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MI
H

Sept.

FEDERAL RE

ANK OF ST. LOUIS

mew

Page

Current Problems Facing the
United States Economy
Recent Developments in
Qovernment Foreign
Exchange Transactions
Farm Income in the
Eighth District
Eighth District Business Loans
>L. 44 • No. 9 • SEPT. ’62
FEDERAL RESERVE BANK
OF ST. LOUIS
P. O. Box 4 4 2 • St. Louis 66. Mo.




14
16

Current Problems Facing the
United States Economy
I HE UNITED STATES ECONOMY is operating
at a high level. Total expenditures on goods and serv­
ices reached a high of $552 billion during the second
quarter of this year. Industrial output has continued
to expand in recent months. Despite such favorable
indications, many discussions have emphasized three
basic problems: (1) the lack of vigor at the present
stage of the current recovery; (2) the relatively slow
rate of economic growth over the past several years
compared with other industrialized nations; (3) the
continuing deficit in the United States balance of pay­
ments. This article will review these problems and
the various proposals which have been put forth as
possible solutions.1

The Problems
Economic activity improved sharply in the nine
months from February 1961, the trough month of
the 1960-61 recession, to November 1961. In this period
industrial production expanded at an annual rate of
about 16 per cent. The unemployment rate declined
from 6.9 per cent to 6.1 per cent and most other
indicators of business conditions showed similar im­
provement. But the rapid upsurge of industrial pro­
duction has moderated since the early months of
recovery. While there has been further improvement
in the labor market, unemployment has remained re­
latively high as has unused capacity in many industries
(see Table I, page 3).
1 The proposals for improving the economic well-being of the United
States presented in this article represent a broad sample of opinions
expressed by financial journalists and academicians. No one pro­
posal or appraisal should be interpreted as representing the official
opinion of the Federal Reserve Bank of St. Louis, the Federal
Reserve System, or any Governmental agency.

Page 2




Not only is there a belief by some analysts that the
current recovery has faltered but considerable dissatis­
faction has been expressed concerning the perform­
ance of the economy during the past decade. From
the peak of the 1949-53 expansion to the second quar­
ter of 1962, the index of industrial production rose at
a 3.0 per cent annual rate. This rate of economic
growth has occurred during a period when the econ­
omies of most other industrialized nations have been
expanding at extremely rapid rates ( see Chart 1). The
Western European nations and Japan have made tre­
mendous advances. The reported growth of the econ­
omies of the Soviet bloc nations has been such as to
inject economic growth into cold war politics. How-

States had been a surplus country. However, from
1950 to the second quarter of 1962 the United States
experienced deficits in its balance of payments aver­
aging $2.0 billion per year. During this period $5.6
billion of U. S. gold reserves were transferred to
foreign ownership. A portion of the gold and dollars
accumulated abroad associated with our payments
deficit probably constituted a desirable adjustment.
Hie reserve positions of these countries generally were
low following World War II. This condition produced
trade and currency restrictions which, in turn, tended
to reduce the amount of international trade.

ever, comparison of growth rates between the United
States and other nations may not be completely appro­
priate. The expansion of the economies of these
nations represents in part a recovery from extremely
low levels of activity which resulted from the devas­
tations of war.
Another evidence of shortcomings of the economy
which is often cited has been the growth of unused
resources over the period. Unemployment as a per
cent of the civilian labor force was 2.6 per cent in
July 1953, the peak month of the 1950-53 expansion.
At the two subsequent peaks, August 1957 and May
I960, the unemployment rate was 4.2 per cent and 5.1
per cent, respectively. There has also been a succes­
sive rise of unused facilities in the major materials in­
dustries (see Table I, column 5). A favorable aspect
of the period as a whole has been the relatively stable
prices in the United States compared with rising price
levels in most other leading countries.

There has been an improvement to the U. S. balance
of payments during 1961 and the first half of 1962.
In the preceding three years, 1958-1960, the United
States experienced deficits in its balance of payments
averaging $3.7 billion per year. The deficit amounted
to $2.5 billion in 1961 and was at a seasonally adjusted
annual rate of $1.5 billion during the first six months
of this year.

The third major problem facing the economy has
been the successive deficits in the balance of pay­
ments. For many years prior to 1950 the United

An important feature of the deficit payments posi­
tion of the United States since 1950 is that it has
prevailed in the face of a substantial balance-of-

Table I

Economic Performance of the United States during the Past Decade
(1)

Peaks

(2)

Number of
Months from
Previous Peak

(3)
Average Annual
Rate o f Change
in Industrial Production
from Previous Peak
(Per Cent)

Unemployment
Rate
(As a Per Cent of
the Labor Force)

(6)

(5)

(4)

Per Cent Of
Unused Capacity in
Major Materials
Industries

Average Annual Rate of Change
in Prices from Previous Peek
(Per Cent)
Wholesale

Consumer

July 1953 ................. .......

56

8.0

2.6

9*

1.3

2.3

August 1957 ..............

49

2.2

4.2

16*

1.7

1.3

M o y I9 6 0 ................. .......

33

3.0

5.1

19

0.4

1.6

2.4

4.1

11*

0.3

-0-

3.8

5.3

23

— 0.2

1.2

26 Months after
Above Peaks
September 1955 .........
October 1 9 5 9 * * .........
July 1962 ...................

^ Quarterly figures for periods prior to 1959.
* * The comparability of the data is impaired by the July to November 1959 strike in the steel industry.




Page 3

*

trade surplus i.e., excess of merchandise exports
over imports (see Chart 2). However, this surplus
has not been large enough to offset military and
foreign assistance expenditures and the outflow of
both long-term and short-term capital. As a result of
Chart 2

United States B a la n c e of Trade
a n d N et P a y m e n ts Position
(+)Surpl us; (-)Deficit
Bi l l i ons of Dol l ar s

Billions of D o l l a r s

S e a s o n a lly A d ju ste d

A N N U A L DATA

Q U ARTERLY DATA

]-....
.. f —j- ...-.2 4 — f-— f — j-....f....■ f......I — ■ ....I j—

24

16

16

JVm-

Net Payments Position L
1
1946

1948

1950

1952

1954

195 6

1958

1960

the deficits during the 1950’s and early 1960’s, for­
eigners have accumulated a large amount of short­
term dollar assets. A large portion of these dollar
assets is held by official institutions. When these
institutions consider their dollar holdings excessive
relative to their gold holdings, they frequently convert
dollars into gold.
Short-term capital movements have contributed to
the pressures on United States gold reserves already
reduced by the longer run deficit in the balance of
payments. With the re-establishment of currency con­
vertibility by most Western European nations in 1958,
money balances have become more mobile. Americans
may move surplus funds into foreign money markets
and add to the already large foreign holdings of dol­
lars. Short-term capital movements instituted by for­
eign nationals may lead to substantial shifts in the
ownership of dollar balances from foreign private
to official holders. As mentioned above, when for­
eign central banks accumulate dollars, they may make
demands on U. S. gold reserves. Because of the size
and volatility of foreign dollar holdings and the fact
that the dollar is the principal reserve currency, the
gold reserves of the United States are particularly
sensitive to short-term capital movements.




Various proposals have been presented with some
frequency by economic analysts as possible solutions
to the major questions that have been raised: how to
increase the pace of the current expansion as well as
the longer run rate of economic growth and at the
same time improve the balance of payments. This
article will concentrate on the proposals for fiscal and
monetary actions. Fiscal policy refers to the taxing and
spending activities of the Government. Monetary policy
pertains to central bank actions which affect changes
in the quantity of money or interest rates. Because a
country at all times is taking fiscal and monetary
actions, there must of necessity be some combination
or “mix” of monetary and fiscal policies. It should be
recognized that the use of other tools such as debt
management and measures to strengthen the inter­
national payments system also have their place in
solving these complex issues.2

1962

l l E xclu d in g m ilita ry tra n sfe rs u n d e r grants.
|2_ D e ficit m e a su re d by net de c lin e in U.S. g o ld a n d net in c re a se s in
fo re ign -h e ld d o lla r a sse ts. S in c e 1961 g o ld sa le s are net of c h a n g e in
c o n v e rtib le cu rrencie s held b y E x c h a n g e S t a b iliz a t io n Fund.
S o u rce : U.S. Dep a rtm e nt o f C o m m e rc e
Latest d a ta plotted: 2nd Q u a r t e r 1962 e stim a te d

Page 4

Solutions

The following discussion will outline some policies
frequently suggested for stimulating domestic recovery
and growth and for correcting a serious international
payments deficit. Finally, the proposals designed as
a simultaneous attack on both the domestic and inter­
national problems will be discussed. It will be ap­
parent that the proposals to improve either the do­
mestic economy or the international payments position
have to be modified when the problems which these
policies are designed to correct are considered simul­
taneously.
In general, stimulative fiscal and monetary policies
are suggested as means of increasing the current
level of economic activity and the rate of economic
growth. Stimulative fiscal actions are generally be­
lieved to involve lower tax rates or larger Government
expenditures and possibly greater budget deficits.
Stimulative monetary actions are generally believed
to be provided by a more rapid expansion of the
money supply accompanied by lower interest rates.
On the other hand, fiscal and monetary policy prescrip­
tions for reducing the deficit in the balance of pay­
ments call for a reduction in the deficit in the Federal
budget, higher interest rates, and a relatively low rate
of money supply expansion.
2 For a discussion of the international payments system and means
being undertaken to strengthen this mechanism see "The Inter­
national Payments System” in the May 1962 issue of this Revie ,
and "Recent Developments in Government Foreign Exchange
Transactions” in this issue.

Proposals to Improve the
Domestic Economy

Proposals to Improve the
Payments Deficit

Reducing tax rates or increasing Government ex­
penditures is expected to lead to an increase in the
demand for goods and services. If taxes are reduced,
but Government expenditures maintained, the in­
creased demand would be expected to come from
the private sector of the economy. On the other hand,
if taxes are held constant but Government expend­
itures increased, the initial expansion in total demand
is expected to come largely from the public sector.

Suggestions for reducing the deficit in the balance
of payments differ substantially from the proposals
offered as solutions to the present slow rate of recov­
ery and the longer run growth problems. A com­
monly suggested means of achieving a better inter­
national payments position is to pursue restrictive
fiscal and monetary policies.

Reducing both tax receipts and expenditures has
been suggested as another approach to increasing the
rate of economic growth. Proponents of this approach
contend that such a policy would lead to greater bus­
iness confidence and an increase in private investment.
There are some, however, who argue that this policy
would actually reduce the rate of economic expansion
because total demand would fall. Individuals would
save a portion of the increase in their disposable in­
come and thus would not fully offset the decrease in
Government spending.
The role of monetary policy to promote recovery
and growth as viewed by some is to increase the
public’s holdings of money at a rate sufficient to gen­
erate an appropriate level of total demand. When the
public’s actual holdings of money and other liquid
assets exceed their desired level, total demand tends
to rise. If their actual holdings are less, total demand
tends to fall. Another way of viewing monetary action,
although not inconsistent with the money supply view,
is in terms of its effect on interest rates. According to
this view an “easy” or stimulative monetary policy is
one that promotes low interest rates, particularly long­
term rates. It is suggested that such a policy would
encourage domestic private investment and thus lead
to a period of expansion based on private capital
formation.
While appropriate fiscal and monetary measures
may not be inflationary, an excessive deficit in the
budget or an excessive increase in the money supply
accompanied by unduly low interest rates will lead
to inflation. It is thought by some that a moderate
amount of inflation may be conducive to relatively
rapid economic growth. On the other hand, rising
prices may be an obstacle to sustainable economic
growth. Furthermore, as will be pointed out below, a
rising price level could be detrimental to solving the
balance of payments deficit.




A relatively restrictive Federal budget is expected to
improve the possibility of a continuation of the present
stable price level. Confidence in the stability of do­
mestic prices, which would tend to maintain export
receipts, encourages foreign central banks to hold dol­
lars rather than converting these dollar holdings into
gold. Budget deficits are frequently associated with
inflationary pressures, loss of exports, and a weakening
of the external value of a nations currency. A tight
fiscal policy, it is argued, would indicate to foreign
holders of dollar balances that the U. S. authorities
were taking the necessary actions to maintain the
value of the dollar.
A relatively tight monetary policy is also suggested
by some observers as a means of improving the balance-of-payments situation. Higher short-term interest
rates would reduce the incentive to exchange short­
term dollar assets for higher yielding foreign assets.
Movements of short-term funds from this country in
response to yield differentials often result in a transfer
of dollar balances to foreign central banks. In turn
these transfers often lead to an outflow of gold and
speculative activity against the dollar. Higher long­
term rates in the United States might reduce foreign
long-term borrowing in the U. S. capital market.
However, it should be noted that interest rate differ­
entials may not be the only factor which makes the
U. S. capital market attractive to foreign borrowers.
Other capital markets often are not large enough to
supply the needed funds and there are still numerous
restrictions in the capital markets of many countries.
Since relative price stability in this country is con­
sidered almost essential if the balance-of-payments
deficit is to be reduced, it is often suggested that the
rate of expansion of the money supply remain nominal.
A low rate of money supply creation would be con­
sistent with central bank attempts to keep interest
rates at a relatively high level. The continuation of
Page 5

relative price stability, which it is hoped would ac­
company a tight monetary and fiscal policy, would
minimize the possibilities of an increase in imports
and a decline in exports. Indeed, if price stability in
this country were accompanied by price increases
abroad this would probably increase our already
favorable trade balance by causing imports to decline
and exports to rise.

Proposals to Achieve Balance between
Domestic and International
Requirements
This brief resume of the suggestions for fiscal and
monetary actions designed to stimulate the present
recovery and economic growth and to alleviate the
deficit in the balance of payments points out the
contradictory nature of the various proposals. It is
not surprising, therefore, that most suggestions for
improving the overall economic situation of the coun­
try incorporate a modification of the fiscal and mone­
tary policy combinations outlined above. Perhaps the
most frequent suggestion is for an easy fiscal policy
(an increased budget deficit) and a somewhat tighter
monetary policy (higher interest rates). Such a policy,
it is argued, might serve to reduce the capital outflow
and at the same time keep prices stable yet increase
total domestic demand for goods and services. Propo­
nents of this view frequently argue that, since interest
rates have remained relatively low for the past two
years, the current lack of vigor in the economy is not
the result of a lack of credit but of a weakness in
demand. This situation would be helped by incurring
a larger Government deficit which would provide an
increase in total demand for goods and services.
A major problem which opponents of this course
of action generally point to is that if the increased
budget deficit is financed by short-term Govern­
ment borrowing, the public s liquidity would be in­
creased and the effect would be similar to an expansion
in the money supply. On the other hand, if the increased
Government debt is financed by issuing longer term
securities this would tend to cause long-term interest
rates to rise. Private borrowers would find the cost
of borrowing higher and at least a part of the benefit
of the increased Government deficit might be offset
by a decline in private investment.
Another proposal is for a somewhat more rapid
expansion of the money supply with fiscal policy
remaining about unchanged. The advocates of this
policy contend that the economy requires that amount
of money and those interest rates which will stimulate
Page 6



a greater utilization of resources and a greater de­
mand for loan funds for investment. If such condi­
tions are fostered, it is believed, interest rates will
rise naturally and the outflow of hot money and cap­
ital will be stopped. High interest rates which result
from a high domestic demand for investment funds
reflect an expanding economy and might be sustained.
These observers contend that the opposite policy, that
of high interest rates and tight money in a time of
economic slack, is self-defeating. Such action may
limit the demand for goods and services, compound
the unemployment problem, and thus make the main­
tenance of a high level of interest rates even more
difficult.

Conclusion
As discussed above, the problem of. the simultane­
ous occurrence of a balance-of-payments deficit and
of a less than satisfactory rate of recovery and growth
is a difficult one. Adjustments which are likely to
improve the payments deficit may tend to depress the
domestic economy. The problem is one of the oldest
in economics. In fact, one could say that the gold
standard was abandoned by many countries in the
1930’s because it made the adjustment to payments
deficits automatic and thus tied the level of eco­
nomic activity in a country to its position in inter­
national trade. The situation discussed in the article
shows that to some degree the western world still has
the problem under the present international monetary
system.
Despite the complexity of the problems and policy
implications, it should not be inferred that the United
States will be unable to solve the problems within the
framework of existing institutional arrangements. There
are other tools of policy available to supplement mon­
etary and fiscal actions. Debt management operations
may be used to alter relative interest rates, thus allow­
ing a more stimulative supply of money without a
substantial reduction in short-term interest rates. The
surplus countries may be willing to accept a larger
burden of the foreign aid and military assistance pro­
gram. Strengthening of the resources of the Interna­
tional Monetary Fund and increased cooperation
among central banks have reduced the impact of short­
term capital movements on our gold reserves. A fur­
ther reduction of tariff and quota restrictions against
United States exports would be of help both to our
payments situation and to the domestic economy.
These and other steps which might be taken suggest
that the longer run outlook for the United States
economy is strong. We need not accept either a
continuing low rate of economic growth or a contin­
uing payments deficit in the years ahead.

Recent Developments in

Government Foreign Exchange Transactions
F o r e ig n e x c h a n g e tr a n sa c t io n s and exchange rates are of increasing concern to the central
bankers of the world. Official interest in foreign ex­
change markets has developed against the background
of continuing payments imbalances magnified by
movements of short-term capital. With a view toward
lessening the problem of sudden and substantial shifts
of short-term funds, central banks have broadened the
scope of their foreign exchange transactions.
Exchange rate fluctuations are the price responses
to changes in money flows between nations. Changing
exchange rates, however, are more than responses to
money flows. They may, together with other factors,
actually influence the direction and magnitude of spec­
ulative capital movements that so frequently impose
severe strains on the international payments system.1
Central bankers are now cooperating to moderate
abrupt changes in exchange rates that are considered
to reflect temporary destabilizing forces.
The most noteworthy development in the recent
growth of official participation has been the re-entry
of the United States into foreign exchange transac­
tions for the first time since the 1930’s. The Treasury
began limited operations in March 1961, and in Feb­
ruary of this year the Federal Reserve System an­
nounced that it was prepared to enter the exchange
markets for its own account.
The governments and central banks of most other
countries have long considered it right and proper to
be active in foreign exchange markets. Moreover, the
Bretton Woods Agreement of 1944, supplemented by
the European Monetary Agreement of 1958, requires
that central banks or government stabilization funds
intervene in foreign exchange markets to limit ex­
change rate fluctuations above and below currency
par values established in agreements with the Inter­
national Monetary Fund. Until 1961 the United States
role in foreign exchange markets was passive except
} For an elementary exposition of the international payments system
f and moves to strengthen it, see "T he International Payments Sys­
tem,” May 1962, this Review.




that the United States Treasury maintained the fixed
relationship between gold and dollars at the rate of
$35 per ounce. The official institutions of other IMF
member nations intervened in the markets to establish
exchange rate ceilings and floors for their currencies
in terms of dollars (Table I).
Table I
EXCHANGE RATES FOR MAJOR FOREIGN CURRENCIES
(In U.S. dollars per Unit)

Currency
Pound S t e r l in g ...................

Par
Value
2.80

Central Bank Intervention
Limits*
Upper
2.82

Lower
2.78

C anad ian D o l l a r ............

.925

.93425

.91575

Deutsche M a rk .

.2500

.251890

.248139

Swiss F r a n c ............

.228676

.232829

.224719

Netherlands G uilder . . ..

.276243

.278358

.274160

Italian Lira . .................

.001600

.001612

.001589

French F r a n c ...................

.20255

.204082

.201045

Belgian F r a n c .....................

.02

.020151

.019851

* Established under the European Monetary Agreement at approximately
three-quarters of one per cent on either side of the par value (except for
Switzerland, which maintains margins of about 1.75 per cent on either
side of parity), rounded to the nearest six decimal places. In the case of
Canada, which is not a signatory of the EMA, the margins are main­
tained at one per cent on either side of parity, in accordance with the
IM F agreement.
Source: Board of Governors, Federal Reserve System.

Although most foreign central banks have been
active participants in foreign exchange markets for
many years, they confined most of their transactions
to the spot market in which delivery of exchange is
made within a few days. Within the past two years,
however, official institutions have made more exten­
sive use of forward exchange transactions.
A forward transaction is a contract which calls for
the delivery, at a future date, of a specified amount
of one currency (marks, for example) in exchange
for some other currency (dollars, for example) at an
exchange rate fixed at the time the contract is made.
At the time the contract falls due, the spot rate for the
currency may be above or below the rate specified for
the maturing forward transaction. This has no effect
Page 7

on the contracted rate. Generally, forward contracts
involve time periods of one, three, and six months
although arrangements can be made for other matur­
ities. The buying and selling of particular currencies
on a forward basis determines the market price (the
forward rate) at which the currencies stated in the
contract are exchanged. Forward rates, like spot rates,
fluctuate in response to varying pressures of supply
and demand. In some respects, forward exchange
transactions may be considered the foreign exchange
counterpart of commodity “futures” transactions.
The primary objective of the increase in official
foreign exchange transactions is to defend the system
of currency convertibility at stable exchange rates
against the pressures of speculative short-term capital
movements. The monetary authorities consider such
a defense an important part of the world’s quest for
a better balance in international payments. It should
be emphasized, however, that official foreign exchange
transactions in both forward and spot markets are not
designed to cure a basic imbalance in a nation’s pay­
ments position; they serve merely to provide time
during which basic programs have a chance to be­
come effective.
The purpose of this article is to answer the general
question: what are the characteristics of foreign ex­
change markets that warrant official intervention, in
both forward and spot markets? The question calls
for an examination of the relationship between spot
and forward exchange transactions and the forces
influencing the spreads between spot and forward ex­
change rates. Such spreads, together with interest
rate differentials and speculative attitudes, determine
the direction and magnitude of short-term capital
movements. As important sellers and buyers of spot
and forward exchange, central banks and govern­
ments are in a position to influence the spread be­
tween spot and forward rates, and thus to offset or
reinforce the other factors affecting capital move­
ments.
S o
h rt-T rm C p l M v m n s A T re t t
e
a ita o e e t :
h a o
E c a g S b
x h n e ta ility

Before considering forward markets, it may be use­
ful to review briefly the reason for official concern
over short-term capital movements and the relation­
ship of these movements to the existing structure of
currency par values.
Since 1958 when most nations re-established cur­
Page 8




rency convertibility, short-term funds have been rela­
tively free to move from one nation’s money market
to another. Some movements have been generated by
interest differentials; others by speculative fears or
anticipations arising out of the disturbing basic im­
balances in the payments position of leading nations.
Such capital movements, if large in volume, may
impose a serious strain on the existing structure of
exchange rates. A heavy short-term capital flow usu­
ally leads to a sharp drop in the official reserves of
the country losing funds. The drain on official reserves
develops out of the efforts of the monetary authority
in that country to support the external value of its
currency. To keep the value of its currency from
dropping below the prescribed limit, the central bank
sells dollars and gold in the purchase of its own cur­
rency. If the loss of reserves due to a short-term
capital outflow is added to losses incurred by a basic
deficit, there is danger of further capital outflows aris­
ing out of speculative fears over the ability of the
nation to continue business at the established ex­
change rate.
A country receiving short-term funds may also
experience difficulties, particularly if it has been in­
curring surpluses in its basic balance of payments.
The monetary authority of such a country will usually
be required to enter the foreign exchange market to
prevent the value of its currency in terms of dollars
from rising above the limit prescribed. Its accumula­
tions of dollars in the support operation (selling its
own currency for dollars) may lead to such large
holdings as to cause concern on several counts. For
the United States it poses a threat of further drains
on a gold stock that has been declining substantially
For the surplus country, the continued and rapk
accumulation of official reserves may not only leat
to unwanted domestic liquidity, but also lead to dis
cussion and rumors of the possibility of a revaluation
(a rise in the par value of the currency). Additional
short-term capital inflows are likely to feed on these
possibilities and impose additional pressures on ex­
change rates and disturbing changes in official reserves.
It is important to note that “leads and lags” in
commercial payments may be the most important
form of short-term capital movements whenever the
par value of a particular currency becomes suspect
Residents of the country with the weak currency will

attempt to settle their commercial obligations in for­
eign currencies more rapidly in order to avoid the
higher costs involved in a devaluation of the weak
currency. At the same time the flow of commercial
receipts to the weak-currency country tends to lag
behind normal payment schedules. Exporting firms
in the country threatened with devaluation delay the
conversion of foreign currency earnings into their own
currency as long as possible. Within a given period
of time, the net result of this change in the timing of
payments and receipts is a reduction in the country’s
receipts from abroad and an increase in the net pay­
ments outflow.
An example of the above occurred during the first
four months of 1962. There were expectations in the
exchange markets that the value of the Canadian
dollar would decline. This led to a substantial build­
up of so-called “leads and lags” in commercial pay­
ments which involved an acceleration of Canadian
payments abroad and a slowing up in the flow of
Canadian receipts from abroad. This payments situa­
tion imposed additional strain on Canadian foreign
exchange reserves. The monetary authorities were
obliged to sell a substantial amount of their reserves
to support the exchange value of the Canadian dollar.
F r a d E c a g M rk
ow r
x h n e a ets
2

The Function of Forward Exchange Transactions
The rationale underlying the use of forward con­
tracts in international finance is that they transfer the
risks stemming from possible changes in exchange
rate relationships from exporters, importers, and in­
vestors to persons and institutions that specialize in
assuming these risks. Forward contracts also permit
speculation involving no immediate cash outlay.
As long as spot exchange rates may fluctuate, even
within narrow limits, there is risk involved for those
who expect to convert one currency into another. An
American exporter who sells goods to Britain for ster­
ling payable in three months is concerned about the
rate at which he may convert his sterling claims into
dollars. An American investor who has placed short­
term funds in the British money market has a similar
concern. If, for example, the price of sterling drops
from 2.81 to 2.78 between now and the time the
2 For an excellent technical introduction see A. R. Holmes, The
N ew York Foreign Exchange Market (Federal Reserve Bank of
New York, March 1 9 59). Paul Einzig’s A Dynamic Theory oj
| Forward Exchange (St. Martin’s Press, Inc., N. Y . 1961) is a
r detailed presentation of the mechanics, history, and policy impli­
cations of forward exchange transactions.




American exporter or investor is supposed to receive
sterling, the 3 cent difference per pound may amount
to a significant reduction in the profits scheduled to
accrue from the sale of goods or in the net interest
received from the investment in a British money
market instrument.
By entering the forward exchange market, an Amer­
ican, who expects future receipts denominated in
pounds, can remove the uncertainty of how many
dollars his future pound receipts will command. The
exporter sells a contract in which he promises to
deliver, at a stated future date, pounds in exchange
for dollars at the market price existing for forward
pounds at the time the contract is initiated. The ex­
porter now knows the exact amount of dollars he
will receive for pounds. The expected pound balance
arising from the trade or investment transaction can
be used to make delivery of pounds under the terms
of the forward contract.
At the same time that traders and investors may be
conducting forward sales to protect themselves against
a fall in the spot rate of the currency they expect to
receive, there are others who are concerned about
a future rise in the spot rate. The American importer
who is to pay pounds in the future faces the prospect
of a rise in the cost of his imports if the pound sterling
spot rate rises in the meantime. As a defensive meas­
ure, he may buy a forward sterling contract which
obligates the seller to deliver at some specified date
in the future a specified amount of sterling in ex­
change for dollars at a price determined in the for­
ward market when the contract is purchased. The
importer is now able to concentrate on the normal
problems of his business without the additional prob­
lem of exchange rate fluctuations. Similar considera­
tions apply, of course, for foreign exporters, importers,
and investors who expect to buy or sell dollars in
the future.
The use of forward contracts has been given con­
siderable impetus in recent years by fears of possible
changes in the established exchange parities (devalu­
ation or revaluation). The IMF policy of exchange
rate stability does not preclude the possibility that a
country with a serious and continuing deficit in its
balance of payments will seek and receive permission
from the IMF to reduce the value of its currency rela­
tive to other currencies. Since 1949, substantial de­
valuations of particular currencies have taken place
as countries have sought to improve their payments
positions.

Conversely, a chronic surplus country might re­
value its currency, i.e. raise the value of its currency
relative to the dollar and other currencies. This was
done in early 1961 when the “par values” of the Ger­
man mark and the Dutch guilder were raised 5
per cent.
Forward Exchange Rates: Premiums
and Discounts
Rates of forward exchange, determined by the in­
terplay of demand and supply pressures, may be
quoted in the same terms as spot rates— many cents
so
for a unit of foreign currency. Forward rates may
also be quoted in terms of a premium or discount
against the spot rate. Often such a premium or dis­
count is expressed on a per cent per annum basis.
The spread between the forward rate and the spot
rate is expressed as a percentage of the spot rate. If
the forward rate is higher than the spot rate, the differ­
ential is expressed as a per cent per annum premium.
If the forward rate is below the spot rate, the differ­
ential is referred to as a per cent per annum discount.
For example, the spot rate for sterling may be 279.02
cents while the forward rate for 3-months pounds
may be lower (at a discount) at 276.26 cents. The
difference between the two rates of 2.76 cents for 3
months becomes approximately 11.04 cents on a year­
ly basis. Since 11.04 cents is 3.96 per cent of the spot
rate of 279.02 cents, the forward rate for pounds in
this case would be quoted at a discount of 3.96 per
cent per annum. For the person selling forward
pounds for forward dollars in order to protect himself
against a drop in the pound spot rate, this 3.96 per
cent represents a cost of covering his spot transaction.
In this discussion of forward premiums and dis­
counts for the pound sterling it is important to note
that a premium on the forward pound corresponds to
a discount on the forward dollar (but of a slightly
different magnitude). Similarly, a discount on the for­
ward pound means that the forward dollar is offered
at a premium.
The spread between spot and forward rates can
change because of changes in either the spot or for­
ward rate or both. The resulting premium or discount
reflects the play of the interest rate differential be­
tween markets as well as the play of noninterest
factors, including changes in market expectations.
Page 10




The Relationship between Forward
and Spot Rates
Generally the forward exchange rate of a high
interest rate country will be quoted at a discount
against the spot rate. The forward rate drops below
the spot rate under the combined impact of spot
purchases to exploit the higher interest rate, and the
forward sales designed to cover the risk of a future
fall in the spot rate. For example, since early 1960
short-term interest rates in London have been consid­
erably higher than those in New York (Chart 1).
Under these circumstances, investors with liquid
funds would tend to move into sterling short-term
assets to take advantage of the interest differential
(interest arbitrage). If these investors covered their
spot sterling investments, by selling forward sterling
for forward dollars, the sterling spot rate would tend
to rise and the sterling forward rate would tend to
fall. The per cent per annum discount on forward
sterling represents the interest equivalent of the cost
of covering the investment in a sterling asset (Chart
2). This cost increases as forward sales and spot pur­
chases continue. Eventually, if no other factor inter­
venes, the percentage discount on forward pounds
equals the gain acquired from the interest differential.
At this point, the incentive to invest in the highinterest-rate country on a covered basis (if interest
arbitrage is the sole objective) disappears. The for­
ward exchange rate is then said to be at interest parity.
This relation between the spot and forward ex­
change rate holds only when forward rates primarily
reflect interest rate differences. The spread between
forward and spot rates may change when forward
rates reflect the influence of other forces such as sea­
sonal or cyclical swings in payment flows or uncer­
tainty about par values. A case in point illustrating
the behavior of forward rates under unsettled market
conditions occurred in the second half of 1960 and
early 1961. Despite a record shift of funds from New
York to London in this period, the forward discount
on the pound did not increase enough to offset the
interest differential between New York and London
(Chart 2). The covered yield differential in favor of
United Kingdom Treasury bills in London amounted
to approximately one per cent (Chart 3). This con­
tinuing differential indicated that some traders and
investors were putting funds into London without

iterest Arbitrage, N ew York/London
day data
r Cent Per A n n u m

Per C ent Per A nni

Chart 1

8

8

6

6

4

4

2

2

0

0

6

6

Rate Differential and 3-Month Forward Sterling
4

4

2

2

0

0

-2

-2

-4

-4

6

-6

Chart 3

.............................
Rate Differential wit h Forward Exchange Cover

4

2

A

4

2

In F a v c r o f L o n d o n

0

0
In F a v o r o f N e w Y o r k I f

2

-2

1

-4

1 I I

1

I I

1959

1

1 1 1

1

I I

I I

I I

1111

1960

S o u rc e : B o a rd of G o v e rn o rs of the F e d e ra l R e serve System

1 1 1 L 1 1 1 L 1 J._ 1 1 1 I I
,1 . . .
1 9 61

111111

■4

1962
Latest d a ta p lo tte d : A u g u s t 17, 1962

n

LHESE CHARTS illustrate interest rate and
e> change rate relationships.
The "rate differential” line in Chart 2 is the
s t read between the London and New York Treasy bill rates as recorded in Chart 1. Since early
>60 the spread has been in favor of London.
The forward sterling rate is plotted in Chart 2
a per cent per annum discount or premium.




The line in Chart 3 is the net incentive to mo re
funds (-f- in favor of London, — in favor of Ne w
York). It is the algebraic sum of the interest ra
differential and the forward per cent premium
discount. Since the last half of 1961 the forwa
discount on sterling has virtually offset the inter*
spread in favor of London.

covering the risk of exchange fluctuations in returning
from pounds to dollars. Apparently they were willing
to speculate that the external value of the pound would
not fall against the dollar. In fact at that time there
were some who believed that, if anything would hap­
pen, the value of the dollar would decrease relative to
the pound. In such an unsettled foreign exchange
situation, the discount on forward pounds, amounting
to less than the prevailing interest differential, proved
to be only a minor obstacle to the continued move­
ment of funds from New York to London.
The fear or anticipation of a revaluation or devalua­
tion of particular currencies may completely submerge
interest rate considerations. For example, in March
1961 immediately after the German mark and the
Dutch guilder were appreciated there were rumors
of further changes in these two currencies as well as
new parities for other currencies. These rumors led
to a massive flow of funds from London to Zurich and
Frankfurt. There was also a net inflow to these centers
from New York. As a result, the forward premium on
marks rose above 3.5 per cent per annum.
As this recent experience with the German mark
shows, a strong speculative belief in the likelihood of
a revaluation of a particular currency will usually
cause the forward rate of that currency to be quoted
at a premium against the spot rate. Speculators will
make heavy forward purchases as well as heavy spot
purchases of the currency in question. Once the spot
rate reaches its support ceiling, however, it can rise
no further because of central bank intervention. Un­
less similar intervention occurs in the forward market,
the forward rate is bound to rise above the spot rate.3
For the country experiencing a capital inflow the
existence of a substantial forward premium on its
currency acts as a force that accelerates the inflow
and reduces possibilities of an outflow. A covered
inflow is made more profitable by the existence of a
forward premium.
The forward premium also accelerates the commer­
cial flow of funds into the strong currency. Such a
movement of funds is generally described as reflecting
“leads and lags” in commercial payments. In March
1961, for example, German exporters with prospective
3 Central banks are not required to limit the fluctuations in forward
rates.




dollar receipts did not follow the usual practice of
selling forward dollars for marks to protect them­
selves against exchange risks. The excessive discount
on forward dollars (premium on marks) made this
too costlv. Instead, the German exporters borrowed
dollars from European or American banks and con­
verted these dollars into marks immediately. Subse­
quently, the dollar receipts from their exports were
used to pay off their dollar loans. They found that
the interest cost of their loan was less than the cost of
covering their trade receipts with a forward sale of
dollars.
For Germans considering short-term investment
abroad ( involving, e.g., a switch of marks into dollars)
the forward premium constituted a cost obstacle. If a
German commercial bank had bought dollars (spot)
with marks to invest abroad at short-term it would
have been concerned about the prospect of covering
its dollar investment with a forward sale of dollars for
marks. The large premium on forward marks (dis­
count on the dollar) would probably have wiped out
whatever gains the banker anticipated from such an
investment in dollars. Official attempts to encourage
an outflow of capital to reduce the degree of domestic
liquidity in Germany had to contend with the barrier
of a high forward premium on the mark.
In this situation the high forward premium on
marks intensified the flow of dollars into marks on a
spot basis, with no relief from offsetting outflows.
With mounting pressures on the spot price of marks,
the German central bank was obliged to purchase
dollars in the foreign exchange markets in order to
keep the mark from rising above its dollar ceiling. As
German official dollar holdings increased, there were
additional gold demands on the United States Treas­
ury.
Official Intervention in the Forward Exchange
Markets
In the face of forward premiums and discounts that
bore no relationship to interest parities, the monetary
authorities of various nations in the Spring of 1961
came to the conclusion that official transactions in
the forward market within the framework of coopera­
tive agreements were necessary to defend the existing
payments system. The purpose of official intervention

to undertake foreign exchange operations on its own
account. It has since acquired some convertible cur­
rencies through reciprocal arrangements with other
central banks.4

in the situation that prevailed at that time was to
increase the market supply of forward marks, Swiss
francs, and Dutch guilders, so as to reduce the high
forward premiums on these currencies (viewed alter­
natively as large discounts on the dollar).

The Treasury-Federal Reserve inventory of convert­
ible currencies provides the basis for covering for­
ward sales of such currencies. Spot transactions to
modify temporary speculative exchange rate pressures
are also possible. U. S. holdings of convertible cur­
rencies may also be exchanged for excess dollar hold­
ings of foreign central banks in order to reduce the
potential drain on U. S. gold reserves.

The United States Treasury, through its Stabiliza­
tion Fund, undertook its first foreign currency opera­
tions in March of 1961 to reduce the premium on the
forward mark. The U. S. sales of forward marks and
arrangements for future covering transactions were
worked out in agreement with the German Central
Bank. In May 1961 the United States with the aid of
borrowed Swiss francs, worked out similar arrange­
ments with Switzerland, selling francs forward against
dollars. Later in the year, forward sales were con­
ducted in Dutch guilders. On occasion, Treasury
operations also involved spot transactions. Within the
framework of their relatively modest scale, the opera­
tions have already proven that they can accomplish
their objectives.

The cooperation among official institutions in the
forward exchange markets is but one part of the array
of cooperative actions adopted since early 1961. Quite
apart from the specific agreements among the mon­
etary authorities, the important point is that the
monetary authorities of the western monetary system
are acting in unison. This should do much to make
the international payments system operate more effec­
tively.

To increase the scope and flexibility of U. S. official
transactions in foreign exchange markets, the Federal
Reserve System in early 1962 announced its readiness




S

u

a b l e

m

b

s

c

r

t o

a i l i n g s

i p

t h e

t o

t

i o

B o x

4 4 2 ,

e n t ,

S t .

t o

s

p u b l i c

b a n k s ,

i n s t i t u t i o n s , a n d

D e p a r t m

n

w

t h i s

F e d e r a l

b a n k ’s

i t h o u t

b u s i n e s s

o t h e r s .

L o u i s

4 For more complete details see "Foreign Exchange Markets, Jan­
uary-June 1962”, M onthly Review, Federal Reserve Bank of New
York, August 1962, pp. 106-107.

F o r

M

c h a r g e ,

i n f o r m

a t i o n

B a n k

o f

a r e

a v a i l ­

i n c l u d i n g

o r g a n i z a t i o n s ,

R e s e r v e

6 6 ,

R e v ie w

w

e d u c a t i o n a l

r i t e :

S t .

b u l k

R e s e a r c h

L o u i s ,

P

. O

.

i s s o u r i .

Page 13

Farm Income
in the Eighth District
Cash Receipts

C a sh RECEIPTS from farm marketings in
the seven district states during the first half of
this year were about $2.8 billion or 3 per cent
above the first-half total of 1961 (Table 1).
Receipts from livestock and livestock products
in the area, estimated at $1.8 billion, were only
a fraction of a per cent greater than in the same
period last year.

Crop marketings estimated at $964 million were
10 per cent greater the first half of this year than
in 1961, reflecting slightly higher prices for most
crops and a larger carryover of cotton.
Receipts from the previous year’s soybean
crop were also higher than in the first half of
last year.

Table 1

CASH RECEIPTS FROM FARM MARKETINGS - EIGHTH DISTRICT STATES
First Half 1962 and 1961
(1,000 dollars)

Livestock and Products
______ 19621961
I n d i a n a ..............

$

349,246

$

Crops

% Change

349,070 + 0 . 1

1962
$

161,791

$

Total C ash Receipts
1961"/.Change

164,551

— 1. 7
+ 2 0 .2

19621961
$

511,037

$

% Change

513,621 —

0.5

1,062,061

970,896 +

9.4

Illinois .

609,538

594,500 + 2 . 5

452,523

376,396

M is s o u r i. .

335,337

338,608 — 1.0

78,605

80,030

—

1.8

413,942

418,638 —

1.1

Kentucky .

139,599

142,066 — 1.7

65,783

72,848

—

9.7

205,382

214,914 —

4.4

Tennessee .

126,636

127,091 — 0.4

52,631

52,569

+

0.1

179,267 179,660

128,016

130,576 — 2.0

77,555

54,942

+ 4 1 .2

205,571

185,518 + 1 0 . 8

121,866

127,107 — 4.1

75,180

77,617

—

3.1

197,046

204,724 —

3.8

8th Dist. S ta t e s . .

$1,810,238

$1,809,018 + 0 . 1

964,068

878,953

+

9.7

$ 2,774,306

$ 2,687,971 +

3.2

U n ite d S ta t e s .

$9,439,584

$9,500,839 — 0.7

$5,259,227

$5,000,457

+

5.2

$14,698,811

$14,501,296 +

1.4

M ississippi

.

A rkansas .

Source: United States Department of Agriculture

Page 14




—

0.2

Tabl* 2

Tabl* 3

INDICATED CROP PRODUCTION

YIELD PER ACRE OF SELECTED
CROPS—EIGHTH DISTRICT STATES

EIGHTH DISTRICT S TA TE S 1
(1,000 bushels)
A ve rage
1962

1961

1 9 5 1 -6 0

1 9 62
As % O f
1961

1962
At % Of
A ve rage
19621

1 9 5 1 -6C

C o r n ..............

1,30 2,78 8

1 ,27 2,12 8

1,1 2 6,13 4

102.4

115.7

W in t e r W h e a t .

12 4 ,9 3 3

16 4 ,2 4 4

13 3,97 3

76.1

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

14 2,80 8

15 1,49 8

227,931

9 4 .3

6 2 .7

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

16 ,4 53

18,051

1 7 ,4 5 7

91.1

245,061

102.2

163.0

3,8 9 5

109.9

50.4

Corn

bu............

Cotton

lbs.............

Wheat

bu............

30.8

33.3

26.6

Soybeans

bu............

25.5

25.5

2 2 .2

94.2

3 9 0 ,9 7 7

68.4

1 9 5 1 -6 0
A ve ro ge

93.2

O a ts

69.4

1961

113.2

Hay

Soybeans

....

3 9 9 ,5 4 3

(1 ,0 0 0 b a le s )
C o tto n

..........

4 ,4 1 0

4 ,0 1 2

1 A r k a n s a s , Illin o is , In d ia n a , K e n tu ck y , M is s is s ip p i, M is s o u r i, a n d T e n n e s­
se e. W it h e x c e p tio n o f A r k a n s a s , o n ly a p o rtio n o f e a c h o f these
s ta te s is in the E ig h th F e d e ra l R e se rv e D istrict.

549

499

427

1 August 1 estimates

Source: United States Department of Agriculture

Source: United States Department of Agriculture

Crop Production

Yields

Generally good crop conditions over most of
the area indicate higher farm income for the
rest of the year than in the second half of 1961.
Output of major cash crops is expected to be
greater than last year (Table 2), with soybean
and com output up about 2 per cent and cotton
production 10 per cent higher. The winter wheat
harvest, however, was below that of a year ago
and oats and hay production are expected to be
lower.

Higher than average yields per acre are indi­
cated (Table 3). Cotton yields were estimated as
of August 1st to be about 10 per cent greater
than last year. Com and soybean yield estimates
are at near record levels. Dry weather in parts of
the area has damaged pastures quite severely.
Corn, cotton, and soybean yields may be down
from August 1st estimates in some parts of the
district but not sufficiently to greatly alter overall
prospects.




Page 15

Eighth District Business Loans
G,

<HANGES IN VOLUME OF BUSINESS LOANS
at commercial banks are considered an important in­
dicator of national and local business developments.
Generally, the volume of business loans expands when
business activity rises and contracts or expands at a
slow rate with falling business activity. In local areas
this pattern may not be followed in all cases, especially
if business loans are made for other than local business
purposes.

Business Loans
W e e k l y R e p o rt in g B a n k s
S ea so n a lly A d ju tto d Data

1 9 5 7 -5 9 = 1 0 0
130

United States

1 9 5 7 -5 9 = 1 0 0
130

120

Business loans are composed of industrial and com­
mercial loans, open market paper, and acceptances. A
significant part of these loans are short-term loans to
manufacturers, wholesalers, and retailers for the pur­
pose of financing inventories of goods in the produc­
tion and distribution channels.
The accompanying charts present data on business
loans at weekly reporting banks in the United States,
the Eighth Federal Reserve District, and five of the
metropolitan areas in the Eighth District. The data
have been adjusted for seasonal variations. The meth­
od by which seasonal adjustments are made is dis­
cussed in the August 1962 issue of this Review.
Business loans at weekly reporting banks through­
out the nation were about unchanged during the
1960-61 recession and for several months following
the February 1961 trough in business activity. From
mid-1961 to July of this year these loans increased at
an annual rate of about 5 per cent. An examination of
the accompanying charts reveals that business loans
at each major metropolitan area moved somewhat
differently from the national pattern and also from
each other. This diverse movement of business loans
at these centers may reflect the differences in these
local economies.
Care should be exercised in interpreting the local
month-to-month changes in the volume of business
loans, since factors other than those normally asso­
ciated with local economic developments frequently
cause changes in the monthly volume of local bus­
iness loans outstanding. For example, the rise in
business loans at St. Louis banks in July 1962 was
due primarily to a greater than seasonal increase in
bank holdings of commodity loans. An increase in
business loans of this nature does not necessarily re­
flect a strengthening of the local economy. Similarly
a change in business loans due to the purchase or sale
of open market paper of firms outside the metropolitan
area should not be regarded as indicating a change in
local business conditions.
Page 16



100

100