Full text of Review (Federal Reserve Bank of St. Louis) : December 1965

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

1965:

CONTENTS
Page

M o n eta ry

1965: Monetary Growth, Real
Product Growth, Price
Increases ....................
1. In tro d u ctio n

l

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

1

2. T h e P o lic y E n v iro n m e n t . . .

2

3. D e m a n d , P ro d u c tio n ,
E m p lo y m e n t, and P ric e s
4 . C re d it D e v e lo p m e n ts

. .

4

...........

6

5. C o m m e rc ia l B an k
E x p a n sio n
................................

8

6 . In te re s t R a te I n c r e a s e s ...........

10

7 . M o n e ta ry E x p a n sio n

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

12

8 . In te rn a tio n a l D ev elop m en ts

12

9 . S u m m ary

14

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

Review Index — 1965

........

16

G ro w th 9 R e a l
P r ic e

P rod u ct

G ro w th ,

In crea ses

1. I n t r o d u c t i o n
F ! C O N O M I C A C T I V I T Y continued to surge upw ard in 1965,
the fifth consecutive year of m arked economic growth. The rise
occurred against a background of substantial monetary expan­
sion and stimulative fiscal actions. The United States balance-ofpayments position improved in the second quarter of the year,
but this change was not prim arily a result of constructive changes
in underlying market forces.
R isin g economic activity was manifested in a substantial in­
crease of output and em ploym ent and in price increases. U n e m ­
ploym ent declined to the lowest levels in several years. Prices
rose more rapidly than in other recent years.

V o lu m e 4 7

•

Num ber

12

FEDERAL RESERVE BANK

A s 1965 began there was a sizeable discrepancy between the
actual and the potential output of the economy. In the fourth
quarter of 1964, with the economy operating at an estimated
96 per cent of its potential, the “full employment gap ” was con­
sidered to be $24 billion.1 Moreover, there had been an absence
of price inflation for several years. Thus, it appeared that 1965
could be an additional year of sustainable economic expansion
with reasonable price stability.

OF ST. LOUIS
P .O . B o x 4 4 2 , S t. L ou is, M o . 6 3 1 6 6




xThe potential gross national product of the U.S. economy was estimated as that
which would be produced if the unemployment rate were at the interim target of
4 per cent. See E co n o m ic R ep o rt o f th e P resident, transmitted to the Congress
January 1965, pp. 81-85.

On the other hand, there was increased concern
about the U.S. balance of payments. W hile the current
account (exports of goods and services minus corre­
sponding imports) had shown improvement in 1964,
this improvement was more than offset by deteriora­
tion in the capital account.
This article undertakes a description of the progress
of the economy during 1965. There is first a discus­
sion of the monetary and fiscal policies which contrib­
uted to the year’s economic successes, followed by an
enumeration of these successes. Next there are dis­
cussions of general credit developments, interest rates,
and monetary expansion in 1965. The monetary ex­
pansion which emerged from the pattern of forces
which existed in 1965 was rapid. United States balance-of-payments experience in 1965 is then described,
along with a discussion of aspects of the Government’s
balance-of-payments program. Following this, conclu­
sions are presented.

ing 1965 stimulated total demand for goods and serv­
ices during the year. If the impact of variations in the
stock of money on final demand occurs with a lag,
monetary developments significant for business activ­
ity in 1965 may have been in part those of an earlier
period.3 On the other hand, there appears to be a
presumption that the effects of fiscal actions are more
nearly simultaneous.4

Money
Growth in the money stock during 1964 and 1965
was rapid by historical standards. Money rose 4.3 per
cent from late 1963 to late 1964 (C hart 1 ). In 1965
Chart 1

B illio ns of D o llars

M o n e Y S u p p ly

BiMions of Do||ars

Discussion of developments during a year is aided
by the perspective of experience over a longer period.
Throughout much of this article, developments during
the year ending in late 1965 are compared with those
in a corresponding year-earlier period and the period
of economic expansion beginning in early 1961. Fu r­
ther, experience from the peak year 1960 to late 1965
is compared with experience during the 1950-53, 195357, and 1957-60 periods. The initial and terminal years
defining these periods are peaks in national business
activity.2 Such “peak-to-peak” comparisons provide a
basis for gauging relative growth trends.
Several of the charts accompanying the article are
designed to facilitate comparison of the past five years
with experience during the two preceding five-year
periods. The selection of these five-year periods is
arbitrary but does permit an evaluation of a recent
substantial period of time in relation to other periods
of the same length. The period since early 1961 has
been one of strong and continual monetary and eco­
nomic expansion. The other two five-year periods
were not; each included at least one period of pro­
longed stability or decline in the stock of money; each
included at least one business recession. The charts
highlight the dissimilarity of experience during these
periods and afford a basis for considering why the
periods were so different.
2. T h e P o lic y E n v ir o n m e n t
A substantial rise in the stock of money and marked­
ly expansive fiscal developments both before and dur2 Postwar peaks in national business activity, according to the
National Bureau of Econom ic Research, were in 1948, 1953,
1957, and 1960.

Page 2



Latest data plotted: N ov e m b e r preli mi nary

money continued to rise at about this same rate. From
early 1961 to the end of 1964 the money supply grew
at a 3.2 per cent annual rate. The rate of growth has
been relatively stable. There is a view that the econ­
omy is inherently resilient and, under ordinary circum­
stances, will not stray far from a stable path unless
shocked away by wide movements in the monetary
and fiscal environment.5 In the 1956-60 and 1951-55
3 For discussions of lags in the response of economic activity to
public policy measures see Thomas Mayer, “The Inflexibility
of Monetary Policy,” R ev iew o f E co n o m ics a n d Statistics, Nov.
1958, pp. 358-74; Milton Friedman, “The Effects of a FullEmployment Policy on Econom ic Stability: A Form al Analysis,”
E ssays in P ositive E co n o m ics (Chicago: University of Chicago
Press, 1 9 5 3 ), pp. 117-32; and John M. Culbertson, “Friedman
on the Lag in E ffect of Monetary Policy,” Jou rn al o f P olitical
E con om y , Dec. 1960, pp. 617-21.
4Edgar C. Brown, Robert M. Solow, A lbert Ando, and John H.
Kareken, “Lags in Fiscal and Monetary Policy,” Stabilization
P olicies, Commission on Money and Credit (Englew ood Cliffs,
N .J.: Prentice-H all, Inc., 1 9 6 3 ), pp. 1-63.
3 For an elaboration of such a view see Milton Friedman, “A
Monetary and Fiscal Framework for Econom ic Stability,” T h e
A m erican E co n o m ic R eview , June 1948, pp. 245-64.

periods the growth in money was slower and less
even.0 (Section 7 provides a more complete discus­
sion of monetary expansion in 1965.)

Federal Budget
Fiscal actions were stimulative in 1965. The full
employment surplus declined from an annual rate
of $4.8 billion in the last half of 1964 to approximate
balance in the last half of 1965 (Chart 2). Govern­
ment expenditures, which rose only slightly from the
second quarter of 1964 to the second quarter of 1965,
jumped sharply in the recent third quarter. Expend­
itures in the third quarter of 1965 were 7 per cent
higher than one year earlier. W hile receipts rose in
1965, their increase was moderated by reductions in
excise taxes.
Chart 2

Full E m p loym e n t B u d g e t

been the case. A reduction in excise taxes effective
in May 1965, though not affecting money incomes di­
rectly, raised “real” incomes by increasing the quanti­
ties that each dollar could purchase. As a result, final
demands for the product of the economy were stim­
ulated. This may also have served to enhance the profit
outlook of businesses and, thereby, to stimulate invest­
ment.
Measures which reduce the net flow of Federal re­
ceipts from a given income stream, in addition to their
more or less direct effect on consumer spending and
business investment, serve to cause the Federal deficit
at that level of income to be greater than would other­
wise be the case. Thus, credit demands by the Federal
Government at that level of income are greater than
would otherwise be the case. In short, as a result of
tax rate decreases or expenditure increases, upward
pressures are exerted on interest rates at any given
level of income.

Monetary Policy—Fiscal Policy Trade-Off
Federal budget actions to stimulate, maintain, or
limit final demand may be viewed as an alternative
to monetary actions. But whereas stimulative fiscal
actions serve to raise interest rates at any given level of
income, stimulative monetary actions tend to reduce
them. Figure 1 is a greatly simplified illustration of
this proposition. The red line represents a locus of all
combinations of monetary policy, fiscal policy, and
interest rates which are consistent with any given rate
of increase in final demand. For example, the rate of
increase in final demand could be that which results
in full employment—or which results in an acceptable
choice or “trade-off” between employment increases
and price increases.
Sources: Board of Governors of the Federal Reserve System
and Council of Economic Advisers

A salient characteristic of 1965 and of the business
expansion since 1961 has been the emphasis placed on
fiscal actions as a means of stimulating economic activ­
ity. In 1962, during an early phase of the expansion,
depreciation schedules and tax credits were changed.
These measures were taken with a view to stimulating
investment. In early 1964 tax rates both for personal
incomes and for corporations were lowered. By virtue
of the reduction in rates on personal incomes, after-tax
income rose more rapidly than would otherwise have
6 The standard error of the estimate around linear trends for
1961-64, 1956-60, and 1951-55 are $1.0 billion, $1.5 billion,
and $1.1 billion, respectively.




Figure I

Monetary Policy and Fiscal Policy Trade-Off
INTEREST RATES

If higher interest rates would contribute to achieve­
ment of ultimate goals of public policy, for example if
Page 3

they could serve to foster a more viable international
balance-of-payments situation, it would be useful to
move along the red line toward “tighter” monetary
policy and “easier” fiscal policy.7

the recent third quarter, up 7 per cent from the corre­
sponding year-earlier period (Table I). Such spending
has risen at a 6 per cent annual rate since 1960. Con­
sumer outlays in relation to after-tax income remained
near the 92 per cent level during much of 1965, after
a moderate decline immediately following the 1964
tax cut.

To the extent that fiscal policy is not flexible in the
short run, there is at any given time only one rate of
monetary expansion and one level of interest rates
which is consistent with optimum final demand.

Business Spending. Investment spending rose $9.4
billion or 10 per cent in 1965, reaching $102 billion in
the third quarter.9 Unless the public decides to save
more out of any given level of income, a rise in in­
vestment is accompanied by a substantially greater
rise in income. Variations in investment are therefore
strategic in the income determination process. Fixed
investment in 1965 was 8 per cent greater than in 1964.
Since 1960 fixed investment has risen at an average
annual rate of 6 per cent, about the same as in the
1953-57 period and about twice as rapidly as in the
1957-60 and 1950-53 periods (T ab le I ) .

3. D e m a n d , P r o d u c t io n , E m p lo y m e n t ,
a n d P r ic e s
The continued expansive monetary environment
along with successive doses of fiscal stimulation nur­
tured a sustained rise in total demand during 1965.
The increase in aggregate demand, in turn, resulted in
part in more real product and employment and in part
in price increases.

Dollar Demand fo r Goods and Services
Dollar demand for the economic product continued
to rise rapidly in 1965. Total spending by consumers,
business, and government on currently produced
goods and services reached an annual rate of $669
billion8 in the third quarter, 7 per cent higher than
in the third quarter a year earlier (Table I). Since 1960
total spending has risen 6 per cent per year, a some­
what more rapid rate of growth than in the 1957-60
and 1953-57 periods.

Business added to total spending by building inven­
tories in 1965. In the third quarter inventories were
accumulated at a $6.1 billion annual rate compared
with a $3.8 billion rate a year earlier. Notwithstand­
ing the accumulation, inventories in relation to sales
continued to edge downward during most of 1965. A
few years ago, when desired inventories were appar­
ently greater in relation to sales than now, a given dol­

Far and away the bulk of total spending, $637 bil­
lion or 95 per cent, was for domestically produced
goods and services. The remainder, $32 billion or 5
per cent, was for foreign goods and services. Imports
were 12 per cent higher than in 1964 compared with
an average annual rate of increase of 6 per cent since
1960.
Consumer spending. The major portion of total spend­
ing was directed, as always, to­
ward consumer goods. Consumer
spending reached $432 billion in

lar increase or decrease in sales resulted in a much
greater change in inventories than has recently been
the case when the desired inventories-to-sales rela­
tionship is apparently lower.
9 Investment spending includes fixed investment and changes in
business inventories. Fixed investment includes spending on
residential structures in addition to spending on plant and
equipment.
Table I

DOLLAR

7To the extent that interest rates
(as a cost of borrowing) are an im­
portant consideration in investment
decisions, higher interest rates may
limit investment and growth. Hence,
a choice between a more rapid rate
of growth and international Dalance
may emerge. If higher interest rates
were chosen for international con­
siderations, it may be that such fiscal
tools as tax credits or other incentives
may be desirable to facilitate growth.
8 Gross national product in the third
quarter of 1965 was $677.5 billion.
In estimating GNP, imports are sub­
tracted from exports and the differ­
ence is presented as net exports. GNP
exceeds total spending by the amount
of net exports.

Page 4



DEMAND

FO R G O O D S

AND

S E R V IC E S

(Valued at Current Prices)
Growth in Dollar Demand (Annual Rates)

Total expenditures
Consumer
Business
Fixed investment
Government
Gross national
product1

3rd Qtr.
1965

3rd Qtr. 1964
Previous
Peak to Date
to

(Billions)

3rd Qtr. 1965

1960-65e

1957-60

1953-57

$669.4
432.2
102.0
95.9
135.2

6 .9 %
6.8
10.2
8.0
5.1

5 .9 %
5.7
6.4
6.0
6.2

4 .7 %
4.9
3.3
2.3
5.0

4 .6 %
5.2
6.6
6.3
1.3

677.5

6.7

5.9

4.5

4.9

Peak-to-Peak Period s
1950-53
8 .8 %
6.4
— 0.9
3.3
29.2
8.6

e— E s tim a te d
i T h e sum o f co n su m e r, b u siness, a n d g o v e rn m e n t e x p e n d itu re s plus n e t e x p o rts (e x p o rts m in us im p o rts).

Results Flowing fro m Dollar Demand

C hart 3

T otal C iv ilia n E m p lo y m e n t

Real product. In response to the attraction of ag­
gregate money demand, there was a strong rise in out­
put in 1965. Real output expanded 5 per cent in the
year ending in the third quarter. This increase com­
pares with a 5.2 per cent rise in the preceding year
and an average growth of 4.5 per cent since 1960.
Growth in real output in earlier comparable periods—
aside from the 1950-53 period of the Korean W a r—
was substantially less rapid (Table II).
The bulk of national output, about 94 per cent, was
sold in domestic markets. The remainder went to for­
eign markets. Despite Government efforts to expand
exports, the rise in 1965 was only 5.4 per cent com­
pared with 13 per cent the preceding year and a 7 per
cent average annual rate of increase since 1960. Net
exports (exports less imports) declined from the third
quarter of 1964 to the third quarter of 1965 (Table II) .

Latest d a t a plotted: N o v e m b e r

As an indication of the strength of the labor market,
employment rose one and one-half times as rapidly in
1965 as did the population of working age (Table I I I ) .
This means that “marginal” workers were drawn into
the labor market. These workers may have been less
productive than those already employed. If this were
the case, it would provide some indication that de­
mands for workers are rising more rapidly than the
economically efficient “capacity” of the labor force.

Expanding economic output in 1965 and since 1961
was made possible by growth in physical capacity, im­
provement in technology, and increased employment
of labor. Physical capacity was increased by fixed in­
vestment expenditures which rose at a 6 per cent rate
in 1965, unchanged from the rate in 1964. Since 1960
such spending has risen at a 5 per cent average annual
rate, a substantially more rapid rate of growth than
in earlier peak-to-peak periods (Table II) .

G RO W TH

Employment. Employment expanded rapidly in
1965. From November 1964 to November 1965 total
civilian employment rose 3 per cent (Chart 3). In
the preceding year employment rose 2.1 per cent.
Since 1960, the most recent peak in business, employ­
ment has risen at a 1.6 per cent annual rate, some­
what more rapidly than in the 1953-57 and 1950-53
periods and nearly twice the rate of increase in the
1957-60 period (Table III).

IN

Table III
E M P L O Y M E N T A N D P O P U L A T IO N
O F W O R K IN G A G E
(Annual Rates)
Population Aged 18-64
Employment
2 .9 %

1964-651
1960-65
1957-60
1953-57
1950-53

AND

S E R V IC E S

(Valued at 1958 Prices)
Growth in Output (Annual Rates)

Total (GNP)
Consumer
Business
Fixed investment
Government
Net exports
e— Estim ated




3rd Qtr.
1965

3rd Qtr. 1964 Previous
Peak to Date
to

(Billions)

3rd Qtr. 1965

$609.7
396.7
92.9
87.0
112.9
7.3

4 .7 %
5.1
8.0
5.8
2.2
— 16.1

1 960-65e
4 .5 %
4.5
5.2
4.8
3.4
9.9

Peak-to-Peak Periods
1957-60
2 .5 %
3.1
1.7
0.6
2.1
— 11.5

1.8%

1.6

1.3

0.9

0.8

1.2
1.2

0.7
0.7

1 N ovem ber to November.

Table II
R EAL O U T P U T O F G O O D S

S o u r c e : U . S . D e p a r t m e n t of L a b o r

1953-57

1950-53

2 .3 %
3.5
3.0
2.9
— 2.7
54.1

5 .1 %
2.9
—4.1
—0.4
23.6
— 25.9

Unemployment declined sig­
nificantly in 1965. As a share
of the labor force, unemploy­
ment averaged 4.3 per cent in
the three months ending in
November 1965 compared with
5.1 per cent a year earlier. U n ­
employment of married men de­
clined from 2.4 per cent a year
ago to 2.0 per cent.
Prices. Prices rose more rapid­
ly in 1965 than in other recent
years. Price increases have been
substantial and quite general,
responding to strong total dePage 5

mand. As Table IV indicates, each of
the major price indexes rose at an in­
creased rate, with wholesale prices
showing the most pronounced surge.
The rate of increase in wholesale prices
of industrial goods, 1.3 per cent in the
year ending in October, compares with
essentially no increase in the five years
since 1960. Further, the change in the
trend of these prices may have been
greater than the indexes indicate since,
in response to strong demand, transac­
tions prices have probably risen relative
to quoted prices.

Table IV
P R IC E S
(Annual Rates of Change)

The rise in prices during 1965 may be viewed as the
social cost of such marked expansion in employment
and decline in unemployment. There may be a trade­
off between further gains in employment or declines
in unemployment on the one hand and price increases
on the other. Figure 2 is a greatly simplified illustra-

2

PRICES
(rate of in crease)

Late 19651

1960-65e

1957-60

1953-57

1950-53

1 .2 %
2.0
0.9
1.4
0.6
0.3
0.1
1.4

1 .7 %
3.3
1.1
1.2
1.0
0.6
0.6
2.0

1 .3 %
3.0
0.5
0.6
0.6
1.7
2.5
2.5

3 .6 %
4.0
3.2
3.7
2.7
2.2
2.7
3.3

1.8 %
2.6
1.3
2.6
0.7
2.3
1.3
1.92

Peak-to-Peak Periods

e— E s tim a te d
1 O c to b e r u nless o th e rw ise in d ica te d .
2 T h ird q u a rte r.

Price—Em ployment Trade-Off"

F ig u r.

Previous
Peak to Date

Consumer price index
Services
Commodities
Food
Nonfood
Wholesale price index
industrial commoditi es
Implicit deflator

The major part of the increase in consumer prices
was accounted for by rising prices of services ( includ­
ing housing). In service industries, or other areas of
the economy where technological gains are relatively
limited, price increases are a means by which produc­
tive factors needed for those uses can participate in
the general rise in living standards. Unless increases
in real income are made available to the general pop­
ulation by price decreases in sectors experiencing
greatest technological gains, there must be an expan­
sion in dollar incomes via price increases if society
wishes to hold workers and other productive facilities
in sectors of more slowly improving technology. Only
if there are price decreases in fields of greatest effi­
ciency can increases in the general level of prices be
avoided.

E m p lo y m e n t a n d Prices T r a d e -O ff

Year Ending

tion of such a trade-off.10 The solid red line represents
the locus of combinations of rates of increase in em­
ployment (or, alternatively, declines in unemployment)
and prices which emerge, given our institutional
structure and productive process,11 from successive
increases in final demand. The figure is drawn to sug­
gest that beyond some point, as the rate of growth in
final demand increases further, a rise in employment
is accompanied by an increasingly rapid rise in prices.
The conjunction of dotted red lines depicts the “ac­
ceptable” trade-off alluded to in connection with Fig ­
ure 1, p. 3.

4.

C r e d it D e v e lo p m e n t s

Credit Uses
Credit flows to ultimate users were at an annual
rate of $64 billion in the third quarter of 1965 (Table
V ) .12 W hile demands for credit were strong, the flow
was $6 billion less than one year earlier. After re­
maining near an annual rate of $70 billion from the
third quarter of 1964 to the first quarter of 1965,
the flow of credit declined, chiefly reflecting a shift
by the Federal Government from net borrowing to
net debt repayment.
W hile total credit flows were less in the third
quarter of 1965 than a year earlier, there was a rise
10Figure 2 is of necessity drawn from some starting point in
terms of capacity utilization and rate of unemployment.
u F or example, the success of a wage-price guideline policy
may alter the trade-off between prices and employment.
12 D ata reported in this section for the third quarter of 1964 are
averages of the second, third, and fourth quarters. Data for
the third quarter of 1965 are averages of the second and third
quarters. To the extent that there is an upward trend in
credit flows, the third quarter of 1965 is biased downward.
Averages are used instead of the annual rate of flow for a
single quarter in an effort to reduce the effects of random or
irregular movements. These data are from the ffow-of-funds
statistics published regularly in the Federal Reserve B ulletin .

Page 6



Table V
FUNDS

R A IS E D

Credit Sources

BY U L T IM A T E U S E R S

(Billions of Dollars, Seasonally Adjusted Annual Rates)
Credit Flows
3rd Qtr.
19651
Total .............................................. 63.5
U. S. Government.................... —4.1
Foreign borrowers....................
2.1
Private domestic nonfinance3 . 65.5

Changes in Credit Flows

3rd Qtr.
1964 2

1960

69.8
6.4
4.9
58.6

33.1
— 2.0
2.0
33.0

3rd Qtr. 1964
to
3rd Qtr. 1965
— 6.3
— 10.5
— 2.8
6.9

1963
to
1964

1960
to
3rd Qtr. 1965

8.9
1.7
1.3
5.9

5.9
—0.4
0.1
6.3

1 A verage of second quarter and third quarter (prelim inary).
2 Average of last three quarters.
3 Includes households, businesses, and state and local governments.
T otals m ay n ot add due to rounding.

Source: Board of Governors of the F ederal Reserve System (Flow -of-funds accounts).

in flows to the private domestic economy. Private
domestic borrowing rose $7 billion over the rate in
the third quarter of 1964, reaching an annual rate of
$66 billion (Table V). This expansion in private
credit flows was about the same as the annual aver­
age rise since 1960.

Funds flowed from surplus to
deficit spending units through
several channels. A substan­
tial portion of credit demands,
about 70 per cent in 1965,
was met through financial in­
termediation (Chart 4). The
remainder was met chiefly
from direct lending by house­
holds, nonfinancial businesses,
or state and local governments
(Table VI, Private domestic
nonfinance).

Intermediaries supplied funds to borrowers at a $47
billion annual rate in the third quarter of 1965, $2.1
billion greater than the flow in the same period of
1964 (Table V I) . 13 Intermediaries serve economic
functions for both lender and borrower. They are a
means by which the lending surplus unit can efficiently
make funds available and at the same time experience
little risk. Rather than lend to the ultimate borrower,
a surplus unit can hold the liability of a financial in-

The Federal Government reduced its debt at a $4
billion annual rate during the third quarter of 1965,
whereas it borrowed heavily during late 1964 (Table
V). Had there not been a change in tax laws, Federal
13 Intermediaries include savings and loan associations, mutual
debt reduction would probably have been even great­
savings banks, insurance companies, noninsured pension plans,
finance companies, security brokers and dealers, and open-end
er. During the period of economic expansion since
investment companies. Tim e deposits in commercial banks
1961 the Federal Government has generally been a
are also included as intermediated funds.
net borrower. In contrast,
Table VI
in earlier periods of rising
economic activity the Fed­
FUNDS A D V A N C E D
eral Government was fre­
quently a net supplier of
(Billions of Dollars, Seasonally Adjusted Annual Rates)
funds.
Credit Flows
Changes in Credit Flows
Foreign “takings” of cred­
it were at an annual rate
of $2.1 billion during the
third quarter, down nearly
$3 billion from the rate in
the corresponding year-ear­
lier period. From 1963 to
1964 the flow of foreign
borrowing increased $1.3
billion but on the average
has risen only $100 million
a year since 1960 (Table
V ). The slowdown in bor­
rowing during 1965 reflects
largely the effects of a pro­
gram of voluntary credit
restraint (discussed on p.
14).




3rd Qtr.
19651
Total to ultimate users..................
63.5
Intermediation..........................
47.0
Nonbank finance3 ................
27.6
Commercial banks
19.4
(time deposits)4 ...............
Other ..........................................
16.7
Commercial banks (other)5 . . — 0.8
Monetary authorities...........
3.2
Federal Government. . . . . . .
4.8
Foreign . ................................. — 1.6
Private domestic nonfinance*5
11.1
Memo: Commercial banks (total)
18.5

3rd Qtr. 1964
to
3rd Qtr. 1965

1963
to
1964

1960
to
3rd Qtr. 1965

33.1
25.6
19.8

— 6.3

8.9
1.4

5.9
4.2
1.5

5.8
7.6
3.1

4.3
— 8.5
—9.0
— 0.4

3rd Qtr.
19642

1960

69.8
44.9
29.8
15.1
25.2

8.2
3.6
4.0

0.8

1.0

1.2
0.2

8.4
23.3

2.3

8.9

2.1
— 2.2

0.8
— 2.6
2.7
—4.8

1.1
0.3
7.6

2.6
0.5

1.1
—0.4
3.8
2.9

2.7

1.8
— 0.8
0.5
0.5
— 0.5

2.1
1.9

1 A verage of second qu arter and third quarter (prelim inary).
-A v erage of last three quarters.
3 Includes savings and loan associations, m utual savings banks, insurance com panies, noninsured pension plans,
finance com panies, security brokers and dealers, and open-end investm ent com panies. The figures are net;
that is, credit raised by these institutions is subtracted out.
J Funds m atched by tim e deposits.
'•Earning assets of banks, less security issues and funds m atched by tim e deposits.
uIncludes households, businesses, and state and local governm ents.
Totals m ay not add due to rounding.

Source: Board of Governors of the Federal Reserve System (Flow-of-funds accounts).
Page 7

termediary. Financial intermediaries pool risk and
thereby reduce average risk. Gains from risk reduction
are passed on to borrowers in the form of lower com­
petitive interest rates Intermediaries also provide a
service to borrowers by pulling together small and
large amounts of funds and putting together loans
tailored to specific needs.
Commercial banks have been increasingly involved
in intermediation (Chart 4). The flow of time deChart 4

Interm ediation in Relation to Total Funds
Raised by Ultim ate Users

Per Cent

Per Cent

plied through expansion of commercial bank time de­
posits was greater. Banks were apparently able to
offer increasingly attractive terms to surplus spending
units and to provide borrowers with funds on favor­
able terms, thereby diverting demand away from com­
petitors.

Changes in Assets
Earning assets of commercial banks rose at a $20
billion annual rate in the recent third quarter, reach­
ing $294 billion (Table V I I ) . 14 In the corresponding
year-earlier period earning assets rose at a $24 billion
annual rate, and in the first quarter of 1965, at a $29
billion rate.
Although total earning asset expansion of commer­
cial banks was less in the third quarter of 1965 than a
year earlier, there was a continued expansion in bank
holdings of loans and securities originating from the
private economy and from state and local govern­
ments. Commercial bank holdings of earning assets
other than U.S. Treasury securities rose at a $27 bil­
lion annual rate in the third quarter of 1965, reaching
$231 billion. In the third quarter of 1964 these assets
rose at a $25 billion annual rate (Table V II) . On the

Source: Board of Governors of the Federal Reserve System (Flow-of-Funds Accounts)
Latest data plotted: 1965 estimated

posits— including certificates of deposit and savings
deposits—was at an annual rate of $19 billion in the
third quarter of 1965, more than $4 billion greater than
in the corresponding yearearlier period (Table V I).
Flows of time deposits have
expanded at an average
of nearly $3 billion per year
since 1960. In 1953 banks
intermediated, through the
flow of time deposits, 12
Tofal earning a sse ts.................... .
per cent of total funds rais­
Earning assets other than
ed by ultimate users; they
U.S. Government securities . .
U.S. Government securities . . . .
intermediated 18 per cent
State and local obligations... .
in 1957 and 1960 and 30
Business lo a n s .......................... .
per cent in 1965 ( Chart 4).
Real estate lo a n s......................
The factors contributing to
Consumer cre d it........................
Other bank loans4 ....................
this change are discussed
Other earning assets...............
on p. 9.
5. C o m m e r c i a l B a n k
E x p a n s io n
While total credit expan­
sion was less in the third
quarter of 1965 than a year
earlier, the amount supPage 8



14 Data discussed in connection with Table V II are from the
flow-of-funds accounts. Third quarter data for 1964 are av­
erages of the second, third, and fourth quarters. Third quar­
ter 1965 data are averages of the second and third quarters
(see footnote 12).
Table VII
C O M M E R C IA L B A N K C R E D IT
(Billions of Dollars)
Levels

Flows 1

3rd Qtr.
19652

3rd Qtr.
1964 3

1960

294.3

271.7

201.7

231.1
63.2
36.9
60.6
47.0
32.2
99.5
15.5

207.0
64.7
32.5
51.7
42.5
28.8
85.0
18.2

138.2
63.5
17.6
40.2
28.7
20.6
61.9
9.4

3rd Qtr.
19643

1960

19.6

23.8

9.0

26.8
— 7.2
5.9
9.9
5.7
4.7
13.4
— 2.8

24.8
— 1.0
4.1
9.4
4.5
2.7
11.6
2.0

7.3
1.7
0.6
2.2
0.6
1.7
2.8
1.4

3rd Qtr.
1965 2

1 S e a so n a lly a d ju ste d a n n u a l ra te s .
2 A v e ra g e o f th e la st th re e q u a rte rs. L e v e ls d a ta a r e e stim a te d .
3 A v e ra g e o f se co n d q u a r te r a n d th ird q u a r te r (p re lim in a ry ).
4 C o n ta in s th e fo llo w in g c a te g o r ie s (figures a re fo r 1 9 6 0 le v e ls ):
H o u se h o ld s ........................................................ 7 . 2
F a r m b u s i n e s s .................................................. 5 .0
N o n fa rm n o n co rp o ra te b u s in e s s ............ 9 .1
C o rp o r a te b u s i n e s s .................................... 3 1 .1
S a v in g s a n d lo a n a s s o c ia tio n s ............... 0 .2
F in a n c e c o m p a n i e s ...................................... 6 .2
R e st o f th e w o r l d ......................................... 3 .0
T o ta l .....................................................
6 1 .9
T o ta ls m a y n o t a d d d u e to ro u n d in g .
Source: B o a rd of G o v ern o rs o f th e F e d e r a l R e se rv e S ystem (F lo w -o f-fu n d s a c c o u n ts ).

average, this flow expanded $3.8 billion per year from
1960 to the third quarter of 1965.
Business loans were the most rapidly growing class
of commercial bank assets. The flow into such assets
in the third quarter of 1965 was at a $10 billion annual
rate, about the same as a year earlier (T a b le V II).
Since 1960 the flow has risen $1.5 billion per year. Real
estate loans and obligations of states and local subdivi­
sions each expanded at a $6 billion annual rate in the
third quarter of 1965, somewhat greater than the flow
a year earlier. Consumer loans rose at a $5 billion
annual rate compared with a $3 billion rate in the
third quarter of 1964.

Financing the Expansion
Funds for expansion of commercial bank assets other
than U.S. Government securities were from two chief
sources: growth in time deposits (and other market
instruments) and reductions in holdings of Treasury
securities. Also, the reserve base increased more than
necessary to accommodate the growth in time depos­
its as a result of Federal Reserve System actions and
member bank borrowing from the Federal Reserve
System.
Merchandising Tim e Deposits. The “merchandis­
ing” of time deposits and other liabilities has been the
chief means by which the banking system has acquired
funds.15 In the third quarter of 1965 time deposits
rose at a $19 billion annual rate compared with a $15
billion rate in the third quarter of 1964 and a $6 bil­
lion rate in 1960. Commercial bank time deposits con­
sist of an assortment of liabilities. In terms of both
flows and outstanding amounts the most important
time deposits are passbook savings accounts, which are
generally available to depositors on demand, and
large denomination certificates of deposit, which are a
highly liquid short-term market instrument.16
The flow of savings deposits at weekly reporting
member banks (the only readily available source of
current data for such deposits) rose at an annual rate
of $5.2 billion in the third quarter of 1965, reaching
$44 billion. In the third quarter of 1964 these sav­
ings rose at a $3.4 billion annual rate.
Large negotiable certificates of deposit at weekly
reporting banks rose at a $3.1 billion annual rate in the
third quarter of 1965, reaching $16 billion at the end
of the quarter. By late September C D rates offered
15 Commercial banks have also obtained funds through sale of
subordinated debentures and capital notes.
16 See this R ev iew of March 1963 for an article entitled “Move­
ments in Tim e and Savings Deposits, 1951-1962.”




by many large commercial banks had reached the max­
imum permitted by the Board of Governors, and the
spread between these rates and the yields on threemonth Treasury bills became much less than previous­
ly. Effective D ecem ber 6 the Board of Governors
raised the maximum rate on C D ’s from 4.5 per cent to
5.5 per cent.
From a modest beginning of just over $1 billion in
late 1960, certificates of deposit have since risen at a
rapid pace. From the end of 1960 to the third quarter
of 1965 they increased on the average about $3 billion
per year. In mid-1960 yields on other short-term mar­
ket instruments such as Treasury bills fell below max­
imum rates banks could pay on time deposits. Through­
out the economic expansion beginning in early 1961
rates paid on C D ’s have generally been above the yield
on U. S. Treasury bills.
Reduction of Holdings of Treasury Securities. Com­
mercial bank holdings of U. S. Treasury securities
declined sharply in 1965. During the recent third quar­
ter bank holdings of these securities declined at a $7.2
billion annual rate, reaching a level of $63 billion. One
year earlier banks held $65 billion of these assets.
Because a large share of these securities are used
as “pledged” assets behind deposit liabilities to the
Federal Government and state and local governments,
the extent to which they can be reduced further is lim­
ited. Treasury securities also serve individual banks
as a buffer for deposit losses.
The banking system does not gain funds from secu­
rity sales. However, such sales are the initial step in
the process whereby banks shift from these relatively
low yielding assets to loans or other relatively high
yielding assets.
Member Bank Borrowing. As a source of additional
reserves to the banking system member bank borrow­
ing has been negligible in recent years. Borrowing
from Reserve Banks declined at a $70 million annual
rate during the third quarter of 1965, reaching $500
million at the end of the quarter. During the compar­
able year-earlier period such borrowing rose at a $200
million annual rate.
Commercial bank borrowing both from banks and
nonbank sources rose markedly in the third quarter of
1965, continuing an upward trend which began in
1961. Such borrowing rose at a $3 billion annual rate
and was $4.1 billion at the end of the quarter. During
the corresponding year-earlier period interbank bor­
rowing declined at a $3 billion rate.
Page 9

Interbank borrowing does not add to total reserves
or to total investible funds of the banking system. It is
one of several mechanisms whereby excess reserves of
the banking system are kept at an economically effi­
cient level. Viewed from the standpoint of net changes
over a year, interbank borrowing may be considered
simply as a type of intermediation, whereby banks
transfer funds from one to another. The borrowing
banks are enabled to make more loans or purchase
more securities, while the lending banks extend corre­
spondingly less credit to the public.
Member Bank Excess Reserves. Bank asset expan­
sion is limited by the level of required reserves in rela­
tion to the total amount of reserves available. Required
reserves cannot legally exceed the total reserve base
of the banks. In practice, given the total reserve base,
the extent to which required reserves can rise is in­
fluenced further by the banking system’s desire or need
to hold reserves in excess of legal requirements. Excess
reserves were about unchanged during the third quar­
ter of 1965 and totaled about $350 million at the end
of the quarter. From the third quarter of 1964 to the
recent third quarter excess reserves declined $60 mil­
lion (Chart 5). Excess reserves were $360 million in
November.
Chart 5

Excess Reserves & Borrow ings of M em ber Banks
Millions of Dollars

Millions of Dollars

6 . In te r e s t R ate In c re a se s
Demands for funds in 1965 were strong, reflecting
the marked rise in business activity. Since supplies of
funds did not keep pace with rising demand, interest
rates were higher in D ecem ber 1965 than a year earlier.
Most of the rise in interest rates occurred after mid­
year, a time of the year when there are strong seasonal
demands for funds. In early Decem ber the Federal
Reserve discount rate was raised from 4.00 per cent
to 4.50 per cent, and the maximum rate permitted
under Regulation Q on time certificates of deposit
was raised from 4.50 per cent to 5.50 per cent.
Interest rate increases occurred during the year on
marketable debt of both short and long maturity. Yields
on three-month Treasury bills rose from 3.84 per cent
in Decem ber 1964 to 4.40 per cent in Decem ber 1965
(T ab le V I II ). These yields rose somewhat in early
1965 and then rose further after midsummer. The
secondary market yield on certificates of deposit rose
from 4.16 per cent in Decem ber 1964 to 4.90 per cent
in Decem ber 1965. Rates paid on newly issued C D ’s
in October and November were frequently quoted at
4.50 per cent, the maximum then permitted under
Regulation Q; they rose to about 4.75 per cent after the
maximum was raised to 5.50 per cent in December.
During the past year rates on prime commercial paper
maturing in four to six months rose from 4.17 per cent
to 4.70 per cent. Yields on directly placed finance
company paper increased from 3.98 per cent to 4.58
per cent, and yields on 90-day bankers’ acceptances
rose from 4.00 per cent to 4.55 per cent.
Table VIII
SELECTED

IN T E R E S T R A TES

Averages of Daily Figures
(Per Cent Per Annum)
Dec. 19651

Some analysts regard the level of excess reserves as
a measure of monetary tightness or ease. They reason,
quite correctly, that the amount of excess reserves at
any given time represents, in a certain abstract sense,
the unused lending capacity of the banking system.
But in another sense, the existence of excess reserves
is evidence of the impracticability of every bank’s
keeping its reserves at exactly the legal requirement in
every reserve computation period. Other analysts ac­
cordingly prefer to emphasize dynamic operations
through time, stressing what has been happening to
total reserves or other aggregate reserve measures
(discussed on p. 1 2 ).
Page 10



Prime commercial paper
(4 to 6 months).................................................. .........4.70
Finance company paper placed directly
(3 to 6 months).................................................. .........4.58
Prime bankers' acceptances
(90 d ays)............................................................. ........ 4.55
U.S. Government Securities
(Taxable)
3-month bills .................................................. ....... 4.40
6-month b ill s ..........................................................4.58
3- to 5-year bo nd s.................................................4.79
Long-term bonds ..................................................4.45
CD's (secondary market rate)2 ................................... 4.90
Corporate bonds (A a a )..................................................4.68
State and local government bonds (A a a )................. 3.40
Conventional mortgages....................................... .......5.90

Dec. 1964
4.17
3.98
4.00

3.84
3.94
4.07
4.14
4.16
4.44
3.01
5.80

1 E s tim a te d . D e c e m b e r e stim a te s a re fo r th e w e e k e n d in g D e c e m b e r 1 7 .
2 N e g o tia b le tim e ce rtific a te s of d e p o sit a t c o m m e rc ia l b an k s.

Chart 6
Selected Yields

FEDERAL RESERVE SYSTEM ACTIONS
DURING 1965
P u rch ase s o f
U. S. G o v e r n m e n t S e c u r itie s
Millions of Dollars
1964

............................................ 3,451

1965 (through Decem ber 1 5) ........................... 3,780
1962

1963

1964

1965

*Monthl y a ve ra g es of w eek ly figures, s e c on d ar y market rates for negot iab le time
certificates of d eposit with a maturity of three months.
Sources: B oard of G o v e r n o r s of the Fe deral Reserve System
a nd S al omon Brothers & Hutzler.
Latest d a t a plotted: N o v e m b e r

Accompanying the increases in short-term interest
rates were increases in yields on debt of greater matur­
ity. Yields on long-term Government bonds increased
from 4.14 per cent to 4.45 per cent in the year ending
in December. Corporate Aaa bond yields rose from
4.44 per cent in late 1964 to 4.68 per cent in Decem ber
1965. Yields on state and local government Aaa bonds
increased from 3.01 per cent to 3.40 per cent. Conven­
tional mortgage interest rates changed relatively little
over the past year, reflecting weakness in residential
construction.

Interpretation of the Interest Rate
Increases
The rise in interest rates has been viewed by some
as evidence of restrictive monetary action. However,
as suggested above, to the extent that the recent mix
of total stabilization policy includes greater fiscal stim­
ulation, there is a rise in the interest rate consistent
with that mix and with any given level of final demand
(see Figure 1 ). Thus, interest rates could have been
lower if monetary expansion had been greater, but this
would have caused total Government economic policy
to have been even more stimulative than it was.
According to another interpretation, not inconsistent
with the first, the working up in interest rates indicates
that credit demands tended to exceed forthcoming sup­
plies at earlier prevailing rates. In this view, rising in­
terest rates were necessary for additional funds to be
attracted into the market or into intermediation and
for limited funds to be allocated efficiently. Also, the
rise in interest rates since mid-1965 has been in some
measure a manifestation of seasonal pressures.

Effects of Interest Rate Increases
There are several ways by which interest rate in­
creases may affect economic activity. Because rising




D is c o u n t R a t e (N e w Y o r k )
In effect January 1, 1 9 6 5 ................................................... 4

%

Decem ber 6, 19651 ................................................................ 4%%
In effect Decem ber 24, 1 9 6 5 .........................................

4%%

R e s e r v e R e q u ir e m e n t s
Per Cent of Deposits
Demand Deposits Time Deposits
R e s e rv e A ll O th e r R e se rv e
C ity
M em ber
C ity
B anks
B an k s
B an k s

A ll O th e r
M em b er
B an ks

In effect
January 1, 1965

I 6V2

12

4

4

In effect
Decem ber 24, 1965

16V2

12

4

4

M a r g i n R e q u ir e m e n t s o n S t o c k s
In effect January 1, 1 9 6 5 ...................................................

70%

In effect Decem ber 24, 1 9 6 5 ............................................ 70%

M a x im u m

In t e r e s t R a t e s P a y a b le o n

T im e a n d S a v i n g s D e p o s it s

Savings Deposits
L e s s th a n 1 Y e a r
1 Y e a r o r M o re

Other Time
Deposits
3 0 D a y s to
9 0 D ays

9 0 D ays
o r M ore

In effect
January 1, 1965

4%

4%

4

%

4%%

Decem ber 6, 1965

4%

4%

5V2%

5y2%

In effect
Decem ber 24, 1965

4%

4%

5%%

5y2%

lrThe d isco u n t r a te c h a rg e d b y th e F e d e r a l B e s e rv e B a n k of St.
L o u is w as ra ise d fro m 4 p e r c e n t to 4 M> p e r c e n t effective D e c e m ­
b er 1 0 , 1 9 6 5 .

Page 11

interest rates are reflected in declining security prices,
such an increase implies a decline in wealth and, there­
by, may restrict total spending. Also, rising interest
rates make saving more attractive relative to current
spending. Finally, and not necessarily inconsistent
with the other two, rising interest rates—representing a
cost to the borrower—serve to restrict investment or
consumption of durable goods.
Under some conditions it is desirable to limit spend­
ing and investment, and under other conditions it is
undesirable. Public policy can under some conditions
and to some extent limit a rise in interest rates. Greater
monetary expansion may meet rising demand for loan
funds. That is, rather than to rely on intermediation
as a means of attracting funds via rising interest rates,
there can be a step-up in the pace at which the com­
mercial banking system is permitted to “monetize”
debt.
The rise in interest rates during the past year occur­
red despite a rapid monetary expansion. While a major
portion of credit demands were accommodated through
intermediation and direct placement of saving, there
was excess demand which was in part dissuaded by
the rise in interest rates and by rationing by lenders
and in part accommodated by monetary expansion.
If monetary expansion had been less, interest rates
would have risen more. For interest rates to have been
prevented from rising, the money supply would have
to have been increased yet more rapidly.
7. M o n e t a r y E x p a n s io n
The stock of money, demand deposits plus currency,
reached $166 billion in November 1965, up 4.2 per
cent from a year earlier. The increase consisted of a
$4.8 billion rise in demand deposits and a $2 billion
expansion in currency.
The rise in money proceeded at an uneven pace.
From October 1964 to April 1965 money rose at a 3
per cent rate; then the rate of increase more than
doubled. Money has risen at an average annual rate
of 3.4 per cent since early 1961 compared with an
average rate of 1 per cent in the 1956-60 period and a
3 per cent rate from 1951 to 1955.
Whether variations in the rate of increase in money
stem chiefly from the supply side, and then induce
changes in interest rates, spending, and economic ac­
tivity in general, or whether the variations in supply
are brought about by the economic process itself, is a
question which has recently received increased atten­
tion.
According to one view, the essence of monetary con­
trol consists of bringing about an appropriate rate of
Page 12



growth in the stock of money. It assumes that the
stock of money can be controlled by the central bank
by varying the rate at which it supplies reserves to the
banking system.
During 1965 total reserves of member banks were
expanded $1 billion or 4.5 per cent compared with a
4.2 per cent expansion in the preceding year. Expan­
sion in total reserves since 1961 has been more rapid
and continual than in earlier periods, rising at an
average annual rate of 3.8 per cent compared with 1.3
per cent in the 1956-60 period and 2.9 per cent in the
1951-55 period.
Increases in time deposits, government deposits, and
interbank deposits—which do not represent an expan­
sion in money as ordinarily defined— impounded a sub­
stantial portion of the increment to total reserves in
1965. Reserves available for expansion of private de­
mand deposits, the major component of the money
supply, rose $330 million or 2 per cent in the year
ending in November. Since April 1965, however, the
annual rate of increase in these reserves has been about
4 per cent. Since 1961 they have expanded at a 1.5
per cent annual rate.
An alternative view concerning the determination of
the supply of money visualizes the causation as run­
ning from changes in demand to changes in supply.
According to this view, “ ... banks are not constrained
in their ability to supply deposits by the existence of
legal reserve requirements or by the level of bank
reserves. . . . Since this is true for each and every
bank in the system, the constraint on bank deposits
... is derived from the public’s desire to hold bank
deposits.”17 It may be that these two views are not
necessarily contradictory. It may be a question of
which is the more expedient or useful way of view­
ing the process.
8. In t e r n a t io n a l D e v e lo p m e n t s
Developments both in the domestic U.S. economy
and in other major industrial countries of the world
continue to exercise an important influence on the
U.S. balance of payments.

Current Account
Imports of goods and services in the third quarter
of 1965 were at an annual rate of $31.8 billion, 12 per
17Lyle E . Gramley and Samuel B. Chase, Jr., “Time Deposits
in M onetary Analysis,” Federal Reserve B ulletin , October
1965, p. 1385. Also see James Tobin, “Commercial Banks as
Creators of ‘Money,’ ” B an kin g a n d M on etary Studies, edited
by Deane Carson (Homewood, 111.: Richard D. Irwin, Inc.,
1 9 6 3 ), pp. 408-19.

cent above the third quarter of 1964.
This rise was basically responsive to
the 7 per cent growth in gross national
product in the same period. Since
1961 the money value of G N P has
increased at an average annual rate of
7 per cent, while imports have increas­
ed at an 8.5 per cent rate. As the ec­
onomy’s productive capacity becomes
more fully utilized (i.e., reduction in
unemployment and increase in opera­
ting rates), imports increase more rap­
idly for a given increase in GNP.

Table IX
U . S. B A L A N C E O F P A Y M E N T S
(Billions of Dollars)
1st Half 1965
(Annual Rate)
Current a c c o u n t ............................
Exports of goods and services...
Imports of goods and services...
Transfer payments........................
Private capital ( n e t ) ...................
Long-term c a p ita l..........................
Direct investments......................
Bank lo a n s..................................
O th e r...........................................
Short-term cap ita l..........................
Governm ent transactions (n e t)1.
Errors and o m is s io n s ..................
Balance of payments on regular
transactions ...............................

6.0
37.5
— 30.5
— 1.0
——3.5
— 5.2
— 4.0
— 0.6
— 0.5
1.7
— 3 .5
— 0.4

1964

1960

7.8
37.0
— 28.5
— 0.8
— 6.2
— 4.2
— 2.4
— 0.9
— 0.9
— 2.0
— 3 .6
— 1 .2

3.4
27.2
— 23.2
— 0.7
— 3.5
— 2.1
— 1.5
— 0.2
— 0.4
— 1.4
— 2.8
— 1.0

Change
1960-1964
4.4
9.8
—5.3
—0.1
— 2 .7
— 2.1
—0.9
—0.7
—0.5
—0.6
— 0.8
— 0.2

U.S. exports of goods and services
in the third quarter of 1965 were at an
annual rate of $40 billion, an increase
— 3.9
0.8
— 1.3
— 3 .1
of 7 per cent over the same period in
1964 and slightly lower than the 8
1 In c lu d e s n e t G o v e rn m e n t g ra n ts an d c a p ita l outfli
i; e x c lu d e s tra n sfe r p a y m e n ts (e .g ., social
s e c u rity ) to p riv a te fo reig n ers w h ich a re in c lu d e d i th e c u r r e n t a c c o u n t.
per cent rate of growth since late
Source: U . S. D e p a rtm e n t of C o m m e rce .
1960. The annual growth in world­
showed very little improvement from 1960 to 1964.
wide imports in the same period (exclusive of the
Although
there was substantial improvement in the
United States) has also been about 8 per cent. On the
current account, it was largely offset by deterioration
other hand, exports of other industrial countries in
in the capital account.
the European Economic Community (Common M a r­
ket) and Japan have increased at an 11 per cent
annual rate since late 1960. Against this index U. S.
export performance has not been especially impressive.

Capital Account
U. S. capital outflow in the first two quarters of
1965 was at a $3.6 billion annual rate compared with
a $6.5 billion outflow in 1964. This turn-around was
accounted for primarily by direct administration policy
measures (discussed below). In addition, increased
domestic demand for credit and a moderate rise in
interest rates may have contributed to the improve­
ment.

Administration Measures
Table IX indicates that the U. S. balance of pay­
ments, as measured on a regular transactions basis,18
18 The regular transactions method of measuring the U. S. bal­
ance of payments includes the following major transactions:
(1) changes in U .S. official reserve assets (gold and convertible
foreign currencies); ( 2 ) changes in liquid liabilities to for­
eign official institutions (e.g ., central bank s); ( 3 ) changes in
liquid liabilities to foreign private persons.
In the “official settlements” definition of the balance of
payments which has recently been adopted by the D epart­
ment of Commerce, changes in liquid liabilities to foreign
private persons ( 3 above) are excluded and certain minor
nonliquid liabilities to foreign official institutions are included
as part of the balance-of-paym ents position. For an explana-




Starting in 1960 the administration took a variety of
measures to strengthen the current account of the bal­
ance of payments. These included (1) the negotia­
tion of military sales contracts (mainly to Germany
and Italy) in direct proportion to U. S. military spend­
ing in those countries, (2) the tying of economic aid
to U. S. sources of supply, and (3) introduction of a
large number of relatively small administrative actions
to encourage exports (e.g., improved export insurance
coverage, establishment of trade centers abroad).
Price stability in the United States relative to Europe
also helped to widen the trade surplus. Finally, past
foreign investments began paying off handsomely and
resulted in a large growth in investment income.
However, because of stimulative monetary and fiscal
policy and high total demand in Europe, interest rates
there generally rose more rapidly than those in the
United States, so that our capital outflows increased
and only moderate net improvement resulted in our
overall balance of payments. There was some appre­
hension that a more stringent monetary policy leading
to higher interest rates in this country would trigger
a domestic recession which “would rapidly create
tion of these changes see, T h e B a la n ce o f P aym en ts Statistics
o f th e U nited States: A R ev iew a n d A ppraisal, Report of the
Review Committee for Balance of Payments Statistics to the
Bureau of the Budget, April 1965 (popularly referred to as
the Bernstein R ep ort).

Page 13

forces for easy money that would be likely to prove
irresistible.”19
To reduce capital exports without a lower rate of
monetary expansion and higher interest rates, the
Interest Equalization Tax ( I E T ) was proposed to the
Congress in mid-1963. The IE T was designed to raise,
by approximately one percentage point, the long-term
rates to foreign borrowers in the U.S. capital market
while leaving long-term rates to domestic borrowers
unchanged. However, because of the large gaps in
application (especially exemption of bank loans) the
tax resulted in a shift in the composition of capital out­
flow rather than in reduction in net amount. As a con­
sequence, the balance of payments showed little im­
provement and additional measures were deemed nec­
essary.
It was decided to ask for the voluntary cooperation
of banks and corporations. This approach was em­
bodied in the President’s announcements on February
10, 1965 which consisted of the following proposals:
( 1 ) The Interest Equalization Tax was broadened to
include bank loans of one year or more. (2 ) Banks,
other financial institutions, and nonfinancial corpora­
tions were requested to refrain from engaging in
some otherwise profitable foreign business and finan­
cial activities. Specifically, banks were asked to limit
their net increase in claims on foreigners, both longand short-term to 5 per cent of their level on Decem ­
ber 31, 1964. Nonbank financial institutions were
asked to take broadly parallel action. In addition, some
500 industrial corporations with large international in­
vestment positions were asked to improve their indi­
vidual balance of payments during 1965. Considerable
latitude was given regarding how this improvement
was to be brought about— increased exports, increased
remittance of dividends and interest on previous for­
eign investments, reduction in new foreign invest­
ments, recall of short-term funds held abroad, etc.
The immediate effect of the voluntary program was
quite satisfactory. In the first quarter of 1965 the bal­
ance of payments was in deficit at a $3.1 billion annual
rate, only half the rate of deficit of the fourth quarter
of 1964. In the second quarter of 1965 the U. S. bal­
ance of payments showed a small surplus ($500 mil­
lion seasonally adjusted annual rate) for the first time
since the third quarter of 1957. However, in the third
quarter the balance of payments again deteriorated.

ments can only be answered by additional experience
with the program. The sharp deterioration in the third
quarter does not provide compelling evidence against
the possibility of further improvement, just as the sur­
plus in the second quarter did not provide evidence of
continued improvement.
W hether doing something about the capital move­
ments directly is most appropriate may depend in part
on whether the causes of the flow are considered nat­
ural or artificial. Given existing exchange rates and
relative price levels, capital flows may be thought of
as natural if, in the countries receiving the capital,
interest rates and profits are higher because the mar­
ginal efficiency or productivity of capital is higher
than in the capital exporting countries. Capital flows
may be thought of as artificial if the interest and profit
differentials which might attract the capital are caused
(1 ) by excessive total demand in the surplus coun­
tries, (2 ) by extreme and inappropriate mixes of
monetary and fiscal policies in either surplus or defi­
cit countries, or (3 ) by the juxtaposition of free and
controlled capital markets in either the surplus or the
deficit countries.20
If, in surplus countries, the disequilibrating capital
flows are induced by interest rate differentials which
are caused artificially, then a restoration of balance in
the international accounts may be promoted by re­
moval of these influences. For example, extremely ex­
pansionary fiscal policy may be a major cause of the
high interest rates in some surplus countries. Substan­
tially lower interest rates and reduced capital imports
in those countries might be achieved by less expan­
sionary fiscal policy. An easier monetary policy might
be used to maintain an appropriate income level.
However, a deficit country cannot dictate such ac­
tion to surplus countries, and the introduction of direct
restraints on capital outflow may be the only type of
action available to neutralize these artificial stimulants
by other countries to capital exports from this country.
9. S u m m a r y

W hether the voluntary controls will contribute more
than a temporary improvement in the balance of pay-

Expansion of total demand in 1965 was sufficiently
rapid to bring about a substantial reduction in the
margin of the nation’s unused resources. The gap
between actual and estimated potential gross national
product narrowed to $15 billion in the third quarter,
38 per cent less than at the beginning of the year. The
actual product in the third quarter was 98 per cent of
the somewhat arbitrarily estimated potential. Employ­

19 Secretary of the Treasury D'ouglas Dillion, address before the
American Bankers Association Annual Monetary Confer­
ence in Princeton, New Jersey, March 19, 1965.

20 See “Fiscal Policy, Monetary Policy, and International Dis­
equilibrium,” in the Septem ber 1965 R ev iew of the Federal
Reserve Bank of St. Louis.

Page 14




ment rose to 73 million in November, and the unem­
ployment rate declined to 4.2 per cent, probably bring­
ing about still further reduction of the gap. This year’s
improvements have involved costs or a trade-off, how­
ever. The rate of increase in prices has jumped
sharply, and, while the balance of payments showed a
modest surplus in the second quarter, it again dete­
riorated in the third quarter.
The monetary and fiscal situation which prevailed
in late 1964 and early 1965 along with monetary and
fiscal developments in 1965 were important factors in
bringing about the aggregate demand that emerged.
Thus, monetary and fiscal policies were important in­
gredients in shaping the trade-off between employ­
ment and prices.
W e now face the problem of determining optimum
total demand for the future. W hat are the price level
and employment effects which will come from various
possible levels of total demand? W hich combination
of employment and price level is best for the nation?
W e must choose not only the total demand we think
best in the light of the trade-off choice, but also the
best combination, or mix, of public policies to provide
it. The combination of fiscal and monetary policies
used to achieve the sought-after total demand in­
volves a choice between effects on the balance of
payments and effects on domestic investment.
Every other nation faces these same choices—the
determination of optimum total demand and the mix




S

of policies to obtain it. Their decisions along with
ours have a great bearing on the balance of payments
of the various nations. Other nations can affect the
U. S. balance of payments both by the total demand
which they foster and the mixes of fiscal and monetary
policy which they adopt to achieve the sought-after
total demand.
Total demand in each country in 1966 will be de­
pendent, among other factors, upon: (1 ) decisions of
consumers to spend and of business to invest, (2 ) Gov­
ernment spending and taxing policies, and ( 3 ) mon­
etary policy. Public policy in each country should
attempt to choose some combination of elements 2 and
3 that will provide an acceptable combination of inter­
nal production and price developments. In seeking the
desired total demand each country should use a com­
bination of monetary and fiscal measures which will
contribute to tolerable balance in th e ; international
accounts of all nations. Also, as the various countries
decide on the combination of fiscal and monetary
policy to achieve the desired domestic total demand,
it is important that they choose combinations which
promote acceptable trade-offs between investment
and growth on the one hand and balance-of-pay­
ments considerations on the other hand.
Choices regarding the future are affected by policy
actions of the recent past and the present. In the
United States the stimulative monetary and fiscal sit­
uation of the last half of 1965 will probably impinge in
some measure on economic developments in 1966.

U BSC R IP T IO N S to this b a n k ’s R e v ie w are a v a ilab le to th e 'public w ithou t

ch arg e, in clu din g b u lk m ailings to banks, business organizations, ed u ca tio n a l
institutions, an d others. F o r inform ation w rite: R esearch D ep artm en t, F e d e r a l
Preserve B an k o f St. Lou is, P. O. Box 442, St. Louis, M issouri 63166.

Page 15

REVIEW INDEX— T9 6 5
Month
of Issue

Title of Article

Jan.

C ontinued M onetary and Econom ic Expansion
1964 Econom ic D evelopm ents in the Central
M ississippi V alley
Farm Products in th e Central M ississippi V alley

Feb.

1964 O perations o f th e F ederal Reserve Bank
o f St. Louis
F ed eral D ebt L en gthen ed
Trends in G overnm ent Expenditures

Mar.

Apr.

May

June

G row th in M oney Slows
Currency an d D em and D eposits
R ecent International D evelopm ents
Earnings and Expenses o f Central M ississippi
V alley B anks During 1964
E conom ic A ctivity Continues to A dvance in
Early 1965— M onetary Expansion Slows and
Fiscal D evelopm ents A re Little Changed
F ed eral R eserve O pen M arket Transactions
and th e M oney Supply
Bank Credit Expansion Accom panies Econom ic
A dvance
R ecent E conom ic Trends in Four M etropolitan
Areas
Im plem entation o f F ed eral Reserve Open M ar­
k et P olicy in 1964
E conom ic Expansion Continues
R ecent Trends in Farm Credit

Page 16



Month
of Issue

T itle of Article

July

Econom ic Expansion Has M oderated
Em ploym ent G row th in the Central M ississippi
V alley
Agriculture at M idyear

Aug.

Trends in Com m ercial Banking, 1945-1965
Recent M onetary and Fiscal D evelopm ents
M ore Stimulative
Spending in Five District Cities

Sept.

Interest Rates, B udget Policy, and M onetary
Policy
Fiscal Policy, M onetary Policy, and Interna­
tional D isequilibrium
Econom ic Expansion in Central M ississippi
V alley Cities
A griculture in the Central M ississippi V alley

Oct.

Fiscal Ease and M onetary G row th
Interest Rates, 1914-1965
Farm Land Prices

Nov.

M oney Supply Increases R apidly
Em ploym ent and Population Trends in Per­
spective

Dec.

1965: M onetary G row th, R eal Product G rowth,
Price Increases