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• P . O . B O X 4 4 2 • S T . L O U IS 6 6 , M O.


Current Economic Developments
The Discount Mechanism and Monetary Policy
Trends in Government Expenditures


This issue released on Septem ber 22

VOL.. 42 • No. 9 j SEPTEMBER '60

Current Economic Developments
Business Conditions
INVENTORY LIQUIDATION by businesses in July
and probably in August as well slowed the pace of
business activity. The industrial production index in
August, at 109 per cent of the 1957 average, was
slightly below its March-July level and was 2 per
cent below the peak reached last January. Output of
materials and consumer goods changed little, and out­
put of equipment remained about constant. Manufac­
turing employment declined between mid-July and
mid-August, after seasonal factors are taken into ac­
count. Unemployment, on a seasonally adjusted basis,
rose to 5.9 per cent of the civilian labor force. The
number of unemployment compensation claims con­
tinued to rise in late August, suggesting continued
slackness in labor markets.

consumer spending has remained stable at a relatively
high level, it has not increased as much so far this
year as had evidently been expected by some manu­
facturers, in particular the makers of major household
appliances. Manufacturing of appliances and parts is
a major activity in several Eighth District areas.
A continuing decline in residential construction has
weakened demand for lumber, another major Eighth
District product. Expenditures for private residen­
tial building in the nation in August were 16 per cent
below the year-earlier rate. Residential construction
contract awards in the Eighth District’s five largest
metropolitan areas combined were 25 percent less in
total value during the first seven months of this year
than in the same period of 1959.

The turn from inventory accumulation to inventory
liquidation in manufacturing had been foreshadowed
for several months by the efforts of steel users to work
off excess stocks and by a gradual decline in manufacturers new orders for durable goods. New orders
for durable goods in July, after seasonal adjustment,
were 2 per cent lower than in June and were below
the level of sales for the eighth consecutive month.

The most recent Department of Commerce-Securities and Exchange Commission survey of business
plant and equipment expenditures indicates a leveling
off in planned business outlays for fixed capital in the
second half of the year, at a rate somewhat lower than
had been indicated by earlier surveys. Government
outlays, however, at both the Federal and the State
and local levels, are continuing to rise.

How far the inventory liquidation will go depends
upon the state of final demand for goods. Although

Federal Reserve Actions
During August and early September discount rates
were lowered at all Federal Reserve Banks from 3.5
per cent to 3.0 per cent. The lower rate became effec­
tive at the Federal Reserve Bank of St. Louis on
August 19. This is the second time this year that the
Federal Reserve Banks have lowered their discount
rates; in June the twelve Reserve Banks decreased
their rates from 4 per cent to 3 per cent.

Industrial Production








On August 8, the Board of Governors amended
Regulation D, which relates to member bank reserves
and reserve requirements, in three ways.1 These ac­
tions made available to member banks approximately
$600 million of additional reserves. Although these
changes were made in anticipation of greater seasonal
credit needs in the fall, they implemented an Act of
Congress, passed July 28, 1959, which affects vault
cash and reserve requirements.

Latest d a t a plotted: Aug us t

1 See “Changes in M em ber Bank Reserve Requirem ents,” in
August 1960 issue of this Review, pg. 7.

Page 2

The Act authorizes the Board of Governors to per­
mit member banks to count part or all of their vault
cash as reserves in addition to their balances with
Federal Reserve Banks. This action was presumably
taken to correct an inequity which arose because some
banks, particularly country banks, required larger
amounts of vault cash for operating purposes than
other banks. It also provides for the abolition of the
classification ‘ central reserve city” by July 28, 1962.
The Act increases from 20 to 22 per cent the maxi­
mum reserves that reserve city banks may be required
to maintain on net demand deposits. It reduces from
26 to 22 per cent the maximum reserves and from 13
to 10 per cent the minimum reserves that the central
reserve city banks may be required to hold to make
them the same as the maximum and minimum require­
ments for reserve city banks. In addition, the Act
authorizes the Board of Governors to classify banks
in central reserve cities as reserve city banks or coun­
try banks and banks in reserve cities as country banks
if their business resembles the business of banks in
the lower classifications more than that of banks in
their geographical location.

ment changes, the System added funds through open
market operations in recent weeks. Open market op­
erations, that is, buying assets, primarily Government
securities, in the market and paying for them with re­
serves or selling assets for reserves, have been the
primary tool of monetary actions. These actions which
are conducted on an almost daily basis usually receive
little attention in the press. From the week ended
July 27 to the week ended September 14, average
System holdings of securities rose about $55 million,
adding a like amount to member bank reserves. About
$2 million represented outright purchases of Treasury
bills, $48 million was in the form of purchases of
Government securities with an agreement by the seller
to repurchase within a short period of time, and the
remainder, about $5 million, was net purchases of
bankers’ acceptances. These reserves were more than
offset, however, by money market drains, chiefly gold
outflows, a Labor Day flow of currency into circulation
and a contraction in float (central bank credit ex­
tended on checks in process of collection). Member
banks also reduced their borrowed reserves $52 mil­
lion in the period.

The recent amendments to Regulation D liberalized
the proportion of vault cash member banks can count
toward meeting their reserve requirements. Country
banks are now permitted to count vault cash in excess
of 2H per cent of demand deposits as part of their
reserves instead of the 4 per cent set last December 1.
Central reserve city banks and reserve city banks are
now allowed to count vault cash in excess of 1 per
cent instead of 2 per cent of demand deposits in
meeting their reserve requirements.

Total Effective Reserves

As a step toward eliminating the differential in re­
serve requirements on net demand deposits between
central reserve city banks and reserve city banks, the
amendments to regulation D reduced the require­
ment for central reserve city banks from 18 per cent
to 17/2 per cent. This action reduces the differential
from 1/2 percentage points to 1 percentage point. The
requirement for reserve city banks is now 16J£ per cent.

In the first two weeks of September, total effective
reserves of member banks, seasonally adjusted, rose
Money & Bank Reserves
Seasonally Adjusted
Billions of Dollars

Billions of Dollars

M o n e y S u p p ly *



............ 1

ir ........................E ffe c tiv e R eserves*

It has been estimated that these changes which
became effective August 25 for country banks and
September 1 for central reserve city and reserve city
banks will make available about $600 million of addi­
tional reserves, $480 million through the change in the
vault cash requirement and $125 million arising out
of the reduction in reserve requirements for central
reserve city banks.
In addition to lowering discount rates and providing
more reserves through vault cash and reserve require­

"L a st W e d n e sd a y of Month
♦•M onthly A v e ra g e s of D a ily Figures
Latest d ata plotted: A u g u st prelim inary

Page 3

Total Effective Reserves of Member Banks
W eekly A ve rages of D aily Figures
Billions of D ollars

Billions of Dollars

1 For data previous to September 1, figures are total reserves less $125 million
for estimated change in reserve requirements. Data after September 1 are
total reserves.
2 Seasonal adjustment factors were obtained roughly by averaging daily figures
for each calendar day for the five years 1955-59. These were divided by the
average level for the entire five years. The seven calendar date factors were
then averaged to obtain the weekly factors. Unadjusted data were divided by
weekly average factors to obtain the seasonally adjusted data.

after drifting lower during August (See chart).2 Re­
serves of member banks declined from early in Jan­
uary to mid-April. There was a large rise in April
and since this time reserves have increased only
moderately in an irregular fashion. Total effective
reserves averaged about $18.5 billion in early Jan­
uary, reached a low of about $17.8 billion during the
first few weeks of April, and averaged about $18.4
billion in recent weeks.
The decline in total reserves since the first of the
year has resulted primarily from a substantial decline
in member bank borrowing. Member bank borrow­
ing which averaged about $950 million in early Jan­
uary has declined almost continuously to an average
level of about $290 million in the five weeks ending
September 14. As a result, free reserves, the difference
between excess reserves and borrowings, have gone
from minus $360 million in January to plus $350 mil­
lion in the five weeks ending September 14.

Bank Credit and the Money Supply
According to preliminary data, commercial bank
credit expanded slightly in August but at a lower rate
than during July. Loans expanded moderately while
investments remained about unchanged. Total bank
credit has been rising since April after declining mod­
erately during the first quarter.
2 Effective reserves are defined as total reserves adjusted for
changes in reserve requirem ents. These adjustments are made
in order to make total reserves of m em ber banks com parable
between periods in w hich changes in reserve requirem ents
have taken place.

Page 4

Reflecting the rise in bank credit, the
money supply increased slightly during
August. The money supply which declined
almost steadily from July 1959 through
May of this year has now risen in each of
the last three months. The rise has been
small and as a result the quantity of money
is still below the April 1960 level.
The turnover of demand deposits at
the 337 reporting centers outside the seven
largest financial centers rose in August
after declining during July. The velocity
of money on a three-month moving aver­
age basis rose steadily from mid-1958 to
March 1960. Since March the velocity
of money appears to have leveled off.

Interest Rates
There were divergent patterns in the movement of
interest rates during August and early September.
Yields on Treasury bills rose, although still well below
the rates in existence during the first few months of
1960. Interest rates on long-term Government bonds
rose slightly during August and early September. In
contrast, yields on corporate bonds declined rather
significantly in this period.
In early August when the discount rate was still 3.5
per cent, three-month Treasury bills were yielding 2.2
per cent. The reduction in the discount rate to 3.0 per
cent brought this rate more nearly in line with other
short-term rates, thereby increasing somewhat the
effectiveness of open market operations in affecting
total reserves. Even with the recent rise in short-term
bill rates, the discount rate remains about .40 percentage points above the three-month bill rate. In com­
parison, this spread averaged .17 percentage points
from 1951 through 1959. Therefore, despite the 1
point reduction in the discount rate since June, com­
mercial banks as a whole may find it more advanta­
geous to use additional reserves gained through Fed­
eral Reserve net purchases of Government securities
to repay their borrowings from the central bank rather
than as a base to expand bank credit.

The Discount Mechanism and Monetary Policy

T h e PRIMARY OBJECTIVES of the Federal Reserve System are to provide monetary conditions that
will facilitate economic growth, a high level of em­
ployment, and price stability. The System’s ability to
contribute toward these objectives rests, in large
measure, upon affecting the money supply. To this
end, the Federal Reserve depends chiefly on its ability
to affect member bank reserves which in turn affect
the quantity of bank credit and money. The proximate
objective then is to influence, at any given time, the
volume, cost, and availability of bank reserves in such
manner as to promote the primary objectives noted
In order to regulate member bank reserves the
Federal Reserve authorities have three major instru­
open market operations, discount rate changes,
and changes in reserve requirements. During the
period June-August the System made net open market
purchases of about $730 million, lowered the discount
rate at most Federal Reserve Banks in two steps from
4 per cent to 3 per cent, and made adjustments in
reserve requirements and vault cash which were ex­
pected to make available about $600 million of re­
serves. As a result, total reserves of member banks
expanded and the cost of borrowing additional re­
serves from the Reserve Banks was reduced.1 Of all
these actions taken by the System, the change in the
discount rate probably received the most attention,
while the change in reserve requirements was noted
mainly in official and banking circles and the public
remained relatively unaware of the direction of open
market operations. This concern with movements in
the discount rate arises because such changes are
viewed by many as an indication of a change in Fed­
eral Reserve policy. This article attempts to analyze
the role of discount policy in relation to overall mone­
tary actions and thereby place changes in the discount
rate in perspective.
Member banks obtain additional reserves from time
to time by borrowing from their Reserve Bank. Typ­
ically, a member bank will borrow from a Federal
1 See

“R ecen t Financial Developm ents” in this month’s Review.

Reserve Bank in order to avoid a temporary reserve
deficiency arising from an unexpected drain in its
deposits. The individual bank has several means by
which it can obtain additional reserves. It may dispose
of assets (usually a short-term marketable security
such as Treasury bills), borrow in the Federal funds
market, borrow from a correspondent bank, or borrow
from the Reserve Bank.2 The decision as to which
form the adjustment will take is influenced to a large
extent by policies and actions of the System.
The primary function of the Federal Reserve System
under the original act of 1913 was to provide for a
more elastic currency. As originally conceived the
discount mechanism was to be the major instrument of
this policy. Member banks were permitted to discount
notes, drafts, and bills of exchange of relatively short
maturity arising out of actual commercial and agricul­
tural transactions. Three years later Government se­
curities were added to the list of eligible paper.
During the 1930’s, when member banks had large
excess reserves, the discount mechanism assumed pri­
marily a standby significance.
During the war and until the Treasury-Federal
Reserve "accord” in 1951, member banks made their
short-run reserve adjustments chiefly by buying or
selling Government securities rather than borrowing
from the Federal Reserve. In this period banks held
large quantities of these securities, the prices of which
were supported by the Federal Reserve.
After the accord, member banks once again began
to rely more frequently on the discount mechanism to
make short-run reserve adjustments. During this
period the amount of outstanding borrowing rather
closely paralled fluctuations in the level of economic
activity. Member bank borrowing reached peak levels
in the months of December 1952, April 1956, and
August 1959. Borrowings were lowest in this period
2T h e

Fed eral funds market consists of the borrowing and lend­
ing, primarily by m em ber banks, of deposit balances at the
Fed eral Reserve Banks. F or a more complete discussion of
this institution see “T h e Fed eral Funds M arket,” in the April
1960 issue of this Review.

Page 5

during the months of July 1954 and July 1958. These
dates correspond roughly to the peaks and troughs of
business cycles since 1951.
Table I
Selected Months
(Monthly averages of daily figures.
In millions of dollars)
April 1951 ..............................................
December 1952 ........................................
July 1954 ..............................................
April 1956 ..............................................
July 1958 ...............................................
August 1959 ...........................................
August 1960 ......................................... .


Discount Policy

Discount policy at any time consists primarily of
two aspects: administration of the "discount window”
and setting the discount rate.

Administration of the Discount Window
The twelve Reserve Banks administer the function
of lending to member banks in their respective dis­
tricts as well as setting the rate which is subject to
approval by the Federal Reserve Board. The princi­
ples used by each Reserve Bank in judging an appli­
cation for a loan are set forth in Regulation A of the
Board of Governors which reads in part as follows:
Federal Reserve credit is generally extended on a
short-term basis to a member bank in order to enable
it to adjust its asset position when necessary because
of developments such as a sudden withdrawal of
deposits or seasonal requirements for credit beyond
those which can reasonably be met by use of the
bank’s own resources. . . . Under ordinary condi­
tions, the continuous use of Federal Reserve credit
by a member bank over a considerable period of
time is not regarded as appropriate.
In considering a request for credit accommodation,
each Federal Reserve Bank gives due regard to the
purpose of the credit and to its probable effects
upon the maintenance of sound credit conditions,
both as to the individual institution and the economy
generally. It keeps informed of and takes into ac­
count the general character and amount of the loans
and investments of the member banks. It considers
whether the bank is borrowing principally for the
purpose of obtaining a tax advantage or profiting
from rate differentials and whether the bank is
extending an undue amount of credit for the specu­
lative carrying of or trading in securities, real estate,
or commodities, or otherwise.
Administration of the discount privilege does not
change with shifts in monetary policy. The Reserve
Banks are aided in their enforcement of Regulation A
by the traditional reluctance of some commercial
banks to remain indebted.
Page 6

The Discount Rate
The discount rate is the interest rate charged by
the Reserve Banks on loans to member banks. This
then becomes the cost of obtaining additional reserves
through such borrowing. As brought out above a
member bank has several alternatives in adjusting to
short-run changes in its reserve position. The decision
as to which method is adopted is determined in large
part by the relative cost. The relative cost is frequent­
ly determined by 1 ) the loss or gain realized on the
sale of a short-term earning asset, and 2 ) the relation
between the discount rate and other short-term money
market rates.
Insofar as an individual member bank is concerned,
an adjustment in its reserve position through any of
the alternative methods stated above solves the bank’s
immediate problem. From the standpoint of monetary
policy the type of reserve adjustment is important.
Adjustments in reserves which are made through
transactions in the Federal funds market or in Treas­
ury bills represent merely a transfer of funds. No re­
serves are created or destroyed in this process. On the
other hand, borrowing or the repaying of borrowing
from the Reserve Banks increases or diminishes total
reserves of the banking system. As we have seen, this
is the variable upon which the System operates in
order to affect bank credit.
Open market operations have been in recent years
the primary means through which the Federal Reserve
exercises control over member bank reserves. Changes
in borrowing from the Reserve Banks, which are at
the initiative of the individual member banks, may
offset temporarily the effects of open market opera­
tions. However, since the discount rate has an in­
fluence on the decisions of member banks either to
borrow from the System or make their temporary re­
serve adjustments in some other way, the relationship
of the discount rate to other market rates may tend to
cause member bank borrowing in the aggregate to
supplement, rather than offset, open market policies.
The following set of examples are designed to show
how discount policy combined with open market op­
erations function first in a period when the Federal
Reserve is attempting to exercise credit restraint, and
then again in a period of credit ease. It will be as­
sumed in both cases that the banking system is ini­
tially in a state of equilibrium. That is, total bank
credit is at a desired level and excess reserves and
borrowings from the Reserve Banks are at levels
which the member banks consider satisfactory. In
addition we will assume that the economy is operat­
ing at a relatively high level and experiencing growth
with prices about stable.

Example 1—
Credit Restraint.

sary to further increase their indebtedness to the Fedral Reserve. Although the intent of the System is to
restrain the credit expansion, it will permit the use of
the discount window to cushion the shock of reserve
stringency for individual banks. In this sense the dis­
count mechanism will act as a safety valve.

Assume for the moment that the demand for bank
credit increases and that interest rates and prices are
tending to creep up, and that the System would de­
cide that supplying additional reserves via open mar­
ket operations to meet this credit demand would be
inflationary. As the demand for credit increases, mem­
ber banks will seek additional reserves by selling
securities or borrowing from the Federal Reserve. As
short-term interest rates rise relative to the discount
rate, banks will find it more desirable to adjust their
reserve positions by increased borrowings from the
System rather than by selling Treasury bills. As a
result commercial bank credit would expand—
reserves being supplied by the System in the form of
additional loans to member batiks.

It should be recognized that the increase in member
bank borrowing will offset initially the objectives of
open market policy oriented toward restraint. To
make this borrowing more costly and reduce the in­
centive to use the discount window the System may
raise the discount rate. It may be noted that the Fed­
eral Reserve policy of restraint is already underway.
The rise in the discount rate is not a signal initiating
a change in policy as much as it is a move to strength­
en a policy already in effect.

In order to slow up the rate of increase in member
bank reserves, the System might reduce its open mar­
ket purchases or allow market forces (gold outflows,
cash drainage, or a rise in Treasury balances) to pinch
reserves. Commercial banks would now find that in
order to avoid reserve deficiencies it becomes neces-

Example 2—
Credit Ease
Starting once again from our assumed initial posi­
tion, let us consider what happens if the demands for
credit begin to slow up or contract, market interest
rates are falling, and the possibility of a weakening

Borrowings? Discount Rate & Treasury Bill Rate
Millions of Dollars



Millions of Dollars










*Member Bank Borrowings from Federal Reserve Banks
Latest data plotted: August preliminary

Page 7

in economic activity appears. The banking system
will probably find itself with more than the desired
level of borrowing and may begin to repay borrow­
ings from the Federal Reserve. The Federal Reserve
with a view to encouraging full use of resources may
supply reserves through open market purchases of
securities. As interest rates continue to fall relative to
the discount rate, banks would have an added incen­
tive to repay their debt to the Reserve Banks rather
than use their reserves for lending or investing. Thus,
despite Federal Reserve action to increase reserves,
the decline in outstanding borrowing may actually
reduce reserves and total bank credit. In order to re­
duce the incentive to make further adjustments in
reserves through repayment to the System the discount
rate might be lowered. Here, again, the change in the
discount rate cannot be considered as signalling a
change in Federal Reserve policy, but rather a move
designed to reinforce open market operations. The
marginal advantage of the new-found reserves now
rests with expanding investments or loans. Thus, the
reserves made available to banks as their loans de­
cline will be used to expand investment holdings when
the discount rate is lowered relative to other money
market rates. If investments increase more than loans
decline, total bank credit and the money supply would
tend to rise.

to borrow and a stronger incentive to use excess re­
serves to repay outstanding borrowings). In such
situations the discount rate tends to reduce the effec­
tiveness of the open market operations designed to
encourage credit expansion.
In light of the above analysis, many of the discount
rate changes made by the Federal Reserve System
may be considered as "technical adjustments” to mar­
ket rates reflecting the efforts of monetary authorities
to establish a relationship between the discount rate
and other market rates appropriate for the effective
accomplishment of the objectives of open market op­
In recent years, among the numerous proposals pro­
viding for some modification in the operations and
policies of the Federal Reserve System, are those re­
lating to the discount mechanism. Several of the
better known proposals are listed below.
Alternative M

As has been pointed out in the examples above, dis­
count rate changes can be used to keep changes in
member bank borrowing from adversely affecting
open market operations. Appropriate discount rate
policy may be used to supplement open market oper­
ations as well as providing a safety valve. In practice,
a major difficulty in implementing discount policy is
to maintain the discount rate in proper relation to
other short-term rates, primarily Treasury bills.

One alternative which has been advocated
would eliminate all discretion associated with discount
rate policy. This plan involves tying the discount rate
automatically to a particular short-term money market
rate. The Treasury bill rate usually is recommended
for this purpose. This procedure would eliminate the
possibility of the discount rate becoming out of line
with the Treasury bill rate and would still retain fully
the safety valve advantages of discounting. Since
1956 the Canadian central bank has followed this
procedure by setting its discount rate each week at %
of one per cent above the latest average tender rate
for Canadian Treasury bills.

The Federal Reserve may not find it feasible to
adjust the discount rate to maintain the desired rela­
tionship between it and other rates, for reasons relat­
ing to Treasury financing, sudden changes in short­
term interest rates, and public reaction to discount
rate changes. Thus, it is possible that with infrequent
discount rate changes, the movement of other rates
can alter the effectiveness of a given discount rate. In
periods of boom with rising interest rates, a constant
or “lagging” discount rate would provide the same
incentive to member bank borrowing as a reduction
in the discount rate with other rates unchanged. Sim­
ilarly, in periods when credit policy is oriented toward
ease a discount rate which lags behind the fall in
market rates increases the "effective” cost of member
bank borrowing, thus inducing a decline in member
bank borrowings (reflected in a greater reluctance

There are three primary arguments against such a
technique. First, no one market rate is really "ideal”
as a guide and if it happens that the bill rate becomes
out of line with other short-term rates this would
automatically place the discount rate out of line also.
Second, there is no general agreement even among the
advocates of this plan as to the frequency with which
the discount rate should be changed. Many argue that
weekly changes generate too much uncertainty. If a
longer period is adopted, such as a month, lags in the
discount rate as against other rates become an in­
creasing problem. Third, fixing the discount rate in a
set relationship with the bill rate eliminates the pos­
sibility of actively changing the discount rate to con­
tribute to economic stability by supplementing open
market operations.

Page 8

2. Another alternative is an adaptation of the
method described above which would eliminate the
last criticism. This plan would tie the discount rate
to the bill rate but would allow the spread between
the two to vary with changes in monetary policy. The
discount rate may be placed below or above the Treas­
ury bill rate, depending upon the degree of ease or
restraint the System wished to follow. The spread be­
tween the two rates would not vary with changes in
the bill rate but would be changed only in response to
a change in Federal Reserve policy. The advantages
claimed for this procedure are that technical adjust­
ments would be made automatically and any change
in the spread would be associated with a definite
change in monetary policy. This would eliminate any
doubt as to whether a given change in the discount
rate represents a change in policy or is merely a tech­
nical adjustment to changing market conditions.
3. There is some support for eliminating the dis­
count mechanism entirely. This would leave open
market operations as the primary tool of monetary

policy. Member banks would then have to make their
reserve adjustments through carrying larger idle cash
balances, the Federal funds market, other forms of
interbank borrowing, the securities market, or chang­
ing their loan policy. Otherwise, they would be sub­
ject to penalties. Since banks would not be permitted
to borrow, there would be no changes in member
bank borrowing which might frustrate the economic
stabilization policies of the System. The plan, how­
ever, would eliminate the "safety-valve” feature of
discounting during periods when the Federal Reserve
is attempting to curb credit expansion through open
market sales. During such periods reserve adjust­
ments might become extremely costly and subject
individual banks to severe penalties.
A modified version of this approach would be to
maintain a relatively high discount rate of about 2
or 3 percentage points above the current Treasury bill
rate. This would usually discourage borrowing. In an
emergency there would still be a safety valve with
only a modest penalty.

Advance Refunding Offer by the Treasury

Advance refunding is a method of marketing
United States Government securities whereby the
holder of an outstanding bond is offered the option
to exchange for a new, longer bond with a higher
coupon interest rate, some years in advance of the
maturity date on the old bond. Advance refunding
is an important technique in the marketing of U. S.
Government securities involving the following ad­

a longer-term security; avoids any immediate book
loss for tax purposes and, if nontaxable, in most
instances is not required to take a book loss; acquires
a security whose market yield is at least equal to,
and in most cases slightly higher than, that on out­
standing issues of comparable maturity, and earns a
rate of return over the life of the new security only
equalled, if he does not exchange, by reinvesting at
maturity of the old security at higher than present
market yields.
The U. S. Treasury achieves substantial im­
provement in the present unbalanced maturity struc­
ture of the public debt; reduces its dependence on
inflationary bank borrowing; retains its customers for
long-term securities; and holds down its long-run
cost of managing the public debt.

The investor gains an immediate increase in
interest return, in consideration of his acceptance of

1 A description of the exchange offering can be obtained
by writing to the Fed eral Reserve Bank of St. Louis.

on September 9 an advance refunding of bonds sold
during World War II which mature between 1967
and 1969.1 Holders of these bonds are offered the
opportunity of exchanging the 2V per cent bonds for
new 3^6 per cent bonds maturing in twenty years,
thirty years, and thirty-eight years.

Page 9

Trends in Government Expenditures
F ro m 1929 THROUGH 1959, annual spending
by all governmental units in the United States rose
from $10 billion to $132 billion (Chart 1). This up­
surge has aroused public interest in the purposes for
which such outlays are made. Some people suggest
that government spending should be timed to promote
economic stability, pointing out that since such out­
lays have become a larger component of national out­
put, the economy has become more vulnerable to
expenditure fluctuations than before. Others argue
that the amount of government spending should be
largely based on the need for goods and services and,
therefore, its effect on economic stability is a second­
ary consideration. Increased government spending
has also intensified the perennial question of the role
of government in a private economy. There are those
who feel that government has been spending money
which could better be spent by the private sector,
while there are others who believe that government
should perform even more services. Regardless of
which position is taken concerning the rise in govern­
ment spending, however, its relationship to the in­
crease in activity in the rest of the economy should be
recognized. To place this growth in better perspective
is the purpose of this article.
Total Government Spending in Perspective
The increase in Federal, State, and local government
spending from $10 billion to $132 billion between 1929
and 1959 was only a part of a tremendous expansion
in the demand for goods and services that occurred in
all sectors of the economy during that period. Govern­
ment expenditures, however, increased their relative
share of gross national product from 10 per cent to 27
per cent (Chart 2 ). Since spending by various gov­
ernmental units for various purposes changed at wide­
ly different rates, the 17 percentage-point relative in­
crease in government outlays becomes more meaning­
ful if broken down into the purposes for which the
funds were applied by Federal and State and local

Federal Government Expenditures
From slightly under $3 billion or one-fourth of total
government expenditures in 1929, Federal outlays
grew to about $91 billion or two-thirds of all govern­

ment spending by 1959 (Chart 1). The rise in Federal
Government spending represented an expansion of
from 2.5 per cent to 19 per cent of gross national prod­
uct (Chart 2). For purposes of analysis, government
disbursements have been broken down between pur­
chases of goods and services and other spending which
includes interest payments, transfer payments, grantsin-aid and subsidies.
Five-sixths of Federal purchases of goods and serv­
ices in 1959 pertained to national defense (Chart 3).
Amounting to about $46 billion, these purchases in­
cluded outlays for the military functions of the De­
partment of Defense, the development and control of
atomic energy for peaceful uses as well as for military
purposes, stockpiling and expansion of defense pro­
duction, and military assistance to foreign countries.
From less than 2 per cent of GNP from 1929 to World
War II, national defense purchases grew to more than
40 per cent during the war. After diminishing to 5
per cent following the war, they expanded again dur­
ing the Korean conflict, and then leveled off in 1955
at about 10 per cent of GNP. This rise in national
defense expenditures over the past 30 years accounted
for almost half of the relative increase in spending by
all governmental units.
A relatively minor part of Federal purchases, about
$8 billion in 1959, was related to government adminis­
tration, conservation and development of natural re­
sources, and commerce and housing. These purchases
fluctuated both in dollar terms and as a percentage
of GNP during the thirty-year period. In 1959 they
equaled 1.7 per cent of GNP, compared with a low of
0.5 per cent in 1945, a peak of over 4 per cent in 1939
and about 1 per cent in 1929.
Other Spending
Federal Government spending for purposes other
than purchases of goods and services increased from
about $1 billion in 1929 to over $37 billion in 1959.
Interest payments increased, reflecting the expansion
of debt during World War II. They were also in­
fluenced by a decline in interest rates in the 1930’s
and a rise since the end of the war. Other types of
spending also rose as demands by citizens for more

in Federal outlays (Chart 1). The increase in State
and local spending from 1929 through 1959 was slight­
ly greater than the rise in GNP. These expenditures
totaled about 8 per cent of GNP in 1929, declined in
relative importance during World War II, and since
the war rose to about 10 per cent in 1959 (Chart 2).

government services grew. Transfer payments in­
creased as a result of the expansion in old age and
retirement benefits in recent years. After increasing
only slightly for many years, grants-in-aid to State and
local governments grew rapidly after 1956, largely
because the Federal Government quadrupled its aid
for highway building. Subsidies
fluctuated, but during the 1950’s
B illio n s o f D o lla r s
their direction was upward as the
Government spent more to stabil­
ize farm prices and farm income.
The rise in Government outlays,
other than those for goods and serv­
ices, represented an expansion of
from 1 per cent to 7 per cent of
GNP and accounted for slightly
less than half the rise in spending
relative to GNP by all governmen­
tal units over the past three dec­
ades. The relative increase in in­
terest payments, transfer payments,
grants-in-aid, and subsidies oc­
curred in two almost equal steps.
The first period of relative expan­
sion was the decade of the thirties.
Government transfer payments and
grants-in-aid to states both rose.
The second period occurred during
1944, 1945, and 1946, when interest
paid by the Government began to
rise primarily because of the in­
crease in Government debt during
the war. Since 1946, while one or
more of these four types of expen­
ditures may have been more im­
portant than the others, as a group
they fluctuated around 7 per cent
of GNP.



While State and local govern­
ment outlays increased from about
$8 billion in 1929 to $47 billion in
1959, they declined in relative im­
portance from about three-fourths
to about one-third of total Govern­
ment spending, reflecting the climb

_ j

1 1 1 1 ! 1 1 I ! 1 1 1 1 Lii


1 1T T

1 1 1 T—

Government Expenditures/^,
as a Per Cent of G N P / /







_i i i i
Per C en t
i i

and Local
State <
i i i i __ i _ I__ i__ i _

__ 1_ 1_ 1 - .. , _.J__ 1 1 1 __ 1 1 1_ 1
_ _ _ L.
__ __ __ — __ _ __
Chart 3




r i 7 i






Components |
of Federal Government
Ptirchases 1
as a Pei' Cent of (5NP /

1 '"T ' 1 !

1 1 1 1 '



Per C ent
1 I 1 ' 50

I N a tio n c 1 D e fe n s e P u rc h a s e s









State and Local Government

B illio n s o f D o lla r s

Chart 1


F e d e r a l Piu r c h a s e s

o tiher F e d e ra l
P u rc h a s e s
1 __ i__ i__ i— i— 1 __ 1 __ i—

T J__ L_JL_!__ __ L..J.

1 1 *1

1 1 n

\ 1

Page 11



State and local government purchases of goods and
services, which accounted for the bulk of spending by
these governmental units amounted to $44 billion or
9.2 per cent of GNP in 1959. They included spending
for education, highways, health services, police and
fire protection, sanitation, housing and community re­
development, local recreation, and general govern­
ment. Throughout the 1930’s and early 1940’s, annual
State and local government purchases amounted to
about $7 billion. They were relatively more important
as the economy contracted during the depression
and, conversely, declined in relative prominence as
the defense effort grew during World War II. During
the latter period, military requirements took prece­
dence over civilian requirements, and a backlog of
demand for services provided by State and local gov­
ernments developed. These demands were intensified
by a growing population and since 1945 by the accel­
eration in the trend toward urbanization and “suburb­
anization.” The demand for increased local provision
for education and roads has been particularly pressing.

The dollar spending of all governmental units rose
sharply between 1929 and 1959. Placing government
growth in perspective with expansion in the rest of
the economy, however, we see that the increase in
government outlays has not been nearly so great on a
relative as on an absolute basis. Consideration of only
the dollar amount of growth can be highly misleading.

Other Spending
Transfer payments by State and local governmental
units, primarily relief payments and unemployment
benefits, rose from $0.2 billion in 1929 to over $3.3
billion in 1959 as State and local governments as­
sumed greater social responsibilities. Net interest pay­
ments, which amounted to $542 million in 1929, rose
to $687 million in 1959 after a decline to $253 million
in 1947. They declined in relative importance between
1929 and 1959, however. From 0.5 per cent of GNP in
1929, net interest payments diminished by 1947 to
about 0.1 per cent, where they remained through
1959. Much of the fluctuation in interest payments re­
sulted from changes in interest rates; however, over
the period under review there was a substantial rise
in the size of the debt itself. Transfer payments and
interest payments by State and local governments fluc­
tuated around 1.0 per cent of GNP throughout the
past three decades with the exception of several de­
pression years when they rose to about 2.5 per cent.

Total governmental spending grew from 10 per
cent to 27 per cent of the gross national product in
the past 30 years, but the growth was neither contin­
uous nor general. About half of the expansion oc­
curred in national defense spending by the Federal
Government. Defense purchases, after climbing from
2 per cent of GNP to 40 per cent during World War
II, returned to 5 per cent following the war, rose to
about 13 per cent during the Korean conflict, and sub­
sequently leveled off at about 10 per cent under the
pressure of continuing international tension.
Spending by all governmental units for purposes
other than military rose from 8 per cent of GNP in
1929 to 17 per cent in 1959. Outlays by the Federal
Government for interest, transfer payments, grantsin-aid, and subsidies, like defense purchases, increased
in two steps. They rose from about 1 per cent of GNP
to about 4 per cent during the depression, as the Gov­
ernment increased its transfer payments and grantsin-aid, and from about 4 per cent to over 7 per cent
during 1944, 1945, and 1946 as interest and transfer
payments climbed. From 1947 to 1959, these Federal
expenditures grew at about the same rate as expendi­
tures in the economy as a whole.
State and local governments in 1959 were spending
at a slightly greater rate than they did during 1929.
They spent about 8 per cent of GNP during 1929 and
about 11 per cent during the depression years but the
rate dropped to a 4 per cent level during World War
II. Since then, however, State and local government
outlays rose to about 10 per cent of GNP as various
governmental units tried to satisfy the desires of their
citizens for more services. This pattern contrasted
sharply with the growth in Federal spending which
took place in several steps until a level was reached
that has been maintained for several years.