FEDERAL RESERVE SYSTEM Its Purposes and Functions · FIRST EDITION, 161,000 COPIES First printing May 1939 Second printing June 1939 Third printing December 1939 Fourth printing January

THE

FEDERAL RESERVE SYSTEM

Its Purposes and Functions

BOARD OF GOVERNORSOF THE FEDERAL RESERVE SYSTEM

WASHINGTON 25, D. C.1947

Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

FIRST EDITION, 161,000 COPIES

First printing May 1939Second printing June 1939

Third printing December 1939Fourth printing January 1941Fifth printing December 1941

SECOND EDITION

First printing November 1947

PRINTED IN U. S. A.

BY THE NATIONAL PUBLISHING COMPANY

WASHINGTON, D. C.


FEDERAL RESERVE BUILDING, CONSTITUTION AVENUE AT 20TH STREET, WASHINGTON, D. C.Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

TABLE OF CONTENTSCHAPTER PAGE

I P U R P O S E OF THE F E D E R A L R E S E R V E SYSTEM 1

The principal purpose of the Federal Reserve is toregulate the supply, availability, and cost of moneywith a view to contributing to the maintenance of ahigh level of employment, stable values, and a risingstandard of living.

II FUNCTION OF BANK RESERVES 10

In the regulation of the supply of bank credit, ormoney, the Federal Reserve depends chiefly on itsability to increase or decrease bank reserves, whichconstitute the legally required basis of bank credit,or money.

III GENERAL METHODS OF REGULATION 24

The principal Federal Reserve methods of generalregulation of the volume of bank credit, or money, arediscounts for member banks, purchases and sales ofsecurities in the open market, and changes in reserverequirements.

IV SELECTIVE METHODS OF REGULATION 38

In addition to general methods of regulation theFederal Reserve has special powers to regulate theterms on which transactions in stock market securitiesare financed and for a period during and immediatelyafter the war it had authority to prescribe terms onwhich consumer credit could be extended.

V STRUCTURE OF T H E F E D E R A L R E S E R V E SYSTEM 48

All national banks and many State banks are membersof the Federal Reserve System. There are twelveFederal Reserve Banks, each serving one of thedistricts into which the country is divided. Thefunctions of the Federal Reserve are entrusted to theBoard of Governors of the Federal Reserve System,the Federal Reserve Banks, and the Federal OpenMarket Committee.

v


CONTENTS

CHAPTER PAGE

VI RELATION OF FEDERAL RESERVE TO CURRENCY . 62

The Federal Reserve pays out currency in response topublic needs and absorbs redundant currency. Itsoperations result in making the entire currency supplyelastic.

VII RELATION OF FEDERAL RESERVE TO GOLD 68

Gold and Federal Reserve credit are the principalsources of member bank reserves. Consequently goldmovements are reflected in changes in the demand forFederal Reserve credit. Gold certificate holdings ofthe Federal Reserve Banks set the limits of FederalReserve credit expansion.

VIII THE MONETARY EQUATION 74Gold movements, currency in circulation, and Fed-eral Reserve credit are the principal factors thatinfluence the volume of member bank reserves—thebasis of the money supply. The relationships amongthese factors may be called the Monetary Equation.

I X S E R V I C E F U N C T I O N S OF THE F E D E R A L R E S E R V E

B A N K S 79

The twelve Federal Reserve Banks hold the legalreserves of member banks, furnish currency for circu-lation, facilitate the collection and clearance of checks,exercise supervisory duties with respect to memberbanks, and are fiscal agents of the United StatesGovernment.

X BALANCE SHEET OF THE FEDERAL RESERVE BANKS 89

The credit operations of the Federal Reserve Banksare reflected in their balance sheet. Comparisons fordifferent dates reflect changes in fundamental monetaryconditions.

XI BANKING AND MONETARY AGENCIES OTHER THANTHE FEDERAL RESERVE 101

There are several agencies other than the FederalReserve with functions and responsibilities in thesame general field but no other that has the primaryresponsibility for regulating the money supply.

vi


CONTENTS

CHAPTER PAGE

XII W A R SERVICE OF THE FEDERAL RESERVE 105

During the war the primary duty of the FederalReserve was to facilitate the financing of militaryrequirements and of production for war purposes.

XIII SUMMARY 111The Federal Reserve as it operates at present isthe product of constant adaptation to changing con-ditions. It has to deal today with monetary problemsthat are far different from those that occasioned itsestablishment.

PUBLICATIONS OF THE BOARD OF GOVERNORSOF THE FEDERAL RESERVE SYSTEM 116

INDEX 119

vii



FOREWORD

Central banking is essential to the economic stabilityand progress of any modern country. The centralbanking organization may be a single bank, as inEngland, or a system of regional banks with a nationalgoverning body, as in the United States. The maincentral banking function, however, is similar in allcountries. It is to endeavor, within the powers grantedby law or vested by custom, to see that the moneysupply is neither too large nor too small for the mainte-nance of stable economic progress. In the UnitedStates the long-run objective of the Federal ReserveSystem is to do its part in fostering monetary andcredit conditions favorable to sustained high employ-ment, stable values, and a rising level of consumption.

Federal Reserve operations are subject to constantadaptation to changing conditions; in their daily rou-tine they are rather complex and replete with techni-calities that cannot be presented fully in brief compass.Nevertheless it is believed that no essentials have beenneglected in this short and simplified account of pur-poses and functions.

This revision of the initial 1939 edition undertakesto bring the original text up to date. While FederalReserve policy continues to be affected by the after-math of war finance, this edition is primarily concernedwith the System's responsibilities and functions in

IX


FOREWORD

peacetime. In so far as possible discussion of specialwartime functions has been reserved for one chapternear the end of the book.

E. A. Goldenweiser, for many years Director of theDivision of Research and Statistics of the Board ofGovernors and now a member of the Institute forAdvanced Study at Princeton, New Jersey, is primarilyresponsible for the preparation of this volume. BrayHammond and other members of the staff of the Boardof Governors, who prepared the first edition, have alsocontributed to the revision.

T H E BOARD OF GOVERNORS OF THEFEDERAL RESERVE SYSTEM

Washington, D. C.November 21, 1947


CHAPTER I

PURPOSE OF THE FEDERAL RESERVE SYSTEM

The principal purpose of the Federal Reserveis to regulate the supply, availability, and costof money with a view to contributing to themaintenance of a high level of employment,stable values, and a rising standard of living.

ON December 23, 1913 President Woodrow Wilsonsigned the Federal Reserve Act establishing the

Federal Reserve System. Its original purposes, as con-ceived by its founders, were to give the country anelastic currency, to provide facilities for discountingcommercial paper, and to improve the supervision ofbanking. Over the years the System has developed abroader objective, namely, to help prevent inflationsand deflations, and to do its share in creating condi-tions favorable to sustained high employment, stablevalues, and a rising level of consumption. This broaderobjective was well stated by President Roosevelt whenthe new Federal Reserve Building was opened inOctober 1937: "I dedicate this building to progresstoward the ideal of an America in which every workerwill be able to provide his family at all times with anever-rising standard of comfort." The Federal ReserveSystem is dedicated to this ideal.

The reader may wonder what connection there isbetween employment, wages, the standard of living,and the Federal Reserve System. The Federal Reservemay seem to be a remote institution, dealing exclu-sively with bankers, and serving them in some mysteri-ous way. If this is the reader's frame of mind, he

1


2 THE FEDERAL RESERVE SYSTEM

needs only to look in his pocketbook to see whetherhe has a Federal Reserve note, or, for that matter, anyother piece of money. Seven-eighths of the country'scurrency is in the form of Federal Reserve notes andthe Federal Reserve System, through its influence onthe money supply, has an influence on every personin the country. The influence of the Federal Reserve,however, is not limited to its power to issue FederalReserve notes. It extends to the money supply as awhole, by far the larger part of which consists of bankdeposits. It is clear that an institution which caninfluence the money supply is of importance to every-one. This book is written for the purpose of describ-ing the ways in which the Federal Reserve System in-fluences changes in the money supply and how itcarries out its other functions.

Before the establishment of the Federal ReserveSystem the supply of money was limited and did notrespond to changes in the country's needs. Banks insmaller cities and rural regions maintained balanceswith banks in larger cities, which they were permittedto count as reserves. A very large volume of thesereserve balances was maintained in New York andChicago. Many banks, furthermore, as a matter ofconvenience and custom and as a means of utilizingidle funds, kept balances in the financial centers overand above their legal requirements. New York,Chicago, and St. Louis were designated as centralreserve cities, and national banks in these places wererequired to maintain all their legal reserves in theform of cash in their own vaults.

Under these circumstances, when banks throughoutthe country were pressed for funds by their deposi-tors and borrowers, the demand converged on a


PURPOSE OF THE FEDERAL RESERVE 3

few banks situated in the financial centers. In ordi-nary times the demand was not excessive, for whilesome out-of-town banks would be drawing down theirbalances, others would be building theirs up. But attimes when business was unusually active the demandbecame widespread and intense. It was particularlyacute during the crop-moving season. At such timesbanks all over the country would call on banks in thefinancial centers for funds, which the city banks wereto supply and charge to the reserve balances of thecountry banks. Because no facilities for obtainingadditional funds were available to the city banks, thesituation would become very tight. To meet the out-of-town demand the banks in the financial centerswould sell securities and call loans or refuse to renewexisting loans or make new ones, with the result thatsecurity prices would fall, interest rates would risesharply, loans would have to be liquidated, and bor-rowing would become difficult.

Panics and crises of this kind were apt to occurevery few years. The problem had been under publicdiscussion and study for a long time when, followinga crisis of unusual severity in 1907, Congress ap-pointed a National Monetary Commission for the pur-pose of determining what should be done. There wasactive and thorough consideration of the question forseveral years and Congress, though it greatly modifiedthe plan recommended by the Commission, eventu-ally adopted legislation embodying the results of studyboth by the Commission and by other authorities in-side and outside Congress. This legislation is theFederal Reserve Act, which became law on December23, 1913 and provided machinery by which varyingdemands for money by the public could be met.



Practically every modern country has a centralbank for the performance of functions correspondingto those performed by the Federal Reserve System.In England it is the Bank of England, which has beenin existence since the end of the seventeenth century;in France it is the Bank of France, established byNapoleon I; and in Canada it is the Bank of Canada,which began operations in 1935. In the United Statesthere is a regional system of twelve Federal ReserveBanks, and the coordination of their activities iseffected through the Board of Governors in Wash-ington.

The duties of the Federal Reserve, in addition tothe regulation of the money supply, include functionsthat relate primarily to the maintenance of regularservices for the member banks of the Federal ReserveSystem, the United States Government, and the pub-lic. These services are principally the following: hold-ing member bank reserve balances; furnishing currencyfor circulation; effecting telegraphic transfers of funds;facilitating the clearance and collection of checks;examining and supervising State member banks andobtaining reports of condition from them; collectingand interpreting economic information bearing oncredit problems; and acting as fiscal agents, custodians,and depositaries for the Treasury and other govern-mental agencies.

Since the principal function of the Federal Reserveis to regulate the money supply, the following threequestions should be answered in general terms at theoutset: (1) What constitutes the money supply? (2)How do changes in this supply affect the lives of thepeople? and (3) By what means does the Federal Re-serve regulate this supply?



(1) What constitutes the money supply? From thepoint of view with which this book is concerned themoney supply consists of all kinds of paper moneyand coin that are in circulation and of deposits heldby the banks for their depositors. That paper moneyand coins (currency) are a part of the money supplyneeds no elaboration or explanation. A statement ofthe composition of our currency will be given later.The reason that bank deposits are also included in themoney supply is not far to seek. When a person has$10 in his pocket and $100 in the bank he is in a posi-tion to spend $110 at any time. These two kinds ofmoney represent his cash resources; they serve thesame general purpose and they can be converted intoeach other at any time; that is, currency can be con-verted into a bank deposit by taking it to a bank, anda bank deposit can be converted into currency by tak-ing it out of a bank. The amount of currency and ofdeposits in June 1947 is shown below (in billions ofdollars):

Paper money and coin (currency) 28Bank deposits:

Demand 83Time 56

It will be seen that the amount of bank deposits ismuch greater than the amount of currency. We havelong since acquired the habit of keeping most of ourmoney in the banks and of making most of our pay-ments by drawing checks on our deposits with thebanks. Our habits in this respect, however, changefrom time to time. Sometimes we keep more cash andsometimes less. Such changes in money habits havecertain technical consequences to be referred to later.For a general idea of the functions of the Federal



Reserve, however, the two kinds of money, pocketmoney and bank money, should be considered to-gether, because both kinds originate in bank credit,over the volume of which the Federal Reserve exertsa regulatory influence. Because bank deposits consti-tute the major part of our money supply, and becauseboth deposits and currency are closely related to loansand investments of banks in a manner described later,the phrases "money supply" and "volume of bankcredit" as used in this study generally mean the samething, namely, the means of payment owned by thepeople of the country.

(2) How do changes in the supply of money affectthe lives of the people? Everyone believes that he isbetter off financially if he has more money. But moreconcretely the question of whether the supply ofmoney is adequate depends on whether the manu-facturer has or can get enough money at a reasonablecost to buy his raw materials and pay the wages ofhis employees, whether the farmer has enoughmoney or can borrow enough to finance his opera-tions, whether the merchant has or can get enoughmoney at a nonprohibitive rate to lay in a stock ofgoods, whether consumers as a group have enoughmoney to buy what they require and what is pro-duced. When money is scarce or hard to get, or coststoo much, factories and stores may curtail opera-tions and lay off employees. Diminished wages causehardship to workers, who curtail their purchases; thismakes it still more difficult for the merchants, who re-duce their orders for goods. Manufacturers in turnfind it necessary to lay off more workers. A seriousdepression, unemployment, and distress may follow.

The course of events leading to the reverse of these



developments is similar. If consumers possess andare prepared to spend so much money that they tryto buy more goods than the manufacturers canproduce by manning their plants to capacity,an increase in the supply of money in the hands ofconsumers cannot add to the country's output. It canonly bid up prices, that is, make purchasers pay morefor the same amount of goods. If merchants andothers tried to buy more goods than usual, so as toprofit by the rise in prices, manufacturers might beinduced to try to expand their plants, thus biddingup the prices of construction materials and wages. Noone profits by these advances because production costsgo up as much as consumer prices and the cost ofliving as much as wages. In the end, the spiral breaksat some point, perhaps because prices get so high thatconsumers, even though many of them receive higherwages, can no longer buy the goods produced. Then adownward spiral develops, and the higher values haverisen on the upswing, the more abruptly and lowerthey are likely to fall on the down turn. Unemploy-ment and distress will follow.

These are the ways in which excessive changes inthe money supply can affect the lives of the peo-ple. The story is oversimplified in that it does notinclude all the factors that affect the level of economicactivity, but it serves to indicate the tendencies thatmay develop if money is too plentiful, too cheap, ortoo easily obtainable, or if it is too scarce, too dear, ortoo hard to get. It is by influencing the supply, cost,and availability of money that the Federal Reservehas an influence on the lives of the people.

(3) By what means does the Federal Reserve influ-ence the money supply? This is the principal subject



of this book and the main points should be statedbriefly at the outset. Practically all of the money weuse reaches us, directly or indirectly, through thebanks. We may receive our pay in cash in an envelope,but the firm which pays us will have cashed a checkat the bank before making up its pay roll. Therefore,the supply of money in the country depends almostentirely on the ability of banks to meet the monetaryrequirements of industry, trade, agriculture, and othersectors of economic life. The ability of banks to meetthe money needs of the people depends in turn onthe amount of reserves they hold. This amount isaffected by Federal Reserve operations. Banks canlend and invest money only in proportion to thereserves at their disposal. The way the system ofreserves works, and the fact that under it our bankscan lend in the aggregate several times as muchas they have in reserves, will be discussed later.What needs to be understood from the beginning isthat the Federal Reserve, through the determinationof the cost and other conditions on which banks canobtain additional reserves, can influence the amount ofmoney that they may pass on to the public throughloans and investments. The Federal Reserve thus hasthe power to influence the country's money supply.

In an economy like ours, where practically all trans-actions are settled in money, regulation of the moneysupply gives the Federal Reserve great powers andplaces on its management a grave responsibility. Thereare serious limitations on this power and many factorsthat affect the flow of money, as distinguished fromits supply. The Federal Reserve alone cannot assurethe maintenance of satisfactory economic conditions.These depend, in addition to the supply of money, on



the demand for it, over which the Federal Reserve canexert only an indirect and limited influence. They alsodepend on a great variety of other things, includinggovernmental policies in regard to expenditures, taxes,and debt; the distribution of income among differentgroups of the population; the bargaining strength andpolicies of management and labor and of agricultureand other sectors of the economy; the power of mono-polies; the course of foreign trade and foreign invest-ment; and the prospects for peace. The Federal Re-serve has little power to influence the flow of moneyinto particular channels or to insure that it will beused at all. But the money supply, which the FederalReserve can influence, is of itself an important factorin the people's economic life. The country relies onthe Federal Reserve for such regulation of the moneysupply as will facilitate the maintenance of stable eco-nomic conditions, high employment, and a risingstandard of living.


CHAPTER II

FUNCTION OF BANK RESERVES

In the regulation of the supply of bank credit,or money, the Federal Reserve depends chieflyon its ability to increase or decrease bank re-serves, which constitute the legally requiredbasis of bank credit, or money.

COMMERCIAL banks, like other business organi-zations but unlike the Federal Reserve Banks, are

in business for the purpose of making money. Wheninvestors put their money in the capital stock of abank they expect to earn a return on their investmentand look to the managers of the bank to make thisreturn as large as possible within the limits of safety.The bulk of a bank's earnings comes from the returnsit receives from loans to customers and holdings ofsecurities. Consequently it is usually a bank's policy toput as much as possible of the money it receives ascapital and as deposits into loans and investments.Every bank is required by law, however, to hold asreserves an amount of uninvested funds equal to adesignated portion of its deposits.

Historically, reserve requirements were imposed bylaw for the purpose of protecting depositors—to assurethat banks did not expand credit to the point thatthey could not meet their depositors' withdrawals.This was before establishment of the Federal ReserveSystem when there was no central bank at which a bankcould discount paper in order to obtain additionalreserves in time of temporary need. Consequentlyreserve requirements, although they restrained creditexpansion, did not protect depositors; the banks could

10


FUNCTION OF BANK RESERVES 11

not pay out to their depositors the funds they wererequired to keep as reserves. Other ways of protectingdepositors have since been developed and bank reserveshave come to be considered primarily as the mediumthrough which the money supply can be regulated.It is because the Federal Reserve can influence thevolume of reserves available to banks that it caninfluence the money supply.

If a bank is a member of the Federal Reserve Sys-tem, at the present time (June 1947) it is required tokeep the following percentages of its deposits asreserves:

Time deposits, all member banks 6Demand deposits:

Reserve and central reserve city banks 20Other member banks 14

On the average these percentages work out for allmember banks at about 15 per cent. As will be ex-plained later, reserve requirements are subject tochange by the Board of Governors of the FederalReserve System within certain limits. Banks that arenot members of the Federal Reserve System are subjectto reserve requirements that vary from State to State.

Bank reserves are the basis of our money system.Their operation is described below in general and some-what simplified form. When a member bank receives adeposit of $100, in currency or in the form of a check onanother bank collectible through clearing, it mustdeposit $15 with a Federal Reserve Bank as requiredreserves against the deposit and is free to lend orinvest the remaining $85. This percentage of reservesrepresents the general average required under existinglaw and regulation, taking all member banks and alltypes of deposits into consideration. When there is



an adequate demand for loans from customers or asupply of suitable securities in the market, the bankwill invest practically all of the $85 and will keep asreserves only the $15 prescribed by law. In practicethe bank will keep a little more than the $15 becausethe law requires it to keep its entire legal reserve withthe Federal Reserve Bank, and in addition the bankneeds some cash in its till to meet the demands ofcustomers without delay. But since currency canalways be obtained promptly from the Federal Reservethe amount kept in bank tills is relatively insignificant.For purposes of exposition it may be assumed, there-fore, that all of the money above the required 15 percent is lent or invested by the banks. In practice thiswas not the case during the depression and the periodprior to our entry into the war, largely because goldimports were providing reserves and the businesssituation was not conducive to the expansion of loans.More recently banks once more tend to make use ofnearly all their available funds.

It is on the relationship between the volume of re-serves and the amount of bank lending that the Fed-eral Reserve chiefly depends for regulating the supplyof money. Methods possessed by the Federal Reservefor influencing the amount of bank reserves will bedescribed in the next chapter. The present chapterattempts to describe how changes in bank reservesaffect the volume of money.

Assume that a bank has $8,500 of loans and invest-ments, $1,500 of reserves with the Federal Reserve,and $10,000 of deposits, leaving out for the presentother items in the balance sheet. The bank's ratioof reserves to deposits is at the legal minimum of 15per cent. Consequently, if a customer wants to borrow,



the bank cannot meet his needs out of its own re-sources because it has no funds available for lending.It must obtain additional funds if it wishes to makeadditional loans.

For the purpose of describing the operation of thebanking system, let us assume that there is only oneBank and that all the people keep their deposits withthis Bank and go there to obtain all their bank loans.Let us give the Bank enough resources to make itpossible to think of it as representing all the banksin the country. Let us assume that the relevant itemsin its balance sheet are as follows (in billions ofdollars):

Loans and investments 85Reserves with the Federal Reserve Banks 15Deposits 100

Ratio of reserves to deposits 15 per cent

The Bank would not be in a position to make anyadditional loans or investments: its funds would be inuse up to the limit permitted by law. Let us assumethat the Federal Reserve believes that additionalloans will be in the public interest and that it adds10 billion dollars to the Bank's reserves in a mannerthat also increases the Bank's deposits by the sameamount (using one of the methods described in thenext chapter). Then the simplified balance sheet ofthe Bank would be (in billions of dollars):

Loans and investments 85Reserves 25Deposits 110

R a t i o of reserves to deposits. . . . . . . . 22.7 per cent

The Bank would have a higher ratio of reserves to de-posits (22.7 per cent) than is required by law (15 percent). Therefore, it could make additional loans andinvestments. A little figuring will show that the Bank



has the 16.5 billion dollars of reserves required forits deposits of 110 billion dollars and also has 8.5 billiondollars of reserves above requirements, or excess re-serves. Let us assume that the public is eager to getadditional money and wants to borrow as much as theBank will lend. Let us assume also that the proceedsof the loans will be kept on deposit with the Bank.This is not a far-fetched assumption, because borrowersmost likely want the money in order to pay otherdepositors in the Bank. While there will be transfersfrom one deposit to another, no deposits will be with-drawn from the Bank, and the total of deposits willremain at the higher level made possible by the in-crease in reserves. Another calculation will show thaton the basis of the 8.5 billion dollars of excess reservesthe Bank can add 56 billion dollars to its loans andinvestments. The Bank's balance sheet would then be(in billions of dollars):


Ratio of reserves to deposits 15 per cent

This simplified picture of bank transactions indicatesthat a deposit of 10 billion dollars of reserve moneywith the Bank gave rise to a growth of 56 billion dollarsin loans and investments and of 66 billion in deposits.This calculation, which leaves out of account manycomplications, shows what a powerful instrument Fed-eral Reserve action can be. It can provide the basisfor an increase in the money supply not merely by theamount that it adds to the Bank's reserves, but byabout six times that amount. This is true becausethere can be a multiple expansion of deposits on thebasis of the additional reserves.



Consider now the course of events in case the FederalReserve decides that there is too much money and thatthe amount should be diminished. Suppose that itreduces the Bank's reserves by 5 billion dollars, usinga method that will reduce deposits by the sameamount. The balance sheet will then read (in billionsof dollars):


Ratio of reserves to deposits 10.5 per cent

The Bank would be deficient in reserves to the extentof 4.5 per cent of deposits, or more than 4.2 billiondollars. In order to comply with the law the Bank, ifit were not able to call on the Federal Reserve, wouldhave to call loans or sell investments, and thus absorbdeposits to the extent of about six times its deficiencyin reserves, that is, by 29 billion dollars. If its deposi-tors repaid loans or repurchased 29 billion dollars ofinvestments by drawing on their deposits, the resultwould be (in billions of dollars):


Ratio of reserves to deposits 15 per cent(the legally required minimum)

Once more we see the powerful effect of FederalReserve action, this time in the direction of contrac-tion. By reducing the Bank's reserves by 5 billiondollars the Federal Reserve caused a liquidation of 29billion of loans and investments and a reduction of 34billion in deposits, or money.

It is because of the fact that the Federal Reserveby adding to the Bank's reserves can enable it to in-



crease its loans and its deposits by several times theamount added that Federal Reserve dollars are oftencalled "high-powered" dollars as compared with ordi-nary deposit dollars or "low-powered" dollars.

In our exposition so far we have considered oneBank, large enough to represent all the banks in thiscountry, as doing all the banking business. We haveassumed that the Bank will lend or invest as muchmoney as the law will permit. This has often beentrue of the banking system in the past, and is approxi-mately the situation at the present time (June 1947).We have also assumed a uniform reserve requirementof 15 per cent, which represents the current averageof the requirements on both types of deposits, timeand demand, in all groups of banks, and we haveassumed that all the money lent by the Bank will bekept on deposit. To the extent that the public choosesto withdraw some of the money in currency, this willnot be the case. In a later chapter, changes in the pub-lics demands for currency from time to time will be de-scribed. It is sufficient for the purposes of this chapterto know that the people's demand for currency changesin response to business conditions and is not affecteddirectly by the amount of loans made by the banks.It is, therefore, proper to disregard currency with-drawals in a description of the way bank credit expandsand contracts.

The process of reserve operation in the simplifiedsituation in which one Bank does all the banking busi-ness may now be transferred to the more complexsituation in which thousands of banks make loans andinvestments and hold deposits.

It has been seen that our consolidated Bank canexpand its loans and investments by as much as 56



billion dollars if the Federal Reserve adds 10 billiondollars to its reserves. No individual bank can do thatbecause borrowers may wish to take the money outof the lending bank. In fact, a borrower is more likelythan not to use the deposit created by his loan to writechecks to pay various people. He has borrowed themoney presumably for the purpose of making pay-ments; he would not ordinarily undertake to pay in-terest on a bank loan for the purpose of carrying anunused deposit account. Consequently, a bank doesnot lend more than it has in free funds; if it did, itwould not be able to honor its depositors' checks. How,then, can the banking system lend at least six timesas much as it obtains from the Federal Reserve if eachindividual bank of which the banking system is com-posed cannot lend any more than it receives? Is thisnot a paradox?

What appears to be a paradox is really a simpleand understandable matter. In substance what hap-pens is similar to what happens when a given amountof money, by being passed from hand to hand, buysseveral times as much as its face value. In order toestablish a parallel between the two, let us assumethat all of the people through whose hands the moneypasses will put aside 15 per cent of all their receipts assavings and immediately spend the other 85 per cent.The first person receives $100; in accordance with thecondition just laid down, he puts aside $15 and spends$85—let us say to buy clothing. The tailor whoreceives the $85 puts away 15 per cent of it andspends $72.25—let us say to buy furniture. The fur-niture dealer saves 15 per cent and spends $61.41.This process continues, as is indicated in the accom-panying table, until in the end the entire original



$100 has been put aside as savings and articles to thetotal value of $566 have been bought. The amountreceived by all the people in the aggregate was $666,the value of the articles bought was $566, and thesavings were $100. This corresponds closely to whathappens in the case of the banking system. On thebasis of $100 added to reserves the total amount ofdeposits increases by $666, total loans and investments

THE MULTIPLYING CAPACITY OF MONEY IN BANK OR COMMODITYTRANSACTIONS

Transaction 12345

6789

10

1112131415

1617181920

Total for 20

Additional transactions

Grand total

Amount receivedor deposited

$100.0085.0072.2561.4152.20

44.3737.7132.0527.2423.15

19.6816.7314.2212.0910.28

8.747.436.325.374.56

$640.80

25.86

$666.66

Amount spentor lent

$ 85.0072.2561.4152.2044.37

37.7132.0527.2423.1519.68

16.7314.2212.0910.288.74

7.436.325.374.563.88

$544.68

21.98

$566.66

Amount setaside

$ 15.0012.7510.849.217.83

6.665.664.814.093.47

2.952.512.131.811.54

1.311.11

.95

.81

.68

$ 95.12

4.88

$100.00

by $566, and reserves by $100, the original amountreceived. The power of money to do business in a total



amount several times as large as the sum used totransact the business is due to the fact that moneypasses from hand to hand and in so doing continuesto pay for purchases.

There is one difference between bank transactionsand commodity transactions. In the case of commodi-ties the net result is final. The purchasers own thearticles bought and their savings and have no furtherobligations. In the case of banks, the transactions re-sult in loans and investments, which represent obliga-tions due to the banks, and also in deposits, whichrepresent bank liabilities to the public. Aside fromthe fact that banking transactions create two sets ofobligations that cancel each other, while commoditytransactions do not, the two cases are parallel. Themultiplying capacity of money arises from the factthat it is universally acceptable and passes from handto hand, each time paying for a transaction. In prin-ciple, the bank case does not differ from the commod-ity case. The arithmetic applicable to both cases ispresented in the table on the opposite page.

This analysis has an important bearing on the ques-tion of the source of power to create money. It issometimes maintained that, since the banking sys-tem can lend several times as much as it obtains inreserves, it creates money by a stroke of the pen. Inthe light of the preceding description it is clear thatthis statement is not correct in relation to any singlebank. An individual bank can lend only such moneyas it acquires from its stockholders, its depositors, orthe Federal Reserve. In the meantime the money,after it leaves the hands of the first bank, continuesto do business as it passes from bank to bank or fromperson to person.



What is important to Federal Reserve operationsis that the issuance of a given amount of what hasbeen termed high-powered money by the Federal Re-serve may create a volume of ordinary money that isseveral times as large as the amount issued, and that,on the other hand, Federal Reserve withdrawal of agiven amount of high-powered money may result inliquidation of several times that amount of loans andinvestments and of deposits, that is, of ordinarymoney. It is this leverage which our banking proce-dure and law give to the Federal Reserve that resultsin its power to cause large changes in the total moneysupply by undertaking much smaller operations.

These are the principles on which our banking sys-tem operates. In practice an individual bank does notmatch one transaction against another. There is acontinuous flow of funds into the bank from its deposi-tors, who bring checks on other banks and currencyto be added to their deposits. And there is a continu-ous outflow of funds as depositors write checks ontheir own accounts or cash checks drawn on otherbanks. The bank must constantly watch its depositsand its reserves to make sure that its reserves are suffi-cient to comply with legal requirements. The occasionto borrow from the Federal Reserve Bank usuallyarises, not from a desire to make an additional loanwhen the bank has no funds to spare, but from theneed to replenish reserves which have declined belowthe required level as the net result of all the transac-tions that have gone through the bank.

There is another point that needs to be clarified.While in the practical workings of the banking systemthe bulk of deposits originates in the granting of loansor the purchase of investments by banks, each indi-



vidual banker knows from day-to-day experience thatdeposits are brought to him by his customers, and hisability to make loans and investments arises largelyfrom the receipt of his depositors' money. This isanother apparent banking paradox which causes muchconfusion. The fact is that deposits originating inloans and investments move from one bank to anotherin the course of business and seldom stay with thebank of origin. The series of transactions is as follows:when a banker makes a loan he credits the amount tothe borrower's deposit account; the depositor writeschecks against it in favor of various people who depositthem at their banks. Thus the lending banker is likelyto retain or receive only a small portion of the depositshe creates, while a portion of the deposits created byother banks is brought to him by his customers. Henceboth statements are generally speaking true; takingthe banking system as a whole the bankers originatedeposits by making loans and investments, but eachindividual banker's ability to lend or invest ariseslargely from deposits brought to him by his customers.

While a bank must watch its reserve balance withthe Federal Reserve Bank to make sure that it islarge enough, this does not mean that the balanceremains unused. Under Federal Reserve rules reserverequirements are related to reserve balances main-tained on the average over a period (a week for centralreserve and reserve city banks and half a month forother member banks). While maintaining his averagereserve balance at or above the required minimum, abanker may make constant use of his account.Through it he can settle adverse balances withother banks through the clearings and transfer fundsto other cities. He uses his reserve account with the



Federal Reserve Bank in much the same way that adepositor uses his checking account. But he must becareful to see that over the reserve period the accountaverages at or above the amount required in relationto his deposits.

MEMBER BANK RESERVE BALANCES

It has been stated that banks as business organiza-tions endeavor to use all their available funds inprofitable ways and keep as reserves only the mini-mum required by law. During most of the life of theFederal Reserve, member banks have used practicallyall their funds and have had practically no excess re-serves. During the depression and the war period,



however, conditions were different, as is brought outby the accompanying chart.

In the thirties there was a large movement of goldinto the country which increased the reserves ofmember banks. At the same time there was only alimited demand for loans acceptable to banks. Con-sequently, the banks had a considerable volume ofreserves in excess of requirements, or excess reserves.As credit expanded during and after the war, as cur-rency demand increased rapidly, and as reserve re-quirements were increased in a manner described inthe next chapter, excess reserves declined and at thepresent time (June 1947) they once again constitutea relatively small proportion of total reserves.


CHAPTER III

GENERAL METHODS OF REGULATION

The principal Federal Reserve methods of gen-eral regulation of the volume of bank credit,or money, are discounts for member banks,purchases and sales of securities in the openmarket, and changes in reserve requirements.

IT has been shown how changes in bank reservesinfluence the volume of bank credit or money. It is

the purpose of this chapter to describe the threemethods by which the Federal Reserve may influencethe amount of bank reserves. These methods are dis-counts, open market operations, and changes in re-serve requirements.

Discounts

When a bank has lent or invested all of its availablefunds and has no reserves above legal requirements, itmay obtain additional reserves by turning over a partof its portfolio to a Federal Reserve Bank. It mayrediscount one or more of its customers' notes with aReserve Bank, or it may give its own note to a Re-serve Bank, using paper from its own holdings ascollateral. The second procedure, known as an ad-vance, differs from the first in form only, not in sub-stance. In either case the Reserve Bank gives themember bank credit in its reserve account for theamount of the accommodation and thereby increasesthe legal reserves of the member bank. For this servicethe Reserve Bank charges interest at a rate which isknown as the discount rate.

24


GENERAL METHODS OF REGULATION 25

Originally the Federal Reserve Act prescribed rigidlimitations on the kind of paper that was eligible forobtaining Federal Reserve credit. All obligations ofthe United States Government were eligible, and suchcommercial paper as represented loans of limited ma-turities to meet the current needs of commerce, indus-try, or agriculture. Loans made for investment or spec-ulative purposes, that is, for carrying or trading ininvestment securities other than bonds and notes ofthe United States Government, were not eligible. Ex-perience showed, however, that these limitations werenot in themselves effective in preventing too muchlending in prosperous times, when eligible paper wasplentiful, and that they hindered adequate assistanceby the Federal Reserve to member banks in times ofdepression, when eligible paper was scarce. Conse-quently, the limitations were in effect removed by lawand at present a Reserve Bank may make an advanceto a member bank on its note secured by any collateralsatisfactory to the Reserve Bank. In case the collateralis not of the kind described as eligible, however, theReserve Bank must charge an extra 1/2 per cent ormore of interest.

When a member bank applies for accommodation,a Federal Reserve Bank is under no obligation togrant the credit; its decision is expected to rest on itsjudgment concerning the applicant's need and the useto be made of the additional funds. In the language ofthe law: "Each Federal Reserve Bank shall keep itselfinformed of the general character and amount of theloans and investments of its member banks with aview to ascertaining whether undue use is being madeof bank credit for the speculative carrying of or trad-ing in securities, real estate, or commodities, or for any



other purpose inconsistent with the maintenance ofsound credit conditions; and, in determining whetherto grant or refuse advances, rediscounts or other creditaccommodations, the Federal Reserve Bank shall giveconsideration to such information."

A member bank with satisfactory collateral canusually obtain the desired accommodation from aFederal Reserve Bank. The policy of the FederalReserve in encouraging or discouraging borrowing bymember banks expresses itself principally not in grant-ing or refusing loans but in the rate charged for dis-counts and advances. Traditionally, when the FederalReserve was of the opinion that expansion of themoney supply would be desirable in the public interest,it set its discount rate at a low figure in relation toprevailing market rates. When it believed that furtherexpansion would be harmful, it raised the discountrate. Hence the discount rate in effect at the FederalReserve Banks, and particularly a change in this rate,has at times been an important indication of FederalReserve policy; a high rate or an advance in rate indi-cated that there appeared to be danger of too muchmoney and inflation; a low rate or a reduction in therate indicated that in Federal Reserve opinion anincrease in the supply of money would be in thepublic interest. The discount rate, therefore, notonly has represented the cost of accommodation atthe Federal Reserve Banks but has reflected FederalReserve judgment as to whether there was too much,too little, or the right amount of money for doing thecountry's business.

In many periods since the establishment of theFederal Reserve System the discount rate has been theprincipal method of expressing Federal Reserve policy



with respect to the money supply. For a number ofmore recent years, however, first as the result of aninflow of gold from abroad, which gave member banksadditional reserves without recourse to borrowing fromthe Reserve Banks, and later as the result of wartimedevelopments to be discussed later, discounts formember banks have been relatively small and thediscount rate has been of relatively minor importancein Federal Reserve policy. Nevertheless, discounts andthe discount rate can have an important bearing onthe money supply. Their influence is increased by thecustomary reluctance of member banks to show in-debtedness on their balance sheets.

Open Market Operations

Open market operations as a method of influencingthe money supply differ from discount operationsprimarily because they are undertaken at the initiativeof the Federal Reserve, not at the initiative of themember banks. In the case of discounts the FederalReserve can do no more than establish a discountrate until a member bank applies for credit accommo-dation. In the case of an open market operation theFederal Reserve decides of its own accord that thereis too little or too much money and proceeds to buyor sell in the open market—i.e., from or to any onewho is in the market—such obligations as it is per-mitted by law and chooses to acquire. Obligations ofthe United States Government are the principal kindof paper thus bought or sold.

The process through which open market operationsby the Federal Reserve are reflected in the volume ofmember bank reserves may be briefly described asfollows: if the Federal Reserve decides to buy 100



million dollars of United States Government securities,it notifies the dealers in such securities and they sup-ply the securities to the Federal Reserve; in pay-ment the dealer receives a Federal Reserve Bank'scheck. The dealer deposits the check with a memberbank, which in turn deposits it with a Federal ReserveBank. The result is that the Reserve Bank has added100 million dollars to its holdings of United StatesGovernment securities, and has added the sameamount to the reserve deposit of some member bank.How this amount of additional reserves may resultin a growth of about six times that amount in themoney supply has been described in the precedingchapter.

If the Federal Reserve decides that it wishes toreduce the amount of member bank reserves, andthrough them the money supply, it sells Governmentsecurities to a dealer. In payment the dealer draws acheck on a member bank in favor of a Federal ReserveBank, and the Reserve Bank deducts the amount fromthe reserve deposit of the member bank. If the amountis 100 million dollars, the result is a decrease by thatamount in Federal Reserve holdings of United StatesGovernment securities and a corresponding decline inthe member bank's reserves. As has been indicated inthe preceding chapter, such a decrease in reserves, ifnot met in some other way, would necessitate a reduc-tion of about six times that amount in member bankdeposits and hence in the money supply.

Member banks, however, would be reluctant to callenough customers' loans or sell enough securities tocause an extreme contraction in bank credit, andthe Federal Reserve would hesitate to insist on aradical reduction in the money supply. What would



probably happen is that member banks, finding them-selves short of legally required reserves, would try toreplenish them at least in part by obtaining discountsor advances from the Reserve Banks. The ReserveBanks would generally grant such loans, at the dis-count rate. As a result, the Federal Reserve wouldhold a smaller amount of Government securities anda larger volume of discounts than before, while mem-ber banks would have a smaller volume of deposits(because of the dealer's check) and would be in debtto the Federal Reserve. For the sake of simplicity thisleaves out of account the reduction in required reservesthat would result from the decrease in member bankdeposits.

In this connection the member banks' reluctance toshow indebtedness, which has been mentioned before,has an important bearing on the effects of open marketoperations. If purchases by the Federal Reserve aremade at a time when member banks are substantiallyin debt to the Federal Reserve, it is probable thatmember banks will use at least part of the reservesthey acquire as the result of the purchases to reducetheir debt. On the other hand, as has already beenstated, the loss of member bank reserves resultingfrom sales by the Federal Reserve in the open marketwill probably be made up at least in part by additionalborrowing from the Federal Reserve.

Federal Reserve action in the open market, there-fore, is not likely to result in a rapid multiple expan-sion or contraction of member bank deposits. Instead,under ordinary conditions, it is likely to result in adecline or an increase in member bank indebtedness,with no immediate substantial change in memberbank reserves. But this does not mean that the action



would have no effect on the money supply. Whenmember banks are out of debt to the Federal Reservethey are much more willing to make loans and invest-ments and thus to increase their deposits; when theyare heavily in debt they not only are less willing tomake additional loans but are inclined to reduce thevolume of their loans and investments. They maynot call loans, but they will probably be less willingto make new loans or to renew old ones as they comedue. And the Federal Reserve is in a position toencourage this process by raising the discount rate.

Open market operations, therefore, work moregently than would be the case if additions to or sub-tractions from member bank reserves through FederalReserve purchases or sales led to an immediate mul-tiple expansion or contraction of bank deposits. Theyare nevertheless a powerful influence on the moneysupply because, by decreasing (or increasing) memberbank indebtedness, they tend to encourage (or dis-courage) expansion of deposits at member banks.

The accompanying chart shows how increases inFederal Reserve holdings of United States Govern-ment obligations (that is, open market purchases) inthe past have been accompanied by declines in hold-ings of discounts, and, on the other hand, how de-creases in security holdings (that is, open market sales)have been reflected in increased holdings of paper dis-counted for member banks. In the past, the FederalReserve has tended to make complementary use ofthese two instruments of credit policy.

Brief reference should be made to another elementin Federal Reserve credit which has not been impor-tant in recent years but was of considerable momentin the past, namely, dealings in bankers' acceptances.



A banker's acceptance is a draft, usually drawn by aseller of goods against the buyer, which is "accepted"by a bank so that the bank becomes primarily liable

SYSTEM HOLDINGS OF DISCOUNTS ANDUNITED STATES GOVERNMENT SECURITIES

on the instrument and lends its own credit to that ofthe buyer. In this country most acceptances arise outof exports or imports. A seller of cotton, for example,may draw a draft payable in ninety days on a buyerin Liverpool. The buyer may have an arrangementwith a bank in New York whereby the bank will acceptthe seller's draft on the buyer, thus enabling the sellerto negotiate the draft, and the buyer will reimbursethe accepting bank upon maturity of the instru-ment. These instruments, known as acceptancesor bills, bear three signatures, those of the seller, thebuyer, and the accepting bank. They usually aresecured by goods in the process of shipment, and maybe accompanied by shipping documents. They areconsidered to be paper of the highest quality.



The Federal Reserve Banks generally stand readyto buy acceptances at a slight discount, that is, at adiscount rate slightly higher than the rate prevailingin the open market. Such purchases are a form ofcredit expansion intermediate between discounts formember banks and open market purchases. They aresimilar to discounts in that the initiative for their saleto the Reserve Banks comes from member banks ordealers, the Reserve Banks merely announcing therate at which they are willing to buy. On the otherhand, the purchase of acceptances is similar to openmarket purchases in two respects: in both operationsthe Federal Reserve will buy not only from memberbanks but also from others, and neither operationplaces the seller in debt. There is no indebtednessadded to the condition report of a member bank whenit sells an acceptance to a Reserve Bank. The memberbank has sold a bill, endorsed by it, which is reportedmerely as a contingent liability. Consequently pur-chases of acceptances by the Reserve Banks do not havethe effect of borrowing by member banks; they do notput the banks in debt and therefore do not make themless willing to extend credit to their customers.

In recent years the volume of acceptances has be-come relatively small and the Reserve Banks havepurchased them only in minor amounts. Their placein the financial system has been taken by three-monthTreasury bills. These bills are issued weekly by theUnited States Treasury, usually at rates determinedby competitive bids. During the war the FederalReserve adopted the policy of purchasing all Treasurybills offered at a fixed rate of % per cent, and ofallowing banks an option to repurchase bills sold atthe same rate. Member banks, particularly those in



financial centers, tended to treat their Treasury billholdings as equivalents of cash, selling and repur-chasing them to adjust their reserve positions inresponse to current movements of funds. In the sum-mer of 1947 the wartime policy of the Federal Reservewith regard to Treasury bills was discontinued andbill rates were once more permitted to find higher levelsin response to conditions in the market.

Source of Federal Reserve Lending Power

As has just been described, when the Federal Re-serve makes a discount for a member bank or buys aUnited States Government security in the market, itgives credit for the proceeds to a member bank in itsreserve account. The member bank may use suchadditions as reserves for its deposits or, if it happensto be in need of additional currency to meet a publicdemand, it may withdraw them in Federal Reservenotes or other currency.

The question arises as to the source and the limitsof the Federal Reserve's lending power. The limitsare set by the legal requirement that Federal ReserveBanks must hold a 25 per cent reserve in gold certifi-cates against their notes in circulation and their de-posits. Their combined liabilities for notes and de-posits consequently must not exceed four times theirgold certificate holdings. Only in emergencies canthis requirement be suspended and only for shortperiods and at penalty rates.

The source of Federal Reserve lending power is inthe System's authority to issue Federal Reserve notesand to create bank reserves in an amount exceeding theFederal Reserve Banks' holdings of gold certificates.At present the authorized ratio is four to one. The



issue of notes is an act of creating money. It is forthis reason that, as will be explained later, notes areissued to the Federal Reserve Banks by the FederalReserve Agent, a representative of the Federal Gov-ernment. When a Federal Reserve Bank gives amember bank credit in its reserve account for a dis-count, the basis is laid for the creation of additionalmoney through loans and investments by the bankingsystem. Member banks also give deposit credit tocustomers who have obtained loans, but Federal Re-serve transactions differ from member bank opera-tions in two important respects: (1) member banksare required by law to keep deposits with the ReserveBanks, while depositors of member banks are legallyfree to withdraw their deposits at any time, and (2)the Reserve Banks can issue notes, while the memberbanks cannot.

The answer to our question, therefore, is that thelending power of the Federal Reserve Banks arisesfrom the authority given to them by law to createmoney, and the limits of this power are set by therequirement that their liabilities on notes and depositsmust not be in excess of four times their holdings ofgold certificates.

Changes in Reserve Requirements

Discounts and open market operations by the Fed-eral Reserve Banks, as has been seen, result in changesin the volume of member bank reserves. Changes inreserve requirements, which are the third method ofregulating the money supply, have no direct influenceon the total of member bank reserves but affect theamount of reserves that member banks must hold asdeposits with a Federal Reserve Bank, and conse-



quently the amount available for lending or investing.For example, when the reserve requirement is 15 percent, a member bank must keep in its reserve accountwith a Federal Reserve Bank $15 out of every $100of its own deposits, and has $85 left to lend or invest.If reserve requirements were raised to 20 per cent,the member bank would have to keep $20 uninvestedand have only $80 to lend, and if requirements werereduced to 10 per cent, it would need to keep only $10uninvested and would have $90 to lend or invest. Thusa change in reserve requirements changes the rulesunder which member banks must operate.

These are the effects of changes in reserve require-ments on an individual member bank, but in additionthey change the rate at which multiple expansion willoperate. On a 15 per cent reserve requirement $100of reserves will support bank deposits of $666, as wasshown in the table on page 18. On a 20 per cent basis$100 will support $500 of deposits, and on a 10 percent basis it will support $1,000 of deposits. It will beseen that changes in reserve requirements are an ex-tremely powerful instrument for reaching the volumeof money through bank deposits.

Originally the Federal Reserve Act prescribed cer-tain reserve requirements and made no provision forchanges by the Federal Reserve. The percentages ineffect on June 21, 1917, were:

Time deposits, all member banks 3Demand deposits:

Central reserve city banks 13Reserve city banks 10Country banks 7

Central reserve cities now are New York and Chicago ;in June 1947 there were about sixty reserve cities,including most of the larger cities of the country; banks



outside of these cities are known for purposes ofdetermining reserve requirements as country banks.

Banking legislation empowering the Federal Re-serve to change reserve requirements was enacted firstin 1933 and has not been changed extensively since itwas revised in 1935. As the law stands today (June1947) the Federal Reserve has authority to increasereserve requirements to twice the ratios stated in thelaw and subsequently to reduce them to any levelthat is not below these ratios. The range of discretionand the requirements in effect at present are as follows(in percentages):

Time deposits, all member banks..Demand deposits:

Central reserve city banks.. . .Reserve city banks

Country banks

Range3 to 6

13 to 2610 to 207 to 14

In effect,June 1947

6

202014

Changes in reserve requirements may be made appli-cable to any or all the groups of banks shown abovebut must be uniform for all banks within a group.

Federal Reserve Bank lending power is in no wayaffected by changes in member bank reserve require-ments, even though they may change the demand forReserve Bank credit. They are reflected in changesin the distribution of Federal Reserve Bank depositsbetween the required and the excess reserves ofmember banks.

Because changes in reserve requirements are a verypowerful instrument they are used only on infrequentoccasions. When changes are made they apply to allthe banks in a group, regardless of the reserve positionof the individual banks. As a matter of fact, evenwhen banks in the aggregate have a large volume ofexcess reserves, there are sure to be some banks that



have none. An increase in requirements makes itnecessary for such banks to acquire additional re-serves either by reducing their loans and invest-ments or by borrowing. Because of this effect onindividual banks, increases in reserve requirementshave been made only at times when the totalof excess reserves was so large that such deficien-cies as resulted in individual cases were small. Forexample, when requirements were raised by 50 percent in August 1936, member banks as a group hadexcess reserves of more than 3.0 billion dollars; afterthe increase in requirements they still had an excess ofover 1.8 billion dollars. In the spring of 1937, beforethe first of a series of increases in requirements, mem-ber banks had more than 2.0 billion dollars of excessreserves, and they still had about 0.9 billion afterrequirements had been increased to the maximumpermitted by law.

Action on reserve requirements is not adapted today-to-day changes in banking and monetary condi-tions. It expresses itself in changes in percentages,which generally result in large aggregate inroads onthe available reserves of member banks. Frequentchanges in requirements by small percentual amountswould be disturbing to member banks and would com-plicate their bookkeeping and their customary way ofdoing business. For these reasons this method of in-fluencing the volume of available bank reserves andthe supply of money is usually employed only for thepurpose of adjusting the banking structure to large-scale changes in the country's supply of monetaryreserves. It is not employed to make frequent delicateadjustments to current changes in the supply ofmoney. For this purpose the Federal Reserve dependsprincipally on discount and open market operations.


CHAPTER IV

SELECTIVE METHODS OF REGULATION

In addition to general methods of regulation theFederal Reserve has special powers to regulatethe terms on which transactions in stock marketsecurities are financed and for a period duringand immediately after the war it had authorityto prescribe terms on which consumer creditcould be extended.

THE instruments of credit policy so far discussed,discounts, open market operations, and changes in

reserve requirements, relate to the volume and costof bank credit in general, without regard to the partic-ular field of enterprise or economic activity in whichthe credit is used. Thus they are distinct from thetwo instruments of control, now to be discussed, whichare particular or selective. These two are applicableto stock market credit and consumer credit, respec-tively. Selective instruments of Federal Reserve regu-lation do not, as do general regulations, approach theproblem through influencing bank reserves. Insteadthey prescribe the terms on which certain kinds ofloans may be made, or credits granted, regardless ofwhether the banks have abundant or scanty reserves.These methods are supplementary to methods of gen-eral regulation, and their merit is that they make itpossible to restrain the flow of money into certainfields at times when conditions in the economy as awhole are such as to make general restraints on thegrowth in the volume of money undesirable. For ex-ample, an unhealthy stock market speculation maydevelop and call for restraint at a time when credit

38


SELECTIVE METHODS OF REGULATION 39

for production and trade is not expanding and whenthe application of general instruments of regulationmight do harm to the country's over-all economicactivity. At such a time the Federal Reserve coulddecide to employ its power to regulate margin require-ments.

Margin Requirements

The Federal Reserve authorities have long beenenjoined by law to restrain the use of bank credit forspeculation; they are to keep themselves informed,in the language of the law, as to "whether undue useis being made of bank credit for the speculative carry-ing of or trading in securities, real estate, or commodi-ties" and they are authorized to take certain restric-tive action to prevent undue use of credit in thesefields. Since 1934, the Board of Governors of theFederal Reserve System has also had the specific powerto curb the excessive use of credit for the purpose ofpurchasing or carrying securities by limiting theamount which holders of securities may borrow uponthem for this purpose either from banks or from secu-rities brokers and dealers.

This amount is always less than the current marketvalue of the securities, and the difference between thetwo is called the margin. Thus if a loan of $7,500 issecured by stock worth $10,000, the margin is $2,500or 25 per cent of the value of the stock. The Board'sregulations may be thought of as prescribing eitherminimum margin requirements or maxium [maximum] loan values;for the greater the margin required, the less theamount that can be borrowed.

The Board's regulations apply to the margin thatmust be required at the time the security is pur-



chased. If the collateral security for the indebtednesssubsequently declines in value, the regulations do notmake it necessary for the borrower either to put upadditional collateral or to reduce the indebtedness.The limitations apply only to credits obtained for thepurpose of buying or carrying securities registered onnational stock exchanges;1 they do not apply to anyloan for commercial purposes, even though the loanbe secured by stocks. In any case the bank or brokermaking a loan may require additional collateral if hedeems it necessary.

For several years before the war, the Board's regula-tions required margins of 40 per cent, but during thewar requirements were raised first to 50 per cent, thento 75 per cent, and in 1946 to 100 per cent. When themargin required was 40 per cent, one could borrow forthe designated purpose 60 per cent of the value of hiscollateral security; when it was 50 per cent, he couldborrow 50 per cent; when it was 75 per cent, he couldborrow only 25 per cent; and when it was 100 percent, he could borrow nothing. To require a marginof 100 per cent was in effect to forbid loans for thepurpose in question. The reason for so drastic a re-quirement was that inflationary pressures were verystrong and any growth whatever in stock marketcredit would increase them. The 100 per cent require-ment was in effect from January 1946 to February1947, when it was reduced to 75 per cent, making itpossible for banks and brokers to lend 25 per centof the value of the collateral.

1 The provisions of the law make some distinctions betweenbrokers or dealers and banks; brokers or dealers cannot extend crediton unregistered securities except temporarily in connection withcash transactions; banks are not restricted by margin requirements inmaking loans on securities other than stocks.



The control effected by margin requirements, thoughbearing directly on the lender, puts restraint uponthe borrower and dampens demand. It can be usedaccordingly to keep down the volume of stock marketcredit even though lenders are abundantly able andeager to lend. The extent to which margin require-ments may restrain borrowers can be illustrated verysimply. Before the regulation was authorized, a personhaving, say, $1,000 to put in the market could arrangewith a broker, if the broker was willing to accept therisk, for the purchase of 100 shares of stock at $100a share—that is, $10,000 worth—the stock being heldby the broker as collateral for the $9,000 he was lend-ing and giving him a margin of 10 per cent. If thestock rose or fell $5 a share, the borrower would havea profit or loss of $500. Customary margins in pre-regulation days ranged from 10 to 25 per cent. Underthe present requirement of a 75 per cent margin, thebuyer could arrange to purchase only about 13 sharesat $100 each, and a rise or fall of $5 a share wouldbring him a profit or loss of only $65. It is obviousthat high margin requirements greatly reduce thegains or losses to be realized by buying with borrowedfunds, and cut down the amount of credit which canbe obtained for this purpose. Furthermore, with highmargins the pressure of forced selling to bolster ac-counts during market declines is reduced.

Another effect of high margin requirements is inrestricting the amount of pyramiding that can takeplace in a rising market, that is, the extent to whichtraders may add to their holdings, when the marketis rising, without putting up additional money oradditional securities but merely by borrowing againstthe additional market value of securities already held



in their accounts. In case 100 shares of stock pur-chased for $10,000, for example, should rise in valueto $15,000, the increase of $5,000 would suffice, undera 10 per cent margin requirement, not only to marginthe increase in value of the original 100 shares but inaddition to margin an additional purchase of 300shares. Under a 50 per cent margin requirement, how-ever, the increase of $5,000 market value would suffice,after allowing for the increased margin of $2,500 onthe original 100 shares, to permit the purchase of onlyabout 33 shares. Restriction of pyramiding is animportant restraint on rising stock prices as well as onthe growth of credit employed in the stock market.

By the control of margin requirements excessive useof credit in the stock market, which has caused seriousdisturbances to the economy in the past, has beenplaced under control. The danger of a stock marketboom financed by credit and followed inevitably by adisastrous collapse has been largely eliminated. Aboom and a collapse in the stock market is still pos-sible—on a cash basis, but without the use of creditit is not likely to assume the proportions it had in thepast, as for example in 1929. At that time creditextended by brokers alone had increased to at least10 billion dollars, a peak from which it fell to three-quarters of a billion by the middle of 1932. This riseand fall in stock exchange loans was accompanied byan advance in prices of common stocks to an indexnumber of 238 in the autumn of 1929 followed bya drop to 36 in the middle of 1932. This boom andbust in the stock market caused a great deal of damageand contributed to the development of depression inthe thirties. With the inauguration of control of creditgoing into the stock market the likelihood of an episode



like the one that culminated in 1929 has becomeremote.

Aside from having to do with a specific use ofcredit, the authority with respect to security loansdiffers from other Federal Reserve powers in reachingoutside the Federal Reserve System to banks that arenot members of the System and to brokers and dealersin securities. I t is closely related, however, to otherregulatory powers of the Federal Reserve authorities,because the use of credit for purchasing or carryingsecurities has an important bearing upon its use forbusiness purposes in general.

Consumer Credit

Temporary control of consumer credit was estab-lished in 1941 by Executive Order of the Presidentunder authority of an act of Congress (enactedOctober 6, 1917, and subsequently amended) givinghim certain emergency powers. The purpose wasto curb the use of credit for the purchase of auto-mobiles, electric refrigerators, radios, washing ma-chines, vacuum cleaners, household furniture, andother consumers' goods and services. Consumers' goodsand services were becoming scarce because the equip-ment, materials, and labor required for their produc-tion were being transferred to the war effort. At thesame time, since employment was general and payrolls were large, the purchasing power of consumerswas increasing. In this situation, with decreased supplyand increased demand, there was every reason forexpecting prices to rise exorbitantly. The President,accordingly, under authority of his emergency powers,instructed the Federal Reserve authorities to regulate



the use of consumer credit so that it would not beused to accentuate the demand.

In compliance with the Executive Order, the Boardof Governors issued Regulation W, prescribing termsupon which credit might be granted. At the outset itapplied only to instalment credit, including both in-stalment sales and instalment loans, in which formthe great bulk of consumer credit was being generated.

The restraints imposed by Regulation W on instal-ment credit were twofold: they limited the amount ofcredit that might be granted for the purchase of anyarticle listed in the regulation, and they limited thetime that might be agreed upon for repaying theobligation. Instalment loans not related to the specifi-cally listed articles were subject only to limitationon the time of repayment. Thus, for example, a per-son buying an automobile had to make a down pay-ment of at least a third of the purchase price, andagree to pay the balance within eighteen months. Thiswas a larger down payment than had generally beendemanded by dealers and a shorter allowance of timethan had been permissible. The result was a reduc-tion in the aggregate amount of credit currently ex-tended for the purchase of automobiles and in thetime it was allowed to run. But a more fundamentaleconomic result was reduction of the demand forautomobiles at a time when they could not be pro-duced in volume, when prices were tending to rise,and when the nation needed all the money its citizenscould refrain from spending. What was true of auto-mobiles was true of other goods and services boughtwith credit funds.

The scope of the regulation was later broadened toinclude a larger number of articles requiring down



payments and to cover charge accounts and single-payment loans. Requirements were made more re-strictive as to down payments and maturities oninstalment credits; charge accounts were closed againstfurther purchases (of listed articles) unless paid bythe tenth day of the second calendar month followingthe purchase date; and single-payment loans of definedcategories were limited to ninety days with limitedrenewals.

The regulation of consumer credit went much fur-ther than the regulation of stock market credit inextending responsibilities of the Federal Reserve au-thorities outside the field of banking. It applied to theoperations of sales finance companies, personal loancompanies, department stores, dealers in automobiles,electrical appliances, household furnishings, musicalinstruments, dry goods, and many others. These creditgrantors, if engaged in instalment business, were re-quired to register with the Federal Reserve Bank ofthe district in which they were situated and if not soengaged were given a blanket license. They were fur-nished instructions and information about the proce-dure to be followed in extending consumer credit, theirrecords were subject to inspection, and they could bepenalized for violating the regulation.

In the two-year period immediately following thewar, regulation of consumer credit was continued,though some of the terms were relaxed and thescope of the regulation was contracted to aboutwhat it was at the outset. The reason for continuingit was that the supply of goods was at the time alto-gether inadequate relative to the demand, in whichcircumstances the danger of an inflationary rise inprices was extreme. Restraint upon the use of credit



in purchasing scarce articles was intended to lessenthe pressure for a rise in prices and help to restrain it.In addition, fixing minimum down payments for im-portant consumers' durables and the maximum length-of-contract for consumer instalment financing in gen-eral tended to cause competitive business forces totake the direction of lowering prices instead of keep-ing, them up by means of offering easier and easiercredit terms.

One reason why consumer buying on instalmentswas subjected to special regulation is that variationin the volume of such buying has a disturbing influ-ence on business stability. Purchases on an instalmentbasis are likely to be large at a time of general pros-perity when the demand for goods is pressing on thesupply and consequently prices are likely to rise. Atsuch a time instalment purchases are likely to increasestill further a demand for goods that is already largerthan can be easily supplied. On the other hand, at atime of depression and unemployment, when the de-mand for goods is low relative to the supply and isdeclining, the necessity for many purchasers on instal-ment to meet their payments tends to reduce stillfurther the amount of money available to consumersfor current purchases. This tends to intensify the de-pression. It is believed by many that regulation ofinstalment purchases, prescribing stiffer terms in aboom period and permitting easier terms in a depres-sion, would tend to reduce somewhat the swings fromprosperity to depression and would therefore supportthe main purpose of Federal Reserve policy.

Resting as it did on an Executive Order of the Presi-dent and not on explicit legislation by Congress, theregulation of consumer credit by the Federal Reserve



authorities was a temporary form of credit control.It has been terminated as of November 1, 1947, afterhaving been in effect a little over six years. Such acontrol could be made permanent only in case Con-gress should decide to give it that status by specificstatutory authorization.

Selective instruments of national credit policy,though used in their modern form for less than fifteenyears, have been developed far enough with respect tostock market credit and consumer credit to show thatsuch instruments can be a useful complement tothe older and more general instruments—discountrates, open market operations, and reserve require-ments. They are flexible in themselves and can helpto make credit policy in general more flexible. Theirdistinguishing characteristics are that they are appli-cable to parts of the economy instead of to the economyas a whole and that they can be used to restrain thedemand for credit without operating, as general instru-ments do, through the stiffening of money rates.


CHAPTER V

STRUCTURE OF THE FEDERAL RESERVE SYSTEMAll national banks and many State banks aremembers of the Federal Reserve System. Thereare twelve Federal Reserve Banks, each servingone of the districts into which the country isdivided. The functions of the Federal Reserveare entrusted to the Board of Governors of theFederal Reserve System, the Federal ReserveBanks, and the Federal Open Market Com-mittee.

SO far we have spoken of the Federal Reserve as aunit without reference to its structure or to the

distribution of duties and responsibilities among itscomponent parts. This presentation has the advan-tage of emphasizing that from the point of view ofregulating the money supply the responsibility restson the System as a whole and that all of its parts per-form their allotted functions in accordance with poli-cies directed toward accomplishing a common objec-tive. Consideration of the System's structure, however,is now in order.

MembershipThe Federal Reserve System at the end of 1946 had

6,900 member banks. This number included all bankswith national charters, which are required to belong,and such banks with State charters as voluntarilychose to belong, were qualified for membership, andwere accepted by the Federal Reserve. While in numbermember banks were somewhat less than one-halfof all banks in the United States, they held more thanthree-fourths of the country's bank deposits. Thedifferent kinds of banks in this country at the end of

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STRUCTURE OF SYSTEM 49

1946 and the amount of their deposits are shown inthe accompanying table. It will be noted that thistable does not include Federal Reserve Banks, whichare fundamentally different from commercial banks.

ALL BANKS IN THE UNITED STATES, DECEMBER 1946

Kind of bank

Member bankNonmember bank

Total

Classes of member banks:NationalState2

Classes of nonmember banks:CommercialMutual savings

Number

6,9007,685

14,585

5,0071,893

7,147538

Deposits1

(In millions of dollars)

Demand

78,92013,526

92,446

52,19426,726

13,526

Time

27,19023,610

50,800

18,4128,779

6,75616,854

1 Excluding interbank deposits.2 Includes three mutual savings banks.

It will be noted that of demand deposits, which arethe closest equivalent to currency in serving as meansof payment, member banks hold over 85 per cent.Consequently Federal Reserve policies have a directinfluence on institutions holding about nine-tenths ofthe country's more active bank deposits.

Obligations and Privileges of Member Banks

By becoming members of the Federal Reserve Sys-tem, banks become eligible to use all of the System'sfacilities and, in return, undertake to abide by certainrules that have been developed by law and regulationfor the protection of the public interest. Nationalbanks are chartered by the Comptroller of the Cur-rency, a Federal Government official, and are subject



in their operations to the National Banking Act aswell as to the Federal Reserve Act. State-charteredbanks that choose to become members of the FederalReserve System retain their charter privileges butagree to be subject to the general requirements of theFederal Reserve Act. Since these banks join the Sys-tem voluntarily they have the privilege of withdraw-ing from membership on six months' notice.

Principal among the obligations assumed by mem-ber banks are: (1) to subscribe to the capital of theFederal Reserve Banks an amount equal to 6 per centof the member's capital and surplus. (Of this, one halfmust be paid-in and the other half is subject to call.No part of the second half has been called.) (2) Tocomply with the reserve requirements of the FederalReserve and to keep the required reserves without in-terest with the Federal Reserve Banks. (That this isa much more important obligation than the first isclear from the fact that late in June 1947 the totalpaid-in capital of the Federal Reserve Banks was about190 million dollars, while required reserves of memberbanks were in excess of 15,000 million, or nearly eightytimes as large as the capital.) And (3) to be subject tovarious requirements of the Federal Reserve Act withrespect to branch banking, holding company regula-tion, interlocking directorates, and other matters, and,in the case of State member banks, also to generalsupervision and examination by the Federal Reserve.

In return, member banks are entitled to the followingprincipal privileges, among others: (1) to borrow fromthe Federal Reserve Banks when in need of additionalfunds; (2) to use Federal Reserve facilities for collect-ing checks, settling clearing balances, and transferringfunds to other cities; (3) to obtain currency whenever



required; (4) to receive a cumulative dividend of 6per cent on the paid-in capital stock of the FederalReserve Banks; and (5) to participate in the electionof six of the nine directors of each Federal ReserveBank.

Federal Reserve Banks

For purposes of administering the Federal ReserveSystem the country is divided into the twelve dis-tricts shown in the map on page 52. The districtboundaries do not always follow State lines and Statesin many instances form parts of more than one dis-trict. There is a Federal Reserve Bank in each districtand some of the Reserve Banks have branches. A listof the districts and branches is given below:

Federal Reserve Bank of Boston District Number 1Federal Reserve Bank of New York District Number 2

Branch at Buffalo, New YorkFederal Reserve Bank of Philadelphia District Number 3Federal Reserve Bank of Cleveland District Number 4

Branches: Cincinnati, OhioPittsburgh, Pennsylvania

Federal Reserve Bank of Richmond District Number 5Branches: Baltimore, Maryland

Charlotte, North CarolinaFederal Reserve Bank of Atlanta District Number 6

Branches: Birmingham, AlabamaJacksonville, FloridaNashville, TennesseeNew Orleans, Louisiana

Federal Reserve Bank of Chicago District Number 7Branch at Detroit, Michigan

Federal Reserve Bank of St. Louis District Number 8Branches: Little Rock, Arkansas

Louisville, KentuckyMemphis, Tennessee


FEDERAL RESERVE SYSTEM 52 T

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Federal Reserve Bank of Minneapolis District Number 9Branch at Helena, Montana

Federal Reserve Bank of Kansas City District Number 10Branches: Denver, Colorado

Oklahoma City, OklahomaOmaha, Nebraska

Federal Reserve Bank of Dallas District Number 11Branches: El Paso, Texas

Houston, TexasSan Antonio, Texas

Federal Reserve Bank of San Francisco District Number 12Branches: Los Angeles, California

Portland, OregonSalt Lake City, UtahSeattle, Washington

Each of the twelve Federal Reserve Banks is a cor-poration organized and operated in the public service.The Federal Reserve Banks differ essentially from pri-vately managed banks in that profits are not theobject of their operations, and their stockholders,which are the member banks of the Federal ReserveSystem, do not have the powers and privileges thatcustomarily belong to stockholders of privately man-aged corporations.

Each Federal Reserve Bank has nine directors, threeof whom are known as Class A directors, three as ClassB directors, and three as Class C directors. Class Aand Class B directors are elected by member banks,one director of each class being elected by small banks,one of each class by banks of medium size, and one ofeach class by large banks. The three Class A directorsmay be bankers. The three Class B directors must beactively engaged in the district in commerce, agricul-ture, or some other industrial pursuit, and must not beofficers, directors, or employees of any bank. The three



Class C directors are designated by the Board of Gov-ernors of the Federal Reserve System. They must notbe officers, directors, employees, or stockholders of anybank. One of them is designated by the Board ofGovernors as Chairman of the Reserve Bank's boardof directors and as Federal Reserve Agent.

Under this arrangement, business men and otherswho are not bankers constitute a majority of the direc-tors of each Federal Reserve Bank. The directors areresponsible for the conduct of the affairs of the ReserveBank, subject to the supervision of the Board of Gov-ernors. They choose the Reserve Bank officers, but thelaw requires that their choice of President and FirstVice President be approved by the Board of Governors.The salaries of all officers and employees are also sub-ject to the approval of the Board of Governors. Eachbranch of a Federal Reserve Bank has its own boardof directors, a majority of whom are selected by theReserve Bank and the remainder by the Board ofGovernors. The provisions of law circumscribing theselection of Reserve Bank directors and the manage-ment of the Reserve Banks indicate the public natureof the Reserve Banks.

Decentralization is an important characteristic ofthe Federal Reserve System. Each Reserve Bank andeach branch office is a regional and local institution aswell as part of a nation-wide system. Its officers andemployees are residents of the Federal Reserve dis-trict, and its transactions are with regional and localbanks and businesses. I t gives effective representationto the views and interests of the particular region towhich it belongs and at the same time helps to admin-ister nation-wide banking and credit policies.

The income earned by the Federal Reserve Banks



from their operations is used to cover their expenses,including the expenses of the Board of Governors inWashington, to pay 6 per cent dividends to members,and to make additions to surplus. In case of liquida-tion of the Reserve Banks the surplus would go to theUnited States Government.

While the Federal Reserve Banks earn an income,their operations are not carried on for this purposebut are determined by Federal Reserve credit policies,which are discussed in other chapters. For many yearsthe System's net earnings were turned over in largepart to the Government as a franchise tax. At a timewhen these earnings were small and after the Congresshad directed the Reserve Banks to contribute half oftheir surplus to the capital of the Federal DepositInsurance Corporation, the provision for the franchisetax was repealed. Recently, however, earnings of theReserve Banks have once more been large, as theresult of war financing. The Federal Reserve has,therefore, adopted a procedure by which it turns overto the Treasury nine-tenths of its earnings above ex-penses and dividends. The Federal Reserve makesthese payments on the basis of authority contained ina section of the law dealing with Federal Reservenotes. This is another illustration of the public charac-ter of the Federal Reserve.

From the point of view of credit policy the FederalReserve Banks make the decisions regarding whatloans and discounts to individual member banks willbe in harmony with the objectives of the Federal Re-serve System. The Reserve Banks also establish thediscount rate, but it must be approved by the Boardof Governors, which also has authority to makechanges in the rate on its own initiative. In connec-



tion with open market operations the Federal ReserveBanks, in groups prescribed by law, elect five of thetwelve members of the Federal Open Marke t Com-mit tee—to be described later.

Board of Governors

The Board of Governors of the Federal ReserveSystem is a governmental institution with offices inWashington, D. C. It consists of seven members ap-pointed by the President of the United States andconfirmed by the Senate. Members are appointed forterms of fourteen years, so arranged that one termexpires every two years. No two members of theBoard may come from the same Federal Reserve dis-trict. The Board's expenses are paid out of assess-ments upon the Reserve Banks.

It is the Board's duty to supervise the workings ofthe Federal Reserve System. As already indicated, theBoard appoints three of the nine directors of eachFederal Reserve Bank, including the Chairman, whois also the Federal Reserve Agent, and the DeputyChairman. Appointments of the President and FirstVice President of each Federal Reserve Bank are sub-ject to the Board's approval. The Board also issuesregulations that interpret the provisions of law relat-ing to Reserve Bank operations. It directs the Sys-tem's activities in bank examinations and in economicresearch and publications. The Board represents theFederal Reserve System in most of its relations withexecutive departments of the Government and withcongressional committees. It is required to exercisespecial supervision over foreign contacts and inter-national operations of the Reserve Banks. It issues anannual report to Congress and publishes weekly a



statement required by law of the assets and liabilitiesof the Federal Reserve Banks. It issues a monthlyFederal Reserve Bulletin and other periodic or occa-sional publications.

Of the principal monetary actions of the FederalReserve the Board has full authority over changes inreserve requirements and margin requirements. Italso has authority to establish the maximum rates ofinterest that member banks may pay on time deposits.It "reviews and determines" discount rates establishedby the Reserve Banks. While the terms of consumercredit were being regulated, the Board had sole re-sponsibility for their determination and enforcement.In general, the Board of Governors is responsible forformulating national credit policies and for supervisingtheir execution. The members of the Board are alsomembers of the Federal Open Market Committee.

Federal Open Market Committee

This Committee, comprising the seven members ofthe Board of Governors and five representatives electedby the Federal Reserve Banks, has the responsibilityof deciding when and how much to buy or sell in theopen market and under what conditions. The FederalReserve Banks, in their operations in the open market,are required by law to carry out the decisions of theOpen Market Committee. The Committee meets inWashington four times a year, or oftener if necessary,and reviews the business and credit situation with thehelp of its staff, which is drawn from the staffs of theBoard of Governors and the Reserve Banks. In viewof the importance of open market operations as instru-ments of Federal Reserve policy the Federal OpenMarket Committee is a vital organ of the System. In



meetings of the Committee representatives of the Re-serve Banks bring to the council table their knowledgeof regional conditions and members of the Boardpresent the national aspects of the current situation.Decisions about open market policy are made in thelight of such discussion.

Advisory Committees

The Federal Reserve Act provides for a FederalAdvisory Council of twelve members, one from eachFederal Reserve district, selected annually by theFederal Reserve Bank through its board of directors.Council members are usually selected from amongrepresentative bankers in each district. The Councilmeets in Washington at least four times a year. Itconfers with the Board of Governors on business con-ditions and makes advisory recommendations regardingthe affairs of the Federal Reserve System. It con-stitutes a link between the Board and representativesof banking in the twelve districts.

In addition to the Federal Advisory Council the Sys-tem has a number of conferences and committees thathelp in reaching understanding on common problems.Of these the most important is the Conference ofPresidents of the Federal Reserve Banks, which meetsby itself and with the Board at least three times a year.

The Money Market

In order to understand the functions of the FederalReserve System, the structure of which has been out-lined in the preceding pages, it is necessary to place itin the country's financial organization. For FederalReserve influence reaches beyond the confines of mem-bership in the Federal Reserve System.



For many of the most important responsibilities ofthe Federal Reserve System, the point of contact withthe banking and financial organizations of the countryis what is customarily called the "money market."The "money market" has no formal organization orspecific place of business as stock markets and com-modity markets have, but it is none the less a reality.As far as large transactions are concerned, modernmeans of communication make the country practi-cally one money market. Well-established borrowerswith high credit ratings can negotiate bank loans onmuch the same conditions in one city as in another;for if money is scarce and dear in one center, the sup-ply tends to be replenished at once from other centerswhere it is more abundant. Relatively small transac-tions originating from local needs and represented byloans based on close contact with local conditions arehandled by many regional money markets in whichrates charged and other conditions vary considerablyfrom place to place. Contacts of these local moneymarkets with the national money market are chieflythrough balances kept by local banks with city corre-spondents. Funds of these regional banks are likelyto flow into the financial centers when not required forlocal use and to be recalled when local demand de-velops. Through this flow of funds, banks in all partsof the country maintain a degree of contact with thenational money market. Their actions have an influ-ence on conditions in that market and they are inturn influenced to some extent by developments in thefinancial centers. The movements of funds in and outof the national money market are no longer disruptiveas they frequently were before the organization of theFederal Reserve System. The Reserve Banks now



stand ready to supply additional funds to money mar-ket banks when needed and to absorb redundant funds.

Money market transactions take place throughbanks and related institutions, but the market com-prises the customers of banks as well as the banksthemselves. Thus, when the United States Treasuryborrows by the sale of its obligations in the moneymarket, the lenders—that is the buyers of the obliga-tions—will be not only banks, but insurance com-panies, investment trusts, private individuals, andother holders of funds for investment. The moneymarket derives much of its character as a marketfrom the operations of dealers who specialize in buy-ing and selling acceptances and securities. Being theprincipal financial center, New York City is the heartof the American money market.

As in any other kind of market, demand will some-times exceed supply, and supply will sometimes exceeddemand; rates of interest and discount will sometimesrise and sometimes fall. I t is the responsibility of theFederal Reserve authorities to watch over the market,to prevent fluctuations from becoming violent, andthrough purchases or sales and rate policies to en-deavor to maintain orderly credit conditions. Mostof the measures taken by the Federal Reserve authori-ties have their most direct influence on the moneymarket through the medium of bank reserves.

The functions exercised by the Federal Reserveare directed for the most part to the money marketas a whole and not to the individual banks. Indeed,the individual banker may not be aware of FederalReserve action save indirectly. His bank's operationsby themselves may disclose only that his customersare bringing in more deposits than they are checking



out, or checking out more than they are bringing in,or are increasing or decreasing their demand for loans.Federal Reserve policies, however, also affect the at-titude of banks toward prospective borrowers andtoward investment opportunities. When funds areabundant banks lend and invest more freely than whentheir funds are limited as the result of Federal Reserveaction. Nonmember as well as member banks, in factall financial institutions, are affected by Federal Re-serve operations in the money market that make moneymore or less abundant and more or less costly toborrowers.


CHAPTER VI

RELATION OF FEDERAL RESERVE TO CURRENCY

The Federal Reserve pays out currency in re-sponse to public needs and absorbs redundantcurrency. Its operations result in making theentire currency supply elastic.

AN important purpose of the establishment of theFederal Reserve Banks in 1914 was to provide an

elastic currency. Prior to that time the currency hadconsisted principally of Treasury notes secured bygold or silver and of national bank notes which had tobe secured by specified kinds of United States Gov-ernment obligations that were extremely limited inamount. As a consequence, additional paper moneycould not be easily supplied when the nation's busi-ness so required and currency would become hard toget and command a premium. Currency shortages,together with other related developments, caused sev-eral financial panics. It was one of the tasks of theFederal Reserve to prevent such panics by providinga kind of currency that would respond in volume tothe needs of the country. The Federal Reserve note issuch a currency.

Federal Reserve notes are paid out by the twelveFederal Reserve Banks to member banks on requestand are charged to their reserve accounts. Any FederalReserve Bank can obtain the notes from its Federal Re-serve Agent, a representative of the Government, uponpledging gold certificates, so-called eligible paper,or United States Government obligations. Conse-quently, whenever the public needs more currency,member banks can obtain it from a Federal Reserve

62


RELATION TO CURRENCY 63

Bank, which in turn can secure it from a Federal Re-serve Agent on the pledge of practically any ReserveBank asset. The only limitation is that the ReserveBanks must have, in their own hands or pledged witha Federal Reserve Agent as part of the collateral forFederal Reserve notes, gold certificates amounting tonot less than 25 per cent of the Federal Reserve notesin circulation, in addition to having in their ownpossession gold certificates amounting to not less than25 per cent of their deposit liabilities. (Prior to 1945the required percentage was 40 for notes and 35 fordeposits.) Under this system the volume of currencyincreases when the public's needs become larger, anddeclines when they become smaller. In the latter casemember banks, on receipt of currency from their de-positors, redeposit it with the Federal Reserve Banks,which turn it over to their Federal Reserve Agentsand redeem the assets previously pledged as collateralfor the notes.

As has been stated earlier, Federal Reserve notesconstitute about seven-eighths of all the currency incirculation. The other kinds of currency are UnitedStates notes (a remnant of Civil War financing), vari-ous issues of paper money in process of retirement,silver certificates, silver coin, nickels, and cents. Fed-eral Reserve notes are not issued in denominationssmaller than $5, and so all of the $1 and $2 bills (aswell as some bills of larger denominations) are in otherforms of paper money, chiefly silver certificates andUnited States notes. At the end of June 1947 thetotal amount of currency in circulation was 28.3billion dollars, of which 24.0 billion were Federal Re-serve notes. Of the remainder the largest amountconsisted of silver certificates. All of the kinds of



currency in circulation in the United States are legaltender and the public makes no distinction amongthem. It may be said that the Federal Reserve hasendowed all forms of currency with elasticity sincethey are all receivable at the Federal Reserve Bankswhenever the public has more currency than it needs,and they may all be paid out by these Banks whendemand for currency increases. Therefore, in the sub-sequent discussion reference will be made to the totalof currency in circulation rather than to any particu-lar kind.

It has already been stated that the amount of cur-rency in circulation changes in response to changes inthe public's needs. These changes are substantial andfrequent. The demand varies for different days of theweek, for different days of the month, and for differentseasons. It increases before holidays such as MemorialDay, Independence Day, and Labor Day, when manypeople take trips and need more ready cash. There isan extraordinary increase in the demand before Christ-mas, when cash is used for Christmas shopping or asgifts. After the holidays, the currency is promptlydeposited in the banks by the merchants, hotel keepers,and others with whom it has been spent, and thebanks send it to the Federal Reserve Banks.

In addition to seasonal changes in the demand forcurrency, there are changes that reflect variations inbusiness conditions. When business is good, the de-mand for currency increases, and when business de-clines the demand also declines. While most paymentsin this country are made by check, some types of pay-ments are made principally in currency. The mostimportant of these are pay rolls and retail trade, andstatistics show that the amount of currency in circula-



tion fluctuates in response to changes in the volume ofthese two kinds of payments . There have been occa-sions, as in 1930-32, when the demand for currency in-creased because numerous bank failures caused peopleto withdraw their deposits from other banks. Dur ingthe war the amount of currency in circulation increasedgreatly in response to a variety of influences: thegrowth of pay rolls, retail trade, and t ravel ; removal ofmany people from their usual places of residence; pay-ments to members of the armed forces; larger incomesof people not in the habi t of using banks ; and nodoubt hoarding of currency for various reasons. Thedemand for additional currency subsided after thewar, bu t the volume in circulation is still extraor-dinarily large.

From the point of view of the Federal Reserve andmember banks, changes in the demand for currencyhave a special significance t h a t arises out of our sys-tem of reserve requirements. As has been explained,reserve requirements of member banks are expressedas percentages of their deposits. If the public borrows,say $1,000, from a bank and leaves i t on deposit to betransferred from bank to bank by check, the amountof reserves tha t the banking system mus t hold in-creases by only $150. If, however, the public wishesto withdraw the proceeds of the loan in currency, themember bank must obtain the currency from a Re-serve Bank, which will charge the full amount with-drawn to the member bank's reserve account. Conse-quently the reserves of the bank—and of the bankingsystem as a whole—will diminish by the full $1,000.

If the banking system had no excess reserves, itwould have to obtain addit ional reserves. In eithercase, the Federal Reserve could make i t unnecessary



for the member banks to borrow from the ReserveBanks, if it thought it desirable to do so, by buyingan equivalent amount of Government securities in theopen market. Whichever procedure was followed, thedemand for Federal Reserve credit and Reserve Bankholdings of discounts and securities would increase;but the increase would be $150 in the case of the de-mand for $1,000 of deposits and $1,000 in the case ofdemand for an equal amount of currency. Because theincrease in the demand for Federal Reserve credit isso much greater when the public withdraws its fundsfrom banks in currency than when it leaves them ondeposit, the volume of discounts and securities held bythe Federal Reserve Banks is greatly influenced bychanges in the demand for currency.

One effect of the fact that a demand for currencyresults in a greater demand for Federal Reserve creditthan does a similar demand for deposits is that the Fed-eral Reserve Banks' need for reserves to meet their ownrequirements increases much more when currency isflowing out to the public than when bank credit ex-pansion takes the form of a growth in deposits. TheReserve Banks are required to hold the same ratio ofreserves in gold certificates against their Federal Re-serve notes in circulation and against their deposits,(25 per cent) but when the public demand is for $1,000in currency, the Federal Reserve Banks pay out thatamount of Federal Reserve notes—and their reserverequirements increase by $250. If, however, the pub-lic's demand is for $1,000 in deposits, member bankreserves, which are the deposits against which theReserve Banks must hold reserves, increase by only$150 and the reserves needed by the Reserve Banksby only $37.50 (25 per cent of $150). Consequently



an increase in currency ties up more than six times asmuch of the Reserve Banks' reserves as does an identi-cal increase in bank deposits.

It is principally because of the great growth in cur-rency in circulation during the war that the FederalReserve Banks' ratio of reserves to combined note anddeposit liabilities declined to a point where Congressdeemed it wise to reduce the reserve requirement ofthe Reserve Banks from 40 per cent for Federal Re-serve notes and 35 per cent for deposits to 25 per centfor each kind of liability. The amount of reserves thatthe Reserve Banks actually hold, however, is alwaysconsiderably larger than the minimum required bylaw. This is because the Reserve Banks are not oper-ated for the purpose of making a profit and conse-quently do not extend additional credit simply be-cause they have enough reserves to enable them to doso. The volume of Federal Reserve credit to be ex-tended is decided on the basis of demand of the publicfor currency and bank deposits and of the policiespursued by the Federal Reserve to encourage or dis-courage this demand. As has already been stated, thesepolicies are determined by considerations of the publicinterest rather than by the availability of unusedreserves at the Federal Reserve Banks.


CHAPTER VII

RELATION OF FEDERAL RESERVE TO GOLD

Gold and Federal Reserve credit are the prin-cipal sources of member bank reserves. Con-sequently gold movements are reflected inchanges in the demand for Federal Reservecredit. Gold certificate holdings of the FederalReserve Banks set the limits of Federal Reservecredit expansion.

THERE is a dual relationship between the FederalReserve and gold. It may be said that gold is both

the basis and the principal competitor of FederalReserve Bank credit. It is the basis of Reserve Bankcredit because the power of the Reserve Banks tocreate money either through adding to their depositsor issuing Federal Reserve notes is limited by therequirement of a 25 per cent reserve in gold certificatesagainst both kinds of liabilities. Consequently, thetotal of Federal Reserve notes and deposits must notexceed four times the amount of gold certificates heldby the Reserve Banks. Thus gold sets the limits ofReserve Bank credit expansion.

Gold is a competitor of Federal Reserve Bank creditfor the reason that, when the United States acquiresmore monetary gold, additional reserves become avail-able to the member banks without their having toresort to a Reserve Bank for credit. Except to theextent that there is a more than temporary decline inthe amount of currency in circulation, gold and ReserveBank credit are by far the most important sources ofmember bank reserves. The more gold comes to thecountry from abroad or from domestic mines, the lessdemand there is for Reserve Bank credit. These rela-

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RELATION TO GOLD 69

tionships require more detailed explanation and de-scription.

It should be mentioned first that what the FederalReserve Banks hold is not gold but gold certificates.By the terms of the Gold Reserve Act of 1934 all themonetary gold in the country, that is all the gold thatis not used in industry and the arts, must be turnedover to the Treasury, which pays $35 an ounce for it.The Treasury pays for the gold by check and issues anequivalent amount of gold certificates to the ReserveBanks. The Treasury must hold gold at the rate of $35an ounce for all the gold certificates it issues.2 Conse-quently, while the title to the gold is in the Govern-ment, the greater part of it is held as cover for the goldcertificates in the possession of the Reserve Banks andmay not be used for any other purpose. The ReserveBanks are the only institutions permitted by law tohold gold certificates, which are no longer permitted tocirculate. Except for a small amount that has not beenturned in and that may have been lost, destroyed, orsent abroad, gold certificates are used exclusively asreserves of the Federal Reserve Banks. In practice theReserve Banks hold only a relatively small amount ofthe certificates; most of them are represented by acredit in a gold certificate account on the books of theTreasury. This serves the same purpose and saves theunnecessary expense of printing and shipping the notes.

At the end of June 1947, the Treasury held gold inthe amount of 21,266 million dollars: of this amount20,087 million was cover for gold certificates, 156 mil-lion was held as the statutory reserve against UnitedStates notes, and the remainder, 1,024 million, was in

2 The amount of gold that the Treasury must hold as cover for eachdollar of gold certificates can be changed only by an Act of Congress.



the general fund of the Treasury. Only the gold inthe general fund is at the free disposal of theTreasury.3

The process by which gold produced in the UnitedStates or imported from abroad reaches the Treasuryand is reflected in additions to the reserves of memberbanks and Federal Reserve Banks is not difficult tofollow. The gold is taken to an assay office of theUnited States Treasury, which pays for it by check.The seller of the gold deposits this check with a memberbank, which in turn deposits it with a Reserve Bank,where it is added to the reserve balance of the memberbank and charged to the account of the United StatesTreasury. The Treasury replenishes its account byissuing an equivalent amount of gold certificates to theReserve Bank. Assume that the gold is worth a milliondollars. Then the gold stock of the Treasury, thegold certificate holdings of the Reserve Bank, thereserve balance of the member bank, and the bankdeposit of the seller of the gold will all increase by amillion dollars.

On the other hand, if a member bank has the re-quired license from the Treasury to export a milliondollars in gold, the member bank draws a check fora million dollars on its reserve deposit, the FederalReserve Bank turns over a million dollars of gold cer-tificates to the Treasury in exchange for gold, and theTreasury furnishes the gold to the member bank.The result is that gold holdings of the Treasury, gold

3 When gold was revalued from $20.67 to $35.00 an ounce in 1934,there accrued to the Treasury 2.8 billion dollars, of which 2 billionwas placed in a Stabilization Fund. Most of the remainder was usedindirectly to retire national bank notes. In 1947 part of the2 billion dollars in the Stabilization Fund was used to pay the goldportion of the United States subscription to the InternationalMonetary Fund, and the balance was added to Treasury cash.


RELATION TO GOLD 71

certificate holdings of the Reserve Bank, and thereserve balance of the member bank have all beenreduced by a million dollars. It should be mentionedthat gold movements in recent years have been handledalmost exclusively by governments and central banks,so that gold transactions proceed through official chan-nels. Sometimes gold transactions with foreign coun-tries are effected without a physical movement of goldinto or out of this country. A foreign central bankmay purchase gold in the United States and have it"earmarked," or segregated, for its account at the Fed-eral Reserve Bank of New York, or it may sell some ofits earmarked gold to the United States Treasury.Movements in and out of earmarked accounts have thesame effect on our banking system as exports andimports of gold. "Earmarked" gold belongs to foreignauthorities and is not a part of the monetary goldstock of the United States.

These processes are essentially the same as theywere when gold itself was held by the Federal ReserveBanks and when circulation of gold coins was per-mitted. The only difference is that the title to the goldis in the Treasury and the Reserve Banks hold claimson it in the form of gold certificates. The effects ofgold movements on the reserves of Federal ReserveBanks and member banks and on bank credit and thetotal money supply are unchanged by the alteredprocedure.

It has been shown that gold imports (or exports)increase (or decrease) the reserves of Federal ReserveBanks and, therefore, their ability to issue notes andcreate deposits. The effect of gold movements onmember bank reserves is the same as that of FederalReserve discount or open market operations. When



gold comes in, it increases member bank reserves inthe same way as would an equivalent amount of dis-counts or open market purchases by the ReserveBanks; when gold goes out, it diminishes member bankreserves in the same way as would the paying off of adiscount by a member bank or the sale of a securityby a Reserve Bank. It is for this reason that the de-mand for Reserve Bank credit diminishes when goldcomes in and increases when gold goes out. Some-times the Federal Reserve makes loans on gold toforeign authorities and this has the same effect oncredit conditions in this country as any other advanceby a Reserve Bank.

Movements of gold from one country to another arethe ultimate means by which international balances aresettled. On one side of the balance sheet are all thegoods, services, and securities the United States, forexample, has sold to foreigners, and on the other sideare all the goods, services, and securities the UnitedStates has bought from foreigners. There are otheritems that enter into one or both sides of the balancesheet such as expenditures of tourists abroad, remit-tances by immigrants to their mother countries, andgifts to foreign countries. If, after all of these itemshave been taken into account, there is still a balancedue to the United States from abroad, it can be met byforeigners broadly in one of two ways: by borrowingin the American market, or by sending gold to theUnited States. Shipment of gold is usually the lastresort employed to cover the balance. In recent years,owing to the world-wide demand for American goodsand securities and the scarcity of exportable commodi-ties abroad, the balance due to the United States byforeign countries has been very large. It has been


RELATION TO GOLD 73

covered by public and private loans to foreign coun-tries and by large imports of gold. These gold importshave been an important factor in credit conditions inthe United States.

Disregarding currency movements in and out of theFederal Reserve Banks, which follow the independentpattern explained in the preceding chapter, gold andFederal Reserve Bank credit are the two principalsources of member bank reserves, which in turn arethe basis of member bank credit and of the total moneysupply. It is for this reason that large gold importsmake it more difficult for the Federal Reserve to regu-late the supply of money. When member banks receivereserves through gold imports they can expand theirloans and investments and thus increase the moneysupply without being obliged to apply for accommoda-tion to the Federal Reserve Banks. Furthermore, theycan increase it by several times the amount of theaddition to their reserves through gold imports, justas they can on the basis of any other growth inreserves. At times the Federal Reserve has been ableto offset the effects of gold imports by equivalent salesof securities in the open market, and at other timesby raising member bank reserve requirements. Butthere have been times when the Federal Reserve haslacked the means of offsetting the effects of goldimports. At such times its ability to influence thevolume of money in the domestic economy is restrictedby gold imports. The maintenance of international fi-nancial stability, under which gold movements usuallyremain moderate in amount, is consequently of greatimportance to the effective execution of central bank-ing functions.


CHAPTER VIII

THE MONETARY EQUATION

Gold movements, currency in circulation, andFederal Reserve credit are the principal factorsthat influence the volume of member bankreserves—the basis of the money supply. Therelationships among these factors may be calledthe Monetary Equation.

MEMBER bank reserves, the basis of the moneysupply, and all the principal factors that affect

their volume have now been discussed separately andmay be brought together in what may be called themonetary equation. The four factors in this equationrepresent the channels through which all the numer-ous forces in the country's economic life affect theposition of the Federal Reserve Banks and the mem-ber banks. It has been shown that gold imports, de-creases in currency in circulation, and extension ofFederal Reserve credit add to member bank reserves;that gold exports, increases in currency in circulation,and contraction of Federal Reserve credit diminishmember bank reserves.

Of the four factors, gold movements are largelyindependent of Federal Reserve regulation. They de-pend on international financial conditions. For manyyears they have not been responsive to relative levelsof interest rates, as they were in the past, but havebeen determined by official policies of central banksand governments. Currency movements in and outof circulation are likewise largely independent of Fed-eral Reserve regulation. They follow their own coursein response to business conditions and the public's

74


THE MONETARY EQUATION 75

habits and preferences. Federal Reserve credit is thebalance wheel between these two more or less inde-pendent factors and member bank reserves. It is thechief means by which the Federal Reserve, throughinfluencing the volume of member bank reserves, candischarge its responsibility to regulate the volume ofbank credit and the total money supply. The FederalReserve can use its credit powers either to initiatechanges in the volume of member bank reserves or tomodify changes caused by gold or currency move-ments. Action to offset the effects of gold and cur-rency movements will or will not be taken, dependingon whether these effects are in harmony with currentFederal Reserve monetary policy.

Member bank reserves, although affected by theoperations of the three other factors in the monetaryequation, are not themselves an entirely passive ele-ment. They respond to economic forces that are notnecessarily reflected in gold or currency movementsand their independent responses are subject to regu-lation by the Federal Reserve. For instance, at timesof vigorous demand for bank credit by the public anda consequent growth in bank deposits, member banksneed more reserves. The need for additional reservesexpresses itself in a demand for additional ReserveBank credit, which may be met by the Federal Re-serve through additional discounts or open marketpurchases. Also, within limits specified by Congress,the Federal Reserve may change the reserve require-ments of member banks.

The course of the four factors of the monetary equa-tion since January 1934, when gold was revalued, isindicated in the chart on page 76. It will be seenthat from 1934 through 1941 the principal movement



MAJOR FACTORS IN THE MONETARY EQUATION

was in gold, and that the monetary gold stock of theUnited States was increasing rapidly. This was aperiod of depression when the Federal Reserveauthorities were pursuing a policy of monetary easein order to encourage economic recovery. Conse-quently, they did not tighten Federal Reserve creditin order to moderate the expansionary effects of thegold inflow on member bank reserves. Reserve Bankcredit remained stable at 2.5 billion dollars. The effectof the gold movements was in part offset by an in-crease of currency in circulation but in the main it wasreflected in a growth of member bank reserve balances.Gold shipments to this country stopped after we en-tered the war and our Allies began to receive ourexports under lend-lease. In fact, gold flowed out ofthe United States, reflecting chiefly our large-scale


THE MONETARY EQUATION 77

purchase of goods from South American countries.Currency in circulation went up rapidly and was theprincipal factor in reducing member bank reserves.In response to increasing demand, Federal ReserveBank credit expanded tenfold, from 2.5 to 25.0 billiondollars. In 1946, the first year after the war, all thefour factors remained relatively stable, and in 1947,with some decrease in currency in circulation and inmember bank reserve balances, and a resumption ofgold imports, Federal Reserve Bank credit showed asubstantial decline.

In a simplified way, the foregoing analysis indicateshow the factors of the monetary equation are inter-related, and how ups and downs in any of them arereflected in appropriate changes in one or more of theothers. Behind all of the movements shown on thechart is the impetus of innumerable economic forces.

Other factors enter into the monetary equation, butfor the most part they are of either minor or transitoryimportance. Silver purchases by the Treasury, for ex-ample, have the same kind of effect on member bankreserves as have imports of gold. These purchases aremade by the Treasury in accordance with a policy laiddown by law and they are paid for in effect by theissuance of silver certificates. These certificates, issuedin accordance with the silver policy and independentlyof the demand for currency, result in a redundantsupply. The surplus currency is returned to the memberbanks and is deposited for credit to their reserve ac-counts with the Federal Reserve Banks. The silveroperations of the Treasury, however, have a relativelyminor effect on monetary conditions. Silver certificatesin circulation at the end of June 1947 amounted toabout 2 billion of the total of more than 28 billion dol-



lars of currency in circulation, and should be comparedwith 16 billion of member bank reserve balances.Furthermore, changes in the volume of silver certifi-cates are relatively slow.

For the most part, the remaining factors that affectthe volume of member bank reserves reflect variousoperations of the United States Treasury. Usuallythey are either temporary in character or minor inamount, but at times they have been of great im-portance. The financing of World War II, discussed inChapter XII, is a good example of the far-reachingeffects of Treasury operations under abnormal con-ditions.


CHAPTER IX

SERVICE FUNCTIONS OF THE FEDERAL RESERVEBANKS

The twelve Federal Reserve Banks hold the legalreserves of member banks, furnish currency forcirculation, facilitate the collection and clearanceof checks, exercise supervisory duties with re-spect to member banks, and are fiscal agents ofthe United States Government.

THE reserve accounts which member banks main-tain with their Reserve Banks are kept in active

use. The member banks are constantly drawing onthem and replenishing them in day-to-day transac-tions. The banks are required to maintain their reservebalances at a level determined in relation to their de-posits, but these deposits constantly change. Memberbanks are permitted to draw on their reserve accounts,but must maintain an average level equal to the legalrequirements. Central reserve city and reserve citymember banks are permitted to average their reservesover a weekly period and country banks over a semi-monthly period. Transactions in member bank reserveaccounts entail a heavy amount of continuous workfor the Federal Reserve Banks, which includes:

Furnishing coin and paper money for circulation;Receiving and sorting deposits of currency;Receiving, sorting, collecting, and clearing checks.

How Currency is Distributed

There are two principal ways by which any indi-vidual gets paper money and coin. Either he draws itout of his bank and has it charged to his account; or

79



he is paid for his labor, his services, or his merchandisewith money that has been drawn out of a bank bysomeone else. Practically all money, therefore, passesinto and out of banks at one time or another.

There are times when banks are called on to pay outmore currency than they receive and there are timeswhen they receive more than they pay out. In agricul-tural regions there is a heavy demand for currency attimes when crops are being harvested; in cities there isa heavy demand for currency at certain times in thesummer. Moreover, the demand varies for differentkinds of currency. Some communities use more cointhan others and less paper money, and some use more ofcertain denominations than others do.

In accordance with this demand, banks providethemselves with the amounts and kinds of currencythat the people in their communities want. Memberbanks depend upon the Federal Reserve Banks for re-plenishment of their supply, ordering what they re-quire and having it charged to their reserve accounts.Nonmember banks generally get their supplies frommember banks.

The twelve Federal Reserve Banks in turn keep alarge stock of all kinds of paper money and coin onhand to meet this demand. This includes both FederalReserve notes, which are their own liabilities, and coin,silver certificates, and United States notes, which theyobtain from the Treasury, giving the Treasury creditin its checking account for the amounts obtained.

Before establishment of the Federal Reserve Banksin 1914, the means of furnishing currency for circula-tion were unsatisfactory. A gap existed between theTreasury and the banking system, and demand for in-creased circulation could not always be met promptly.


SERVICE FUNCTIONS 81

This was the case in the panic of 1907, and as alreadyindicated the experience of that year was one of thethings that led to formation of the Federal ReserveSystem. The currency mechanism provided under theFederal Reserve Act has worked satisfactorily—cur-rency moves into and out of circulation automaticallyin response to increase or decrease in the public de-mand. The Treasury, the twelve Federal ReserveBanks, and the thousands of local banks throughoutthe country form a system of currency distributionthat reaches every community, that enables currencyto be furnished promptly where it is needed, and thatalso enables surplus currency to be retired from cir-culation at times when the public demand subsides.

Collections, Clearances, and Transfers of Funds

Currency is indispensable, yet it is used only for thesmaller transactions of present-day economic life. Ahundred years ago it was used much more generally.Since then the use of bank deposits has increased tosuch an extent that payments made by check are nowmany times greater than payments made with papermoney and coin.

The use of deposits is facilitated by the service ofthe Federal Reserve Banks in clearing and collectingchecks through the reserve accounts of member banks.For example, suppose that a manufacturer in Hart-ford, Connecticut, sells $1,000 worth of electrical equip-ment to a dealer in Sacramento, California, and re-ceives in payment a check on a bank in Sacramento.The check is an order on the Sacramento bank to paythe Hartford manufacturer $1,000. Obviously, theHartford manufacturer does not want to make a tripto California to collect the $1,000, nor does he want to



pay postage and insurance on a shipment of currency.He does not ordinarily want currency at all. What hewants is to have $1,000 placed to his credit in hischecking account. Accordingly, he deposits the checkin his Hartford bank. The Hartford bank does notwant currency for the check; it wants credit in its re-serve account at the Federal Reserve Bank of Boston.Accordingly, it sends the check to the Federal ReserveBank of Boston. The Federal Reserve Bank of Bostonsends it to the Federal Reserve Bank of San Francisco.The Federal Reserve Bank of San Francisco sends itto the bank in Sacramento. The bank in Sacramentocharges the check to the account of the depositor whowrote it, and either remits the amount to the FederalReserve Bank of San Francisco or authorizes the SanFrancisco Reserve Bank to charge the amount to itsreserve account. The Federal Reserve Bank of SanFrancisco thereupon credits the Federal Reserve Bankof Boston. The Federal Reserve Bank of Boston inturn credits the account of the Hartford bank. Thusthe check effects the transfer through the Federal Re-serve Banks of $1,000 of deposit credit from the check-ing account of the dealer in Sacramento to the check-ing account of the manufacturer in Hartford.

Since promptness is important in collecting checks,the Federal Reserve Banks extend to member bankshaving a substantial volume of checks payable in otherFederal Reserve districts the privilege of sending suchchecks direct to other Federal Reserve Banks for col-lection. The Hartford bank might, therefore, haveforwarded the $1,000 check direct to the Federal Re-serve Bank of San Francisco for collection, at the sametime informing the Federal Reserve Bank of Bostonof its action. Credit would then have been given to



the Hartford bank's reserve account by the FederalReserve Bank of Boston on the basis of this informa-tion just as if the check had been sent through Boston.

The Federal Reserve Banks and the AmericanBankers Association cooperate closely in improvingcheck collection practices. Together they have de-veloped the practice now followed of reporting by wirethe nonpayment of any check for $1,000 or more.Therefore, if the $1,000 check received by the Hart-ford manufacturer had been dishonored for any reason,he would have been notified promptly of this fact bywire. Another practice similarly sponsored is that ofusing a check routing symbol. This is the denominatorof the fractional number printed in the upper right-hand corner of many checks. This symbol tells transitclerks at a glance where each check should be sent tofacilitate its prompt presentation. The check routingsymbol makes it possible for checks to be routed moreaccurately and more speedily.

Even though a bank is not a member of the FederalReserve System, it may nevertheless arrange to main-tain with the Federal Reserve Bank what is called a"clearing balance." Checks drawn on other bankswhich are received by the nonmember bank and for-warded by it to the Reserve Bank may be credited tothis clearing balance, and checks drawn against thenonmember bank and deposited in other banks may bepaid with funds from the balance.

Checks which are collected and cleared through theFederal Reserve Banks must be paid in full by thebanks on which they are drawn, without deduction ofa fee or charge. That is, they must be paid "at par."The Federal Reserve Banks have greatly shortenedand simplified the process of clearing and collecting



checks. By doing so, they have improved the meansby which goods and services are paid for and by whichmonetary obligations are settled; they have also re-duced the cost to the public of making payments andtransferring funds. The Federal Reserve Banks alsohandle other items for collection besides checks, suchas drafts, promissory notes, and bond coupons.

In order to make transfers and payments as promptlyand efficiently as possible, the twelve Federal ReserveBanks maintain a gold certificate fund in Washingtoncalled the Interdistrict Settlement Fund, in which eachReserve Bank has a share. Through this fund moneyis constantly being transferred by telegraphic orderfrom the account of one Reserve Bank to that of an-other. Many millions of dollars of transfers and pay-ments are made every day, including large transfers formember banks and for the United States Treasury.

Supervisory Functions

Each of the Federal Reserve Banks has an examin-ing staff for the examination of State member banksin its district. The Federal Reserve Banks themselvesare examined by the examining staff which the Boardof Governors maintains.

Among other supervisory powers exercised by theFederal Reserve authorities with respect to banks arethe following:

1. The power to take disciplinary action, includingthe following specific powers: to remove officers anddirectors of member banks—after citation in the caseof national banks by the Comptroller of the Currencyand in the case of State member banks by the FederalReserve Agent—for continued violation of banking lawor for continued unsafe or unsound banking practice;



and to suspend member banks from recourse to thecredit facilities of the Federal Reserve System if it isfound that they are making undue use of bank creditfor speculation in securities, real estate, or commodi-ties.

2. The power to grant permits to national banks toexercise trust powers.

3. The power to grant permits to holding companiesso that they may vote the stock of member banks con-trolled by them. Such companies are usually corpora-tions which own a majority of the stock of one or moremember banks.

4. The power to permit member banks to engage inbanking abroad by establishing branches in foreigncountries and by investing in the stock of corporationsorganized under the provisions of State laws or ofSection 25(a) of the Federal Reserve Act (so-calledEdge Act corporations) to engage in international orforeign banking. With the Board's permission, sevenlarge banks situated in New York, Boston, and SanFrancisco were maintaining foreign branches in June1947, about seventy-five in all, situated in twenty-onedifferent countries; four of the corporations were oper-ating six branches and two fiduciary affiliates in fourforeign countries; and two corporations were conduct-ing their foreign banking business in New York.

Fiscal Agency Functions

The twelve Federal Reserve Banks carry the princi-pal checking accounts of the United States Treasury,handle much of the work entailed in issuing and re-deeming Government obligations, and perform numer-ous other important fiscal duties for the United StatesGovernment.



The Government has an enormous amount of bank-ing business to do. I t is continuously receiving andspending funds in all parts of the United States. Itsreceipts come mainly from taxpayers and purchasersof Government securities and are deposited in theFederal Reserve Banks to the credit of the Treasury.Its funds are disbursed mostly by check, and thechecks are charged to the Treasury's account by theFederal Reserve Banks.

The Federal Reserve Banks also perform importantservices for the Treasury in connection with the publicdebt. When a new issue of Government securities issold by the Treasury, the Reserve Banks receive theapplications of banks, dealers, and others who wish tobuy, make allotments of securities in accordance withinstructions from the Treasury, deliver the securitiesto the purchasers, receive payment for them, and creditthe amounts received to the Treasury's checking ac-count. The Reserve Banks also redeem securities asthey mature, make exchanges of denominations orkinds, handle transfers and conversions, pay interestcoupons, and do a number of other things involved inservicing the Government debt. They issue and redeemUnited States savings bonds and upon request holdthem in safekeeping for the owners. For the conven-ience of the Treasury and also for the convenience ofinvestors in Government securities, it is necessary thatthere be facilities in various parts of the country tohandle such transactions, and the Federal ReserveBanks furnish these facilities. Since the Federal Re-serve authorities are constantly in touch with themoney and investment markets, the Treasury followsthe practice of consulting them for their advice as tothe terms and conditions that will affect the sale andthe refunding of Government obligations.



Under instructions from the Treasury, each FederalReserve Bank manages the war loan deposit accountsof banks in its district. These accounts are so calledbecause they were authorized during World War I toexpedite the Government's wartime financing; theycontinued to be used during peace years, and duringWorld War II the Treasury's financing program againmade them very important. Nonmember banks aswell as member banks of the Federal Reserve Systemmay become "special depositaries" of the Treasuryand carry war loan deposit accounts by complyingwith the Treasury's requirements. The principal re-quirement is the pledge with a Federal Reserve Bank,as fiscal agent of the Treasury, of Government securi-ties or other acceptable collateral that will fully securethe balance in the account. A bank designated as awar loan depositary credits to the war loan account theproceeds of its customers' and its own subscriptionsto Government securities issued by the Treasury fromtime to time. As the Treasury calls for the funds, theyare transferred to a Treasury account at a FederalReserve Bank and become available for disbursement.War loan deposit accounts are a convenient and practi-cally indispensable device for the sale of Governmentsecurities in large volume. They greatly facilitatethe payments for the securities purchased and theTreasury's receipt of the payments.

In connection with the lending and other financialactivities of such Government agencies as the Recon-struction Finance Corporation and the CommodityCredit Corporation, the Federal Reserve Banks act ascustodians of collateral and securities. This involvesnot only safekeeping but disbursement of funds uponreceipt of proper documents and maintenance of accu-



rate records of large quantities of securities, warehousereceipts for commodities, and other valuable paperswhich are constantly in process of being received,transferred, and returned, as loans are granted, aspartial payments are made, and as maturing obliga-tions are paid off or renewed.

The Federal Reserve Banks are reimbursed by theUnited States Treasury and other Government agen-cies for much of the expense incurred in the perform-ance of fiscal agency functions.

Because of its situation in one of the principal finan-cial centers of the world, the Federal Reserve Bank ofNew York acts as the agent of the United States Treas-ury in gold and foreign exchange transactions. It actsas depositary for the International Monetary Fundand the International Bank for Reconstruction andDevelopment; it receives deposits of foreign govern-ments and central banks and performs certain inci-dental services as their correspondent. These servicesinclude handling their short-term investments in thismarket and holding gold under earmark for them inthe United States. All the Federal Reserve Banksparticipate in the foreign accounts carried on the booksof the Federal Reserve Bank of New York, which, inthese matters, acts as agent for the other Federal Re-serve Banks. The Board of Governors in Washingtonexercises special supervision over all relationships andtransactions of Federal Reserve Banks with foreignbanks and governments and with the InternationalMonetary Fund and the International Bank.

The service functions that have been described ab-sorb the attention and time of the greater part of theFederal Reserve Bank personnel.


CHAPTER X

BALANCE SHEET OF THE FEDERAL RESERVEBANKS

The credit operations of the Federal ReserveBanks are reflected in their balance sheet. Com-parisons for different dates reflect changes in fun-damental monetary conditions.

T HE major credit functions described in the pre-ceding chapters are reflected in the balance sheet

of the twelve Federal Reserve Banks, which is madepublic every Friday and shows the condition of theReserve Banks on the Wednesday immediately preced-ing. The statement appears in the Friday issue of theprincipal daily newspapers of the country and is usuallyaccompanied by explanatory comment, particularly asto changes in member bank reserves and related factors.

The statement as of December 31, 1946, in con-densed form for the most part but with a few itemsthat are not included in the statement published regu-larly, is given on the following page. Only the mostimportant items are shown separately.

Explanation of Asset Accounts

1. GOLD CERTIFICATES on hand and due from theUnited States Treasury. The law does not permit theFederal Reserve Banks to own gold and forbids the useof gold or gold certificates in circulation, but it author-izes the Treasury to issue gold certificates to the Fed-eral Reserve Banks for the gold it acquires. In ex-change for these certificates the Treasury obtains creditin the checking accounts it maintains with the FederalReserve Banks. The Federal Reserve Banks do not

89



hold any large amount of gold certificates, however,their actual receipt being unnecessary and cumber-some; instead the Reserve Banks and the Treasurykeep a book record of gold certificates due the Federal

BALANCE SHEET OF THE RESERVE BANKS, DECEMBER 31, 1946

MillionsASSETS of

dollars1. GOLD CERTIFICATES on hand and due from U. S. Treasury 18,3812. Other cash 2683. U. S. GOVERNMENT SECURITIES 23,3504. DISCOUNTS FOR MEMBER BANKS 165. Acceptances purchased6. Loans on gold 1477. Other earning assets 18. Uncollected items 2,7639. Miscellaneous assets 80

TOTAL ASSETS 45,006

LIABILITIES

10. FEDERAL RESERVE NOTES 24,94511. Deposits:

a. RESERVES OF MEMBER BANKS 16,139b. U. S. Treasurer's account 393c. Other deposits 822

12. Deferred availability items 2,02013. Miscellaneous liabilities 9

TOTAL LIABILITIES 44,328

CAPITAL ACCOUNTS

14. Capital stock 18715. Surplus . 46716. Other capital accounts 24

TOTAL LIABILITIES AND CAPITAL ACCOUNTS 45,006

Reserve Banks. This account includes both therelatively small amounts of certificates actually de-livered to the Federal Reserve Banks and the muchlarger amount due them from the Treasury. The pro-cedure is a method by which the Government makesmonetary use of its gold; instead of putting the golditself in circulation, the Treasury pledges it while re-


BALANCE SHEET OF RESERVE BANKS 91

taining physical possession of it. The arrangement givesthe Reserve Banks an asset in the form of a claim onthe United States Treasury, evidenced on the booksof the Treasury.

To meet the requirements of the law, a portion ofthe gold certificates due the Reserve Banks is set asideas a redemption fund for Federal Reserve notes; theamount of this fund, which was 794 million dollars onDecember 31, 1946, is included in the total shown onthe statement.

2. Other cash is coin and paper money (excludinggold certificates and Federal Reserve notes) in theReserve Bank vaults.

3. UNITED STATES GOVERNMENT SECURITIES com-prise Treasury bills, Treasury certificates, Treasurynotes, and United States bonds. Since Reserve Bankpurchases of securities, as explained in earlier chap-ters, are a means of creating Reserve Bank credit—and in recent years the most important means—theamount of securities held also measures the amountof Reserve Bank credit created by such purchases.Accordingly, it is one of the most significant items ofthe Reserve Bank statement and reflects one of themost important aspects of the central banking func-tion. Open market transactions are authorized by theFederal Reserve Act, Sections 12A and 14.

All United States securities owned by the ReserveBanks on December 31, 1946, had been purchased bythem from previous owners—banks, dealers in securi-ties, and others. The law authorizes the Reserve Banksto hold at any one time as much as 5 billion dollars ofGovernment obligations acquired directly from theTreasury. Such direct transactions are infrequent,however; during the year 1946 they did not occur at all.

4. DISCOUNTS FOR MEMBER BANKS. This item shows



the amount of Federal Reserve Bank credit created bylending to member banks.

5. Acceptances purchased. These are prime bankers'acceptances purchased by the Federal Reserve Banksat the established buying rate when offered for sale bybankers, dealers, and others. At the date of this state-ment the Federal Reserve Banks held no acceptances.These purchases are authorized by the Federal ReserveAct, Section 14, paragraph 1.

6. Loans on gold. These are loans made to foreigncentral banks and foreign governments on the securityof gold owned by them. These loans are authorized bythe Federal Reserve Act, Section 14, paragraph 2.

7. Other earning assets in recent years have com-prised loans to provide working capital for industry,as authorized by Section 13(b) of the Federal ReserveAct, and advances to individuals, partnerships, andcorporations on the security of direct obligations ofthe United States, as authorized by Section 13, para-graph 13 of the Act.

8. Uncollected items are checks and other cashitems deposited with the Federal Reserve Banks andstill in process of collection at the time the statementis made up.

9. Miscellaneous assets consist of several items, ofwhich the principal are the bank premises owned bythe Federal Reserve Banks, the premium on securitiesowned, and accrued interest receivable.

Explanation of Liabilities and Capital Accounts

10. FEDERAL RESERVE NOTES, which constitute theprincipal part of currency in circulation, have beendescribed in previous chapters.

11. Deposits consist mainly of the RESERVES OF



MEMBER BANKS. They also include checking accountsof the United States Treasury and other governmentalagencies, deposits of foreign banks, and clearing ac-counts maintained by nonmember banks authorized bySection 13 of the Federal Reserve Act.

12. Deferred availability items are of technical sig-nificance. The account arises from the fact that Fed-eral Reserve Banks do not give immediate credit forall checks deposited with them for collection, thecredit being deferred according to a time schedulewhich allows for the time taken by the checks ingoing through the mail to the banks upon which theyare drawn. Since the time actually taken is oftengreater than allowed in the schedules, the result isthat some credit is given before the checks are col-lected. This is reflected in the fact that "uncollecteditems," shown among the assets (No. 8), is generallyconsiderably larger than "deferred availability items."The difference represents an amount of credit beingextended by the Federal Reserve Banks and is usuallyreferred to as Federal Reserve Bank "float."

13. Miscellaneous liabilities consist of several items,the principal ones being discount on bills and securi-ties, miscellaneous accounts payable, and accrueddividends.

14. All of the capital stock of the Federal ReserveBanks is owned by banks that are members of theFederal Reserve System. See Chapter V.

15. Surplus is governed by Sections 7 and 13b ofthe Federal Reserve Act. Section 7 surplus isaccumulated from the earnings derived by the Re-serve Banks from their loans and investments. Ordi-narily these earnings are adequate to cover the expensesof the Reserve Banks, the 6 per cent per annum



dividend payable to member banks, and additions tosurplus. Around the year 1920 and again in very re-cent years the net earnings of the Federal ReserveBanks were large; but at other times they have beenrelatively small. Some of the Federal Reserve Banksin certain years have operated at a loss. The surpluscan be drawn on to meet deficits and pay dividends inyears when operations result in loss, but it cannot bedistributed otherwise to the stockholding memberbanks. The law provides that, if the Reserve Banksare dissolved, any surplus is to be paid to the UnitedStates.

Section 13b surplus represents funds received fromthe Secretary of the Treasury for the purpose of makingloans to industry in accordance with Section 13b ofthe Federal Reserve Act, plus or minus the net earningsor net loss arising from using such funds. This surplusamounted to 27 million dollars at the date of thestatement.

16. Other capital accounts at the date of thisstatement comprised only reserves for contingenciesamounting to 24 million dollars. At other times it willinclude also unallocated net earnings for the year tothe date of the statement.

Historical ComparisonIt is plain from a glance at the statement that four

accounts are by far the largest, namely, gold certificatesand Government securities, (1) and (3) among theassets, and Federal Reserve notes and reserves of mem-ber banks, (10 and 11a) among the liabilities. Theseaccounts are also the most significant, for they reflectthe essential central banking operations of the FederalReserve Banks, as described in preceding chapters. In



the course of years these accounts have undergone im-portant changes in volume resulting from changedeconomic and monetary conditions generally; and toindicate these changes the figures at the end of 1920,1930, 1940, and 1946 are tabulated as follows:

COMPARISON OF BALANCE SHEETS OF FEDERAL RESERVE BANKS INFOUR DIFFERENT YEARS

(In millions of dollars, as of December 31)

1 Includes gold owned by Federal Reserve Banks.2 Includes 217 million dollars of so-called Federal Reserve "Bank

notes," which are no longer issued.3 Included in "miscellaneous liabilities."

Account

ASSETS1. Gold certificates on hand and

due from U. S. Treasury. . .2. Other cash3. U. S. Government securities. .4. Discounts for member banks. .5. Acceptances purchased6. Loans on gold7. Other earning assets8. Uncollected items, etc9. Miscellaneous assets

Total assets

LIABILITIES10. Federal Reserve notes11. Deposits

a. Reserves of member banks.b. U. S. Treasurer's account. .c. Other deposits

12. Deferred availability items. . .13. Miscellaneous liabilities

Total liabilities

CAPITAL ACCOUNTS14. Capital . .15. Surplus, Sec. 7. . .16 Surplus Sec 13b17. Other capital accounts

Total liabilities and cap-ital accounts

1920

1 2,060264287

2,687260

66828

6,254

23,553

1,7815723

51919

5,952

100202

(3)

6,254

1930

1 2,941220729251364

860781

5,201

1,663

2,4711928

56411

4,756

170275

(3)

5,201

1940

19,760275

2,1842

18

94488

23,262

5,931

14,026368

1,732833

2

22,892

1391572747

23,262

1946

18,381268

23,35016

1471

2,76380

45,006

24,945

16,139393822

2,0209

44,328

1874402724

45,006



The first thing to be noted in this tabulation is thata number of items, including several of the most im-portant, have greatly increased since 1920. On theother hand, one important account, discounts for mem-ber banks, is much smaller than it used to be.

GOLD CERTIFICATES. The increase in the amount ofgold certificates reflects the enormous increase in thiscountry's stock of gold that occurred principally in thedecade between 1930 and 1940. It also reflects the re-valuation of gold in terms of dollars. In 1934, by theterms of the Gold Reserve Act the value of gold waschanged from $20 an ounce to $35 an ounce and therebythe value of the stock of monetary gold in the UnitedStates was raised from 4 billion to about 7 billiondollars. Domestic production of gold also increased thestock, but by far the greatest factor was the shipmentand sale of foreign gold to this country. Between Janu-ary 31, 1934 and December 31, 1940, imports of goldexceeded exports by more than 14 billion dollars. TheTreasury purchases all gold produced in the UnitedStates or imported. By issuing gold certificates to theFederal Reserve Banks, as has been explained earlier,the Treasury obtains credit in the checking accountsit maintains with those Banks.

During the war the country's stock of gold declinedsomewhat but more recently it has been growingrapidly. The sale of gold by the Treasury entailsreduction in the amount of gold certificates issuableby it to the Federal Reserve Banks.

GOVERNMENT SECURITIES and DISCOUNTS FOR MEM-BER BANKS. The increase in United States Govern-ment securities reflects several important develop-ments. In 1920, Federal Reserve Bank credit wasbeing furnished mainly in the form of discounts for



member banks, but a few years later member bankshad to a great extent ceased to borrow at the ReserveBanks. At the same time, open market purchases ofGovernment securities had become important as ameans of supplying member banks with the reservesthey had previously obtained by rediscounting.

Between 1930 and 1940, member banks borrowed atthe Reserve Banks less than in the decade before, andthe Federal Reserve authorities purchased more Gov-ernment securities. The increased purchases occurredmainly in the years 1931, 1932, and 1933, when theReserve Bank holdings rose from 729 million dollarsat the close of 1930 to 2,437 million at the close of1933. This was the period of economic depression andbanking weakness that culminated in the crisis ofMarch 1933, and the Reserve authorities bought securi-ties for the purpose of easing the money market andoffsetting the decline in the volume of money that re-sulted from liquidation of bank loans. The ReserveBank portfolio of Government securities remainedclose to 2,500 million dollars till the end of the decade.

The more recent increase between 1940 and 1946in the amount of Government securities held occurredprincipally in the years of United States participationin the war, 1942-1945. In this period the public debtgrew from 58 billion to 278 billion dollars, Govern-ment securities were regularly offered in the market,and the Reserve authorities were under obligation tokeep the market orderly and stable. The principaldrain on member bank reserves during this periodarose from the extraordinarily large demand for cur-rency. Federal Reserve Bank holdings of Governmentsecurities became very large during this period, reach-ing a high point of nearly 25 billion dollars in thelatter part of 1945.



FEDERAL RESERVE NOTES. The volume of FederalReserve notes outstanding was unusually high in 1920.In that year, which was one of high prices, the amountof currency in circulation was larger than ever before,and Federal Reserve notes made up by far thegreater part of total circulation. For the remainderof the decade the volume of notes was substantiallyless. But in 1931, 1932, and 1933 it greatly increasedas a result of the banking weakness of that period andthe general withdrawal of deposits from banks in cur-rency. Thereafter the amount rose steadily until1940. In 1940 the volume of Federal Reserve notes be-gan to increase far more rapidly than at any previoustime, in response to accelerated demand for currency.At the end of the war in 1945 the total currency incirculation was over 28 billion dollars. This wartimeincrease arose from several causes, the most importantof which were that employment was general, wageswere high, and a relatively large number of personskept more money on hand than usual. The volume ofFederal Reserve notes is directly affected by the publicdemand for currency. When more currency is wanted,the public obtains it through the banks, and theamount of Federal Reserve notes increases; when thepublic wants less it returns the surplus through thebanks and the amount decreases.

RESERVES OF MEMBER BANKS. Increases that haveoccurred since 1920 in the country's gold stock and inthe amount of Reserve Bank credit have tendeddirectly to augment the volume of member bank re-serves. On the other hand, member bank reserves aredirectly reduced when depositors withdraw currencyfrom banks. Hence, roughly speaking, bank re-serves equal the total of monetary gold and Re-



serve Bank credit, less the amount of currencyin circulation. Since all three of these formativeelements reflect in some way the basic economic andpolitical conditions of the whole world, so too do mem-ber bank reserves. For instance, the tremendousgrowth in the monetary gold stock between 1930 and1940 reflected the unsettled conditions that were driv-ing gold to the United States from other countries; thegreat expansion in Reserve Bank credit that resultedchiefly from purchases of United States Governmentsecurities during World War II reflected the immenseincrease in the public debt necessitated by participa-tion in a global war; and the expansion of currencyin circulation during the war reflected the magnitudeof the war effort on the home front. The volume ofmember bank reserves, therefore, is not the productof domestic policy alone; indirectly it is also theproduct of conditions arising from developments allover the world.

The relation of member bank reserves to the otheraccounts in the Federal Reserve Bank statement maybe illustrated by adding together gold certificates andFederal Reserve Bank credit and subtracting from thetotal the amount of Federal Reserve notes. The re-mainder, as shown in the following examples takenfrom statements for the years indicated, is not greatlydifferent from the amount of member bank reserves.

1920 1930 1940 1946Gold certificates, etc 2,060 2,941 19,760 18,381U. S. Government securities 287 729 2,184 23,350Discounts for member banks 2,687 251 2 16

Total 5,034 3,921 21,946 41,747Federal Reserve notes 3,553 1,663 5,931 24,945

Remainder 1,481 2,258 16,015 16,802Reserves of member banks 1,781 2,471 14,026 16,139



To account for differences between the actualamount of member bank reserves and the remaindershown by addition and subtraction of the other itemswould require the introduction of numerous items nototherwise relevant to this discussion. It is sufficientfor present purposes that the existence of a close rela-tion between member bank reserves and the otheraccounts be understood.

The principal other changes in the Federal ReserveBank statement over a period of years have occurred initems 8 and 12 ("uncollected items" and "deferredavailability items"). The recent great increase inthese accounts, which reflect the volume of bank checksdeposited with the Federal Reserve Banks and in proc-ess of collection, is a consequence of the greatly in-creased volume of monetary payments in recent years.


CHAPTER XI

BANKING AND MONETARY AGENCIES OTHER THANTHE FEDERAL RESERVE

There are several agencies other than the Fed-eral Reserve with junctions and responsibilitiesin the same general field but no other that hasthe primary responsibility for regulating themoney supply.

SINCE the Federal Reserve System is not the onlyofficial agency in the monetary and banking field,

its operations cannot be fully understood withoutsome reference to certain other agencies. The mostimportant of these are the Treasury Department, theOffice of the Comptroller of the Currency, the FederalDeposit Insurance Corporation, the State bank super-visors, certain Government agencies that make loansand that guarantee loans made by banks, and certaininternational lending organizations. These are de-scribed briefly in the following paragraphs.

The Treasury is the Government department withwhich the Federal Reserve System* is most closelyrelated. The reason for this is twofold. In the firstplace, a great part of the work of the Federal ReserveBanks is performed by them as fiscal agents of theTreasury; and in the second place, the Federal Re-serve authorities have the responsibility of regulatingcredit conditions in general and particularly those inthe money market, where the 'Treasury constantlygoes to borrow money. It is important to the Treasurythat Government financing be facilitated by themaintenance of a stable and orderly market for Gov-ernment securities and it is important to the Federal

101



Reserve that the nature and timing of Treasury offer-ings and redemptions be in harmony with currentmonetary policies. The Treasury also has specialor occasional operations—for example, the purchaseand sale of gold and silver—that affect bank reservesand hence the responsibilities of the Federal Reserveauthorities. The close relationship of Treasury andFederal Reserve functions makes necessary a constantcooperation between the two organizations, apart fromthe fact that the Federal Reserve Banks are fiscalagents of the Treasury.

The Office of the Comptroller of the Currency is abureau of the Treasury Department. It was establishedin 1863 to supervise the system of national bankswhose organization under Federal charter was author-ized that year. When the Federal Reserve System wasestablished fifty-one years later and national banks inthe continental United States were required to becomemembers of the System, they became subject to regu-lations of the Federal Reserve authorities also.

The Federal Deposit Insurance Corporation wasestablished in 1933. Deposits in national and Statebank members of the Federal Reserve System are in-sured up to $5,000 for each depositor, as are the depositsof nonmember banks that voluntarily qualify for in-surance. At the present time most of the nonmemberbanks are qualified. Banks whose deposits are insuredby the Corporation are in certain respects subject toits regulations and insured nonmembers are subject toexamination by it.

In addition to the two Federal agencies just men-tioned, each of the forty-eight States supervises banksincorporated under its law. In this situation, it isnecessary for the various agencies with supervisory


OTHER BANKING AND MONETARY AGENCIES 103

responsibilities to cooperate and consult with one an-other for the development of consistent standards andprocedures in bank examination.

Congress has given certain powers to make loans,largely with public funds, to a number of Federalagencies. These agencies are principally the Recon-struction Finance Corporation, which under certainconditions is authorized to lend to business enterprises,financial institutions, municipalities, and public agen-cies and corporations; a group of agricultural creditagencies under the Farm Credit Administration, whichmake various types of agricultural loans; the RuralElectrification Administration, which makes loans toencourage the use of electricity in rural areas; and theExport-Import Bank, which makes loans, mostly for-eign, to promote the export and import trade of theUnited States. The Federal Reserve Banks are author-ized to act as fiscal agents of many of these organiza-tions. The loans made by these and other agencies areintended to supplement the lending activities of com-mercial banks, particularly in fields where the latterare inhibited from making loans by law, custom, or thenature of the risk. Besides making loans, some of theforegoing Federal agencies and certain others havebeen authorized by Congress to guarantee and insureloans made by banks and other financial institutions.In particular, the Veterans' Administration has beenauthorized to guarantee and insure loans (so-called"G.I." loans) that may be obtained from banks andother institutions by veterans of World War II, andthe Federal Housing Administration, under certainconditions, can insure home mortgage loans made bybanks and other financing institutions.

Two international institutions, the International



Monetary Fund and the International Bank for Re-construction and Development, which have offices inWashington, D. C, have functions that relate themclosely to the Federal Reserve System. They are notpart of the American banking and monetary system,but they affect the domestic money market throughtheir operations in gold and through the influence theyhave on the demand for credit in this country. TheUnited States shares with other nations the ownershipand control of these two institutions and has repre-sentatives on their directing bodies appointed by thePresident with the Senate's approval. In order to co-ordinate the policies and operations of these repre-sentatives and of all agencies of the Government thatmake foreign loans or engage in foreign financialtransactions, Congress has established the NationalAdvisory Council on International Monetary andFinancial Problems, whose members are ex officio theSecretary of the Treasury, who is Chairman of theCouncil, the Secretary of State, the Secretary of Com-merce, the Chairman of the Export-Import Bank, andthe Chairman of the Board of Governors of the Fed-eral Reserve System. Any Federal Reserve Bank,upon request of the International Monetary Fund andthe International Bank, may act as the depositary andfiscal agent of these institutions.


CHAPTER XnWAR SERVICE OF THE FEDERAL RESERVE

During the war the primary duty of the Federal Reserve was to facilitate the financing of military requirements and of production for war purposes.

IN time of war the duty of the Federal Reserve, as of everyone, is to support the country’s war effort.

The Federal Reserve provides machinery for aiding the Government to finance the enormous expenditures necessitated by war. The United States has participated in two world wars since the establishment of the Federal Reserve, and in both wars the Reserve System has taken an active part in helping to finance the requirements of the Government. The amount of money to be spent to fight a war is determined by Congress, which also has the responsibility of deciding how much of the money shall be raised by taxation. The difference between the revenue raised by taxes and total expenditures has to be met by borrowing. It is the responsibility of the Treasury Department to determine the character of obligations on which the Government will borrow and the rate of interest it will pay to investors. In these matters the Federal Reserve is consulted and makes recommendations, particularly with respect to how the war needs may be met with as little inflationary effect as possible. After policy decisions have been made, it is the duty of the Federal Reserve to see to it that the banking system is in a position to absorb any public debt essential for war expenses that is not purchased by investors other than banks.

105



It was the policy of the Treasury and the Federal Reserve during the war to make every effort to encourage nonbank investors to absorb as much as possible of the public debt, and to leave as little as possible for the banks. The reason for this is apparent from preceding chapters. When an individual or a corporation pays taxes or buys a Government bond, the Treasury comes into possession of money that was already in existence and owned by the taxpayer or bond purchaser. There is no addition to the money supply and no additional upward pressure on prices, except to the extent that funds previously held idle may have been put to use, or to the extent that the bond buyer or taxpayer borrows from a bank to pay taxes or to buy Government securities. As the Treasury acquires more money with which to buy war goods, someone else has correspondingly less money to spend on civilian goods. When, however, a bond is bought by the banking system, no one gives up his money to the Government; new money is created in the form of a bank deposit to the credit of the Government. As the Government spends this money and it passes into the hands of the public, it is added to the general money supply and becomes available for the purchase of such civilian goods as are in the market.

Since production for civilian use is limited in wartime by the concentration of the nation’s effort on production for war purposes, the additional money arising from bank purchases of Government bonds may result in more money for civilian purchases than there are goods and services to be bought at existing prices. The extra money cannot lead to increased output, since the industrial plant and manpower are already in use to their full capacity. Consequently, if


WAR SERVICE OF FEDERAL RESERVE 107

the extra money is used, it results in an upward pressure on prices. It becomes an inflationary influence, which during the war is held in check by direct controls over prices, by rationing, and by allocation of materials.

In order to avoid or minimize this inflationary pressure during the war, many things were 'done to channel Government bonds into the hands of individuals and corporations; in other words, to have the bond purchases absorb existing and current savings rather than bring additional money into existence. Campaigns to place War Savings bonds, drives to sell war bonds, and other measures were actively pursued by the Treasury and supported by the Federal Reserve. But the Federal Reserve had the responsibility for seeing that the banks had enough funds to absorb the Government securities that were not taken by nonbank purchasers. Prevention of inflation had to become secondary to providing the sinews of war. The Federal Reserve was able to regulate security loans and consumer credit by methods which did not interfere with the total supply of money and to use its influence to discourage speculative purchases of Government securities by the use of bank credit. But it had to suspend the use of general methods of restraining the growth in the money supply.

At the outbreak of the war the Federal Reserve declared its determination to see to it that banks had adequate funds for war needs. This undertaking was carried out throughout the war period. For the purpose the Federal Reserve established a low rate for discounts based on short-term Government securities. It agreed to purchase, at a fixed rate of % per cent, all three-month Treasury bills offered in the market,



and by open market purchases supported all Treasury issues that needed support. With this assistance from the Federal Reserve, the Treasury was able to meet the enormous war needs of the Government at extremely low rates and to maintain at all times a strong market for United States Government obligations.

In addition to this the Federal Reserve acted as the agent of the Government in its undertaking to guarantee or provide bank loans to contractors who could not otherwise have financed production for the war effort. This service, which employed the organization and contacts of the Federal Reserve in efficiently directing many billions of dollars into war production, made an important contribution to the war effort.

By cooperation of the War Department, the Navy Department, and the Maritime Commission with the War Production Board and the Federal Reserve authorities, an arrangement was developed, and authorized by Executive Order of the President, for insuring or guaranteeing loans that were needed to finance essential war production. The loans were made by commercial banks or other lending institutions which, to protect..themselves from excessive risk, often obtained guarantees covering portions of loans. The guarantee was given by the War Department, the Navy Department, or the Maritime Commission, depending on which was primarily interested in the contract which the loan was to finance. The Federal Reserve Banks acted as their agents.

For example, a manufacturer may have had machinery for the production of cartridges but not money enough to buy the necessary materials or to pay the necessary wages. A commercial bank may not have


WAR SERVICE OF FEDERAL RESERVE 109

felt justified in lending him the amount he needed unless it had a guarantee. In such a case the War Department, in order to obtain the cartridges, would be willing to give that guarantee, and the bank would be willing to pay a fee for it. An agreement would accordingly be made by which the War Department obligated itself to purchase 75 per cent or another designated portion of the loan upon the bank’s demand. The manufacturer would then be granted the loan and could begin making the cartridges ordered by the War Department. Such guarantees were authorized for 8,771 loans aggregating 10.3 billion dollars.

Aggregate results of financing the war may be summarized as follows: from the middle of 1940 to the end of 1945 the United States Government had to raise the incredibly large sum of 380 billion dollars, chiefly for war purposes. Of this amount, 153 billion was raised by taxation, 132 billion came from sales of securities to nonbank investors, and 95 billion was financed by bank credit. As a consequence, and notwithstanding the efforts to minimize bank participation in war finance, the total of bank deposits and currency increased 112 billion dollars, that is, about threefold, during the war. In addition, the public (including Federal and State government agencies and trust funds, insurance companies, other businesses, and individuals) holds 130 billion dollars of United States Government obligations, which it is in a position to sell or cash at any time and thereby to acquire more money with which to purchase goods and services. The inevitable heritage of war is an enormous expansion of money and a grave threat of inflation.

With the termination of the war the Federal Reserve must once more direct its policies toward regula


tion of the money supply. Its task is made extremely complex and difficult by the great financial dislocation caused by the war. The vast amount of Government securities held by individuals, corporations, endowments, and savings institutions, including insurance companies, makes it desirable to continue to protect these securities from wide variations in price. Furthermore, a rise in the cost of money would increase the cost of the debt to the Government, that is, to the taxpayers. While the interest rate at which the Government was able to borrow was low, the annual cost of the debt is nevertheless 5 billion dollars. If the general level of interest rates went up, the cost of the debt, as it came due and was refunded, would increase further. In these circumstances the Federal Reserve must rely in part on selective rather than general methods of control and must also develop new techniques adapted to new domestic and world conditions.

These serious problems are before the Federal Reserve at the present time and it is too early to describe the methods that it will be able to devise and be authorized to use in meeting the new situation. But, whatever changes in technique the Federal Reserve may have to adopt, its general objective remains unchanged. To repeat what has been said before, this objective is to contribute to the maintenance of stable production and values, high employment, and a rising standard of living.



CHAPTER XIII

SUMMARY

The Federal Reserve as it operates at present isthe product of constant adaptation to changingconditions. It has to deal today with monetaryproblems that are far different from those thatoccasioned its establishment.

THE basic powers of the Federal Reserve author-ities relate to money and banking. They are mone-

tary in that they deal with the means of payment,which consists in part of currency and in part ofdeposit credit.

Before the Federal Reserve System was organized,the outstanding defects of American banking werediagnosed as "inelastic currency" and "scattered bankreserves." Establishment of the System promptlycleared the way for the anticipated improvements.Elasticity of the currency was achieved. The machin-ery for note issue proved adequate for the purposeand in time was found to work almost automatically.For many years, including the war period, the volumeof currency in circulation has expanded and contractedsmoothly and efficiently in accordance with the vary-ing requirements of the public, and the currency func-tion of the Federal Reserve Banks has become a matterof routine, virtually free from uncertainties and diffi-cult administrative problems.

The reserve function, on the other hand, has assumedfar greater importance. It has come to be recognizedas much more than a matter of "pooling" or "mobiliz-ing" scattered reserves and making available to banksin need of funds the surplus reserves of banks that

111



have more than they need. It involves a power to createreserve funds and to extinguish them. If the funds lentby a Federal Reserve Bank, or paid by it for securities,were merely the funds deposited with it by its memberbanks, the loans and the purchases would not enlargethe total volume of reserve funds. In fact, however,they do enlarge the total volume of reserve funds. Byacquiring the obligation of a member bank or otherobligor and in exchange crediting an equivalent amountto the reserve balance of the member bank, a FederalReserve Bank expands its assets and its liabilities,and these continue expanded so long as the obligationis held. The action is creative.

This does not mean that the power of the FederalReserve authorities is unlimited. The law limits theirpower to expand their deposits—that is, the reservebalances of member banks—and to expand their noteissue by requiring that these liabilities not exceedfour times their holdings of gold certificates. More-over, Federal Reserve action does not result in an in-creased use of bank credit unless there is a demandfrom the public for the credit. The Federal Reserveauthorities are able to expand bank reserves to meetalmost any conceivable demand for credit once thatdemand comes into existence and also to discour-age a demand for credit when it shows signs ofdeveloping speculative excesses. They possess nomeans, however, of impelling bank customers to bor-row or of impelling bankers to lend.

The powers of the Federal Reserve to regulate thevolume of bank credit, or money, are one of the impor-tant factors in determining economic conditions. Thepurpose of Federal Reserve functions, like that ofgovernmental functions in general, is the public wel-


SUMMARY 113

fare. Federal Reserve policy must be viewed in thelight of its objective—which is to maintain monetaryconditions favorable for an active and sound use of thecountry's productive facilities, a high level of employ-ment, and a rate of consumption reflecting widely dif-fused well-being. In carrying out their policy, theFederal Reserve authorities take into account the fac-tors making up the prevailing situation and use theirpowers in the way that seems to them best calculatedto contribute, with other agencies, to economic stabilityand progress.

In review, the principal means through which theFederal Reserve authorities may exercise their powersover bank credit are the following:

DISCOUNTS. Through the power to raise or lowerReserve Bank discount rates and the power to discountand make advances, the Federal Reserve authoritiesare able to influence both the cost and availability ofbank credit and to supply individual banks with addi-tional reserve funds.

OPEN MARKET OPERATIONS. These operations di-rectly affect the volume of reserves: purchases of secu-rities by the Federal Reserve authorities supply bankswith additional reserve funds, and sales of securities di-minish the volume of such funds. As a means of creditexpansion, these operations are limited by the reserveposition of the Federal Reserve Banks, and at thecommercial bank level by the demand for bank credit.As a means of credit contraction, they are limited bythe amount of securities held by the Reserve Banks.

RESERVE REQUIREMENTS. Raising or lowering re-quirements as to the reserves which member banksmaintain on deposit with the Federal Reserve Bankshas the effect of diminishing or enlarging the volume of



funds that member banks have available for lending.Under existing law, the requirements may be raisedfrom the present level for New York and Chicagomember banks but not for other member banks; theymay be reduced by one-half at banks outside NewYork and Chicago and by about one-third at banksin those cities.

SELECTIVE CONTROLS. AS has been stated in earlierchapters, the foregoing powers directly affecting thevolume of member bank funds have no immediate effec-tiveness with respect to the utilization of those funds.In the field of stock market speculation, however, theReserve authorities exercise direct control. During thewar and early postwar period they also exercised directcontrol in the field of consumer credit. The Reserveauthorities may also exercise limited influence overthe credit practices of banks through bank supervisionand examination.

In addition to the credit functions described, theFederal Reserve Banks perform certain services ofwhich the most important are: holding member bankreserve balances; furnishing currency for circulation;facilitating the clearance and collection of checks andthe transfer of funds; and acting as fiscal agents, cus-todians, and depositaries of the United States Govern-ment.

In recent years the most important problems affect-ing Federal Reserve policy have arisen from war. Thecountry's war effort had to be financed, and the shareof the Federal Reserve in that task called for the mostcareful and extensive use of its powers. A stable mar-ket had to be maintained where the credit needs ofthe Government and of industry could be satisfiedpromptly and at low cost. The Federal Reserve


SUMMARY 115

authorities maintained such a market by ready pur-chases of Government obligations at par, by low moneyrates, by arranging guaranteed credit for war produc-tion, and by restraint upon the use of credit for specu-lating in securities and for financing civilian consump-tion. But war financing, a part of which had to bemet by selling Government obligations to the banks,left the country in possession of a supply of moneyfar greater than needed in peacetime and potentiallyinflationary in its influence. Furthermore, the size anddistribution of the public debt greatly complicate thetask of regulating the money supply.

The Federal Reserve System was established in anera when the monetary problem was one of scarcityand rigid limitation on expansion; it has come tooperate in an era when the problem is instead one ofsuperabundance and of rigidities in the way of con-traction.


PUBLICATIONS OF THE BOARD OF GOVERNORSOF THE FEDERAL RESERVE SYSTEM

ANNUAL REPORT of the Board of Governors of the FederalReserve System. Issued each year. Available withoutcharge upon request.

FEDERAL RESERVE BULLETIN. Issued monthly. Subscriptionprice in the United States and its possessions, Bolivia, Can-ada, Chile, Colombia, Costa Rica, Cuba, Dominican Repub-lic, Ecuador, Guatemala, Haiti, Republic of Honduras, Mex-ico, Newfoundland (including Labrador), Nicaragua,Panama, Paraguay, Peru, El Salvador, Uruguay, andVenezula [Venezuela] is $2.00 per annum or 20 cents per copy; else-where, $2.60 per annum or 25 cents per copy. Group sub-scriptions in the United States for 10 or more copies to oneaddress, 15 cents per copy per month, or $1.50 for 12 months.

FEDERAL RESERVE CHARTS OF BANK CREDIT, MONEY RATES,

AND BUSINESS. Issued monthly. $9.00 per annum, or $1.00per copy. In quantities of 10 or more copies of a particularissue for single shipment, 75 cents each.

BANKING STUDIES. Comprising 17 papers on banking andmonetary subjects by members of the Board's staff. August1941; reprinted March 1947. 496 pages. Paper cover.$1.00 per copy; in quantities of 10 or more copies for singleshipment, 75 cents each.

BANKING AND MONETARY STATISTICS. Statistics of banking,monetary, and other financial developments. November1943. 979 pages. $1.50 per copy.

T H E FEDERAL RESERVE ACT, as amended to November 1, 1946,with an Appendix containing provisions of certain otherstatutes affecting the Federal Reserve System. 372 pages.50 cents per paper-bound copy; $1.00 per cloth-bound copy.

116


PUBLICATIONS 117

POSTWAR ECONOMIC STUDIES. (8 pamphlets)—No. 1. Jobs,Production, and Living Standards; No. 2. Agricultural Ad-justment and Income; No. 3. Public Finance and Full Em-ployment; No. 4. Prices, Wages, and Employment; No. 5.Private Capital Requirements; No. 6. Housing, Social Secu-rity, and Public Works; No. 7. International MonetaryPolicies; No. 8. Federal Reserve Policy.

The price for the set of eight pamphlets is $1.25; 25 centsper pamphlet, or, in quantities of 10 or more for single ship-ment, 15 cents per pamphlet.

Copies of this book, THE FEDERAL RESERVE SYSTEM—ITS PUR-POSES AND FUNCTIONS, may be secured in paper cover withoutcharge, either individually or in quantities for classroom andother use. Clothbound copies are sold at 75 cents each, and ingroup orders of 10 or more copies for single shipment at a specialprice of 50 cents each.

In addition to the publications listed, the Board issues periodicreleases, special studies, chart books, and reprints. Lists of avail-able material may be obtained upon request. Inquiries regardingpublications should be directed to the Division of AdministrativeServices, Board of Governors of the Federal Reserve System,Washington 25, D. C.



INDEX

PAGEAcceptances:

Bankers', as element in Federal Reserve credit 31Item in condition statement of Federal Reserve Banks. . . . 92

Affiliates, holding company, permits granted by Federal Re-serve authorities 85

American Bankers Association, cooperation with Federal Re-serve in check collection practices 83

Assets and liabilities of Federal Reserve Banks:Balance sheet 89Definition of items in statement of condition 90

Balance sheet for the Federal Reserve Banks:Assets and liabilities 90Description of items 89

Bank credit:Regulation of 24Relation of gold to 68Relation of reserves and deposits to 66Reserves of banks as basis for 10

Bank examinations: (See Examinations.)Bank supervision by Federal Reserve authorities 84Banking and monetary agencies other than Federal Reserve.... 101Board of Governors of Federal Reserve System:

Annual report to Congress 56Building, dedication of 1Duties of 56Expenses assessed on Federal Reserve Banks 55Members of 56Publications of 57,116

Branch banks:Federal Reserve System:

Directors 54List of 51

Foreign, power of Federal Reserve authorities to permitestablishment of 85

Brokers and dealers in securities, margin requirements 39Capital accounts of Federal Reserve Banks 94Capital stock: (See Stock, capital.)Central banking functions of Federal Reserve authorities 4Central reserve cities 35Charts:

Federal Reserve System 52Major factors in the monetary equation 76Member bank reserve balances 22System holdings of discounts and United States Govern-

ment securities 31Check routing symbols, use of 83Clearing and collection:

Checks, as function of Federal Reserve System 4Collections, clearances, and transfers of funds 81Service function of Federal Reserve Banks 81

119


120 INDEX

PAGE

Coins, circulation of 63, 80Collateral for loans from Federal Reserve Banks 25Commodity transactions compared with bank transactions 19Comptroller of the Currency:

Examination of national banks 84Relation with Federal Reserve System . . . 102

Condition statements of Federal Reserve Banks, descriptionof items 90

Conference of Presidents of Federal Reserve Banks 58Consumer credit:

Authority of Board of Governors to control 43Termination of control 47

Country banks, reserve requirements of 36Credit: (See Bank credit.)Credit policies, authority of Board of Governors to formulate

and supervise execution of 57Currency:

Amount in circulation, influence on volume of memberbank reserves 74

Changes in amount in circulation, reasons for 64Coins, circulation of 63, 80Distribution by Federal Reserve Banks 79Elasticity achieved by Federal Reserve System 62, 111Federal Reserve notes: (See Federal Reserve notes.)Furnishing for circulation as function of Federal Reserve

System 4Influence of Federal Reserve System on supply of 2Relation of Federal Reserve System to 62Relation of supply to bank deposits 5Silver certificates 63United States notes 63

Deferred availability items, definition of term in statement ofcondition 93

Deposits:All banks in United States 49Insurance by Federal Deposit Insurance Corporation 102Liability item in condition statement of Federal Reserve

Banks 92Relation to loans and investment of banks 14Reserve requirements at Federal Reserve Banks reduced

to 25 per cent 67Reserve against: (See Reserves.)War loan accounts, management by Federal Reserve Banks 87

Directors:Federal Reserve Banks, classes of 53Federal Reserve branch banks 54Member banks, power of Federal Reserve authorities to

remove 84Discount rate:

Authority of Board of Governors to review and determine 57Changes as indication of Federal Reserve policy 26Establishment by Federal Reserve Banks 55


INDEX 121

PAGE

Discounts:Asset item in statement of condition of Federal Reserve

Banks 91, 96Influence on bank reserves 24Power of Federal Reserve authority to influence cost and

availability of bank credit 113Dividends of Federal Reserve Banks 55Earnings of Federal Reserve Banks, purpose of 55Eligible paper 25Examinations:

Federal Reserve Banks 84National banks by Comptroller of the Currency., 84Nonmember insured banks by Federal Deposit Insurance

Corporation 102State member banks 84

Executive Orders:Consumer credit, giving Board temporary control over 44War loans, insuring or guaranteeing loans needed to finance

war production 108Federal Advisory Council, members and duties of 58Federal Deposit Insurance Corporation:

Examination of nonmember insured banks 102Relation with Federal Reserve System 102

Federal Open Market Committee:Composition of 57Duties of 57

Federal Reserve Act, date of passage 1Federal Reserve Bank of New York, agent of Treasury in gold

and foreign exchange transactions 88Federal Reserve Banks:

Balance sheet of 89Branches of 51Capital stock of 53, 90, 93Collections, clearances, and transfers of funds as function of 81Currency distribution as function of 79Custodians of collateral and securities for Government

agencies 87Directors, classes of 53Earnings of 55Examination of 84Fiscal agency functions 85Income 54Lending powers, sources and limitations of 34List of 51Relations with Treasury 101Service functions of 79Summary of services performed 114Supervisory functions 84Surplus of 55, 90, 93

Federal Reserve districts:List of 51Map of 52

Federal Reserve lending power, sources of 33


122 INDEX

PAGEFederal Reserve notes:

Circulation of 62Interest charge paid to Treasury 55Power of Federal Reserve System to issue 2Reserve in gold certificates required against 33Reserve requirement at Federal Reserve Banks reduced to

25 per cent 67Review of circulation since 1920 98

Federal Reserve System:Functions relating to member banks, United States Govern-

ment, and the public 4Influence on supply and availability of money 7Map of . . . . : . . . . 52Means of influencing money supply 7Membership in 48Purposes of 1Relation to employment, wages, and standard of living 1Structure of 48Summary of powers and functions 111War service of 105

Fiscal agents, function of Federal Reserve System acting forTreasury and other governmental agencies 4, 85

Float, term used in connection with condition statement ofFederal Reserve Banks 93

Foreign banking corporations, authority to establish 85Foreign banks, Federal Reserve Bank of New York as agent for 88Foreign branches, establishment of 85Foreign exchange, Federal Reserve Bank of New York as agent

of United States Treasury 88Franchise tax, payment by Federal Reserve Banks 55Gold:

Amount held by Treasury 69Loans on, asset item in condition statement of Federal

Reserve Banks 92Movement of, effect on volume of member bank reserves. 23, 74Relation of Federal Reserve System to 68Transactions with foreign countries 71

Gold certificate fund 84Gold certificates:

Amount held by Federal Reserve Banks 69Asset item in statement of condition of Federal Reserve

Banks 90, 96Legal requirement against notes in circulation and deposits. 33, 67

Government agencies, relation to Federal Reserve System.. . . 103Government securities:

Asset item in statement of condition of Federal ReserveBanks 91, 96

Buying and selling as means of influencing money supply.. 27Issuance and redemption as function of Federal Reserve

Banks 85Services performed by Federal Reserve Banks in connec-

tion with issuance 86Guarantees covering war loans 108


INDEX 123

PAGEHolding company affiliates, power of Federal Reserve authori-

ties to grant voting permits 85Instalment buying, control of Board of Governors over 44Insurance of deposits 102Interdistrict Settlement Fund 84International Bank for Reconstruction and Development:

Federal Reserve Bank of New York as depositary for 88Functions as related to Federal Reserve System 104

International Monetary Fund:Federal Reserve Bank of New York as depositary for 88Functions in relation to Federal Reserve System 104

Legislation:Federal Reserve Act, passage of 1Reserve requirements, empowering Federal Reserve to

change 36Liabilities of Federal Reserve Banks 90Loans:

Governmental agencies, power given by Congress to 103Member banks, authority of Federal Reserve Banks over. . 55Paper eligible for rediscount at Federal Reserve Banks. . . . 25Relation of reserves and deposits to 8, 14Securities, regulation by changes in margin requirements. . 39War, guaranteed by War and Navy Departments and Mari-

time Commission 108Loans and investments, capital and deposits of banks as

basis for 10Map of Federal Reserve System 52Margin requirements, regulation by Board of Governors 39, 57Maritime Commission, guarantee of war loans by 108Member banks:

Loans and discounts, authority of Federal Reserve Banksover 55

Number of 49Obligations and privileges of 49Officers and directors, power of Federal Reserve authorities

to remove 84Membership in Federal Reserve System:

Number and classes of members 48Obligations and privileges of 49

Monetary equation, factors affecting volume of member bankreserves 74

Money: (See also Currency.)Effect of supply on lives of people 6Function of Federal Reserve System regulating supply.... 4Influence of discounts and discount rate on supply of 27

Money market, responsibility of Federal Reserve System inconnection with 59

National Advisory Council on International Monetary andFinancial Problems 104

National banks:Chartered by Comptroller of the Currency 49Number of 49Supervision by Comptroller of the Currency and Federal

Reserve System 102


124 INDEX

PAGENational banks—Continued.

Trust powers, authority of Federal Reserve to grant permits 85National Monetary Commission, appointment to devise new

banking system 3Navy Department, guarantee of war loans by 108Nonmember banks:

Clearing balance, maintenance with Federal Reserve Banks 83Examination of 84Number of 49Operations of Federal Reserve in the money market,

effect on 61Open market operations:

Influence on money supply 27Summary of Federal Reserve authority over 113

Par clearance of checks 83Presidents of Federal Reserve Banks:

Appointment of 54, 56Conference of 58

Public debt:Annual cost of 110Policy of Treasury during war to encourage nonbank

investors 106Services performed by Federal Reserve Banks in connec-

tion with 86Publications of the Board of Governors 57, 116Pyramiding of stocks, effect of high margin requirements on . . . . 41Rates, discount: (See Discount rate.)Reconstruction Finance Corporation:

Federal Reserve Banks as custodians of collateral andsecurities for 87

Functions as related to Federal Reserve System 103Rediscounts, eligible paper to obtain Federal Reserve credit. . . . 25Regulations, Board of Governors:

Reserve requirements 36Securities loans, by changes in margin requirements 39W, Consumer Credit, restraints imposed by 44

Reserve cities 35Reserve requirements:

Authority of Board of Governors over 57Changes in, as method of regulating money supply 34Deposit liabilities of Federal Reserve Banks, reduction to

25 per cent 67Effect on demand for currency 65Federal Reserve notes, reduction to 25 per cent 67Legislation empowering Federal Reserve to change 36Percentages now in effect 36Percentages originally prescribed 35Power of Board of Governors in fixing 11Summary of Federal Reserve authority over 113

Reserves:Accounts maintained by Federal Reserve Banks for member

banks 79Effect of changes on volume of money 12Effect of open market operations on 27


INDEX 125

PAGEReserves—Continued.

Excess, effect of movement of gold on 23Excess of member banks with Federal Reserve Banks. . . . 22Functions of 10Holding for member banks by Federal Reserve System 4Holdings of banks, influence on supply of money 8Maintenance of reserve balances by banks prior to passage

of Federal Reserve Act 3Member banks:

Increase or decrease, effect on deposits and loans andinvestments 15

Review of changes since 1920 98Ratio to combined note and deposit liabilities 67Regulation of 24Summary of functions and powers of Federal Reserve 112Volume of, influence of gold movements, currency in circula-

tion and Federal Reserve credit 74Roosevelt, President Franklin D., statement at dedication of

new Federal Reserve Building 1Safekeeping of securities, Federal Reserve Banks as custodians

of collateral and securities for Government agencies. . . . 87Securities loans, regulation by changes in margin requirements. 39Service functions of the Federal Reserve Banks 79Silver, purchases by Treasury, effect on member bank reserves. 77Silver certificates:

Amount in circulation 77Denominations and amount of 63

Stabilization fund, amount of 70State member banks:

Examination of 84Number of 49Obligations and privileges of 49

Stock, capital of Federal Reserve Banks:Amount of 90Dividends on 51, 55Ownership of 53, 93

Stock market credit, authority of Board of Governors to control 39Surplus of Federal Reserve Banks -. 55, 90, 93Treasury bills, place in financial system 32Treasury Department:

Earnings of Federal Reserve Banks, portion paid to 55Relations with Federal Reserve System 101

Trust powers, authority of Federal Reserve to grant permits tonational banks 85

United States Government, relation of Federal ReserveSystem to 4

United States Government securities: (See Government secu-rities.)

Voting permits, power of Federal Reserve authorities to grant.. 85War Department, guarantee of war loans by 108War financing, summary of efforts of Federal Reserve System. . 114War loan deposit accounts, management by Federal Reserve

Banks 87War loans, Executive Order for insuring and guaranteeing loans 108War services of the Federal Reserve 105


Documents

FEDERAL RESERVE SYSTEM Its Purposes and Functions · FIRST EDITION, 161,000 COPIES First printing May 1939 Second printing June 1939 Third printing December 1939 Fourth printing January