rates respond with a lag and at any particular time may
not reflect accurately the existing supply and demand situation. In
some cases, the stated interest rate may not change, but the rate
may be effectively varied through changes in other factors such as
the amount a bank requires a borrower to leave on deposit or the
extent to which lenders acquire assets at a discount or a premium.
In market sectors where interest rates tend to be less flexible,
lenders give more emphasis to nonprice factors in allocating funds
among borrowers whenever credit demands press actively against
the supply of funds. While lenders always tend to be selective to
some degree in satisfying borrowers, they adhere to stricter lend
ing standards and screen credit-worthiness of borrowers more
carefully when credit demands are- strong and market conditions
are tight. Borrowers then become obliged to shop more intensively
In order to find lenders whose loan standards and terms they can
meet, and some borrowers will fail to find such lenders. Thus, an
increase in demand for funds relative to supply not only causes
interest rates to rise but also has a direct effect on the readiness
and extent to which borrowers can obtain funds,
Federal Reserve anti-inflationary actions, therefore, tend to be
accompanied by both rising interest rates and more emphasis by
lenders on credit standards and other nonprice factors in allocating
funds. Counterrecession actions taken by the System, on the other
band, tend to be associated with declining interest rates and reduced
emphasis by lenders on nonprice influences.

THE FEDERAL RESERVE ANSWERS

Ranpra of Interest Rate Variation
Since the restoration of flexible monetary policy in 1951, the
range of fluctuation in long-term interest rates has widened from
that of the preceding 15 years. The range, however, has not been
greater than during many cycles preceding the Great Depression of
the thirties. Short-term rate adjustments to shifts in monetary
policy have characteristically been rapid. Yield movements on
longer term obligations, although of smaller amplitude than on
shorter term securities, appear to have quickened in recent cycles,
compared with earlier ones.
There are no simple explanations for the extent and pattern of
interest rate movements since 1951. Certainly, our experience is
too brief and the analytic tools of economics still too incomplete
to permit any freehand generalizations. Nevertheless, some sig
nificant factors can be pointed to.
In the past decade or more, there occurred a rather marked
upward shift of the interest rate structure as a whole in many
countries, including the United States. In the United States, this
followed a period of exceptionally low rates, brought about during
the depression of the 1930’s and arbitrarily maintained during war
time and for a period thereafter. With the structure of interest
rates at a higher level, there should be no surprise that fluctuations
in market rates during the past decade exceeded those of the two
preceding decades.
Apart from this, there are other important considerations. Ex
perience shows that, in a period of active economic development
and growth, one important factor is the limited (or even conflicting)
effectiveness of measures other than monetary policy in curbing
the recurrent inflationary pressures generated by an unduly rapid
expansion of credit demands. Monetary policy can limit the avail
ability of bank credit and, to a degree, of credit in general, but by
itself it is not equipped to prevent or correct serious imbalances
that might have their origin in the unwise spending or investing of
available funds, whether their source Is in bank credit or other
savings forms.
Over the past decade, furthermore, the trend in public debt has
been upward, with some increases in periods of strong economic
expansion and rising private demands for credit. The net effect of
the government’ s fiscal policy in these periods and for the decade
as a whole has been to absorb savings. Consequently, the supply of
funds has been less than would otherwise have been available while
the demand for funds has been augmented, thereby enlarging the
gap obtaining in credit markets between the demand for and supply
of funds and generally feeding inflationary pressures. Under these

QUESTION V

circumstances, inadequate reliance on fiscal and other policies to
help contain inflationarypressures contributed to successive periods
of fairly sharp upward interest rate movements. These movements
were not fully reversed during the comparatively moderate reces
sions of the ten-year span.
Another factor of importance has been the growing sensitivity
of professional investors to prospects of changes in the govern
ment’s fiscal position, or in Federal Reserve policy, as forces
affecting the markets. This heightened responsiveness in the market
means that some market participants try to make at once most of the
adjustment in their portfolios that might be expected to become
desirable.
Inflationary psychology has also been important in intensifying
interest rate rises at times during recent years. As e:q>lained pre
viously, expectations of a rising price level tend to increase the
demand for funds while limiting amounts lenders are willing to
place in fixed income investments. Sharp rises in interest rates,
coupled with rising prices of inflation hedges such as stocks and
land, are manifestations of a reluctance to lend associated with
inflationary psychology. The relationship of anti-inflationary mone
tary policy to interest rates and inflationary attitudes is doubleedged. Such a policy may be associated with relatively large rises
in interest rates because of the prevalence of these attitudes. On
the other hand, since a policy of restraint has the effect of modi
fying the public’s expectations, such a policy will help to temper
pressures on interest rates related to expectations of a rising
price level.
In summary, the restoration of flexibility to monetary policy has
permitted fluctuations in economic activity and market conditions
to be reflected to a greater extent in cyclical movements of interest
rates. In the postwar years before 1951, when the Federal Reserve
was in effect maintaining an interest rate ceiling, upswings in eco
nomic activity and the demand for funds were not reflected in in
terest rate movements, and demand pressures resulted more in
price increases. In the past decade of flexible monetary policy, the
range of interest rate variations associated with shifts in credit
demands, while not large in longer-run historical perspective, has
been wide enough to occasion comment and discussion, especially
in the light of the preceding decade and a half of low and relatively
stable interest rates.
Upward interest rate movements will tend to be smaller when
fiscal and monetary policies both are helping to limit credit demands
and to encourage the flow of savings. But whether interest rate
changes are small or n ot, th e y a r e important under free and flexible
market conditions, as signals of the trend in credit markets and

THE FEDERAL RESERVE ANSWERS

credit policy, and as integral parts of a market mechanism that
adjusts effectively to each new situation.
Flexible Rates and Securities Markets
While the interest rate movements associated with inflationary
pressures in the past decade have taken place over fairly sustained
periods, these upswings have been the cumulative effect of much
less dramatic changes in prices and yields on securities in day-today trading. It is these very short-term changes that are most
closely related to the performance of the securities markets. Hence,
an evaluation of the danger that interest rate movements might
disrupt these markets should focus on the magnitude and implica
tions of the day-to-day changes associated with the longer term
upswings in interest rates. On this phase of the question, it is as
sumed that the expression “to disrupt the market” means to create
a situation in which trading in securities would be severely curtailed,
because price declines and yield advances, rather than helping to
clear the market of outstanding sell orders, would be leading to ac
celerated selling and a drying up of demand.
The very short-term changes in price and yield behavior typ
ically consist of variations in both directions, the net resultant of
which may be seen in retrospect as a clearly defined upward or
downward sweep. This may be illustrated in terms of the sustained
advance in yields on long-term government bonds that occurred from
their cyclical low in April 1958 to their high in early January 1960.
Over this period of about 20 months, the average yield on bonds
due in more than 10 years rose from 3.05 percent to 4.44 percent,
or 139 basis points. This advance did not occur evenly; indeed, much
of the rise, particularly in its early phase, was concentrated within
fairly brief intervals. It is worth noting, however, that on only onesixth of the 428 trading days of the whole period from mid-April
1958 to early January 1960 did the yield average show an advance
of more than 2 basis points, that is of 2/100 of a percentage point.
On only one-twelfth of the 428 days did average yields rise more
than 3 basis points. On the other hand, on three-fourths of the
trading sessions, daily variations in long-term yields were less
than 2 basis points. Stated in terms of price change, the cyclical
adjustment of l 2/5 points in yields was associated with daily vari
ations in prices that were generally less than $3,33 per $1,000 of
securities, that is, less than one-third of one per cent.2
On some trading days, to be sure, price and yield changes were
significantly larger. Thus, over one weekend in mid-July 1958, re ^On a 25-year, 3 l /2 percent bond, a change of 2 basis points in
yield represents a change of about $3,300 for $1,000,000 of securities.

QUESTION V

fleeting the impact of an international political crisis in the Middle
East on an already disturbed market, long-term yields advanced
9 basis points,3 On a few other occasions that summer average
yields rose as much as 5 or 6 basis points and on two days in Octo
ber average yields declined about 7 basis points.
Although disturbed market conditions are likely to be associated
with sharp changes in prices and yields, it does not follow that
larger-than-usual changes in quotations necessarily represent some
degree of market unsettlement. In any freely functioning market,
temporary imbalances inevitably develop from time to time between
the supply that enters the market and the demand that arises to
absorb it. If prices are unable to adjust flexibly in response to these
gaps, perhaps because of institutional rigidities or of attempts to
support the market, there will be increased danger either of a dry
ing up of trading or of breakdown in the market mechanism.
Day-to-day changes in yields in the market for Government
securities are likely to attract more attention at times of rapid
economic transition. Changes in prices and yields at such times
are significantly influenced by expectations of participants in this
market. When a major turnaround in economic activity appears to
be taking place, for instance, reappraisals as to the outlook for
interest rates are likely to cause market participants to adjust
their positions or to alter the timing or the maturity area of their
purchases in response. These actions and attitudes have the effect
of accelerating the yield adjustments that are already in process at
such times.
The size of initial yield adjustments at cyclical turns, presumed
or actual, depends in part on the extent to which active traders
revise their expectations and the firmness with which they hold
their revised views. Uncertainty, or the possibility that expectations
may not be borne out by events, is always present in a securities
market. Risks associated with uncertainty are necessarily assumed
by those who engage in the positioning of securities in the hope of
experiencing capital gains. Losses incurred from such speculative
positioning do not reflect any failure of the securities markets to
function properly.
Erroneous expectations that are widely enough held to influence
the direction of securities prices, or overreactions to other de
velopments affecting prices, are ordinarily corrected promptly by
the securities market itself. Only rarely would such a situation
b r i e f l y in July 1958, when an international crisis coincided with
continued liquidation of speculative positions and the approach of
a large Treasury financing, the Federal Reserve found it necessary to
enter the m a r k e t f o r t h e purpose of correcting disorderly conditions.

THE FEDERAL RESERVE ANSWERS

justify official intervention—assuming that such intervention could
toe based on a knowledge superior to that of the market concerning
sustainable price and yield levels and relationships. Experience
over a number of years suggests that the occasional emergence of
erroneous expectations in the securities market has not been such
as to limit significantly the flexible use of monetary policy as a
means of countering economic instability.
On the contrary, uncertainties as to market prices for certain
types of assets reinforce the effectiveness of countercyclical mone
tary policy. Holders of longer term Government bonds in particular
have come to recognize that such securities, while generally con
tinuously marketable, are not shiftable into an assured amount of
cash at all times before maturity. In other words, debt instruments
of differing maturity vary in degree of liquidity. Moreover, the
facility with which longer term government debt may be converted
into money diminishes with the build-up of inflationary pressures.
Such differences and variations in liquidity of longer maturities
of debt serve as a countercyclical force, and do not imply any im
pairment of market functioning.
The foregoing discussion of relationships between cyclical move
ments in interest rates and performance of securities markets has
been concerned with short-term changes in prices and yields that
may occur within the course of a major cyclical upswing. There
remains the question as to whether the level to which interest rates
move itself poses a threat to the proper functioning of the securi
ties markets.
When yields on longer term bonds reach levels that represent
new peaks within the recent experience of market participants, ex
pectations of further rise may lessen and the possibility of a
decline in rates may acquire increased importance in the minds of
participants. At such a point, some investors will begin to readjust
their portfolios in the direction of larger holdings of long-term
securities and some other investors who had been on the sidelines,
so to speak, will be drawn into the market, thus tending to change
the relation between market supply and demand and contributing to
a reversal in the movement of market rates. Apart from effects
stemming from such influences as notions of “normal" interest
rate levels or technical tax considerations, absolute levels of in
terest rates in themselves appear to have had little influence on
the functioning of the securities markets in recent years.
Potential Sources of Security Market Disruption
During the ten-year period since early 1951, in which yields on
securities have been free to reflect the full interplay of supply and
demand, the performance of the securities markets has been broadly

QUESTION V

satisfactory # Intervals of market unsettlement have been infrequent
and brief and the markets generally have cleared effective buy and
sell orders with reasonable promptness. With the government se
curities market playing a central role, yield developments in the
centralized securities markets have been closely linked. Changes
in yields in particular markets, therefore, have reflected the con
ditions in the economy as a whole with respect to the supply of and
demand for funds and not merely the specific pressures acting on
the particular market.
That the markets have continued to perform satisfactorily, and
without serious disruption even in periods of rapid economic ex
pansion, has reflected the fact that comparatively moderate advances
in interest rates in day-to-day trading have served to attract buying
and to discourage selling. Markets for most issues of government
securities have been kept continuous because professional traders
and dealers have been willing to take positions in the securities
traded. Investors have generally been willing to put available funds
into new issues whenever these issues have offered returns that
compared favorably with yields on alternative opportunities for
investment.
While the securities markets have performed reasonably well
in the past several years, it should be recognized that certain con
ditions, if permitted to develop, might at some point lead to a
serious disruption of the markets. Essentially such conditions
might well emerge if the public, i.e., investors, savers, lenders,
and borrow ers, were to lose confidence in the ability of the govern
ment to contain inflationary pressures. Should inflationary expecta
tions become pervasive, even sharp advances in interest rates
might be unable to reduce sufficiently a developing imbalance be
tween supply and demand in markets for funds. The risk of disrup
tion of the securities markets becomes greater when the federal
government runs a heavy budget deficit at a time when strong
business and consumer demands for goods and services are exert
ing pressure on available resources. Under such conditions the
combined impact of private and public demands for funds may
severely test the capacity of the financial mechanism.
Debt management policies may also subject the securities mar
kets to unusual strain if the Treasury is unable over a period of
time to issue enough longer term securities to counter the effects
of the passage of time on the maturity of existing debt. Such a
build-up in the size and frequency of the Treasury’ s need to re
finance maturing debt would result in the concentration of the
government’ s debt in short maturities. In such circumstances
Treasury refinancing, by contributing to a condition of redundant
liquidity, could complicate the task of monetary policy.

THE FEDERAL RESERVE ANSWERS

The strength of the securities markets depends basically on the
stability of the economy. In an economic climate in which decision
makers are confident that inflationary pressures will be effectively
countered by appropriate Federal financial policies—including
fiscal measures, debt management, and monetary policy, they may
be expected to continue to respond to interest rate movements in
a way that contributes both to stability of the economy and to prop
er functioning of the securities markets.

QUESTION VI
In what ways does the existence of a national debt of
approximately the present size, composition, and owner
ship distribution, assist and in what way does it hamper
the effectiveness of monetary policy?
ANSWER VI
Summary
On balance, a national debt of the present size, composition,
and ownership distribution neither “assists* nor “hampers* to any
significant extent the effectiveness of monetary policy. The exist
ence of the debt obliges the Federal Reserve System, however, to
adapt its policy actions to compensate for influences that result
from shifts in the composition and ownership of the debt.l
In an important respect, the existence of a large public debt
might be said to assist the monetary authorities. A standardized,
riskless public debt, in a wide range of maturities and owned by
all types of investors, is a powerful force for the transmission from
one area to another of financial impulses set in motion by monetary
policy or by the interplay of market forces themselves. The size of
the debt, its wide ownership both within and outside the commercial
banking system, and the active market in which it is traded enable
ilt should be clear that the question and this statement distinguish
sharply between the outstanding debt and surpluses or deficits
which arise from current fiscal policies. Substantial changes in
the size of the debt in a short period raise many important prob
lems for monetary policy, and for economic stability generally,
which are not treated here.

QUESTION VI

the Federal Reserve to rely principally upon impersonal operations
in short-term Government securities. By supplying or absorbing
reserves in relatively small amounts through its open market
operations in these securities, the Federal Reserve is able to exert
workable control over the aggregate volume of bank reserves.
The transferability of the marketable public debt, and the ex
tent to which at least shorter maturities may substitute for cash,
does influence the formulation of monetary policy, however. In
particular, the tendency during periods of credit restraint and
rising interest rates for shorter-term Government securities to be
substituted for money in many portfolios, leads to increased veloc
ity of money. This in turn requires continuous study of financial
flows in assessing whether any given monetary policy is having the
desired effect. Moreover, to some extent the present composition
of the debt forces the Treasury to be “in the market” more often
than would be desirable from the point of view of monetary policy.
This does not necessarily “hamper the effectiveness of monetary
policy,” in the words of the question, but it does at times make the
execution of policy more difficult.
The Shiftabilitv of Public Debt
U.S. Government securities are more liquid than other obliga
tions of comparable maturities, because of both their freedom from
credit risk and the breadth of the market in which they may be
traded. The size of the public debt relative to the total of all debt,
the fact that some Government securities are held by many types
of investing institutions, and the fact that Government securities
normally may be bought or sold in large quantities, have made
these obligations the principal medium for portfolio adjustments.
Through purchases or sales of Governments, the impact of shifts
in the pattern of the flow of funds through the financial markets
may be ‘ cushioned” for the individual institutions directly affected.
The monetary authorities, accordingly, can apply varying de
grees of pressure upon the commercial banks without creating un
duly severe localized pressure upon the credit structure.Such reg
ulation, shaped by means of orderly market processes, normally
requires substantial transfer of short-term government debt among
commercial hanirw and between banks and other financial institu
tions and investors. In other industrial countries that still lack
such a broad and active market for highly liquid and widely held
money market instruments, central banks usually rely on changes
in reserve requirements or rediscount quotas to achieve similar
effects or, in some instances, resort to moral suasion or even to
direct controls. In this country, the existence of a large number of
independent banks would make application of detailed regulation
exceedingly cumbersome and perhaps impracticable. A broad

THE FEDERAL RESERVE ANSWERS

national market for Government securities provides an adjustment
mechanism that avoids resort to these methods.
On the other hand, the size and distribution of the public debt
has conditioning effects on central bank policy. Because of the
relative ease of transfer of Government obligations, and the extent
to which at least shorter maturities may substitute for cash, mone
tary policy actions might be partly offset through changes in the
ownership of the debt that influence the velocity of money. Monetary
policy must accordingly be formulated to allow for this influence
in order to achieve the desired effects on the ultimate availability
of money and credit.
Execution of monetary policy has been further complicated in
recent years by structural shifts in the ownership and maturity of
the debt that have resulted from the passage of time and from debt
management policies. Frequent debt management operations have
on balance handicapped the conduct of monetary policy, particularly
as to timing, thereby lessening its effectiveness to some degree.
These recent problems are not, however, inherent in a debt of the
present size; in part they have reflected stresses growing out of the
sizable expansion and restructuring of debt of all types.
The following sections briefly describe the major ways in which
the debt influences the formulation of monetary policy, first under
a restrictive monetary policy and then under a policy of ease.
Effects of the Debt on Monetary Restraint
When interest rates are rising in a situation of increasing credit
demands and limitations on credit supplies, the relative attractive
ness of money versus interest-bearing liquidity instruments falls
while the implicit cost of holding money increases. The resulting
shifts in ownership and maturity structure of the debt exert an in
fluence on the impact of monetary policy. Periods of most rapid
economic expansion, in the intermediate phase of the cycle following
recovery from recession, are typically periods of most active de
mands for credit of all types. Commercial banks as a group may
respond to loan demands either with new funds supplied to them by
(or with the acquiescence of) the Federal Reserve System or with
funds derived from shifting assets to nonbank holders. Other finan
cial intermediaries are similarly able to add to their inflows of
funds from other sources by liquidating Government securities.
In recent business expansions, the periods of heaviest credit de
mands have coincided with periods of largest net cash accumulations
by business corporations and by other nonfinancial institutions and
individuals. These nonbank sources of credit usually employ a large
part of their surplus funds to purchase U.S. Government securities

QUESTION VI

from commercial banks and other financial intermediaries. In this
way, funds for net credit expansion are provided in a manner that
is reflected in the monetary statistics as an increase in the veloc
ity of money rather than as an increase in the money supply itself.
In most postwar experience, this process has principally in
volved transactions in short-term public debt, although when prices
of bonds were pegged, Government securities of any maturity were
equally liquid and served the purpose. On the other hand, if the
Treasury had not provided the commercial banks and other insti
tutions with a supply of marketable short-term obligations which
could be used to adjust for current cashflows, the market probably
would have generated instruments to perform the function. It is
questionable, however, whether such paper could ever be as liquid
and shiftable as short-term U.S, Treasury securities.
Another part of the role of the short-term Treasury debt in
periods of monetary restraint, in addition to facilitating shifts of
funds between banks, financial intermediaries, and others, is the
movement of short-term debt among investors which does not in
volve net selling by financial intermediaries. Typically, a large
business corporation (or state fund, municipal fund, etc.) will at
tempt to operate on minimum cash balances. Cashflows are usually
projected in advance, and unexpected changes are provided for
through alterations in holdings of short-term Government securities.
Over a period of seasonal cash drain and return flow, for example,
a large corporation may hold an almost constant cash balance, while
the total of its cash and short-term Governments swings frequently
and substantially. The great bulk of such flows of funds remains
within nonbank sectors, so that cash losses by one firm, industry,
or region are ultimately offset by gains elsewhere that provide the
cash to purchase the short-term securities being sold by the ulti
mate losers of funds.
In periods of economic expansion, short-term Government se
curities have thus increasingly replaced cash in the balance sheets
of these institutions for all purposes except near-term transactions
requirements, with a resulting increase in the velocity of money.
A fluctuating portfolio of short-term Government securities permits
the same amount of money--or even a smaller amount as efficiency
in cash management increases—to support an expanding volume of
transactions.
The net effect of all this upon the effectiveness of restrictive
monetary policy is to require, in policy formulation, consideration
of the availability of the entire range of liquid assets in determining
the appropriate amount of the particular liquid asset—money—over
which monetary policy has the most direct influence. When there
is a huge public debt heavily concentrated in shorter maturities,

THE FEDERAL RESERVE ANSWERS

changes in the volume of commercial bank credit and the money
supply may not be as reliable measures of the effects being achieved
by monetary policy as in different circumstances*
During periods of monetary restraint in recent years, changes
in the maturity structure of the public debt have been such as to
shorten the average maturity. This has added directly to the supply
of money substitutes and, in general, to the liquidity of the economy.
Such maturity shortening has come about not as a matter of inten
tional debt management policy, but because of the difficulties in
volved in selling intermediate- and longer-term obligations during
periods of credit restraint and, typically, rising interest rates.
Recently, the interest rate ceiling on Treasury bonds has further
complicated the Treasury’ s debt management problem.
Another problem of debt composition that has been troublesome
in periods of monetary restraint is the management of the large
volume of nonmarketable debt. Attrition of savings bonds increases
as yields on competitive investments rise. This requires current
financings through marketable issues to cover the reduction in
nonmarketable debt, and places additional demand on the money
market. The fact that savings bonds, being redeemable on demand,
tend to take on the characteristics of short-term debt in periods
of rising business activity works at odds with what may be desirable
from a monetary policy standpoint.
The purely technical problems of managing a debt of the
present size tend to make execution of a policy of monetary re
straint more difficult, especially with regard to timing, but also
from the standpoint of restrictiveness per se. At and around periods
in which the Treasury is conducting a major financing, the Federal
Reserve System is obliged, by the risk of upsetting that financing,
to avoid overt policy actions or changes in the availability of credit
and money. A debt of the present size and distribution of maturities
necessarily involves frequent, large Treasury debt operations. As
a consequence, the Federal Reserve System periodically, and some
times for rather lengthy periods, finds itself restrained from taking
policy actions that it otherwise might have taken.
Effect of the Debt on Monetary Policy at Time of Monetary Ease
In periods when monetary policies are directed at easy avail
ability of credit and money, reserves supplied to the commercial
banks are employed to bid short-term Government securities away
from other investors, as well as to service their customers* loan
requirements. As a result, the money supply probably responds
more promptly to reserve availability because of the existence of
a large volume of such securities than it would if the banks were
required to rely solely upon the extension of bank loans. Commercial

QUESTION VII

bank demand for short-term Governments in periods of monetary
ease has helped to drive short-term rates quickly and significantly
lower. Purchases of short-term Governments enable the banks to
rebuild their secondary reserve liquidity assets from the low point
to which they have been driven in the preceding phase of the busi
ness cycle, in preparation for servicing customer credit require
ments once the economy again begins to turn upward.
Medium- and long-term interest rates also decline in response
both to decreased credit demands and the increased availability of
bank credit. As short-term rates reach low levels and demands
fall off, banks, as well as other investors, become more inclined to
add medium- and longer-term securities to their portfolios. The
Treasury at times may take advantage of the lower rates and in
creased demands to increase their offerings of longer-term securi
ties. To some degree, this may tend to limit the reduction in
long-term interest rates and the stimulating effect of lower rates.
Since, however, lessened Treasury borrowing in the short-term
market would tend to lower rates in that sector and thus encourage
shifting of lenders into longer-term issues, the net effect on the
average level of rates would be minimized and that on the rate
structure would probably not be great enough to interfere with
policy objectives. If such debt management shifts were very large
and repeated, however, they might have material effects.
During business recessions, attainment of the goals of monetary
policy is assisted by the fact that all maturities of Government
securities become relatively liquid. When prices of securities are
rising, it is easy to dispose of them without risk of loss, and this
tends to offset the effect on liquidity of debt lengthening. Reduction
in liquidity later, as interest rates start rising and prices of se
curities start declining is, of course, an essential part of the
monetary policy.
In concluding, it should be noted that the size, structure, and
ownership of the public debt are but a few of the numerous elements
in the total financial and institutional framework to which Federal
Reserve policy is adapted. Any effort to treat a single component
of an interlocking process as an independent force contains elements
of artificiality. The national debt is an important part, but only one
part, of the entire complex and continuously changing debt structure
in the United States, and thus of the financial environment in which
Federal Reserve policy is shaped and becomes effective.

QUESTION VII
Are changes in the velocity of money an important im
pediment to the effectiveness of monetary policy? Have

THE FEDERAL RESERVE ANSWERS

they been an important impediment at any time in the
post-accord period? Are there any actions that the
monetary authorities can take to influence velocity di
rectly, aside from taking changes in velocity into account
in decisions relating to the customary credit control in
struments?

ANSWER VH
Summary
Changes in velocity—at least in the short run—are reflections
of the economy’ s adaptation to changes in credit conditions. Rising
credit demands tend to be accompanied by increasing borrowing
costs, particularly if monetary restraints are needed to contain
inflationary pressures. Consequent increases in interest rates in
duce borrowers to economize on the use of cash balances in order
to limit the amounts they will have to raise in credit markets, and
at the same time induce holders of idle cash balances to avail
themselves of the increased rates available from investment of
these funds.
Such responses, which are reflected in rising velocity, are
indications that monetary policy is becoming effective, and are not
necessarily impediments to policy. Admittedly, if changes in veloc
ity were erratic and large, they might complicate the formulation
of appropriate monetary policy, but the changes that have occurred
in post-accord cycles have been consonant with fluctuations in eco
nomic activity and sufficiently gradual to distribute the pressures
of monetary restraints throughout the economy without disruption
of financial markets.

Money and Other Liquidity Instruments
The cyclical and other short-term fluctuations in velocity, su
perimposed on what clearly appears to be a postwar upward trend,
are among the many given facts which monetary authorities must
consider in determining the proper degree of pressure on, or stim
ulation of, growth in the money supply required to achieve the ob
jectives set at any given point of time. Like all statistical measures
that relate flows and stocks, variations in income velocity may

QUESTION VII

reflect changes in either or both of its determinants—the stock of
money and the flow of expenditure.1
In modern society, money performs at least two distinct func
tions, serving as a liquid store of value as well as a means of
payment. Any changes in the extent to which a given money stock
is used for either or both of these functions, therefore, will be re
flected in statistical measures of velocity, Such changes may result
in the long run from institutional and technological developments
that lead to a speeding up of the payments flow, thus reducing the
need for cash balances in relation to a given volume of payments.
This is, by and large, a one-way process, resulting in a gradually
increasing efficiency of money in its function as a means of payment.
Money is unique in the sense that it alone serves as a generally
accepted means of payment (although the total volume of settle
ments calling for money can be reduced by a variety of offsetting
devices). On the other hand, the function of money as a liquid store
of value, held to provide for emergencies and for other purposes,
can be fulfilled by a variety of substitutes,
Economic units, including Government units, usually distribute
their holdings of liquid assets in such a way as to balance the income
-1-Two interrelated velocity concepts are used in monetary analysis.
The first, income velocity, by relating expenditures for final products
to the stock of money

disregards the layering of payments

for intermediate products, transfer payments, and payments flows
arising from transactions in existing assets. The second, transT
Debits
P , but actually measured as D em ^dD e^ i it s }

encompasses all types of payments made through the medium of
demand deposits, irrespective of their economic significance. ^
Both measures have well-known conceptual and statistical lim i
tations. Since the end of World War n, the two measures of velocity
have moved in roughly parallel fashion. Neither the ratio of nonGNP payments to final purchases nor the porportion of currency
to demand deposits has fluctuated widely.
Admittedly, each statistical measure of velocity has its advan
tages. The following discussion focuses on income velocity, which
is directly related to the concept of liquidity that is of considerable
importance in monetary analysis. Either of the two over-all velocity
measures constitutes an oversimplification. In particular, differ
ential changes in various segments of the economy or among types
of payments flows are not given explicit recognition when only ag
gregate national ratios are used.

THE FEDERAL RESERVE ANSWERS

from such assets (after costs incurred in their investment) against
possible losses and inconvenience arising from their conversion
into cash. Clearly, current and anticipated fluctuations in interest
rates for money market instruments are a key element in deter*
mining at any given time the proportion of total liquidity that will
be kept in the form of demand deposits. Thus, fluctuations in veloc
ity reflect the composite effect of forces arising from the two main
functions performed by money.
The initial policy actions of the monetary authorities affect the
reserve positions of member banks, resulting in marginal changes
in the availability of credit. These changes, along with other factors,
lead to fluctuations in interest rates, which, in turn, lead to shifts
between money and the assets that perform some money functions *
In periods of monetary restraint, rising interest rates induce a re structuring of liquidity reserves in favor of nonmoney assets, thus
shifting some part of money balances previously held for liquidity
purposes into active use. This process is reflected in a rising
cyclical velocity of money*
Velocity in the Long Run
Some of the apprehensions with respect to the potentially neutral
izing influence of changes in velocity can be traced to the failure to
distinguish between cyclical and long-run elements (see Chart VII-1).
Throughout the postwar period—before as well as after the
accord—the trend of velocity has been upward. It was interrupted
only by three mild cyclical declines, corresponding to the three
moderate recessions since the end of World War II, and by a short
and very mild decline that followed the econoihic upsurge after the
outbreak of war in Korea,2 The peak in velocity reached during
each cyclical upswing has been consistently well above the previous
peak, and the declines that have occurred on the downswings have
in all cases been considerably smaller than the preceding advances.
This longer run rise over the entire postwar period is traceable
largely to the overhang of money supply stemming from war finan
cing (and from the preceding years of depression) and to institutional
developments which have tended to widen the range of other available
liquidity instruments and to improve their marketability. Velocity
also declined in the 1930’ s, as the forces of depression reduced the
use of money while the volume was maintained or increased. As the
chart shows, only in recent years has monetary velocity approached
the rate that generally prevailed in the 1920’ s.
~2The only two other post-World War n declines, in the fourth
quarter of 1949 and in the third quarter of 1959, reflected the slow
ing down of business activity caused by steel strikes.

QUESTION Vn

As the volume of payments has expanded along with economic
activity in the postwar period, some business firms (as well as
households and governments) found that available cash was sufficient
to meet their increased cash outflows; others tended to hold to a
minimum the additions to cash for transactions purposes. At the
same time, the justification for holding money for precautionary
motives has been reduced not only by the greater stability of the
postwar economy, but also because various transactor groups have
come to regard a wide range of interest-earning assets as an al
ternative to cash balances.
Treasury bills, commercial paper, savings-type deposits, and
various other liquid assets are convertible into money at virtually
no risk of loss. The attractiveness of such assets rises with the
level of interest rates. Once acquainted with these media, however,
some business firm s and government units, as well as individuals,
have continued to use them even when interest rates have declined.
This practice is likely to continue in the future, unless interest
rates decline to very low levels that are expected to prevail long
enough to justify abandoning the arrangements which have been set up.
The practice of investing temporary excess balances in the money
market was, of course, widespread among industrial corporations
in the 1920*s before it fell into almost complete disuse as a result
of the depression and the war .The subsequent upward trend in veloc
ity (see Chart VII-1) thus reflects in part the resumption by more
and more firm s of policies analogous to those abandoned during the
long period of excess liquidity. As a result, cash ratios of nonbank
corporations, state and local governments, and of various other
nonbank institutions have tended to decline, though at varying rates,
in the post-accord years.
Developments in the consumer sector, where incomes have
risen rapidly and tend to fluctuate less, have had analogous effects
on velocity. Several factors have combined to limit the need or in
centive to increase cash balances. Various means of making pur
chases without immediate payment, such as charge accounts and
credit cards, came to be widely used, and form s of interest-earning
asset holdings (savings accounts) were well publicized and tailored
to meet a variety of needs. At the same time, more and more con
tingencies could be met without requiring immediate use of cash
reserves.
Thus, structural developments in the financial sphere, including
changes in the amount, composition, and distribution of the public
debt, have resulted in the long-run decline of money as a fraction
of total liquid assets since World War II. They have given renewed
emphasis to the fact that money has two dimensions, supply and
velocity. By facilitating shifts between money and a whole array

THE FEDERAL RESERVE ANSWERS

INCOME AND TRANSACTIONS VELOCITY

Annually

Q uarterly

CHART VII-1

QUESTION VII

of assets of varying degrees of liquidity, the further development
of financial markets has permitted a more intensive utilization of
the money supply.
It is uncertain to what extent, in the years to come, various
money market instruments and such assets as time and savings
deposits will continue to displace money in meeting liquidity needs
and thus tend to increase velocity of demand deposits. But, surely,
a much larger proportion of the total money supply is now used for
transactions needs, and less as a liquid store of value, than at any
time since the 1920*8. Further long-run gains in velocity arising
from possibilities of economizing on cash balances may well be
more moderate, therefore, than since the end of World War II.3
Velocity Swings Over the Cycle
Short-term fluctuations in velocity could be an important im
pediment to monetary policy and to economic stability if they were
erratic. The occurrence of such fluctuations would, indeed, suggest
that shifts between money and near-moneys respond to unpredictable
influences rather than primarily to changes in economic conditions.
This, however, is not the case.
The timing of short-term changes in velocity has generally been
closely parallel to that of cyclical fluctuations in over-all economic
activity. During the downturn, as incomes decline, the desire to
increase liquidity is great. At the same time, falling interest rates
reduce the incentive to minimize cash balances. The money supply
does not decline as much as do aggregate transactions, partly because
of the desire to maintain liquidity and partly because of monetary
policies adopted to combat recession. As inventories are liquidated
and debt is reduced, cash positions are gradually restored and
velocity tends to fall* In the upswing, velocity rises as enlarged
cash balances are drawn on to finance increases in spending. Thus,
cyclical variations in velocity result, in the main, from changes in
the volume of economic activity, reinforced by rising or declining
attractiveness of alternative means for acquiring and maintain
ing liquidity.
SThe various conceptual and technical limitations attached to the
numerator and the denominator in both velocity ratios as usually
computed are not discussed here. It should be noted, however, that
the expanded role of the federal government has tended to increase
statistical measures of income velocity. Treasury deposits are
excluded from measurements of the money supply used in the at
tached chart, while U.S. government expenditures are included in
GNP, When federal outlays rise, the numerator of the velocity ratio
is increased while the denominator is not affected directly (even
though Treasury deposits may in fact be rising or falling). The net
effect
is to increase the computed measure of income velocity.

THE FEDERAL RESERVE ANSWERS

Some gains in velocity are undoubtedly not reversible; this has
been notably true during the post-World War II period. Moreover,
each successive increase in velocity reduces possibilities for
further economizing of cash for transaction purposes and/or in
the management of liquidity reserves.
In view of the complexities of the modern financial system,
continuous adaptations to change present challenges to monetary
policy, some of which are more formidable than others. Changes
in velocity belong to the category of adjustments within our mone
tary and credit system which can be fairly easily and rapidly identi
fied. Short-run variations in velocity can be meaningfully interpreted
only within a broader framework of analysis encompassing changes
in the entire credit and liquidity situation of the economy during a
given period.
Velocity and the Working of Monetary Controls
It is sometimes contended that changes in the role of different
kinds of financial assets have weakened the ability of monetary
authorities to influence effectively the liquidity of the economy, that
variations in velocity tend to offset, at least in part, changes in the
money supply brought about by the monetary authorities, and that
such changes in velocity constitute an “escape hatch” from the
pressures the monetary authorities are trying to exert. Credit re
straint, it is argued, causes rises in interest rates; these, in turn,
lead to shifts of some idle balances into the hands of active users,
which increases velocity to an extent that largely frustrates the
intent of the restrictive monetary policy. While it is recognized
that the effect on total demand of the rise in velocity might perhaps
be offset by still further restraint on bank reserve positions, it is
alleged that such a policy is not generally feasible because beyond
a given point such tightening would disrupt financial markets.
While factors other than responses to monetary policy affect
changes in velocity, in the long run as well as cyclically, important
forces affecting velocity clearly arise as a reaction to changes in
monetary policy. In particular, moves toward restraint, by limiting
the availability and raising the cost of additional money, intensify
the search for alternatives for money, as well as the desire to
economize on cash for transactions purposes,
At any given point of time the proportion of liquid assets that
various economic units will want to hold in the form of money
(as well as the total volume of liquid assets) will depend on their
current operations as well as on expectations as to future level of
several economic variables. The supply of each category of altern
ative liquid assets is responsive to demand. Yet, the degree of
liquidity of each category of near-moneys depends on the precise

QUESTION VII

conditions under which they are convertible into money. By operating
on bank credit and the money supply—the ultimate source of liquid
ity the monetary authorities exert an indirect but fairly effective
influence on the entire liquidity structure of the economy.
Even though this influence is pervasive, it is not instantaneous and
may involve various lags, Since response usually involves shifts in
holder preference between money and other liquid assets, more in
clusive liquidity ratios tend to show greater stability than income
velocity. The important fact to recognize is that changes in money ve
locity are not an independent force in the credit situation, but rather
m irror the behavior of many complex changes in the liquidity condi
tions of the entire financial structure and the economy as a whole.
On the surface, increases in velocity in response to tightening
Federal Reserve policies, which normally are accompanied by
rising short-term rates, may appear as an avoidance of the impact
of monetary policy actions. In fact, such increases are a reflection
of the speed with which the effect of such actions travels beyond the
confines of the banking system. The result—in line with the intent
of monetary authorities—is a rearrangement of liquid asset hold
ings that maximizes the use of the existing stock of money and thus
speeds the effects of restraint throughout the economy. Moreover,
as is noted in the answer to Question VIII, the rise in interest rates
accompanying the increase in velocity itself reinforces monetary
restraints.
Changes in velocity, along with other mechanisms built into our
monetary system, serve to spread the effects of a flexible monetary
policy. An increase in velocity is one of the mechanisms that per
mit the spending patterns and commitments existing at the point of
initial impact of restraint to be honored. Thus, the pressure of added
restraint is distributed throughout the economy. Conversely, when
policy eases, a mechanism, provided by the financial markets, is
needed that will make the ease truly general and that will translate
the additional demand for assets by some banks into increases in
the money supply. Changes in velocity thus reflect reactions to past
actions of the monetary authorities as well as set the stage for the
determination of subsequent policy moves.
Had short-run fluctuations in velocity been unexpected and vio
lent, rather than systematic and mild, they might have complicated
the formulation of monetary policy appropriate to the particular
economic situation, In actual experience, they have been sufficiently
gradual to permit the economy to adjust itself to changes in credit
conditions. The suggestion that direct measures to stabilize velocity
of money (income or transactions) might be required (except per
haps for a small range of fluctuations to allow for adjustment lags)
implies that monetary policy cannot rely on the crucial position of

THE FEDERAL RESERVE ANSWERS

money within the liquidity structure and on the play of interest rates
to affect the total liquidity of the economy.
Behavior of the holders of liquid assets in the major economic
sectors since the accord does not bear out these apprehensions.
Moreover, the long and difficult process of eliminating from the
economy much of the excess liquidity generated during the depres
sion and war years has gradually reduced ratios of money supply
to current output, and thus has made the entire liquidity structure
more responsive to monetary policy.

QUESTION VIII
Has the rise in the volume of near-money assets—such
as savings deposits, savings and loan shares, and short
term Treasury securities—diminished the importance
of the money supply proper, and thereby reduced the ef
fectiveness of monetary policy?
ANSWER VHI
Summary
The long-run rise in the volume of near-money assets, absolutely
and in relation to the money supply, has not reduced the effectiveness
of monetary policy, for over most of the period interest rates have
been free to exercise their allocative function. The diffusion of hold
ings of liquid assets and their diversification has added to the flex
ibility of the financial mechanism, but it has not destroyed, or even
impaired, the key role of money in the liquidity structure of our
economy. The restrictive effects of rising interest rates, and the
stimulating effects of declining interest rates, together with c e r
tain institutional factors which have tended to limit the substitution
between liquid assets and cash balances, have permitted changes in
monetary policy to affect the entire liquidity structure.
Shiftability of Government Debt
When banks have abundant holdings of Government securities,
as they have had in postwar years, they customarily liquidate sub
stantial portions of their portfolios during periods of credit re
straint. This enables them to meet the growing demands for loans

QUESTION VHI

that are characteristic accompaniments of the rapid growth in
total demand.
So long as income is constant and the nonbank purchases of
Government securities are financed by diversions of funds from
consumption spending, direct investment spending, or lending to
others, a growth in the volume of bank loans would involve merely
a rechanneling of funds from one use to another, with no necessary
increase in the rate of total spending. Under these circumstances
the shifting of government debt out of the commercial banks will
not lead to an expansion of total credit except to the extent that
nonbank acquisitions of government debt are financed by an increase
in savings. Thus, the shifting of Government securities clearly is
not an unstabilizing influence operating contrary to the aims of
monetary policy.
Some analysts have focused attention on the fourth alternative
method by which nonbank acquisition of Government securities may
be financed; investors may simply substitute Treasury issues for
cash balances without reducing their current spending or lending
operations. Such a development is always possible so long as exist
ing cash balances exceed minimum levels needed to maintain current
rates of spending. Its likelihood is greater when the banks are sell
ing prim arily short-term government debt, such as Treasury bills.
These instruments serve well as liquid reserves in place of cash.
To the extent that bank sales of Government securities result
merely in the absorption of cash balances without depressing either
the spending or the lending of the buyers, the additional spending
financed by the growth in bank loans is not offset by greater re
straint imposed on other types of spending. In this case, the Federal
Reserve’ s influence over the level of bank credit is effective, but
nonbank credit expands through the sale of bank-held government
debt to nonbank buyers.
Thus, it is claimed, the existence of a large block of short-term
government debt in the hands of banks provides a potential “escape
valve* whereby a Federal Reserve policy of credit restraint may
be met by a more efficient utilization of the already existing money
suPPly. This process would be manifested by a rising velocity of
circulation as the nonbank buyers of government debt economized
on their cash holdings without curtailing their current spending or
lending to other borrowers. Such a development, with its sympto
matic acceleration in monetary velocity, would tend to reduce the
effectiveness of maintaining a given quantitative restraint on the
level of bank credit and the money supply. A similar activation of
cash balances could be achieved through sales of short-term securi
ties by the Treasury directly to nonbank investors.

THE FEDERAL RESERVE ANSWERS

Financial intermediaries may also resort to the liquidation of
short-term government debt when they wish to expand their loans
at a rate that exceeds current cash inflows. Again, to the extent that
the purchasers of the Treasury issues being liquidated merely use
them to substitute for working cash balances, the velocity of c ir
culation of money rises.
In addition, some spending units, such as nonfinancial corpor
ations, may come into a period of monetary restraint holding large
amounts of liquid Treasury securities. If such holdings satisfy their
liquidity needs, these spending units may be willing to draw down
their cash balances in order to finance additional spending without
having to resort to borrowing.
In all of these cases the suitability of short-term Treasury se
curities as liquid reserves may permit an increase in velocity of
money that is beyond the direct control of Federal Reserve policies
and which must be considered in the determination of the proper
rate of growth of bank credit and the money supply. Holdings of
longer-term Treasury debt are not generally regarded as presenting
so significant a problem for monetary control. This is mainly be
cause most potential purchasers regard longer-term Treasury is
sues as less liquid than short-term government debt, owing mainly
to the greater fluctuations in their market values that reduce their
reliability as liquid reserves. The kinds of interest rate adjustments
that accompany heavy selling pressures in the markets for longerterm Government securities involve capital losses that many in
vestors, including banks, are somewhat reluctant to take. Such
securities can be made liquid, of course, by Federal Reserve pur
chases and particularly by an established and recognized policy of
purchasing at fixed prices, as was the case in postwar years
before the accord.
Role of Thrift Institutions
All marketable or redeemable assets are in some degree “liquid”
in that they provide a potential source of cash for their holders.
However, the liabilities of certain financial intermediaries are,
along with Government securities, perhaps the most important near
moneys in the contemporary American economy. Redeemable fixedvalue claims, such as deposits at mutual savings banks and savings
and loan shares, stand out as the most prominent of the nonmonetary
liquid claims against financial intermediaries, The funds acquired
by the intermediaries when their claims are issued in return for
cash are normally used to extend credit; in the United States, the
credit of private financial intermediaries that issue such claims is
concentrated heavily in the field of mortgage lending.
A build-up of claims against intermediaries may represent a
substitution, by those who acquire them, for other securities, for

QUESTION VUI

direct investments, or for cash balances. To the extent that indi
viduals acquire such claims by reducing their current spending
or their purchases of securities, lending by intermediaries merely
offsets this reduction in spending. To the extent that the growth in
the share capital or deposits of thrift institutions represents a
substitution of these liquid claims for working cash balances, a
greater portion of the money supply is activated and the total vol
ume of nonbank credit and of spending is increased.
It is clear that the growth of nonbank intermediaries which issue
fixed-value claims has provided an important additional source of
highly liquid assets, one that is accessible to many investors who
do not normally participate in the securities markets. Some analysts
have argued that a distinction between commercial banks as creators
of money and nonbank intermediaries as channelers of savings may
be overdrawn. They contend that nonbank intermediaries are also
able to “create liquidity” in such a way as to contribute to a rise
in the total volume of economic activity without a corresponding
rise in bank credit and the money supply, i.e., through a rise in
the velocity of money.
This aspect of the argument, too, may be overemphasized, how
ever, because the liquid claims createdby these financial institutions
are not a substitute for money as a medium of exchange. So long as
the quantity of money can be adjusted to compensate for velocity
changes, the economy’s responsiveness to monetary policy is not
impaired, even though liquidity needs may be increasingly met
through other types of assets.
Time and savings deposits at commercial banks comprise an
other form of institutional near-money. Time deposits are usually
acquired by depositing currency or by shifting from demand deposits,
In both cases, the basis for expanding bank credit is enlarged. In
particular, a shift from demand to time and savings accounts at
com m ercial banks allows for an expansion of commercial bank
credit (unless the Federal Reserve reduces the availability of bank
reserves), because the reserve requirement against time deposits
(currently 5 percent) is lower than are the requirements against
demand deposits. Shifts of funds from demand deposits to time and
savings deposits at commercial banks and acquisition of time de
posits for cash may or may not be associated with a reduction in
spending or lending on the part of those who acquire the time deposits,
Relation to Monetary Policy
Skepticism has been expressed about the ability to compensate
for rising velocity through greater quantitative restrictions on bank
credit and the money supply. This skepticism derives from the
prem ise that monetary restraint itself leads to an accelerated sub

THE FEDERAL RESERVE ANSWERS

stitution of liquid nonmonetary assets for cash at a rate sufficient
to negate financial restraints. Such a development is conceivable
only under highly limiting assumptions.
Monetary controls will lack force in those situations where the
community is able to finance large increases in the total volume of
credit and transactions out of idle cash balances with little or no
changes in interest rates. If interest rates were so low that holders
of loanable funds as a group were unwilling to lend at any lower
rate, they would hold cash balances in preference to earning assets.
Under such circumstances, a given degree of restraint on bank
credit and the money supply might be counteracted for a period of
time by continuing activation of idle balances.
More relevant for monetary policy is consideration of the kinds
of financial conditions under which substitution of liquid nonmonetary
claims for working cash balances involves a penalty. When infla
tionary pressures threaten, rising credit demands may lead to a
more active use of the money supply, but they do not permit an
unrestrained expansion of credit. During the economic upswing of
1958-59, for example, there occurred a noticeable rise in the veloc
ity of circulation of money that was undoubtedly accomplished
partly through the substitution of liquid claims for working cash
balances. This development was accompanied by a marked restraint
on financial markets, even though bank credit was permitted to grow
somewhat. The significant increases in interest rates reflected in
part large credit demands, but also in part the fact that holders of
cash were unwilling, without the inducement of rising interest rates,
to economize on their cash balances by substituting liquid claims
for them in sufficient amounts to meet all demands.
Institutional Factors
Aside from the effects of the rise in interest rates, certain in
stitutional factors also operate to limit the degree to which shifts
from cash balances to liquid assets can soften the impact of mone
tary restraint.
The extent of liquidation of short-term Treasury issues by finan
cial institutions during a period of rising credit demands is limited.
This is because each institution has only limited quantities of these
securities, and because many of them are unwilling or unable to
reduce materially their holdings of liquid assets in order to extend
further loan credit. Since this consideration is taken up in answers
to other questions, it is sufficient to note here that, during the p roc
ess of shifting short-term Treasury debt to the nonbank sector,
banks and other lending institutions undergo a loss of liquidity which
inhibits their willingness to continue the shifting process as finan
cial pressures mount.

QUESTION IX

Some savings institutions are restricted in their ability and
freedom to offer more attractive rates of return to their share
holders or depositors as credit demands intensify. For example,
the portfolios of mutual savings banks and savings and loan associations, concentrated largely in long-term mortgages, are relatively
inflexible. That is to say, composition of their portfolios cannot be
significantly changed by sales of assets and purchases of others in
a short period of time, nor would short-period increments in assets
be large enough to effect a significant change in composition.
Hence, a very large rise in the rate of return may be necessary
to justify more than a nominal rise in the rates paid to depositors
or shareholders which must, of course, be applied to existing as
well as to new deposit or share accounts. This limitation on the
rise in rates paid on the liquid liabilities of thrift institutions re
stricts their ability to mobilize funds in a period of tight credit
availability. When the period of credit stringency is prolonged,
however, these institutions may be able to afford increases in their
dividend rates sufficient to activate cash balances remaining idle.
Mutual savings banks in some states are not permitted to pay
rates above a specified ceiling. There is considerable evidence that
these ceilings have in some cases effectively ruled out rate in
creases that would otherwise have been offered by these banks,
making impossible any further inducements to substitute savings
deposits for cash.
The growth of time deposits at commercial banks during periods
of financial restraint may also be limited by the ceiling on interest
paid on these claims under Federal Reserve Regulation Q. During
1959, the growth in time deposits was quite small compared to
previous years, as the 3 percent ceiling interest rate made it diffi
cult for banks to attract time balances in the face of rising returns
on other form s of investment.

QUESTION IX
Have shifts of funds by depositors, shareholders, policy
holders, etc,, between financial institutions perhaps
induced by interest rate differentials for savers, pre
sented serious obstacles to the effectiveness of monetary
policy at any time in the post-accord period?

THE FEDERAL RESERVE ANSWERS
ANSWER IX

Summary
Shifts of funds among financial institutions have not presented
serious obstacles to the effectiveness of monetary policy in the
period since the Treasury-Federal Reserve Accord. Most changes
in the structure of savings in this period have been continuations of
longer-term trends in savings preferences to which monetary policy
has continued to adapt. Large short-run fluctuations have occurred
principally in time and savings deposits at commercial banks, but
only in late 1956 and early 1957 did these fluctuations impinge to
any great extent on policy formulation.
Channels of Influence
The highly developed financial markets of our economy offer
savers a great variety of outlets for investments of surplus funds.
It is not surprising, therefore, to find shifts over time in public
preferences among different types of liquid assets.
For the most part, such shifts have tended to be longer-run
adjustments to institutional and structural changes in the economy.
In addition to interest rate differentials, geographic differences
in rates of population growth, changes in laws affecting various
types of financial institutions, and innovations in the development
of new and attractive saving forms have also been important in
giving rise to long-run changes in the composition of liquid asset
holdings.
Shifts among forms of saving are also influenced by the fact that
not all savings instruments are completely substitutable for one
another, and by the related fact that nominal differences in interest
returns may overstate real differences. Moreover, different forms
of savings are often “earmarked” for particular purposes. Finally,
some savings flows are not within the discretion of beneficiaries to
divert, as in the case of industrial pension plans. These aspects of
competing savings forms condition and limit the extent of the shift
ing from institution to institution that will occur in response to
short-run changes in interest rate differentials.
While monetary policy is formulated in light of general liquidity
of the economy, it is not its function to determine the institutional
structure of saving or the composition of investment uses to which
savings are put. Monetary policy endeavors to provide cash balances
in amounts appropriate to the needs of an economy growing at sus
tainable rates, and to ensure the sound functioning of the banking
system through which cash balances are provided.

QUESTION IX

Shifts in public preferences as to the composition of financial
asset holdings can influence the formulation and execution of mone
tary policy, nevertheless, to the extent that they significantly affect
the public’ s demands for cash, the liquidity of the economy, or the
competitive viability of the commercial banking system. Thus,
changes in the composition of savings can bear on monetary policy
if they involve transfers of funds between demand deposits and
other liquid assets, or if they involve transfers among other liquid
assets that influence the rate of turnover in cash balances. Special
consideration must be given to fluctuations in one savings form —
time and savings deposits at commercial banks—partly because of
the Federal Reserve’ s statutory responsibility for establishing
maximum interest rates that member banks can pay on these de
posits, and partly because changes in the volume of these deposits
affect member bank reserve positions.
Developments Since 1951
In the period since the Treasury-Federal Reserve Accord in
1951, shifts in savings among institutions that have been most sig
nificant from the standpoint of the effectiveness of monetary policy
have been the flows of funds into and out of commercial bank time
and savings deposits. Cyclical fluctuations in these deposits have
been mainly in time deposits, which are held principally by foreign
depositors, corporations, and state and local governments. When
short-term market yields—particularly those on Treasury bills—
dropped sharply after mid-1953 and again in early 1958, flows of
funds into time deposits increased substantially. When market yields
on short-term investments rose, as after mid-1954 and again after
mid-1958, funds flowed rapidly out of time deposits. The magnitude
of time deposit fluctuations has been large—from an increase of
about $1.5 billion in 1954 to a small net decline in 1955, and from
a rise of $2.5 billion in 1958 to a decline of $2 billion in 1959.
Savings deposits at commercial banks, held mainly by consumers,
have generally not fluctuated in response to movements in short
term rates in the moneymarket, although the slowing in growth rate
of these deposits in 1955 and again in 1959 suggests that they have
some degree of sensitivity to competitive rate movements. The
most abrupt rise in savings deposits occurred in early 1957 after
an amendment to Regulation Q, effective at the beginning of the
year, permitted increases in rates on time and savings deposits at
commercial banks for the first time in two decades. It is estimated
that consumer holdings of savings deposits, which had increased
at a rate of between $1 and $1.5 billion over the first halves of the
years from 1951 to 1956, jumped by more than $3 billion in the first
half of 1957 and continued to rise at a rapid rate throughout the
remainder of the year and throughout 1958.

THE FEDERAL RESERVE ANSWERS

100

Shifts into and out of time and savings deposits at commercial
banks immediately affect bank reserve positions. Fluctuations in
''time deposits, in particular, to the extent that they represent shifts
between these deposits and Treasury bills, immediately affect the
market in which Federal Reserve open market operations are usu
ally conducted. The economic consequences of shifts in time de
posits have been limited, however. For the most part, they have
represented reallocation of liquid asset portfolios with little or
no apparent effect on current spending plans of the holders. Nor
have the fluctuations impeded management of the open market ac
count in the execution of policy under current directives,1
The large shift in consumer holdings of savings deposits that
followed the rate increase at the beginning of 1957 was accompanied
by a somewhat greater than seasonal decline in consumer holdings
of demand deposits and currency.2 Consumer spending for goods
and services continued to increase rapidly in this period, as did the
rate at which their cash balances were being used. The pressure
of consumer demands was reflected in further increases in con
sumer prices, and contributed to the continuing need for restraint
on monetary expansion.

QUESTION X
Have such financial institutions as commercial banks,
insurance companies, savings and loan associations
and mutual savings banks managed their portfolios in
such a way as to present serious obstacles to the ef
fectiveness of monetary policy at any time in the post
accord period? What is the role of and how effective is
the so-called *lock-in” effect (to avoid capital losses)
in inhibiting financial institutions from selling off as
sets to make new extensions of credit?
iSee answer to Question XXII for a more detailed description of
recent developments in the area of commercial bank time deposits,
^Consumers were at the same time making other changes in their
financial asset portfolios—redemption of savings bonds increased
and the rate of growth in mutual savings bank deposits and savings
and loan shares slowed somewhat—and consumers 9incomes were
continuing to rise. It seems plausible, nevertheless, that some of
the $3 billion rise in savings deposits at commercial banks in the
first half of the year was directly associated with the decline in
consumer holdings of currency and demand deposits.

QUESTION X

lOi
ANSWER X

Summary
Monetary policy does not attempt to channel flows of credit to
or away from specific uses. Monetary policy is primarily concerned,
therefore, with those portfolio decisions of financial institutions
that influence the total volume of bank credit and money or the rate
of use of money supply. Institutional portfolio changes that can in
fluence the total volume of money or its turnover are (a) those
involving sales of assets to the banking system which result in an
increase in the money supply, (b) those involving sales of assets to
other purchasers which result in activation of idle cash balances,
and (c) those involving acquisition of new assets in amounts greater
than new savings inflows and therefore resulting in institutional
borrowing from banks.
Such portfolio changes need not affect the total supply of bank
credit unless the Federal Reserve concomitantly changes the avail
ability of bank reserves. Hence, exceptfor the activation of existing
cash balances, portfolio changes by financial institutions need not
interfere with the effectiveness of monetary policy. Since flexibility
was restored to monetary operations in 1951, policy has been able
to keep an effective rein on the availability of bank reserves. Finan
cial institutions other than commercial banks have continued to
liquidate Government securities over this period, presumably ac
tivating idle balances in the process, but these sales have not been
of such a magnitude as to create serious obstacles to the effective
ness of monetary policy.
Portfolio Adjustments Through Sales of U.S. Government Securities
Wartime financing and limitations on private investment oppor
tunities resulted in a major distortion of the portfolios of financial
institutions. At the end of World War II, the four major financial
groups cited in the question— commercial banks, insurance com
panies, savings and loan associations, and mutual savings banks—
held more than $111 billion of federal government debt, almost
half of the total outstanding. Such holdings represented almost
three-fifths of the total assets of these institutions,
Containing this surfeit of liquidity in a period of rising civilian
demands for still scarce goods and services would have been a
difficult task for monetary authorities under the best of circum
stances. Hobbled by the requirement of supporting Government
security prices in early postwar years, monetary policy could do
little to prevent the transformation of a large part of this insti
tutional liquidity into actively used money. In the four-year period

102

THE FEDERAL RESERVE ANSWERS

from the end of 1946 to the end of 1950, these institutions reduced
their holdings of Government securities by $22 billion—$10 billion
more than the reduction in outstanding public debt.Meanwhile, with
other asset holdings rising rapidly, Government securities in insti
tutional portfolios fell from almost three-fifths to less than twofifths of the total assets of these institutions, and from almost half
to about two-fifths of the public debt outstanding.
Since the beginning of 1951, or roughly the period in which
monetary policy has been able to operate flexibly in countering
excessive fluctuations in demands for bank credit, institutional
holdings of Government securities have generally continued to de
cline, but at a much slower pace than in the pre-accord period.
In contrast to the reduction of $22 billion, or one-fifth, in the first
four postwar years, these holdings declined only $9.5 billion, or
one-tenth, over the next nine years.
The difference in pace at which institutions have shifted their
portfolio structure in the post-accord period has reflected many
factors in addition to the flexible application of monetary policy.
Moreover, institutions have differed widely in their response to
changing economic developments and credit policy. In some in
stances, rapid gains in savings inflows have called for additions
to holdings of cash and Governments in order to maintain required
or desired liquidity positions. Thus, savings and loan associations*
holdings of Government securities increased more than threefold
from 1950 through 1959, almost keeping pace with the rise in their
other asset holdings.
Where liquidity considerations have been less important in
portfolio management, or where other sources of liquidity have
been available, holdings of Government securities have continued
to decline. The contractual nature of much of the income of life
insurance companies—both from policy premiums and debt amorti
zation—and the large volume of high quality bonds and governmentinsured mortgages in their portfolios have apparently reduced the
need of these companies for liquidity reserves in the form of
Government securities, and such holdings have continued to decline
while other investments have increased. At the end of 1959, Govern
ment securities accounted for not much more than one-fifteenth of
insurance company assets compared with more than one-fifth in
1950 and about one-sixth in immediate prewar years.
To the extent that sales of Government securities result in
activation of idle cash balances, they contribute to the need for
more restraint on the growth of the money supply during periods
of inflationary pressures than might be required in the absence of
such increases in the rate of money use. Sales of Government
securities by life insurance companies, however, could have con

QUESTION X

103

tributed only a relatively small amount to the rise in deposit veloc
ity in most years since the accord. The largest annual reduction in
Government security holdings was the $1 billion decline in 1956,
whereas in the earlier postwar period annual reductions ranged up
to almost $3.5 billion in periods of strong credit demands, such as
occurred in 1948, In 1959, a year of peak demands for credit when
interest rates reached new postwar highs, net liquidation of Govern
ment securities by life insurance companies amounted to only $300
million.
The small size of recent portfolio adjustments by life insurance
companies is all the more impressive when one takes into consider
ation the extent to which current investment of life insurance com
pany funds is determined by lending commitments made earlier,
often in a quite different economic climate. Forward commitments
outstanding represent from two-thirds to three-fourths of the annual
gross cash flows of insurance companies. Sharp increases in credit
demands accompanying rapid economic recovery cause a drain
on insurance company investment resources from several direc
tions: through increased demands for policy loans, withdrawals of
funds left under deposit-type arrangements, and a reduced volume
of debt prepayments, all occurring at a time when rising interest
rates open new and more profitable outlets for investment. Such a
conjunction of events probably explains in part the billion dollar
decline in insurance company holdings of Government securities
in 1956. It is significant to note, however, that insurance companies
did not permit forward commitments to rise to so high a level, rel
ative to cash flows, during the upswing in credit demands in the
latter half of 1958 and in 1959 as they had in 1956.
Mutual savings banks have also been substantial net sellers of
Government securities over the post-accordperiod, but the amounts
sold in any one year have again been relatively small. The largest
reduction occurred in 1951 when net sales exceeded $1 billion; in
recent years, liquidation has fluctuated between $300 million and
$500 m illion.
The continuing reduction in Government security portfolios by
such institutional investors as life insurance companies and mutual
savings banks suggests that they are not completely “locked in” by
unrealized capital losses on their portfolios. Nevertheless, the
moderate size of reductions in recent years also suggests that there
are limits on the losses they are willing to take in order to finance
new portfolio additions. With total investmentportfolios much larger
than in earlier postwar ysars, most financial institutions would have
to make fairly large changes in portfolio composition to effect sub
stantial changes in investment income. Markets for seasoned se
curities, however—even those for Government bonds cannot absorb
a substantial volume of sales offerings in short periods without

104

THE FEDERAL RESERVE ANSWERS

significant price effects. This sensitivity of bond markets has been
an important factor limiting shifts in composition of institutional
portfolios in recent years.
Commercial bank portfolios of Government securities have shown
swings of much wider amplitude, rising from $5 to $8 billion in
years when credit conditions were easing, and declining by as much
when monetary restraints limited growth of bank credit during
periods of excessive demand. Commercial banks are not as limited
in portfolio management by possibilities of losses on securities as
are many other institutional investors, in part because a larger
proportion of their Government security holdings are short term
and therefore not subject to price fluctuations as wide as those on
longer-term issues, and in part because losses on security sales
can be deducted in full from income for tax purposes. Both factors
serve to moderate the influence of the so-called “lock-in” effect on
bank portfolio management.
On the other hand, Government securities can be carried on
bank balance sheets at cost, i.e., declines in market value need not
be recorded until securities are sold. Recognition of losses through
security sales might reflect adversely on bank management and,
more importantly, might impair capital and surplus accounts, the
size of which limit certain bank lending practices. Moreover, many
smaller commercial banks are subject to the 30 percent rather than
the 52 percent income tax rate, and this reduces their tax incentive
for portfolio switching.
On balance, these deterrents appear to exercise a strong degree
of influence. A study of bank portfolio practices in one Federal Re
serve district during a period of rising interest rates and demands
for loans (1959) indicates that a majority of banks did not take full
advantage of unrealized capital losses to increase current incomes
or reduce tax liabilities.! To a major extent, therefore, the large
fluctuations in bank holdings of Government securities in recent
cycles must reflect changes in portfolios of shorter-term issues
or longer-term securities closely approaching redemption dates.
These fluctuations in bank portfolios cannot be considered a
major obstacle to monetary policy, however, since such a conse
quence of restraint can be taken into account in the formulation of
policy. The degree of restraint appropriate to particular phases of
economic expansion is established not only in terms of the absolute
size of the money supply but also in terms of its rate of use.
^Monthly Review, Federal Reserve Bank of Kansas City (June 1960).

QUESTION X

105

Other Aspects of Institutional Portfolio Management
Financial intermediaries on occasion supplement the funds avail
able to them from savings inflows, debt repayments, and security
sales by borrowing from commercial banks and others. For the
most part, such arrangements are regarded as temporary accom
modations to meet seasonal or other short-term incongruities
between cash inflows and loan commitments.
There has been at least one occasion in the post-accord period
when the duration of such borrowing has given the impression that
short-term banking funds were being utilized by thrift institutions
as a substitute for permanent capital to finance long-term invest
ments. The situation that developed in 1955 with respect to mortgage
warehousing was soon corrected, however, and this type of bank
lending has remained under continuing review, through both regular
statistical reporting and the examination of individual banks.
Savings and loan associations have available to them a govern
mental source of funds which is used not only for seasonal adjust
ments but also to some extent to accommodate cyclical and long-term
needs arising out of lending activities in excess of current savings
flows in particular communities. During periods of credit tightness
member savings and loan associations have borrowed heavily from
the Federal Home Loan Banks to acquire new mortgages and to
fulfill commitments. At the end of 1959, outstanding borrowing from
the FHLB exceeded $2 billion and had increased during the year
by about $800 million.
The FHLB must borrow in capital markets at going rates, and
the interest they charge on advances to member associations re
flects FHLB borrowing costs. The curbing effect of rising interest
rates on FHLB borrowing and advances may not be quickly trans
mitted to member savings and loan associations, however, if the
FHLB follows a practice of making advances for a period without
counterbalancing sales of debentures in capital markets. It is to the
advantage of associations to continue to borrow even at high interest
rates to acquire mortgages, because the funds advanced to mortgage
borrowers tend to remain as high interest rate mortgage loans on
the associations* books after the associations have retired their
debt to the FHLB.
Monetary policy does introduce a corrective element in this
p rocess. As interest rates rise in periods of expansion, and as
costs of borrowing and advances by the FHLB rise, individual
mortgage borrowers at the margin may postpone financing through
savings and loan associations. This corrective element does tend
to restrain the demand for credit during periods of credit tightness,
but the effect on mortgage market responses may have a substantial
time lag.

THE FEDERAL RESERVE ANSWERS

106

QUESTION XI
To what extent do such factors as changes in liquidity
positions, loan-deposit ratios, legal and supervisory
standards, etc., operate to affect credit availability in
periods of expanding credit demands?

ANSWER XI
Summary
Liquidity requirements, loan-deposit ratios and other limits on
investment practices imposed by custom or law on financial institu
tions may have an important influence upon the availability of credit
for particular uses. Except to the extent that they relate to holdings
of cash, however, they do not necessarily limit the availability of
total credit. The acquisition of liquid assets other than cash by
financial institutions in order to meet liquidity standards provides
funds which sellers of these assets can reinvest, thereby keeping
unchanged the total amount of credit available.
Sales of liquid assets by financial institutions in order to meet
expanding credit demands do not necessarily change the total credit
supply either. In the process, however, such sales can activate idle
cash balances and, in an inflationary situation, this requires greater
restraint over the expansion of the volume of money. The existence
of liquidity standards can therefore assist monetary policy by slowing
the pace and limiting the extent of changes in institutional portfolio
structures. Minimum requirements with respect to cash balances,
of course, provide an ultimate limit on the extent to which velocity
can increase in an expansionary period.
Lenders and borrowers may for a time adjust to increasing credit
stringency by economizing in the use of cash balances or by liqui
dating existing assets in order to finance new investments—financial
or physical—that offer higher returns. These adjustments will tend
to be self-limiting, however, as the processes of economizing on
cash balances and liquidation of existing assets bring portfolio
structures closer to the minimum liquidity standards dictated by
custom, prudence, or statute.
Not only is this process of liquidating existing assets to provide
additional lending capacity ultimately self-limiting, but it is by no
means inevitable that such individual adjustments will have the net
effect of increasing the over-all availability of credit. While lenders

QUESTION XI

107

may substitute less liquid assets such as loans, mortgages, or co r
porate securities for more liquid ones such as U.S. Government
securities, these securities—or their equivalent in new issues—
must simultaneously be absorbed elsewhere unless a comparable
reduction in federal debt is taking place. Such transactions do not
constitute a net addition to the pool of loanable funds.
Just as institutional sales of liquid securities do not necessarily
increase the availability of credit in the aggregate, so purchases of
liquid securities by these institutions would not necessarily dimin
ish or limit growth in the over-all supply of credit. If lenders or
investors acquire short-term U.S. Government securities, for exam
ple, the sellers of those securities have funds for other uses and
there is no decrease in the total supply of credit.
Because transactions in liquid securities do not necessarily
change the aggregate availability of credit, such devices as security
reserves for banks—or for other financial institutions—are not
effective means of controlling the over-all supply of credit in a
strong expansionary period, unless there is at the same time an
effective control over cash reserves. Security reserves can be
effective only in case the following conditions are satisfied: (1) the
supply of reserve-eligible securities is limited, (2) required re
serves other than securities must be held in cash, and (3) the avail
ability of cash is controlled.
Some increase in over-all credit availability is likely to take
place if the process of portfolio shifting is accompanied by rising
interest rates which stimulate an increase in savings flows. This
should ordinarily be viewed as accomplishing the purposes of
monetary policies rather than being in conflict with them.
Alternatively, the rate of turnover of the existing money supply
could be accelerated and this increased turnover—unless offset by
monetary policy—could have the same effects as expansion in the
total availability of credit. Whether this occurs would depend not
only on the desire of financial institutions to liquidate existing
assets but also upon the willingness o f‘the rest of the community
to convert idle demand deposits into less liquid but interest-bearing assets.
The task of monetary authorities in offsetting increased turnover
resulting from sales of financial assets might be made more difficult
if institutional portfolio adjustments were concentrated in Govern
ment securities and were, as a result, having a serious impact on
the market for these securities. Consequently, the existence of
liquidity standards, by limiting the rapidity and extent to which in
stitutions will change portfolio structure, contributes to the ease
and effectiveness with which monetary policy can be executed during
periods of expanding credit demands.

108

THE FEDERAL RESERVE ANSWERS

How quickly liquidity standards will exert effective restraint
depends in part upon the extent to which current levels of liquidity
exceed those customarily considered necessary and desirable. Ex
cessive liquidity, such as obtained at the end of World War II, and
which included cash balances well in excess of normal requirements,
permitted a prolonged period of credit expansion. Much of this
excess has been absorbed, however, in financing the rapid rise in
private debt over the past 15 years. In postwar cycles, there have
been significant increases in institutional liquidity during reces
sionary phases—although in small amounts relative to the wartime
experience—and this liquidity has helped to foster recovery. In
succeeding expansionary periods, liquidity has declined, and the
trend over the postwar period as a whole has been toward reduced
liquidity. The scale of liquidity reductions in expansion periods has
been much smaller in recent cycles than earlier, suggesting that in
many instances liquidity is approaching minimum requirements. It
m aybe, therefore, that financial institutions, as well as the sectors
of the economy dependent on them for financing, are now in a posi
tion of being more responsive to monetary restraint.
Commercial banks. For the commercial banking system, pri
mary liquidity and ability to expand credit maybe fairly effectively
limited by Federal Reserve control over the supply of basic re
serves. Secondary liquidity is largely based upon the traditions,
standards, and needs of individual banks. From the viewpoint of the
individual bank, the impact of limitations on the availability of basic
reserves will appear initially in a “ squeeze” on its secondary
liquidity. It is only after the bank has reached the limit of these
secondary reserves that it must resort to other means of reserve
adjustment, which in turn limit its ability to lend.l
Whether measured in terms of the relation of loans to deposits
or by similar ratios, the degree of liquidity varies widely among
banks by size classes and geographically. While important signifi
cance cannot be attached to any single ratio for the banking system
as a whole, there is evidence that individual bank standards with
respect to maximum loan-deposit ratios do function to limit ex
pansion of loans or certain other assets. Expansion of total bank
credit, however, is ultimately limited by the volume of basic re
serves available to the banking system as a whole.
In recent years, during recoveries from recessions, banks have
been able to finance loan expansion in large part by liquidation of
Government security holdings acquired during preceding periods of
credit ease. As monetary policy has moved to restrain excessive
growth in demand deposits, further bank loan expansion has increasiThis process is described in more detail in the replies to Ques
tions I and XV,

QUESTION XI

109

ingly tended to become subject to limitation because of high loandeposit ratios, although in successive postwar cycles there has been
a tendency to push “ceiling” ratios higher. The limiting effect may
persist for a time even after pressures of credit demand have eased,
since it may take some time for individual banks to readjust their
loan portfolios. The time lag will be longer if loan-deposit ratios
have previously been pushed close to ceiling levels during e^qpansionary phases of the cycle.
In attempting to hold their ratios at levels they regard as desir
able, banks will often revise their lending policies and standards.
Since bank preference for different types of loans varies consider
ably, these adjustments may at times involve curtailment of lending
in less preferred areas while other types maybe little affected. The
declines in real estate and security loans at city banks in the first
half of 1960 undoubtedly reflected such adjustments in loan policies.
Bank supervisory authorities, in contrast, strive to avoid cyclical
changes in the criteria which they use in appraising the soundness
of bank assets. Supervisory appraisal standards ordinarily function
in a way that should not, in itself, alter bank credit availability in
periods of expanding credit demands. In practice, bank lending is
generally conducted well within established supervisory standards,
Banker awareness that loan policies will be reviewed in terms of
intrinsic rather than transitory market values of the collateral
behind loans, as well as in terms of needs for proper diversification,
may moderate the pace of ejqmnsion in certain types of loans in
periods of rapidly rising credit demands. With a given volume of
reserves and deposits, liquidity standards may thus affect the dis
tribution of bank credit—between loans or other assets considered
as nonliquid and those deemed to be liquid—but these standards do
not necessarily affect the total volume of bank credit.
Life insurance companies. Life insurance companies are not
subject to liquidity needs comparable to those of financial institu
tions having demand liabilities or liabilities of relatively short
maturity. The contractual nature of much of the income of life
insurance companies and the actuarial basis of much of their liabil
ities minimize the need for large reserves of liquid assets.
During the war, when life insurance resources expanded and the
supply of investments other than U.S. Government securities was
limited, life insurance companies greatly expanded their holdings
of Government securities. In the early postwar years, when prices
of Government securities were supported by the Federal Reserve
and when other long-term credit demands were large, these institu
tions rapidly shifted their assets. This process, except to the extent
that it was offset by other Federal Reserve operations or by reduc
tion in the public debt out of budgetary surplus, in effect added

110

THE FEDERAL RESERVE ANSWERS

greatly to the over-all liquidity of the economy because it added to
the supply of basic reserves available to the banks.
After the discontinuance of rigid Federal Reserve support of the
market in 1951, life insurance companies continued to reduce their
holdings of U.S. Government securities, but at a slower pace. As a
consequence, over the postwar period as a whole there has been a
substantial and fairly persistent decline—to the lowest level since
1933—in the ratio of Government securities and cash to total assets
of life insurance companies.
Liquidity problems of insurance companies have arisen primarily
from occasional disparities between their cash inflows and the out
flow of investment funds committed earlier. Under these conditions,
insurance companies have made temporary adjustments by borrow
ing from banks, by warehousing mortgages and by accelerating
liquid asset reductions. They have also tended to reduce their will
ingness to commit loan funds in advance and have markedly changed
the composition of new commitments made. Commitments have
shifted away from investment areas where interest rates can have
only limited response to rising credit demands, such as Governmentunderwritten mortgages, and more funds have been committed to
areas where rates are more flexible, such as business securities.
Legal and supervisory standards, as they apply to insurance
companies, vary somewhat from one state to another, but they are
mainly concerned with the quality of long-term investments. As a
result of the requirement that private investments meet certain
standards of quality, the lowering of the ratio of cash and Govern
ments to total assets may have been at a slower rate than if these
standards had not existed, but the effect does not appear to have
been a significant determinant of insurance company investment
behavior.
Other institutions. Savings and loan associations and mutual
savings banks channel most of their flows of savings into the mort
gage market. Mutual savings banks confine their credit extensions
for the most part to deposit inflows and the proceeds of liquidation
of Government securities. Savings and loan associations may sup
plement savings inflows by borrowing from the Federal Home
Loan Banks.
Willingness to borrow from the FHLB becomes subject to re
straint as the FHLB pays higher rates on its debentures in tight
capital markets and increases its rate on advances to member
savings and loan associations. This does not necessarily mean an
increase in over-all credit. Funds borrowed by FHLB must be ob
tained in the market and thus are diverted from other uses, except
to the extent that they may cause an increase in bank credit and the

QUESTION XII

111

money supply that would not otherwise have occurred. Likewise, an
increase in the liquidity position of savings associations does not
necessarily cause a decrease in the total volume of credit out
standing.
Member savings and loan associations are required to maintain
a liquidity reserve of cash and U.S. Government securities amount
ing to 6 percent of share capital. In addition, the Federal Home Loan
Bank Board has, from time to time, restricted advances to associ
ations when credit demand was excessive. The Home Loan Banks
are required to keep liquid reserves against deposits made with
them by member associations. In December 1955, the Federal Home
Loan Bank Board increased the liquidity requirements of the Banks
to 75 percent of members* deposits with the Banks, from the former
requirement of 20 percent. The Board also required that the Home
Loan Banks establish a new liquidity reserve to accommodate some
unanticipated demands for advances. These requirements undoubt
edly slowed the rate of increase in conventional mortgage lending,
which was no larger in 1956 than in 1955, though they probably had
no effect on total credit extended by savings institutions; this is
determined by the amount of savings placed with them.

QUESTION Xn
To what extent is the Federal Reserve concerned with
the level of bank earnings and the adequacy of bank capi
tal; what powers and actions are available for the Federal
Reserve to utilize if it wishes to affect such magnitudes?

ANSWER XII

Summary
In addition to its primary function of regulating bank credit and
the money supply, the Federal Reserve also has certain statutory
responsibilities for maintaining a sound banking system through
supervision of its member banks, Although actions taken in dis
charging these functions are designed and carried out in the interest
of the public at large rather than particular groups, these actions
influence bank earnings, which in turn affect the ability of banks to
maintain adequate capital. The System’ s concern for bank earnings

112

THE FEDERAL RESERVE ANSWERS

or bank capital derives from their relevance to the System*s re
sponsibilities for maintaining a financial structure that is sound
and conducive to economic growth.
Banks must have adequate capital in order that they may assume
the reasonable risks and provide the credit essential for growth
of the economy. Long-term growth in the money supply, too, re
quires that banks have adequate capital as well as sufficient reserves.
The ability of commercial banks to perform these functions effect
ively in a growing economy is perhaps the most relevant test of
adequacy of earnings and capital. Adequate earnings are essential
to build up capital funds through internal accumulation or through
sales of new stock.
Actions taken by the Federal Reserve which may influence the
level of bank earnings or the adequacy of bank capital must be con
sistent with the Federal Reserve’ s primary responsibility for reg
ulating bank credit and the money supply. Under the provisions of
the Federal Reserve Act, all Federal Reserve monetary policy
actions must have regard to their effects on the general credit
situation of the country, the accommodation of commerce and busi
ness, and prevention of injurious credit expansion or contraction.
Under the Employment Act of 1946, they must also have regard to
the objectives of maximum employment, production and purchasing
power. Any assumption by the Federal Reserve of a direct concern
for the level of bank earnings might at times involve inconsistencies
with these main responsibilities.
In order that banks may maintain adequate capital to meet the
economy’ s growth needs, gradual increases in their capital funds
are needed. Some adequate level of earnings is necessary for this,
although increases in bank earnings do not necessarily or auto
matically result in improvements in bank capital positions.
Retained earnings have been the principal source of additions
to bank capital in the postwar period, although this method of in
creasing capital is a slow process. The alternative method of in
creasing capital, however, through the sale of additional stock, is
ulso largely dependent on past and prospective earnings. The ratio
of capital to assets of member banks declined sharply in the 1930’ s
and early 1940’ s, and the slow growth during the postwar period
has not been adequate to restore earlier levels.
Economic Functions of Bank Capital
The capital funds of a commercial bank have long been visualized
as fulfilling a duty to depositors, to afford them a cushion of pro
tection against losses. Since the advent of Federal deposit insurance,
this cushion serves in part as protection to the government as
well as to depositors not fully covered by insurance.

QUESTION XII

113

This function of bank capital has focused attention on the rela
tion between total capital funds and risk exposure.Ratios of capital
funds to risk assets are frequently employed as rough indicators of
the adequacy of a bank’ s capital from the depositors’ viewpoint.
Another point of view is that of the economy at large which needs
a properly functioning credit mechanism. If commercial banks are
to contribute to growth and prosperity, they must be prepared to
take reasonable risks in meeting the credit needs of legitimate
borrow ers. A good banker is an expert in identifying sound and con
structive risk-taking as distinguished from risk-taking that is
speculative or otherwise undesirable. But, in order to contribute
to economic growth by sound risk-taking, the bank must have ade
quate capital against the possibility that losses may develop. Only
in this way can it be prepared to finance enterprises that may in
volve some reasonable but socially desirable degree of risk.
Furthermore, when a borrower runs into adverse circumstances,
the banker needs to appraise the situation and determine whether it
will be best to require liquidation or to extend further time or credit
for working out the problem. It would be undesirable if a shortage
of capital made it impossible for the bank to take the risks that a
further extension—even if judged sound—would involve. In time of
recession, when a significant proportion of a bank’ s borrowers may
have such problems at the same time, the bank should be able to
use its best judgment in deciding its policy with respect to each
borrow er. A stronger capital position enables bankers to adhere to
more uniform lending standards during the different phases of the
business cycle.
The optimal functioning of the banking system in the interest of
the broader economy, therefore, can only be achieved if each banker
is able to make decisions based on his best judgment of the position
of the credit applicant and that of the economy. He ought not to be
inhibited in this by any shortage of capital and consequent inability
of the bank to carry the risks that would otherwise be acceptable.
Powers Relating to Capital Adequacy
Under the Federal Reserve Act, adequate capital is one of the
requirements for admission of state banks to membership in the
System. The Act states:
No applying bank shall be admitted to membership
unless it possesses capital stock and surplus which,
in the judgment of the Board of Governors of the Fed
eral Reserve System, are adequate in relation to the
character and condition of its assets and to its existing
and prospective deposit liabilities and other corporate
responsibilities.

114

THE FEDERAL RESERVE ANSWERS

Various other provisions of the Federal Reserve Act and the
National Banking Act are designed to protect capital adequacy.
Member banks are prohibited from paying dividends out of capital;
they can be paid only out of current and accumulated earnings.
Member banks may not reduce their capital without the consent of
the appropriate supervisory authority, and if a member bank’ s capi
tal becomes impaired, the deficiency must be made up within a
stated time; otherwise the bank can be expelled from membership
in the case of state member banks or forced into liquidation in the
case of national banks.
In addition to these specific legal provisions relating to capital
funds, Federal Reserve authorities have certain supervisory func
tions over member bank operations which indirectly have a bearing
on capital adequacy.! A regulation of the Board of Governors pre
scribes adequate capital as one of the conditions of continuing mem
bership for state member banks. Periodic examinations of individual
banks are conducted to ascertain the degree of risk inherent in bank
assets and other facts bearing on the condition of banks.
Bank supervision embraces a wide variety of functions. Some are
technical, relating mainly to operations and compliance with banking
laws and regulations. In a more significant sense, however, super
vision is concerned with broader questions such as the composition
of assets, lending and investingpolicies, competency of management,
risk exposure and adequacy of capital funds. The primary objective
is to help maintain a system of individual banks, each financially
sound and always in a position to meet its liabilities.
There is no single standard or formula for measuring adequacy
of capital that is applicable to all banks. No two banks are exactly
alike with respect to the quality and composition of assets, structure
of liabilities, and competency of management. Capital adequacy can
be determined only by analyzing these and other relevant information
for each individual bank.
Powers Relating to Earnings
The powers of the Federal Reserve that affect bank earnings
fall into two main categories: those related to bank supervisory
functions and those related to monetary policy actions.
As to the supervisory function, it is frequently said that super
visory criticism s have an important effect in inhibiting bank aclln practice, Federal Reserve supervisory functions relate mainly
to the operation of state member banks. Primary responsibility
for supervising the operations of national banks is vested in the
Digitized forComptroller
FRASER
of the Currency.

QUESTION XII

115

quisitions of risky assets that would ordinarily tend to promise
higher interest yields than items involving less risk. In this sense,
standards of the Federal Reserve and of other bank supervisory
agencies may affect bank earnings. Supervisory policies of these
kinds, however, are not influenced by any purpose or desire to affect
bank earnings.
Related to the supervisory function is the authority of the Board of
Governors to regulate the rates of interest paid on time and savings
deposits. Such payments obviously affect bank costs and earnings.
Bank supervisory agencies, both federal and state, also have im
portant powers relating to the chartering of new banks or permitting
banks to open new branches. Decisions in these fields (made p ri
marily by agencies other than the Federal Reserve) are often in
fluenced by considerations of bank earnings. In order to open a new
banking office, the supervisory authority ordinarily requires a
showing that there are reasonable prospects of adequate earnings.
With respect to Federal Reserve actions in the field of monetary
policy, the choice of instruments used in implementing policy affects
bank earnings. The proper exercise of monetary policy, however,
ordinarily calls for the use of certain instruments under a given
set of conditions—regardless of the effects on bank earnings. If
bank earnings were considered as an important basis for such de
cisions, this could interfere with the effective use of the instruments
of monetary policy.
A special problem as to the effect of monetary instruments arises
in connection with changes in reserve requirements. Given a cer
tain volume of funds to be supplied to the banking system, a lower
ing of reserve requirements tends to increase bank earnings as
compared with the effect of Federal Reserve open market purchases
of Government securities, A higher percentage re serve requirement
increases the amount of assets held in nonearning form , and thus
tends to reduce bank earnings, while a low percentage requirement
permits a larger proportion of bank resources to be held as earn
ing assets and tends to increase earnings. Requirements should
never be so high as to prevent banks from earning enough to enable
them to maintain an adequate capital position.
The level of reserve requirements that member banks are re
quired to hold with the Federal Reserve will also affect, in the long
run, the attractiveness of membership in the Federal Reserve Sys
tem, and national chartering as against state chartering, in the case
of both existing and newly formed banks.
Finally, it may be pointed out that Federal Reserve policies
affect interest rates and that the level of interest rates affects bank

THE FEDERAL RESERVE ANSWERS

116

earnings. Theoretically, bank earnings would be increased by a rise
in the general level of interest rates. At the same time, a policy
that results in higher interest rates could affect bank earnings ad
versely by restricting the ability of banks to expand credit and by
reducing the prices of securities they may wish to sell to make
loans. Because the economic effects of changes in the level of in
terest rates so far transcend any possible importance of bank
earnings, however, no conscientious monetary authority would ever
exert its influence in the direction of higher interest rates for the
purpose of increasing bank earnings. The Federal Reserve has not
been influenced, in taking actions that might affect the level of in
terest rates, by the effect on bank earnings.

QUESTION Xin
What criteria are used in determining the instrument
mix to be utilized to achieve policy objectives under
varying circumstances? That is, what factors are
weighed in determining the extent to which relative re
liance should be placed upon changes in discount policy,
open market operations, reserve requirements, and
margin requirements to achieve a given change in credit
conditions?

ANSWER X m
Summary
There are no criteria which can be said to be utilized especially
for the purpose of determining the relative reliance which is placed
upon changes in discount policy, open market operations, reserve
requirements, or other instruments. The combination of instruments
brought to bear on a particular credit situation is the result of an
effort to employ each of the instruments as effectively as possible.
Thus, rather than setting forth specific criteria which are used to
determine the “instrument mix,” the following reply discusses how
different instruments, or combinations of instruments, are, in fact,
employed in making desired adjustments in reserve availability.
It suggests that both open market and discount operations are con
tinuously employed as complementary parts of a single policy, while
changes in reserve requirements are ordinarily made infrequently

QUESTION XIH

117

for the purpose of absorbing or releasing reserves in response to
longer-run developments.
Criteria for Monetary Policy
Monetary policy endeavors to adjust the availability of member
bank reserves so as to make the greatest possible contribution to
the accomplishment of the broad goal of sustainable economic growth,
The System’ s experience is that the nature and interdependence of
available instruments of policy largely determine the instrument
mix appropriate to a given economic situation. Intensive use of one
particular instrument in pursuit of some secondary objective would
almost always detract from the effectiveness with which the primary
objective could be accomplished.
It is almost never the case that credit conditions will be affected
in exactly the same way by changes in one or another of the basic
instruments of policy. In a simple computation of the volume of
reserve funds available to the banking system for bank credit ex
pansion, it is true that a specific reduction in reserve requirement
would provide the same volume of reserves as the purchase of a
corresponding volume of securities in the open market by the System
account. However, the effects which follow from the use of one in
strument or the other on banks’ willingness to lend, on security
markets, and on the public generally, may vary considerably.
The effect of a purchase or sale of securities, a change in the
discount rate, or a change in reserve requirements, must always
be judged in relation to the whole range of economic forces at the
time. The choice of the instrument or instruments to be used, and
the decision as to intensity of use, flows from an appraisal of the
probable effect of current and prospective Federal Reserve oper
ations in the developing economic situation. Primary attention is
always focused on those actions that will contribute most effectively
to the broad objectives of policy, taking into account the interrela
tionship among these actions.
Open Market Operations and the Discount Mechanism
Open market operations and discount operations are the two
major ways in which the volume of Federal Reserve credit avail
able to the banking system is altered. These operations are essen
tially complementary. The fact that open market purchases and
sales occur frequently, while changes in the discount rate are made
at infrequent intervals, obscures to some extent the fact that reserve
adjustments take place almost every day through one or both mech
anisms and thus both open market policy and discount policy are
continuous.

118

THE FEDERAL RESERVE ANSWERS

Reserves obtained through borrowing are typically accompanied
by a spreading atmosphere of credit restraint, as contrasted with
the effect of a corresponding amount of reserves injected by open
market operations and appearing in a bank as a normal deposit gain
or favorable clearing balance. Administrative restraint exercised
by discount officials, together with the reluctance of banks to bor
row, make it likely that a bank forced to borrow will in turn begin
to search for Federal funds, seek correspondent accommodation,
offer securities for sale, sell participations in its more merchant
able loans, and/or curtail its direct loan activity. Appraisal of the
market atmosphere resulting from these developments is one of
the important judgments in the formulation of monetary policy.
When a seasonal demand for reserves may be expected, for
example, and an expansive credit climate is desired, the open mar
ket account might purchase the full amount of securities necessary
to supply the reserves. If an element of credit restraint is desired,
however, some or all of the reserve demands might be left to be
satisfied via member bank borrowing.
The myriad of payment flows within the banking system are
continually creating temporary reserve surpluses in some banks
and reserve deficits in others. When a customer suddenly transfers
funds, the bank receiving the transfer can be just as unprepared to
cope with a reserve influx as is the paying bank with its reserve
loss. Accordingly, for varying spans of time, newly shifted reserves
may not be fully employed; in the absence of borrowing or some
other acquisition of new reserves by the paying bank, the national
total of reserves effectively at work may shrink.
Thus, discount policy and open market policy are inevitably
integral parts of a single policy. In order to be fully effective, each
depends upon and, in a sense, assumes parallel action with respect
to the other. For example, a more restrictive open market policy
achieves the desired effect on commercial bank loan and investment
activity only because reserves alternatively obtained by borrowing
are accompanied by restraining effects. Conversely, a restrictive
discount policy would be meaningless if reserves were freely avail
able through open market sales to the System account at prices for
the securities offered that involve no sacrifice to the seller. In other
words, shifts between policies of ease and restraint often do not
involve absolute changes in the total amount of reserves available
to the banking system, but rather changes in the sources of reserves
as between reserve credit made available through open market op
erations, on the one hand, and loans and advances to member banks,
on the other. Hence, in the formulation of policy, discount operations
and open market operations are not considered as alternative means
of accomplishing a given objective, but are adjusted together, in

QUESTION X ni

119

order for them to contribute effectively to the achievement of the
desired objective.
Within this framework, the specific factors weighed in the for
mation of open market policy are an appraisal of general economic
conditions, an assessment of the relation to these conditions of the
availability of money and bank credit, and an estimate of the re
serve needs that are likely to arise as a result of seasonal and
special factors peculiar to the period. Criteria employed in the
determination of discount rate changes generally involve the same
considerations, combined with attention to the nature and extent of
the use being made of the discount privilege and the relation of the
existing discount rate to market rates on assets that banks would
generally buy or sell in the adjustment of their reserve positions.
Reserve Requirements
Authority to adjust reserve requirements, as an instrument of
monetary policy in the United States, was added to System powers
in the 1930’ s, and therefore there has been less experience with its
use than with either of the other two major instruments of policy.
In fact, the role of reserve requirements as the fulcrum for policy
actions related to the volume of bank credit and money, in contrast
to their role as a source of liquidity, has only been generally under
stood and accepted since the 1920’ s. Even theoretical discussion of
changes in reserve percentages as an instrument of policy was very
limited until the 1930’ s. For this reason, there is less factual back
ground and more disagreement as to the conditions under which
reserve requirement changes can be used effectively in the accom
plishment of the broad objectives of policy.
Apart from technical considerations, there is a widespread
feeling that changes in reserve requirements should be made in
frequently, because such action constitutes “a change in the rules
in the middle of the game,” which can present difficult problems
of adjustment for many medium- and sm all-sized banks, Concern
over this aspect of reserve requirement changes is not based solely
on consideration for the problems created for banks and bankers.
The repercussions of sizable changes could be serious for many
current and potential borrowers and, in some cases, for whole
communities.
A wide variety of possible schemes for adjusting reserve re
quirements have been considered in this country from time to time,
and a number of variations have been employed in other countries.
These include special deposit, secondary and supplementary reserve
requirements, required liquidity ratios, and other schemes. The
specific authority in the Federal Reserve Act to change reserve
requirements was originally intended to permit the Federal Reserve

120

THE FEDERAL RESERVE ANSWERS

to absorb some of the large volume of excess reserves generated
in the period from 1933 to 1935, “whilethey were unused and widely
distributed, rather than allow them to become the basis of an ex
cessive credit expansion.” ! This was done in the summer of 1936,
when reserve requirements were raised by one-half for all banks
and all classes of deposits. In January 1937, a further increase of
one-third was announced, which, when completed, brought required
reserves to the then authorized maximum of double the basic per
centages stated in the law.
Discussion at the time indicates clearly that it was intended and,
in fact, assumed that reserve requirements would be maintained
at levels higher than the basic percentages prescribed in the law
only when injurious credit expansion could not be effectively con
trolled by open market and discount policy. In view, however, of the
manyfold increase in the reserve base that resulted from the large
gold inflow in the 1930’ s and from Federal Reserve purchases of
securities in World War II, the higher level of reserve require
ments established to absorb these additions to reserves became
more generally accepted.
In its most recent action to amend the portion of the Federal
Reserve Act which deals with reserve requirements, there was no
expressed intention on the part of the Congress that the Board should
make special efforts, in using the reserve requirement changes as
a monetary instrument, to achieve particular percentages within
the ranges specified for the purpose of accomplishing some second
ary objective. In the absence of such expressed intention, it seems
reasonable to assume that changes in requirements should be lim
ited to those occasions when they can make a positive contribution
to the accomplishment of the basic objectives of monetary policy.
In the System’ s experience, changes in reserve requirements
have made their optimum contribution when changes of more than
temporary import in the bank reserve situation have been called
for. In prewar years, reserve requirements were increased in order
to absorb an unnecessarily large volume of excess bank reserves.
Postwar increases were applied in an attempt to absorb reserves
supplied by Federal Reserve support of Government security prices.
Most changes in reserve requirements in recent years have been
made in recession periods, when decreases in reserve requirements
have been used to supply bank reserves simultaneously to all parts
of the economy.

IE .A , Goldenweiser, “Instruments of Federal Reserve P olicy,”
Banking Studies (Washington: 1941), p. 409,

QUESTION XIV

121

Regulation of Stock Market Credit
The conditions under which authority has been granted to reg
ulate credit by selective measures, i.e., prescriptions of a minimum
equity or a maximum maturity on credit extended for certain specific
purposes, have not been such as to lead to the development of cr i
teria which would relate their use to the general instruments of
policy. Authority to regulate consumer and real estate credit has
been limited to relatively brief wartime situations, when the use
of general instruments of policy was circumscribed.
The continuing authority to regulate stock market credit is spe
cifically related in the law to the excessive use of credit for pur
chasing or carrying securities. It was adopted in part because of
the excessive importance that stock market credit had occupied in
the country*s credit structure.
While bearing directly on the lender, margin requirements put
restraint on the borrower and thus dampen demand. A very impor
tant aspect of this restraint is the limitation it places on the amount
of pyramiding of borrowing that can take place in a rising market
as higher prices create higher collateral values and permit more
borrowing on the same collateral. The purposes of regulation through
margin requirements are to minimize the danger of excessive use
of credit in financing stock market speculation and to prevent the
recurrence of speculative stock market booms based on credit finan
cing, such as culminated in the price collapse of 1929 and the sub
sequent severe credit liquidation.

QUESTION XIV
What criteria are utilized in determining when and by
how much to alter discount rates? Has the Federal
Reserve tried to maintain any particular relationship
between discount rates and market interest rates?

ANSWER XIV
Summary
The discount rate derives its significance from the role played
by member bank borrowings in the process by which the banking

122

THE FEDERAL RESERVE ANSWERS

system responds to monetary policies, The discount rate, and the
discount facilities of the Federal Reserve banks, complement open
market operations in affecting the ability of the banks to extend
credit and create deposits.
From the viewpoint of the individual bank, the discount rate is
the price paid for a temporary loan of reserve funds from its Federal
Reserve Bank, Whether in order to meet its legal reserve require
ments, the bank will wish to borrow from this source or, alterna
tively, borrow elsewhere or dispose of an asset such as Treasury
bills will depend in part on the relative costs of these alternative
sources of reserves; that is, the relationship of the discount rate
to short-term market rates.
From the viewpoint of the effectiveness of monetary policy, it
makes an important difference which of these sources banks tend to
choose. If banks borrowfrom each other or sell short-term Treasury
securities, bank reserves in the aggregate are not affected; if they
borrow from the Reserve Banks, even though each bank borrows
only temporarily, additional reserves are drawn into the banking
system, providing the basis for credit and monetary expansion.
Changes in discount rates are designed therefore to affect or to
restore the margin of preference of member banks as between the
various methods of reserve adjustment. Most commonly, changes
are designed merely to keep discount rates in line with short-term
market rates. Occasionally discount rates may be altered in a way
that leads market rates in order to provide a signal to the public
that the economic situation and, accordingly, the posture of mone
tary policy have changed.
Criteria for Rate Changes
As a general rule, the timing of discount rate changes depends
upon changes in short-term market rates of interest; that is, market
rates on those short-term liquid assets—ranging from the shortest
term Treasury bills to Government and other securities of some
what longer maturity—that banks hold as secondary reserves. A l
though there is no simple mechanical relationship between the
appropriate discount rate and the constellation of existing market
rates, discount rate policy is guided by the desirability of preventing
so large a differential that member bank borrowing is unduly en
couraged or discouraged.
Thus discount rates tend to follow market rates, usually with
a lag. There have been periods, however, when discount rates have
remained high or low relative to market rates for a considerable
span of time. In some instances, the frequency of Treasury financing
operations has left few if any opportunities when discount rates

QUESTION XIV

123

could be altered conveniently. In other cases, it was considered
that market rates were under the influence of transitory forces and
would soon return closer to earlier levels and therefore to discount
rates. In addition, it has not been considered necessary to lower
discount rates as far as market rates decline in periods of reces
sion and monetary ease; in such periods, member bank borrowings
fall to very low levels, and discount rates have little influence on the
actions of banks. At times, balance-of-payments considerations may
affect the timing and extent of discount rate changes. In so far as
discount rates interact with and influence short-term market rates,
they have an impact on international short-term capital movements,
A change in discount rates is frequently regarded by the public
as an indication of a change in, ora reinforcement of, the direction
of existing monetary policy. Possible public reactions to discount
rate changes are accordingly taken into account when such changes
are being considered. From the viewpoint of monetary policy there
are times when it is desirable to utilize a change in discount rates
as a signal to the public that the economic situation and the posture
of monetary policy have changed. This might call for a change in
discount rates in a way that leads rather than follows market rates.
Most commonly, however, changes in discount rates are of a routine
nature, designed merely to keep discount rates in line with market
rates. This guiding principle is based on the role of member bank
borrowing in the bank reserve adjustment process.
Discount Function and Bank Reserve Adjustments
As an instrument of monetary policy, the discount rate is only
one aspect of the discount function, which in turn is utilized in a
complementary manner with open market operations,!
Discount rates are prices that member banks pay for a tem
porary loan of reserves in the form of advances or discounts at
Federal Reserve banks. The individual member bank that faces a
potential deficiency in its legal reserve position has the immediate
choice among (1) borrowing at the Reserve Banks, (2) borrowing
elsewhere, as in the Federal funds market, or (3) disposing of as
sets such as Treasury bills. These short-run reserve adjustments
may be followed by more basic adjustments, including curtailment
of lending activity.
In periods of credit restraint, open market operations are con
ducted in a way which leads an increasing number of banks to ex
perience a frequent need to take positive action to maintain their
reserves at required levels. In such periods, banks generally are
_ i The relationship among the different instruments of monetary
policy is discussed in the answer to Question XIII.

124

THE FEDERAL RESERVE ANSWERS

faced with rising loan demands, while the reserves being supplied
by Federal Reserve open market operations are limited. The actions
that individual banks take to avail themselves of the funds for loan
expansion (for example, selling U.S. Government securities or draw
ing down correspondent balances) will unavoidably deprive other
banks of reserves. As the latter banks react to such reserve drains
and also attempt to expand their own loan portfolios, they in turn
take actions that draw reserves from other banks. Each bank that
loses reserves in this way faces a reserve adjustment problem and
may choose among the three alternatives noted above, unless it has,
and is willing to reduce, excess reserves.
How the individual bank decides among these alternatives will
depend, in part, on relative costs. The cost of borrowing at the
Reserve Bank is measured by the discount rate, although the will
ingness and ability of banks to borrow at the Reserve banks is also
influenced by considerations other than cost.2 The cost of borrow
ing Federal funds is, of course, measured by the rate on Federal
funds. In periods when bank reserves are underpressure, this rate
tends to stay at or only slightly below the discount rate. The cost
of adjusting a reserve position by selling securities is measured
by the interest earnings foregone—that is, by the current or ex
pected market yields on those types of securities that banks hold as
secondary reserves.3 Treasury bills, other short-term Government
obligations, bankers’ acceptances, and commercial paper are the
main types of secondary reserve assets heldby banks; during peri
ods of prolonged credit restraints many banks are likely to draw
down most of their secondary reserves, and Government securities
with one or more years to maturity may be the relevant asset.
It cannot be assumed that banks will always select the method
involving the lowest cost. Other considerations also influence their
decisions. For example, reluctance to borrow or Reserve Bank
administrative action may discourage borrowing even when discount
rates are below the relevant market rates. On the other hand, banks
differ in their access to the money market and therefore in their
ability to avoid borrowing. Unexpected reserve drains may in some
circumstances leave a bank with no alternative but temporary b or
rowing, even when rate relationships make such a course relatively
costly; thus some minimal borrowing is always present, even in
recessions when the discount rate is significantly higher than mar
ket rates. Nevertheless, the margin of preference of individual banks
among the alternative means of reserve adjustment is influenced
2See also the replies to Questions XV and XVI.
3ln the case of highly temporary needs for funds, the transactions
costs involved in selling and rebuying securities might be a rele
vant cost factor. Tax considerations might also be an influence.

QUESTION XIV

125

by their costs, in particular by the relationship between the discount
rate and market rates.
There are important differences in impact as between member
bank borrowing and the other methods of reserve adjustment. When
a bank sells securities or borrows Federal funds in order to re
plenish its reserve balance, it does so at the expense of other banks*
reserves (assuming that the Federal Reserve is not a purchaser of
securities at the time). Bank reserves in the aggregate are not
affected by such transactions. Net credit availability is not affected
unless the reserves so obtained would otherwise have remained
unused.
On the other hand, when banks increase their discounts at the
Reserve Banks, they are drawing additional reserves into the banking
system. Each discount or advance is temporary, and the borrowing
bank must soon repay. Thus a growing volume of indebtedness to the
Reserve Banks makes for an atmosphere of greater restraint on
credit expansion than would exist if the same volume of reserves
were provided by means of open market operations. In order to help
maintain such a restrictive credit policy, the Federal Reserve at
times finds it desirable to alter the relationship between discount
rates and market rates. This will influence the preference of banks
as between discounting and other methods of reserve adjustment;
in particular, increases in discount rates will tend to make sales
of securities a more advantageous form of adjustment than dis
counting, from the viewpoint of individual banks.
Discount Rates Over the Credit Cycle
In periods of credit restraint, when loan demands are expanding
in relation to credit supplies, market interest rates will be under
upward pressure. The rise in market rates will occur not only be
cause business and consumer demands for funds are growing but
also because banks will be selling securities to finance loan expan
sion, In these circumstances, an increasing number of banks will
experience drains of reserves and face the alternative of borrowing
at the Reserve Banks, borrowing Federal funds, or selling short
term liquid assets in order to avoid deficiencies in legal reserve
positions. As market rates on short-term securities rise relative to
discount rates, member banks will become more willingto borrow.
The number of member banks indebted to Reserve Banks will in
crease and more of them will renew or repeat their borrowing in
successive periods.
In order to help keep the flow of Reserve Bank credit through the
discount window under control and to help maintain the restrictive
discipline of indebtedness on member bank lending activity, Reserve
Bank discount rates are likely to be raised in these circumstances.

THE FEDERAL RESERVE ANSWERS

126

Higher discount rates in relation to market rates will not only re
strain new borrowing but also encourage repayment of existing debt
to the Reserve Banks,
In a period when monetary policy is attempting to restrain strong
loan demands, short-term market rates are likely to cluster around
the discount rate, but are unlikely to fall very much below the dis
count rate. If, under these conditions of strong loan demands, dis
count rates were raised significantly in relation to market rates,
member banks would tend to shift away from borrowing at Reserve
Banks and toward selling short-term securities, in view of the lower
cost of the latter means of reserve adjustment. Such sales by banks
in turn would act to raise short-term interest rates relative to the
discount rate. If market rates once again exceeded the discount
rate, resulting in a tendency toward increased borrowing, a further
rise in the discount rate would be appropriate.
In periods when credit is easing and loan demands are less
pressing, short-term market rates tend to fall below the discount
rate. In these circumstances discount rates may be lowered in order
to reduce the incentive to banks to repay indebtedness to the Re
serve Banks and thus encourage banks to utilize a greater portion
of reserve accretions in expanding their loans and investments.
Furthermore, reductions in discount rates may serve to confirm
to the public somewhat more dramatically than concurrent open
market operations that a condition of lessened restraint or greater
ease is being sought by the Federal Reserve.
When short-term market rates are below the discount rate, any
given level of member bank borrowings will be more restrictive than
when market rates are above it. This is so because, with market
rates below the discount rate, member banks have a stronger in
centive to repay borrowings. Thus, open market operations will have
to take this tendency into account in working with discount operations
to achieve a given pace of bank credit and monetary expansion. If
the discount rate were low relative to market rates, banks might
have a tendency to increase their borrowings. In order to maintain
a given pace of bank credit and monetary expansion in these c ir
cumstances, open market operations would have to be modified
appropriately.

QUESTION XV
Does member bank borrowing act as an escape mech
anism through which the banking system can avoid a

QUESTION XV

127

restrictive monetary policy? Is there any danger that
it could do so? What criteria are employed in deter
mining the amounts which individual banks (and the
banking system) may borrow from the Reserve Banks?
Are these criteria the same at each Reserve Bank?

ANSWER XV
Summary
Member bank borrowing does not provide an escape mechanism
from a restrictive monetary policy .^ts function^atH ^isjs to permit
a gradual and orderly response on the part of banEsTo the reserve
pressures*--some of which could otherwise be fairly abrupt—that
accompany a restrictive policy. A great variety of temporary,
seasonal, and emergency flows of reserves impinge upon banks.
Whenever these prove to be of a size or duration greater than that
expected and prepared for by the banks affected, borrowing from the
Federal Reserve Banks can assist in meeting the developing reserve
pressures pending a more permanent adjustment.
The extent of borrowing both by individual banks and the banking
system is controlled by the operation of three restraining influ
ences: (1) the discount rate, or the cost of borrowing; (2) ingrained
bank reluctance to borrow, or to remain in debt once a borrowing
action is taken; and (3) the exercise of administrative discipline by
Federal Reserve officials.
The latter restraint rests upon a continual review of the ex
perience of each bank borrowing at the Federal Reserve banks.
Relative size, frequency, and duration of borrowings are noted,
and these are related to the apparent trends in the loans, deposits,
and investments of the borrowing bank. Whenever it appears from
such reviews that a borrowing bank may be using Federal Reserve
credit for other than temporary, sjgasonal, or emergency needs be
yond those which can reasonably be met from the bank’ s own
resources, administrative contactawith the bank are made. Explana
tions of the circumstances are sought, prospects tor future retire
ment of debt are reviewed and, where appropriate^ positive program
for the adjustment of earning assets is encouraged; The basic guide
lines for such administrative action, which are the same for all Fed
eral Reserve banks, consist of a formal regulation on discounting and
a variety of interpretative rulings issued by the Board of Governors
and revised or expanded from time to time as the necessity has arisen.

128

THE FEDERAL RESERVE ANSWERS

Discounting in Relation to Individual Bank Needs
Commercial banks are subject to a vast variety of inflows and
outflows of funds. Some flows are routine and easily prepared for,
while many others are unexpected, of uncertain duration, or too
large to be easily met. Each bank pays its depositors upon demand.
Accordingly, it must try to forecast the demands of its customers
and arrange its own asset holdings to yield cash at the times and
in the amounts needed to satisfy the demands upon it. At the same
time, it must endeavor to meet the legitimate credit needs of its
community and to earn an adequate return for its stockholders. In
such circumstances, it i s hardly surprising that banks sometimes
find the demands upon them exceeding their preparations.
Borrowing from the Federal Reserve banks is one means by
which member banks meet unexpected drains, pending a more per
manent adjustment. The alternative sources of outside funds to meet
unexpected pressure, while varied, are not always conveniently
available at the times and in the amounts needed. For example,
sales of Federal funds and purchases of U.S. Government securities
for same-day payment cease well before the end of each business
day, yet subsequent drains upon a bank’ s reserve balance can de
velop from late transfers of funds at the order of customers. On
other occasions, banks needing cash for a few days will find the
volume of available Federal funds fluctuating a good deal from day
to day, and as a consequence few can be assured of obtaining all
the funds they need from this source. Sale of securities and re
purchase after a few days when cash pressures are past is another
means of raising temporary funds, but the difference between the
“bid” and “asked” prices in the market can make this a relatively
expensive source of funds, and the changed tax status of the re
purchased issue could be disadvantageous to the bank involved.
For needs of longer duration, such as seasonal swings in loan
demand, short-term securities might be liquidated or correspondent
banks drawn upon for credit. Correspondent banks, however, are
themselves subject to reserve pressures which can occasionally
condition the amount of assistance they can extend to other banks.
On the other hand, the ability of a bank to build up short-term se
curities in anticipation of a seasonal concentration of demands
depends in part upon the relative size of the peak and off-peak needs
of its community. Some seasonal swings are so great that matching
them with the acquisition of, say, Treasury bills in the off season
would require a bank to constrict its off-peak financing of local
businesses and consumers. A difficult aspect of the planning for
accommodation of these seasonal swings is the fact that the amounts
needed may vary in unexpected fashion from year to year, depending
upon such factors as the weather in agricultural areas during the
growing season or in resort areas.

QUESTION XV

129

Most difficult of all for the banks are the problems that may be
associated with localized economic adversities. Crop failures, work
stoppages, and the like can produce heavy deposit losses and bur
geoning credit needs. Sales of liquid securities by banks caught in
such a vise of circumstances may provide some funds, but when
demands exceed the proceeds of asset sales that can be effected
without undue cost to the bank, there is clear need for some source
of funds as an alternative to the curtailing of loans to the hardpressed community.
Restraints upon Discounting
It is to assist in meeting the above types of needs that the dis
count facility is provided. From published regulations and pro
nouncements, member banks are aware of the privilege of borrowing
to cover temporary, seasonal or emergency needs beyond the bounds
which can reasonably be met from their own resources. The use of
borrowed funds, however, is intended to be a temporary supplement,
and not a substitute for a bank’ s adaptation of its own asset holdings
to the underlying supplies of and demands for credit in its com
munity. Three different influences, singly or in combination, operate
to keep member bank borrowings from departing too far from these
standards. These are (1) the discount rate, (2) bank reluctance to
borrow, and (3) administrative action by discounting officials.
(1) The role of the discount rate in influencing borrowing is
discussed elsewhere in these answers. Suffice it to say here that
the discount rate represents a cost which banks weigh chiefly in a
relative sense. The pertinent comparisons are not only between the
discount rate and the yields obtainable from various competing de
mands for the banks’ funds, but, even more importantly, the discount
rate and the cost of alternative sources of funds with which to meet
demands. Depending upon the placement of the discount rate in the
structure of market rates and the particular alternatives open to
each individual bank, the discount rate could be a factor encouraging
or discouraging borrowing in any specific case. Rate considerations,
however, are not the most important of the influences at work that
shape bankers’ attitudes towards borrowing.
(2) A second influence conditioning bank borrowing is the wide
spread reluctance of banks to borrow. The factors contributing to
bank reluctance to borrow are several, A common expression is
that “it is not sound banking” to rely in any important degree upon
borrowing. Reference is made to the fact that banks are already
“in debt* to their depositors, with repayment due upon demand, and
that it can be imprudent to incur additional debt, of a prior claim
nature, to such existing liability, If these are not the views of the
banker, he may nonetheless be strongly influenced if he believes
that such views are held by his directors or his larger depositors.

130

THE FEDERAL RESERVE ANSWERS

Historical experience can contribute to a desire to avoid borrow
ing on the part of some bank officials .In the 1920’ s and early 1930’ s,
some of the banks that borrowed to avoid portfolio contraction ulti
mately failed, with greater loss to their remaining depositors and
stockholders than would have occurred had these banks been closed
at the first concerted outflow of deposits. The result was a kind of
penalty upon the loyalty of customers which was of concern to many
conscientious bankers. Finally, a number of bankers over the years
have had the experience of being questioned by Federal Reserve
discount officials concerning their borrowing, and some bankers
particularly sensitive to such inquiries are desirous of avoiding
any recurrence.
Reluctance to borrow varies among banks, depending upon the
experience and outlook of the management. Moreover, the corporate
attitude of each bank also shifts over time, as experiences fade into
history and the official family changes. Consequently, bank reluc
tance to borrow is a highly individualistic brake upon use of the
discount window. In most cases, however, it appears to be a deter
rent sufficiently strong to prevent any excessive use of discounting,
(3)
To identify any excessive use of discounting which may be
developing, each Federal Reserve bank undertakes a continuing re
view of the experience of each borrowing bank. Relative size, dur
ation and frequency of borrowings are noted. Changes in individual
bank deposit totals are followed, and trends in the composition and
aggregate total of the bank’ s loans, U.S. Government security hold
ings, and other earnings assets are analyzed. From reports of the
borrowing banks and internal Federal Reserve records, information
on these developments is obtained quarterly, semimonthly, weekly,
and even daily in some instances.
Whenever it appears from such reviews that a borrowing bank
may be using Federal Reserve credit for other than temporary,
seasonal, or emergency needs beyond those which can reasonably
be met from the bank’ s own resources, administrative contacts
with the bank are made. Administrative contacts may be made by
letter, telephone, or personal visit, or by a combination of these
approaches. Explanations of the local circumstances and bank poli
cies contributing to the need for borrowing are sought. Prospects
for the retirement of borrowing are reviewed, and if no changes in
loans or deposits promise to provide enough funds to retire the debt
within the bounds of time regarded as appropriate, a positive pro
gram for the adjustment of earning assets is encouraged.
Borrowing banks are not in a position to ignore the counsel of
Federal Reserve officials. Borrowing is done on the basis of

QUESTION XV

131

short-term notes,1 While it is standard practice for Reserve Banks
to accept without question original notes presented by a member
bank, such notes are collected at maturity by an automatic charge to
the reserve account of the borrowing bank, and successive replace
ment notes may be accepted or not as the Reserve Bank deems ap
propriate, In point of fact, even the refusal of renewal requests is
a very rare occurrence (always preceded by a prior warning), be
cause borrowing banks typically endeavor to adjust their operations
within the limits as generally set forth in the published regulations
and more specifically interpreted in the administrative contacts by
System officials.
A variety of procedures currently serve to keep discount ad
ministration relatively homogeneous among the various Federal
Reserve banks. The basic guidelines for discount policy are set
forth in a formal regulation (Regulation A) issued by the Board of
Governors pursuant to authority conveyed by the Federal Reserve
Act. Over the years a variety of interpretations have been issued by
the Board concerning various parts of the Regulation, and these
have been published in the Federal Reserve Bulletin and summarized
in the Board*s Published Interpretations. This material is available to
member banks as well as Federal Reserve banks, making it easier for
each to understand the intended scope and limitations of discounting.
The conformity of each Reserve Bank to these standards in its
discount administration is tested by the examiners of the Board of
Governors in its annual examination of each Federal Reserve bank.
More informally, the presidents of the Reserve Banks often discuss
and compare discount experience during their attendance at meet
ings of the Federal Open Market Committee and of the Conference
of Presidents. Finally, the discount officers of the various Reserve
Banks meet from time to time to discuss common problems and
compare discount practices.
The uniformity of discount administration gained by these steps
cannot be measured with any degree of precision, A comparative
analysis of borrowing statistics for the various Federal Reserve
lM ost current bank borrowing is accomplished by notes secured
by the pledge of U,S, Government securities. As a standard operating
practice, all Federal Reserve banks limit the maturity of such notes
to fifteen days or less. Exceptions to this general practice, which
have been rare in recent years, may take several forms: Under the
law, banks may borrow for periods of up to three months on collat
eral notes secured by U.S. Government obligations or eligible cus
tomer paper, or for periods of up to four months at a higher rate if
the notes are secured by ineligible assets. Member banks may re
discount eligible customer paper for the remaining life of the cus
tomer note within certain maturity limits set by law.

THE FEDERAL RESERVE ANSWERS

132

districts is not by itself an adequate basis for arriving at broad con
clusions as to the uniformity among districts in the administration
of the discount window. Allowances must be made for basic differ
ences in geography, economic organization, and banking structure
among the twelve districts. Statistics based on administrative action
are also an inadequate basis for policy comparisons. Identical poli
cies pursued may result in different statistical results merely be
cause of a difference in procedures developed at the various Banks
for making such contacts and in the timing of these contracts.

QUESTION XVI
To what extent is member bank borrowing limited by
the cost of borrowing and to what extent by reluctance
to borrow and by “policing” ? What are the major ad
ministrative problems involved in policing the discount
window? Does the Federal Reserve discount rate function
as a “penalty” rate? Should it so function? What are
the arguments for and against a mechanical tie between
the Treasury bill rate and the discount rate, as in
Canada?

ANSWER XVI
Summary
To the extent that comparisons can be made, it appears that the
most widespread restraining influence upon borrowing is the tra
ditional reluctance of banks to be in debt, “Policing” actions by
Federal Reserve officials directly involve only a minority of b or
rowing banks, although it seems likely that the effect of any admin
istrative contact continues for some time and spreads beyond the
particular bank involved. Within broad limits, cost changes do not
appear to produce any overpowering response in the volume of bank
borrowing. In particular, the capacity of a low rate to invite borrow
ing is limited; however, the modest increments to reserves that
result from marginal, rate-induced borrowings are believed to ex
ercise some influence upon market atmosphere and rate levels.
In the “policing” of the discount window, probably the most
persistent problem is one of communication—that is, the conveying
of a correct and uniform understanding of the appropriate usage of

QUESTION XVI

133

the discount mechanism. A second problem encountered from time
to time is the tendency for bankers to be somewhat optimistic as to
the likely duration of unexpected reserve drains and hence some
times to be slow in adjusting thereto. Bank adjustment may also be
inhibited in some cases by the size of capital losses which will be
realized if securities are sold to retire debt. Federal Reserve offi
cials must be alert in such instances to encourage the appropriate
degree of asset adjustment without undue delay.
With the other restraints upon borrowing which are operative
in the American banking system, the discount rate does not, and
need not, serve solely as a “penalty*9 rate. Nor is there necessity
for a stable rate relationship such as might be sought through tying
the discount rate to the Treasury bill rate. For that matter, the
variety of asset positions maintained by the uniquely large number
of banks in this country makes it a practical impossibility for any
one rate, at any reasonable level, to be a “penalty” rate for all banks
and at all times. The monetary authorities can utilize discretionary
changes in the Federal Reserve discount rate to exercise a gentle,
across-the-board influence on bank borrowing decisions in coordi
nation with the use of other and more powerful tools of flexible credit
and monetary policy.
In addition, discount rate changes also are a focus of attention
within the financial community. This characteristic, some believe,
can lead to occasional distortions or perversities of borrower re
sponse. The evidence reviewed, however, does not indicate any
dominance of this type of perverse reaction.
Difficulties in Distinguishing Borrowing Restraints
Any detailed comparisons of the restraints upon borrowing that
are exercised by the discount rate, by bank reluctance to borrow,
and by discount administration, respectively, must be undertaken
with some caution. The results of these differing restraints are
blended together in the final consideration by a bank as to whether
or not it should apply for credit at a Reserve Bank, Perhaps not
even the banker himself will always be able to say which factor was
the most important in the decision by his management or board of
director s ,l
Moreover, as times and bank personnel change, the relative
power of each of the three restraining influences also changes. For
example, the comparative strengths of the various restraints on
borrowing will vary with the fluctuations in general business and
financial activity. In such fluctuations, it is not only the current
-tThis answer should be read in conjunction with the answers to
Questions XIV and XV.

134

THE FEDERAL RESERVE ANSWERS

state of affairs that may moderate the influence of one restraint as
against another, but also the changing expectations of bankers and
the market regarding the future course of business and credit. As
an illustration, the cost of borrowing compared with the alternative
cost of selling securities should appear less onerous if the banker
anticipates an early decline in credit demands (and hence a rise in
securities prices) than if he looks forward to a sustained period of
increasing credit pressure.
These considerations are not the only ones affecting bank borrow
ing interms of changing business and credit demands. When business
expands, the increased flow of payments and the heightened interest
of deposit owners in economizing on cash produces a greater number
of unexpected pressures upon banks, and thus multiplies the number
of occasions when bankers must make decisions concerning borrow
ing or alternative action. Even if the proportion of such decisions
made in favor of borrowing were to remain the same, the number
and amount of borrowings within the banking system would rise.
Such developments must not be mistaken for a basic shift in the
application of one or more of the three restrictive influences on
borrowing. This has sometimes happened, for example, with respect
to Federal Reserve “policing” actions. Such administrative actions
are far more numerous in periods of prosperity than in recessions,
primarily because of more instances of extended bank borrowing.
The above cautions should make it clear that a purely statistical
review of the record of bank borrowing is an uncertain means of
determining causes and effects. There are instances, however, that
can be cited in which the directions of influence of the three types
of restraint on borrowing are sufficiently at odds to give some idea
of the relative order of strength attaching ta each at the time. It is
in this frame of reference that the following evidence is cited.
Discount Rate as a Deterrent
With respect to the discount rate as a deterrent cost of borrow
ing, the most relevant comparison is with the costs of alternative
sources of ready funds. Comparison of such costs with the changing
amounts of funds borrowed does not suggest that there is a powerful
borrowing response to changing cost considerations. For example,
during the first and fourth quarters of 1959 the yields on threemonth Treasury bills, the shortest term and most marketable type
of Treasury debt, averaged appreciably higher than the discount
rate, while in the second and third quarters this rate relationship
was reversed (Table XVT-1). Yet the proportion of banks borrowing
was not far different in these periods.
Furthermore, the average amount borrowed in the second quarter
exceeded that fo r the first quarter, and the amount borrowed in the

QUESTION XVI

135

TAB LE X V I -1
C om parison o f Discount Rate, T reasu ry B ill
Y ield, Amount o f B orrow ings and Number
o f Borrow ing Banks, Quarterly, 1956-59

Y ear and
Quarter

A verage
discount rate,
N .Y .F .R . Bk.
(percen t)

A verage m arket
yield, 3 -month
T reasu ry bills
(percen t)

A verage
borrow ing
from F.R. Bks.
(m illion s o f dollars)

P roportion o f
m em ber banks
borrowing^
(percent)

1956
1
2
3
4

2.77
2.50
2.72
2.85
3.00

2.62
2.33
2.57
2.58
3.03

831.2
866.3
933.3
809.3
715.7

15.9
16.3
17.1
15.6
14.7

1957
1
2
3
4

3.11
3.00
3.00
3.21
3.24

3.23
3.10
3.14
3.35
3.30

836.8
627.0
975.0
970.0
775.0

17.2
16.4
18.9
16.4
17.1

1958
1
2
3
4

2.16
2.68
1.84
1.80
2.30

1.78
1.76
.96
1.68
2.69

293.9
277.0
130.3
279.0
489.3

15.9
15.4
n.a.
n.a.
16.4

1959
1
2
3
4

3.36
2.64
3.18
3.61
4.00

3.37
2.77
3.00
3.54
4.23

798.8
555.3
788.0
955.7
896.3

20.3
19.4
21.6
20.6
19.7

n.a. - not available,
Details may not average to totals because of roundings
lNumber of banks borrowing at any time in the quarter as a pro~
portion of all member banks. Annual figures are averages of quar
terly totals.

136

THE FEDERAL RESERVE ANSWERS

third quarter exceeded that for the fourth, a pattern in contradiction
to that suggested by rate relationships alone. Over a longer time
span, bill rates averaged below the discount rate for almost all of
1956, and then above the discount rate for most of 1957, yet the
borrowing averaged about the same in both years.
The pertinence of such comparisons is reduced by the growing
prosperity and credit restraint which were characteristic of 1956-57
and of 1959. In addition, the rate margin noted—between the discount
rate and the three-month Treasury bill rate—may have become in
creasingly inapplicable to borrowing decisions in 1957 and again in
1959 because of the reduced bill holdings of banks.
A comparison of amount and cost of borrowing which is free of
some of these uncertainties can be made with respect to the year
1952. In the period 1950-52, a corporate excess profits tax was in
effect which provided a strong inducement to expanded bank borrow
ing. A survey of 1950 and 1951 bank experience revealed that onefifth to one-fourth of insured commercial banks were subject to
this tax (Table XVT-2). Moreover, the proportion of banks subject
to excess profits tax ranged upward from three-tenths to two-fifths
among bank size groups with total capital accounts of $250,000 or
more, the size range which includedmost Federal Reserve member
banks. A provision of this tax allowed a proportion of average bor
rowing to be counted as capital in computing the rate of return to
be exempt from the excess profits tax levy. Technicalities aside,
the practical effect for a bank in the excess profits tax bracket was
that by borrowing at the 1.75 percent discount rate then prevailing
it could earn as much as a 2 percent after-tax gain on such debt,
even if the proceeds of the loan were allowed to lie idle .2 In effect,
in such cases a negative discount rate existed.
Given such a striking incentive to borrow, discounts and ad
vances at the Federal Reserve banks rose sharply during 1951 and
1952 to a peak re serve-period average of approximately $2 billion
near the end of the latter year. Part of this increase may be attribu
ted to factors other than tax considerations, for the rise started
from the depressed borrowing levels immediately following the
cessation of Federal Reserve support of the Government securities
market and was quickened by the growing business boom of 1951-53.
On the other hand, the rise might have been retarded somewhat by
the lack of familiarity on the part of some banks with the discount
process.

^For banks allowed a 12 percent return upon invested capital
under the law. For illustrative applications of this excess profits
tax, see Donald C. Miller, “Corporate Taxation and Methods of
Corporate Financing, ” American Economic Review (December 1952),

QUESTION XVI

137
TABLE XVI-2

Excess P rofits Taxes Incurred By
Insured C om m ercial Banks on Taxable
Income, By Size of Bank, 1950 and 1951
Size of bank
(Total capital
accounts,
June 30, 1951)
$4,000,000 and over
$750,000 - 3,999,999
$250,000 - 749,999
Under $250,000
Total

Number of
insured
com m ercial
banks
1

Percentage of banks in
each size group incurring
excess profits taxes
1950
1951

284
1,384
3,877
7,868

35
33
41

33
30
37

1 13,413

iData for banks with total capital accounts of $4 million and over
do not include estimates for 5 nonrespondent banks, 16 banks with
preferred stock or capital notes or debentures, and one atypical
bank. These exclusions are reflected in the “total” data. Data for
the other size groups are estimates for all insured banks in each
group.
SOURCE: Federal Reserve Bulletin, June 1952, p. 604.

Even with this marked tax incentive to borrowing, the number
of borrowing banks remained in the minority. Also, the total amount
borrowed remained less than 10 percent of aggregate reserve bal
ances and only one-third higher than the peaks of borrowing reached
in subsequent years of high-level business activity in which no such
rate advantage obtained. Such evidence suggests that, while the dis
count rate has undoubtedly had marginal significance in decisions
to borrow or not to borrow, the capacity of a relatively low rate to
invite borrowing is limited by other influences.
The modest increments to reserves that can result from mar
ginal rate-induced borrowings undoubtedly exercise some influence
upon market atmosphere and rate levels (as is discussed in greater
detail below), but the point of note in the present section is the fact
that rate-induced changes in borrowed reserves are likely to be
small in volume relative either to total reserve balances or to the
capacity of open market operations to offset them if desired.

138

THE FEDERAL RESERVE ANSWERS

Relative Effectiveness of the Tradition Against Borrowing
Available information suggests that the most widespread current
restraining influence on borrowing is the traditional baiik reluctance
to be in debt. This consideration is expressed again and again by
bankers who habitually do not borrow from their Reserve Banks.
The number involved is large. During the average quarter of 1959,
four out of five member banks did not borrow from the Federal
Reserve (Table XVI-1). This proportion is only modestly smaller
than that for 1957, the latest previous year of strong credit demands,
although it is appreciably below the quarterly average for the re
cession year of 1958.
Here again, other factors may be contributing to the size of this
group of nonborrowers. A good many banks are located in areas
with such gradual or predictable financial movements that needs to
borrow rarely arise. Other small banks regard the act of borrowing
and attendant close calculation of reserve positions as more costly
in management time and interest outlay than the value lost by leav
ing an uninvested excess reserve balance to cover unexpected drains.
Still other banks find it cheaper or otherwise preferable to cover
borrowing needs as they arise by purchases of Federal funds or ob
taining accommodation from a correspondent. Many of the banks
that use these other avenues of accommodation also borrow from
the Federal Reserve at one time or another. The chief exceptions
are those country banks that sell loan participations without re
course to their city correspondents. Thus, they accommodate their
larger customers and at the same time avoid the need to show any
formal liability for borrowed funds on their financial statement.
When full allowance is made for these possibilities, the pre
ponderance of banks that do not borrow from the Federal Reserve
remains sufficiently large to suggest a strong, widespread, and
persistent desire to avoid borrowing within much of the banking
structure. Furthermore, such desire also appears to exist in milder
degree in the minds of many occasional borrowers whose preference
not to borrow is sometimes overridden by circumstance.
Deterrent Effects of Discount Administration
The restraint exercised by voluntary banker reluctance to bor
row is complemented by the administrative limitation of borrowing
performed by the Federal Reserve banks* “Policing” actions by
Federal Reserve discount officials directly involve only a minority
of borrowing banks, which are in turn a minority of the banks in the
System. On the surface, therefore, administrative actions are not
nearly as pervasive an influence as bank tradition against borrowing.

QUESTION XVI

139

The proportion of banks contacted in this connection during the
course of a year varies from a minor to a moderate fraction of the
total number of banks borrowing, and depends upon the number of
extended borrowing cases generated by the underlying credit cli
mate of the period. These contacts come whenever a member bank
is deemed to be departing from the standards for borrowing estab
lished in Regulation A , The number of contacts with any one bank
may be one or several, depending upon the complexity of its reserve
problems and the progress made in a program of appropriate asset
adjustment, if any is needed.
Any one or a series of contacts continues to have an effect on the
individual bank involved and also spreads well beyond the particular
instance. News of an administrative contact tends to be passed along
to other banks, creating a broadened awareness that Federal Re
serve credit is intended for limited purposes. Member banks natu
rally desire to avoid criticism from the Reserve Bank, and accord
ingly the majority of borrowing banks are interested in operating
within limits acceptable to discount officials. All told, the restraining
influence of policing by discount officials appears to be substantial,
but much less pervasive than bank reluctance to borrow. Adminis
trative action, nevertheless, reinforces this reluctance and also
tends to limit the amount and duration of borrowing which does occur.
Problems of Discount Administration
In undertaking the administrative limitation of borrowing, Federal
Reserve officials experience a variety of problems. Probably the
most persistent problem in this area is one of communication—
that is, the conveying of a correct understanding of the appropriate
usage of the discount mechanism. Concerning the tradition against
borrowing, a variety of experiences have conditioned individual
banker views toward borrowing. For example, many banks are not
familiar with the discount mechanism. For nearly two decades be
fore 1950, only minor use was made of rediscounting because of the
ready availability of reserves from other sources. Even in the
1950*8, the majority of banks were not ordinarily borrowers. The
Federal Reserve System itself has changed the emphasis placed
upon borrowing as compared with these earlier decades, and the
latest revision of the Board’ s Regulation A on the subject, issued
in 1955, was considerably more explicit than its predecessors on
the standards of appropriate borrowing,
As a result of these changes, discount officials of the Reserve
Banks meet widely varying attitudes in contacting member banks.
Sometimes the problem is not too liberal bank resort to the dis
count window but the reverse, a tendency to respond too restrictively
to any hint of Federal Reserve criticism , Repeated contacts are
sometimes necessary before communication and an appropriate

140

THE FEDERAL RESERVE ANSWERS

understanding can be established between the discount officer and
the member bank.
A second type of problem that can arise in discount adminis
tration involves banker expectations. There is some tendency for
banks to regard unexpected reserve pressures as temporary, in
the absence of knowledge to the contrary. When cash positions are
short, borrowing may be undertaken to cushion such pressures un
til their likely duration becomes clearer.
Hopeful anticipations of some turn in reserve drains may o c
casionally persist beyond the point of realistic appraisal. It is the
responsibility of discount officials to discuss such cases and sug
gest appropriate reconsideration of prospects. Such instances be
come more numerous during periods of monetary restraint when
growing demands for funds and more attractive investment outlets
may generate subtle drains upon bank deposit totals of a more last
ing nature than the bank immediately detects. Oftentimes bank ad
justment to one reserve drain has only begun when a second and
third round of pressures have developed from added loan requests
or successive declines in deposits. Such compounding of drains can
occasionally lead to a substantial span of indebtednesses disposals
of the bank’ s earning assets run behind needs for funds.
A final difficulty worthy of mention is the size of realized capital
losses that can result for banks faced with the necessity of selling
securities to adjust to reserve pressures in the advanced stages of
a period of credit expansion. If interest rates have moved up con
siderably, the price depreciation below book value can be substantial
on intermediate- and longer-term securities acquired during p re
ceding periods of credit ease.
If securities are sold, the offset to earnings in the year of sale
can be large, and may conceivably even extend to a temporary re
duction in total capital accounts. Banks are understandably reluctant
to realize such losses. The Federal Reserve System, furthermore,
is concerned with the maintenance of adequate bank capital cushions
to support deposit liabilities. A decline inprices of existing assets,
however, is one of the mechanisms by which a restrictive monetary
policy slows bank credit expansion. In these periods, discount offi
cials must be careful not to let bank borrowing extend to the point
of dulling the restraint on bank lending that stems from declines
in prices of bank investments.
The Discount Rate as a “Penalty” Rate
While administrative contacts are experienced only by banks that
rely unduly on the discount mechanism, the prevailing discount rate

QUESTION XVI

141

is a factor known to all members and applicable uniformly to each.
It may or may not be a “penalty” rate, depending upon the bank being
considered and the particular bank assets or liabilities to which
borrowing is being related. Over the longer run, the basic source
of funds for an individual bank is the deposits which it can attract
and maintain. For a bank which has previously gained loanable funds
by deposit increase, the discount rate charged on borrowings usually
represents a step-up from the marginal out-of-pocket costs of ob
taining and servicing increases in deposits, In this broad view,
borrowing appears as a relatively expensive source of funds.
To measure the theoretical profitability of borrowing, an alterna
tive comparison may be made between the discount rate and the net
return to be gained from earning assets in which borrowed funds
might be invested. In most circumstances, both the loans and the
securities in the typical bank’ s portfolio are likely to yield a gross
return higher than the prevailing discount rate. But certain partially
offsetting expenses must be recognized. Acquisition and servicing
costs are usually nominal for securities, but they can bulk quite
large in the case of some types of loans. In addition, the prudent
banker also makes some allowance for the risks of loss which he
is assuming, both for default of payment at maturity and for possi
ble depreciation of market value in the case of sale before maturity.
The end results of such balancing of considerations are not always
easy to foresee. In most situations, it is likely that the net return
available on most components of a bank’ s loan and investment port
folio would equal or exceed the discount rate.
It should be pointed out, however, that these opportunity cost
considerations are of a longer-run nature, and may recede into the
background in the circumstances in which a bank is deciding whether
to borrow. At such a point, a bank usually would not have sufficient
time to meet its need for funds by attracting additional deposits.
On the other hand, if it raises funds by borrowing, both its own re
luctance and the attitude of Federal Reserve discount officials would
prevent it from keeping the borrowed funds long enough to take ad
vantage in any dependable way of the long-run average net rates of
return available on loans and investments. When under immediate
reserve pressure, a bank’s alternatives to borrowing from the
Federal Reserve are only those assets and alternative borrowing
possibilities which can generate cash on short notice. To the extent
that a bank in such a situation is considering the cost of borrowing,
its practical comparisons are with the rates, charges, and net cur
rent yields associated with its alternative sources of liquidity.
Against some of these sources, the discount rate will sometimes
appear as a “penalty” rate; against others, it will not.
Obviously, it costs more to borrow than to draw down any excess
reserve balance or any excess deposit with a correspondent bank.

142

THE FEDERAL RESERVE ANSWERS

In addition, the discount rate is ordinarily the practical ceiling for
Federal funds quotations, and hence borrowing from the Federal
Reserve banks is usually at least as expensive as, and often more
costly than, resort to the Federal funds market. On the other hand,
the alternative of borrowing from correspondent banks usually
carries an interest cost equal to or higher than the discount rate.
The fact that borrowing from correspondents also may involve other
indirect costs (e.g„ pressure for increased interbank deposit bal
ances) tends to make this source more expensive than borrowing
from Federal Reserve banks.
Finally, a bank may also raise funds by selling its liquid earning
assets, such as Treasurybills, commercial paper, or other Govern
ment or private issues of the shortest maturity owned. In this area
of “money market” earning assets, rate relationships are close and
changes come frequently. For example, in the eight years, 1952-59,
the discount rate averaged above the market rate on three-month
Treasury bills in twenty quarters but below in twelve quarters,
with this relationship shifting seven different times.
It should be noted that the yields on money market assets have
tended to fluctuate more than the discount rate. Consequently, the
relative cost of selling such assets as compared with discounting
is likely to be greater during periods of credit restraint than during
credit ease. Indeed, the market rates on such assets often fall be
low the discount rate during easiest credit periods. Among other
factors, the greater fluctuations in money market asset yields re
flect the tendency for such assets to be the residual assets in bank
portfolios, and hence to be disposed of as other needs materialize
during periods of credit expansion. As a consequence, in the later
stages of credit growth, more and more banks may have disposed of
all (or all except some irreducible minimum) of their “money market”
assets. For banks denuded of such easily disposable assets, the
alternative to borrowing may then become the sale of intermediateterm Treasury notes and bonds. Such sales may well involve sacri
fices in return larger than the discount rate.
The foregoing discussion should make it clear that the discount
rate as administered in the United States is not a “penalty” rate
for all banks or at all times. Furthermore, within the domestic in
stitutional structure there are limits as to the extent of any “penalty”
margin which could be maintained during periods of strong credit
demand. As credit pressures mount and market rates move higher
relative to the discount rate, a larger number of marginal borrowing
decisions tend to be resolved in favor of borrowing. Such decisions
result in the inflow of modest increments of reserves to the credit
markets, thereby moderating in some degree the supply pressures
contributing to the rise in market rates. Other Federal Reserve
actions intended to restrain bank credit expansion of course take

QUESTION XVI

143

into account the reserve effects of increased member bank borrow
ing, and look to the various restraints attending such borrowing to
assist in promoting the desired degree of restraint upon over-all
bank credit growth.
The attributes of the discount rate as a cost, which have been
outlined in this answer, have led the Federal Reserve System to
utilize the discount rate as a tool of flexible monetary policy. In
grained banker reluctance to borrow is slow to change, and the
initiative in such changes rests with the individual banks. Discount
administration is controlled by the Federal Reserve, but it is im
practical to attempt to make important countercyclical changes in the
promulgation or enforcement of appropriate borrowing standards.
A change in the discount rate represents the only across-the-board
action which the Federal Reserve System can take with a view to
generally affecting bank borrowing decisions.
At times when banks appear overcautious in borrowing, and as
a result are tending to tighten credit availability more rapidly than
underlying economic conditions and the level of the aggregate re
serve base warrant, holding down the discount rate in the face of
rising market rates can serve to ease the “penalty,” or widen the
“benefit,” to be considered in future bank borrowing decisions. The
reverse is true in periods of overborrowing. Such widening or nar
rowing of rate margins is a way of influencing banking decisions.
The discount rate is in fact an important complement to open market
operations in the execution of flexible credit and monetary policy.
Tying the Discount Rate to the Treasury Bill Rate
Discount rate changes are typically the most overt of all central
banking policy actions and involve difficult judgments as to the ap
propriate timing and degree of action. Rate changes exercise not
only a cost effect upon the banking system, but also a psychological
effect upon observers of financial affairs everywhere.
With the aim of avoiding the difficult judgments as to when to
change discount rates and by how much and of minimizing psycho
logical impacts, measures have been proposed to tie the discount
rate to some independently determined market rate, such as the
three-month Treasury bill rate. Among the central banks of the
major industrial nations, one—The Bank of Canada—has adopted
the system of a “tied” discount rate. The applicability of such a de
vice depends, of course, upon the characteristics of the national
financial structure, which can vary widely from country to country.
Whatever the virtues of the tied rate in other environments, this
kind of device would have both advantages and disadvantages under
the present United States monetary system. The more important
are reviewed below under the general headings: (a) cost effects and
(b) signal effects.

144

THE FEDERAL RESERVE ANSWERS

Cost effects. The most obvious advantage claimed for setting
the discount rate at a specified margin above, say, the average
auction rate on 91-day Treasury bills (as in Canada) is that it would
provide a relatively constant differential between the cost of borrow
ing from the central bank and the cost of bank adjustment by disposi
tion of Treasury bills. 3 A stable “penalty” for borrowing would thus
be automatically maintained, since the yields on most other money
market instruments move more or less in sympathy with the rates
on Treasury bills. The advantage that particularly appeals to some
proponents of the device is that it would enable the central bank to
continue a “penalty” relationship without overt action during periods
when market rates were moving upward.
On the other side of the argument, there are times when the
central bank may deem it advantageous to be able to alter the rela
tive cost involved in borrowing. As was pointed out earlier, the
two major restraints upon borrowing other than relative cost—
the tradition against borrowing, and Federal Reserve administrative
standards—are not easily modified by the monetary authorities* If
shifting economic conditions made it important to encourage a change
in bank willingness to borrow, a change in the discount rate relative
to market rates would be the one quick and direct means of doing so.
Even if a stable “penalty” rate for each instance of borrowing
were to be desired, simply tying the discount rate to a focal money
market rate would not necessarily accomplish that purpose. Ideally,
the rate relationship should be established with those instruments
which represent the alternative source of liquidity for banks that are
prospective borrowers.4 But such alternative sources of funds are

3certain transitory exceptions to this statement are conceivable
(e.g., when a rapid rise in market bill yields occurs between the
weekly auctions), but they are not likely to happen with sufficient
frequency to alter the general analysis presented here.
Alternative proposals might suggest that the discount rate be
established at a level equal to, or even below, the Treasury bill
rate or some other market rate. Because historical experience
and conventional argument have been in terms of a “penalty” m ar
gin of the discount rate over the bill rate, the discussion in this
section is cast in those terms. The basic import of the various
pro and con arguments, however, is believed to apply regardless
of the size or the sign of the rate margin specified, inasmuch as
they flow from the rigidity of the “tied” rate relationship.
4The text discussion is phrased in terms of banks, for in the
United States the primary borrowers from the central bank are its
(Footnote continued on following page)

QUESTION XVI

145

not the same for all banks and at all times. This point applies with
particular force to the U.S. banking system, which is unique in its
large number of banks. Thus what might be a “penalty” cost for
one bank might well be a profitable borrowing rate for an oth er, 5
In the United States, accommodation of reserve pressures pend
ing bank adjustment via sales of money market instruments is not
the only role of the discount window. It is also intended to be avail
able to assist banks in meeting seasonal or other temporary needs
for funds beyond the dimensions which can reasonably be met by
use of their own resources, and in meeting emergency demands of
extended duration which may arise from national, regional, or local
difficulties. These borrowing needs arise less frequently and less
generally than do those associated with money market adjustments,

(Footnote 4 continued from previous page)
member commercial banks. In some other banking systems, such
as in Canada and Great Britain, central bank credit is extended
prim arily or exclusively through loans to securities dealers. In such
circumstances, the question of appropriate rate relationships maybe
answered differently. In the case of central bank loans to dealers
specializing in a narrow range of securities, an interest rate tied to
the market rate on a major category of such assets is likely to pro
duce a more stable influence on the cost than could be true for a
“tied” rate charged to banks, which typically handle a much wider
range of earning assets.
§The choice of the auction rate on 91-day Treasury bills as the
base for the discount rate would pose a particular problem. In re
cent years such bill rates have moved through wide temporary and
seasonal swings which were largely unrelated to the degree of pres
sure prevailing in the banking system. This experience reflects the
growing importance in the bill market of nonbanking institutions,
particularly industrial corporations. At the end of 1959, for example,
reporting commercial banks in the Treasury Survey of Ownership
held only 12 percent of all Treasury bills outstanding, (Treasury
Bulletin, March 1960, p, 49.)
In Canada, by way of contrast, the proportion of Treasury bills
held by chartered banks on December 30, 1959, was 35 percent,
although this higher percentage reflects in part the fact that Canadian
banks have agreed to a secondary reserve requirement which involves
holding as much as 7 percent of their deposits in bills, (Statistical
Summary. The Bank of Canada (January 1960), pp, 18-19,)
Insofar as the United States is concerned, in periods of credit
ease bank holdings of T r e a s u r y bills tend to increase in importance,
but in such periods bank reliance upon borrowing also becomes in
consequential, Heavy bank borrowing periods tend to coincide with
periods of minimum bank position in the bill market.

146

THE FEDERAL RESERVE ANSWERS

but they are nonetheless important in our system with its large
number of independent banks that are small enough to be dependent
upon the economic fortunes of local areas. So long as the central
bank is to retain a uniform discount rate, not differentiating among
borrowers, the logical course is to establish the discount rate at
whatever level appears the best compromise between the cost con
siderations of money market adjustment and those appropriate to
necessitous seasonal or emergency assistance.
In the U.S. banking system, a “penalty* discount rate is not as
important as in other countries for the functioning of an effective
discount mechanism. Major reasons for this are the well-established
banker tradition against borrowing and Reserve Bank discourage
ment of extended borrowing by member banks. With such restraints
operative, decisions concerning the discount rate may be shaped in
part by noncost considerations. Prominent among these is the
“signal effect* of discount rate changes.
Signal effect. When discretionary changes are made in the dis
count rate, the announcement of the change itself is likely to have
consequences beyond its direct effect on member bank borrowing.
On occasion, such an announcement is the first clear indication of
a change in monetary policy.
It is sometimes said that because of the attention attracted by
discretionary rate changes, there is some risk of an exaggerated
public reaction to such changes. Focus of attention on shifts in the
discount rate could lead to an underemphasis upon the many more
fundamental supply and demand influences flowing through credit
markets. At the extreme, some segments of public opinion might
under certain conditions come to believe that other market rates
were set or controlled by the manipulations of the discount rate.
Such a view might lead to ill-considered opposition to discount rate
action that would be desirable on general economic grounds. Tying
of the discount rate to the bill rate has been proposed as a means
of avoiding or minimizing the “signal effect” risks.
Elimination of the signal effects of discount rate changes would
deprive the monetary authority of a tool which can sometimes be
useful in implementing its policy, A discretionary discount rate
change is probably the most widely publicized step that a central
bank can take. Yet for all its attention-catching nature, it has little
or no immediate effect on the available supply of bank reserves. In
this respect the discount rate is a useful complement to the other
major tools of credit policy,
A problem sometimes raised in connection with discretionary
rate changes is that of perverse market response. It is argued that
a discount rate increase would be taken by individuals and businesses

QUESTION XVn

147

as an authoritative confirmation of a developing business boom,
and accordingly would stimulate additional demands for credit in
anticipation of higher prices and greater credit restraint in the
future. Seriously destabilizing results upon the volume of credit
extended would not, however, be likely to occur unless borrowers
reacted perversely to discount rate changes and lenders did not*
As a matter of practice, a variety of reactions is ordinarily ap
parent among both borrowers and lenders, and this variety of re
action in itself makes for stability. In addition, lenders ordinarily
are more closely attuned to financial developments than are bor
rowers, and hence are more likely than borrowers to perceive the
portents of a rate change and to act on the basis of such knowledge
in credit contracts.
A search of the record for evidences of perverse market re
sponse to discount rate changes is undertaken in the following
answer. No significant perverse response is detected, In all like
lihood, the many other factors underlying business decisions to
borrow or not to borrow—and bank decisions to lend or not to lend—
were of sufficient importance to outweigh any specific destabilizing
response to Federal Reserve action.

QUESTION XVII
What is your view regarding the statement that a
rise in the discount rate actually increases demands
for credit by business firm s, because it generates
expectations that business will be good and money
tighter in the future ?
ANSWER XVII

Summary
While many business decisions are greatly influenced by ex
pectations as to prospective economic and financial developments,
there seems little logical or statistical support for the supposition
that a rise in the discount rate would increase business demand
for credit. The primary factor in a company’ s decision to ac
celerate or initiate expansion plans is more likely to be the
economic outlook for its own industry and/or products. The rela
tion between a rise in the discount rate and the prospect of good

148

THE FEDERAL RESERVE ANSWERS

business for a given industry must appear indirect, at best, to
most businessmen. At some times, a rise in interest rates may
bring acceleration of borrowing plans that are already well under
way, but it would likely stimulate the hasty initiation of entirely
new plans.
In recent years, changes in other money rates have generally
preceded changes in the discount rate. Thus, businessmen who
consider money rates a “leading indicator” would have found the
clues they sought in these other rates. Empiric evidence available
on business borrowing in recent years does not support the view
that business demands for credit increase when the discount rate
is raised.
It seems extremely doubtful that businessmen generally view
Federal Reserve action with respect to the discount rate as an
indicator of the prospective course of economic and credit condi
tions, or that they actually increase their demands for credit
following a rise in the discount rate.
Most discount rate changes in recent years have followed,
rather than led, changes in other money rates. Thus, if there are
businessmen who look to money markets for clues to prospective
economic developments, they would find such clues sooner in
rates other than the discount rate. Those who look to current
money markets for clues to the prospective cost of their own
future borrowing would also find such clues earlier in other rates,
A change in the discount rate usually serves to confirm the evi
dence already at hand and to add an indication that the Federal
Reserve considers it advisable to restrict or expand, as the case
may be, the availability of additional bank credit. On some occa
sions, perhaps when actions to counteract seasonal or special
factors may have obscured the basic intent of current open market
operations, a change in the discount rate has clarified the situation
by indicating that Federal Reserve policy has changed,
A rise in the discount rate may induce some business firm s to
advance the timing of borrowing they had planned to do at a some
what later date, but this shift in timing, even when it does occur,
does not augment business credit demands except in the very short
run. Moreover, it takes time to arrange new borrowing, especially
long-term borrowing in the capital markets. The only businesses
able to step in quickly, fearing that rates will go even higher, are
those whose expenditure plans have already been made and whose
credit arrangements are practically completed, or those who have
credit lines.
The circumstances are likely to be rare when very many busi
nessmen would feel that the relationship between prospective busi

QUESTION XVH

149

ness conditions and current changes in discount rates is so direct
that a rise would induce them to borrow contingently or to initiate
outlays they had not previously intended to make. Cost of credit, as
mentioned earlier, is only one of a number of factors that enter
into business decisions to undertake outlays that require outside
financing. Evidence that the cost of such financing may be in a
rising trend seems at least as likely to result in a re-examination
of the urgency of any project that is in the initial planning stage,
though it may result in an acceleration of plans that are further
along.
Neither is there reason for businessmen to assume that, once
the discount rate has been increasing for some time, other rates
will continue to rise and that the next change in the discount rate
will be another increase. Based on cyclical money market move
ments in the past, however, it would be reasonable to make this
assumption when the increase in the discount rate is the first after
a series of declines, as in the spring of 1955 and in the fall of 1958,
Some businessmen may view these initial increases as convincing
evidence that the tide has turned and that the economy has entered
a new phase of expansion. Most businessmen who are aware of the
course of discount rate movements are also likely to be knowledge
able about other economic and financial developments, especially
those closely related to their own business; their expenditure plans
and credit demands are probably more influenced by such develop
ments than by increases in the discount rate per se .
One way to test the validity of the statement that a rise in the
discount rate actually increases demands for credit by business
firm s is to examine changes in business borrowing before and after
increases in the discount rate. Such an examination cannot be as
conclusive as would be desirable. Apart from the fact that we know
only how much credit businesses actually received, rather than
how much they were attempting to raise, it is difficult to tell from
actual data how much larger or smaller business credit expansion
might have been without the rise in the discount rate. Also, the
data are customarily subject to wide fluctuations from month to
month which reflect the strong influence of seasonal factors in the
case of demands for bank loans, and the presence or absence of
extremely large security issues in the case of capital market
financing,
The attached charts show, for the period since the beginning of
1955, changes in the discount rate of the Federal Reserve Bank of
New York and two different measures of business demand for credit.
Chart XVII-1 shows changes in business loans at all commercial
banks plus public offerings and private placements of corporate
security issues for new capital. The sum of these two components
is plotted as a three-month moving average in order to moderate

THE FEDERAL RESERVE ANSWERS

150

FE D E RA L RESERVE DISCOUNT
R A TE AND BUSINESS BORROWING

B illion s
o f d o lla rs

P e rce n t

2.0

—
D iscount Rate
---------->

1 .5

i
1
I
1
1
1

\ !'
ii
1.0

i•

0 .5

uLl

<-Lt

U_i

1956

1957

1958

lL i

1955

lI l
1959

* B orrow in g at banks and in s e c u r itie s m a rk e ts, 3 month m oving a v erage.

CHART XVII-1

1>'4
1

i_U
I960

QUESTION XVII

151

the influence of the seasonal and special factors noted above. While
the chart shows considerable short-run fluctuation in business
borrowing, the general impression conveyed is that initial changes
in borrowing have generally preceded, rather than followed, initial
changes in the discount rate, and that borrowing has not continued
to rise after later increases in the discount rate. The recurrence
of the usual seasonal drop in borrowing in late 1959 and early 1960,
though the discount rate was the highest in 30 years and a further
rise was generally expected, may be worth noting.
Chart XVII-2 measures business credit demand in terms of
forthcoming large public offerings of corporate securities,1 Similar
data are not available for privately placed securities nor for busi
ness loans at commercial banks. A series on forthcoming issues
measures credit demand at a somewhat earlier stage than the actual
sale of securities, though not at as early a stage as would be most
appropriate for examining the effect of increases in the discount
rate on business decisions to borrow.
Chart XVII-2 suggests that there is little relation between
changes in the discount rate and registrations of new corporate
security issues. The discount rate was raised on six occasions in
1955-56, once in 1957, and five times in 1958-59. On five of these
twelve occasions the volume of forthcoming issues rose immediately
after the increase in the discount rate; in seven cases it declined.
Broad movements in the volume of forthcoming issues also seem
to show no consistent relationship to changes in the discount rate.
The volume was generally declining in 1955 while the discount rate
was rising, but it showed an upward tendency as the discount rate
continued to be increased in 1956. During the 1958-59 period of in
crease in the discount rate, the volume of forthcoming large public
corporate issues was relatively stable at a very low level.
Thus the only recent period when increases in the discount rate
appear to have been accompanied by expansion in the prospective
volume of public security offerings was the period from March
through August of 1956. The increase in financing began during
March, after the discount rate had been unchanged at 2 1/2 percent
for five months. It appears to have been related to the very large
increase in business expenditures for plant and equipment both cur
rent and in prospect.
It hardly seems likely that the more optimistic plans for capital
outlays could be attributed in any appreciable degree to the earlier
J-The series shown on the chart includes all corporate new capital
issues of $15 million and over in registration with the Securities and
Exchange Commission at the end of each month.

THE FEDERAL RESERVE ANSWERS

152

B illion s
o f d o lla rs

F EDERAL RESERVE DISCOUNT R A T E AND
SCHEDULED CO RPORATE SECURITY OFFERINGS
Percent

1 .4

1.2

F orth com in g
C orp ora te Issu es
D iscou n t rate

1.0

/> I

ill

'I i*
!<"
'!
»i1
<
11n'
j H*
i ii
i

n
0 .4 ■

!II/
If
il
»

0 1 111 i i 1 i

1955

1956

1957

1958

CHART XVII-2

1959

1960

QUESTION XVm

153

increases in discount rates during 1955. On the other hand, heavy
borrowing demands no doubt contributed to the further rise in the
discount rate in 1956.

QUESTION XVm
Do the monetary authorities currently make any effort
to accommodate monetary policy to differences in
regional economic conditions, particularly in regard
to discount policy?

ANSWER XVIH
Summary
Because our credit and money markets are essentially national
in character, monetary policy is largely shaped by national rather
than regional considerations. The domestic economy is a large free
trade area with fixed exchange rates within which there is free
movement of funds which affect the credit base. Adjustments in
interregional trade are corrected in part by regional changes in
price and income levels; in part this adjustment is made through
the national credit and money markets.
There is also an expansible supply of interregional bank re
serves created by the lending practices of the Reserve Banks; any
region has access to additional funds to tide over temporary balanceof-payments difficulties. Monetary policy is designed for the eco
nomic welfare of this whole free trade area. The pooling of banking
reserves as provided for by the Federal Reserve System results in
the movement of a relatively large share of short-term funds through
the national market. Thus short-term money rates in any Federal
Reserve district are unlikely to remain out of line with the prevail
ing national market. In fact, all form s of domestic financing are at
least marginally sensitive to the influence of a national credit and
money market and thereby to national monetary policy.
Since national economic developments are a composite of those
taking place regionally, regional considerations are necessarily
weighed in assessing the need and consequences of a national
monetary policy. The collection and analysis of economic data de

154

THE FEDERAL RESERVE ANSWERS

picting both regional and national trends provide the basis for better
understanding of the relationship of regional to national economic
change, as well as for a better informed policy determination.
Representatives of the Reserve Banks not only participate in
national policy formulation but also interpret national policy and
its objectives to their own communities, thus encouraging a wider
public understanding of national decisions and contributing to im
proved effectiveness of general policy. Policy that is responsive to
both national and regional developments and considerations has the
merit of being broadly based and therefore more acceptable to public
opinion which in the end must approve of it.
In recent years, there have been few circumstances in which it
has been deemed desirable to maintain regional differences in dis
count rates for an extended period. Conditions might arise in the
future, however, in which some differentials might be appropriate
over fairly extended periods. Administration of the discount window,
however, does provide a means of giving account to unusual develop
ments affecting economic conditions within a region that may call
for cushioning or stimulation from the monetary side.
Discounting and Open Market Operations
The question of differentials in discount rates among Federal
Reserve districts may be clarified by reference to the historical
record. From the establishment of the System until about 1922,
the discount rate was considered the most important single instru
ment of monetary regulation. During the 1920*3 open market opera
tions assumed a more significant role in System policy.
Experience with the open market instrument made it clear that
there was a close interrelationship between discount and open market
operations. Open market operations were occasionally used to ab
sorb reserves, and at such times, member banks as a group in
creased their borrowing at the Reserve Banks in order to adjust
their reserve positions. This development had a tightening effect on
the money market which resulted in conditions calling for increases
in Reserve Bank discount rates. When open market operations pro
vided reserves to the market, member banks as a group were en
abled to reduce their indebtedness to the Reserve Banks, This
resulted in an easing of the money market and in conditions favor
able to discount rate reductions.
Open market operations were conducted in both Government
securities and bankers’ acceptances. Those in Government securi
ties were employed principally to effect major policy shifts, while
operations in bankers* acceptances were used primarily to help
seasonal variations in reserve needs. Many temporary money
Digitized forcover
FRASER

QUESTION XVm

155

market variations were covered by discounting, and some banks
outside the money markets used discounting for more or less ex
tended periods. In general, attention was directed to the discount
rate as a major indicator and instrument of System policy.
The banking crisis of the early thirties together with the large
inflow of gold from abroad in the late thirties resulted initially in
a liquidation of member bank indebtedness to the Reserve Banks
and subsequently in an accumulation by the banks of large excess
reserves. This period was followed by a decade dominated by war
finance and postwar adjustment problems in which additional re
serves needed by the banking system were freely made available
through Federal Reserve open market operations in support of
Government security yields and prices. Thus, over this period of
nearly two decades, member banks had little occasion to obtain
discounts or advances from the Federal Reserve banks. For the
time being, discount operations were an inactive instrument of
monetary policy and the Reserve Bank discount rates, which were
generally uniform, had little more than symbolic importance.
Since the Treasury-Federal Reserve Accord in 1951, open market
operations and discount policy have again functioned as complementary instruments in influencing changes in credit conditions. In
resuming a more active use of discount operations, the System care
fully reviewed its entire experience both with regard to the adminis
tration of discounts and with regard to determining discount rates.
One result of this review was a basic revision of Regulation A of the
Board of Governors concerning Reserve Bank discounting for or
lending to member banks. The revised regulation restated and
clarified the principles that the Reserve Banks had applied his
torically in discount administration and thus contributed to further
evolution of standard practices among the Reserve Banks in ad
ministering their discount windows.
Throughout the history of the System the effects on general
credit conditions of the use of the interrelated instruments of open
market and discount operations have been largely channelled through
central money markets. Banks outside the money centers required
to make reserve adjustments have done so either by drawing upon
balances with correspondents in central markets or by liquidating
open market paper in such markets. Banks with more reserves than
needed have tended to put these funds to use in central money mar
kets, Banks in outlying areas, unable or not choosing to make ad
justments through national markets, have used the discount facilities
of the regional Reserve Banks,
Regional Patterns in Rates
In the early years of the System’s existence there was some
tendency toward uniformity of regional discount rates. Proponents

156

THE FEDERAL RESERVE ANSWERS

of such uniformity felt this would effect a better adjustment of
commercial bank rates over the nation as a whole, as well as im
prove the interconnections between regional and local credit
markets.
In 1921, Senator Harris proposed unsuccessfully to amend the
Act to provide for uniform rates and to give the Board sole power
to fix them. Nevertheless, during the period 1922-1923,1 a differ
ential pattern of regional rates was established, which was con
tinued until 1927. In agricultural regions discount rates were higher
and less frequently changed than in industrial and financial districts.
Rates were uniform for areas in which conditions were essentially
similar but differed among areas of varying development in financ
ing requirements and credit conditions.
Discount rates again became uniform for all practical purposes
during 1927, when most or all of the districts had the same rate
throughout the year and when rate changes made at the several
Banks were close together and in the same amount. Whether or not
uniform discount rates were desirable was still an unsettled ques
tion, however, and opinion differed among Reserve Banks. Differ
entials existed for some months in 1928 and again in 1929. During
the 1930*s although some variation in discount rate practice con
tinued, depressed economic activity, generally low credit demands,
and the accumulation of excess bank reserves from an inflow of
gold from abroad resulted in a tendency toward elimination of dis
count rate differentials. Since the early 1940*8, rates in all districts
have been uniform except during relatively short intervals.
The National Character of Credit Markets
Of the total net debt in the nation, about two-fifths is composed
of obligations of the federal, state and local governments. Those
securities are exchanged in national markets; business is conducted
for all sections of the nation at one time and at virtually the same
price for any given security. The widespread ownership and con
venient liquidity of Government securities have supplied a common
denominator to the entire credit system*
Within the private credit sector, practically all residential
mortgage financing is affected by national competitive factors,
although there remain important regional differences in rates and
availability. Much of the credit extended to individuals for con
sumption purposes also is responsive to national conditions of
credit availability. Many farm ers seeking real estate credit can
*A single rate for discounts for all classes of paper was adopted
in 1922, in contrast to the earlier practice in which rates varied
Digitized foraccording
FRASER to class of paper, maturity, and security.

QUESTION XVm

157

obtain local accommodation on terms fairly comparable with those
offered by national lenders. Corporations place their bonds through
distribution channels covering the nation and larger businesses,
whose operations may be regional or national in extent, obtain most
of their short-term credit from sources which conform to national
or industry-wide influences. Federal legislation creating lending
authorities and loan guarantee programs has also contributed to
rate uniformity.
Of the variety of credit demands, the only forms which appear
essentially local are the short- and intermediate-term borrowings
by farm ers and smaller business. Even these forms of borrowing,
however, are not insulated from national market influences. The
possibility of taking advantage of some source of funds other than
local helps to keep credit charges and terms, after allowance for
administrative and risk costs, close to national averages. These
local credits are concentrated in the commercial banking system
which has access to national pools of funds through selling assets
or borrowing.
The short-term money market, particularly since World War II,
has undergone marked growth in unity and breadth, and has
strengthened its links to the long-term credit markets. Specializa
tion has developed to meet the needs of large classes of borrowers
and lenders, and transactions are accomplished rapidly and at low
cost. These changes have accompanied the improvements in com
munications systems and knowledge of markets, together with new
provisions for the transfer of funds and other money market
instruments.
Financial institutions as a whole have been more integrated into
a national system. Thus, interest rates are more closely inter
related and differentials in rates paid have substantially diminished.
In the U,S, Government securities market and Federal funds market,
business is conducted for a widened variety of customers in in
creasing volume at nearly uniform interest rates.
At the bank loan counter, the prime rate on commercial loans
is now an important aspect of the money market rate structure and
follows fairly closely movements of market rates. The prime rate
reflects the forces of competition in the open market as well as
among banks. Moreover, syndicate lending and more general use
of other form s of participated loans have further narrowed rate
differentials within the banking system.
Possible Bases for Differentials in Discount Rates or Policy
Although it is recognized that credit and money markets have
become predominantly national in scope, discussions of discount

158

THE FEDERAL RESERVE ANSWERS

policy and discount rates during postwar years have continued to be
concerned with whether or not differentials in discount rates are
desirable. They have focused particularly on possible bases for
discount rate differentials.
Although most of the Reserve districts contain varieties of
business interests similar to those in the nation as a whole, at any
one point of a business development some parts of the nation may be
sluggish while others are reflecting rising or high levels of activity.
Over-all levels of activity will include segments of the economy in
which resources are underutilized. Moreover, not all sectors will
be experiencing the same rates of growth. It has been suggested
that a uniform discount rate or discount policy takes inadequate
account of these differences.
This suggestion underestimates the variety of economic activity
that goes on within each Federal Reserve district. Moreover, the
many economic advantages that arise from a single market for
goods and services make it clearly inappropriate to consider the use
of discount rate differentials or other adaptations of monetary policy
that would contribute to regional barriers within the nation.
To the extent that inflationary and deflationary trends operate
along industry lines rather than through geographic areas, the
ejqperience of a particular,producer is probably more closely re
lated to that of other producers in the same industry, wherever
located, than to the fortunes of hi&districtneighbors. Consequently,
one part of a depressed industry may be located in a district ex
periencing high levels of activity while another part of the same
industry may be in a district that is experiencing a slackening.
In recent years, there have been large internal population shifts
within the United States, The principal economic impact of such
shifts on areas gaining population is a need for more funds for
housing and community facilities—schools, water and sewage works,
roads, and the like. Such needs are financed largely in national
credit markets. Lower discount rates in expanding areas than in
other areas might not enable more of these demands to be met
locally and might retard needed inflows of funds from other regions.
Use of lower discount rates to assist underdeveloped areas within
the country would assume that the areas contain investment oppor
tunities and that lack of funds is limiting their development. In
underdeveloped areas, however, the critical shortage is likely to
be either entrepreneurial skill or risk capital on an equity or long
term loan basis, rather than bank credit, which is necessarily short
or relatively short in term. Lower discount rates than in other r e
gions would not encourage the necessary flow of risk capital into
underdeveloped areas. Neither would they necessarily aid chronically

QUESTION XVU3

159

depressed areas, which need more fundamental measures of re
suscitation. Finally, because of the national character of the market
for other instruments used by banks in adjusting reserve positions,
differential discount rates may not accomplish their intended pur
pose, although they may create technical problems for discount
administration.
Kate Changes
Even though long-maintained regional differences in discount
rates have not been considered appropriate in recent years, present
procedures for establishing rates permit differentials ifthey become
desirable at any time. The discount rate is reviewed every two
weeks, at meetings of the boards of directors of the Reserve Banks,
as provided by statute. At meetings, the president of the Reserve
Bank usually will recommend to his board either a change or con
tinuance of the present rate, and this recommendation is discussed
and acted upon by the directors. At times, the board chairman or
any other director will open the discussion. In addition to its own
views about financial and business developments—local and national,
the board of directors has available economic information and
analysis furnished by the staff of the Reserve Bank as well as the
advice of operating officers engaged in administering policy.
At meetings of the Federal Open Market Committee, where open
market policy is formulated, consideration is also given to the
relationship of open market operations to discount operations and to
other monetary instruments. These discussions are conducted
against the background ofthe national and district-by-district review
of banking and business conditions. All of the Reserve Bank presi
dents attend the meetings and contribute to the discussion* In these
discussions, members of the Board of Governors may at any time
question the appropriateness of existing discount rates.
Discount Administration
The existence of the regional Reserve Banks and the fact that
initiative1 in borrowing lies with the member bank offer assurance
that variations in local needs will be recognized. Discount officers
take account of the degree of pressure on the reserve positions of
individual banks and the reasons for such pressures—distinguishing
factors operating in the banking system as a whole from those
operating in the individual bank. Appraisal of changing conditions on
district levels and their review in relation to national conditions is
continuous. Since this procedure permits some adjustment to indivi
dual local situations, monetary authorities have more freedom than
would otherwise be the case to determine general credit policy on
the basis of national considerations.

THE FEDERAL RESERVE ANSWERS

160

Although the discount mechanism is administered uniformly,
the regulation provides for modification to meet unusual situations.
The foreword to Regulation A governing discounting states in part:
“Federal Reserve credit is also available for longer periods when
necessary in order to assist member banks in meeting unusual
situations, such as may result from national, regional, or local
difficulties or from exceptional circumstances involving only par
ticular member banks.”
Recent examples of these situations during the postwar period
were the hurricane and flood which affected large parts of the
Connecticut valley in 1955 and the prolonged droughts in the Midwest
in other years. The Reserve Banks gave special consideration to the
borrowing needs of banks in the affected areas.
The discount mechanism helps to maintain a continuous avail
ability of bank credit and so to provide a more satisfactory dis
tribution of banking accommodation to the public. The complementary
nature of open market operations, in which the initiative lies with
the Federal Open Market Committee, and the discount powers, which
lie mainly with the Reserve Banks, answers the peculiar needs of the
unit banking system for fluidity of funds.

QUESTION XIX
What are the pros and cons of reserve requirements
based on the turnover of deposits rather than upon
their amount? What are the pros and cons of reserve
requirements based on bank assets rather than upon
liabilities?

ANSWER XIX
Summary
The principal function of the legal reserve requirement is to
serve, along with control over the volume of reserves, as a base
for regulating the volume of bank credit and the money supply. The
required percentage thus provides the fulcrum for the quantitative
regulation of bank credit and money r When total reserves available
to the banking system exceed the required reserves by more than a
customary margin, expansion in bank loans and investments tends to

QUESTION XIX

161

occur; and on the other hand, when the supply of reserve funds is
limited in relation to required reserves, expansion in bank loans
and investments is inhibited.
If reserve requirements were based on deposit turnover, changes
in total required reserves would reflect changes in the use of money
as well as in the amount of money balances held. The distribution
of required reserves among individual banks might also be more
equitable from some points of view. On the other hand, it may be
said that the Federal Reserve System already has ample ability to
adjust the reserve position of the banking system in accordance with
changes in the use of money, and to consider turnover rates as well
as other characteristics in assigning individual banks to reserve
classes.
If reserve requirements were based on bank assets, this could
lead to a relative lowering of market interest rates on the kinds of
paper having the lower requirements. However, assuming that
Government securities were the favored class, it is doubtful whether
the government would obtain any real net interest saving, and other
possible advantages from this form of reserve requirement seem
questionable.
Requirements Based on Deposit Turnover
The term “turnover” or “activity” requirements refers to a
rule, such as has been proposed by students of banking from time to
time, whereby each bank’ s reserve requirement would be related
to its volume of deposit activity rather than only to its volume of
deposits. Under one such plan, a part of the bank’ s reserve require
ment, in any given week or month, would be based upon the volume
of checks written by the bank’ s depositors as recorded on its books
during a preceding period, while the rest would be determined as a
percentage of the bank’ s deposit liabilities.
In its effects on the banking system, an activity requirement
would differ in two main respects from the type of requirement now
used. It would cause the total required reserves of all member
banks combined to fluctuate in a somewhat different manner than is
now the case. It would also distribute required reserves among the
individual banks in a different manner.
Bank deposit activity is a rough measure of the volume of money
payments that are made in the economy. Fluctuations in the volume
of money transfers are directly correlated with movements in total
economic activity. Indeed, they are more sensitively correlated with
such movements than are fluctuations in the volume of bank deposits.
In general, in periods of prosperity when demands for credit are
strong, the rate of deposit turnover increases. That is to say, while

162

THE FEDERAL RESERVE ANSWERS

pressures of credit demand tend to expand the money supply, the
volume of money payments is likely to be increasing even faster.
Hence, in such periods, the total required reserves of banks would
increase faster under an activity requirement than under the present
form of requirements. Stated in another way, with an activity re
quirement the ratio of total required reserves to deposit balances
would automatically rise in periods of prosperity and it would auto
matically tend to fall in periods of declining business.
As between different banks at the same time, the banks with the
higher rates of deposit turnover include most of the largest banks.
These banks carry many of the major deposit accounts of large or
national businesses, which tend to be more active than the accounts
of individuals or of most kinds of small or local businesses. Most
of these large banks already have higher requirements than other
banks, however, because they are now classified as reserve city or
central reserve city banks, for which the present required per
centages are higher, although the existing differentials are not based
on differences in deposit activity.
Effects on total reserve requirement of all banks. One argument
in favor of basing reserve requirements upon deposit activity is
that under the present system, large changes in the use of money in
the economy are not reflected in any change in total reserve re
quirements. With an activity requirement, changes in the use of
money as well as changes in the total amount of money balances held
would be reflected in required reserves.
To perform their function most effectively, it may be argued,
reserve^ requirements should reflect the demand for money in both
of its main functions, (1) as a store of value and (2) as a medium of
exchange. The member banks and the Reserve Banks would thus be
put on notice by changes in the demand for reserves whenever a
change in the use of money occurs as well as when there is a change
in its volume.
The automatic movements of an activity reserve requirement
could not be e je c t e d to obviate the need for continuous operations
and policy modifications by the Federal Open Market Committee and
other Federal Reserve policy-determining groups in accordance
with economic developments and credit demands. However, these
automatic movements would ordinarily reduce somewhat the magni
tude of the specific Federal Reserve actions needed.
Distribution of reserve requirements among individual banks.
An activity requirement would result in differentials among banks in
their ratios of reserve requirements to deposits. These differentials
could be viewed as a more appropriate method of distributing the
total volume of required reserves than the present system which

QUESTION XIX

163

classifies banks into broad groups, especially if it is assumed that
banks holding the more active deposits ought to be more limited in
their credit-granting ability than banks with deposits that are re
latively inactive.
The well-established distinction between demand and time de
posits for reserve requirement purposes reflects such a principle
as to rate of use. Similar differences in rate of use exist between
different demand deposit accounts. Through an activity require
ment, allowance would be made for such differences and a given
deposit would have the same requirement regardless of the bank in
which it might be located.
Under the present arrangement, in which the reserve require
ments for central reserve and reserve city banks are higher than
for country banks, something of the same effect is achieved, because
the city banks tend to be those that have higher rates of deposit
turnover. However, there are quite a number of exceptions where
banks with high activity are now classified as country banks, or
vice versa.
Arguments against adoption of an activity reserve requirement.
The function of the reserve requirement, in monetary regulation, is
to serve as a fulcrum so that the monetary authority, with its ability
to vary the total reserves of the banking system, can thereby regu
late the volume of bank credit and deposits. For this purpose, no
great importance attached to the manner in which the reserve re
quirements are determined, as long as the authority is able to learn,
with reasonable accuracy, the amount of reserves required at any
given time and the amount actually held, and is able to vary this
relationship by means of open market operations (or other actions)
when that seems desirable.
The volume of money payments in the economy is indeed of
great importance in determining whether monetary restraint or an
expansionary influence is needed. An “activity requirement” would
seem to have the advantage of causing changes in the volume of
payments automatically to affect the reserve position of banks in a
restraining or expansionary direction. However, the Federal Re
serve already can, and does, take into account such changes in the
volume of payments when it is making its policy decisions. It takes
them into account explicitly when it considers data on payments and
implicitly when it uses data on the many kinds of economic activity
which affect the volume of payments. Thus, even though instruments
of monetary control themselves relate to the volume of money and
credit rather than to activity, the effects can be about the same as
if the instruments were directly based on deposit activity.
Under these circumstances, the question arises whether an
activity requirement would have advantages such as to justify the

164

THE FEDERAL RESERVE ANSWERS

very considerable effort that would be required to substitute it for
the present system.
The introduction of an activity reserve requirement would in
volve substantial administrative complications. The basic matter
of requiring banks to ascertain and report the total amount of their
debits to deposit accounts does not in itself seem serious; these
figures can readily be determined as a by-product of a bank’ s
ordinary bookkeeping operations. There would be various other
problems, however. The novelty and strangeness of the system would
involve revision of established practices and concepts. The relating
of reserve requirements to the volume of deposits, as done now,
has the advantage of being familiar and customary, and is generally
accepted.
A difficulty of application may arise because some types of
moderate-sized businesses develop an extremely large volume of
receipts and payments in relation to the amount of their deposit
balances. It might be desirable to provide some special exception
for the banks handling accounts of such businesses. Moreover, there
are various possibilities whereby a bank, with cooperation from its
customers, could avoid the full effect of an activity requirement.
Hence, the problems associated with initiating and administering an
activity requirement would seem numerous and difficult.
Another problem is that of a time lag. An activity requirement
would need to be based on the bank’s activity for some period in the
past, rather than for merely the latest week or month. Because of the
effects of seasonal fluctuation in activity, it might be best to base
the requirement upon the bank’ s total volume of debits for the pre
ceding 12-month period. This would seem to introduce a time lag.
However, it might not be serious, because sharp downturns in
general business activity have been accompanied by sharp reductions
in deposit turnover, which have generally, in turn, caused the 12month average also to follow rather promptly.
Requirements Based on Bank Assets
As pointed out at the beginning of this reply, the function of re
serve requirements now is to provide a fulcrum for the quantitative
regulation of bank credit and money. With this as the purpose, the
question arises whether basing the requirements on banks’ assets,
rather than on their volume of deposits (or deposit activity), might
be a more effective regulative instrument.
Basing a reserve requirement upon a bank’ s total assets would
not have any special advantage over using the bank’ s total deposit
liabilities; the possible advantage of a requirement based on assets
would lie in the ability to be selective in providing different treat

QUESTION XIX

165

ment for different kinds of assets. Theoretically, such selectivity
could be carried to any desired degree of detail, but the following
discussion will relate to a system based on the distinction between
holdings of U.S. Government securities and other kinds of earning
assets,1
There are several kinds of situations in which it might be desired
to restrain especially the expansion of bank assets other than
Government securities, and in which this kind of selectivity might
therefore seem useful. First, such a situation might arise in time of
war or national emergency if it became necessary to limit the
expansion of bank credit to the amounts needed by the government.
Second, in other periods when monetary restraint is necessary, an
instrument of this kind could be used to make it more attractive for
banks to hold Government securities, as against liquidating them in
order to expand other assets.
The main effects of such an instrument may be summarized as
follows: It would cause a new differential between the interest rates
on Government securities enjoying a special reduced reserve re
quirement and the interest rates on other types of assets. If this
were accompanied by a rise in the level of interest rates on assets
other than these Government securities, it could help to restrain the
growth of such other credit. However, the widened differential would
also tend to cause a gradual shifting of such assets from banks to
other lenders. Because of this, it is unlikely that any effective
control over the total amount of credit extended to nongovernmental
borrowers would be achieved, except during an initial temporary
period when the instrument was first introduced.
To indicate the effects more clearly, let us assume a requirement
of 10 percent against Government securities and 20 percent against
other loans and investments, and assume also that of the amounts
that the bank lends or invests, no part will remain on deposit at this
bank. If the bank had $10 million of excess reserves and wanted to
use this amount to buy Government securities, it could buy about
$9,1 million; the remaining $0,9 million of reserves would become
the required 10 percent to be held against this asset. If the bank

*It should be noted that if it were desired to establish other classi
fications of assets to be favored (or the reserve) through the use of
an asset reserve mechanism, numerous administrative problems
would need to be solved, such as those of defining the classes of
credit to be favored or restrained, determining the classification of
particular assets, and establishing equitable relationships between
banks and other lenders.

166

THE FEDERAL RESERVE ANSWERS

wished instead to acquire other loans or investments with these ex
cess reserves, only about $8.3 million could be bought; the 20 per
cent reserve requirement on these assets would be $1.7 million.
Thus, with the funds needed for this $8.3 million investment, it
could have bought $9,1 million of Governments,
Under the present system of reserves against deposits, a bank
with excess reserves of $10 million could increase earning assets
of any kind by that amount, assuming that none of the proceeds were
left on deposit. Shifts from one type of asset to another can be made
on a dollar for dollar basis,
Under an asset reserve system as outlined above, the bank would
prefer Governments to other earning assets until the yield on the
latter exceeded that on Governments by enough to compensate for the
difference in reserve requirements. This refers, of course, to the
net yield after making allowance for risk factor sand servicing costs,
giving consideration also to any customer relationships of the bank
that might be involved (including, where applicable, a borrow er’ s
willingness to leave part of the proceeds of his loan on deposit in
this bank),
Hence, in view of the importance of banks in the market for
Government securities, there would undoubtedly develop a new re
lationship between the interest rates on Government securities (or
on those classes enjoying the reduced reserve requirement) and the
rates in other credit markets in which banks participate. That is,
there would have to be an extra differential in addition to the
previous customary spread between rates on Governments and other
rates.
Some intangible factors might further cause a bank to hold, for
liquidity purposes, somewhat more Governments than would other
wise be indicated; it is not clear whether these effects would be
quantitatively significant. First, in case of a reserve loss from
deposit outflow, the bank would no longer have an automatic reduc
tion in required reserves, as it has now. Second, banks often regard
holdings of Governments as “insurance” that they will be able to
meet customer borrowing needs, and they would need to be prepared
to liquidate more than $1 million of Governments for each million of
loan expansion.

Effects on government financing. In considering the pros and cons
of this kind of regulation, we must first consider whether it would
provide an assured market for the amount of securities that the
government might need to sell, or whether the government would
merely gain an interest rate advantage, enabling it to do its financing
at lower rates (relative to other rates in the market) than it would

QUESTION XIX

167

otherwise have to pay. The latter would seem to be the case. Under
the example cited, it is true that the banking system as a whole would
be enabled to expand its holdings in the favored class of securities
by about twice as much as the expansion that would be possible in
other assets, but each individual bank’ s investment would be limited
by its own reserve position at the time. The bank would still prefer
other assets if the yield differential became big enough—that is, if
the yield on other assets were higher by enough to compensate for
the reserve requirement against them. Furthermore, the government
might not obtain any real net interest saving from the relatively
lower interest rates on its securities.
Effects on credit markets. Although the ability of banks to acquire
loans and investments, other than items in the exempted class, would
indeed be limited by the higher reserve requirement against them,
total credit expansion in the economy might not be effectively limited
by this requirement. This is because, with a sufficient credit demand
from private borrowers, nonbank investors might gradually be lured
by the interest differential into switching out of Government securi
ties (which banks could absorb) and into items that the banks wanted
to dispose of. While other investors could hardly extend regular
commercial loans like a bank, they could take other loans or securi
ties that would normally be held by banks. Mortgage loans and per
haps some kinds of open market paper would tend to flow to other
lenders rather than to banks; and large businesses might replace
bank borrowings with bond issues or with loans from savings insti
tutions. Any such shift could only occur under the pull of interest
rate differentials.
An arrangement of this kind would tend to cause substantially all
of the favored (Government) issues to go into bank portfolios, if the
total amount outstanding were not too great. Because of the special
advantage of these securities to banks and the consequent willingness
of banks to buy them on a lower yield basis, they would become
relatively unattractive to all other classes of investor s. Incidentally,
for the longer run, such an insulation of a large share of government
debt outstanding could be quite harmful to the functioning of Govern
ment securities markets.
As a result of these processes, the purposes of adopting an asset
reserve system, intended to provide abetter control over expansion
of the money supply through bank acquisitions of assets other than
Government securities, might be frustrated. The main effect, in
stead, might be that of gradually shifting many of these credits from
banks to other lenders, rather than achieving the desired control
over either the total amount of such credits or the total volume of
bank assets and the money supply.

THE FEDERAL RESERVE ANSWERS

168

QUESTION XX
Does the existence of nonmember banks represent a
serious source of escape from monetary controls and
perhaps lead to an unhealthy competitive situation
between member and nonmember banks?
ANSWER XX
Summary
Differences in reserve requirements between member and non
member banks give nonmember banks a competitive advantage that
tends to weaken their incentive to join the Federal Reserve System
and provides an inducement for member banks to withdraw from the
Federal Reserve System, This problem is not general, but there are
areas of the country in which it exists.
The fact that nonmember banks are not subject to the same re
serve requirements as member banks is a source of some escape
from monetary controls. However, as long as nonmember bank de
posits represent such a small percentage of the deposits of all banks,
the existence of nonmember banks and of varying reserve require
ments presents no serious problems in this respect.
Relation to Monetary Controls
Present statutory reserve requirements are different for central
reserve city member banks, reserve city member banks, and country
member banks; requirements for nonmember banks are different and
vary among the states. Consequently, the volume of deposits that can
be supported by a given volume of reserves varies not only with
respect to the category of the member banks which hold them but
even more importantly with respect to whether they are held by a
member or a nonmember bank.
The reserve requirements of nonmember banks are usually less
stringent than those of member banks, and both types of banks fr e
quently compete for the same business and the same customer. The
difference in reserve requirements gives nonmember banks a com
petitive advantage that tends to weaken their incentive to join the
Federal Reserve System. Similarly, it provides an inducement for
member banks to withdraw from the Federal Reserve System,
Differences between member and nonmember bank reserve r e
quirements are competitively disadvantageous to member banks not

QUESTION XX

169

only because of lower percentage reserve requirements prescribed
in some states, but also because of differences in the composition of
reserves. Member banks are required to hold their reserves against
deposits in the form of balances with Federal Reserve banks or in
allowable cash. Balances with other banks are a deduction item in the
computation of net demand deposits subject to reserves and therefore
affect required reserves only to a fractional degree.
Nonmember banks, on the other hand, may hold their reserves in
the form of vault cash, balances due from other commercial banks
and, in some states, certain amounts of securities of the United
States, state governments, or other political subdivisions. In one
state, there are no legal reserve requirements.
Only the vault cash of nonmember banks, which amounts on the
average to about 2,3 percent of their total deposits, is a fully effec
tive reserve in a monetary and credit sense, i,e „ in limiting the
availability of money and credit. It absorbs basic reserve funds,
most of which must be obtained directly or indirectly from the
Federal Reserve.
The reserves of nonmember banks consist largely of balances on
deposit with correspondent banks. The maintenance of such balances
does not restrict credit and monetary expansion for the banking sys
tem as a whole, except to the extent that the correspondent banks
hold reserves against these deposits in the form of vault cash or of
balances at the Federal Reserve banks. For the most part, such
nonmember bank reserve balances are available for lending by their
correspondent banks and thus may contribute to the process of
multiple credit expansion on the basis of a given amount of basic
reserves—balances with the Federal Reserve banks and cash in
vault.
Reserves consisting of securities, permitted in some states, are
not an effective general restraint on the expansion of money and
credit because they are not immobilized assets; on the contrary, they
are earning assets which reflect credit expansion. A reserve re
quirement in the form of specified securities, e.g., United States
Government securities, may limit the amount of nonmember bank
funds which can be invested in private loans and other types of
securities but may not restrict an expansion of total credit or the
money supply, unless the available supply of the re serve-eligible
securities is sufficiently limited.
Even though there is no direct limitation on credit expansion by
nonmember banks, as they expand loans they are likely to lose de
posits to member banks, which in turn are required to immobilize a
significant fraction of such deposits in the form of reserves. In addi
tion, an adverse clearing balance in itself will restrict nonmember
bank expansion.

170

THE FEDERAL RESERVE ANSWERS

Competitive Consequences
At the present time, about one-half of the banks in the country are
not members of the Federal Reserve System, but these banks are
smaller on the average than member banks and hold only 16 percent
of the total deposits of the country. Thus, the nonmember reserve
requirements affect only a small proportion of total deposits of all
commercial banks. Nonmember banks, however, are distributed un
evenly throughout the country. In relative importance their total de
posits vary from approximately 5 percent of total deposits of all
commercial banks in the Federal Reserve District of New York to
approximately 35 percent in the Federal Reserve District of St.
Louis. Thus, although the problem is not general, it is of conse
quence in some areas.
Problems arising from the existence of nonmember banks have
long been recognized by Federal Reserve authorities and by other
students of banking. It has been suggested that identical reserve re
quirements might be applied to all commercial banks in the country.
Such identical requirements might be considered analogous to the
federal regulations that have been maintained on stock market credit.
These regulations have applied to nonmember as well as member
banks and other lenders and have been administered with the co
operation of state bank supervisors.
For reasons of established practice, uniform reserve require
ments could be administered by state banking departments. Approxi
mately half of the states have already enacted legislation which
would permit state authorities to vary reserve requirements of
nonmember banks in a degree consistent with changes made in re
serve requirements of member banks. Thef’e remain, however,
important differences in the types of assets that can be counted as
reserves.

QUESTION XX

171
TABLE

XX - I

T ota l D eposits And N um ber O f C om m ercia l Banks In U.S.
D ecem ber 31, 1959

F ederal
R e s e rv e
D istrict

T ota l

M em ber N onm em ber

P e r ce n t o f total in D istrict
M em ber

N onm em ber

D eposits (In m illio n s o f d olla rs)
B oston
New Y ork
Philadelphia
Cleveland
Richm ond
Atlanta
Chicago
St. L ou is
M inneapolis
Kansas City
Dallas
San F r a n c is c o
T otal

9,103
47,824
11,081
16,748
11,865
14,759
34,728
10,334
7,060
11,135
12,807
32,459

7,799
45,435
9,312
14,783
8,442
10,566
28,291
6,774
4,824
8,483
10,670
29,299

1,304
2,389
1,769
1,965
3,423
4,193
6,437
3,560
2,236
2,652
2,137
3,160

85.7
95.0
84.0
88.3
71.2
71.6
81.5
65.6
68.3
76.2
83.3
90.3

14.3
5.0
16.0
11.7
28.8
28.4
18.5
34.4
31.7
23.8
16.7
9*7

219,903

184,678

35,225

84.0

16.0

N um ber o f Banks
B oston
New Y o rk
Philadelphia
Cleveland
Richm ond
Atlanta
C hicago
St. L ou is
M inneapolis
Kansas City
Dallas
San F r a n c is c o
T otal

421
601
656
939
957
1,348
2,468
1,477
1,301
1,808
1,119
379

277
508
499
572
447
403
1,005
488
477
755
633
165

144
93
157
367
510
945
1,463
989
824
1,053
486
214

65.8
84.5
76.1
60.9
46.7
29.9
40.7
33.0
36.7
41.8
56.6
43.5

34.2
15.5
23.9
39.1
53.3
70.1
59.3
67.0
63.3
58.2
43.4
56.5

13,474

6,229

7,245

46.2

53.8

THE FEDERAL RESERVE ANSWERS

172

QUESTION XXI
To what extent are U.S. monetary policies influenced
by such international considerations as interest rates
abroad, the U.S. balance-of-payments position on current
account, the direction of long-term international lending,
and shifts by foreigners between their holdings of bank
deposits, Government securities and gold?

ANSWER XXI
Summary
External developments that may affect demand and supply factors
in this country necessarily enter into assessments of the domestic
situation with which monetary policy has to deal at any given
moment. Moreover, attention must always be paid to factors in
fluencing the balance of payments between this country and the rest
of the world, and, in particular, to developments which evidence,
or could lead to, a shaking of confidence, at home or abroad, in the
stability of the dollar.
To maintain this confidence, the government, and also those who
guide private actions, must follow policies that will contribute to the
maintenance of reasonable equilibrium in the balance of payments,
or facilitate a return to equilibrium. While considerations related to
the international transactions of the United States do not change the
underlying objectives of monetary policy, which are to contribute to
the maintenance of U.S. financial stability and to sustainable growth
in the U.S, economy, they do at times have a bearing on the choice
of actions to be taken. Monetary policies designed to contribute to
achievement of the domestic objectives can contribute to achievement
of the external objective also. This they do chiefly by giving time and
opportunity for adjustment mechanisms here and abroad to bring the
long-run balance on current international transactions into line with
the long-run balance of international capital transactions and grants.
Fluctuations in the balance of payments due to moderate cyclical
forces here and abroad do not create enduring problems of balanceof-payments adjustment. Fluctuations due to minor disturbances of
confidence may present troublesome problems, but such problems
should be surmountable if underlying economic and financial condi
tions are making for improvement in the long-run balance.
The strong reserve position of the United States and its demon
strated past record of flexibility in monetary policies are important

QUESTION XXI

173

assets in maintaining confidence in the dollar in the event of tem
porary adoption of policies appropriate for dealing with a recession
at a time when the balance of payments is in deficit.
During most of the postwar period, the effects of relationships
between interest rates here and abroad have not been such as to be
significant factors in the determination of U.S. monetary policy.
International capital movements are influenced by many factors be
sides interest rates. The problem that was posed for the Federal
Reserve by the outflows of liquid capital in 1960 was not of halting
all such outflows, but rather of doing its part to minimize the
speculative disturbances associated with the capital outflows.
Assessment of Current Economic Situation
Exports and imports of goods and services by the United States
are each equivalent to about 5 percent of the Gross National Product
and amount to slightly more than expenditures for new residential
construction in the United States. Thus, demand conditions abroad,
international competitive pressures in markets for manufactured
goods, and supply conditions for internationally traded materials and
foodstuffs all influence demand and supply conditions in this country.
The relative importance of external influences is not measurable
simply by the volume of trade actually consummated. While exports
and imports have direct effects on domestic output and income, ex
ternal events also exert indirect effects on U.S.business investment
and production plans and on U.S. business inventory policies, through
market price developments and the general climate of business
expectations.
For example, during the 1953-54 recession in the United States,
economic activity in Europe was expanding rapidly and sensitive
commodity prices were accordingly stronger than many had expected
them to be. Undoubtedly the economic situation abroad contributed to
early recovery in the United States, not only through the increase in
U.S. exports that actually occurred in 1954, but also through indirect
effects of the kinds that have been mentioned.
Again, in the spring of 1959 it was becoming evident that a
general upturn in economic activity in other industrial countries was
under way. By the autumn it was clear that foreign demand for U.S.
products had risen. At the same time, the world supply position for
many raw materials and foodstuffs was not as tight as it had been in
1955 at a corresponding point of time in the U.S. business cycle.
Such facts and judgments as these, about foreign developments
that may influence demand and supply factors in this country, need to
be integrated with the mass of facts and judgments about purely

174

THE FEDERAL RESERVE ANSWERS

domestic developments in arriving at decisions of monetary policy.
External developments, therefore, may be said to influence monetary
policy in the sense that, through their effects upon the U.S. economy,
they continually modify the situation with which monetary policy has
to deal.
The state of the balance of payments of the United States with
other countries is itself an important feature of the general economic
picture. In assessing the forces acting on the balance of payments,
account must be taken of demand and supply conditions abroad as
well as in this country, both as to goods and services and as to
capital and credit. Developments which evidence, or could lead to, a
shaking of confidence, at home or abroad, in the stability of the
dollar will always call for careful attention.
Bearing of the Balance of Payments on Monetary Policy
Developments in the balance of payments between the United
States and the rest of the world may help or hinder the achievement
of stability and growth in this country. For this reason, the choice
of actions to be taken in pursuing the underlying objectives of
monetary policy—to contribute to the maintenance of U.S. financial
stability and to sustainable growth in the U.S. economy—may be
influenced at times by considerations related directly to the inter
national transactions of the United States,
A deficit in our over-all balance of payments represents a failure
of our exports of goods and services to match the total flow of dollar
claims being placed at the disposal of the rest of the world through
imports, net lending and investment, and government grants and
private donations. A deficit so defined is evidenced by accumulation
by the rest of the world of liquid dollar assets and gold from trans
actions with the United States. Foreign purchases of gold from the
United States reduce our gold reserves, andforeign net acquisitions
of dollars increase our liabilities in such forms as bank deposits,
Treasury bills, and other lqiuid assets owned by foreigners.
Persistent large deficits in the balance of payments could pose
a threat to financial stability in the United States, by raising doubts
not only abroad but also in this country about our ability to maintain
the exchange value of the dollar in terms of gold. Flight from the
dollar into goods, foreign currencies, and gold, motivated by fear of
dollar devaluation or of the institution of exchange controls, would
disrupt in manifold ways the orderly processes of growth. It is
important to prevent such threats to financial stability.
The limit on the extent to which U.S.payments deficits generated
by current transactions and ordinary capital transactions can con
tinue is not subject to precise specification. U.S.gold reserves are

QUESTION XXI

175

large. More importantly, the U.S. dollar is an international reserve
currency—that is to say, foreign monetary authorities want to hold
dcfilars as part of their reserves. During the eleven years from the
end of 1949 to the end of 1960, foreign monetary authorities in
creased their gold holdings by more than $11 billion (nearly $7.5
billion of which came from the United States) and their short-term
dollar holdings by about $7.5 billion. In addition, foreign commercial
banks and others increased their short-term dollar holdings by
$4 billion.
To retain the advantages of having a currency that is used for
international reserves and to guard against possibilities of a flight
from the dollar, it is essential that confidence in the dollar be main
tained. Three things are important in this connection.
First, as our gold reserves exist for the purpose of being avail
able to cover temporary deficits in the balance of payments, it is
essential that they always be readily available for that purpose.
Second, it must be clear to all observers that policies are being
followed that will maintain reasonable equilibrium in the underlying
elements of the balance of payments, or facilitate a return toward
equilibrium whenever large deficits in the balance of payments
emerge for whatever reason. Private policies as to pricing and other
competitive actions enter into the question, and also government
policies, including those of the monetary authorities.
Third, when outflow of short-term capital for any reason become
so heavy as to create a large deficit in the balance of payments and
accordingly lead to a sizable drain onU.S.gold reserves, the prob
lem arises of how to prevent the generation of unjustified apprehen
sions that might cause a snowballing of the capital outflows and the
gold drain.
With respect to monetary policy, actions aimed at contributing
to domestic financial stability and sustainable growth during times
of strong pressures of demand clearly help at the same time to
minimize deficits in the balance of payments. During times of slack
demand, dilemmas may be posed for monetary policy. For example,
toward the end of 1960 when rising unemployment and declining
output justified the Federal Reserve’s policy of credit ease and
might have justified further lowering of interest rates, consideration
had to be given in the choice of actions to the effects of low interest
rates, along with other factors, upon capital outflows, the gold drain,
and confidence in the stability of the dollar.
Adjustment of the Balance of Payments
The implications for U.S. monetary policy of a deficit in the
balance of payments depend upon the forces that have given rise to

176

THE FEDERAL RESERVE ANSWERS

the deficit. The large balance-of-payments deficits of 1958, 1959,
and 1960 reflected four main sets of forces, two of them more en
during than the others. First, the postwar economic and financial
reconstruction of other industrial countries made them again im
portant competitors of the United States in markets here and abroad.
Second, during the postwar period the United States assumed heavy
international responsibilities, one indication of which is the annual
expenditure abroad of $3 billion to support U.S. military forces.
Third, imports were stimulated by rapid U.S. recovery from the
1957-58 recession while exports were curtailed by the lag in
European recovery and by international readjustments in some other
foreign markets, as in Latin America. Fourth, while exports rose
strongly after mid-1959 and imports fell off, large amounts of short
term capital, both U.S. and foreign, movedfromthe United States to
foreign countries in 1960.
Cyclical forces here and abroad are constantly affecting the bal
ance of payments. Although their effects may be felt in one direction
or another for extended periods, forces that are eventually reversed
do not create enduring problems of balance-of-payments adjustment.
Fortunately, the international reserve position of the United States
can absorb the impacts of such forces. The more difficult problems
of long-run adjustment in the balance of payments relate to those
parts of the disequilibrium that are caused by deeper-lying shifts in
the international competitive situation or by actions taken by the
government in response to noneconomic considerations.
Solutions to this problem lie partly outside the province of the
monetary authorities. The contribution that monetary policy can
make is to foster credit conditions conducive to over-all price
stability in the United States in a manner that will permit adjustment
mechanisms here and abroad to function. Our deficit is the surplus
of the rest of the world, and rising international reserves in other
countries permit relaxation and dismantling of controls on inter
national trade and give governments and central banks greater lee
way in allowing or encouraging expansion of demand. In the United
States, meanwhile, the spur of foreign competition forces American
producers to make their goods more saleable both here and abroad.
Fundamental adjustments such as these are essential to the estab
lishment and maintenance of equilibrium in our international balance
of payments.
Policy in a U.S. Recession
The process of adjustment of the balance of payments may extend
through more than one cycle of expansion and contraction in foreign
demand for U.S. exports and through more than one cycle (perhaps
differently timed) of recovery and recession in the United States.

QUESTION XXI

177

Existence of a balance-of-payments deficit at the time of a re
cession should not divert the monetary authorities of the United
States from following policies otherwise appropriate in such a situa
tion, What is needed for long-run adjustment of the U.S. balance of
payments is not deflation, but avoidance of inflation, continuing ex
pansion of our productive resources, and an effective response by
the U.S. economy to competitive pressures and opportunities.
The ability of the Federal Reserve and other agencies of the
government to follow appropriate policies in a recession without
major disturbance of confidence in the U,S, dollar rests on two fac
tors, First, as has been noted above, the international reserve posi
tion of the United States is strong enough to absorb considerable
drains of gold or accretions of liabilities. Second, and equally im
portant, the record of the past has demonstrated that the adoption
of appropriate policies in a recession does not mean abandoning
either the objective of avoiding inflation or the aim of achieving
reasonable equilibrium in the balance of payments.
If, despite such facts as these, private capital outflows initially
stimulated by differences in credit conditions here and abroad lead
to a sizable drain on U,S, gold reserves, and if the capital outflows
and the gold drain create a minor disturbance of confidence, the
monetary authorities may be faced with troublesome problems in
reconciling the domestic and external objectives. But when under
lying economic and financial conditions are making for improvement
in the long-run balance of our international transactions, such
problems should be surmountable.
Interest Rates, Capital Movements, and Gold
Cyclical changes in the relative strength of demands for goods
here and abroad are often accompanied by corresponding shifts in the
relative strength of demand for capital and by opposite shifts in the
availability of liquid funds. Changes in international capital move
ments that result from these shifts are influenced by many factors,
including relative interest rates in various countries. Speculative
forces at times play an important role.
In the postwar years before 1960, changes in the balance-ofpayments surplus or deficit of the United States were determined
less by changes in capital movements than by changes in trans
actions in goods and services. The change from an over-all deficit
of $1#2 billion in 1955 to a surplus of $500 million in 1957, and the
subsequent change to a deficit of $3,8 billion in 1959, were both
dominated by changes in exports and imports of goods and services.
Exports increased by nearly $7 billion and then declined by about
$3,5 billion. Imports increased by $3 billion from 1955 to 1957, and
by a further $2,5 billion from 1957 to 1959. In contrast, the net

178

THE FEDERAL RESERVE ANSWERS

outflow of U.S. private capital increased only by $2 billion from 1955
to 1957, and then decreased by about $1 billion. Changes in the net
inflow of foreign long-term investment in private U.S. enterprises
and securities were still smaller. Changes in the flow of foreign
funds into and out of dollar liquid assets are discussed later; these
do not affect the balance-of-payments surplus or deficit as here
defined.
A restrictive monetary policy makes its most important con
tribution to restoring equilibrium in the balance of payments through
its effects on exports and imports. In the short run, however, it may
also influence capital movements in a way that will help to minimize
an over-all deficit. Since the end of 1958, when most European
countries restored external convertibility of their currencies, inter
national flows of liquid funds have been larger than they were in the
earlier postwar years, and the potential influence of credit conditions
and interest rates in various countries upon international payments
balances has increased correspondingly.
The $1 billion decline in private U.S. capital outflow from 1957
to 1959 and the increase in inflow of foreign long-term capital served
as partial offsets to the $6 billion shrinkage at that time in the goods
and services export surplus. It is perhaps significant that this
alteration of the net capital flow occurred mainly from 1958 to 1959,
at a time when U.S. interest rates were rising and interest rates in
several major European countries were declining. Interest rate
changes may at times have appreciable effects on international
capital movements. The changes in net capital flow from 1957 or
1958 to 1959, shown in the accompanying table, were due, however,
only in minor part to interest rate changes in the United States and
other leading financial markets.
During 1960, when the goods and services export surplus ex
panded significantly, an increase again occurred in private capital
outflow. In this instance, the year-to-year shift in capital move
ments was fully as large as the improvement in the current account,
and the increase in net exports from the first half to the second half
of 1960 was more than offset by increased capital outflow. The
widening of short-term interest rate differentials after mid-1960
between the United States and some European countries played a
large role in this development, by attracting short-term investments
abroad. But it would be a serious oversimplification to lay stress
solely on short-term rate differentials. In addition, loans and credits
to borrowers abroad were stimulated by the increasing availability
of funds in the United States, At the same time, prospects of capital
gains on both equity and fixed-income securities abroad attracted
movements of funds, and speculation on currency values was an
additional influence of considerable importance. As estimates given
in the table show, a large amount of capital outflow in 1960 took
form s not identifiable from the available statistical reports.

QUESTION XXI

179

In 1958 and 1959, as well as in 1960, the shifts in some of the
types of capital movements listed in the table had not represented
responses to current changes in interest rate differentials. Most
foreign purchases of U.S. private long-term securities in recent
years have been in common stocks rather than in interest-bearing
securities, and most of the U.S. purchases of foreign long-term
securities other than those newly issued have been purchases of
stocks. In addition, changes in the outflow of direct investment in
subsidiaries or branches abroad of U.S. corporations are determined
primarily by business opportunities and plans.
Net outflows of U.S. bank loans to foreign borrowers are affected
to some extent by money market conditions in the United States, and
offerings of foreign and international institutions’ securities in U.S.
markets are at times significantly affected by absolute and relative
levels of interest rates here. While influences such as these did
affect the outflow of bank loans and of capital raised by new issues
in recent years, other forces played an important role in the 1958
increase in outflow and in the reduction from 1958 to 1959, as well
as in the new increase in 1960.
For example, the foreign demandfor U.S. bank loans originates to
a considerable extent in countries without highly organized money
markets, and this demandfor credit varies with changes in the trade
or in the balance of payments of the borrowing countries. The decline
in U.S. purchases of newly is sued foreign securities after the spring
of 1958 reflected partly the timing of new issues in this market by
the International Bank for Reconstruction and Development, and this
timing was apparently influenced by interest rate changes. But
offerings by other foreign issuers remained about as large in 1959
as in 1958, despite the rise in U.S. rates. Canadian borrowings in the
United States, which generally provide a considerable part of the new
foreign issues, were evidently influenced by the level of Canadian
interest rates relative to U.S. rates, and Canadian rates rose even
more than U.S. rates from 1958 to 1959. In 1960, however, new
Canadian issues in this country fell off, despite a continuation of
relatively high interest rates in Canada,
There has been omitted from the discussion thus far one impor
tant category of capital transactions* These are the transactions
within the U.S, market that do not contribute to the over-all surplus
or deficit as commonly defined; they reflect decisions as to the
forms in which accretions to foreign liquid assets will be held.
In 1958 the total addition to foreign and international institutions’
liquid dollar assets plus purchases of gold from the United States
was $3.5 billion, and in 1959 it was $3.8 billion, apart from a $1.4
billion addition to International Monetary Fund holdings through the
additional U.S, subscription made that year. In 1958, $2,3 billion of

180

THE FEDERAL RESERVE ANSWERS

the total was taken in gold and $1.2 billion in dollar liquid assets
of various types. In 1959, U.S. transfers of gold to foreign countries
and international institutions were $1.1 billion, the increase in
special noninterest-bearing notes held by the IMF was $1.3 billion,
and foreign and international institutions’ holdings of other dollar
liquid assets increased $2.8 billion.
Interest rate increases in the United States and declines in other
leading financial markets had only a minor effect on the magnitude
of the total increase in gold and dollar liquid assets. This magnitude
was determined by the over-all surplus in the balance of payments
of the rest of the world with the United States. Even in the distribu
tion of total foreign gains between gold and liquid dollar assets, with
gold a smaller part in 1959 than in 1958 and dollar assets a larger
part, interest rate changes played only a minor role.*
The distribution of foreign asset gains between gold and dollars
is determined by two sets of decisions, in only one of which relative
interest rates play any part. Foreign commercial banks and others
may be induced by interest rate differentials (in excess of costs of
covering foreign exchange risks) to make short-term investments
in the United States, Insofar as this happens, their purchase of
dollars in foreign exchange markets for this purpose are balanced
by sales of dollars by others, including foreign central banks. Thus,
given an over-all U.S. balance-of-payments deficit during a partic
ular period, additional purchases of interest-bearing dollar assets
for foreign nonofficial accounts ordinary mean, in the first instance,
smaller accretions to foreign official dollar holdings than would
otherwise have occurred.
Some foreign monetary authorities hold their reserves mainly
in gold, some mainly in dollars, and others in both form s. These
practices of central banks with respect to the choice between dollar
assets and gold, while differing from country to country, have shown
no significant tendency to vary in response to changes in interest
yields available on dollar assets.
Thus, the direct effect of interest rate differentials on move
ments of foreign funds into or out of dollar assets is limited almost
exclusively to private transactions,2 a movement of foreign private
1-Although relative rates on time deposits and Treasury bills had
the effect of creating a preference for the form er in 1958 and for
the latter in 1959, such shifts between types of dollar assets have
no effect on the distribution of foreign asset gains between gold and
dollars.
^Official holders of dollars do, of course, make shifts from one
type of dollar asset to another in response to relative interest rates
onFRASER
the different types. See preceding footnote.
Digitized for

QUESTION XXI

181

funds into dollar assets, accompanied by reduction inforeign official
gains of reserves, may then lead indirectly to reduction in foreign
official purchases of gold.
The final outcome as to foreign acquisitions of gold from the
United States depends not only on the extent to which private short
term investments in the United States are influenced by interest
rate changes, and on the reserve policies of the foreign countries
from which the funds move, but also on all other elements in the
balance of payments and on the country-by-country pattern of sur
pluses or deficits. In 1959, for example, gold purchases from the
United States were much smaller than in 1958 largely because
countries that customarily convert reserve gains into gold had
much smaller increases in their official reserves in 1959 than in
1958; these reductions in reserve gains were only in part the result
of movements of foreign private short-term investments in response
to interest rate changes.
In 1960, foreign private holdings of dollar liquid assets in
creased much less than in 1959, After July, the rise in total U.S.
short-term liabilities to foreign commercial banks and other private
persons gave place to a decline. Like the 1960 movements of U.S.
short-term capital and movements of unidentified capital, this net
outflow of foreign private funds in the latter part of 1960 responded
to a variety of forces associated with the strength of demands abroad
for goods and for liquid capital, including the pull of interest rates,
and also in part to speculative influences. Despite great improve
ment in the goods and services export surplus, the outflows of
foreign and U.S. private funds resulted in large additions to foreign
official reserves. Net purchases of gold from the United States
amounted to $1.7 billion in 1960.
To sum up, certain types of international capital movements
affecting the surplus or deficit in the over-all balance of payments
are responsive to changes in the relation between U.S. and European
interest rates, but others are not. Furthermore, the disposition by
the rest of the world of its liquid asset accretions as between gold
and dollar assets depends to a great extent on factors other than
interest rate relationships.
Gold movements reflect the whole state of the U.S. balance of
payments, the country-by-country pattern of foreign balance-of payments surpluses or deficits, and prevailing practices with respect
to holding reserves in dollars. Responses of capital movements to
interest rate changes alone cannot match in ultimate importance to
various influences that affect for better or for worse the competitive
position of the United States and the maintenance of confidence in
the stability of the dollar.

THE FEDERAL RESERVE ANSWERS

182

TABLE XXI - 1
N e t F lo w s o f P r i v a t e C a p ita l
(In m illio n s o f d o lla r s )
C a le n d a r Y e a rs
1958
1959

1957
A.

H a lf y e a r s . I 9 6 0
2nd p .
1st

O u tflo w s a f f e c tin g th e s u r p l u s o r
d e f ic it in th e b a la n c e o f p a y m e n ts 1

N e w is s u e s l e s s re d e m p tio n s :
I n te r n a tio n a l in s titu tio n s
C anada
O th e r

171
205
42

350
328
192

2
382
150

80
163
86

2
6
114

S h o r t - t e r m (n e t ), in c lu d in g b a n k lo a n s
L o n g - te r m b an k lo a n s (n e t )^
S u b to ta l

306
258
188
335
1 ,0 1 1 1 ,3 6 4

89
183
802

215
+ 54
598

1 ,0 1 3
95
1 ,2 2 6

U .S . d i r e c t i n v e s t m e n t s (n e t )
O th e r lo n g -te rm (n e t p
F o re ig n d ir e c t a n d p o rtfo lio in v e s tm e n ts
o t h e r t h a n U .S . G o v t , s e c u r i t i e s ( n e t )
(in flo w ,-)
S u b to ta l

2 ,0 5 8 1 ,0 9 4
386
106

1 ,3 1 0
189

566
65

975
92

- 361 - 24
1 ,8 0 3 1 ,4 5 6

- 548
951

- 337
294

10
1 ,0 7 7

2 ,8 1 4 2 ,8 2 0

1 ,7 5 3

892

2 ,3 0 3

T o ta l
E s t i m a t e o f c a p ita l u n r e c o r d e d 4 (in flo w
B.

I n c r e a s e in f o r e i g n p r i v a t e s h o r t » t e r
d o lla r a s s e ts 3

- 250

100

- 300

450
------

- 950
------

282

226

1 ,1 2 6

449

- 478

p. = preliminary
*I.e„ excluding recorded foreign movements into or out of dollar
liquid assets (U.S. short-term liabilities and U.S. Government
securities). The only item in the first part of the table reflecting
recorded changes in foreign assets in U.S. is “foreign direct and
portfolio investments...” Other items reflect changes in U.S.private
assets abroad. The estimate of “capital unrecorded” necessarily
refers to both foreign and U.S. capital.
^Change in long-term claims on foreigners reported by banks in
the United States, “mainly loans with an original maturity of more
than one year” (Federal Reserve Bulletin).
^Mainly net purchases of outstanding foreign securities. Derived
by deducting “long-term bank loans (net)” from the Department of
Commerce balance-of-payments item “U.S. private capital, other
long-term (net).”
^Very rough estimates based on the assumption that year-to-year
variations in the balance on unrecordedtransactionsaredue chiefly
to unrecorded capital transactions.
^Change (increase,+) in short-term liabilities to foreign countries,
excluding official accounts, reported by banks in the United States
(Federal Reserve Bulletin).
Source: Department of Commerce balance-of-payments data, except
as indicated in footnotes.

QUESTION XXII

183
QUESTION XXII

What are the repercussions of interest rate regulations
on time deposits with respect to the competitive position
of the various financial intermediaries, flows of domes
tic funds, and the composition of foreign holdings of
dollar assets?
ANSWER XXn
Summary
The competitive position of commercial banks has been affected
by the regulation of interest they could pay on time and savings de
posits in that at times they have not been able to match rates paid
by other intermediaries or available in the market in periods of
high interest rates. The flows of domestic funds and the composi
tion of foreign dollar assets may have been affected, though in de
grees that can be assessed only roughly.
Regulation, however, has not been the only factor checking rate
increases. An appreciable proportion of insured commercial banks
paid rates under the ceilings permitted by regulation in higher
interest rate periods such as mid-1956 through the third quarter of
1957, and in the second half of 1959 through the first quarter of 1960,
To some extent commercial banks may have been reluctant to
raise rates paid on time and savings deposits to the level permitted
by regulation, even when market interest rates went up, because of
the prohibition on the payment of interest on demand deposits. Banks
prefer not to “compete with themselves,” The extent to which banks
would have posted higher rates if the regulatory ceilings had permit
ted them to do so,or in the absence of regulation, is thus conjectural.
Moreover, because of other services available, some depositors find
it convenient to keep their savings on deposit at commercial banks
and will do so even at a lower interest return. Many other factors
have caused shifts in competitive relationships and new directions
in the flow of funds.
Interest rates have unquestionably been used aggressively as a
competitive device by various savings intermediaries, including
commercial banks themselves. Savers have also become more
conscious of other alternatives such as investment in marketable
U.S. Government obligations. The result of these influences, how
ever, is probably concentrated on the outlets used for financial
saving; the effect on the total amount of saving is far from evident.

184

THE FEDERAL RESERVE ANSWERS

The clearest case in which regulation of rates on time and saving
deposits has influenced the employment of funds is that of foreignowned dollar assets. Some foreign owners of dollars appear to be
quite sensitive to interest rate differentials and to have switched
back and forth between time deposits and Treasury bills as rate
advantages have alternated. A similar though less clearly marked
sensitivity seems to be found in the movements of state and local
government liquid investments. Money market commercial banks
now are “selling” negotiable time certificates of deposit to domes
tic corporations, and a market is being maintained in these certifi
cates by at least one dealer.
The flow of funds into savings institutions has changed in pace
several times in the last few years; differentials in rates offered
clearly have been one of the factors causing these shifts. However,
as suggested above, the responsibility for these differentials is only
partly regulatory.
Initial Rationale for Regulation
Mandatory regulation of interest paid on time and savings de
posits was adopted largely because of the opinion that high rates
of interest paid by some commercial banks in the 1920’ s had con
tributed to the serious losses they suffered during the depression
of the 1930’ s. The banks that failed or got into financial difficulties
during that period were often found to have paid exceptionally high
rates for time and savings deposits and to have had vulnerable loan
and investment accounts, particularly the latter. A connection
seemed to exist between these facts. Deterioration in the quality
of assets, brought to light during the depression, seemed to have
been related in part to excessive efforts at income maximization
during the preceding boom. Active competition among banks led
many individual institutions to commit themselves to rates they could
not continue to pay while pursuing a prudent loan and investment
policy. Factors other than excessive interest payments, of course,
accounted for some of the adverse loan and investment experience.
Early Regulatory Experience
The initial regulation of interest rates on time and savings de
posits by the Federal Reserve Board in 1933 (Regulation Q) es
tablished a blanket 3 percent rate ceiling on time and savings de
posits. The regulation, applicable only to member banks of the
Federal Reserve System, did not press with any severity on the
level of rates that banks were actually paying. In 1935, when this
blanket rate ceiling was reduced to 2\ percent, very few banks
were forced to decrease the rates they were paying, since voluntary
reductions in response to lower levels of market interest rates had
already been widely made.

QUESTION XXII

185

A schedule of maximum time deposit rates by maturities became
effective at the beginning of 1936 and at the same time the FDIC
initiated a parallel regulation of the rates paid by insured nonmember commercial banks. These rates are shown in column 3 of
Table XXH-1. The change was principally an adjustment of the
regulatory terms to the requirements of the Banking Act of 1935.
T A B L E XXII - 1
In te r e s t Rate C eilin g s A u th orized by Regulation Q
O c t ./ 3 l /3 3
to
J a n . / 3 l / 35

F e b ./l/3 5 J a n ./l/3 6
to
to
D e c ./3 l/3 5 D e c ./3 l/5 6

J a n ./l/5 7
through fir s t
quarter 1961

Savings d e p o s its
)
(
2 - 1 /2
T im e d e p o s it s --in it ia l )
(
m a tu rity:
)
(
6 m onths and o v e r )
3
2-1 /Z (
2 -l/2
90 days to 6 m o n th s )
(
2
30 days to 90 days )
( 1
Under 30 days
(not p erm itted ; defined as dem and d ep osits)

3
2 - 1 /2
1

During the first two decades of Regulation Q, its prescribed
maxima were almost always appreciably above the rates banks were
actually paying. Although market interest rates moved up slightly in
the early postwar period, serious pressure on the regulatory ceil
ings did not come until 1955, and to an even greater extent in 1956,
when stronger demands for credit induced a number of savings in
stitutions to increase the interest rates they offered for funds.
For the first time in two decades, Regulation Q could be said to
be limiting the level of rates that might have been paid by some
commercial banks. This was not generally true, however, as rela
tively few insured commercial banks were paying rates at or near
the regulatory ceiling when Regulation Q was amended near the end
of 1956. The amendment raised permissible rates effective January
1* 1957. During 1957 expanding investment opportunities combined
with a variety of other factors stimulated more active promotional
efforts by almost all institutions seeking time and savings deposits.
Posted rates were increased in many banks and supplementary
competitive devices were widely adopted. Advertising, premiums,
and more liberal computational methods were used to attract new
business.
In the brief recession at the end of 1957 and in early 1958, market
rates of interest declined sharply but remained low for only a short
time. No appreciable number of commercial banks and only a few
competing savings institutions reduced the rates of interest or divi

186

THE FEDERAL RESERVE ANSWERS

dends paid on time and savings deposits and share accounts. Even
the somewhat more volatile rates paid on time certificates of deposit
by money market banks appear to have been maintained at rather
high levels relative to the reduced levels of open market interest
rates. With time deposit rates relatively advantageous to investors,
commercial banks and other savings institutions attracted a large
inflow of funds.
In late 1958 market interest rates once more rose, and in 1959
reached the highest levels of the past 30 years. Because of the
limitations imposed by Regulation Q, however, those commercial
banks that were seeking aggressively to attract or maintain deposits
were unable to follow the rise in market rates by increasing the
rates offered on time and savings deposits. Thus, regulatory rates
had finally come into close touch with the market. The increase of
time deposits was slowed down and in some quarters almost halted.
Savings and loan associations continued to increase materially the
dividend rates they offered, thereby maintaining or enlarging differ
entials above the rates of interest permitted by Regulation Q.
In recent years time and savings deposits have assumed a posi
tion of increased importance in the affairs of commercial banks.
During the past decade they have grown from 28 to 36 percent of
total commercial bank deposits. With a slackening in the growth of
demand deposits, individual banks have increased their endeavors
to attract new funds through time and savings deposits. Some cor
porate customers, enjoying a strongbargainingposition with respect
to their bankers, have induced banks to accept time certificates of
deposit as acceptable compensatory balances. In a few cases these
time certificates have subsequently been discounted below par
through money brokers, thereby providing a higher rate of return to
the purchasers.
More active pursuit of time and savings deposits has raised some
problems of bank liquidity. Funds attracted with only mild competi
tive efforts probably tend to remain with relative stability in the
institution holding them. Funds obtained as the result of more
vigorous competitive efforts probably are not quite as stable and
should be protected by a wider margin of liquidity.
Economic Background
Regulation Q was promulgated against an economic background
of relatively slack demands for funds and low interest rates. Dur
ing the 1930’ s commercial banks reduced the rates they paid on time
and savings deposits considerably below the regulatory ceilings.
Some even refused to accept time deposits, or allowed additions to
be made to savings accounts only by established customers in small
regular amounts.

QUESTION XXII

187

When the economy passed from the prolonged depression of the
1930*3 into a state of defense preparation, and then into war, the
situation with respect to savings flows changed radically. Federal
government borrowing exceeded the entire flow of voluntary saving,
and substantial monetary expansion ensued.
During the war period, private competition for savings was
not vigorous. With a negligible supply of new mortgages coming into
the market, savings and loan associations were moderate in their
promotional efforts. While mutual savings banks were not as closely
tied by tradition to mortgages as outlets for funds, their promo
tional activities also tended to be restricted. Savings institutions
helped to promote the sale of Treasury savings bonds and increased
their own holdings of Government securities.
In the early postwar period, official support of U.S. Government
securities prices, and the attendant influence on the yields from
other securities, held the earnings of most savings institutions at
relatively low levels. In such an environment, promotional efforts
on the part of these institutions tended to be restrained. Neverthe
less, the increasing demand for mortgage funds and more active
borrowing by corporations stimulated greater competitive zeal
considerably before this influence was fully reflected in an upward
trend of interest rates.
The rise in interest rates following the termination of Federal
Reserve support of low market rates on Government securities
encouraged more aggressiveness in promoting new saving and in
expanding facilities for handling savings funds. The sustained high
levels of economic activity and the continuing demands for funds,
even during the brief periods of moderate economic recession,
supplied even stronger motives to the principal financial inter
mediaries for vigorous and aggressive pursuit of new savings.
Although investment quality of commercial bank portfolios is
generally quite high, appreciable differences in the rates of both
gross and net earnings on investments are encountered. Some banks
acquired a substantial proportion of their present portfolios in
earlier periods of lower rates, while other banks bought the bulk
of their present holdings in recent higher rate periods. The turnover
of portfolios because of special tax considerations may partly
obscure these differences among banks but it would not obliterate
them.
Because of variations in earning capacity, the rates that banks
can appropriately offer customers on time and savings deposi s
also vary appreciably. The differences are of a character that can-

not be fully matched by a regulatory c la s s ific a t io n of rates. Many
differences among individual banks are more appropriate y
with on a case-by-case basis.

188

THE FEDERAL RESERVE ANSWERS

The prohibition of the payment of interest on demand deposits
has also caused banks to hesitate about increasing the rates they
offered for time and savings deposits even when room for such
increase existed under the regulatory ceilings. In the ever sharpen
ing postwar competition for funds, banks have been aware of the
investment alternatives available to those who managed corporate
or individual liquidity positions. Aside from perfectingthe services
offered demand deposit customers, including loan services, little
more can be done to lure funds back into demand deposit accounts.
When banks raise rates on time and savings deposits, they are in
effect “competing with themselves,®
Competitive Influences on the Flow of Savings
When the statutory base underlying Regulation Q was first
adopted, the commercial and mutual savings banks were the domi
nant savings institutions. Although some degree of competition pre
vailed among various types of savings institutions, the competition
many commercial bankers felt most keenly came from other banks.
Since that time, however, the competititve pattern has changed
appreciably. A number of other savings outlets and institutions, all
of which lie outside the formal regulatory pattern, have emerged as
strong competitors.
The most vigorous and aggressive of these competing savings
institutions are unquestionably savings and loan associations. The
increased supply of mortgages and the improved earnings from them
have permitted associations to increase their dividend rates
materially. This improvement in earnings has been particularly
marked in some areas of the country such as California, where
savings and loan associations live in an environment of such strong
demands for funds that they have not only competed vigorously for
funds in their own localities, but have advertised nationally and used
a variety of other competitive devices to attract money.
Most savings and loan associations have grown faster than the
mutual savings banks or commercial banks in the same areas. They
are now attracting a larger gross inf low of funds each year than that
received by life insurance companies. While savings and loan asso
ciations are not subject to a formal regulation limiting the dividend
rates paid to shareholders, the federal and state authorities that
charter and supervise these institutions provide some check on the
level of dividend rates.
Credit unions are a smaller, but nevertheless rapidly growing
competitor for savings funds. While these institutions offer a
savings outlet to only a limited portion of the population, they have
nevertheless grown rapidly and have attracted funds in considerable
volume in the locations where they operate, The dividend rates paid

QUESTION XXII

189

by credit unions show considerable dispersion but in general have
been slightly higher than the dividends paid by savings and loan as
sociations and considerably higher than rates that commercial banks
pay on savings deposits.
In a very broad sense both life insurance companies and pension
funds could be viewed as competitive with depositor share-account
type of savings institutions. In practice, however, the buyers of in
surance contracts and the holders of pension rights probably do not
view these arrangements in many instances as alternatives to, or
competitive with, savings accounts.
The securities of the federal government compete for private
investment funds. Effective competition is now offered by market
able obligations of the government, and savings bonds have been
attractive to investors in some periods. Savings bond interest rates,
however, are not directly comparable with rates offered by other
savings instruments because of the penalty on redemption before
maturity.
The marketable securities of the federal government have re
cently proved to be effective competitors with time and savings de
posits in a variety of ways. The Treasury bill is treated as an
alternative to time certificates of deposits by foreign holders of
liquid dollar assets, by some state and local governments, and by
many corporate treasurers. The section below shows that there has
been a reciprocal relationship between the relative rates offered by
banks and Treasury bill rates, and the shift of funds into or out of
these investment vehicles.
Recently, some holders of savings deposits have also become
more aware of the investment merits of intermediate- and longerterm marketable U.S. Government securities and have bought them
when attractive yields were available. High-yielding new issues such
as the “magic fiv es” of August 1964 (offered in October 1959) induced
appreciable withdrawals of funds from savings accounts. When
yields in the secondary market have approached this level, U.S.
Government security dealers have received larger numbers of small
or odd-lot purchase orders for marketable U.S. bonds. This suggests
that when the yield is attractive, individual investment inU.S.
Government securities has taken place with increasing frequency
even outside the periods of new Treasury offerings.
Corporate equities, and mutual funds composed mainly of cor
porate equities, have also been effective competitors for savings
funds. The capital gains from sharply rising stock market levels
and the widespread fear of secular inflation have contributed to their
attractiveness. While yields from some equities have sometimes

been attractive in comparison with interest rates on time and savings

190

THE FEDERAL RESERVE ANSWERS

deposits, it does not appear that yield differentials have been a major
influence; indeed, the yields on many of the most popular equities
have been appreciably below the rates available on time and savings
deposits. To a major extent transactions in corporate equities or
mutual funds simply represent redistribution of stock ownership in
the secondary market. This produces no net inflow of saving into
equities. The funds invested by some are merely transferred to
others who sell their holdings. The high prices for corporate
equities, however, have unquestionably encouraged an increase in
the volume of new equity issues and so encouraged some net inflow
of funds.
Competititve Position of Time Deposits
Since the re-establishment of a flexible market for U.S. Govern
ment securities and the advent of greater fluctuations in yields, a
clear cyclical pattern has developed in the movement of time de
posits into and out of commercial banks. This movement appears to
be dominated by the relative yields available in market instruments,
primarily the Treasury bill, and the rates of interest offered by
commercial banks on time deposits.
In 1954, when Treasury bill rates dropped sharply, commercial
banks quickly gained a large volume of time deposits from
foreigners, from state and local governments, and from business
corporations. This movement ceased abruptly in 1955 and some loss
in deposits was experienced. The pattern of rapid gain quickly
emerged again in early 1958 when low Treasury bill rates brought
another very large movement of foreign funds, state and local
government funds and corporate funds into commercial banks.This
inflow, however, ceased abruptly when bill rates started to go up
in late 1958 and during 1959. During 1959, in fact, commercial
banks suffered a sizable net loss of time funds, presumably to the
bill market.
Whether these swings in the acquisition and loss of time de
posits would have existed in the absence of an interest rate regula
tion is not altogether clear. It is worth noting, however, that this
movement took place in 1954 and was reversed in 1955 before
regulatory rates pressed with any severity on the rates that banks
might have normally wished to pay for competitive reasons. Even
in the absence of regulation, reciprocal movement probably would
take place unless banks adjusted their rates as frequently and as
fully as Treasury bill yields changed. Rates have not been adjusted
with this degree of frequency.
Competitive Position of Savings Deposits
Passbook savings deposits do not show such a clear cyclical
pattern. The movements of savings deposits into commercial banks

QUESTION XXH

191

and into mutual savings banks were not greatly different in 1954 and
1955. A notable fact, however, is that larger gains took place in
1957. During that year many commercial banks, spurred by a
higher regulatory ceiling, promoted vigorously the attraction of these
funds as a matter of business policy. In the first three quarters of
1958, time deposit gains as well as savings deposit increases con
tinued at an accelerated pace, but then tapered off as savings insti
tutions not restrained by regulatory limits on the rates they paid
increased their competitive efforts and offered still higher prices
for funds.
Although savings deposits appear to be less responsive to fluctua
tions in short-term interest rates than are time deposits, the slow
down in the rate of savings deposit growth since early 1959 shows
that external competition is exerting more influence. In some areas
of the country, commercial banks have lost savings deposits at a
time when some competitive institutions have been growing at record
rates.
Marketable Time Certificates of Deposit
Some money market commercial banks have long refused to
accept time deposits from domestic nonfinancial corporations. Their
general feeling seemed to be that to do so would have made one de
partment of their banks competititve with another department. It is
evident, however, that many attractive liquidity vehicles are avail
able to nonfinancial domestic corporations, particularly Treasury
bills. Recognizing this fact, money market commercial banks early
this year began to negotiate time certificates of deposit with domes
tic corporations in a form that was specially tailored to insure their
marketability. One of the dealers in U.S. Government securities
“makes” a market in these time deposit certificates. The amount
outstanding had already passed the half billion dollar mark by early
May 1961. Some of these certificates of deposit appear to have
originated as compensatory balances which were then sold by the
corporation holding them.
Time Deposits and Foreign Dollar Holdings
The form in which dollar assets are held by foreign central banks
or by other foreigners has been influenced by the regulation of time
deposit rates. Those dollar funds that foreign governments and
central banks do not convert into gold are largely invested in
Treasury bills, bankers* acceptances, or time deposits at commer
cial banks. Foreign central banks often hold a portion of their dollar
funds with the Federal Reserve Bank of New York, and the Bank acts
as agent for them in the investment of dollar funds. Many foreign
central banks and other foreign interests also maintain close banking
relationships with one or more of the money market commercial
banks.

THE FEDERAL RESERVE ANSWERS

192

Correspondent relationships with foreign customers depend on
and require the furnishing of many kinds of banking services. Money
market commercial banks expect the maintenance of an adequate
deposit balance as a part of the price for these services, just as
for their services to domestic customers. A time certificate or de
posit is usually viewed as a discharge of a part of the customers*
obligation even though interest is paid on such accounts.
Existing tax legislation (Internal Revenue Code, Sec. 861(a)(1)(C)
and 881) exempts from taxation the income received by foreign
holders from time deposits and bankers* acceptances, but some
foreign holders are subject to certain taxes on income received from
the securities of the U.S. Government. Thus, yields on U.S. Govern
ment securities must be somewhat above the rate paid on time de
posits to be competitive with them.

QUESTION XXni
To what extend are and should bank examination
standards be related to and integrated with general
monetary policies? For example, are or should stand
ards be eased in periods of recession and tightened
in boom periods, along with similar changes in monetary
policies? What would be the dangers and advantages
of such an integration?
ANSWER XXIH
Summary
The objectives of bank examination and supervision are to keep
individual banks in sound condition and to preserve a strong, viable,
and competitive commercial banking system. The intrinsic value of
assets is considered in the examination and supervisory processes
and, basically, the same standards of appraisal are imposed regard
less of fluctuations in economic conditions.
Standards designed to be eased in periods of recession and
tightened in boom periods, complementing similar changes in mone
tary policies, could not be applied simultaneously to all banks be
cause of the nature of the examination and supervisory processes.
Such shifts of standards might impair the nondiscriminatory charac
teristics of the examination and supervisory processes, and would

QUESTION XXIH

193

likely diminish the contribution of these processes to a strong
banking system and a sound economy.
At the outset, it should be made clear that although the terms
“bank examination” and “bank supervision” are frequently used
interchangeably, in practice bank examination is only one phase of
bank supervision, “Bank supervision” in its broader aspects em
braces not only examination of banks, but in addition, other impor
tant activities performed by banking authorities. Supervision
includes, for example, actions taken in the discharge of continuing
responsibilities with respect to the organization and chartering of
banks, issuance and interpretation of regulations, formulation of
corrective requirements based on findings in examinations, permis
sion to merge and establish branches, changes in capital structure or
corporate powers, and liquidation and dissolution proceedings if and
when banks discontinue operations.
Fundamentally, bank supervision is directed toward the protec
tion of the public interest. In relation to the individual bank, the
objective of supervision is to foster the maintenance of each institu
tion in sound and solvent condition and under good management, in
order to protect depositors and assure continuation of essential
banking services in the community. With respect to all banks, its
further objective is to help maintain a banking system that will
continuously adapt to the financial needs of a growing economy.
Focusing now upon the more familiar aspect of bank super
vision—the visitorial bank examination function—its immediate
objectives are to develop information as to the financial condition
and soundness of the individual institution, to ascertain its operating
policies and practices and whether it is complying with applicable
laws and regulations, and to appraise the capabilities and perfor
mance of its management in relation to its responsibilities. The
bank examiner in the field is primarily a fact-finder and appraiser.
His task is to report the facts as found and base his conclusions as
to asset quality, capital adequacy, and management performance on
those facts.
After reviewing the facts and conclusions reported by the field
examiner, the supervisory authority— not the examiner—formulates
expressions of supervisory policy and prescribes necessary correc
tive requirements regarding criticized phases of the banks’ affairs.
The supervisory authority adjusts expressions of supervisory policy
and corrective requirements with respect to individual banks in light
of the composite experience derived from the examination and
supervision of many banks.

In an economy characterized by periods of nationwide contraction
and expansion,the policies of bank supervision need to avoid impeding

194

THE FEDERAL RESERVE ANSWERS

or deterring individual banks in making necessary adjustments to
changing conditions. Insofar as possible, supervisory policies should
function so as to facilitate banking adaptations to these changes. It
would be both unwise from the standpoint of bank supervision and
damaging to the banking system as a whole if bank examination
standards and practices should operate so as to increase unneces
sarily the pressure for forced liquidation of bank assets at times
when financial markets are sensitive to deflationary dangers, or
if they were relaxed in boom times when markets are strong and
prices of equities and goods are advancing.
In this connection, the Revision in Bank Examination Procedure,
or so-called “Uniform Agreement,” of the three federal supervisory
agencies and the Executive Committee of the National Association of
Supervisors of State Banks, adopted in 1938 and amended slightly in
1949, was designed particularly to further the maintenance of eco
nomic stability. Through its emphasis upon appraisal of bank assets
in terms of intrinsic values, rather than current market values, the
Agreement operates to prevent appraisals of bank assets in the
examination process from being unduly influenced by transitory
market conditions associated with fluctuations in economic activity.
It also operates to minimize differences in the approach to the
appraisal of bank assets as among examiners of the same or
different supervisory agencies.
An attempt to relate and integrate bank examination standards
to cyclical movements in the economy other than through the adoption
of bank supervisory policies such as those embodied in the “Uniform
Agreement” would seem to be neither feasible nor desirable. The
frequency with which banks are examined varies as between bank
supervisory agencies. All agencies change the sequence of examina
tion from year to year to maintain an element of surprise and to
obtain a clearer insight into the patterns of seasonal expansion and
liquidation of bank portfolios than that afforded by periodic reports
of condition. As a consequence, the intervals between successive
examinations of an individual bank may vary from several months to
approximately two years.
Any decision to complement changes in monetary policy by
applying more rigorous or less rigorous appraisal standards in
examinations, therefore, would result in the application of divergent
standards of appraisal with respect to the same or similar types of
assets in different banks, or over a period of time in the same bank.
Such a policy might impair confidence in the nondiscriminatory
characteristic of the examination and supervisory process.
In summary, as a general policy, bank examination and super
visory procedures consider the intrinsic value of assets and impose
basically the same standards of appraisal regardless of fluctuations

QUESTION XXm

195

in economic conditions. Bank examination standards designed to be
eased in periods of recession and tightened in boom periods, to
complement similar changes in general monetary policies, would
require substantial changes in this established approach to the
appraisal process. Such shifts in standards would be extremely
difficult to administer, and might not be in the best interests of
either the banking system or the bank supervisory function. It is
believed that the present supervisory policy based on intrinsic
values and designed to maintain banking stability will tend to pre
serve a strong, viable, and competitive commercial banking system,
and that efforts directed toward this end are the most constructive
and worthwhile contribution that bank supervision can make in
support of monetary policy.

QUESTION XXIV
How important are bank supervisory and examination
policies in influencing the portfolio policies of com
m ercial banks and the composition of bank assets?
For example, are certain types of loans and invest
ments considered inappropriate for banks, either
altogether or beyond specific amounts? Can or should
bank examination procedures be designed which facilitate
economic growth? For instance, do present examina
tion standards inhibit certain types of loans which could
contribute to economic growth? Do they impede the
free mobility of credit resources? Can or should they
be designed to facilitate credit mobility to encourage
its flow to highest priority users?
ANSWER XXIV
Summary
The influence of bank supervisory policies on the portfolio
policies of commercial banks cannot be measured quantitatively.
Other than for the enforcement of legal restrictions, in reviewing
commercial bank assets supervisors and examiners are guided by
broad banking principles regarding the quality, collectibility, and
diversification of assets in relation to the deposit liabilities,
liquidity, and capital adequacy of the particular bank.
It is not the function of bank supervision to attempt, through
influence on the banker, to make funds more readily available for

196

THE FEDERAL RESERVE ANSWERS

particular groups of borrowers or less available for others. The
role of bank supervision is not to encourage or discourage banks in
assuming credit risks but to apply standards of prudence in
assessing credit risks which are taken. Due to the breadth of our
markets for investments and loans, the fact that a particular invest
ment or loan may not prudently be acquired by one bank does not
mean that it will not be acquired by some other bank or other lender,
or that economic growth will suffer.
The nature and extent of the influence of bank supervisory
policies on the portfolio policies of commercial banks cannot be
measured quantitatively. Moreover, in considering the above ques
tions, a distinction shouldbe made between (1) supervisory influence
in preventing banks from acquiring assets which, if acquired, would
be in violation of the statutes and regulations, and (2) supervisory
influence in restraining banks from making loans or investments
which, while within the broad limits of their legal authority, would
not be desirable or prudent to acquire in light of their existing asset
or liability structure. In this response, primary consideration is
given to the second type of influence; also, no attempt is made to
differentiate between bank examiners in the field and the follow-up
activities by bank supervisory authorities.
Other than for the enforcement of legal restrictions, supervisory
and examination activities with respect to the types and quality of
commercial bank assets are concerned with the maintenance of
solvent banks, a strong and viable banking system, and sound credit
conditions. In reviewing the portfolios of banks, supervisors and
examiners are guided by the following broad banking principles;
(1) The funds of banks should be invested in assets of good
quality which afford reasonable assurance of ultimate collectibility
and regularity of income. Moreover, the types of assets acquired
need to bear a reasonable relationship with the nature of the busi
ness conducted by the bank, the type of customer served, and the
locality.
(2) Diversification of bank assets by type and maturity is
desirable to avoid undue concentration of risk. Where banks have
large concentrations in local extensions of credit, diversification
may be afforded through acceptable outside investments,
(3) Because of the special debtor-creditor relationship existing
between banks and their depositors, the particular types and maturi
ties of assets held by banks should take into account the nature of
their deposit liabilities. That is, the assets of banks (except cash,
bank balances, and amounts invested in essential physical facilities)
need to have a maturity composition related to the character and
composition of their deposit liabilities.

QUESTION XXIV

197

(4) The investment and lending policies of a bank should be
formulated with a view to avoiding either continuous or excessive
resort to borrowing by the bank.
(5) The capital structure of a bank should be adequate in relation
to the character and condition of its assets and to its deposit liabili
ties and other corporate responsibilities. If a bank becomes under
capitalized, it may be faced with the alternatives of either (a) in
creasing its capital through the sale of additional shares, or (b)
reducing its capital needs by reducing the risk or increasing the
liquidity of its assets, or both.
(6) In general, a bank should have sufficient cash and readily
marketable assets of high quality and short maturity to provide for
current operating requirements and to offset any temporary or
highly volatile deposits, whether in demand or time form. All other
deposits should be invested in loans and other obligations with
maturities so arranged that normal rotation will provide funds for
substantial deposit withdrawals andfor new loans. Due regard should
also be given to maintaining reasonable ability to reinvest at pre
vailing interest levels in order that a satisfactory average rate of
return may be realized over a period of time.
Privately owned banks naturally seek to invest their funds profit
ably and without abnormal risk of loss. It is not the function of bank
supervision to attempt, through influence on the banker, to make
funds more readily available for particular groups of borrowers or
less available for other groups. In no case is a bank supervisory
agency justified in encouraging a bank to undertake unreasonable
risks in attempting to meet the credit needs of business, nor in
discouraging particular extensions of credit unless such advances
involve over-concentrations with respect to that bank, or other
unsound banking practices which may contribute to endangering the
safety of depositors’ funds.
With respect to investment securities, bank supervisors give
consideration to the matter of diversification as to industry and
maturity, as well as credit quality. Consequently, criticism by
supervisors may, to some extent, restrain bankers from making
investments which in themselves would be acceptable but when
added to the existing portfolio might result in unwarranted concen
trations in long-term or medium-grade securities, or poor diver
sification as to industry or maturity.
Commercial banks, however, are only one of several kinds of
purchasers in the market for investment securities, and any effect
that com m ercial bank investment policies might have on issues of
such securities is considerably modified by the activities of large
members of other investors in these markets. Ordinarily when

198

THE FEDERAL RESERVE ANSWERS

banks participate in the markets for investment securities it is to
attain suitable liquidity, assure appropriate diversification, or
obtain income on funds not currently employed in loans. Under the
type of banking system in the United States, such participation will
usually tend to be subordinated to the banks’ primary functions of
serving depositors and other types of borrowers.
Although the protection of depositors is a primary concern of
supervisors, this does not mean that supervision is directed toward
the elimination of all risk. All credit transactions necessarily in
volve some element of risk. Banks exist as credit institutions with
the purpose of meeting the legitimate borrowing needs of the com
munity, locally and at large. The role of bank supervision is not to
prevent banks from taking credit risks but to apply standards of
prudence in assessing the credit risks which are assumed.
Prudence in lending may tend to inhibit the making of loans
by a particular bank in two general kinds of situations: (1) when
credit-worthiness of individual loans is either clearly deficient or
borderline, and (2) when the loans are individually credit-worthy but
would represent undue concentrations of risk for a particular bank.
However, if that particular bank does not make the loans in question,
it does not necessarily follow that the loans will not be made by
some other bank or other lender, or that economic growth would
suffer. The correspondent banking system usually provides a
reasonably satisfactory means of shifting loans of the second type
to some other institution. The first type of loan presents more
problems and deserves to be discussed in more detail.
Sound bank management and sound bank supervision, both of
which apply similar lending standards, allow considerable latitude
for financingthe development of new enterprises.The most important
requirement in such cases is the character and experience of the
management of the new enterprise. Even if the new enterprise can
provide relatively little capital, if it has suitable management it
usually can obtain enough financing—frequently from banks—to get
started on a modest scale and test the merits of the project. Such a
modest beginning may be a positive advantage to a new enterprise by
helping to limit the size and seriousness of the mistakes that often
occur in any pioneering effort. Furthermore, new enterprises are
often considerably strengthened by the sound financial and other
policies that good bank management, reinforced by good bank super
vision, attempts to get borrowers to follow.
Certain kinds of lending activities—certain types of consumer
credit, for example—have not been pioneered as directly or as
vigorously by banks as by some other lenders, and banks have
sometimes tended to enter such fields only after others have de
veloped them. As the principal source of the nation’ s money supply,

QUESTION XXIV

199

it is proper that banks be circumspect about undertaking broad new
lines of lending or investing. At relatively early stages of new
ventures, it can be a sound division of functions for a finance com
pany, manufacturer, or vendor to supply the specialized experience
and some of the basic risk capital, while a bank supplies funds sub
ject to less risk and also encourages the new enterprise to follow
tested general principles of management and finance.
Unnecessary restrictions placed by law or supervisory action
in the way of the lending process can, in times of depression, delay
recovery. At such times bank supervisory agencies are alert to see
that unwise or unnecessary restrictions on their part do not impede
the revival of the economy. Looking backward, there seems to be
good reason to believe that bankers and bank supervisors may have
become too deeply concerned in the early 1930*8 about the collection
of loans not considered prime, and unnecessarily rigid in their
attitude toward new extensions of credit. The Revision in Bank
Examination Procedure, or so-called “Uniform Agreement,” of the
three federal supervisory agencies and the Executive Committee
of the National Association of Supervisors of State Banks (adopted
in 1938 and amended slightly in 1949) was designed to further main
tenance of economic stability through emphasis upon appraisal of
bank assets in terms of intrinsic rather than current market values.
It is believed that this agreement would have had a beneficial
influence if it has been in effect in the early 1930*8, Continued
adherence to the principles of the “Uniform Agreement” will con
tribute to the maintenance of solvent banks, a strong and viable
banking system, and the sound credit conditions essential to
economic growth.

QUESTION XXV
What are the pros and cons of having the adminis
trative responsibilities for bank examination and super
vision remain, as at present, divided among a number
of different authorities?
ANSWER XXV

Summary
Complete unification of bank examination and supervisory func
tions necessarily would have to take place under federal law and

200

THE FEDERAL RESERVE ANSWERS

under either an existing or newly created federal agency. It pre
sumably would involve termination or significant abridgment of the
chartering and supervisory powers of the several states and would
present, at least in theory, the following principal disadvantages:
(1) It would require drastic changes in the existing legal structure
of commercial banking, as well as in bank examination and
supervision;
(2) it would disrupt many existing relationships in the banking
structure and in the administrative system of bank examination and
supervision; and
(3) it would precipitate controversy on the grounds that it would
(a) invade states* rights and be inconsistent with the principles of
local self-government; (b) concentrate too much power in the federal
government, and in one agency of that government; and (c) destroy
essential “checks and balances** and benefits derived from the
competitive interplay inherent in the present dual banking structure.
Some of the principal advantages, at least in theory, which might
flow from giving a single authority administrative responsibility for
bank examination and supervision would be:
(1) It would simplify the banking structure of the United States
and the problems of regulating the banking system;
(2) it would eliminate any possible discrimination between
different types of commercial banks and eliminate overlapping in
the administration, interpretation, and enforcement of various
banking laws and regulations;
(3) it would provide greater control over new bank charters,
mergers, and establishment of branches; and
(4) it would facilitate mobilization of bank examination and
supervisory resources to keep pace with the growth and complexity
of commercial bank operations and the banking system as a whole.
In considering possible changes, it is well to bear in mind that
our present system of commercial banking and bank supervision,
including banks operating under state or federal charters, is the
result of an evolutionary process extending over a period of almost
one hundred years. There are at present some areas of overlap and
duplication in functions essential to the discharge of examination
and supervisory responsibilities. The common interests of bank
supervisory agencies, however, have produced working arrange
ments by which much of the seeming duplication in activities is
avoided.

QUESTION XXV

201

There has never been a time in our history when one authority
was charged with administrative responsibility for the examination
and supervision of all commercial banks. Any proposal to consolidate
such responsibility in one body would need to be appraised on the
basis of whether the advantages would outweigh the disadvantages
enough to warrant disrupting established relationships.
Before reviewing the pros and cons of centralizing administra
tive responsibilities for bank examination and bank supervision, it
is desirable to comment briefly on the types, numbers, and deposits
of com m ercial banks in the United States; the agencies now con
cerned with the examination and supervision of commercial banks;
and the areas of cooperation between such agencies.
At present, from the standpoint of supervisory organizations,
there are four classes of banks: national banks, state member banks,
state nonmember insured banks, and state nonmember noninsured
banks. As of December 31, 1959, there were 13,474 commercial
banks in the United States and its territorial possessions operating
a total of 23,126 banking offices and having total deposits of
$219.9 billion. Of this number, all but 366 commercial banks, opera
ting 408 offices and having deposits of $1.4 billion, were insured.
Of the insured banks, 4,542 were national banks, operating 9,515
offices, and 1,688 were state member banks, operating4,207 offices.
These national and state member banks had total deposits of $119.6
and $65.1 billion, respectively, and their combined deposits repre
sented 84 percent of the total deposits of all operating commercial
banks. Insured nonmember commercial banks numbered 6,878,
operated 8,996 offices, and had total deposits of $33,8 billion.
The authorities having administrative responsibilities for the
examination and supervision of the four classes of commercial
banks and the general scope of their activities at the present time
are as follows:
1. The State Banking Authorities
The direct and primary responsibility for the examination and
supervision of all state banks, whether members of the Federal
Reserve System or not, and whether insured or not, rests with the
supervisory authorities of the 50 states. State banks are chartered
by the state, operate under the supervision of state authorities,
and, in the event of liquidation, have their activities terminated in
accordance with provisions of state law.
The number of examinations of each bank made by the various
states varies from one to two annually. Examinations of insured
banks usually are made jointly with the Federal Reserve banks or
the Federal Deposit Insurance Corporation, depending on whether

THE FEDERAL RESERVE ANSWERS

202

the particular bank is a member or nonmember insured bank. Non
insured banks are examined independently. Reports of examinations
made by the state authorities are made available to the Federal
supervisory agencies, and the latter agencies furnish copies of their
reports to the state authorities.
2. The Comptroller of the Currency
The Comptroller of the Currency is under the law directly and
primarily responsible for the examination and supervision of all
national banks. National banks obtain their charters from the
Comptroller and are liquidated under the provisions of the National
Bank Act, administered by the Comptroller.
National banks are examined at least three times every two
years and reports of such examinations are furnished the Federal
Reserve banks and made available to the Board of Governors and the
Federal Deposit Insurance Corporation.
3. The Federal Reserve System
The Federal Reserve has no direct power with respect to
chartering or liquidating banks. Although authorized to examine all
member banks, both state and national, as a matter of practice
neither the Federal Reserve banks nor the Board of Governors
examines national banks, since the Comptroller of the Currency is
directly charged with that responsibility under the law.
All state member banks are examined by the Federal Reserve
banks on behalf of the Board of Governors by examiners approved by
the Board. It is the established policy to make at least one regular
examination of each state member bank during each calendar year,
with such additional examinations of any particular bank as may be
desirable. These examinations usually are made jointly with the
state banking authorities and in all jurisdictions reports of one
agency are made available to the other.
4. The Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation regularly examines
all insured state nonmember banks, usually on a joint basis with
their respective state authorities. Examination reports are ex
changed with state authorities and made available to the interested
federal bank supervisory agencies.
Since all member banks are insured, the Federal Deposit Insur
ance Corporation has access to reports of examinations made by
the Comptroller of the Currency and the Federal Reserve banks.
The Corporation also is empowered to make special examinations of

QUESTION XXV

203

national banks and state member banks whenever such an examina
tion is necessary to determine the condition of any such bank for
insurance purposes. However, such examinations have been infre
quent and have been made only in anticipation of financial assistance
by the Corporation in a rehabilitation program or where a bank
desired to continue as an insured bank after withdrawal from
membership in the Federal Reserve System.
Inasmuch as the examination and supervision of the various
classes of commercial banks are divided among the different state
and federal supervisory authorities, there are unavoidably some
areas of overlapping and duplication in functions essential to the
discharge of their respective responsibilities. Nevertheless, through
arrangement of joint examinations, the waiver of authority to make
examinations, and the exchange of reports of examination, much of
the seeming duplication of examination and supervisory activities is
averted in practice by common interests that result in reasonably
close working arrangements among the several authorities.
In addition to the foregoing accommodations, the supervisory
authorities also have cooperated in the following respects:
(a) Adoption of generally uniform condition and earnings and
dividend reports;
(b) compilation of comprehensive statistical data relating to
banking institutions;
(c) standardization of examination reports forms;
(d) adoption of the so-called “Uniform Agreement” with respect
to the treatment accorded certain types of assets in reports of
examination;
(e) submission of formal reports on the competitive factors
involved in mergers and consolidations, as required by statute, and
informal clearance with respect to new charters and branches;
(f) exchange of information with respect to criminal violations;
and
(g) the joint establishment and operation of the Inter-Agency
Bank Examination School for training and developing bank examining
personnel.
Furthermore, representatives of the three federal supervisory
authorities and the National Association of Supervisors of State
Banks also meet on call to discuss and devise mutually acceptable
approaches to existing and developing problems in the field of bank

204

THE FEDERAL RESERVE ANSWERS

examination and supervision. For example, as an outgrowth of these
meetings, the federal and state authorities issued a joint statement
with respect to bank capitalization, meetings by examiners with
boards of directors, problem bank situations, and internal audits
and controls of banking institutions, with a view to coordinating
practices in these fields of mutual or joint responsibility.
There has never been a time in our history when one authority
was charged with administrative responsibility for the examination
and supervision of all commercial banks. Since such banks are an
integral part of our banking and monetary establishment, as well
as a primary source of strength and sustenance for our whole
operating and expanding economy, it would seem at first glance that
centralization of the examining and supervisory function would be
highly desirable and in the public interest. However, it must be
borne in mind that complete unification of these functions necessarily
would have to take place under federal law and under either an
existing federal agency or a newly created one; presumably, this
would involve termination or significant abridgment of the charter
ing and supervisory powers of the several states.
Some of the principal advantages which might be expected, at
least in theory, to flow from the centralization of responsibility for
bank examination and supervision in a single authority would be:
(1) It would simplify the banking structure of the United States
and the problems of regulating the banking system;
(2) it would eliminate any possible discrimination between
different types of commercial banks and eliminate overlapping
jurisdictions in the administration, interpretation, and enforcement
of various banking laws and regulations;
(3) it would provide greater control over the issuance of new
bank charters and over applications to merge with or absorb banks
and to establish branches. This would facilitate, among other things,
determinations as to the lessening of competition or the creation of
monopolies in commercial banking;
(4) it would provide a basis for more efficient and economic
gathering and processing of banking statistics; and
(5) it would facilitate mobilization of bank examination and
supervisory resources to keep pace with the growth and complexity
of com m ercial bank operations and the banking system as a whole,
and thereby contribute to a better coordinated, more efficient, and
stronger bank supervisory authority.

QUESTION XXV

205

On the other hand, some of the principal disadvantages, at least
in theory, of centralizing responsibility for the examination and
supervision of commercial banks in a single authority might be:
(1) It would require drastic changes in the existing legal struc
ture of commercial banking, as well as in bank examination and
supervision;
(2) it would disrupt many existing relationships in the banking
structure and in the administrative system of bank examination and
supervision; and
(3) it would precipitate controversy on the grounds that it would
(a) invade states’ rights and be inconsistent with the principles of
local self-government; (b) concentrate too much power in the federal
government, and in one agency of that government; and (c) destroy
essential “checks and balances” and benefits derived from the
competitive interplay inherent in the present dual banking structure.
It has sometimes been suggested that some of the advantages
mentioned above could be obtained if all present federal bank
examination and supervisory functions were unified in a single
agency, and that this might be done without making any change in the
primary authority of the several states. Such a rearrangement of
only federal responsibilities would involve less drastic changes in
the existing commercial banking structure than would more sweep
ing proposals for centralization; but it would likely be subject to
many of the other disadvantages outlined above.
In considering possible changes, it is well to bear in mind that
the present system of commercial banking and bank supervision
has evolved over a period of almost a hundred years dating from
the passage of the National Bank Act of 1863. It was substantially
modified and improved by the passage of the Federal Reserve Act
in 1913, and by the Banking Act of 1933, which created the Federal
Deposit Insurance Corporation and included the basic provisions
of law ultimately embodied in the Federal Deposit Insurance Act of
1950.
The evolutionary process of modification and improvement has
resulted in an interchange of banking and bank supervisory concepts
originating both at the state andfederal levels. Although the process
has been slow and not infrequently carried forward in what could
be described as the method of trial and error, it has had as its
objective the creation and maintenance of a strong, viable, and
competitive commercial banking system capable of continuous
adaptation to meet the changing conditions of a growing economy.
The success of the evolutionary process must be measiH*ed by the
present strength and prospects of our commercial banking system

206

THE FEDERAL RESERVE ANSWERS

and our economy. Any proposal to consolidate all banking super
vision and regulation in one body would need to be appraised on the
basis of whether the advantages would sufficiently outweigh the
disadvantages to warrant disrupting established relationships,

Part Two
THE TREASURY ANSWERS

QUESTION I
How much should fiscal policy be relied upon to achieve
our national economic objectives among varying cir
cumstances?
ANSWER I
An appropriate fiscal policy — using the term as the over-all
relationship between federal expenditures and revenues — is funda
mental in this nation’ s efforts to achieve the maximum sustainable
rate of economic growth, maintain abundant employment opportuni
ties, and assure reasonable stability in the value of the dollar. Al
though informed observers generally agree as to the strategic im
portance of fiscal policy in our efforts to achieve our economic
objectives, considerable disagreement exists with respect to the
manner in which such policies should be formulated and applied.
A sizable group of economists argues that fiscal (or “budget”)
policy, in coordination with monetary and debt management policies,
should be used strongly and overtly to counter cyclical trends. A c
cording to this view, a period of actual or threatening inflation,
arising from pressures of demand, would call for a substantial sur
plus in the federal budget. This surplus would be achieved by an
increase in tax rates (or imposition of new taxes), by a decline in
expenditures, or by some combination of the two. Such a surplus,
it is argued, would help dampen total demand for current output,
inasmuch as federal government spending would fall short of rev
enues.
Consistent with this countercyclical approach, the program would
be consciously reversed during a recession. Reductions in tax rates

208

THE TREASURY ANSWERS

and increases in expenditures would contribute to a large budget def
icit, Such a deficit, it is argued, would help to enlarge total demand
for current output and promote recovery, inasmuch as federal
government spending would exceed revenues.
Although this approach to the problem of countering cyclical
swings in order to promote sustainable growth has considerable
merit in principle, it has some serious shortcomings in practice.
Such shortcomings do not involve the desirability of achieving budget
surpluses in prosperous periods and of shifting toward deficits in
recessions but relate instead to the difficulties encountered in the
use of budget policy in the described manner.
Important practical difficulties arise from the fact that decisions
as to taxes and spending programs often, and quite properly, re
flect many factors other than broad economic considerations. More
over, the timely use of budget policy as a conscious countercyclical
weapon is also complicated by the fact that authority over taxation
and spending is not centered in any one branch of the government
but is the joint responsibility of the Executive and the Congress.
Furthermore, experience in the postwar period indicates that it
is much easier to achieve a deficit in a recession than a surplus in
a boom. Large deficits in recessions, only partially offset by modest
surpluses in periods of high and rising activity, complicate the task
of achieving sustainable growth in two ways. First, the net deficit of
the federal government over a period of years is likely to add to
inflationary pressures and to increase the burden borne by monetary
policy in promoting our economic goals. The lack of adequate sur
pluses in the prosperous years following World War II — resulting
in an increase of almost $30 billion in the public debt since 1946 —
has meant that monetary policy has been called upon to bear more
than its proper share of the burden in avoiding inflation and promot
ing sustainable economic growth. This unavoidably heavy reliance
on monetary policy may have contributed to wider swings in interest
rates and capital values than would have been necessary if budgetary
surpluses had been adequate.
In the second place, the complications that may arise in managing
a growing public debt, reflecting net deficits over a period of years,
are likely to impair further the flexible and timely administration
of monetary policy. It is probable that excessive expansion in the
highly liquid short-term portion of the federal debt could be pre
vented more readily if the debt were steady or declining rather than
growing. If the public debt tended to grow in size and to become con
stantly shorter in maturity, Treasury financings would occur more
frequently and in larger amounts, thereby tending to disrupt the
Government securities market and also to restrict the freedom of
action of the monetary authorities.

QUESTION I

209

A large public debt can place a burden on future generations.
Although the real cost of government spending (in terms of the re
sources absorbed in government use), must be borne largely by the
current generation, the economic effects of managing a large public
debt and the impact of the taxes that must be levied to service it can
be shifted to future generations. The transfer operation involved in
interest payments on the debt (now about $9 billion per year) is
hardly frictionless; it involves additional budget expenditures and,
of primary importance, has a significant effect on incentives in the
private sector of the economy. We cannot, therefore, accept the false
comfort of the view that, simply because “we owe most of the debt
to ourselves, * a large public debt is of no real economic concern.
Attempts to vary tax rates and spending to help smooth the busi
ness cycle may well have perverse effects. Changes in fiscal policy
may sometimes take so long to plan, legislate, and put into effect
that many months may elapse from the time the need for action be
comes clear until the change in budget position affects total spend
ing. By the time the actions become effective, the economy may have
changed radically, with the result that large deficits may have their
major impact during periods of rising business activity and surpluses
may be achieved when business activity is declining. This criticism
applies especially to large federal spending programs which require
lengthy periods for planning and for completion. The suggestion has
been made that the federal government build up a backlog of such
projects which could be initiated on short notice. While this proposal
has some merit in principle, the practical difficulties involved are
formidable. Once the basic plans for construction had been com
pleted, local pressures would be exceedingly strong to embark upon
such projects, regardless of the state of the economy. Moreover, it
is highly doubtful that such programs could be used in a truly
countercyclical manner, inasmuch as they would probably be very
difficult, if not impossible, to discontinue once the need for addi
tional stimulation to the economy had passed.
In view of these considerations, any overt fiscal policy action to
dampen cyclical fluctuations should be confined primarily to varia
tions in tax rates rather than changes in public spending programs;
but even this approach involves some important practical difficulties,
stemming largely from the nature in which tax legislation is con
ceived and passed under our form of government. Some observers
have suggested that this difficulty could be overcome through ad
ministrative variation in tax rates to counter cyclical trends, such
as vesting additional authority in the President, Such proposals do
not seem to be feasible, or desirable, under our form of government.
The delegation of such great authority to one man, by transferring
a traditional legislative function to the Executive, would not only
represent a radical change in our governmental system but would

210

THE TREASURY ANSWERS

also greatly increase the opportunity for use of the taxing power for
political purposes.
These considerations do not imply that our only alternative is
to attempt to achieve a rigorous balance in the budget, year in and
year out. The goal of a surplus in the budget during prosperous
periods and, on the average, over a longer period of time also is
highly desirable. Moreover, in view of large automatic swings in
tax receipts and spending over the business cycle, budget deficits
of moderate size are probably unavoidable — and, indeed, desirable
— during periods of declining business activity.
Consequently, serious consideration should be given to operating
under some variation of the stabilizing budget proposal; year in and
year out, budget policy would be geared to the attainment of a sur
plus under conditions of strong business activity and of relatively
complete use of economic resources. On this basis, during a reces
sion, the automatic decline in revenues and increase in expendi
tures — reflecting in part the operation of the so-called "built-in
stabilizers** — would generate a moderate deficit. In prosperous
periods, tax receipts would automatically rise, and certain types of
spending would contract, producing a surplus. Then, over the period
of a complete business cycle, a surplus for debt retirement could
be achieved without the disrupting effects of attempts to balance the
budget in recessions. Variations in tax rates or spending programs
for cyclical purposes would thus be kept to a minimum, although
conditions might well arise in which such variations would be de
sirable.
The technique of aiming for moderate surpluses in inflationary
periods and then of permitting automatic declines in revenues and
increases in spending to provide the major contribution of fiscal
policy in fighting recessions has been criticized on two bases. In
the first place, it is sometimes argued that the automatic shift in
the budget position during a recession will not create a sufficiently
large deficit to be meaningful in promoting economic recovery.
Before this criticism can be evaluated, it is important to understand
that the impact of fiscal policy on over-all demand during; a given
period of time should be measured not by the absolute size of a
federal surplus or deficit but by the extent of the net shift in the
government’ s fiscal position during that period of time. Thus, an
automatic shift from a $6 billion surplus to a balanced position, or
from a $3 billion surplus to a $3 billion deficit, provides approxi
mately the same amount of stimulation to total demand as a shift
from a balanced budget to a $6 billion deficit, or from a $2 billion
deficit to an $8 billion deficit. And it should again be emphasized
that, as long as the avoidance of inflation continues to be our major
long-run stabilization problem, the achievement of a net surplus
over a period of time greatly reduces the burden that must be borne

QUESTION I

211

by monetary policy in combating inflation. Moreover, the achieve
ment of such a surplus would minimize difficulties involved in debt
management, inasmuch as the public debt gradually would be de
creasing rather than rising,
A second major criticism of the stabilizing budget approach (in
which primary reliance is placed upon the operation of the built-in
economic stabilizers) emphasizes the time required to move auto
matically from a surplus to a deficit in the federal budget. Again,
primary emphasis should be placed on the extent of the net shift in
the budget position rather than the early attainment of a deficit in
the budget. Moreover, experience with the built-in stabilizers in
1957-58 indicates clearly that automatic shifts toward deficit in a
recession do indeed occur rather quickly and in large amounts.
It should be recalled that, during this period, the peak of business
activity preceding the recession was reached in the third quarter of
1957, The trough of the recession was reached early in the second
quarter of 1958, Throughout this period, the built-in budget stabiliz
ers were operating strongly, as is shown in the attached table.
Between the third andfourth quarters of 1957, the federal govern
ment’ s position on national income and product account (the most
useful measure of the contribution of fiscal policy to over-all de
mand) moved from a net surplus of $2.6 billion to a net deficit of
$0.9 billion, representing a total expansive shift of $3,5 billion.l
This shift occurred even though federal purchases of goods and ser
vices declined by $600 million. The mainfactors contributing to the
movement from net surplus to net deficit were a $2,1 billion decline
in corporate income tax accruals and a $1,2 billion rise in trans
fer payments to persons, particularly unemployment compensation.
It was not until the first quarter of 1958 that overt fiscal actions
to stimulate recovery, including a tax reduction and a large build
up in federal spending programs, came under serious discussion,
(In its Report dated February 27, 1958, the Joint Economic Com
mittee recommended an acceleration of certain federal spending
programs, but counseled against a tax reduction at that time,) By
this time, however, the federal government’ s net deficit on income
and product account (on an annual rate basis) had risen to $8,1
billion, representing a net expansive shift of $10,7 billion from the
third quarter of 1957, Although government purchases of goods and
services had risen by $600 million over the period as a whole, the
major factors in the $10.7 billion shift toward deficit were declines
of $4.9 billion in corporate tax accruals and $1,4 billion in personal
income tax receipts and a $2,4 billion rise in transfer payments to
persons.
^All figures cited are seasonally adjusted annual rates.

THE TREASURY ANSWERS

212

It is also significant that the major built-in stabilizers (indivi
dual and corporate income taxes) reversed their movement in the
second quarter of 1958; which marked the lowpoint of the recession,
and rose strongly thereafter. Transfer payments to persons con
tinued to rise through the third quarter, but declined in succeeding
quarters. This experience indicates that the built-in stabilizers re
act quickly at both the downward and upward turning points of the
business cycle. On the other hand, it should be noted that federal
spending for goods and services andgrants-in-aidto state and local
governments, reflecting the major overt spending programs to
counter recessionary trends, did not rise significantly above the
levels of the third quarter of 1957 until after the trough of the reces
sion had been reached in April 1958.
Thus, the experience in the recession of 1957-58 lends strong
support to the judgment that automatic shifts in the federal govern
ment’ s fiscal position can provide a powerful and timely stabilizing
force in our free enterprise economy. Moreover, this experience
demonstrates the slowness with which overt fiscal actions operate
and the possibility that they will have perverse consequences because
their effectiveness is delayed and their reversal is difficult. If the
tax cuts or speed-up in federal spending programs advocated by
some observers in early 1958 had been put into effect, this per
versity, other things equal, would have been even more pronounced
and the budget deficit for fiscal year 1959, which totaled $12.4 bil
lion, would have been considerably larger. Although situations may
well arise in which discretionary changes in tax and spendingpolicies
will be desirable in order to help dampen pronounced cyclical
swings, it seems clear that we should continue to place major re
liance on the built-in flexibility in the federal fiscal position.

QUESTION II
Should changes in the tax structure be made for the pur
pose of increasing the effectiveness of the financial sys
tem?

ANSWER II
The basic function of the tax system is to provide revenues to
meet budgetary requirements and to distribute as equitably as pos
sible the burden of the cost of government. In the early days of our

T A B L E 1 -1
F e d e r a l G o v e r n m e n t R e c e i p t s an d E x p e n d it u r e s
o n N a t io n a l I n c o m e an d P r o d u c t A c c o u n t s *
( B i l l i o n s o f d o l l a r s a t s e a s o n a l l y a d ju s t e d a n n u a l r a t e s )
1957
1958
3rd
: 4th
: 2nd
: 3rd
1st
: 4th
q u a r t e r : q u a r t e r q u a r t e r : q u a r t e r : q u a r t e r :q u a r t e r
$ 8 2 .5

$ 7 9 .7

$ 7 5 .4

$ 7 6 .5

$ 7 9 .4

$8 3 .1

3 7 .6
2 0 .2

3 7 .4
1 8 .1

3 6 .2
1 5 .3

3 6 .3
16.1

3 7 .1
18.1

3 7 .4
2 1 .0

1 2 .3
1 2 .4

1 2 .0
1 2 .2

1 1 .7
1 2 .2

1 2 .0
12 .1

1 1 .7
1 2 .5

12.1
12 .6

7 9 .9

8 0 .6

8 3 .5

8 7 .4

9 0 .0

9 1 .4

P u r c h a s e s o f g o o d s an d s e r v i c e s

5 0 .0

4 9 .4

5 0 .6

5 1 .8

5 3 .7

5 4 .3

T r a n s fe r p a y m en ts
T o p erson s
F o r e i g n (n e t )

1 7 .2
1 6 .0
1 .2

1 8 .7
1 7 .2
1 .4

1 9 .6
1 8 .3
1 .2

2 1 .7
2 0 .4
1.3

2 2 .2
2 1 .0
1.2

2 2 .2
2 0 .6
1.6

4 .2
5 .8

4 .2
5 .7

4 .8
5 .6

5 .4
5 .5

5 .6
5 .5

6 .0
5 .7

2 .8

2 .6

2.9

3 .0

2 .6

-.9

-8 .1

- 1 0 .9

-1 0 .6

- 8 .2

-3 .5

- 1 0 .7

- 1 3 .5

- 1 3 .2

- 1 0 .8

F e d e r a l g o v e rn m e n t r e c e ip ts
P e r s o n a l ta x a n d n o n t a x r e c e i p t s
C o r p o r a t e p r o f i t s ta x a c c r u a l s
I n d i r e c t b u s i n e s s t a x an d n o n t a x
a c c r u a ls
C o n t r ib u t io n s f o r s o c i a l in s u r a n c e
F e d e r a l g o v e r n m e n t e x p e n d itu re s

G r a n t s - i n - a i d to s t a t e a n d l o c a l g o v e r n m e n t s
N e t i n t e r e s t p a id
S u b s id i e s l e s s c u r r e n t s u r p lu s o f
g ov ern m en t e n te r p ris e s
S u r p lu s o r d e f i c i t ( - ) o n i n c o m e an d
produ ct accoun t
C u m u la t i v e c h a n g e f r o m 3 r d q u a r t e r o f 1957
* D a ta a s o f N o v e m b e r I 9 6 0 .

214

THE TREASURY ANSWERS

federal income tax, revenue legislation was primarily directed to
obtaining the necessary funds for the operation of the government
through tax laws which were designed to be certain and simple, to
impose the burden equitably, and to permit the collection of rev
enues with a minimum of cost. Tax rates were low and the total
federal revenues constituted such a small proportion of the Gross
National Product that only limited attention was required to be given
to the question of the comparative economic effects of a particular
tax. Today there is necessarily a different emphasis in appraising
tax legislation. The tax structure must also be evaluated in terms
of its impact on the economy, including the financial and credit
system.
The present magnitude of the tax burden emphasizes the impor
tance of the tax structure to the effectiveness of the financial system
and the general performance of the economy. In the current fiscal
year (1960-61), it is estimated that the federal government will col
lect from individuals and businesses about $97.1 billion, or an
amount equal to about one-fifth of the Gross National Product and
one-fourth of the national income. The bulk of this sum represents
amounts collected to pay for the 1961 Budget expenditures. The
balance consists of taxes collected to maintain the trust funds,
through which the social security and highway construction pro
grams are financed. In addition state and local taxes together add
almost $40 billion to the nation’s tax bill.
In discussing possible future changes in the tax structure, it is
important to recognize that the Internal Revenue Code of 1954 made
many structural changes which reduced the deterrent effects of the
federal tax system on the economy. These structural changes in
cluded more realistic depreciation allowances, more liberal carry
over of business losses, better integration of corporation and indivi
dual taxes through partial relief from double taxation, more realistic
and favorable treatment of earnings accumulations by closely held
business, sounder rules for the treatment of corporate distributions,
as well as many others. These structural changes reduced taxes
annually by $1,4 billion. Other changes in 1954 brought the total
reduction to $7.4 billion annually. These changes included the elim
ination of the excess profits tax which reduced the nation’ s tax bur
den by $2 billion; reductions in excise taxes which accounted for $1
billion; and reductions in individual income tax rates which amounted
to $3 billion.
In addition to the $3 billion reduction resulting from lower individ
ual rates, individuals shared to a substantial extent in the s a v in g s
from the excise tax reductions as well as in the benefits provided by
the structural changes in the tax laws. These changes allowed in d iv id
uals to retain more of their earnings. Some of the changes in par*

QUESTION II

215

Substantial relief for small business was provided by the Small
Business Tax Revision Act of 1958, including more liberal loss de
ductions for investors in certain small business corporations, a
further extension of the net operating loss carryback to three years,
an additional first year depreciation allowance, an option to pay
estate tax attributable to a small business interestover a period of
ten years, and an increase in the specific exemption of earnings of
a small business which may be accumulated without being subject
to tax on improper accumulation of surplus. In addition, legislation
in 1958 permitted certain small corporations at their option to be
taxed much like partnerships, thus removing the double tax on divi
dends. This option also helped to eliminate tax considerations as a
factor in the choice of legal form in conducting business.
All these tax changes are believed to have made a substantial
contribution to our economic development in recent years. To meet
the needs of a fast changing economy during the next decade, we will
have to review the tax system methodically to determine possible
changes which might help to reduce the adverse or distorting effects
of taxes on capital markets and on the allocation of resources and
also to determine those changes which will encourage individuals to
invest their savings in new and expanding enterprises.
In its statement on the mission andpolicy issues assigned to Task
Force B, the Commission on Money and Credit cites a number of
specific structural areas which are of special interest in considering
the effect of the tax structure on the flow of savings, on the mobility
of capital, and on business financing. Some of these areas as well as
related topics are discussed briefly below.
Capital Gains
Capital gains have traditionally borne a lower tax because they
have special characteristics and because taxation has a deterrent
effect on the sale of appreciated investments. Even the present re
duced rate of tax on capital gains has various undesirable results,
including a freezing effect on the sale of capital assets and on the
flow of investment funds. The proper tax treatment of capital gains
remains an important and complex problem involving matters of
definition, holding periods, loss offsets, realization rules, and many
others, as well as the applicable rates of tax.
D i s c u s s i o n s o f th e c a p ita l g a in s p r o b l e m f r e q u e n t l y a s s u m e th a t
c a p ita l g a in s a r i s e m a i n l y th r o u g h th e a p p r e c ia t io n o f s e c u r it ie s o r
r e a l e s t a t e . S u c h in v e s t m e n t s a r e i m p o r t a n t s o u r c e s o f c a p ita l
g a in s . O v e r th e y e a r s , h o w e v e r , c a p ita l g a in s t r e a t m e n t h a s b e e n
a c c o r d e d t o a c o n s id e r a b le n u m b e r o f s p e c ia l f o r m s o f in c o m e .
T h e r e a r e p r o p o s a l s t o e x te n d s i m i l a r t r e a t m e n t to s t i l l o t h e r f o r m s
o f i n c o m e . In th e a r e a o f c o r p o r a t e d i s t r i b u t i o n s , t h e r e a r e P r(^ ~
le m s o f d is t i n g u i s h i n g b e tw e e n d iv id e n d s w h ic h a r e ta x a b le a s o r d i

216

THE TREASURY ANSWERS

nary income and the return of investment on liquidation of an enter
prise which is treated as capital gain. Any basic change in the struc
ture of the capital gains tax, such as a substantial reduction in the
tax to minimize the so-called *locked~in* effect on realized gains,
would add to the pressures and to tax avoidance problems in this
area.
To minimize the “ locked-in" effect of the tax on realized gains,
various proposals have been made to defer the tax on realized gains
which are reinvested in capital assets. This type of proposal, gener
ally termed the *roll-over* approach, has some precedent in the
existing tax deferment provisions for reinvestment of funds derived
from involuntary conversions and for the replacement of a personal
residence. Moreover, a similar approach has been used recently in
connection with the advance refunding operations undertaken by the
Treasury in June and September 1960, as discussed in the reply to
Question 5. However, extension of the “ roll-over* approach to other
assets would involve many difficulties of practical application.
Depreciation
Depreciation allowances are an important source of funds for
business capital expenditures. Corporate depreciation is nearly
twice the amount of retained corporate earnings at present levels.
Both the adequacy of depreciation funds and their continuous flow
into investment are important factors in our efforts to achieve
balanced economic growth. The Treasury is in favor of liberalizing
business approaches to depreciation for tax purposes; the question
is how to achieve such liberalization. Since significant short-run
revenue effects are involved in the timing of depreciation, one of
the major problems in speeding up depreciation allowances is how
to minimize short-run revenue losses.
The Treasury is convinced that liberalized depreciation pro
cedures can make a major contribution in neutralizing the deterrent
effects of high tax rates on investment. Properly designed liberalized
depreciation would have the special characteristic of providing its
benefits to those who invest in productive plant and equipment, which
in turn plays a key role in the growth of productivity. It would be
of special significance to many small, new, and growing businesses.
Liberalized depreciation allowances would raise the level of
investment in plant and equipment both immediately and over the
long run. This result, with its accompanying increase in employment
and productivity, is a basic objective of depreciation reform* Since
this form of tax revision would be expected to stimulate business
capital expenditures for modernization and cost cutting, it would also
tend to offset somewhat the fluctuations in capital expenditures for
expansion. This increased emphasis on modernization spending in

QUESTION II

217

all of the varying phases of the economic cycle would not only con
tribute to the production of better products at lower costs but would
also help stabilize employment inasmuch as total business capital
expenditures would be less subject to wide cyclical swings.
Important improvements in depreciation allowances were made
in the 1954 Code and in the Small Business Tax Revision Act of
1958. In addition to these legislative changes, the Treasury has made
significant changes in administrative policy in the past several years
that provide greater recognition to technological improvements and
rapid economic changes in the determination of obsolescence and
depreciation rates* Under the new policy, the Internal Revenue Serv
ice will not disturb depreciation deductions unless there is a clear
and convincing basis for change.
Earlier this year (1960) the President recommended to the Con
gress legislation which would treat the income from the sale of de
preciable business property as ordinary income, rather than as a
capital gain, to the extent of the depreciation deduction previously
taken on the property. An important objective of such legislation was
to make it possible for revenue agents to accept more readily busi
ness judgments of the taxpayers as to the useful life of depreciable
property. With the possibility removed of converting ordinary in
come into capital gain through excessive depreciation deductions,
depreciation would then be primarily a matter of timing. In the
absence of such corrective change in the capital gain rules, adminis
trative decisions to permit faster depreciation would not only im
pair revenues but also encourage artificial and wasteful transactions
in depreciable property. Problems of equity would also arise.
The proposed legislation on capital gains would facilitate better
administration of the existing law and would also contribute to a
better climate in which to consider further legislation.
The Treasury is now conducting a survey of the depreciation
practices and opinions of American business. This study, in which
the congressional tax committees have expressed interest, is de
signed to obtain a better factual basis on which to evaluate further
proposed changes for the liberalization of depreciation allowances.
Double Taxation of Dividends
The 1954 Internal Revenue Code provided partial relief from
double taxation of dividends through an individual dividends-received
exclusion and credit. In so doing, it recognized the fact that under
the existing tax structure earnings of a corporation are taxed twice
— once as corporate income and again as individual income when
paid out as dividends to stockholders. This double taxation results
from the fact that dividends, unlike wages or interest, do not

218

THE TREASURY ANSWERS

constitute a deduction to the corporation. In spite of some uncer
tainty about the incidence of the corporation income tax, there is a
consensus that some part of its aggregate burden rests on the cor
poration, thus making dividend income subject in fact to some degree
of double taxation.
In addition to the question of fairness involved, this double taxa
tion is believed to have had unde sir able effects on equity investment
and on the choice of corporate management as between debt and
equity financing.
The present provisions for partial relief from double taxation
are a modest step toward correcting these problems. In recent
years proposals have been considered by the Congress to repeal
the existing partial relief from double taxation. The Treasury has
opposed such legislation.
Withholding on Dividends and Interest
During the 86th Congress the Senate Finance Committee instruc
ted the staff of the Joint Committee on Internal Revenue Taxation,
in cooperation with the Treasury, to study the possibility of with
holding tax on dividend and interest income as a means of dealing
with the underreporting of these types of income on tax returns.
Studies to date indicate that it would be extremely difficult, if not
impractical, to institute an adequate withholding system for interest
payments at this time. While the mechanics of withholding are less
difficult for dividends, here, too, there are a number of difficult
problems,
A significant portion of dividend and interest payments is
received by individuals not required to file income tax returns, nontaxable individuals filing returns, and tax-exempt organizations.
Withholding would work a hardship on these groups, particularly for
elderly and retired persons, many of whom are in the low-income
brackets and would not owe any tax. They would have to apply for
refunds and would undoubtedly experience some delay in receiving
their full income.
From the standpoint of proper administration, a withholding
system would appear to require dividend and interest payers to
furnish a form similar to the W-2 form used with wages. However,
this would impose heavy burdens upon payers of dividends and in
terest and would add appreciably toth eco 3to f dividend and interest
disbursements. The increased costs would be particularly significant
where the amount of these payments to individual depositors or
stockholders is small. In many instances there are interposed be
tween the payer and the recipient a number of levels or tiers, such
as transfer agents, nominees and fiduciaries. In addition, there is
a large turnover in shareholder accounts.

QUESTION II

219

Without a W-2 type form, the Internal Revenue Service would be
faced with a serious problem. The Service would no doubt be pres
sured to make refunds promptly, as in the case of wages, but without
the benefit of a simple check against the taxpayer’ s copy of the
withholding form and without time to make an audit of the claimant’ s
tax return.
The development and utilization of electronic data processing
machines, which will facilitate the Service’ s matching of information
returns filed by payers of dividends and interest against the returns
of taxpayers, may provide the solution to the problem of under
reporting, Or, if withholding is considered advisable, these facilities
will make it more practical than at the present time.
Much of the gap in reporting of dividends and interest appears due
to negligence, although some of the failure to report may be willful.
The Treasury last year (1959) calledupon many groups active in the
dividend and interest field to cooperate in an educational program
designed to improve voluntary compliance in the reporting of
dividend and interest income. Excellent cooperation was given by
corporations, banks, and individuals. In addition, the Department of
Justice is cooperating with the Service in a vigorous enforcement
program. There is evidence of the program’ s success from District
Directors* offices, from examination of selected tax returns before
and after the program was initiated, and from the increase in tax
receipts from individuals on nonwithheld income.
Deductibility of Interest
Proposals to disallow the deduction of interest under the federal
corporate income tax have been made from time to time over the
years. Among other related objectives, this type of proposal is
intended to broaden the corporate income tax base, increase rev
enues, and discourage debt financing so as to promote a more reces
sion-proof financial structure for corporate business. More
recently, suggestions have been made to disallow the interest deduc
tion as a means of increasing the cost of borrowing and thus rein
forcing monetary policies.
Since the income tax should generally be neutral in its treatment
of various form s of legitimate business expense, there would be
serious doubt as to the desirability of instituting this kind of tax
change for purposes of monetary or credit control. There would
also appear to be questions as to the effectiveness of the plan as a
credit control device. The proposal would apparently enlarge the
area of double taxation of corporate earnings to include nondeductible
interest. Thus the disallowance of the interest deduction would ren
der debt financing unattractive to both borrower and lender, since
common stockholders would in effect be required to absorb the tax

THE TREASURY ANSWERS

220

burden on income paid to bondholders while the security of a loan
would be reduced because of the prior tax load. There would appear
to be doubt whether the resulting reduced level of borrowing would
be more responsive to increases or decreases in interest rates.
Even if such a plan served to discourage borrowing, the further
question is posed: would it necessarily accomplish the underlying
objective of restraining business expenditures during periods of
inflationary pressures, whether financed by equity issues or
borrowed funds?

QUESTION IE
Does the present size of the federal debt threaten the
attainment of our national objectives so that the govern
ment should strive to reduce it?
ANSWER m
Any judgment concerning the appropriate size of the federal debt
relates primarily to fiscal policy, inasmuch as surpluses in the
federal budget result in a declining debt and deficits result in a
rising debt. As was emphasized in the reply to Question 1, an appro
priate fiscal policy would result in net surpluses in the budget over
the full period of the business cycle, which would be reflected in a
gradually declining public debt. This, in turn, would enable monetary
policy and debt management to make a maximum contribution toward
our national economic objectives.
Although the absolute size of the federal debt ($286.5 billion on
June 30, 1960) does not in itself seriously threaten the attainment
of our national economic objectives, it is important to recognize
(as discussed in the reply to Question 1) that a large debt involves
an economic burden resulting from the taxes that must be levied to
cover the interest payments on the debt. The fact that interest pay
ments are transfer payments, rather than those which exhaust re
sources, does not alter the fact that such expenditures must be
financed by the federal government, either through taxation or
borrowing.
From the standpoint of debt management, the absolute size of
the federal debt, although important, is at the present time less

QUESTION III

221

significant than its unbalanced maturity structure. As is emphasized
in the reply to Question 5, the concentration of the marketable debt
in securities of relatively short maturity can interfere with the use
of monetary and debt management policies as instruments of
economic stabilization. Frequent and large-sized Treasury financ
ings the corollary of a large debt unduly concentrated in short
maturities — make debt management more difficult and interfere
with effective monetary policy actions.

QUESTION IV
How much should debt management policy be relied upon
to achieve our national economic objectives under
varying circumstances?

ANSWER IV
The ability of the American economy to achieve our national
economic objectives, namely, to sustain orderly growth without in
flation, to generate increased employment, to provide sufficient
real capital to finance expansion, and to function as a source of
strength for the entire free world — all of this depends on the main
tenance of responsible financial policies. Debt management is one
of the three main links in the chain of federal financial re
sponsibility. The two strongest links in this chain are a sound fiscal
policy — in terms of the relationship between revenues and expendi
tures — and two, flexible monetary policy administered indepen
dently within government. Without strength in these areas there is
little that debt management alone can do. Combined with effective
fiscal and monetary policies, however, appropriate debt management
can contribute substantially to our over-all financial strength. In
appropriate debt management inordinately increases the burdens on
fiscal and monetary policy.
Debt management policy has three major objectives. First,
management of the debt should be conducted in such a way as to
contribute to an orderly growth of the economy without inflation. In
a period of rapid expansion accompanied by inflationarypressures,
as much of the debt as is practicable should be placed outside of the
commercial banks (apart from temporary bank underwriting) and
should include a reasonable volume of intermediate- and longer-term
securities. In a recessionary period particular care must be taken

222

THE TREASURY ANSWERS

to exercise restraint in the amount of long-term securities issued
in order not to pre-empt an undue amount of the long-term invest
ment funds needed to support an expansion of the economy. A related
aim should be to minimize, as far as possible, the frequency of
Treasury borrowings so as to interfere as little as possible with
necessary Federal Reserve actions or with corporate, municipal,
and mortgage financing.
A second important objective of Treasury debt management is the
achievement of a balanced maturity structure of the debt, one that is
tailored to the needs of our economy for a sizable volume of short
term instruments and also includes a reasonable amount of inter
mediate- and long-term securities. There must be continuous efforts
to issue long-term securities to offset the shortening of maturity
caused by the lapse of time, which otherwise results in an
excessively large volume of highly liquid short-term debt.
A third objective of debt management relates to borrowing costs.
While primary weight must be given to the two objectives just noted,
the Treasury, like any other borrower, should try to borrow as
cheaply as possible. Unlike other borrowers, however, the Treasury
must consider the impact of its actions on financial markets and the
economy as a whole. Consequently, the aim of keeping borrowing
costs at a minimum must be balanced against broader considerations
of the public interest, (For further discussion see the reply to
Question VI.)
These several objectives are not easily reconcilable at all times;
nor can a priority be assigned to one or another of them under all
circumstances.
There is some merit, for example, in the view that Treasury debt
management policy should be geared solely to cyclical considerations
— pressing long-term securities on the market to absorb investment
funds when the economy is expanding and, conversely, issuing highly
liquid short-term securities in a period of recession. Yet in practice
it has proved both impracticable and undesirable to adhere strictly
to this view in disregard of other considerations. The Treasury’s
first obligation is to secure the funds needed to meet the govern
ment’ s fiscal requirements; these requirements cannot be postponed,
A pressing need for cash may force it to market short-term issues
even when the economy is expanding rapidly. The constant shortening
in the maturity of the public debt, however, forces the Treasury to
take advantage of every reasonable opportunity to issue long-term
securities despite the cyclical aspect. From a purely housekeeping
standpoint the Treasury needs to do some funding of short-term
debt into longer-term securities whenever market conditions permit.
Similar difficulties arise with respect to following only the objec
tive of keeping borrowing costs as low as possible. Any gain in terms

QUESTION IV

223

of interest cost must be weighed against the loss in terms of eco
nomic effects. For example, aggressive issuance of long-term
securities in recessions, when interest costs are low, would absorb
too large a part of the investment funds needed elsewhere for re
covery and could even prevent desirable reductions in interest
rates; it would unduly increase the burden on monetary policy and
necessitate much greater monetary ease, complicating the sub
sequent problem of curbing the excesses that may develop in a
boom. On the other hand, exclusive reliance on short-term financing
during recessionary periods could create parallel problems that
would result in a large build-up of near-term maturities which might
have to be refinanced in a period of rapid business recovery. More
over, the liquidity represented by the increase in short-term debt,
which would provide considerable scope for a rise in the velocity of
the money supply, might unduly complicate public policy actions to
promote sustainable growth with price stability during the succeeding
business expansion.
One way of minimizing these difficulties during a recession would
be to rely heavily on new Government security issues of inter
mediate-term maturity. Such issues tend to be bought by commercial
banks in their attempts to bolster earnings in the face of slackening
loan demand and falling interest rates. As banks purchase these
obligations with reserves made available by an expansive monetary
policy, bank credit and the money supply tend to grow, thereby help
ing to counter recessionary pressures. If in a later period of busi
ness expansion interest rates rise and market values of these
intermediate-term issues decline, the continued holding of the
obligations would become more attractive to banks that wish to
avoid taking losses. The holding of intermediate-term issues by
banks would help reinforce a monetary policy designed to prevent
total spending in the economy from rising at an unsustainable pace.
Clearly, the Treasury must follow a middle course in attempting
to reconcile its various objectives. Its concern with the public
interest requires that minimum reliance be placed on short-term
financing during periods of expansion. Similarly, financing in a
recession should be handled so as to minimize interference with
national efforts to promote economic recovery without unduly in
tensifying the subsequent problem of preventing an unsustainable
upsurge in economic activity. At all times, attention should be given
to the objective of borrowing as cheaply as possible consistent with
the other objectives. Finally, constant effort must be directed toward
achieving a balanced maturity structure of the debt.

THE TREASURY ANSWERS

224

QUESTION V
What debt structure should the Treasury have as a
target?
ANSWER V
Treasury debt management should have as one of its principal
goals the achievement of a balance in the maturity structure of the
public debt. A balanced maturity structure is one that is tailored to
the needs of our economy for a sizable volume of short-term instru
ments and also includes a reasonable amount of longer-term securi
ties. Continued issuance of long-term securities is essential to offset
the shortening of maturity caused by the lapse of time, which other
wise results in an excessively large volume of highly liquid short
term debt. Minimizing undue concentration of maturities, par
ticularly in the short-term area, can provide the Treasury with much
needed flexibility so that in its operations it can avoid interfering
with effective monetary policy,
A balanced maturity structure of the public debt is not easily
achieved. Long-term securities, with the passage of time, grow
constantly shorter and bring about a relentless tendency toward a
rising short-term debt. Despite persistent efforts in recent years to
offer longer-term securities (about $50 billion maturing in over five
years were sold from the beginning of 1953 through mid-1960), as
of June 30, i960, almost 80 percent of the marketable public debt of
$184 billion matured within five years, as contrasted with less than
50 percent at the end of 1946 and 67 percent in December 1952,
Moreover, if the total amount of marketable debt does not change,
and no securities of more than five years* maturity are issued, the
under-five-year debt will swell to nearly 85 percent of the total by
the end of 1964. Obviously this maturity structure — both present
and prospective — is far too heavily concentrated in the under-fiveyear maturity area. However, the $70to $80 billion of debt maturing
within one year does not appear to be a major problem since the
liquidity needs of the economy require a very short-term debt of
this general magnitude; the real problem is the excessive amount
of securities maturing in one to five years.
The undue and growing concentration of the public debt in the
under-five-year area has important implications b o t h for the money
and capital markets and for the economy as a whole. If the composi
tion of the debt is permitted to grow continuously shorter, Treasury
refunding operations will occur more frequently and in large*1
amounts. The Treasury might often be forced to refund excessively
large maturities under unfavorable conditions with unduly large

QUESTION V

225

repercussions on the structure of interest rates. This type of re
funding would increase the cost to the Treasury and would tend to
interfere with orderly marketing of corporate and municipal bonds;
it might also disrupt the market for real estate mortgages. More
over, the emergence of a larger amount of highly liquid, short-term
government debt could create inflationary pressures. Excessive
liquidity in the economy and frequent and large Treasury operations
in the market can unduly complicate the flexible administration of
Federal Reserve credit policies essential to sustainable growth.
A balanced maturity structure of the debt, therefore, can make a
major contribution toward sound financial policy by reducing the
frequency, size, and adverse consequences of Treasury financings,
by helping to forestall potential inflationary pressures, and by en
abling monetary policy to function more effectively.
The clear need for a more balanced maturity structure of the
marketable public debt in turn raises the question as to the possible
means of accomplishing the necessary debt extension. Advance re
funding is a promising method of bringing about significant debt
lengthening, so essential in the light of the unbalanced debt structure.
In advance refunding all individual and other holders of selected
issues of existing U.S. Government securities are offered the oppor
tunity to exchange their securities, some years in advance of
maturity, for new securities on terms mutually advantageous to the
holder and to the Treasury, By this management technique the debt
could be substantially lengthened with a minimum of adverse market
and economic effects. Alternatively, the Treasury could offer long
term bonds for cash or in exchange for maturing issues of Govern
ment securities. Although both of these techniques may be useful
under certain circumstances, under present conditions (1960)
advance refunding appears to be the most effective device for
achieving a better maturity structure of the marketable public debt.
The relative advantages of the advance refunding technique are
discussed in considerable detail in, Debt Management and Advance
Refunding. U.S. Treasury Department (Washington, D.C., September
1960,)1 In brief, advance r e f u n d i n g avoids absorbing funds that other
wise would be available for investment in other types of long-term
securities, has much less market impact than a cash offering (or
an exchange at maturity), and on balance, the cost is significantly
loss than if an equal amount of long-term securities were sold for
cash or in direct exchange for maturing issues.
In recent weeks (September 1960) the Treasury successfully
used the advance refunding technique to achieve a better ma i y
structure and ownership distribution of the marketable public de ,

as an Appendix to Part II.
Digitized for ^Reprinted
FRASER

226

THE TREASURY ANSWERS

Total subscriptions of $3,972.1 million (including $3,388.4 million
from public holders and $583,7 millionfrom Government Investment
Accounts) were received to three issues of 2 0 -to 38-year 3^percent
Treasury bonds included in an offering by the Treasury to the
holders of four issues of outstanding 7- to 9-year 2^percent
Treasury bonds, aggregating $12.5 billion. All subscriptions to the
3^percent bonds were allotted in full and the bonds were issued on
October 3, 1960,
These results of this first major effort to lengthen the maturity
of the marketable public debt through advance refunding were very
satisfactory. As indicated, some $4,0 billion of securities scheduled
to mature in 7 to 9 years were shifted to long-term issues maturing
in 20 to 38 years. This increase in the amount of long-term bonds
outstanding is especially significant when viewed in comparison with
total sales of only $9.2 billion of over 15-year securities in the
entire postwar period. As a result of the advance refunding, the
amount of outstanding bonds with maturities beyond 15 years in
creased by nearly one-half, from $8.5 billion to $12.5 billion.
Correspondingly, the average maturity of the marketable public
debt was extended from approximately 50 months to 57 months.
This substantial amount of debt extension was achieved with a
minimum of market impact as evidenced by the relatively small
changes in the prices of the affected issues at the time of the
announcement of the offering, by the small amount of market churn
ing that occurred, and by the absence of any appreciable effect on
the market for long-term Government, corporate, or municipal
bonds. This evidence serves to confirm the judgment that the advance
refunding technique permits substantial debt extension with a mini
mum of adverse market and economic effects. The modest amount
of market trading in the affected issues also suggests that specula
tive purchases were minimal. The absence of speculation, in turn,
indicates that the participants in the exchange were primarily long
term investors who were interested in extending the maturity of
their holdings.
Another question frequently raised and directly related to the
appropriate debt structure is that of the proper distribution of the
debt between marketable and nonmarketable form s. The nonmarketable debt is essentially in two forms — savings bonds and special
issues to the trust funds. Almost half of the nonmarketable debt is
in the form of savings bonds, consisting of over $42 .5 billion of
Series E and H Bonds (which are the only types now being sold) and
less than $5 billion of the older Series F, G, J and K Bonds (which
are now in the process of being redeemed). Most of the remaining
nonmarketable debt is in the form of special issues to the various
Government trust funds and agencies. These funds are invested in
accordance with the legal requirements for each account. Most of

QUESTION V

227

these trust fund investments represent the re-investment of individ
uals* savings placed in Social Security, Veterans Life Insurance,
Railroad Retirement, and Government Employee Retirement Funds.
The nonmarketable debt also includes about $7 billion of investment
bonds, the bulk of which grew out of the 1951 issuance of Series B
Investment Bonds in exchange for 1967-72 marketable bonds at the
time of the Federal Reserve-Treasury Accord.
The existence of both savings bonds and special issues facilitates
debt management. It is obvious that there would be serious objections
to placing the investments of Government Investment Accounts en
tirely in marketable securities. There are very large monthly
fluctuations in investment requirements of the trust funds which
would necessitate equally sizable purchases or sales. In the present
Government securities market, sales or purchases in such sizable
amounts would cause violent price fluctuations and disrupt the
market.
Nor is there any question about the needfor a strong and vigorous
program to attract savings from millions of Americans through the
E and H Savings Bond program. The average dollar invested in E
Bonds stays with the Treasury for approximately seven years,
considerably longer than the average dollar invested by the general
public in marketable securities. Since the end of World War II
financing the volume of E and H Bonds outstanding has grown from
$30 billion to $42,5 billion, representing one area in which there has
been significant Treasury success in selling Government securities
to long-term savers.
In addition to its value as a debt management instrument, the
savings bond program has undoubtedly added to the net amount of
savings generated in the United States during the past 20 years. This
has been accomplished largely as a result of the payroll savings
plan, through which more than 8 million American workers are now
buying bonds on a regular basis,
Nonmarketable securities are entirely appropriate in the struc
ture of the public debt as far as trust funds and E and H Bonds are
concerned. The demand feature of savings bonds does not constitute
an important threat to the stability of the public debt. Redemption
patterns in savings bonds follow a reasonably predictable course and
are not substantially affected by recessionary trends in the economy.
Sales and redemptions respond only gradually over a period of
months to changed terms or economic conditions.
The Treasury’ s experience with nonmarketable securities in
other than these two areas has led to the conclusion, however, that
the nonmarketable instrument is subject to serious reservations in
broader application* During World War II and for a number of years

THE TREASURY ANSWERS

228

therafter, the Treasury sold nonmarketable savings notes running
two or three years to maturity but redeemable on demand at a
predetermined schedule of redemption values. These securities were
helpful, during a period when the Government securities market
was supported by the Federal Reserve, in assisting corporations to
invest their tax reserves. With the advent of a freer market in 1952
and 1953 it became increasingly apparent that, since it was not
administratively feasible to revise the terms of savings notes from
month to month, the Treasury would always be in the awkward posi
tion of either experiencing a flood of sales and small redemptions
at a time when savings note rates were well above market rates for
comparable maturities, or — more serious — wouldfind itself faced
with large redemptions and negligible sales at a time when market
rates became relatively attractive. As a result, note sales were
discontinued in the latter part of 1953.
Although short-term rates fluctuate much more widely than do
rates on longer-term securities, the Treasury also reached the
conclusion two years ago that it was inadvisable to continue to sell
the types of savings bonds designed for larger investors (Series F,G,
J and K). Like savings notes, these securities were popular during
World War n but became increasingly less adaptable as market
movements were amplified in more recent years. Again, heavy re
demptions of F and G Bonds (and the successor J and K Series)
typically occurred when long-term interest rates were high, and
under such conditions their refinancing constituted a problem to the
Treasury, As a result, their sale was discontinued in 1957 and the
amount outstanding has shrunk from $23 billion at the peak in 1951
to less than $5 billion at the present time.
On balance the amount and types of nonmarketable debt appear
to be an appropriate part of the present debt structure. There seems
to be no clear case for altering the present relationship between the
marketable and nonmarketable debt although, as indicated, the
savings bond program plays a particularly vital role in contributing
not only to a better structure of the public debt but also in con
tributing to better thrift habits among millions of Americans.

QUESTION VI
Should the Treasury attempt to minimize the interest
cost of the debt?

QUESTION VI

229
ANSWER VI

The objective of keeping borrowing costs at a minimum is,
as pointed out in the answer to Question 4, a major goal of debt
management. It should be reiterated, however, that the Treasury
must consider the impact of its actions on financial markets and
the economy as a whole. Consequently, the aim of keeping borrow
ing costs at a minimum must be balanced against broader con
siderations of the public interest. Against any gain in terms of
lower interest cost there must be weighed the possible loss in terms
of economic effects. For example, excessive issuance of long-term
securities in recessions when interest costs are low would absorb
too large a part of the investment funds needed elsewhere for re
covery and could even prevent desirable reductions in interest rates.
It would unduly increase the burden on monetary policy and necessi
tate much greater monetary ease, which would complicate the prob
lem of curbing the excesses that might develop later in a boom.
In this context of the broader public interest, however, eco
nomical borrowing remains an important goal of Treasury debt
management. The Treasury does not agree with the view that interest
payments on the debt are of no real significance for the economy as
a whole — a too narrow view premised on the point that interest
payments are not exhaustive in terms of economic resources but
merely represent transfers from taxpayers to bondholders. As noted
in the reply to Question 1, such transfer payments do exert important
economic effects, particularly as related to incentives in the private
sector of the economy.
On the other hand, the significance of the interest payment on the
public debt — now estimated at about $9 billion per year — should
not be overstressed. The average rate paid is still only about 3 1/4
percent, and the total amount of interest is only about 2 1/4 percent
of current national income — not much higher than 20 years ago and
somewhat lower than in the years 1946-50. Moreover, about 30 per
cent of the interest on the public debt is paid on securities held by
the Federal Reserve banks — which return to the Treasury net
earnings after dividends and surplus adjustments — and on securi
ties held in Government investment accounts. In addition, a substan
tial portion of the interest paid on securities held by commercial
banks and business corporations is recouped by the Treasury through
the 52 percent income tax which applies to these investors.
Although Treasury interest rates are higher now than for a num
ber of years, the rates are among the lowest for any central govern
ment in the free world. Both here and abroad interest rates have
risen substantially during the entire postwar period in those nations
which rely upon free market processes and effective monetary and

230

THE TREASURY ANSWERS

credit policies for promoting economic stability. The greatest de
gree of price stability has prevailed in the countries where interest
rates (and debt costs) have been permitted to respond to the impact
of market forces and an appropriate monetary policy.
Too much emphasis on minimizing interest costs as a goal of
debt management can easily lead to long-run difficulties. One of the
major dangers is that excessive use will be made of short-term
securities, on which the interest rate is usually lower than on
longer-term issues. This use of short-term issues can lead to a
piling up of short-term debt which later might severely complicate
debt management and monetary policy. Also, experience has clearly
demonstrated that reliance on money creation to prevent interest
rates from rising during a period of strongly rising business activity
and credit demands can only result in inflation. The goal of holding
down interest charges on the debt cannot be allowed to take prece
dence over the important objectives of promoting sustainable eco
nomic growth with stable prices.
In addition, it may be noted that interest minimization in itself
may be variously defined. There is general agreement that the
Treasury should always strive to market a particular issue at the
lowest possible rate of interest. But choosing between types of
issues on a cost basis alone involves difficult market judgments
as to future rate movements. If long-term rates are currently lower
than short rates but falling, minimization of cost over the long run
would suggest temporary resort to short-term financing. Yet con
tinued concentration of financing in the short area ratchets the costs
in that area and may on balance result in a higher interest cost over
a period of time. There is a constant danger that too much emphasis
on interest minimization per se will lead to overuse of short-term
financing involving both upward pressures on costs and, even more
important, the complications noted previously with regard to effec
tive debt management and monetary policy.
Apart from interest minimization from a cost standpoint, it may
be noted that while the Treasury does not have specific aims with
respect to influencing the level or structure of interest rates in its
debt operations, it should and does take into account the differing
impact of alternative borrowing programs on interest rates in the
context of the current economic conditions.

QUESTION VII

231
QUESTION VII

Should Congress reduce or expand the Treasury’ s
authority to manage the public debt and market new
issues?

ANSWER VII
The authority granted by the Congress to the Treasury for
management of the public debt is quite broad and, except for the
4 1 /4 percent interest rate limitation on new marketable bond
issues, the present authority is sufficiently broad to permit any
debt management operations presently envisaged. The Treasury
regularly reviews its statutory authority, however, and suggests
changes when they are necessary. In 1959, for example, such a
review resulted in congressional action broadening the possible
scope of Treasury operations in the debt management field even
though the most important request — removal of the interest rate
ceiling — was not granted.
Congress provided in 1790 that the President had the power to
borrow money on the credit of the United States for specific pur
poses including the payment of the foreign debt, funding of the exist
ing domestic debt, and assumption of the debts of the several states.
This authority was delegated by the President to the Secretary of
the Treasury, Alexander Hamilton, and this power continued, in
general, until the early Civil War period. In 1861 the Congress
directly authorized the Secretary of the Treasury to conduct the
financing of the War through the issuance of bonds, 1-year notes,
and demand notes.
P rior to World War I, however, the Secretary of the Treasury
had little discretion in the actual carrying out of public debt opera
tions and Congress typically specified the terms and conditions of
each new issue of Government obligations. In World War I, however,
with the tremendous expansion of the debt, Congress recognized the
increasing impracticability of specifying terms and conditions of each
issue and gave the Secretary of the Treasury much broader authority
to determine all terms and conditions except the total amount of the
debt and the maximum interest rate on Treasury bonds.
The Treasury’ s positions with regard to both the interest rate
ceiling and the dollar amount of the debt limit are well known. In our
judgment, the interest rate ceiling on Treasury bonds has no place
in the financial environment in which the Treasury operates, since

232

THE TREASURY ANSWERS

this ceiling can result in an arbitrary and disadvantageous dis
tribution of new Treasury issues. During most of 1959 and part of
1960 it forced the Treasury to finance within the 5-year area and
thereby contributed to a more distorted, andprobably higher, struc
ture of interest rates throughout the economy than would otherwise
have existed. It remains an important impediment to debt manage
ment in the public interest.
To many observers the congressional insistence on an over-all
limitation of the amount of debt outstanding may also seem arbitrary
and unnecessary. The debt limit, however, represents the only focal
point which the Congress can use to interpret the over-all results
of its decisions to spend money and to levy taxes, and until some
better method is devised for handling the government’ s budgetary
affairs in Congress, a statutory debt limit appears to be necessary
and desirable. The Treasury has consistently urged, however, that
the debt limit should provide sufficient leeway to permit reasonable
flexibility in the timing of its debt management operations in order
always to have sufficient margin to cover contingencies, and the
Congress has generally seen fit to make such provisions from year
to year.
There are other current restrictions on the Treasury’ s authority
in debt management which are entirely appropriate and desirable,
for example, the position that the Congress has taken with regard to
special issue investments of the various Government trust funds.
The authority under which most of the larger funds operate properly
contains specific language providing for a formula for the interest
rate on special issues. The limitations placed in the law on the
amount of funds which the Treasury can borrow directly from the
Federal Reserve System are desirable.
The Treasury also strongly favors the provisions of present law
which permit the issuance of only taxable obligations. Fiscal sound
ness lies more in broadening the tax base and tightening loopholes
than in looking toward greater tax exemption. Although tax exemption
would initially add to the attractiveness of the securities, it would
result in a sizable loss of revenue. Furthermore, the market for
tax-exempt issues is limited to those in high tax brackets; to the
extent that the present supply of tax-exempt securities has already
expanded to meet their needs, any additional supply would have to
find a market among investors to whom the tax-exempt feature would
be of less advantage. Therefore, if the market for tax-exempt
securities were substantially enlarged by the addition of Federal
Government securities, any existing rate advantage of tax-exempts
over taxable issues would tend to diminish. The net result might be
to raise the cost of borrowing to all states and municipalities rather
than to lower materially the cost to the federal government.

QUESTION VII

233

The Treasury is also opposed to plans which would require that
a certain proportion of the public debt be retired each year. The
purpose behind such plans is laudable and the Treasury Department
clearly would prefer to see the long-term trend of the debt to be in a
downward rather than an upward direction, thus permitting greater
growth of the private economy and a lessening of chronic pressures
toward inflation. Nevertheless, debt reduction could not and should
not take precedence in evaluating necessary expenditure programs. It
is not practical to require a certain amount of debt reduction each
year and at the same time enact expenditure and tax programs which
are inconsistent with such a requirement.
Suggestions have also been made from time to time that either the
Treasury’ s authority to manage its trust accounts should be
broadened or that the Treasury should have additional authority to
operate a fund which could help stabilize the market for Government
securities, particularly around the time of new offerings. There may
be considerable merit in such a proposal and the Treasury is con
tinuing to study the problem and its implications for a freely func
tioning Government securities market.
In summary, except for the removal of the 4 1/4 percent interest
rate limitation the Treasury does not need other major changes in
legislative authority at this time. As suggested earlier, from time
to time changes in authority are needed, and in 1959 Congress, in
response to Treasury request, enacted some important debt manage
ment legislation. This legislation included the authority granted the
Secretary of the Treasury to postpone recognition of gain or loss for
tax purposes on advance refunding of Treasury obligations, and per
mission to improve savings bonds terms. These legislative changes
have already proved exceedingly helpful in the execution of sound
debt management.

QUESTION Vin
Within its present legislative authority what changes
should be made to permit the Treasury to market its
new issues on a more satisfactory basis?

234

THE TREASURY ANSWERS
ANSWER VIII

The Treasury has taken full advantage of its present legislative
authority, including changes in such authority enacted in 1959, to
market its issues on the most satisfactory basis. A number of new
techniques have been adopted which have materially added to the
Treasury’ s efficiency in managing the public debt. These include:
(1) increased use of the auction technique as it relates to Treasury
bills; (2) inauguration of regular 6-month and l-y ea r bill cycles in
addition to the traditional 91-day issues; (3) pricing of new Treasury
issues at slight discounts or premiums to permit closer adjustment
to existing market prices; (4) advance refunding of outstanding issues
to provide a better debt structure; (5) reintroduction of callable
bonds; and (6) significant improvements in the savings bond program.
The Treasury is continuing to review these and other debt man
agement techniques. The increaseduse of the auction technique, even
within the Treasury bill area, has not proved conclusively to be
economical in comparison with the offering of fixed-coupon issues.
E^qjerience with callable bonds in the offering of the 4 1/4 percent
bonds of 1975-85 in April 1960 indicates that the Treasury can ac
quire the privilege of callability only at considerable cost in terms
of investor disinterest. Similarly, despite the successful experience
in advance refunding in September 1960 in shifting some $4 billion
of securities maturing in 7 to 9 years into issues maturing in 20 to
38 years, more remains to be done in utilizing this technique to re
lieve the congestion in the 1- to 5-year maturity range.
Within the past year (1960) the Treasury has departed from
earlier practice by re sorting to a cash refunding of maturing securi
ties — under the traditional procedure the holders of the maturing
issues have a pre-emptive right to subscribe to the new securities.
The cash method of refunding is a useful tool of debt management
under particular circumstances, especially when the exchange does
not involve a full roll-over of the maturing securities (that is, some
maturing debt is retired) or when it seems desirable to maintain
closer control over possible speculation by specifying the amount of
new securities of different maturity to be issued. As is pointed out
in answer to Question 9, this method also enables the Treasury to
limit speculation by requiring sizable downpayments and making
percentage allotments among investor classes,
A great many other suggestions of new marketing techniques have
been reviewed by the Treasury. For example, experience with the
new one-year bill indicates that the auction technique cannot satis
factorily be adapted to the offering of longer-term securities without
unnecessarily increasing the costs of debt management. Issuance
of bonds guaranteed as to purchasing power is an unacceptable

QUESTION VIII

235

approach, since it would unduly augment inflationary pressures.
With respect to underwriting of new issues, the device of selling
Government securities to commercial banks by credit to tax and
loan accounts appears to be clearly superior either to procedures
which would involve paying substantial commissions to underwriters
of Government securities or attempting to utilize privately formed
syndicates. The Treasury does not agree with the view that Treasury
marketing could be conducted much more efficiently by substituting
a periodic succession of small issues for larger, more irregular
offerings. Such a device would tend continuously to disturb the
market; investor assurance of additions to supply could adversely
affect demand and tend to ratchet the cost of Treasury financing
since each successive issue would have to be attractively priced,
that is, lower in price (higher in rate) than the then current market.
The Treasury also does not consider feasible the idea of funding
any significant part of the public debt into perpetual issues. Treasury
studies thus far indicate little investor interest in a perpetual bond.
Similarly, a lottery bond, such as that used in the United Kingdom,
would probably add little to the flow of savings, but would largely
divert funds now used to purchase savings bonds.
It should be noted, however, that the marketing of Federal
securities is an ever-changing problem, and the present status of
the Treasury’ s review does not necessarily mean that a change in
the market environment will not produce changes in the Treasury
views. The Treasury would be negligent in meeting its debt manage
ment responsibilities if it failed to keep alert to the requirements
of changing conditions.

QUESTION DC
What changes should be m ad e in the Treasury securities
market to make outstanding securities more readily
transferable?
ANSWER IX
Before entering into any discussion of possible improvements in
the Government securities market it is appropriate to comment,
first, on the functions and characteristics of the market for Treasury
securities as the market exists at the present time (November 1960),
and second, on the performance of the market in terms of these
special qualities.

236

THE TREASURY ANSWERS

Quite obviously, the Government securities market performs a
unique function with respect to both monetary policy and debt
management policy. These policy responsibilities make it par
ticularly important that the market operate with a high degree of
efficiency and that those who participate in it conform to the highest
standards of integrity and concern for the public interest. In
implementing monetary policy, the Federal Reserve should be able
to buy and sell Government securities to effect the needed changes
in bank reserves without fear of disrupting the market. In conducting
its financing operations, the Treasury should be able to rely on the
Government securities market for efficient distribution and absorp
tion of new issues. And finally, the needs of private investors in
Government securities must be met promptly and adequately.
To fulfill these varied purposes the Government securities
market must be broad and active. The volume of trading should be
large enough to absorb offerings of securities of the size that in
vestors wish to buy or to sell. Such a market should also exhibit a
fairly wide range of offers and bids so that new purchasers or
sellers will appear at successively lower or higher quoted prices.
In short, the market must be highly competitive, and those handling
transactions in it must have sufficient capitalization to execute
orders efficiently and without delay. Of equal importance, Govern
ment securities dealers must have access to sufficiently detailed and
sufficiently recent information to provide a firm basis for reliable
judgment and prompt action in performing their primary function of
making markets.
Finally, the Government securities market should grow and
change over the years in response to the changes in our financial
mechanisms and in our economy generally. A rigid market struc
ture, unresponsive to changes in the economy of which it is a part,
would soon be unable to perform its necessary functions.
The present market mechanism for Government securities
exhibits many of the elements of strength required for its successful
functioning. Except under certain exceptional circumstances —
which have been carefully analyzed with a view to correction by both
the market itself and by appropriate government agencies — the
Government securities market has provided an effective medium
through which monetary policy actions as determined by the Federal
Reserve and debt management operations as determined by the
Treasury can be effectuated. From the point of view of investor
needs, Government securities dealers generally maintain adequate
inventories for the service of their customers. They have been able
to complete substantial transactions on very short notice — trans
actions that are believed to be normally far in excess of those
handled on the stock exchange or through the over-the-counter
market in corporate and municipal securities. The market for

QUESTION IX

237

Government securities is in fact the largest market in the country
by a substantial margin; its daily transactions average well over
$1 billion of which, of course, the preponderant part is in Treasury
bills and other short-term securities.
Government dealers have demonstrated that they have the in
tegrity and honesty that is needed in handling very large trans
actions, many of which are concluded without the necessity for
elaborate written arrangements that would seriously impede opera
tions, There is no question, in other words, but that the physical
structure of the market as it currently operates is such that investor
needs — however large — are met promptly and efficiently and at
very little cost.
There is, of course, always room for improvement in the func
tioning of any market. An intensive study of possible improvements
in the Government securities market was undertaken by the Treasury
and the Federal Reserve System as a joint staff project in 1959,
Among other matters, three major criticisms which had been
leveled against the present over-the-counter market in U.S. Govern
ment securities were considered in the course of the study. These
criticism s were: 1) That the market is concentrated in a relatively
small group of primary dealers and therefore is not truly competi
tive; 2) That there is little information about the operations of the
dealer market and no real supervision or formal rules governing its
practices despite its special public interest; and 3) That the dealer
market is highly inefficient in handling small “odd lot” transactions,
and is not especially interested in doing so.
There is no question that the primary dealer market is highly
competitive even though it comprises only about 12 nonbank firms
and 5 bank dealers. There is spirited competition among these
dealers for the available volume of business. Any offer to sell at a
price even slightly below the market is quickly accepted, as are
offers to buy at prices only slightly higher than existing market
levels.
Government securities dealers are principally wholesalers
whose customers consist of several hundred nonfinancial corpora
tions; several thousand commercial banks submitting orders both
for their own account and for customers; other securities brokers
and dealers handling transactions for customers; hundreds of insur
ance companies, mutual savings banks, pension funds, savings and
loan accounts, and other financial groups throughout the country;
special funds of state and local governments; personal trust
accounts; and some individuals of substantial means. These inves
tors and traders who use the market generally are very well in
formed and experienced in the investment field. Each is seeking to
get the best possible rate of return, and each continually compares

238

THE TREASURY ANSWERS

the returns available on Government securities with those on
alternative investments. Also, each of the large investors regularly
uses the services of a number of dealers and constantly evaluates
the relative performance of the dealers with whom he is in contact.
The dealer who succeeds in attracting business of this type must
therefore be able to execute buy and sell orders promptly and
efficiently, and the business must be handled in accordance with
high ethical standards. Furthermore, if he is to attract and hold
customers, his advisory service must stand the test of time.
Each primary dealer has nationwide contacts and some of the
larger firm s maintain branch offices throughout the country, since
broad coverage is essential if sufficient volume is to be maintained.
The responsibilities and risks involved in making primary markets
call for the highest level of professional skill and training. A serious
impediment to an increase in the number of primary dealer firms
has been the small number of qualified and experienced personnel
available to work in a new firm .
There appears to be little real substance to the charge — based
on the relatively small number of primary d ealers— that the dealer
market is not competitive. The customers interviewed in connection
with the Treasury-Federal Reserve Study testified to the high de
gree of competitiveness in the market. It should be noted that the
dealer market is an informal market, not organized in any way, and
it should be noted also that the dealer market is not closed in terms
of its present number; any bank, other institution or individual that
desires to become a primary dealer (with sufficient capital plus a
demonstrated ability and willingness to make a primary market for
Government securities on a national basis) would be free to become
a part of the dealer market, and the Treasury would welcome this
development.
With regard to the second criticism — availability of informa
tion — the Treasury and the Federal Reserve have agreed that more
statistics should be available as to the volume and characteristics of
aggregate positions and transactions. As a result of the recognition
of this need, the Federal Reserve and the Treasury in early i960
undertook a new program of gathering uniform information from the
market in considerably more detail than has heretofore been avail
able. This new information is still being gathered and processed on
an experimental basis and no publication of pertinent aggregate data
will be undertaken until uniformity of the statistics has been
achieved.
The Treasury as a result of the study has also expanded its own
survey of ownership of Government securities (which had included
only banks and insurance companies since its inception in 1941) to

QUESTION IX

239

include not only dealers and brokers but alsononfinancial corpora
tions (including data on repurchase agreements, as well as outright
ownership) and savings and loan associations. Further e>spansionof
the survey is now under way to determine more precisely the
characteristics of Government security ownership by state and local
governmental units.
With respect to the charge that the Government securities market
is inefficient in handling small (odd lot) transactions, it is important
to recognize that most small transactions are presented to other
brokers and dealers or commercial banks in the first instance; when
they reach the Government securities market they are handled
promptly by primary dealers at a relatively low cost (in part sub
sidized by the large wholesale transactions that characterize the
dealer operation). Thus it is understandable that dealers view small
transactions purely as an accommodation to established customers,
and the dealers do not actively encourage them as original business.
As a practical matter, by far the largest part of individual in
vestors’ holdings of Government securities — and perhaps an even
greater part of current transactions — is accounted for by United
States Savings Bonds, The Treasury actively encourages small in
vestors to buy these bonds — usually on a regular basis through
payroll savings — so that their security ownership is completely
protected against price fluctuations.
The desire of individual investors to obtain marketable U,St Gov
ernment securities in significant volume has been almost completely
confined to comparatively short periods of time when interest rates
rose to relatively high levels. This interest of individual investors
was particularly strong with respect to the 5 percent Treasury notes
issued in October 1959; such interest was also an important factor
during the latter part of 1959 in the secondary market demand for
other high coupon notes maturing in three to five years. The rela
tively high rates which greatly enhanced demand in this area were,
of course, the direct consequence of the Treasury debt management
being confined to the under-five-year area by congressional refusal
to remove the 4 1/4 percent interest rate ceiling on Treasury
bonds. The result was that substantial amounts of investment funds
were withdrawn from private savings institutions within a short
period of time, with a relatively sharp impact on the private long
term capital market, particularly the mortgage market.
The New York Stock Exchange has carefully considered ways
in which small transactions in marketable Treasury bonds and
longer notes could be actively encouraged. Its officials have con
cluded that it would be difficult under existing conditions to
encourage Exchange specialists to take the financial risk which
would be involved in making a market in Government securities.

THE TREASURY ANSWERS

240

There would also be the problem of developing adequate incentives
for handling Government securities on the Exchange through a
commission schedule that would be competitive with the narrow
spreads prevailing in the over-the-counter market. Stock Exchange
officials also believe that the only way an auction market for
Government bonds could successfully be established would be for
the Treasury to issue tax-exempt bonds to individuals and for the
Federal Reserve to place all transactions in bonds on the Exchange
which, in turn, might involve some official support of the Exchange
market. Neither of these conditions is acceptable to either the
Treasury or the Federal Reserve System.
Any analysis of the adequacy of the Government securities market
should include a careful study of the credit aspects of the trans
actions in United States Government securities. This matter is dis
cussed in the answer to Question X.

QUESTION X
Should speculation in the Treasury securities market
be restricted or encouraged?
ANSWER X
Opinion on the subject of speculation in the Government securi
ties market was reported as follows in the recent study of the market
made jointly by the Treasury and the Federal Reserve:
From the opinions expressed, it was clear that
speculation was viewed generally as any positioning of
a Government security, financed on credit or otherwise,
which anticipates subsequent resale of the issue at a
profit. Considered in these terms there was general
agreement that speculative activity is an essential
ingredient to an effectively functioning securities m ar
ket since it lends continuity and facilitates the sale and
distribution of new issues.1

lSee “Role of Speculation in the Market,” Part I, page 16 of the
Treasury-Federal Reserve Study of the Government Securities
Market, July 1959.

QUESTION X

241

It was further noted in the study that most discussants reporting
opinions on this matter were doubtful as to how the differentiation
between useful market speculation and excessive speculation could
be accomplished in practice.
Any consideration of the use of credit in the Government securi
ties market must take account of the fact that dealers operate very
largely on borrowed funds and must continue to do so if they are to
stay in business. The very fact that they are continually turning over
a huge volume of credit, and the fact that they report daily to the
Federal Reserve Bank of New York, provide the Treasury and the
Federal Reserve with the data needed in appraising the over-all
credit structure of the dealer market.
There have been instances in the past, notably in the summer of
1958, when there were examples of improper extension of credit
which encouraged individuals to finance speculative purchases of
Government securities on an extremely thin margin. These instances
pertained principally to a few banks and corporations rather than to
Government security dealers.
Steps have already been taken to make certain that loose credit
practices are minimized in the future. The New York Stock Exchange
has taken action against one of its member firms which failed to
meet the Exchange’ s margin requirements. The Comptroller of the
Currency has issued instructions to Chief National Bank Examiners
throughout the country prescribing minimum margin requirements
on transactions involving the purchase of Government securities,
and the New York State Banking Department has taken parallel ac
tion. Leading banks and corporations have been cautioned about the
unfortunate consequences of undermargined credit, and the Treasury
will not hesitate to warn them against any credit extensions which
appear to contribute to excessive speculation if and when such
excesses should threaten to recur. The Treasury believes that much
of the undermargined credit extension in 1958 was an unwitting
contribution to speculation and that the officers of banks and nonfinancial corporations so involved are anxious to avoid any repetition
of those events.
The Treasury has also indicated that it intends to remain com
pletely flexible in handling the refinancing of maturing issues to
make either an exchange offering (with pre-emptive rights) or a
cash offering, whichever seems most desirable in the light of market
conditions and related circumstances. Use of a cash offering dis
courages the accumulation of speculative positions in "pre-emptive
rights’* to new issues. It also makes it feasible for the Treasury to
require sizable downpayments and percentage allotments among
investor classes as a further bar to excessive speculation. It is
especially useful when the refinancing involves debt retirement as

THE TREASURY ANSWERS

242

in August i960, at which time the Treasury resorted to a cash
refunding*
The Federal Reserve and the Treasury are continuing to study
other suggestions which have been put forward for improving the
Government securities market. These include the broad question of
the possibility of encouraging or requiring primary dealers to or
ganize themselves to insure more uniform practices.
The Treasury is also continuing its study of the repurchase
agreement mechanism, since the joint Federal Re serve-Treasury
Study of the Government securities market served both to point up
some of the dangers in the abuse of the repurchase mechanism and
to review the feasibility of limitations. Although the Treasury is
confident that the actions already taken will substantially minimize
the problem of undermargined credit extension, there is the possi
bility that it might be necessary at some future date to adopt a
broader approach in order to minimize undesirable speculation and
to seek legislative authority to set margin requirements along the
lines of the present Federal Reserve Regulations T and U,
In summary, we emphasize again that the present Government
securities market is an efficient, competitive market and has proved
to be so under widely varying circumstances. A s a result we con
tinue to adhere to the principle that the market’ s strength stems
from its basic freedom from government regulation.

QUESTION XI
Should the Treasury securities market be insulated
from the rest of the capital market?
ANSWER XI
In recent years various proposals have been made for “insulating”
the Government securities market from other credit markets. In
the early postwar period, most of these proposals (particularly those
that would provide for “ secondary reserve requirements” for com
m ercial banks) were designed primarily as a supplement to general
credit controls. Such devices were offered as a new technique for
controlling bank credit expansion without contributing to disruption
of the Government securities market. In addition, “insulation” has
been advocated, through the establishment of Government securities

QUESTION XI

243

reserve requirements applicable both to banks and other financial
institutions, for the purpose of offsetting the relative decline in the
attractiveness of Government securities to various types of
investors.
The Treasury is strongly opposed tosuchproposals. Experience
since the Treasury-Federal Reserve Accord in 1951 indicates that
a flexibly administered monetary policy is feasible in the postwar
environment, and that such policy need not be supplemented by
further specific controls such as a Government securities reserve
applicable to financial institutions. Indeed, such a supplemental con
trol is not only unnecessary but may have highly undesirable effects
in terms of market allocation of credit and mobility in the flow of
credit to promote economic growth.
Any actions that would attempt to improve the “ competitive posi
tion” of Government obligations by forcing individuals or institutions
to purchase and hold the securities would actually militate against
the long-run goal of promoting a more self-reliant market for
Government securities. Furthermore, the existence of a large
“captive market” for Government obligations would enable the
Treasury to avoid a true test of the market in its debt management
operations, thereby increasing the danger of excessive reliance upon
borrowing, rather than taxation, to meet federal government
expenditures.

QUESTION XII
To what extent are fiscal and debt management policies
influenced by such international considerations as the
U.S. balance-of-payments position on current accounts,
the direction of long-term international lending, and
shifts by foreigners between their holdings of dollar
assets and gold?
ANSWER XII
Recent developments in the international economy provide con
vincing evidence of the need to maintain a strong dollar while
pursuing our complementary economic goals relating to growth and
employment. The world economy of today is markedly different
from that of the early postwar years Reconstruction of war-torn
industrial economies abroad has been largely achieved. These

244

THE TREASURY ANSWERS

industrial nations have made impressive progress in rebuilding,
improving, and enlarging their productive facilities. The result has
been a marked increase in the competitive capacities of these na
tions. The financial counterpart of this change in the international
economy has been a remarkable strengthening of the currencies of
these industrial countries, and the disappearance of most of the
foreign exchange difficulties that earlier plagued them.
These important economic and financial developments, coupled
with a large outflow of dollars from this country in the form of
private long-term capital, government loans and grants, and military
expenditures abroad, have been reflected in a series of deficits in
this country’ s international balance of payments. These deficits,
measured by gold and liquid dollar gains by foreigners in their
transactions with the United States, have occurred in each year since
1950, with the exception of 1957, rising to $3.4 billion in 1958 and
$3.8 billion in 1959. Trends during the first three quarters indicate
that our deficit in 1960 will be in roughly the same magnitude.
These circumstances have required a reorientation of thinking
with respect to our international economic and financial policies.
Moreover, domestic actions relating to fiscal policies and debt
management must now be assessed in the light of our position in the
international financial system.
Two aspects of this new situation deserve special emphasis. In
the first place, the generation of these deficits during the past ten
years has resulted in the accumulation of a large volume of highly
liquid foreign claims on the United States. These claims, which now
total about $17,5 billion, consist primarily of deposits in American
banks and investments in short-term securities of the United States
Government and American businesses. More than half of these
short-term liabilities are held by foreign governments and central
banks and thus represent a direct claim on our gold stock. The re
maining liabilities represent an indirect claim on our gold, inasmuch
as they can become off icial holdings simply by transfer from private
hands to foreign governments or central banks.
In the second place, the official short-term dollar holdings of
foreign countries represent a large share of their basic currency
reserves, supplementing gold for this purpose. Thus the dollar has
become the major reserve currency of the free world and the inter
convertibility of gold and the U.S. dollar has come to form the key
stone of international exchange rate stability. As a consequence, f
confidence in the dollar is important to the monetary systems of the-j
free nations of the world. If confidence in the dollar is ever impaired, ^
the results would not be confined to this nation, but would be feltfi,
throughout the free world.
,a

QUESTION XII

245

The close and continuing dependence of international confidence
in the dollar’ s basic worth upon our domestic financial policies has
been strikingly demonstrated in recent years. The $12.5 billion
budget deficit that occurred in fiscal year 1959 appeared at the time
to convince many foreign observers that this nation would be unable
to avoid a resurgence of inflationary pressure, with consequent
weakening of the dollar both here and abroad. However, the massive
shift from the budget deficit of fiscal 1959 to a $1,2 billion surplus
in fiscal 1960 evidently was a major factor in convincing these ob
servers of the firm intention of this country to maintain fiscal dis
cipline.
Unfortunately, an undertone of concern developed again in the
summer and autumn of 1960, reflecting not only the continuance of a
substantial deficit in our balance of payments but also concern over
the financial policies that might be followed by a new national ad
ministration. This concern was reflected in pronounced speculation
in some of the world’ s free gold markets (principally in London),
which drove the price of gold higher than the official United States
price of $35 per ounce.
These examples of recent experience are cited to emphasize that
appropriate financial policies in this country underlie the economic
strength, not just of the United States, but of the entire free world.

QUESTION x m
Should changes be made in the management of Treasury
cash balances?
ANSWER X in
We believe that the Treasury’ s cash balances are currently
managed in an efficient manner and that further changes in the
handling of Treasury cash are not necessary at this time. Treasury
practices and techniques in the management of its cash balance are,
of course, under continuing review. Within the broad authority under
which the Treasury operates, practices are changed from time to
■inie to make management of the cash balance both as responsive
s possible to the rapidly changing needs of the Treasury and as
ttentive as possible to the impact of cash operations on the monetary
iolicy actions of the Federal Reserve.

246

THE TREASURY ANSWERS

The Treasury has two principal objectives in carrying on its cash
management operations: (1) To maintain a cash balance at the lowest
level consistent with ability to meet the day-to-day payment of the
government’ s obligations, and (2) to neutralize the effects of fluctuat
ing government income and outgo on bank reserves, so as not unduly
to complicate the implementation at monetary policy.
As a practical matter, the procedure for the management of the
Treasury’ s cash balance is highly complex, involving both long-range
projections which extend from twelve to eighteen months ahead and
day-to-day appraisals of the collections and disbursements of all
agencies of the government. Long-range projections require careful
analysis of budget receipts and expenditures, operations in Govern
ment trust funds and other special accounts, and transactions in
volved in the issue and redemption of public debt obligations. These
projections must be reviewed in the light of the limitation on the
amount of public debt obligations which may be outstanding at any
one time and in the light of the timing and frequency of Treasury
financing operations. Day-to-day appraisals in turn require knowl
edge of the factors influencing daily projections of these various
types of activities together with the ability to make a complete
analysis of the flow of funds through more than eleven thousand
individual commercial bank depositaries and the Federal Reserve
banks and branches.
The Treasury’ s operating cash accounts are carried with the
Federal Reserve banks and branches. An annual volume of more
than 425,000,000 checks drawn on the Treasurer of the United States
by government disbursing officers flow back through banking
channels and are charged to these accounts. A substantial part of the
Treasury’ s income is deposited directly in Treasury accounts at
Federal Reserve banks, but the greater part is credited to Treasury
Tax and Loan Accounts maintained in more than eleven thousand
commercial banks throughout the country. Proceeds of sale of most
new public debt securities and several major classes of taxes are
deposited in these accounts. A large portion of the funds flowing into
the Tax and Loan Accounts are generated by the banks as they pay
for newly issued securities or solicit their customers to make
payments due the Treasury through the banks.
On the basis of frequent estimates of its cash position the
Treasury withdraws funds as needed from the Tax and Loan Ac
counts for transfer to its accounts at the Federal Reserve banks.
Thus the Treasury keeps its aggregate cash balance at the Federal
Reserve banks relatively stable, even at times of sharply fluctuat
ing revenues or expenditures, with a minimum of disturbance to the
money market. The Tax and Loan Account System permits the
Treasury to leave funds in the banks and in the communities in which
the funds are generated until such time as the Treasury needs to

QUESTION XIII

247

disburse them. In this way the Treasury discharges a primary
fiscal responsibility of handling government funds in such a way
as not unduly to disturb financial markets.
Over the years numerous changes and improvements have been
made in the Treasury’ s cash management methods. One of the
significant changes in recent years was the establishment of a
separate category of Tax and Loan Accounts involving the largest
banks in the country, those with total deposits of more than
$500,000,000, This grouping (about 50 banks) enables the Treasury
to make immediate withdrawals or redeposits on any day without
advance notice whenever Treasury balances in the Federal Reserve
banks are expected to deviate from the desired level. Another
significant improvement is the special procedure whereby large
income tax payments at peak collection periods are deposited in
Tax and Loan Accounts in banks on which the checks are drawn.
There is a wealth of information available as to the manner in
which cash balances are handled, including material presented to
the Joint Economic Committee during the hearings on Employment,
Growth, and Price Levels in July 1959 (Part6-A, Pages 1190-1205),
as well as in the Treasury answers to questions on debt management
submitted by Chairman Douglas and Vice Chairman Patman of this
Committee in connection with the same study (see Parts 6-C and 10
of the Hearings).
More recently the Treasury completed a careful study of the
activity in its Tax and Loan Account with reference to a particular
request by the Comptroller General of the United States. He recom
mended that consideration be given to amending present laws to
permit commercial banks to pay interest to the Treasury on bal
ances maintained in Treasury tax and loan accounts with such banks
and that the Treasury make direct payments to the banks for the
services they render to the government. The Treasury is opposed
to the payment of interest on balances in Tax and Loan Accounts for
reasons that are detailed in this study which was released to the
public June 15, I960.1 The difficulties and disadvantages inherent
in a system of fees to banks are also reviewed in this study,2 As
^•Report on Treasury Tax and Loan Accounts Services Rendered by
Banks for the Federal Government and Other Related Matters,
Treasury Department Fiscal Service, June 15, 1960, p, 4,
2Ibid, t p, 5. The study also clearly shows that the Treasury is
adequately recompensed in the form of services rendered by the
banks, and that for the majority of banks the expenses incurred in
providing such services exceed their savings on Tax and Loan
Account balances.

THE TREASURY ANSWERS

248

brought out in the study, experience has shown that the tax and loan
account method of managing the Treasury’ s balances is well
adapted to the United States banking system and can be used
successfully to avoid the serious money market disturbances that
might otherwise be a mechanical by-product of large-scale Treasury
operations.
The Treasury believes, therefore, that the present system of
managing its cash position, carefully developed over a period of
many years, provides an efficient and economical way of transacting
the government’ s business, and also reduces to a minimum any
possible adverse effect of Treasury financial operations on the
economic stability of the country. It is our conclusion that it would
not be in the best interest of the government to make fundamental
changes in the system.

QUESTION XIV
Granted that stability of employment and prices are
conducive to economic growth, are there any ways in
which fiscal policy (excluding changes in the tax
system or increased emphasis on certain types of
spending) and debt management policy can contribute
to healthy, sustainable growth in addition to aiming
at stabilizing employment and the price level?
ANSWER XIV
The technique of fiscal policy suggested in the reply to Question
I, which would result in a net surplus in the federal budget over the
full period of the business cycle, would also contribute directly to
healthy, sustainable economic growth because the budget surpluses
would be largest during periods of prosperity, when inflationary
pressures are strong and when there is a shortage of savings to
finance the investment that is essential to healthy growth. The
surplus funds (which reflect government saving) would be used to
retire part of the public debt. Such debt retirement would increase
the availability of investment funds in financial markets and con
tribute to lower levels of interest rates. Consequently, business
expenditures for new plant and equipment, as well as other growthproducing activities, could be more easily financed at lower costs
and
without inflationary expansion of bank credit.

QUESTION XIV

249

Although the role of debt management in contributing directly to
sustainable growth is more limited than that of fiscal policy, it is
important to recognize that appropriate debt management policies
will contribute to an efficiently functioning market for Government
securities. To the extent this goal is achieved, financial markets
in general can be expected to operate more efficiently, which in
turn would facilitate the orderly financing of growth-producing
activities.

QUESTION XV
What do you conceive to be the advantages and dis
advantages of having the Federal Reserve System
independent of the Executive Branch of the federal
government?
QUESTION XVI
Should responsibility for debt management and monetary
policy be given to a single organization such as the
Federal Reserve System or the Treasury?
QUESTION XVII
What degree of coordination between Congress, the
Federal Reserve System, the Treasury, and other
departments and independent agencies of the Execu
tive Branch of the federal government is desirable
in relation to monetary and credit policy in its broadest
sense? Are present procedures adequate to provide
this, and, if not, what suggestions do you have for
improvement?
ANSWERS XV - XVH
Questions XV, XVI, and XVII are closely related and will be
considered together.

250

THE TREASURY ANSWERS

It is sometimes argued that the Federal Reserve should be
directly responsible to the President. This view is based upon the
proposition that this nation must have a strong, unified economic
policy and that a unified approach to economic policy is impossible
so long as authority over monetary policy is vested in an agency
independent of the Executive. This view calls for several comments.
In the first place, the proponents of this approach overlook an
essential fact: Even if the Federal Reserve were made directly
responsible to the President, such accountability would not assure
a “unified economic policy” because, under our system of checks
and balances, economic powers are divided within the federal
government. From the standpoint of the three major federal finan
cial policies, responsibilities are divided as follows: (1) fiscal and
budget policy are the joint responsibility of the Congress and the
Executive; (2) monetary policy has been delegated by the Congress
to the Federal Reserve (although the Treasury does possess some
monetary powers, such as those relating to gold policy and manage
ment of Treasury cash balances); and (3) debt management policy
is the province of the Treasury, under the President, subject to the
general limitations provided by statute. Thus, if we were to achieve
a truly unified government economic policy, some arrangement would
also have to be made to shift to the Executive considerable adminis
trative powers over tax rates and expenditures. Such action seems
both unlikely and highly undesirable under our governmental system
of checks and balances.
Secondly, although the Federal Reserve is often spoken of as
an “independent agency,” it should be recalled that the System was
created by Congress and is responsible to the people through the
Congress. Perhaps it is more correct to say that the Federal
Reserve is independent within government, rather than independent
of government. Therefore, the responsibility of the Federal Re
serve to Congress is on a trusteeship basis rather than on a dayto-day basis. The degree of independence from Congress enjoyed
by the Federal Reserve reflects the judgment of Congress that its
own long-run purposes — which are those of the nation as a whole —
will be best served by such a temporary self-denial of a portion of
its inherent prerogative, under the Constitution, “to coin money
(and) regulate the value thereof . , ,” * This arrangement is based
upon the simple and cor^ncing proposition that monetary manage
ment, involving as it does highly technicaLoperations, should be
handled by independent experts. Moreover, experience in this
country and in many foreign countries indicates strongly that the
highly important task of monetary management, if it is to be im
partially and effectively handled, must be divorced from the
“politics of the day.”
~

QUESTIONS XV - XVII

251

Thirdly, the argument for maintaining a central banking system
that is independent of the Executive is even more convincing. In our
form of government, the Executive has the responsibility of meeting
the fiscal requirements of the government, including the manage
ment of our huge national debt as well as the_borxowingj)f-money to
meet the^government’ s^needs whenever revenues fall short of ex
penditures, In meeting this responsibility, the President and the
Secretary of the Treasury are properly concerned w ith d ra w in g
jisjeconom ically as is possible, in the light of existing market condi
tions and the need to promote other important economic objectives.
If the Executive were to possess the power over the creation of
money (which is the prerogative of Congress and has been delegated
to the Federal Reserve), while at the same time bearing the respon
sibility to borrow to meet the government’ s fiscal requirements as
cheaply as possible, there might be considerable danger of reliance
. on unsound monetary policies to minimize (in the short run) govern
ment borrowing costs, at the. expense of encour^gin^gjnflationary
pressures. This is no idle academic theory; it has happened in this
and other countries.
Do these considerations imply that the various branches of
government possessing authority over economic policy are free to
follow contradictory courses of action? Not by any means. The im
portant point is that there should be basic agreement as to our
national economic objectives and as to the means of achieving these
objectives; the objectives are basically the province of Congress
in adopting legislation, as reflected in the Employment Act of 1946,
the Federal Reserve Act, and various statutes pertaining to taxation,
debt management, and government lending programs. Beyond this,
however, there is a pressing need for informal arrangements to
provide for a free flow of information among the various responsible
agencies and officials. Perhaps a brief description of the informal
arrangements between the Executive Branch and the Federal Re
serve, for the purpose of promoting a coordinated economic policy,
would be helpful in illustrating this point.
Neither the President nor the Treasury participate directly in
the formulation of Federal Reserve policy. However, from time to
time and without a fixed schedule, the President, the Chairman of
the Board of Governors of the Federal Reserve System, the Secre
tary of the Treasury, the Chairman of the President’ s Council of
Economic Advisers, and the economic assistant to the President
meet informally to discuss economic trends and developments.
Moreover, the Chairman of the Board of Governors and the Secre
tary of the Treasury meet for informal discussion at least once
each week, and there are regular weekly meetings — as well as
frequent daily consultations — between Federal Reserve officials,
Treasury officials, and senior staff members of both agencies. At
these meetings, there is a free interchange of ideas and information

THE TREASURY ANSWERS

252

concerning the state of the economy, credit and debt management
problems, and other matters of mutual interest.
These arrangements have worked out well in practice. The im
portant point is that as the two agencies carry out their respective
responsibilities, both have the opportunity for full knowledge of the
other’ s views.
It has frequently been suggested that these informal arrange
ments for exchange of information among the responsible agencies
in the field of money and credit be supplanted by some type of
national economic council, chaired by the President and consisting
of various government officials responsible for economic policies,
including the Chairman of the Board of Governors of the Federal
Reserve System. While such a council might serve a useful func
tion as a forum for an exchange of ideas and information on matters
of economic policy, there is a question as to whether it would be
more effective than the existing informal arrangements described
above. If it were deemed desirable to establish such a body, however,
its function should, of course, be purely advisory in scope, with
adequate provision made for safeguarding the independence of the
Federal Reserve in formulating monetary policy.
In conclusion, it should be noted that the basic question dis
cussed in this reply, relating to the desirability of making the
Federal Reserve responsible to the Executive (or to the Treasury),
was intensively studied by subcommittees of the Joint Committee on
the Economic Report in 1950 and again in 1952. The first sub
committee, chaired by Senator Paul Douglas, recommended that
Congress by joint resolution state that:
. . . it is the will of Congress that the primary power
and responsibility for regulating the supply, avail
ability, and cost of credit in general shall be vested in
the duly constituted authorities of the Federal Reserve
System, and that Treasury action relative to money,
credit, and transactions in the Federal debt shall be
made consistent with the policies of the Federal
Reserve. (Sen, Doc. #129, 81st Cong., 2d S ess„ 1950,
P. 31.)

The second subcommittee, chaired by Representative Wright
Patman, concluded:
The independence of the Federal Reserve System
is desirable, not as an end in itself, but as a means of
contributing to the formulation of the best over-all
economic policy. In our judgment, the present degree
of independence of the System is about that best suited
for this purpose under present conditions. (Sen. Doc.
#163, 82d Cong,, 2d Sess., 1952, p. 4.)

Appendix
DEBT MANAGEMENT
AND ADVANCE REFUNDING

U.S. Treasury Department
September 1960

I, SUMMARY
Debt management is an important link in the vital chain of
federal financial responsibility. The objectives of debt management
are threefold: to contribute to an orderly growth of the economy
without inflation, to minimize borrowing costs, and to achieve a
balanced maturity structure of the public debt. The latter has been
the most pressing problem confronting the Treasury as there has
been a relentless increase in the short-term debt. Related to this,
the Treasury has found it increasingly difficult to retain as cus
tomers long-term investors in Treasury bonds (pars. 1 to 16) A
Advance refunding makes possible significant progress toward
the twin goals of a better maturity structure and ownership distribu
tion of the public debt. In essence, it involves offering all individual
and other holders of an existing U.S. Government security selected
for advance refunding the opportunity to exchange it, some years in
advance of maturity, for a new security on terms mutually advan
tageous to the holders and to the Treasury (par, 17).
Broadly speaking, two types of advance refunding may be dis
tinguished: (a) “senior* advance refunding, in which holders of
securities of intermediate maturity (5 to 12 years) would be offered
the opportunity to exchange into long-term issues (15 to 40 years),
and (b) “junior** advance refunding, in which holders of securities
of shorter maturity (1 to 5 years) would be offered the opportunity
*The numbers refer to the paragraphs which follow the summary.

THE TREASURY ANSWERS

254

to exchange into securities in the intermediate range (5 to 10 years).
The two types of operations are related and keyed to the differing
investor needs and demands in terms of investments of varying
maturity (pars. 18 and 19),
P rior experience with advance refunding in this country— such
as the operations in 1951-52 and in June 1960— has been limited.
These operations were not directly analogous to a senior advance
refunding in which investors in medium-term marketable bonds
would be permitted to exchange for long-term marketable securities
(pars. 20 to 27).
Advance refunding offers significant advantages to the economy,
to long-term investors, and to the U.S. Treasury.
Advantages to the Economy
By facilitating significant debt extension with a minimum change
in ownership, advance refunding:
a. Minimizes the adverse market impact of debt extension
such as that which occurs in the case of comparable cash
offerings (pars. 28 to 30);
b. Avoids the absorption of new, long-term funds in cash
offerings and consequently does not interfere with the flow
of new savings into the private sector of the economy (pars.
28 to 32);
c. Improves the functioning of the U.S. Government securi
ties market by contributing to a better maturity structure
of the marketable public debt (par. 31);
d. Helps to minimize inflationary pressures by reducing the
amount of highly liquid short-term debt, especially in the
case of junior advance refunding (par. 32).
Advantages to the Investor
By participating in an advance refunding, the investor:
a. Gains an immediate increase in interest return, in con
sideration of his acceptance of a longer-term security (pars.
33 and 37);
b. Avoids any immediate book loss for tax purposes and, if
nontaxable, in most instances is not required to take a book
loss (par. 36);

APPENDIX

255

c. Acquires a security whose market yield is at least equal
to, and in most instances slightly higher than, that on out
standing issues of comparable maturity (par. 34);
d. Earns a rate of return over the life of the new security
only equaled, if he does not exchange, by reinvesting at
maturity of the old security at higher than present market
yields (pars. 35 and 37 to 39).
Advantages to the U.S. Treasury
By using advance refunding as a debt management technique, the
Treasury:
a. Achieves substantial improvement in the present un
balanced maturity structure of the marketable public debt
(par. 40);
b. Reduces its dependence on inflationary bank borrowing
(par. 41);
c. Retains its customers for long-term securities (par. 43);
d. Helps keep down the long-run cost of managing the public
debt by avoiding concentration maturities in a given area
(pars. 41 and 42);

e. Reduces the size and frequency of Treasury refunding
operations and minimizes interference with timing of appro
priate monetary policy actions (pars. 12 and 40).
An important impediment to the earlier use of advance refunding
was the tax treatment of the exchanges. This obstruction was rem
edied by new legislation enacted in 1959 which permits the post
ponement of the tax consequences of any capital gain or loss re
sulting from the exchange (pars. 24 and 36).
Another important obstacle to advance refunding has been the
4 1/4 percent statutory interest rate limitation. Although this
limitation still exists, recent declines in interest rates now permit
advance refunding of selected issues (pars. 44 to 50).
Advance refunding, therefore, offers much promise atthe present
time as a way of implementing sound debt management policy as an
integral part of federal financial responsibility (par. 51).

II. DEBT MANAGEMENT AND ADVANCE REFUNDING
1.
The ability of the American economy to sustain orderly growth
without inflation, to generate increased employment, to provide

THE TREASURY ANSWERS

256

sufficient real capital to finance expansion, and to function as a
source of strength for the entire free world— all of this depends
on the maintenance of responsible financial policies* There are
three main links in the chain of federal financial responsibility.
Debt management is only one, but an important one, of these links.
The two strongest links in the chain of financial responsibility are
a sound fiscal policy— in terms of the relationship between revenues
and expenditures— and an independent and responsible monetary
policy. Without strength in these areas there is little that debt
management alone can do. Combined with effective fiscal and mone
tary policies, however, appropriate debt management can contribute
substantially to our over-all financial strength. Inappropriate debt
management inordinately increases the burdens on fiscal and mone
tary policy,
A. The Objectives of Debt Management
2. Debt management policy has three major objectives,
3. First, management of the debt should be conducted in such a
way as to contribute to an orderly growth, without inflation, of the
economy. This means that, except in periods of recession, as much
of the debt as is practicable should be placed outside of the com
m ercial banks (apart from temporary bank under writing). Restraint
must be exercised in the amount of long-term securities issued,
particularly in a recession period, in order not to pre-em pt an undue
amount of the new savings needed to support an expansion of the
economy, A related aim should be to minimize, as far as possible,
the frequency of Treasury trips to the market so as to interfere as
little as possible with necessary Federal Reserve actions and also
with corporate, municipal and mortgage financing.
4, A second important objective of Treasury debt management
is the achievement of a balanced maturity structure of the debt, one
that is tailored to the needs of our economy for a sizable volume of
short-term instruments but also includes a reasonable amount of
intermediate- and long-term securities. There must be continuous
efforts to issue long-term securities to offset the erosion of maturity
caused by the lapse of time, which otherwise results in an exces
sively large volume of highly liquid short-term debt.
5, A third objective of debt management relates to borrowing
costs. While primary weight must be given to the two objectives just
noted, the Treasury, like any other borrower, should try to borrow
as cheaply as possible. Unlike other borrow ers, however, the
Treasury must consider the impact of its actions on financial
markets and the economy as a whole. Consequently, the aim of
keeping borrowing costs at a minimum must be balanced against
broader considerations of the public interest.

APPENDIX

257

6. These several objectives are not easily reconcilable at all
times; nor can a priority be assigned to one or another of them
under all circumstances.
7. There is some merit, for example, in the view that Treasury
debt management policy should take account of cyclical considera
tions— pressing long-term securities on the market to absorb
investment funds when the economy is expanding and, conversely,
issuing short-term securities attractive to banks so as to increase
liquidity in a period of recession. Yet inpractice it has proved both
impracticable and undesirable to adhere strictly to this view in
disregard of other considerations. The Treasury’ s first obligation
is to secure the funds needed to meet the government’ s fiscal re
quirements; these requirements cannot be postponed. A pressing
need for cash may force it to market short-term issues— for which
there is usually a substantial demand— even when the economy is
expanding rapidly. The constant shortening in the maturity of the
public debt means, however, thatthe Treasury also must take advan
tage of every reasonable opportunity to issue long-term securities
despite the cyclical aspect. From a purely housekeeping standpoint
the Treasury needs to do some funding of short-term debt into
longer-term securities whenever market conditions permit.
8, Similar difficulties arise with respect to following only the
objective of keeping borrowing costs as low as possible. Against
any gain in terms of interest cost there must be weighed the loss
in terms of economic effects. For example, aggressive issuance
of long-term securities in recessions, when interest costs are low,
would absorb too large a part of the investment funds needed else
where for recovery and could even prevent desirable reductions in
interest rates. It would unduly increase the burden on the Federal
Reserve and necessitate much greater monetary ease, complicating
the subsequent problem of curbing the excesses that may develop
in a boom,
9, Clearly, the Treasury must follow a middle course in attempt
ing to reconcile its various objectives. Its concern with the public
interest requires that minimum reliance be placed on short-term
financing during periods of expansion. Similarly, financing in a
recession should be handled so as to minimize interference with
national efforts to promote economic recovery. At all times, atten
tion should be given to the objective of borrowing as cheaply as
possible consistent with the other objectives. Finally, constant effort
must be directed toward achieving a balanced maturity structure of
the debt.
B. The Problem of the Short-term Debt
10, For some time, the most pressing debt management problem
facing the Treasury has been that of securing a better maturity

258

THE TREASURY ANSWERS

structure of the public debt. Long-term securities, with the passage
of time, grow constantly shorter, bringing about a relentless in
crease in the short-term debt. Despite persistent efforts in recent
years to offer longer-term securities (some $51 billion maturing
in over five years have been sold since the beginning of 1953), as
of June 30, I960, almost 80 percent of the marketable public debt
of $184 billion matured within five years, as contrasted with less
than 50 percent at the end of 1946 and 71 percent in December 1953.
Moreover, if the total amount of marketable debt does not change,
and no securities of more than five years’ maturity are issued, the
under five year debt will swell to 87 percent of the total by the end
of 1964. This obviously is a maturity structure— both present and
prospective— which is far too heavily concentrated in the under
five year maturity area. However, the $70 billion of debt maturing
within one year is not a major problem since the liquidity needs of
the economy require a very short-term debt of this general magni
tude; the real problem is the excessive amount of securities
maturing between one to five years. (See par. 19, which explains
how both senior and junior advance refundings assist in reducing the
concentration of maturities in this range.)
11. Chart A - l illustrates the changes in the maturity distribution
of the marketable public debt since 1946. The most significant
changes, of course, are the decline in the five-year-and-over
maturity category from $97.5 billion in 1946 to $40.5 billion in
1960 and the rise in the maturities between one and five years from
$24.5 billion to $73 billion.
12. The undue and growing concentration of the public debt in
the under-five-year area has important implications both for the
money and capital markets and for the economy as a whole. If the
composition of the debt is permitted to grow continuously shorter,
Treasury refunding operations will occur more frequently and in
larger amounts. The Treasury might often be forced to refund
excessively large maturities under unfavorable conditions with
unduly large repercussions on the structure of interest rates. This
would tend to interfere with orderly marketing of corporate and
municipal bonds. Moreover, the emergence of a larger amount of
highly liquid, short-term government debt than the economy re
quires could create inflationary pressures. Excessive liquidity in
the economy and frequent and large Treasury operations in the
market can unduly complicate the flexible administration of Federal
Reserve credit policies essential to sustainable growth. A balanced
maturity structure of the debt, therefore, can make a major con
tribution toward sound financial policy by reducing the frequency,
size, and adverse consequences of Treasury financings, by helping
to forestall potential inflationary pressures, and by enabling
monetary policy to function more effectively.

M ATURITY DISTRIBUTION OF THE MARKETABLE DEBT'
1946,1953,1959 and I960

CHART A-1

* Partially tax-exempt bonds to earliest cat! date.
Offc« of U* Sacrrtary of 1M h u u ry

^Including savings notes.
B-1336-C-t

260

PERCENTAGE DISTRIBUTION OF OWNERSHIP
OF TREASURY BONDS AS TH EY APPROACH MATURITY

CHART A -2
THE TREASURY

B -I3 T 6 -A

ANSWERS

* Including redemption for estate taxes.
Olfict of lf » $Knlv> of Itw *rtavx>

APPENDIX

261

C. The Problem of Retaining the Treasury’ s Customers
13. The constant shortening of the debt also has very practical
consequences for the Treasury, since it has made it difficult to
retain as customers many long-term investors who once were
buyers of Treasury bonds. Long-term investors who have found
their holdings of Government securities moving nearer to maturity
have had a tendency to dispose of them and to turn to other types
of long-term investments. As a result, the Treasury has found that
it has lost customers as the passage of time has eroded the long
term characteristics of Government bonds. The securities that were
once long-term but which have become short-term have passed into
the hands of commercial banks, nonfinancial corporations and other
short-term investors, while holdings of Government securities by
long-term investors— savings institutions and individuals— have
been reduced. Even in those cases where the securities have been
retained by long-term investors, such investors have tended to
regard them as part of their liquid holdings. Consequently, by
maturity there is little demand for new long-term Treasury bonds
from the holders of the maturing securities.
14. The case of the 2 1/4 percent bonds maturing in June and
December 1962, as shown in Chart A-2, illustrates what has
happened to the ownership of Treasury bonds with the passage of
time. When these bonds were originally sold during World War n,
they were in the 15- to 20-year maturity area and were purchased
largely by longer-term investors. At the end of 1946, almost half
of them were held by insurance companies and mutual savings banks.
Most of the remainder were held by individuals, some savings and
loan associations, pension funds, etc. Only 4 percent were held by
the com m ercial banks.
15. The picture is strikingly different today. Commercial banks
now own 48 percent of the 2 1/4 percent bonds of 1962, and holdings
of savings institutions and individuals are down very sharply. As is
shown in Chart A-2, much the same sort of shift in ownership has
been taking place with respect to the 2 1/2 percent bonds maturing
between 1967 and 1972; but with maturity still some time off, the
shift has not gone so far.
16. These changes in ownership distribution over time illustrate
the problem that the Treasury has in retaining its customers, but
the statistics alone do not tell the whole story. In many cases, as
longer-term Government bonds shorten up, they come to serve a
liquidity function within the portfolios of savings institutions and
other long-term investors. On maturity, consequently, little replace
ment demand for long-term securities may be expected from these
holders.

262

THE TREASURY ANSWERS

D. Advance Refunding— A Significant Step Toward Solution
17. Advance refunding is a debt management technique that makes
possible significant progress towards the twin goals of a better
maturity structure and ownership distribution of the public debt. In
essence, it involves offering all individual and other holders of an
existing U.S. Government security selected for advance refunding
the opportunity to exchange it, some years in advance of maturity,
for a new security on terms mutually advantageous to the holder and
to the Treasury, Such exchanges promote debt lengthening with a
minimum change in ownership, thus helping the Treasury to retain
its customers for long-term securities. Advance refunding contributes to these objectives with a minimum of adverse effects on
the financial markets and the economy as compared with alternative
ways of debt lengthening. In turn, the investor is offered an oppor
tunity to exchange for a new, longer-term bond with a higher coupon
rate and without an immediate taxable capital gain or loss.
Types of advance refunding,
18. Within the context of the current debt structure there are two
separate but related types of advance refunding that are of particular
interest to the Treasury, They are (a) “senior” advance refunding,
in which holders of securities of intermediate maturity (5 to 12
years) would be offered the opportunity to exchange into long-term
issues (15 to 40 years), and(b) “junior” advance refunding, in which
holders of securities of shorter maturity (1 to 5 years) would be
offered the opportunity to exchange into securities in the inter
mediate range (5 to 10 years).
19. The relationship between these two types of operations is
important in the successful use of advance refunding at certain times
to implement needed debt lengthening. To accomplish best the major
purpose of advance refunding the use at different times of senior and
junior type advance refunding seems desirable. The reasons for this
rest on the fact that securities in the 1- to 5-year range are not
suitable obligations for advance refunding into long-term bonds; yet
it is the relatively large amount of securities ($73 billion) maturing
in 1 to 5 years that constitutes the hard core of the debt management
problem. These securities are now held primarily by short-term
investors, such as commercial banks and business corporations,
which for the most part would not desire to exchange for long-term
issues. Consequently, a two-phased approach, sometimes described
as a “leapfrog” process, involving over time both senior and junior
advance refunding, appears necessary.
a.
A senior advance refunding would be undertaken first to shift
a substantial amount of the 5 - to 12-year maturities into the longerterm area. For this purpose the securities most often referred to as

APPENDIX

263

likely candidates are the 2 l /2 percent bonds issued to help finance
World War n. These securities, often referred to as the “tap
issues, * originally totaling $43.6 billion, are now outstanding in the
amount of $28 billion; and the Treasury’ s ownership studies indicate
that a substantial portion is still in the portfolios of the original
long-term investors. Consequently, no significant changes in owner
ship would be necessary for a successful extension. In fact, a major
purpose in an early undertaking of a senior advance refunding of
some significant part of these securities would be to prevent the
lapse of time from changing their ownership such that holders would
no longer be long-term investors who could be attracted by a new
long-term offering. In addition to forestalling the inroads of time
on ownership, this senior advance refunding would provide additional
space in the intermediate sector and facilitate a junior advance
refunding at a later date.
b.
A junior advance refunding would shift an even larger amount
of securities now in the one-to five-year range into the intermediate
area. Just as an example, such a shift might involve an offering of
6-year bonds to holders of an issue now maturing in two or three
years; an 8-year security for issues maturing in three or four
years; and so on. It should be noted that a junior advance refunding
can be successfully carried out in much larger amounts due to the
characteristics of the intermediate market. There is a much larger
market in the 5- to 10-year area, so that some greater amount of
the debt extension ultimately achieved by use of advance refunding
presumably would represent a shift from the 1- to 5-year into the
5- to 10-year area, with a significantly smaller amount moved out
from the 5 - to 12-year area to the very long area in order to retain
long-term investors as Treasury customers.
Experience with advance refunding.
20.
The Treasury-Federal Reserve Accord of March 4, 1951,
included an advance refunding of existing marketable bonds as one
of its agreed upon provisions* In order to eliminate what appeared
to be an overhanging supply of long-term marketable bonds, holders
of the two longest issues of bank-restricted bonds (the 2 l/2 s of
June and December 1967-72) were offered— 21 years before
maturity of their bonds— an optional exchange into 29-year, nonmarketable 2 3/4 percent Investment Series B bonds convertible
before maturity into 5-year, 1 1/2 percent marketable Treasury
notes. A total of $19.7 billion bonds eligible for exchange into
Investment Series B bonds were outstanding, of which $13,6 billion
were exchanged. <About $8 billion were exchanged by private in
vestors and the balance by the Federal Reserve banks and Govern
ment investment accounts.) In effect, then, the Treasury did advance
refund this amount of its 1972 maturities when it issued the 2 3/4
percent Investment B bonds back in 1951.

264

THE TREASURY ANSWERS

21. Although the major purpose of the 1951 advance refunding
was not to extend debt, it is significant that almost $14 billion of
the 1972 maturities were shifted to 1980— an extension of 8 years.
However, the privilege of converting the new 2 3/4 percent bonds
into 5-year marketable notes in effect reduced the accomplishment
in terms of debt lengthening. In fact, since 1951 more than half of
the 2 3/4 percent bonds have been so converted into the 5-year notes,
22. In May 1952 the Treasury made another offering of the 2 3/4
percent nonmarketable investment bonds to the holders of the re
mainder of the June and December 1967-72s and to the holders of
the 2 l/2 s of 1965-70 and 1966-71,About$1.3billion was exchanged.
(However, one-fourth of the amount subscribed for had to be paid
for in cash,)
23, Other than as a precedent, this experience in 1951-52 is not
analogous since at that time the securities involved in the first
exchange were still at or slightly above par and were not much
below par in the second exchange. The reluctance of investors to take
capital losses was not a material consideration. Moreover, the new
issue was nonmarketable and could be liquidated only under penalty.
24, In the interim period since 1951 an advance refunding of the
tap 2 l/2 s , for example, would not have been particularly attractive
to investors because— except for short periods in 1954 and 1958—
they would have had to take book losses. (See footnote to par, 36 as
to investor reluctance to incur such losses.) Legislation in the fall
of 1959 permits the Treasury to provide exchanges with postpone
ment of tax consequences. This again made practicable (subject to
the 4 1/4 percent statutory interest rate limitation) the undertaking
of advance refunding of marketable issues.
25. On June 6,1960, the Treasury Department offered the holders
of $11,2 billion of the outstanding 2 1 /2 percent Treasury bonds
maturing November 15, 1961, the option to exchange— with the
privilege of deferring the tax consequences—for either 3 3/4 per
cent Treasury notes maturing May 15,1964 (limitedto $3.5 billion),
or 3 7/8 percent Treasury bonds maturing May 15, 1968 (limited
to $1 billion). Holders of approximately $4,9 billion of the 2 1/2
percent Treasury bonds submitted exchange subscriptions, but the
bulk of the subscriptions ($4,6 billion) was for the new 4-year note,
of which $3,9 billion were allotted, and only a relatively small part
(a little over $300 million) for the new 3 7/8 percent bond.
26, This advance refunding, undertaken in June I960, provided a
testing ground for use of the technique in this country under pre

APPENDIX

265

vailing market conditions and ownership characteristics^. This
particular advance refunding was designed primarily to obviate
the difficult problem that would have arisen in refunding the 2 1/2
percent bonds of November 1961 at maturity, as this issue totaled
$11 billion publicly held— the largest single outstanding issue. It
was not undertaken to preserve ownership nor with the e?qpectation
of achieving substantial debt lengthening of the type desired,
27. This refunding clearly demonstrated the feasibility of debt
extension by advance refunding but also demonstrated the difficulty
of extending beyond five years under the 4 1 /4 percent interest rate
ceiling in the market environment then prevailing. The significant
investor response to the note offering enabled the Treasury to
reduce the size of the November 1961 maturity from $11 billion to
$7 billion, thus making it much more manageable at maturity. How
ever, the interest rate ceiling did not permit a significant amount
of extension beyond the seriously congested one- to five-year area
because the eight year bonds could not be made sufficiently attractive
to induce larger acceptance of the issue. This advance refunding also
served a very useful purpose in familiarizing the market generally
with the technique of advance refunding; it gave investors, dealers,
and investment advisers the opportunity to study the different prob
lems which an advance refunding offering presents.
Advantages of advance refunding to the economy.
28. Advance refunding can be accomplished in worthwhile amounts
with a minimum of disturbance to financial markets and to the
economy as a whole. This is because most of the new long-term
bonds taken in the refunding will simply be substituted for shorterterm issues held by investors who are essentially long-term holders.
Because only a small change in ownership is involved, little if any
new savings will be absorbed and the impact on the markets for
mortgages and corporate and municipal securities should be rela
tively small, (See par. 32 for further discussion of this point.)
29. In
amount of
otherwise
long-term

contrast, if the Treasury were to offer a significant
long-term bonds for cash it would capture funds that
would be available for investment in other types of
securities, and the increased supply of long bonds

^The advance refunding technique was used in the Canadian con
version loan operation in the summer of 1958. Some $6 billion of
Dominion of Canada securities having from 6 months to 8 years
to run to maturity were exchanged for securities with maturities
ranging from 3 to 25 years—an operation involving over half of that
country’ s direct marketable debt. Because of the fundamental dif
ferences in the financial systems of Canada and the United States
this experience is of only limited applicability in this country, No
operation of similar scope in relation to the total debt of this
country would be either feasible or desirable.

266

THE TREASURY ANSWERS

competing for those funds would have a marked impact on the
interest rates of all such securities. Similarly, when a long-term
bond is offered in exchange for maturing securities the economic
and market effects are as pronounced as those on a cash offering.
The maturing securities by that time are almost entirely held by
short-term investors (or as liquidity protection by long-term
investors) who do not want long-term bonds. This involves churn
ing in the market as the holders of the rights (maturing securities)
sell to investors who want to exchange for the long bond. Since
the securities are obtained by long-term investors through their
purchases of rights, there is a net absorption of long-term funds
with much the same results as in the case of offering a new long
term issue for cash.
30, In an advance refunding, however, this adverse market im
pact would be largely avoided. Under conditions such as exist today,
when the securities to be refunded are selling at a discount, the
holder’ s motive in taking the longer security in exchange is to get a
better immediate return, as well as a satisfactory return to maturity,
and to do so without registering a loss on his books (if depreciation
from cost exists). The combination of a higher coupon and longer
maturity on the new security being offered in exchange is designed so
that it will tend to sell in the market at a price comparable to that
of the old security. As a result it is reasonable to assume that few
of the securities taken would be sold in the market in the period
immediately following the exchange, and, indeed, the greater part
would probably not be sold for many years. The effect on available
market supply is, therefore, distinctly less than in the case of either
a cash offering or a refunding at time of maturity. Assuming that the
Treasury offers investors in exchange a somewhat higher coupon in
consideration for their taking a longer bond, they can better their
current income and still carry the new bond on their books at the
price paid for the old bond. On balance, then, much more substantial
debt extension may be achieved with no more immediate market
impact than would occur in the case of a cash offering of a nominal
amount of long-term bonds.
31. From a longer-run standpoint, the addition to the supply of
long-term Government securities, and the relief of the congestion
in the area between one and five years, should also contribute to a
smoother functioning market for all U.S, Government securities.
The principal market improvement, of course, would eventually be
reflected in the one- to five-year area, which has been distorted by
the unduly heavy concentration of issues in this maturity range,
but the entire market structure would be brought into better balance.
The breadth, depth, and resilience of the market should also reflect
the improved maturity distribution, including the additional supply
of long-term issues which presumably would result in a broader and
more continuous long-term market.

APPENDIX

267

32.
Similarly, the economic consequences of an advance refunding
involving substantial debt extension would be less pronounced than
cash offerings (or refundings at maturity) since such an advance
refunding would not immediately result in the absorption of addi
tional amounts of long-term funds that usually are being generated
currently in relatively limitedamounts.lt would minimize the inter
ference with the flow of new savings into the private sector of the
economy, such as would result from an equal offering for cash. At
the same time, postponing the shortening process on this portion of
the debt would further reduce the possible movement of these
securities into the hands of short-term investors, thus diminishing
the inflationary potential of the public debt. Although this would tend
to reduce somewhat the flow of funds from intermediate credit
markets to long-term private (non-Treasury) investment, as long
term investors might otherwise sell their holdings in order to
acquire long-term private and municipal investments, the immediate
absorption of new savings still would be much less than in the case
of a cash offering of equal magnitude. Stated differently, there is
no denying that senior advance refunding would reduce somewhat
the shift of funds from the intermediate area into long-term cor
porate, municipal and mortgage financing which otherwise might
occur; but the impact would be spread over a period of years, in
much the same manner as if the Treasury were able from month to
month to market relatively small amounts of long-term bonds for
cash. This latter program does not, however, seem feasible from
a market standpoint.
Advantages of advance refunding to investors,
33. An advance refunding offers tangible advantages to the in
vestor who is willing to exchange for a longer-term security. Most
importantly, the investor would obtain a better immediate return on
his security since the Treasury would offer a higher coupon to
make the exchange attractive. One immediate advantage to the
investor, therefore, is an improvement in current income— to a
rate level that for many institutional investors would more ade
quately cover interest income requirements. The investor is guaran
teed the higher coupon for the entire life of the new security.
34. It should be noted that the investor also obtains a new bond
that at least is equal to, and in most instances a better value than,
the current market for comparable maturity issues. In most cases
the Treasury would be offering a bond with a yield slightly higher
than the current market rate for existing bonds of comparable
maturity when computed at the same price (prior to announcement)
as the bond being exchanged in advance of maturity. Or, viewed
another w a y -in terms of price ^ th e price of anew bond offered by
the Treasury in an advance refunding, if computed at the same yield,
as existing bonds comparable in maturity to the new bond, generally
would be slightly higher than the current price of the old bond.

268

THE TREASURY ANSWERS

35. The increased coupon for the full term of the new issue
carries an additional implication. The investor who did not elect
to exchange would have to replace his existing security at maturity
at higher than present market rates to net the same return as that
being offered over the entire life of the new security. Reinvestment
at the maturity of the old bond would be required at a coupon rate
for the extension period which, if averaged with the lower coupon
rate on the old security to maturity, would be equal to the coupon
rate the Treasury is offering on the new security for the entire
period to maturity. (See pars. 37-39 for an example.)
36. Finally, one further benefit accrues to the investor who
extends in an advance refunding. Under Title IIof Public Law 86-346
passed in September 1959 in preparation for advance refunding, the
Secretary of the Treasury may designate an exchange of one
Treasury security for another as a nontaxable exchange.3 Generally,
this means that in the exchange the value of the existing security on
the books of the investor becomes the book value of the new security.
Therefore, the exchange causes no immediate tax consequences and
investors are not required to take a loss for tax purposes merely
because they exchanged. The gain or loss is deferred until the new
security is redeemed (or disposed of prior to maturity). However, if
a payment to the investor— other than an adjustment of accrued
interest— is involved (which might be the case in some advance
refundings), the book value of the new issue would not be the same
as that of the existing issue and part or all of the payment becomes
immediately taxable,
37. A simple example of an advance refunding offer by the
Treasury will make these added advantages to the investor clear.
^Paradoxically, this legislation was designed primarily to induce
exchanges by nontaxable or partially taxable investors, regulated
by federal or state authorities, rather than taxable institutions.
These nontaxable or partially taxable investment institutions are
usually quite reluctant to incur book losses because of the resulting
decrease in the stated value of their assets. However, the regulatory
authorities are typically willing to permit such exchanges with
postponement of recognition of capital gain or loss on the investors*
books, provided that a change in the Internal Revenue Code es
tablishes an appropriate precedent. Thus, while the legislation
directly affected only holders subject to federal income taxes, it
gave sanction to an accounting practice for public authorities to
apply in the regulation of certain types of financial institutions even
though they may not pay federal income taxes. The advantage to
such nontaxable investors is that they may be permitted to carry
the new, higher rate securities at the same price as the old.

APPENDIX

269

This example is purely hypothetical and intentionally has no^
relationship to any possible or prospective offering, Assume that
nontaxable holders of a 2 1 /2 percent bond due in five years were
offered an opportunity, at a time when the market interest rates
on ten year issues were 4 percent, to exchange in advance of
maturity into a 3 1/4 percent bond maturing in ten years. The
nontaxable holder of the 2 1/ 2 s who takes advantage of the advance
refunding offer has an immediate increase of 3 /4 percent per
annum over the period (five years) to the maturity of the original
security. This would amount to $37,50 on a $1,000 bond, which
could be reinvested as received at compound interest. As a result,
if the nontaxable holder of the 2 1 /2 s did not elect to accept the
advance refunding offer, he would have to reinvest the proceeds of
his 2 l / 2 s on maturity at a rate of at least 4,16 percent on this
hypothetical issue in a five year maturity to earn as much as he
would by accepting the exchange offer. This 4,16 percent minimum
rate of investment is the rate of return for the extension period.
38.
An analysis of the advantages in return to a taxable holder
of the 2 1/2 percent bonds is somewhat more complicated. The
effect of tax provisions varies among different investors, depending
upon the price at which the security being refunded was originally
acquired and the investor’s tax status and plans. On the one hand,
assuming a par for par exchange of the ten year, 3 1/4 percent
bond for the 2 l / 2 s, if the holder had originally acquired his 2 1 /2
percent bonds at a price of, say, $96, he would have realized a
capital gain of $40 per $ 1,000 at time of maturity in five years.
This would involve a $10 tax liability per bond at a 25 percent
capital gains tax at the end of five years. By electing to exchange
for the new issue of 3 l / 4 s he could postpone this tax for an addi
tional five years and continue earning interest on the amount of
the postponed tax for that period. If this investor did not exchange,
the capital gains tax would lower the amount he had available for
reinvestment at the maturity date of the 2 1/ 2 s; on an equivalent
taxable basis he would have to reinvest at a rate higher than 4.13
percent to earn as much as he would by participating in the advance
refunding. For the taxable investor who elected to exchange, the
tax on ordinary income would work in the opposite direction, since
the investor after taxes would net something less than the 3/4
percent additional coupon over the period (five years) to the ma
turity of the original security.
39.
Based on the assumptions in the hypothetical example, the
following table illustrates the rates at which investors who held
the 2 l / 2 s at varying book values would have to reinvest at the end
of five years to be as well off as they would be by accepting an
advance refunding offer of 3 l/4 s , assumingaparfor par exchange.

THE TREASURY ANSWERS

270

Cost (basis)
of 2 1 /2 percent
bond due in
5 years
To nontaxable inves
tors (or before tax).
To taxable investors^—

Rate of return for the
extension of maturity
(5 years)

Any cost-

4,16 percent . 1

101 ---------

(taxable equiva
lent).^
4, 08
4. 09
4. 10
' 4. 11
4. 12
4. 13
4. 14
4. 14
4. 15
4, 16

100 --------9 9 -----------

98----------97----------96----------95----------94 ----------93 ----------92-----------

iBased on semiannual compounding at 4 percent (from assumed
pattern of market rates).
2Assuming coupon income is subject to 52 percent tax and capital
gain is subject to 25 percent tax.
^Coupon rate during extension which, combined with 2 1 /2 percent
until maturity of old bond (five years), would provide the same
return after tax as 3 1/4 percent for ten years.

Advantages of advance refunding to the U.S. Treasury.
40. From the standpoint of the Treasury, advance refunding is
the best means of achieving an urgently needed improvement in the
maturity structure of the marketable public debt. An improved debt
structure, which is the principal advantage accruing to the Treasury
from use of advance refunding, would afford much needed flexibility
in financing operations. It should also result in lower over-all costs
to the Treasury over the years ahead. The size and frequency of
Treasury borrowings will be reduced to the extent the debt can be
funded at long term. In turn, this would minimize the interference
of Treasury financings with the timing of appropriate monetary
policy actions,
41, As noted, advance refunding permits substantial debt
extension with a minimum disturbance to financial markets and
the economy generally. It makes Government bonds more attractive
to long-term investors, thus reducing the Treasury’s dependence

APPENDIX

271

on inflation ary s h ort-term bank borrow in g. It avoids many o f the
disadvantages involved in sellin g lon g -term bonds fo r cash o r in
exchange f o r m aturing iss u e s. S pecifically, it red u ces m arket
in te rferen ce o f heavy refundings (or of reso rtin g to alternative
siza b le cash offerin gs) in relation to corp ora te, municipal and
m ortgage financing. A s a resu lt, the d irect interest co st to the
T re a su ry o f placin g a given amount of secu rities in the lon g-term
area b y m eans o f advance refunding should be significantly le s s
than ^ an equal amount w ere sold fo r cash o r in exchange fo r
m aturing is s u e s . This is because the m arket p r o c e s s o f m obilizing
the cash to redistribu tion that must accom pany a refunding at
m aturity req u ire s a rela tiv ely high interest rate com m ensurate with
the amount issu ed . In an advanced refunding, how ever, there should
be little m arket churning and no need fo r m obilization o f new cash,
th ereby resu ltin g in a low er interest cost than on a cash offerin g
o r routine refunding o f equal amount,
42.
It m ay be noted that only when debt operations a re supported
by a ll types o f in v estors purchasing and holding a wide range of
m a tu rities can the T rea su ry finance on the m ost econ om ical b a sis.
An undue concentration o f the debt in one area is alm ost im m ediately
r e fle c te d in higher in terest co s ts in the area affected and experience
has shown that this tends to fan out a c r o s s the m aturity spectrum .
T h is w as c le a r ly dem onstrated in the past yea r when as a resu lt of
the in terest rate ceilin g the T rea su ry was fo r c e d to concentrate its
financing in the u n d e r -fiv e -y e a r area. Any in crea sed interest cost
is on only a sm all p ortion of the debt and v e r y lik ely w ill be m ore
than o ffs e t by low er co s ts on subsequent routine debt operations
(totaling m any b illion s o f d olla rs each yea r)as the maturity structure
of the debt is brought into better balance. In addition, in viewing the
c o s t a sp ect o f advance refu n din gfrom the standpoint o f the T reasu ry
it should be noted that the in crea sed coupon o v e r the rem aining
life o f the m aturing secu rity (e .g ., fiv e y e a rs in the ca s e o f a hypo
thetical issu e m aturing in 1965) would be o ffse t by a low er coupon
fo r the rem aining y ea rs o f the new secu rity (e .g ., the fiv e ye a rs
follow in g 1965 in this p articu la r ca se) than would have to be paid
now to s e ll a new secu rity at a com parable m aturity.
43.
Fin ally, keeping presen t h old ers o f T re a su ry se cu ritie s as
in v e sto rs in the y e a rs ahead is an im portant task fo r the T reasu ry
in m anaging the debt. Advance refunding m akes a m a jor contribution
tow ard this goal; s p e cifica lly , it greatly im p roves the T re a su ry ’ s
ch a n ces o f retaining its lon g -term cu stom ers, who in recen t y e a rs
have been liquidating T rea su ry s e cu ritie s, as they m ove toward
m atu rity, and rein vesting in n on -T rea su ry s e c u r itie s . The use o f
advance refunding re c o g n iz e s the p re fe re n ce o f each cla ss o f in
v e s to r s f o r se cu ritie s o f suitable m aturity. Thus a princip al m e rit
o f advance refunding is that it enables a lo n g -te rm h old er whose bond
is shortening in m aturity an opportunity to extend b e fo re the m aturity

272

THE TREASURY ANSWERS

shortens to the point where he decides to sell. In effect, it enables
the Treasury to keep typical long bondholders in long bonds and
typical intermediate holders in intermediates.
Advance refunding and the statutory 4 1/4 percent interest limitation.
44. Advance refunding is the least costly method for the
Treasury to retain its customers and to achieve a significant
extension of the debt. Achieving these twin objectives involves some
cost, however, and in setting the terms of an advance refunding the
Treasury must consider whether the cost involved would in any
way conflict with the 4 1/4 percent interest rate ceiling established
by Congress on Government bonds (the only obligations the Treasury
can issue maturing in more than five years).4 Until recently, in fact,
the existence of the ceiling precluded any attempt to undertake an
advance refunding involving a new issue of Government bonds since
the maximum return of 4 1/4 percent the Treasury could have of
fered was below market rates.
45. In relating the interest rate ceiling to advance refunding it is
obvious that the coupon rate on the new security does not represent
the true interest cost to the Treasury of obtaining the debt extension.
To consider only the coupon cost ignores the fact that the Treasury
could allow the existing lower coupon security to remain outstanding
for whatever number of years remain to maturity under the terms
of the original contract with the investor. On the other hand, the
coupon that could be placed on an advance refunding, say for ten
years, would normally be substantially below the ten year market
rate either on outstanding bonds or new issues.
46. The following is a simple illustration—again purely hypo
thetical—of the dollar cost to the Treasury of a ten-year, 3 l/4
percent bond offered to holders of a 2 1 /2 percent bond maturing in
five years. Over ten years the Treasury would pay out in interest
$325 per $1,000 bondat3 1/4 percent per annum. On the other hand,
if the 2 l / 2 s were allowed to run to maturity and then refunded after
five years, the Treasury would pay out only $125 on the 2 l / 2 s for
4This interest rate limitation was established by Congress in
1918, in connection with a particular financing operation of World
War I. Except for the years 1919-22, it did not restrict Treasury
debt management until 1959, when the cost of long-term borrowing
rose above 4 1/4 percent in response to strong pressures of
demand in credit markets. The net effect of the interest rate
ceiling, during most of 1959 and the first half of 1960, was to
force the Treasury to rely almost exclusively on new issues of
Treasury bills, certificates, and notes, which mature in five
years or less and on which no interest rate ceiling exists.

APPENDIX

273

the first five years. The Treasury could, therefore, offer a fiveyear bond at the maturity of the 2 l/2 s and pay out $200 in interest
without exceeding the total interest paid out on a 10-year 3 1/4
percent bond offered in exchange for the five-year 2 1/2 percent
issue. This would be equivalent to selling a 4 percent, five-year
obligation to refund the 2 l/2 s at maturity. This 4 percent rate,
ignoring compound interest, would be the cost of the five-year
extension to the Treasury.
47. This example is oversimplified, however, since the addi
tional coupon cost to the Treasury takes place in the first five
years while the saving in coupon does not take place until the next
five year period. If interest is compounded semiannually (at 4
percent per annum) the cost to the Treasury of the five year exten
sion in advance is 4,16 percent rather than the 4 percent cost in
the simplified illustration. It is this derived interest cost of 4.16
percent that the Treasury would have to take into account in
determining whether or not an advance refunding issue would be
within the 4 1/4 percent interest rate ceiling.
48. It should be further emphasized that this interest cost to the
Treasury results only from the fact that the Treasury could have
allowed the old issue to continue to maturity. In that sense it is a
derived cost computed only to determine whether the advance re
funding complies with the intent of the legal interest limitation.
The cost of refunding five years from now cannot, of course, be
determined in advance. If the cost of refunding in five years should
turn out to be greater than the derived cost of advance refunding
the Treasury would have made a real saving in interest costs by
undertaking an advance refunding. On the other hand, if market
interest rates five years from now are lower, then the additional
dollar cost to the Treasury would be greater than if no advance
refunding had been undertaken.
49. To illustrate these calculations graphically, Chart A-3 shows
the true cost of an extension of a 2 1/2 percent, five-year bond into
a 3 1/4 percent, ten-year bond. The left-hand block shows the addi
tional cost to the Treasury of the 3 1/4 percent coupon over the 2 1/2
percent coupon for the five years to maturity. The right-hand block
shows the true cost of the extension to the Treasury, i.e „ 4.16 per
cent, which is simply the coupon rate (including compounding) which,
if averaged with the 2 1/2 percent return on the security being re
funded (for the five years to maturity), equals the 3 1/4 percent
return the Treasury is offering on the new security for the ten-year
period. The right-hand block also shows the savingto the Treasury
in the extension period in terms of the coupon cost on the new issue
relative to either the derived cost of extension or a 4 percent market
yield (assuming that the market yield curve in the ten-year area is
4 percent).

274

ADVANCE REFUNDING OF A
HYPOTHETICAL 5-YEAR 2 '/z% INTO A 10-YEAR 3!4% BOND*
Relationship of New and Old Bond CoiiDon Rates and Cost of Extension

Assuming /0-year market rate of 4%t which is atso the rate for compounding or discounting to present value.

*Roundedfrom4.(642%.

Olfict of the Sttrtt*> of th*

THE TREASURY ANSWERS

CHART A-3

APPENDIX

275

50. Finally, it may be noted that regardless of the actual level
of market yields, alternative use of cash offerings (or refundings
at maturity) to extend an equal amount of debt would exert upward
pressure on yields. To obtain a substantial amount of debt exten
sion, the coupon rate on such issues would have to be considerably
higher than the market yield prior to announcement— how much
above depending upon the size of the offering. On the other hand,
if the amount offered were limited to avoid market impact, then
a cash financing becomes relatively more “costly" in the broader
context of a lesser achievement in attaining a better debt structure,
Also, it is more “costly” from a broader economic standpoint,
particularly during any recession when interest rates are low, to
turn to cash offerings or refundings at maturity which absorb new
savings that otherwise could contribute to economic recovery.
E. Concluding Comment
51. The advance refunding technique offers much promise in
terms of the achievement of a better maturity structure of the
marketable public debt and the retention of the present long-term
holders as investors in Government securities. It is not a panacea
for all the problems of debt management under all circumstances,
since it is chiefly applicable when large outstanding issues are
selling at substantial discounts and in a market in which there is
willingness on the part of investors to extend the maturity. It is
clearly the best method of bringing about significant debt lengthen
ing, so essential in the light of the unbalanced debt structure, and
at the same time retaining intermediate and long-term investors in
Government securities. It would accomplish this with a minimum of
adverse market and economic effects. Alternatively, the Treasury
could offer long-term bonds for cash or in exchange for maturing
issues of Government securities. While both of these other tech
niques maybe useful under certain circumstances, advance refunding
has great promise at the present time as a way of implementing
sound debt management policy as an integral part of federal financial
responsibility.