Corporate Bonds (Debt Securities) Part 1 Debt capital is money loaned to corporations by investors.

The bond represents the corporations debt. This is a key difference between a bond and stock. Stock represents an ownership interest in the company. If you accumulate enough stock, you will own the company. Whereas, a bond is a loan. You don t own any part of the company. ! bond certificate will state, the corporation s obligation to pay back a specific amount of money, at a specific point in time, at a specific rate of interest. Interest is usually paid twice a year. You also need to understand some terms used in the bond business. Indenture The indenture is the terms of the legal agreement between the corporation and the one loaning them the money. The indenture, which is printed on the bond certificate, contains the following information" The duties and obligations of the trustee #usually a bank or trust company hired by the corporation$, all the rights of the lender #the bondholder$, how and when the principal will be repaid, the rate of interest, the description of any property to be pledged as collateral, steps the bondholder can take in the event of default, and callable features. %earer %earer bonds are coupon bonds. &obody s name is on the bond or the coupon' therefore, they are referred to as coupon bonds. The coupons are submitted twice a year and the authori(ed bank pays the interest. )or instance, a twenty year *+,,,, bond paying -. interest would have /, coupons for */, each. %earer bonds can be used like cash. They are highly negotiable. There are still many in circulation. 0owever, the Ta1 2eform !ct of +3-4 ended the issuance of bearer bonds. 2egistered Today, bonds are sold in a fully registered form. They come with your name already on them. Twice a year, you receive a check for the interest. !t maturity, the registered owner receives a check for the principal. ! partially registered bond is a cross between a registered bond and a coupon bond. The bond comes registered to you' however, it has coupons attached which you send in for payment. %ook 5ntry In +3-6, all 7.S. 8overnment bonds were sold in book entry form. The owner of the bond has no certificate. Instead, your name is in the )ederal 2eserve %oard computer. This computer keeps track of who owns what and how much. !lso, when the interest needs to be paid. ! growing number of other bonds are now being sold in book entry form. The face value of a bond is always *+,,,, unless it is specified otherwise. 9ost municipal bonds are sold in denominations of *:,,,,. ;orporate bonds can be either secured or unsecured. !n unsecured bond is backed by the reputation, credit record, and financial stability of the corporation. These are generally issued by the largest corporations and are regarded as highly safe. These unsecured bonds are known as Debentures . Senior Senior is used to describe the priority of claims. 5very debt security has priority or senior claim to preferred stock #which has priority to common stock$. Senior bonds would indicate that the bonds are either mortgage bonds or e<uipment trust certificates since these bonds are senior to any other type of bonds. Senior debt has a prior claim to assets in the event of a default to all other creditors Subordinated Subordinated means that the claim comes behind or after other claims. ! debenture which is subordinated comes behind every other creditor. 0owever, no matter how subordinated the debenture, it still comes ahead of any class of stock. Types of ;orporate %onds There are various types of corporate secured bonds. The two most prevalent are 9ortgage %onds and 5<uipment Trust ;ertificates . I ll also discuss Income %onds . %ut Income %onds are in a class of their own. 9ortgage %onds ! corporation may issued bonds backed by real estate and=or the physical assets of the corporation. The real assets pledged will have a market value greater than the bond issue. If the company defaults on the bonds, the real assets are sold off to pay off the mortgage bond holders. There are two different types of mortgage bonds. There are open end and closed end mortgage bonds. If the mortgage bonds you bought are secured with closed end assets, the assets which were pledged can only be sold off to pay off your bond issue. 0owever, if the mortgage bond you bought was pledged with open end assets, those assets may also be pledged against other bond issues. In case of a default, the bond holders from other issues will have e<ual claim to those assets.

5<uipment Trust ;ertificates These are very similar to an automobile loan. When you borrow money for your new car, you make a down payment. Then you make your monthly installment payments. !t no time throughout the life of the loan is your car worth less than the outstanding amount of the loan. 9any railroad and transportation companies use this same type of financing. 7sually, 4,. of the purchase price is put down by the company in the form of a down payment. Then the balance is paid off over +: years. When the company is finished paying off the loan, it receives clear title from the trustee. If the company defaults on its loan, the e<uipment is sold off and the bond holders are paid off. 5<uipment Trust ;ertificates are serial bonds. That is, each time a payment is made, a portion of that payment is interest and a portion of that payment is principal. In this way, as previously stated, the loan amount never e1ceeds the collateral value. Income %onds These bonds will only pay interest if earned and to the e1tent earned. Income bonds are the only bonds which are issued where failure to pay the interest in a timely fashion does not lead to immediate default. 7sually, these bonds are issued by a company in bankruptcy. What happens is that a company in bankruptcy meets with its creditors #usually bond holders$ and agrees to issue new income bonds in e1change for the old bonds. %ecause failure to pay interest would land the company back into bankruptcy court, the creditors agree that interest will only be paid to the e1tent earned. The e1change of bonds does not have to be on a one to one basis. It can be .:, or .>: or .4, or any other amount, to the dollar. 2atings of %onds There are two primary rating services which rate bonds. These are Standard ? @oor s and 9oody s. These two services rate the issues that are being offered. They come up with a letter ranking. ;onsulting these two services ratings is a <uick and easy way to determine the issue s safety and security. 9ost issues are rated. 0owever, there are some bond issues which are not rated. If a bond issue is not rated, it could be because of one of two reasons. The first is that the issuer didn t want to pay to have the issue rated. Ar second, it could be because the company is too new to have a credit history or credit rating. Bust because a bond issue is not rated does not mean that it is an unsafe bond. &o rating does not imply this. It simply means what it says. That the issue is not rated. Standard ? @oor s has the following ratings" %onds of %%% or greater are refereed to as Investment 8rade . !dditionally, Standard ? @oor s will use either a C sign or a D sign t indicate relative strength inside the category. )or instance, !!!C indicates that this bond is at the high end of the !!! category. !!! D bonds of the highest <uality !! D 0igh <uality debt obligations ! D %onds that have a strong capacity to pay interest and principal but may be susceptible to adverse effects %%% D %onds that have an ade<uate capacity to pay interest and principal but are more vulnerable to adverse economic conditions or changing circumstances. %% D %onds of lower medium grade with few desirable investment characteristics % D @rimarily speculative bonds with great uncertainties and maEor risk if e1posed to adverse conditions. ;;; D %onds in poor standing that may be defaulted ; D Income bonds on which no interest is being paid D D %onds in default 9oody s has the following grades" %onds of %aa or greater are considered Investment 8rade . !dditionally, 9oody s breaks down each category into + D indicates the highest level within a category, 4 D indicates the middle of the category, and FD which indicates the low end of the category. !n e1ample would be !aa+ which indicates this is the highest level inside the !aa level !aa D %onds of highest <uality !a D %onds of high <uality ! D %onds whose security of principal and interest is considered ade<uate but may be impaired in the future. %aa D %onds of medium grade that are neither highly protected nor poorly secured. %a D %onds of speculative <uality whose future cannot be considered well ensured. % D %onds that lack characteristics of a desirable investment. ;aa D %onds in poor standing that may be defaulted ;a D Speculative bonds that are often in default. ; D %onds with little probability of any investment value #lowest rating$. 2eturn The return is perhaps the most difficult part of understanding bonds for most people. 0owever, it doesn t have to be. !nd I ll try to make it as easy as possible. There are two factors which influence to price of a bond. The first is the demand to borrow money. When a lot a people and companies want to borrow money, the cost of borrowing #interest rate$ goes up. When there is less demand to borrow money, the cost of borrowing #interest rate$ goes down. The second factor which influences the price of a bond is the risk=reward ratio. The more risk

involved in a particular issue, the greater the reward the investor must receive. Therefore, the riskier the issue, the higher the rate of interest will be with respect to that particular issue. &ominal Yield &ominal Yield is the interest rate stated on the face of the bond. This is also referred to as the ;oupon 2ate . ! *+,,,, corporate bond with a stated interest rate #&ominal Yield$ of +,., will pay *+,, per year in interest. The interest will be paid in two *:, payments #semiD annual$. ;urrent Yield The current yield is the annual return in dollars divided by the current market price of the bond. Divide the annul return in dollars #*+,, in our e1ample above$ by the amount the bond is currently trading for. Get s assume the current market price of the bond is *+,4,,. The current yield is *+,, divided by *+,4,, H -.F. or .-FFF. 2egardless of how much the bond changes in price, the nominal yield #interest paid as stated on the face of the bond$ always remains the same. 0owever, because bonds fluctuate in price #they trade and can be bought and sold like stocks$, the return the investor receives fluctuates. @remium and Discount If a bond is trading for more than the face amount #usually *+,,,,$, it is said to be trading at a premium. If a bond is trading for less than the face amount #usually *+,,,,$ it is said to be trading at a discount. Therefore, a bond trading for *+,/,, is trading at a premium and a bond trading at *>,, is trading at a discount. 2emember, if you pay more you get less' and if you pay less, you get more. %asically, if you buy a bond trading at a premium, you get less of a return than the one stated on the face of the bond. !nd if you buy a bond trading at a discount, you get more than the amount stated on the face of the bond. Yield to 9aturity or True Yield When an investor buys a bond for a price other than *+,,,, he still receives *+,,,, in principal reDpayment at maturity. So a person who pays *+,4,, for a bond still only receives *+,,,, at maturity. ;onversely, a person who pays *3,, for a bond, will receive *+,,,, for the bond in principal reDpayment at maturity. The difference between par value #the face value of the bond$ and the amount the investor actually paid for the bond, is also considered yield and has to be included in yield calculations. In other words, somehow the investor needs to account for this difference to better understand what the true value of the bond is to him. There are two different calculations for Yield To 9aturity. The first one is if the investor bought the bond at a discount. The second calculation is used if one bought the bond at a premium. Yield to 9aturity #If you bought the bond at a discount$. ;oupon C @rorated Discount #divided by$ #)ace Ialue C @urchase @rice$ = 4 Where" ;oupon H Dollar amount of annual interest @rorated Discount H Divide the discount by the number of years remaining until maturity to come up with a dollar amount. )ace Ialue H With corporate bonds it s usually *+,,,, @urchase @rice H !mount you paid for the bond Yield To 9aturity #If you bought the bond at a premium$ ;oupon D @rorated @remium #divided by$ J)ace Ialue C @urchase @riceK = 4 The difference here is that the @rorated @remium is subtracted from the ;oupon. 8enerally, Yield To 9aturity is what bond traders look at when evaluating a bond. It is the only yield which takes into account principal, coupon rate, and the time to maturity on a bonds actual yield. Corporate Bonds (Debt Securities) Part 2 ;allable )eatures of %onds #@aying Aff %onds 5arly$

If you borrowed *+,,,, from someone and you could pay it off four years later for *-:,, would youL If you had the cash you Eust might. Well corporations do the same thing. Get s say that MYN ;orp. had a series of bonds outstanding coming due in the year 4,+,. The 4,+, bonds are presently trading at *-:,. MYN ;orp. places an order with their registered rep. who handles their investments and places an order to buy up however many they wish. They can buy any amount they want as long as the bonds are trading. An lightly traded issues the company might make a Tender Affer . With a tender offer, the company would publish an announcement in a large financial newspaper such as OThe Wall Street BournalO and offer to buy back their bonds for *-:, each #sometimes a little more if they want to attract more bond holders$. They can offer to buy back all of the issue or part of the issue. If they offer to buy back part of the issue, it will probably be on a first come, first served basis. So far, we have discussed the company which goes into the marketplace to reDpurchase their bonds or makes a friendly offer to buy back their bonds. There are also situations where the company can force the bondholder to sell back his bonds. This is the ;allable feature of the bond issue. %onds can be either callable or nonDcallable. In either case, this feature will be present in the indenture. If the bond is callable, it will state in the indenture when it is callable and at what price. 8enerally, the company will have to pay a price for the bond which is slightly above par #usually *+,,,, for corporate bonds$. )urther, the earlier the company calls the bonds, the higher the premium they will have to pay for the bonds. This is because the company is forcing the investor to disrupt his income flow. The most common reason for companies and also municipalities to call a bond issue is because they issued the bonds when interest rates were high and they have now come down to a much lower rate. 2emember, that when interest rates go down, bond prices rise. !nd when interest rates go up, bond prices decline. &evertheless, you might be sitting with a bond trading today at *+,/,, and the company has the right to call the bond in at *+,+,,. There s nothing you can do. You knew the bonds were callable when you bought them. You agreed to the terms. The company would then probably sell a new bond issue to repay the bond holders for the bonds the company was buying back. This type of a transaction is called a 2efunding . The new bond issue will have a lower interest rate. Thus, the company will be reducing its financing costs. ;all protection is the amount of time before the bond is callable. %y the way, the best call protection is a nonDcallable bond. !nother thing, bonds are usually called on one of the two dates the interest is due. This makes the computations much easier. Convertible Bonds ! convertible bond is one which is convertible into the company s common stock. The conversion option to the bond is e1erciseable when and if the investor wants to do it. The conversion ratio varies from bond to bond. The terms of conversion are set forth in the indenture. The e1act number of shares or the method of determining how many shares the bond is converted into is printed in the indenture. 9any times the indenture will tell you how many shares of stock the bond is convertible into. )or instance, it might say that it is convertible into 4, shares. Therefore, the conversion ratio is 4,"+. 7nfortunately, it s not always that easy. )or instance, the indenture might state the conversion price. The conversion price is the price per share that the company is willing to trade their shares of stock for the bond. )or e1ample, if the indenture states that the conversion price is *:, per share, the bond is convertible into 4, shares of stock. You divide the par value #usually *+,,,, for corporate bonds$ by the conversion price. Accasionally, the indenture might state that the conversion ratio will change through the years. )or e1ample, the conversion price might be *:, for the first five years, *:: for the ne1t five years, and so forth. There are also antiDdilutive features to the conversion feature. If the stock were to split 4 for +, and the conversion ratio was 4, to + prior to the split, after the split, the conversion ratio would be /, to +. ! stock dividend would also have the same effect. ! stock split would also reduce the conversion price. %ecause convertible bonds have a little something e1tra, the right to convert to common stock, that little something e1tra costs the bond holder. The bond will usually carry a slightly lower interest rate. If the stock price rises, the bond price will also rise. Since most convertible bonds are also callable, the company can force the bond holders to convert the bonds to common stock by calling the bonds. This is known as )orced ;onversion . When a bond is converted to common stock, the corporate debt is reduced. What was formerly debt has now been converted to e<uity. Af course, converting debt #bonds$ into stock #e<uity$ has the effect of diluting the e<uity. The company didn t get any larger with the additional stock. %ut each stockholder s piece of the pie got smaller. If the company s stock declines to a price which makes the convertible feature of the bond worthless, as long as the company is solvent, the bond will trade based on its yield D like any other bond. There is a price level to which a bond will fall and fall no further as long as the company can pay its interest and the principal upon maturity. Ane other term to know is @arity . If the *+,,,, convertible bond is convertible into :, shares of stock, the parity price of the stock is *4,. If the stock moves up to *4:, for the stock and bonds to be at parity, the bonds would have to be trading at *+,4:,. The Money Market 8enerally, corporations raise money by issuing long term debt and e<uity instruments. The money market is the a market which is used for buying and selling short term loanable funds in the form of securities and loans. 9oney is not what is traded in the money market. Short term loans are traded which can be converted into cash rather <uickly. The buyer of a money market instrument is the lender. The seller of the money market instrument is the borrower. 9oney market instruments have a maturity of one year or less. 9ost have a maturity of si1 months or less. The maEority of money market instruments are issued at a discount. This means that the lender of the money does not receive interest payments. 2ather, you might lend *36,,,, and receive *+,,,,,, at maturity. )or the most part, *+,,,,,, is the minimum amount which is traded in the money market. 9oney market instruments are regarded as <uite safe. Af course, there are some instruments

which are considered more safe than others. TD%ills are considered safer than commercial paper. &evertheless, they are all considered low risk. The money market trades both corporate and government debt securities. TD%ills are the maEority of what s traded in the money market. 0owever, Treasury &otes are also traded. Treasury &otes have maturities from one year to ten years. TD%onds are also traded. 0owever, the only TD%onds traded have one year or less to maturity. Ane of the greatest advantages to the 9oney 9arket is the great li<uidity. It is such a huge market that the spreads are kept relatively low. !lso, interest earned from the 9oney 9arket is free of state ta1. Ane last feature of the 9oney 9arket is the absence of business risk. Types of 9oney 9arket Instruments 7.S. Treasure %ills These are issued by the 7.S. 8overnment. They represent 7.S. government obligations. The Treasury Department has weekly F month and 6 month TD%ill auctions. Ance a month the Treasury Department auctions 6 month and 3 month TD%ills. The Treasury Department also offers Ta1 !nticipation %ills through special auctions. TD%ills are issued in denominations of *+,,,,, through *+,,,,,,,,. They have maturities of up to one year. There is an e1cellent secondary market for these. They are highly li<uid. These are discounted in actual days based on a F6, day year. @rime Sales )inance @aper These are promissory notes from finance companies placed directly with the investor. These come in denominations of *+,,,, to *:,,,,,,,,. There is a minimum order of *4:,,,,. These are issued to mature on any day ranging from F days to 4>, days. There is no secondary market for these. 7nder certain conditions, the company will buy back the securities prior to maturity. They will usually adEust the interest rate in this event. These can be either discounted or interest bearing. !nd they are based on actual days based on a F6, day year. Dealer @aper #)inance$ These are promissory notes of finance companies sold through commercial paper dealers. Their denominations range from *+,,,,,, to *:,,,,,,,,. They are issued to mature on any day from +: days to +>, days. There is a limited secondary market. 5arly buyback can usually be negotiated with the dealer. These can be either discounted or interest bearing based on actual days and a F6, day year. Dealer @aper #Industrial$ These are promissory notes of the leading and largest industrial firms. It is sold through commercial paper dealers. They are sold in denominations of *:,,,,,, to *:,,,,,,,,. They mature on certain dates form F, days to +-, days. There is a limited secondary market. These are discounted based on actual days and a F6, day year. @rime %ankers !cceptance These are time drafts drawn on and accepted by a banking institution which substitutes its credit for that of the importer or holder of the merchandise. They range in denominations from *4:,,,, to *+,,,,,,,,. They mature in up to 4>, days. There is a good secondary market in these. The bid is usually +=4 of +. higher than the offer. These are sold discounted in actual days based on a F6, day year. &egotiable Time ;ertificates of Deposit These are certificates of time deposit at a commercial bank. They range in denominations from *+,,,,,, to *+,,,,,,,,. The maturities are unlimited. There is a good secondary market. The rate is based on a yield basis. !nd it is based on actual days for a F6, day year. Interest is paid at maturity. @roEect &otes of Gocal @ublic 0ousing !gencies These are notes of local agencies secured by a contract with federal agencies and by the pledge of the full faith and credit of the 7.S. 8overnment. They are sold in denominations of *+,,,, to *+,,,,,,,,. They mature in periods of up to one year. There is a good secondary market for these. The rate is based on a yield basis. Interest is paid at maturity. !nd it is based on a F, day month and a F6, day year. Ta1 and %ond !nticipation &otes These are notes of states, municipalities, or political subdivisions. They are issued in denominations of *+,,,, to *+,,,,,,,,. They usually mature in periods of F months to + year from the date of issue. There is a good secondary market for these. The rate is determined on a yield basis. Interest is paid at maturity based on usually F, days and a F6, day year. Govern ent and Municipal Bonds

Municipal Bonds 9unicipal %onds #Securities$ are issued by a state or local government. They are debt instruments. The funds go to either support a government s general financing needs or for special proEects. 9unicipal bonds are free from federal ta1 on the accrued interest and also free from state and local ta1es if they are issued in the state of residence. )or e1ample, a resident of &ew York who buys a municipal bond issued by the state of &ew York, will not pay &ew York State or local ta1es on it. 0owever, if the same resident of &ew York buys a municipal bond from a city in ;onnecticut, will pay state and local ta1 on the accrued interest. Peep in mind that any profit reali(ed from the purchase or sale is not e1empt from ta1. Anly the accrued interest is ta1 e1empt. The 7.S. government s )ederal 2eserve system brings 7.S. government, Treasury bonds issues public. There is no agency that handles municipal bond issues. 0owever, there are brokerage firms which speciali(e in bringing out municipal bond issues. There are several types of municipal bonds. They are" 8eneral Abligation %onds, Gimited and Special Ta1 %onds, Industrial 2evenue %onds, 0ousing %onds, 9oral Abligation %onds, Double %arreled %onds, Ta1 !nticipation &otes, %ond !nticipation &otes, and 2evenue !nticipation &otes. These are described below. 8eneral Abligation %onds #8A s$ 8eneral Abligation %onds are backed by the full faith and credit of the issuer for prompt payment of principal and interest. 9any bonds issued by city, county, or school district, also have the added security that they have can raise property ta1es to assure payment. This guarantee is of an unlimited nature. The issuer can raise ta1es as high as they want to pay the bonds. If the property ta1 is not paid, the property can be sold at auction giving the bond holder a superior claim above mortgages, mechanical liens, and other encumbrances. 8eneral Abligation bonds are usually analy(ed in terms of the si(e of the ta1able resources. These bonds are regarded as very safe. Gimited and Special Ta1 %onds These bonds are payable from a pledge of the proceeds against a specific ta1. This ta1 could be a gasoline ta1, a special assessment, or ad valorem ta1 levied at a fi1ed price. 7nlike 8eneral Abligation bonds and their unlimited ability to raise ta1es, with these bonds, the issuer is limited as to its source for the revenue to pay the bonds. These bonds are <uite safe. 2evenue %onds These are payable from the earnings of a revenue producing agency or enterprise. 51amples are water, sewer, school district, airport, etc. States and their subDdivisions create certain agency s and authorities to perform specific tasks. 9any times, the agency or authority has the ability to levy charges and fees for its services #e.g. the water company$. These bonds are analy(ed in terms of historical or potential earnings compared with the bond re<uirements. 7sually, the yield is higher than that of a general obligation bond. This is because ta1es are more secure than revenues. These bonds have built up a good record over a long period of time. Industrial 2evenue %onds The local community creates an Industrial Development !gency. 9ost larger communities have one form of this. The purpose of the agency is to develop industrial or commercial property for the benefit of private users. The agency raises revenue for this by issuing municipal bonds. The money raised from this type of bond issue is used to pay for the construction of the new facilities. The facilities are then leased to the corporate guarantor. The safety of an Industrial 2evenue bond depends on the credit worthiness of the corporate guarantor. 0ousing %onds 0ousing bonds are issued by both state and local governments. They are secured by mortgage repayments on single family homes. !dded protections come from, federal subsidies for low income families, )0! insurance, I! guarantees, and private mortgage insurance. @0! , which are @ublic 0ousing !uthority issues are no longer available. 0owever, some do trade in the secondary market. @0! s are backed by the full faith and credit of the 7.S. government. 9oral Abligation %onds These were brought out in the +36, s in &ew York State. These bonds were issued for a specific purpose #e.g. public housing$. It was implied that in the event of a shortfall, the state would make up the difference. Double %arreled %onds These are ta1 e1empt bonds which are backed by a pledge of two or more sources. These are <uite like general obligation bonds which are additionally backed by a second source of revenue. This usually increases their safety.

9unicipal &otes are short term debt instruments issued by state and local authorities. Their maturities run from about 6, days to one year. They are usually available in denominations of about *4:,,,,. ! municipality uses this type of financing as an interim step in anticipation of future revenue. Ta1 !nticipation &oted #T!& s$ These are issued by cities in anticipation of future ta1 revenue. The security of the issue depends on the security and amount of the ta1 revenue the municipality intends to receive. 7sually, these funds are used to finance current obligations. %ond !nticipation &oted #%!& s$ These are issued when revenue is anticipated from a bond issue. To avoid poor market conditions, an issuer might delay a bond issue. Ar, the issuer might want to combine several proEects into one larger issue. During this process, they issue the %!& s. 2evenue !nticipation &otes #2!& s$ These are issued in anticipation of revenue coming in from the federal government. Ar if a local municipality issues them, they may be waiting for revenue from the state or federal government. 8overnment Securities 7.S. 8overnment securities are the safest of all the bonds in circulation. They have direct government backing or in the case of federal agencies, a moral guarantee. 9ost government issues trade in the secondary or capital market. !lthough some trade in the 9oney 9arket. 7.S. Treasury %ills Treasury %ills have maturities of F months and 6 months. They are auctioned once every week. Ance every month + year TD%ills are auctioned. These are a direct short term obligation of the 7.S. government. TD%ills do not pay interest. They are purchased at a discount. )or e1ample, one might buy a *+,,,,, three month TD%ill for *3,>,,. The investor would then receive *+,,,,, when the TD%ill reached maturity in F months. TD%ills are the only Treasury security issued at a discount. They are also the only Treasury security issued without a stated interest rate. The interest rate is determined at auction. TD%ills are also offered in %ook 5ntry form only. The investor does not receive a certificate. TD%ills are also highly li<uid. 7.S. Treasury &otes 7.S. Treasury &otes are direct obligations of the 7.S. government. These notes have maturities from one year to ten years. TD&otes pay interest on a semiDannual basis. TD&otes always e1pire at par value. The different length notes are auctioned at different periods throughout the year. 7.S. Treasury %onds Treasury %onds are direct obligations of the 7.S. government. They pay interest on a semiDannual basis. These have long term maturities. They mature in +, years to F, years. F, year TD%onds are callable beginning : years prior to maturity. )ederal Gand %anks The )arm ;redit !ssociation supervises these. Goans are made to farmers and ranchers. They are secured by mortgages made by )ederal Gand %anks through the )ederal Gand %anks !ssociation. These are not direct obligations of the 7.S. government. They are, however, considered moral obligations of the 7.S. government. Interest received by investors is free from state and local ta1es but not federal income ta1. )ederal Intermediate ;redit %ank #)I;%$ The )I;% is a group of twelve banks authori(ed to make loans to farmers. The money is to be used for e1penses, machinery, and livestock. The loans may not run for more than +, years. These are not direct obligations of the 7.S. government. They are, however, considered moral obligations of the 7.S. government. Interest received by investors is free from state and local ta1es but not federal income ta1. %ank for ;ooperatives The )arm ;redit !dministration runs these. The banks make loans to farm cooperatives. Interest received by investors is free from state and local ta1es but not federal income ta1. )ederal 0ome Goan %anks #)0G%$

The )ederal 0ome Goan %ank %oard supervises these. This agency is what backs up the nations Savings ? Goan banks. Aver 3-. of the total assets of all Savings ? Goans in the country are held by these banks. The )0G% s loans to member banks to augment their deposits. Simply put, the )0G% issues debt securities in the open market to loan to the S?G s who loan this money to their customer s to buy homes. Interest received by investors is free from state and local ta1es but not federal income ta1. )ederal &ational 9ortgage !ssociation #)annie 9ae$ @reviously, )annie 9ae was a government owned corporation. 0owever, in +36-, it was converted to a privately held corporation whose stock trades on the &ew York Stock 51change. The purpose of )annie 9ae is to buy and sell real estate mortgages. @rimarily, these mortgages are guaranteed by the )ederal 0ousing !uthority #)0!$ and the I!. )annie 9ae gets the resources to purchase these mortgages from private investors and from borrowing from the Treasury Department. )annie 9ae issues mortgaged backed bonds which can be purchased by investors. 0owever, and this is the only case where this is true, the )annie 9ae mortgage backed bonds are subordinated to regular debentures. )annie 9ae bonds pay semiDannual interest and are regarded as <uite safe. 8overnment &ational 9ortgage !ssociation #8&9! s or 8innie 9ae$ When the government split off )annie 9ae into a private corporation, it split )annie 9ae into two parts. 8innie 9ae is the second part. 8innie 9ae is wholly owned by the 7.S. government. 8innie 9ae issues 9odified @ass Through certificates . These certificates represent an interest in a pool of mortgages. The pool includes mortgages from the I!, )0! insured mortgages, and )armers 0ome !dministration guaranteed mortgages. !s people make their mortgage payments, the proportionate share passes through to the investor. @ayments to the investor are paid monthly. 5ach payment the investor receives is part interest and part principal. !fter all, when a person pays their mortgage, they are paying part interest and part principal. The minimum denomination is *4:,,,,. These bonds are backed by the full faith and credit of the 7.S. government. The interest is subEect to state and local ta1es. !ppro"i ate Dates o# Treasury !uctions The following time frames for Treasury auctions is strictly a guideline. The 7.S. Treasury can change them without notice. !dditionally, depending on future economic policy and budgeting decisions, the Treasury auctions might be delayed or altered in some manner. Treasury auctions take place periodically and the money raised is used to fund 7.S. government operations. Therefore, at times, 7.S. Treasury auctions can be increased in fre<uency or decreased in fre<uency as the needs of the 7.S. 8overnment dictate. Treasury %ills +F Week Treasury %ills and 46 Week Treasury %ills are auctioned each 9onday :4 Week Treasury %ills are auctioned every four weeks on Thursday #Thirteen times a year$ Treasury &otes and Treasury %onds Two Year Treasury &otes and )ive Year Treasury &otes are auctioned toward the end of each month. Three Year Treasury &otes are auctioned <uarterly, in early )ebruary, 9ay, !ugust and &ovember. Ten Year Treasury &otes are auctioned si1 times a year, in early )ebruary, 9ay, Buly, !ugust, Actober and &ovember. Thirty Year Treasury %onds are auctioned early in )ebruary, !ugust and &ovember. The deadline for receipt of noncompetitive tenders for 7.S. Treasury securities is normally +,",, a.m. &ew York time, on the day of the Treasury auction. &oncompetitive tenders for 7.S. 8overnment securities received in the mail, will be considered timely if postmarked prior to the date of the Treasury auction, and received in the Treasury office by the issue date of the security re<uested. ;ompetitive tenders for 7.S. Treasury securities must be received in the Treasury office before +4",, noon on the day of the Treasury auction. Denominations !vailable )or 7.S. Treasury Securities 7.S. Treasury %ills *+,,,,, minimum' thereafter, in multiples of *+,,,, Anly cashier s checks, certified personal checks, officially signed Savings ? Goan and ;redit 7nion checks, cash, matured or currently maturing Treasury Securities are acceptable forms of payment for Treasury %ills. Two Year Treasury &otes and Three Year Treasury &otes

*:,,,, minimum' thereafter, in multiples of *+,,,, !ll other Treasury &otes and Treasury %onds *+,,,, minimum' thereafter, in multiples of *+,,,, Deter inin$ %hether &ou're Better (## %ith a Ta" )"e pt Bond (r a *on Ta" )"e pt Bond Ane of the things people want to know the most about bonds is whether they are better off buying a ta1 e1empt bond or one which is subEect to ta1es. !ssume that an individual is in the 4-. ta1 bracket. )urther assume that this individual is considering whether to purchase a corporate bond paying +,. in interest #nominal yield or coupon yield, the amount on the face of the bond$, or a municipal bond paying a nominal yield of >.. 5ither one can be purchased for *+,,,,. The corporate bond will pay the bond holder *+,, annually #two *:, semiD annual payments$ and the municipal bond will pay the bond holder *>, #two *F: semiDannual payments$. !fter ta1es are paid, the corporate bond holder will wind up with *>4 #*+,, M J+D.4-K $ &ot paying any ta1es on the municipal bond, the bond holder will wind up with *>,. !nother way to look at ta1 free bonds and non ta1 free bonds is to compute the ta1able e<uivalent. The ta1able e<uivalent is the amount of interest a non ta1 free bond would have to pay to e<ual the return on a ta1 free bond. !nything greater than this amount would indicate that the non ta1 free bond is a better deal. !nything less than this amount indicates that the ta1 free bond is a better deal. !ny bond with a nominal or coupon yield at this amount and it doesn t matter which one you choose. The formula to determine the ta1able e<uivalent is" Ta1 )ree Yield #divided by$ +,, D the ta1 bracket )or e1ample, assume that the investor is considering that same >. municipal bond and that the investor is in the 4-. ta1 bracket. The calculation is" .,> divided by #+,, D .4-$ then" .,> divided by .>4 e<uals 3.>4. 9eaning that the non ta1 free bond would have to pay 3.>4. to e<ual the return to the investor that he would get with the ta1 free bond. !nything greater than 3.>4. with a corporate bond and the investor is better off with the corporate bond. )or any corporate bond paying less than 3.>4. nominal interest and the investor is better off with the ta1 e1empt bond at >..

Major Bond Rating Agencies

Moody's S&P Fitch &C' Moody's Investor Service Standard & Poor's Corporation Fitch Investors Service !"P" &()) & Phe*ps Credit 'atin+ Co" Fitch DCR Definitions 1-212-553-1653 1-212-208-8000 1-800-#5-FI$C% 1-312-368-3100

Long-Term Bond Rating Definitions

Moody's S&P

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Definitions

Mort$a$e Backed Securities These are debt obligations backed by a pool of mortgages. They usually have a pass through feature. 8innie 9ae s are the most popular type of this security. Investors have an undivided interest in the pool. The investor doesn t own any particular mortgage. 2ather, he has a proportionate interest in the cash flow generated by the entire pool. When we talk about a pass through feature, we mean that multiD payments of interest, principal, and sometimes preDpayment of mortgages, are passed through to the investor. 8innie 9ae s #8overnment &ational 9ortgage !ssociation$ are comprised of I! guaranteed loans or )0! insured mortgages and are backed by the full faith and credit of the 7.S. 8overnment. @ayments are received monthly by the investor. )reddie 9ac s #)ederal 0ome 9ortgage ;orporation$ are another type of pass through. )reddie 9ac s are @articipation ;ertificates or @; s. These are comprised of )0A9; conventional mortgages on single family homes. )reddie 9ac s are not guaranteed by the full faith and credit of the 7.S. 8overnment. Therefore, the yield of )reddie 9ac s is a little better than 8innie 9ae s. )annie 9ae s #)&9!$ are similar to )reddie 9ac s in that they are both participation certificates. )annie 9ae s consist of some conventional mortgages and )0! insured mortgages. )annie 9ae s are not guaranteed by the full faith and credit of the 7.S. 8overnment. 0owever, it is unlikely that the government would permit them to default. The yields on )annie 9ae s are slightly better than 8innie 9ae s. ;ollaterali(ed 9ortgage Abligations #;9A$ are bonds that are collaterali(ed by mortgages or mortgage backed securities. 7nlike a traditional pass through, like we discussed above, a ;9A has a stated maturity. There are short term, intermediate term, and long term, ;9A s. 9ost of the mortgages are traditional mortgages which are not I! or )0! mortgages. !s the principal on the mortgages is being paid off, it is used e1clusively for the newest maturity in se<uence until each maturity has been paid off. 2eal 5state 9ortgage Investment ;onduits #259I; s$ is an entity that holds a fi1ed pool of mortgages and issues multiple classes of interests in itself to investors. The classes of interest are called 2egular Interests and 2esidual Interests . ! regular interest has terms which are fi1ed when the 259I; starts. This type of interest unconditionally entitles the investor to receive a specified principal amount. This particular interest can be issued in either debt or stock. ! 2esidual Interest is another interest which is not a regular interest. This creates a structure similar to preferred stock and common stock. The residual interest has variable interest similar to common stock. )or )ederal Ta1 purposes, all regular interests, regardless of whether they are debt or e<uity instruments, are treated as debt instruments. Therefore, payments that flow through are regarded as interest. )or residual interests, the payments that flow through are treated as ordinary income. +ederal +unds !lmost all banks are members of the )ederal 2eserve system. The )ederal 2eserve re<uires banks to keep a certain percentage of their assets on deposit with the )ederal 2eserve bank which covers their geographic area. %anks loan out the maEority of the money depositors put in them. %ut they are not allowed to loan out all of it. An a daily basis, the amount of money the bank has on deposit with the )ederal 2eserve may fluctuate above and below the amount they actually need to keep on deposit. When the amount on money on deposit with the )ederal 2eserve is greater than the amount the bank needs to keep on deposit, this money is referred to as 51cess 2eserves . When the bank has less than is re<uired to be kept on deposit with the )ederal 2eserve, the bank must borrow money to put on deposit. %ecause banks do not earn any interest on the money they have on deposit with the )ederal 2eserve, they gladly loan out their e1cess reserves to other banks who need to add money to their reserves. The lending banks charge interest for this service. The lending which goes on between banks with their )ederal 2eserve funds is known as )ederal )unds Gending . The rate of interest they charge is known as the )ederal )unds 2ate or )ed )unds 2ate. It is possible for the lending bank to loan the money for longer periods of time than one day. 0owever, almost all the federal funds lending is for one overnight period. The federal funds rate is the most volatile of all the money market rates. ,epurchase !$ree ents (,epos) 2epurchase agreements are the primary way dealers in government securities are able to finance their government securities inventory. 5very week the Treasury Department issues several billion dollars worth of securities. 9ost securities trading is done between dealers. Securities dealers might be buying securities which are valued at a sum greater than their net worth. )or e1ample, a bond dealer might buy +D+=4 billion dollars worth of government securities. The dealer pays the government several hundred million dollars now and enters into a repurchase agreement for the balance.

5ssentially, what the bond dealer does is agree to sell the unpaid balance back to the government with the understanding that he can repurchase them in the future. When the dealer buys the securities back from the government, the dealer pays the government interest. !fter all, the Treasury Department actually financed this transaction for the bond dealer. !fter the auction, and after the repurchase agreement is entered into, the bond dealer starts calling customers who might buy the bonds. !s the dealer sells the bonds, they pull them from the inventory the government is carrying for them and pay off these additional bonds. 7sually, these repurchase agreements are overnight. !s the dealer is usually able to sell the bonds very <uickly. Bankers' !cceptances %ankers acceptances are negotiable instruments #time drafts$ drawn to finance the e1port, import, domestic shipment or storage of goods. ! bankers acceptance is OacceptedO when a bank writes on the draft its agreement to pay it at maturity. When the bank does this it uses the specific word OacceptedO. ! bank may accept the draft for either the drawer or the holder. !n ordinary acceptance is a draft or bill of e1change order to pay a specified amount of money at a specified time. ! draft may be drawn on individuals, businesses or financial institutions. %ut a bankers acceptance, must be drawn on and accepted by a bank. %anks accept these drafts on behalf of their customers, who are obligated to pay the bank the amount financed on or before the maturity date. The bank becomes the primary obligor of the draft or bill of e1change drawn on and accepted by it. !n acceptance doesn t reduce a bank s lending capacity. The bank can raise funds by selling the acceptance. &evertheless, the acceptance is an outstanding liability of the bank and is subEect to the reserve re<uirement unless it is of a type eligible for discount by a )ederal 2eserve %ank. Getters of credit in foreign trade transactions are the most common type of acceptance. The most common everyday occurrence of this is when a 7.S. firm imports goods from a foreign firm and asks a 7.S. bank to issue a letter of credit on behalf of the importer to the foreign e1porter. The letter authori(es the foreign e1porter to draw a time draft upon the 7.S. importer s bank. This is in payment for the goods. The foreign e1porter may discount the draft with the e1porter s bank and receive immediate payment rather than the importer s bank remitting funds under the draft or waiting until maturity for payment. 0owever, this may not be done until the goods have been shipped. Subse<uently, the foreign e1porter s bank forwards the draft and applicable shipping documents to the importer s bank in the 7.S. for acceptance. The 7.S. bank then stamps the word OacceptedO on the face of the draft along with an officer s signature. !t this point the draft becomes a bankers acceptance. In turn, the importer s bank may discount the acceptance for the foreign bank, and the importer s bank will earn the difference between the discounted amount paid to the foreign bank and the face amount of the bill, plus the commission for originating the instrument. The importer s bank will then recover the payment to the foreign bank by selling the acceptance it created in the open market to a dealer or investor. If a company wants to finance both the shipment of goods between foreign nations and, to some e1tent, the storage of goods overseas, they would use a ThirdD;ountry !cceptance. These are primarily used by !sian importers and e1porters. !nd they principally reflect the use of the 7.S. acceptance market. )inance bills are accepted by some banks as a means of e1tending shortDterm credit. They are usually accepted to provide working capital to the drawer of the draft. These instruments are not related to specific transactions. Ardinarily, they can t be discounted or purchased by )ederal 2eserve %anks. %ecause the )ederal 2eserve will not discount or purchase these bills, they are also referred to as Oineligible acceptancesO. 0owever, they must be reported in reports of condition #call reports$. 9ember banks and covered 7nited States branches and agencies of foreign banks must maintain reserves against ineligible acceptances. 7sually, maturities on bankers acceptances that are eligible for purchase range from F, to +-, days. 0owever, at times can e1tend up to nine months. 9aturities are usually arranged to cover the time re<uired to ship and dispose of the goods being financed. With a bankers acceptance, the accepting bank charges a fee for the service. The cost to the borrower is the fee plus the discount on the acceptance. The dealer market for bankers acceptances involves about +: to 4, large firms. 9ost of these firms operate nationwide and also engage in buying and selling 7.S. 8overnment securities. In addition to the dealers, there are domestic and foreign accepting banks, 5dge !ct corporations, other financial and nonDfinancial institutions, governmental units, individuals and central banks, including the )ederal 2eserve, participating in this overDtheDcounter market. ;ongress enacted the %ank 51port Services !ct #O%5S!O$ in Actober of +3-4. @rovided that certain re<uirements are met, Section 4,> of the %ank 51port Services !ct #O%5S!O$ liberali(ed the statutory re<uirements affecting bankers acceptances involving the domestic shipment of goods. It raised the limits on the aggregate amount of OeligibleO bankers acceptances that may be created by a member bank' and allowed portions of bankers acceptances that are conveyed to others through participation agreements to be e1cluded from a bank s limits on bankers acceptances.

In !pril +3-/, the )ederal Apen 9arket ;ommittee changed a position that it had held for years. The use of repurchase agreements on acceptances for reserves management had declined in relative importance in recent years, and the market for acceptances reached a scale of activity which didn t re<uire or Eustify continuing )ederal 2eserve support. Therefore, the )ederal Apen 9arket ;ommittee announced that, effective Buly 4, +3-/, the 7.S. central bank would discontinue the use of repurchase agreements on bankers acceptances in open market operations to manage reserves. The )ederal 2eserve will continue to buy and sell acceptances, as agent, for foreign central banks and to take delivery of acceptances as collateral for advances. The )ed had actually begun pulling out of this market in +3>> when the )ed stopped buying acceptances on an outright basis. )sti atin$ &ields on Treasury Securities Treasury bills #TDbills$ are debt instruments with maturities of one year or less. They are backed by the full faith and credit of the 7.S. government. Treasury bills are lowDrisk investments with a broad and li<uid secondary market. The interest earned on Treasury securities is e1empt from state and local ta1es. 0owever, because TDbills are free of default risk, T bills generally have lower yields than corporate issues of comparable maturities. The reason for this is that TDbills are free of default risk. TD%ill Yields TDbills are purchased by investors at a weekly auction. The investor pays less than face value for the TD%ills and they are redeemed at maturity at face value. The difference between the purchase price and the face value of the TDbill is the investor s return. The investor s return is used in mathematical formulas to determine the yield on TDbills. The discount yield method, takes into account the return as a percent of the face value of a TDbill. It does not use its purchase price. The discount method tends to understate the yield because the purchase price is almost always less than face value. The investment yield method, is also used to calculate the yield. 7nlike the discount yield formula, the investment yield method relates the investor s return to the purchase price of the bill. The discount yield, the investment yield, the high, low and average prices of the auctioned TDbills, are made public in an official Treasury report shortly after the auction. The Treasury uses the discount and investment formulas for calculating yields on all TDbills, e1cept the oneDyear bill. Yields reported by the Treasury are precise to several decimal places. The Discount Yield 9ethod The following formula was supplied by the 7.S. Treasury and is used to determine the discount yield for TDbills that have threeD or si1D month maturities" Discount yield H J)I D @@=)IK Q JF6,=9K )I H face value @@ H purchase price 9 H maturity of bill. )or a threeDmonth TDbill #+F weeks$ use 3+, and for a si1Dmonth TDbill #46 weeks$ use +-4 F6, H the number of days used by banks to determine shortDterm interest rates #the investment yield method is based on a calendar year" F6: days or F66 in leap years$. 51ample This e1ample is taken from an actual 7.S. Treasury Department e1ample. What is the discount yield for a +-4Dday TDbill, auctioned at an average price of *3,6:3.F, per *+,,,,, face valueL Discount yield H J)I D @@=)IK Q JF6,=9K )I H *+,,,,, @@ H *3,6:3.F, 9 H +-4 Discount yield H J#+,,,,,$ D #3,6:3.F,$ = #+,,,,,$K Q JF6,=+-4K Discount yield H JF/,.> = +,,,,,K Q J+.3>-,44K Discount yield H .,6>F3+4 H 6.>/. )or the +FDweek bill, the same formula would be used, dividing F6, by a maturity of 3+ days rather than +-4 days.

The Investment Yield 9ethod When comparing the return on investment in TDbills to other shortDterm investment options, the investment yield method can be used. This yield is alternatively called the bond e<uivalent yield, the coupon e<uivalent rate, the effective yield and the interest yield. The following formula is supplied by the 7.S. Treasury and is used to calculate the investment yield for TDbills that have threeD or si1D month maturities" Investment yield H J)I D @@=@@K Q JF6: or F66=9K 51ample The following e1ample is taken from an actual 7.S. Treasury Department e1ample. What is the investment yield of a +-4Dday TDbill, auctioned at an average price of *3,6:3.F, per *+,,,,, face valueL Investment yield H J)I D @@=@@K Q JF6:=9K )I H *+,,,,, @@ H *3,6:3.F, 9 H +-4 Investment yield H J#+,,,,, D 3,6:3.F,$ = #3,6:3.F,$K Q JF6:=+-4K Investment yield H JF/,.>,K = 3,6:3.F,K Q J4.,,:/3/:K Investment yield H .,>,>F>4 H >.,>. )or the +FDweek bill, the same formula can be used, dividing F6: #or F66$ by a maturity of 3+ days. Yields on Treasury &otes and %onds Treasury notes and bonds, are fullyDbacked 7.S. debt instruments. They have maturities of more than one year and pay the investor a fi1ed annual rate of return or coupon which is paid semiDannually. The return on a Treasury note or bond is e<ual to its face value times the coupon interest rate. )ormulas used by the Treasury to calculate the investment yield on notes and bonds are complicated and vary depending on the maturity of the issue. 0owever, the investment yield on a bond or note held to maturity can be appro1imated with the following formula which was supplied by the 7.S. Treasury" R2 C J#)I D @@$=9KS Investment yield H DDDDDDDDDDDDDDDDDDDD J#)I C @@$=4K 2 H coupon rate )I H face value @@ H purchase price 9 H years to maturity 51ample This e1ample is taken from a 7.S. Treasury Department e1ample. What is the investment yield of a sevenDyear Treasury note issued at a price of *33.>,3, with an annual Treasury announced coupon of > >=-, payable semiDannuallyL 2 H > >=- #>.->:$ )I H *+,, @@ H *33.>,3 9 H >

>.->: C J#+,, D 33.>,3$=>K Investment yield H DDDDDDDDDDDDDDDDDDDDDDDDDD #+,, C 33.>,3$=4 Investment yield H #>.->: C .,/+:>+/$ = #33.-:/:$ Investment yield H >.3+6:>+/ = 33.-:/: Investment yield H .,>34-+, H >.3F. +ederal ,eserve -ocations The )ederal 2eserve D The ;entral %ank of the 7. S. This section is written to provide an overview of the )ederal 2eserve in the 7nited States. The )ederal 2eserve System is the central bank of the 7nited States. In +3+F ;ongress created the )ederal 2eserve. The )ed is charged with the responsibility to foster a sound banking system and a healthy economy. Today the )ed is comprised of +4 regional )ederal 2eserve %anks and the %oard of 8overnors in Washington, D.;. The acts in different roles in our financial system. It serves as a banker s bank, as the government s bank, as a regulator of financial institutions, and as the nation s money manager. The )ederal 2eserve was created out of a need to avoid the cyclical pattern of booms and busts that the 7.S. economy had been e1periencing. !fter a long drawn out battle in ;ongress and the public, a compromise was reached. !nd in +3+F, ;ongress created the )ederal 2eserve System. It is a fairly complicated structure. 0owever, it is through this structure that the )ed is able to insulate itself from narrow, partisan needs and desires. The )ed s mission D to foster a sound and healthy financial system and economy. !s a banker s bank, the )ed s +4 regional %anks provide services to financial institutions that are similar to the services that banks and thrifts provide to businesses and individuals. The payments system is where all financial transactions in the economy flow. The )ed helps assure the safety and efficiency of the payments system. )ed processes millions of payments every day in the form of both paper checks and electronic transfers. When an individual cashes a check or has money electronically, it is most likely the )ederal 2eserve %ank which will handle the transfer of funds from one financial institution to another. This is a fee based service the )ed %anks offer the depository institutions in its )ederal 2eserve District. Institutions can choose to use the )ed s services or those offered by other competitors in the marketplace. The +4 )ed %anks process more than oneDthird of the *+4 trillion in checks written annually in the 7.S. The dollar volume transferred through the )ederal 2eserve s electronic network approaches *4,, trillion which is far larger than the gross national product of the 7nited States. The )ederal 2eserve also acts as the government s bank. In its role as the government s bank or fiscal agent, the )ed processes a variety of financial transactions involving trillions of dollars. The 7.S. Treasury keeps a checking account with the )ederal 2eserve. This checking account is used for incoming federal ta1 deposits and outgoing government payments. !s part of its relationship with the 7.S. government, the )ed sells and redeems 7.S. government securities such as savings bonds and Treasury bills, notes, and bonds. The coin and paper currency of the 7nited States is also issued by the )ederal 2eserve. The currency is actually produced by the 7.S. Treasury, through its %ureau of the 9int and %ureau of 5ngraving and @rinting. The currency is then distributed by the )ederal 2eserve 2egional %anks to financial institutions. @eriodically, the currency circulates back to the )ed %anks where it is counted, checked for wear and tear, and e1amined for counterfeits. If the money is still in good condition, it is eventually sent back into circulation as institutions order new supplies to satisfy the public s need for cash. WornDout bills, are destroyed by shredding. The average *+ bill circulates for appro1imately +- months before it is destroyed. The )ederal 2eserve supervises and regulates financial institutions. )inancial institutions are governed by the rules that the )ed formulates. To help ensure financial institutions operate in a safe and sound manner and comply with the laws and rules that apply to them, there are rigorous e1amination and monitoring procedures that the )ed uses. The e1amination and monitoring duties are carried out by the regional )ederal 2eserve %anks. %anks that are seeking to merge or bank holding companies seeking to buy a bank or engage in a nonDbanking activity, must receive approval from the )ed. Ane of the maEor considerations the )ed takes into account when approving or disapproving a merger is how the transaction will affect competition in the local community. !dditionally, the )ederal 2eserve also implements lawsDDsuch as TruthDinD Gending, 5<ual ;redit Apportunity, and 0ome 9ortgage Disclosure, meant to ensure that consumers are treated fairly in financial dealings.

The )ed is also the Olender of last resortO. )inancial institutions can turn to the )ederal 2eserve if they are e1periencing a significant and une1pected drain on their deposits and can t borrow money elsewhere. The purpose of this lending ability is to prevent one institutions problems from spreading to other financial institutions and possibly destabili(ing the banking system. The )ederal 2eserve is structured in layers. The central bank sits on top. ;omprising the central bank is the %oard of 8overnors. The %oard of 8overnors has > members each serving staggered +/ year terms. 5ach member of the %oard of 8overnors is appointed by the @resident and must be confirmed by the Senate. The %oard of 8overnors oversees the entire System operations, it makes regulatory decisions, and sets reserve re<uirements for banks. There are +4 regional )ederal 2eserve %anks. 5ach of these banks is comprised of a 3 member board of directors drawn from the private sector. !nd each of these +4 banks is independently incorporated. These banks set the discount rate, subEect to approval by the %oard of 8overnors. !nd region by region, they monitor the economy and the financial institutions in their respective region. The )ederal Apen 9arket ;ommittee #)A9;$ is the body inside the )ed which is responsible for key monetary policymaking. The )ed seeks to foster economic growth with price stability. This is done by making decisions which affect the flow of money and credit in the 7nited States. The )ederal Apen 9arket ;ommittee is comprised of the > members of the %oard of 8overnors and the 2eserve %ank presidents, : of whom serve as voting members on a rotating basis. The primary responsibility of the )ed is in formulating and carrying out monetary policy. In order to carry out monetary policy, the )ed acts as the nation s Omoney managerO. The )ed tries to balance the flow of money and credit with the needs of the economy. Too much money in the economy can lead to inflation, while too little can stifle economic growth. The )ed seeks to strike a balance between these two e1tremes. In order to balance the flow of money, the )ed affects the ability of financial institutions to OcreateO checkbook money through loans or investments. This is accomplished by determining the amount of OreservesO that banks and thrifts must hold. Depository institutions are subEect to rules re<uiring that a certain percentage of their deposits be set aside as reserves and not used for loans or investments. %anks and thrifts can keep cash in their own vaults and through balances held in a reserve account at a regional )ederal 2eserve %ank. If a bank or thrift has to keep more cash in reserve, they have less to lend to the public. Through the reserve re<uirement, the )ed indirectly affects the flow of money and credit through the economy. The )ed can affect the reserves through F methods. The first of these is reserve re<uirements. ! higher reserve re<uirement leads to banks and thrifts keeping more money in reserve and less money by banks available to lend and invest. ! lower reserve re<uirement means that the banks and thrifts have to keep less money and reserve. Therefore, they have more money to lend and invest. ;hanging the reserve re<uirement can have a dramatic affect on the economy is used sparingly by the )ed. The discount rate is the second method the )ed has to alter the money supply in the economy. The discount rate is the rate at which banks and thrifts can borrow on an overnight basis from the )ed. %y making it more e1pensive for banks and thrifts to borrow overnight the )ed can make it more e1pensive to obtain money. Thereby, it can inhibit bank lending and investment. The problem with this is that if funds are readily available from other sources to banks and thrifts, this has a very small effect. It is used more to signal future )ed direction than to slow down lending and investment. The third method the )ed has at its disposal to influence the money supply is through open market operations. This is the most fle1ible of the three tools. Apen market operations involve the he purchase and sale of government securities by the )ed. When the )ed wants to increase the flow of money and credit, it buys government securities' when it wants to restrict the flow of money and credit, it sells government securities. Apen market operations affect the supply of money through the reserves of depository institutions. If, the )ederal 2eserve wanted to increase the supply of money and credit, it might purchase *+, billion in government securities from a few securities dealers. The purchase would be paid for by the )ederal 2eserve. The )ed would pay for the securities by adding *+, billion to the reserve accounts that the security dealer s bank keeps at the )ed. The bank would in turn credit the security dealer s account for that amount. The dealer s bank must keep a certain percentage of these new funds in reserve. 0owever, it can lend and invest the remainder. !s these funds are spent and reD spent, the stock of money and credit will eventually increase by much more than the original *+, billion addition. If the )ed wanted to decrease the money supply, it would sell *+, billion in government securities to several dealers. That amount would be deducted from the reserve accounts of the dealers banks. The bank, would deduct *+, billion from the accounts of the dealers. Gess money would end up flowing through the economy. Gike the rest of the 7nited States 8overnment, the )ed has certain checks and balances within it to limit the power any one group inside the )ed can wield. 5ach group inside the )ed has a different authority to act. Anly the %oard of 8overnors can change the reserve re<uirements. SubEect to approval by the )ederal 2eserve %oard of 8overnors, the 2egional )ederal 2eserve %anks have the authority to change the discount rate. !nd open market operations, which many consider to be the most important tool, are directed by the )ederal Apen 9arket ;ommittee #)A9;$.

The )ederal Apen 9arket ;ommittee #)A9;$, is possibly the most important policymaking body. It is comprised of all > members of the %oard of 8overnors and the presidents of the 2eserve %anks. Anly : of the +4 presidents serve as voting members. The president of the &ew York )ed, which handles the open market securities transactions on behalf of the System, serves as a permanent voting member, while the other presidents rotate annually. 5ven though only : presidents vote, all +4 participate fully in each )A9; meeting. The )ed is an interesting central bank. In fact, it is like no other central bank. It is a central bank, but it is decentrali(ed with a system of regional 2eserve %anks responsive to local needs. It is a public institution with a public purpose, but it has some private features such as, directors, Ostockholders,O and selling services. It is governmental, but it is independent within government. It was created by and reports to ;ongress. 0owever, its highest officials, the members of the %oard of 8overnors, are appointed by the @resident and confirmed by the Senate. Its earnings and assets are returned to the 7.S. Treasury. The )ed operates on its own earnings rather than ;ongressional appropriation. The %oard of 8overnors terms are long and staggered, limiting the @resident s influence. !nd unlike other nations central banks, it is separate from the Treasury. The +ederal (pen Market Co ittee

9ost people consider the )ederal Apen 9arket ;ommittee #)A9;$ to be the most important monetary policyDmaking body of the )ederal 2eserve System. The )ederal Apen 9arket ;ommittee #)A9;$ designs policy to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments. The )A9; is responsible for the conduct of open market operations. Apen market operations involve the purchases and sales of 7.S. 8overnment and )ederal !gency securities. These purchases and sales of securities affect the amount of money depository institutions have available to them. In turn, the cost and availability of money and credit in the 7.S. economy is controlled. The )A9; also directs System operations in foreign currencies. The )A9; is comprised of the seven members of the %oard of 8overnors and five 2eserve %ank @residents. The @resident of the )ederal 2eserve %ank of &ew York serves on a continuous basis. The @residents of the other 2eserve %anks serve on a rotating basis for oneDyear terms beginning on 9arch + of each year. 5ach year one member is elected to the ;ommittee by the %oards of Directors of each of the following groups of 2eserve %anks" +$ %oston, @hiladelphia, and 2ichmond' 4$ ;leveland and ;hicago' F$ !tlanta, St. Gouis, and Dallas' and /$ 9inneapolis, Pansas ;ity, and San )rancisco. In this way, rotation is fair and e<uitable. !t the first meeting on or after 9arch + of each year, the ;ommittee elects its ;hairman and Iice ;hairman. Staff officers are also selected to serve the ;ommittee for the coming year. The ;hairman of the %oard of 8overnors is traditionally elected as ;hairman and the @resident of the )ederal 2eserve %ank of &ew York as Iice ;hairman. Afficers and employees of the %oard of 8overnors and the )ederal 2eserve %anks are traditionally selected as staff officers. Afficers include" a Secretary to maintain a record of actions taken by the ;ommittee upon all <uestions of policy' economists to prepare and present to the ;ommittee information regarding business and credit conditions and domestic and international economic and financial developments' 8eneral ;ounsel to furnish legal advice' and two 9anagers of the System Apen 9arket !ccount, one for domestic and one for foreign operations and are charged to e1ecute and to report to the ;ommittee on open market transactions. )A9; must be held at least four times each year in Washington, D.;. 9eetings also have to be held upon the call of the ;hairman of the %oard of 8overnors or at the re<uest of any three members of the ;ommittee. )or the most part, meetings are held once every : to - weeks in the offices of the %oard of 8overnors in Washington. These meetings are usually set and scheduled on a tentative basis at the beginning of the year. If circumstances develop such that consultation or consideration of an action between these regular meetings is needed, members may be called on to participate in a special meeting or a telephone conference, or to vote on a recommended action by telegram or telephone. !t the regular meetings the ;ommittee discusses and votes on the policy to be carried out during the interval between the current meeting and the ne1t meeting. !t least twice a year, the ;ommittee also votes on certain longDrun policy obEectives. %ecause of the confidential nature of financial information discussed at the )A9; meetings, attendance at the meetings is highly restricted. It is limited to ;ommittee members, nonDmember 2eserve %ank @residents, staff officers, the 9anagers of the System !ccount, and a small number of %oard and 2eserve %ank staff. The minutes of these meetings are released Eust after the following )A9; meeting. !nalysts read through the minutes of the prior meeting very closely to try to determine the actions or nonDactions the )ed might take in the future. Written reports from the staff dealing with past and prospective economic and financial developments are sent to each ;ommittee member and to nonDmember 2eserve %ank @residents prior to each meeting. These reports include oral and written reports prepared by the 9anagement of the System Apen 9arket !ccount on operations in the domestic open market and in foreign currencies since the last regular meeting. Aral reports are given by staff officers on the current and prospective business situation, on conditions in financial markets and on international financial developments. The )A9; also considers such factors as" prices and wages, production, retail sales, consumer spending, wages and income, residential construction, e1ports and imports, e1change rate developments, business investment, inventories, business profits, interest rates, fiscal policy, and others. Aral reports on transactions in the System Apen 9arket !ccount since the previous meeting are given by the 9anagers of the !ccount. !fter listening and reading the reports, the ;ommittee members and other 2eserve %ank @residents discuss policy. 5ach participant is usually allowed to e1presses his or her own views on the state of the economy and prospects for the future, and e1presses their individual opinion at to the appropriate direction for monetary policy. 5ach member also makes a more e1plicit recommendation for policy for the coming period between meetings #and for the longer run, if under consideration$. !ll of this is geared toward an attempt for the ;ommittee

to develop a consensus regarding the appropriate course for policy. This consensus of opinion is then incorporated in a directive to the )ederal 2eserve %ank of &ew York. The )ederal 2eserve %ank of &ew York is the bank selected by the ;ommittee to e1ecute transactions for the System Apen 9arket !ccount. The directive issued by the )A9; is designed to provide guidance to the 9anager of the )ederal 2eserve %ank of &ew York in the conduct of dayDtoDday open market operations. @resently, the directive sets forth the ;ommittee s obEectives for longDrun growth of certain key monetary and credit aggregates. It also sets out operating guides for rates of growth in the aggregates and an associated range of tolerable changes in money market conditions for short term monetary policy. @olicy is designed to provide guidance to the )ederal 2eserve %ank of &ew York in setting the supply of reserves in a manner consistent with the nation s broader economic obEectives. Depository institutions are not allowed to use all their deposits. They have to keep a portion in reserve with the )ederal 2eserve. Apen market operations directly affect the level of reserves in the banking system. If, the )ederal 2eserve wanted to increase the supply of money and credit, it might purchase *+, billion in government securities from a few securities dealers. The purchase would be paid for by the )ederal 2eserve. The )ed would pay for the securities by adding *+, billion to the reserve accounts that the security dealer s bank keeps at the )ed. The bank would in turn credit the security dealer s account for that amount. The dealer s bank must keep a certain percentage of these new funds in reserve. 0owever, it can lend and invest the remainder. !s these funds are spent and reDspent, the stock of money and credit will eventually increase by much more than the original *+, billion addition. If the )ed wanted to decrease the money supply, it would sell *+, billion in government securities to several dealers. That amount would be deducted from the reserve accounts of the dealers banks. The bank, would deduct *+, billion from the accounts of the dealers. Gess money would end up flowing through the economy. The %oard of 8overnors is re<uired by law to keep a complete record of the actions taken by the )A9; on all <uestions of policy and to include in its annual report to ;ongress the vote on and the reasons for each action. Therefore, a O2ecord of @olicy !ctionsO is prepared after each meeting and is released to the press and the public a few days after the ne1t regularly scheduled )A9; meeting. !s mentioned previously, the O9inutes of !ctions,O lists policy and nonDpolicy actions and is made available for public inspection at the same time the 2ecord of @olicy !ctions for the corresponding meeting is released. Twice a year, the %oard submits a written report to ;ongress on the state of the economy and the course of monetary policy, pursuant to the O0umphreyD0awkinsO !ct of +3>-. It may also be called to consult with ;ongress on this report. (pen Market (perations 9ost people consider open market operations to be the )ederal 2eserve s most fle1ible means of carrying out monetary policy. Through open market operations, the )ederal 2eserve buys and sells 7.S. government securities in the secondary market in order to adEust the level of reserves in the banking system. Apen market operations enable the )ederal 2eserve to manage money supply growth and reach other monetary policy targets. Ane of three basic tools used by the )ederal 2eserve to reach its monetary policy obEectives are open market operations. The other tools involve changing the terms and conditions for borrowing at the discount window and adEusting reserve re<uirement ratios. The )ederal 2eserve s most fle1ible means of carrying out its obEectives is by the purchase or sale of securities in the open market. The open market is also known as the secondary market and is the same market the rest of us buy and sell securities. The )ed can offset or support seasonal or international shifts of funds and thereby influence shortDterm interest rates and the growth of the money supply. This is done by adEusting the level of reserves in the banking system through open market operations. The )A9; and 9onetary @olicy The )ederal 2eserve s top monetary policyDmaking group, the )ederal Apen 9arket ;ommittee #)A9;$, makes the decisions about the sale or purchase of securities in the open market. These are based on a directive, or set of instructions, developed by the )ederal Apen 9arket ;ommittee #)A9;$ at their periodic meetings. These directives indicate the approach to monetary policy that the )A9; considers appropriate for the time period between its meetings. The manager of the System Apen 9arket !ccount at the &ew York )ederal 2eserve %ank e1ecutes open market operations on behalf of the entire )ederal 2eserve System. The &ew York )ederal 2eserve %ank uses the directive as a guide in making decisions about the dayDtoDday sale or purchase of securities. It is up to the &ew York )ederal 2eserve %ank to determine the best way to carry out the directive. Apen market operations allow the )ederal 2eserve to adEust directly the level of nonDborrowed reserves in the banking system. &onD borrowed reserves represent the maEority of total reserves. This also includes borrowings from 2eserve %anks. Through this marginal adEustment, open market operations influence the federal funds rate. The federal funds rate is the interest rate that institutions pay when they borrow reserves overnight from each other, and is also used for other shortDterm rates. @eriodically, banks ac<uire reserves in the federal funds market in order to meet reserve re<uirements set by the )ederal 2eserve. Apen 9arket Transactions

! government securities dealer who has an established trading relationship with the )ederal 2eserve, is known as a primary dealer. In carrying out open market operations the )ederal 2eserve may buy securities from a primary dealer in the open market and pay for those securities by sending funds to the clearing bank of the primary dealer earmarked for the account of that dealer. This action adds reserves to the banking system. 2eserves are added to the system because the )ed has to pay for those securities with cash. ;onversely, when the )ederal 2eserve sells securities to a primary dealer, the )ed notifies the clearing bank of the primary dealer to debit the account of that dealer. This action drains reserves from the banking system. It drains reserves because the primary dealer has to pay for those securities with cash. There are three different approaches available to the &ew York )ed s System Apen 9arket !ccount manager regarding the type of transaction e1ecuted. This is also dependent on the level or resources in the banking system The transactions the trading desk engages in are usually shortDterm repurchase agreements #2@ s$. 2epurchase agreements #2@ s$ are used in situations that call from temporary additions to bank reserves. When the &ew York )ed uses repurchase agreements #2@ s$ the System buys securities from the dealers, who agree to repurchase them by a specified date at a specified price. When the 2@s mature, the added reserves are automatically drained. When there is a temporary need to drain reserves, matched saleDpurchase transactions with dealers are e1ecuted. These transactions involve a contract for immediate sale of Treasury bills to, and a linked matching contract for subse<uent purchase from each participating dealer. There are times when the System may engage in outright purchases and sales of securities. When this need arises, dealers are re<uested to submit bids or offers for securities of the type and maturity that the &ew York )ederal 2eserve %ank has elected to buy or sell. The highest prices bid for sales and the lowest prices offered for purchases are selected until the desired si(e of the transaction is reached. These purchases and sales add or drain reserves on a permanent basis. Autright purchases and sales are arranged early in the afternoon of the day the are going to occur. !nd they are generally e1ecuted for delivery on the following day. They are used when there are persistent needs to add or drain reserves arising from currency demands and other seasonal and secular developments affecting reserves. 8athering Information, @reparing to !ct The trading desk staff at the &ew York )ederal 2eserve %ank has ongoing talks with the large money center banks about their reserve needs and the banks plans for meeting them. They also have ongoing discussions with primary dealers and how the day might unfold in the securities market as well as how the dealers task of financing their securities positions is progressing. Data on bank reserves from the previous day and on factors that could change proEections for future days is compiled by reserve forecasters in the &ew York )ed s research department and at the %oard of 8overnors in Washington. The Treasury Department also provides information about its balances at )ederal 2eserve %anks. This is usually done through a telephone call each morning at about +,"F, a.m. The &ew York )ed develops a plan based on their discussions with the Treasury Department, primary dealers, and banks and thrifts. The daily plan includes information about financial and foreign e1change market conditions and the behavior of the economy and interest rates. The plan is reviewed with )A9; representatives during a conference call held each morning at about ++"+: a.m. This daily discussion allows the )A9; to monitor closely the trading desk s implementation of the )A9; directive. When the conference call with )A9; representatives is completed, the trading desk is ready to enter the market to e1ecute open market operations. The trading desk at the &ew York )ederal 2eserve %ank calls all of the primary dealers, asking them to submit bids or offers. The dealers bids or offers are evaluated on a competitive bestDprice basis. @rimary dealers who have won the auction, and those who did not, are notified of the results by early afternoon. With an e1change of funds, securities and collateral, the operation is complete for that day. Pri ary Dealers @rimary dealers are banks and securities broker dealers that trade in 7.S. 8overnment securities with the )ederal 2eserve System. !s of December +33:, there were F> primary dealers. @rimary dealers trading volumes in 7.S. 8overnment securities averaged about *4,, billion per day as of December +33:. @rimary dealers are banks and securities brokerDdealers that trade in 7.S. 8overnment securities with the )ederal 2eserve %ank of &ew York. The &ew York )ed s open market desk, An behalf of the )ederal 2eserve, the open market desk at the &ew York )ederal 2eserve %ank trades with primary dealers in order to implement monetary policy directives. The purchase and sale of securities in the open market #secondary market$ adds or removes li<uidity from the banking system. In +36,, the &ew York )ederal 2eserve %ank established the primary dealer system. It started with +- primary dealers and now has about F> primary dealers. !lthough, this number changes from time to time as new primary dealers are added, dropped or merged together. !mended @rocedures for @rimary Dealers

The )ederal 2eserve amended its procedures for selecting primary dealers in +334. This was done to address some problems that had arisen in the previous primary dealer arrangements. The first problem that had arisen was the widespread misconception that the )ed regulated the primary dealer firms. The second problem that had arisen was that the primary dealer designation by the )ed had come to be viewed as giving special status to the firms. !s a result of these misconceptions, the &ew York )ed changed its criteria for administering its primary dealer relationships. The first change eliminated a standard for trading volume with customers. The second change disbanded the )ederal 2eserve %ank s dealer surveillance unit and shifted its focus to market surveillance. This change actually reflected a more accurate definition of the nature of its work. It also emphasi(ed the point that the %ank does not have and did not ever have formal regulatory authority over the primary dealers. !t the same time, the %ank strengthened its market monitoring capability. The market surveillance unit now began to communicate market developments to an interagency working group consisting of the &ew York )ederal 2eserve %ank, the )ederal 2eserve %oard of 8overnors, the Securities and 51change ;ommission, the 7.S. Treasury, and the 7.S. ;ommodity )utures Trading ;ommission. The )ed also increased its efforts to automate Treasury auctions and open up its market operations. It wanted to increase the efficiency of these activities. In !pril +33F, an automated Treasury auction system was started and in +33/, automated open market operations were begun. %ecoming a @rimary Dealer ! firm that wants to become a broker dealer writes the &ew York )ederal 2eserve %ank and re<uests the designation. 7pon receiving this re<uest, the )ed will then check with the applicant s regulator to make sure that it is in compliance with the relevant capital re<uirements. They must be either a commercial bank subEect to supervision by 7.S. )ederal bank supervisors, or broker dealers registered with the Securities and 51change ;ommission. There is no restriction against foreignDowned banks or broker dealers becoming primary dealers. The &ew York )ed s current criteria is <uite stringent and not easily obtained. The following is taken from )ederal 2eserve material. %ankD related primary dealers must be in compliance with Tier I and Tier II capital standards under the %asle ;apital !ccord, with at least *+,, million of Tier I capital. The Tier I component of a bank s <ualifying capital must represent at least :,. of <ualifying total capital and may consist of the following items that are defined as core capital elements" common stockholders e<uity, <ualifying nonDcumulative perpetual preferred stock, and minority interest in the e<uity accounts of consolidated subsidiaries. Tier I capital is normally defined as the sum of core capital elements, less goodwill and other intangible assets. The Tier II component of a bank s <ualifying total capital may consist of the following items that are defined as supplementary capital elements" allowance for loan and lease losses, perpetual preferred stock and related surplus, hybrid capital instruments and mandatory convertible debt securities, and term subordinated debt and intermediate term preferred stock. 2egistered brokerDdealers must have at least *:, million in Tier II capital and total capital in e1cess of the regulatory Owarning levelsO set by the Securities and 51change ;ommission and the Treasury, the two regulatory bodies that oversee nonDbank securities trading organi(ations. These specified minimum levels of capital are designed to help insure that primary dealers are able to enter into transactions with the )ed in sufficient si(e to maintain the efficiency of trading desk operations. !dditionally, the )ed re<uires primary dealers to make reasonably good markets in their trading relationships with the )ed s trading desk. The primary dealer has to participate meaningfully in Treasury auctions. !nd the primary dealer has to offer market information and analysis to the )ed s trading desk which is helpful in the formulation and implementation of monetary policy. The primary dealers also report weekly on their trading activities, cash, futures, and financing market positions in Treasury and other securities. These reports also supply additional information important to surveillance efforts. @rimary dealers trading volume averaged about *4,, billion per day as of December +33:. The primary dealers provide the li<uidity and source for open market transactions to occur. It is through this competitive bidding process in which the Apen 9arket Desk invites all primary dealers to submit propositions in response to its announced operation #i.e. purchases, sales, repurchase agreements, or matchedDsale purchase transactions$. @rimary dealers submit propositions and receive results electronically. 2eview @rocedures 5ach primary dealer is continuously reviewed by the &ew York )ederal 2eserve %ank and evaluated in its role as a trading partner with the %ank. 5ach dealer is e1pected to be a meaningful business counterparty over time, both in si(e and in competitiveness of its propositions. )ailure to meet performance standards, will result in the )ed s withdrawal of the primary dealer designation. If a primary dealer fails to meet re<uired capital standards, the )ed may suspend its trading relationship until the firm s capital position is restored to the appropriate level. !ny decision by the )ed will carry no implication as to the creditworthiness, financial strength, or managerial competence of the firm. The Discount %indo. !ll depository institutions are eligible to borrow at the discount window of a 2eserve %ank as a last resort. !ll loans at the discount window must be secured. The basic type of credit available at the discount window is shortDterm adEustment credit intended to help institutions adEust their reserve balances to une1pected changes in their assets and liabilities. The )ed also has programs that provide longerDterm credit, including seasonal credit. Depository institutions with transaction accounts or nonDpersonal time deposits are eligible to borrow at the discount window of a 2eserve %ank. ! transaction account allows a depositor to transfer payments to a third party. 51amples of these accounts are checking accounts,

negotiable order of withdrawal accounts, saving deposits subEect to automatic transfers and credit union share draft accounts. &onDpersonal time deposits are those of organi(ations, rather than persons. The basic type of credit available at the discount window is shortDterm adEustment credit, although there are provisions for longer term loans to eligible institutions. ShortDterm adEustment credit is available to domestic commercial banks, mutual savings banks, savings and loan associations, credit unions and 7nited States branches and agencies of foreign banks to help them achieve an orderly adEustment to une1pected changes in their assets and liabilities, primarily increases in loans or declines in deposits. Through the use of discount window credit, eligible institutions are given the time necessary to make internal adEustments to these changed circumstances. These institutions may use the discount window for credit assistance when their funding needs can t be met in the money markets. If after reasonable alternative sources of funds, including credit from special industry lenders, are unavailable, 2eserve bank credit is available. 2emember that the institution has to first seek alternative sources. They Eust can t go to the )ederal 2eserve as their first choice. 51amples of special industry lenders include the )ederal 0ome Goan %anks for member savings and loan associations and savings banks and the &ational ;redit 7nion !dministration s ;entral Gi<uidity )acility and credit union centrals for member credit unions. ShortDterm adEustment credit is e1tended at the basic discount rate, plus any surcharge that may be imposed. The )ederal 2eserve %oard introduced a new rate for e1ceptionally large borrowings that result from computer breakdowns or other operating problems associated with the payments system in 9ay +3-6. The rate e<uals the highest of the current discount rates and is applicable unless a problem is clearly beyond the reasonable control of the institution. 9ost discount window loans are secured by 7.S. 8overnment and agency securities and shortDterm customer notes. Goans also may be secured by other forms of collateral, such as State and municipal securities, longerDterm customer notes and mortgage loans covering + to / family residences may also be used. Smaller country and regional banks generally use 7.S. 8overnment and agency securities as collateral. Garger money market banks primarily use customer notes or residential mortgages. 2egulation O!O of the )ederal 2eserve !ct grants the authority and allows the )ederal 2eserve %anks to administer discount window credit. 2egulation O!O was amended effective September +3-, to reflect changes brought about by the International %anking !ct of +3>- and the Depository Institutions Deregulation and 9onetary ;ontrol !ct of +3-,. The provides latitude to The )ederal 2eserve %anks have some latitude for the e1ercise of Eudgment and discretion in the operation of the discount window. This is based on the statutory and regulatory framework of 2egulation !. This allows the window to be e<uitably administered in a manner responsive to the needs of individual institutions and the local and regional conditions affecting those institutions. In making their credit decisions, the )ederal 2eserve %anks consider, an institution s si(e, access to the money markets and other sources of funds, the special circumstances facing the institution, and the geographic and economic environment in which the institution is operating. In the past, the &ew York )ederal 2eserve %ank has limited maturities on adEustment credit advances to not more than two weeks for smaller banks, to one week for larger banks, and to overnight for the largest banks. If institutions need additional time to make adEustments in their assets and liabilities, the discount window loans may be renewed beyond their initial maturity. In addition to shortDterm adEustment credit, The provisions of the )ederal 2eserve !ct and the amended 2egulation O!O authori(e the )ederal 2eserve %anks to provide e1tended credit. This is over and above shortDterm adEustment credit. 51tended credit is provided through three programs designed to assist depository institutions in meeting longerDterm needs for funds. The first program provides seasonal credit, for periods up to si1 months, to smaller depository institutions which generally lack continuous access to market funds. Seasonal credit is mainly associated with agriculture and is heaviest in the summer months. There is also an emergency program which assists institutions that e1perience special difficulties arising from e1ceptional circumstances or practices involving only that institution. !ssistance in these cases is provided only when funds aren t available from other sources. If a situation arises where more general li<uidity strains affect a broad range of institutions such as thrift institutions that emphasi(e longerD term, mortgage assets, credit may be provided to address the problems of the institutions being affected by the general situation. ! rarely utili(ed procedure is for the )ederal 2eserve %ank to advance credit to individuals, partnerships and corporations that aren t depository institutions, if the 2eserve %ank determines credit isn t available from other sources and failure to obtain that credit would adversely affect the economy. This would only be done after consultation with the %oard of 8overnors of the )ederal 2eserve System. ,eserve ,e/uire ents o# the +ederal ,eserve The term reserve re<uirements refers to the percentage of deposits that a bank or other depository institution may not lend out or invest and must hold either as vault cash or on deposit at a )ederal 2eserve %ank. %asically, its money the financial institution took in and can t do anything with. It Eust sits around. !s of September +336, the reserve re<uirement was +,. on transaction deposits, and there were (ero reserves re<uired for time deposits. The 9onetary ;ontrol !ct #9;!$ of +3-, established the authori(ation for the )ed to re<uire financial institutions to hold a certain amount of capital in reserve. It authori(es the )ed s %oard of 8overnors to impose a reserve re<uirement of from -. to +/. on transaction deposits

#checking and other accounts from which transfers can be made to third parties$ and of up to 3. on nonDpersonal time deposits #those not held by an individual or sole proprietorship$. The )ed may also impose a reserve re<uirement of any si(e on the amount depository institutions in the 7nited States owe, on a net basis, to their foreign affiliates or to other foreign banks. 7nder the 9onetary ;ontrol !ct, the )ed may not impose reserve re<uirements against personal time deposits e1cept in e1traordinary circumstances. !nd only after consultation with ;ongress, and by the affirmative vote of at least five of the seven members of the %oard of 8overnors. This act was sort of phased in over time. The 9onetary ;ontrol !ct provided that the re<uirement in +3-, would be only F. for the first *4: million of a bank s transaction accounts, and that the *4:Dmillion figure would be adEusted annually by a factor e<ual to -,. of the percentage change in total transaction accounts in the 7nited States. !n adEustment at the end of +33: put the amount at *:4., million. This was done in order to ease the reserve re<uirements on small banks. The 8arnDSt 8ermain !ct of +3-4 provided for a ,. reserve re<uirement for the first *4 million of a bank s deposits. This level, too, rises each year as deposits grow, but it is not adEusted for declines in deposits. In late +33:, it was raised from */.4 million to */.F million. The transactionsDaccount reserve re<uirement is applied to deposits over a twoDweek period" a bank s average reserves over the period ending every other Wednesday must e<ual the re<uired percentage of its average deposits in the twoDweek period ending 9onday, two days earlier. %anks receive credit in one twoDweek period for small amounts of e1cess reserves they held in the previous period. ! small deficiency in one period may be made up with e1cess reserves in the following period. There are financial penalties for banks that fail to meet their reserve re<uirements. The )ederal 2eserve %ank of &ew York imposed 43: penalties on banks in the 4nd )ederal 2eserve District for failing to meet reserve re<uirements in +33+ and 443 in +334. The penalties totaled *43/,,,, in +33+ and *+/F,,,, in +334. The ability of the banking system to create transaction deposits is dependent on the reserve re<uirements. ! reserve re<uirement of +,., re<uires a bank that receives a *+,, deposit to keep *+, in abeyance and only lend out *3, of that deposit. If the borrower then writes a check to someone who deposits the *3,, the bank receiving that deposit can lend out *-+ and must keep *3 in reserve. !s the process continues, the banking system will e1pand the initial deposit of *+,, into a ma1imum of *+,,,, of money #*+,,C*3,C-+C *>4.3,C...H*+,,,,$. If the reserve re<uirement was 4,., the banking system would be able to e1pand the initial *+,, deposit into a ma1imum of *:,, #*+,,C*-,C*6/C*:+.4,C...H*:,,$. Thus, lower reserve re<uirements should result in increased money creation and, in turn, higher economic activity. 0igher reserve re<uirements should result in reduced money creation and, in turn, reduced economic activity. In real life, reserve re<uirements are not as correlated as demonstrated above. 2eserve re<uirements apply only to transaction accounts, which are components of 9+, a narrowly defined measure of money. Deposits that are components of 94 and 9F #but not 9+$, such as savings accounts and time deposits, have no reserve re<uirements. Therefore they can e1pand without regard to reserve levels. The )ederal 2eserve permits banks to ac<uire the reserves they need to meet their re<uirements from the money market. Af course banks have to be willing to pay the prevailing price #the federal funds rate$ for borrowed reserves. ;onse<uently, reserve re<uirements currently play a relatively limited role in money creation in the 7nited States. The )ed s three main tools of monetary policy are reserve re<uirements, the discount rate #the interest rate that )ederal 2eserve %anks charge depository institutions for shortDterm loans$, and open market operations #the buying and selling of government securities$. 2eserves flow on a continuous basis between banks. This is a result of the always changing supply and demand for these reserves at individual banks. When the )ed engages in open market operations, it adds to or subtracts from the supply of reserves. The more reasonably predictable demand for reserves are, the more effective are the actions that the )ed takes. 2eserve re<uirements for monetary policy purposes are only changed infre<uently. There is a large cost imposed on the banks e<ual to the foregone interest on the amount by which re<uired reserves e1ceed the reserves that banks would voluntarily hold in order to conduct their business. !s a result, the )ed has been hesitant to make changes that would increase that cost. Since the 9;! was passed in +3-, there have been only a handful of policyDrelated reserve re<uirement changes. In 9arch +3-F, the )ed eliminated the reserve re<uirement on nonDpersonal time deposits with maturities of F, months or more, and in September +3-F, it reduced that minimum maturity to +- months. In December +33,, the )ed cut the re<uirement on nonDpersonal time deposits and on net 5urocurrency liabilities from F. to ,.. In !pril +334, it cut the re<uirement on transaction deposits from +4. to +,.. %y historical standards current reserve re<uirements are low. )rom +3F> to +3:-, the rate on demand deposits was always at least 4,. for banks in &ew York and ;hicago, which were known then as central reserve cities. @rior to +3-,, when the 9onetary ;ontrol !ct passed, only banks that were members of the )ederal 2eserve System had to meet the )ed s reserve re<uirements. StateDchartered banks that were not )ederal 2eserve members had to meet their state s reserve re<uirements. 7sually, these individual state re<uirements were lower. !s a result, many banks dropped their )ederal 2eserve membership. 9ember bank transaction deposits fell from nearly -:. of total 7.S. transaction deposits in the late +3:,s to 6:. two decades later. This weakened the )ed s ability to influence the money supply. The 9;! sought To solve this problem, the 9;! authori(ed the )ed to set reserve re<uirements for all depository institutions, regardless of )ed membership status. +loat and Check Clearin$ by the +ederal ,eserve )ederal 2eserve float is money that appears simultaneously in the accounts of two depository institutions. These institutions include commercial banks, savings and loans, savings banks and credit unions, but are widely referred to as banks. )unds in the process of

collection may appear in the accounts of both the institutions that receive the checks for deposit and the institutions upon which the checks are drawn This occurs when check clearing is delayed. If this happens, the amount of money in the banking system is temporarily inflated. 5very day, businesses and individuals deposit millions of checks at banks. When a bank receives a check for deposit, it credits the account of the check depositor on a provisional basis, and then collects the funds from the bank upon which the check is drawn. Depository institutions transfer many of their checks to )ederal 2eserve %anks for collection, rather than sort all the checks and send each one back to the bank it was drawn upon for settlement. )ederal 2eserve %anks then pay the depositing banks for the total amount of the checks. The )ederal 2eserve %anks then collect funds from the banks on which they are drawn. When a )ederal 2eserve %ank receives checks from a bank, it credits that institution s reserve account for the amount of the checks according to a preDarranged Oavailability schedule.O %anks receive credit for checks depending on the time it normally takes to process and present the check to the bank upon which it was drawn. ! )ederal 2eserve %ank gives credit for most checks the ne1t business day. )or almost all other checks, credit is given within two days. The bank on which the check is drawn does not pay the 2eserve %ank until the check is presented to it. )loat is created when a )ederal 2eserve %ank credits a bank for depositing a check and because of check processing delays, has not yet collected the funds from the bank upon which the check is drawn. %oth banks now list the funds on their books. !nd they both keep the funds on their books until the check is presented and the )ederal 2eserve %ank collects funds from the bank on which the check is drawn. Therefore, both banks have use of the same funds for a short time. !s an e1ample, consider the following. ;ompany ! in ;alifornia receives a check for *+,,,, from a customer in &ew York and deposits it in its bank. If the ;alifornia bank forwards the check to the local 2eserve %ank on that day, it will be credited for the *+,,,, according to the availability schedule for that type of check. !t the same time, the *+,,,, will remain in the &ew York bank #and in the drawer s account$ until the check is presented. If the check has not been presented when the )ederal 2eserve credits the depositing bank s reserve account, the same *+,,,, appears on the books of both banks. This e1tra *+,,,, is the float. Ance the check is presented to the &ew York bank for payment, the )ederal 2eserve %ank will collect *+,,,, from it. !t this time the accounts will be settled and the float will disappear. 9any banks send their checks to larger banks and private associations that provide check clearing services. Af course, this is fee based and competes with the )ed. The )ed only processed about /,. of all the checks cleared in +33,. %ecause float in the banking system artificially inflates the level of bank reserves, it can have a maEor impact on monetary policy. )loat can appear <uickly and without warning. It fluctuates randomly and is nearly impossible to predict. !s a result, the )ederal 2eserve must sometimes act to offset shortDterm instability in the monetary aggregates caused by float. This is done through purchases and sales of 7.S. government securities by the use of open market operations at the )ederal 2eserve %ank of &ew York. There is also a term called 0oldover )loat. 0oldover float refers to float that is caused by delays at the processing institution. !n e1ample of this type of delay is checks that arrive at a )ederal 2eserve facility in poor physical condition and cannot be processed on the highDspeed e<uipment that handles most checks. These checks must be processed on semiDautomatic machines or by hand. This causes delays. ;omputer malfunctions, unusually large volumes of checks or machinery breakdowns can also cause delays. Delays in transporting checks to and from 2eserve %anks, which the )ed calls transportation float, can occur because of inclement weather, mechanical failures or air traffic delays. DelayedDpresentment float can occur because of differences in holiday observances. When this happens, some banks will be open on days that others are closed. The )ed has taken some steps to reduce )loat. It now has /- check processing facilities throughout the 7nited States. !nd air charter service was improved. This has reduced the amount of )loat in the system. ;ongress passed legislation that instructed the )ederal 2eserve System to charge banks directly for float as part of its regular services in +3-,. This had a dramatic effect on )loat as it was reduced substantially. !dditionally, the )ed established a nationwide noonDpresentment policy. This allowed later delivery of checks to banks in cities with )ederal 2eserve regional offices. The )ed also initiated the O0igh Dollar 8roupDSort @rogram,O which aided institutions in more remote areas. These actions significantly increased the number of checks that could be collected overnight, which speeded the clearing process and helped to reduce float. !s of +33,, daily average )ederal 2eserve float fell to */F+ million. )ederal 2eserve float does not include float that occurs in the bank accounts of individuals. !n individual who mails a check has use of the funds until the check is charged to their account. This Omail floatO is estimated by the )ederal 2eserve to be hundreds of billions of dollars per year. 0owever, it does not affect reserve accounts and does not have an impact on )ederal 2eserve operations. The +ederal ,eserve and Book0)ntry Procedure @aper 7.S. 8overnment and agency securities have for the most part, been replaced by the computer entries in the %ook 5ntry program of the )ederal 2eserve, 7nited States Treasury and several federal and international agencies. The government believes that government and agency securities are better safeguarded and more rapidly transferred by the nation s depository institutions.

There are a lot of benefits to the bookDentry system. Securities in bookDentry form are less vulnerable to theft and loss. They can t be counterfeited and don t re<uire counting or recording by certificate number. !dditionally, a big benefit to owners is that they don t have to submit coupons to obtain interest payments or present certificates to redeem securities. !ccording to the )ederal 2eserve, as of year end +3--, about 3-.> percent of the outstanding marketable Treasury debt, was in bookDentry form. !ny Treasury securities held in physical form by depository institutions, regardless of the owner, is eligible for conversion to book entry and for transfer by wire. %ook entry of treasury securities is not e1actly new. In the +34, s Treasury securities became transferable by telegraph among banks in different 2eserve districts. !t that time, all transfers re<uired specific approval by the Treasury s ;ommissioner of the @ublic Debt. Subse<uently, these telegraphic transfers of securities became known as ;@Ds, named after the initials of the office approving the transfers. 7nder the early ;@D system, the sender of a security, usually a commercial bank, delivered certificates to the local )ederal 2eserve Affice. That office retired the securities. They then sent a telegram to another )ederal 2eserve office located near the institution receiving the security. The 2eserve office receiving the telegram either issued identical physical securities to the bank to which they were being transferred or were deposited in that bank s safekeeping account at the )ederal 2eserve. There were a lot of difficulties involved in making actual deliveries of physical government securities to and from the )ederal 2eserve %ank in &ew York ;ity #and among the banks and dealers in the city$. %ecause of these difficulties &ew York s 8overnment Securities ;learing !rrangement #8S;!$ was established in +36:. The 8S;! allowed the telegraphic transfer of securities during the day with a net settlement in physical securities at the end of the day. !nother maEor step toward book entry procedure occurred in +36-. ! Treasury regulation in +36- authori(ed the first bookDentry procedures to eliminate paper 7.S. 8overnment securities. 7nder these new procedures, securities were issued and transferred electronically on the records of a )ederal 2eserve %ank. %y the end of +3>>, 8S;! was so successful, it was possible to eliminate it. Several government sponsored agencies have also issued bookDentry regulations. 9any of their securities have been available in bookDentry form since the +3>,s. %eginning in late +3-F, shortDterm agency discount notes also became eligible for book entry. 9ortgageDbacked securities issued by the )ederal 0ome Goan 9ortgage ;orporation and the )ederal &ational 9ortgage ;orporation were issued in bookD entry form beginning in +3-:. !t the present time, >/ depository institutions, as well as several agencies, have direct or onDline access, via computer or terminal links, to the securities transfer network in the &ew York )ederal 2eserve district. Depository institutions include member and nonDmember commercial banks, mutual savings banks, savings and loan associations, credit unions and 7.S. branches and agencies of foreign banks. The network, known as )edwire, allows district depository institutions to transfer securities for their own account or the accounts of customers directly to one another and to depository institutions throughout the 7.S. Securities transfers compose !bout 4- percent of the transactions on )edwire, includes securities transfers. The Treasury began offering new bills e1clusively in bookDentry form in +3>3. In !ugust +3-6, With the introduction of Treasury Direct, the Treasury began marketing all new notes and bonds only in bookDentry form. Treasury Direct makes principal, interest and redemption payments on notes and bonds bought through the )ed directly into an individual investor s account at a financial institution. These payments are made electronically rather than by check. In +3->, the Treasury Direct system was e1panded to include bills. )"chan$e Stabili1ation +und To contribute to e1change rate stability and counter disorderly conditions in the foreign e1change market, the 51change Stabili(ation )und #5S)$ of the 7nited States Treasury was created and originally financed by the 8old 2eserve !ct of +3F/. The !ct authori(ed the Secretary of the Treasury, to deal in gold, foreign e1change, securities, and instruments of credit, under the e1clusive control of the Secretary of the Treasury subEect to the approval of the @resident. The 7nited States adopted the revised articles of agreement of the International 9onetary )und #I9)$ in +3>-. !t that time, ;ongress amended the 8old 2eserve !ct so that the dealings of the 5S) were consistent with 7.S. obligations to the I9). ShortDterm credit to foreign governments and monetary authorities may also be provided by the terms of the 5S). These loans are referred to as Obridge loansO. !nd they are financed through swaps. Dollars held by the 5S) are made available to a country through its central bank in e1change for the same value of that country s currency. The 5S) holds and administers Special Drawing 2ights #SD2s$. Special Drawing 2ights #SD2s$ are assets created by the I9). The I9) lends to countries that need help to finance balanceDofDpayment deficits. SD2s were created to increase international li<uidity. They are permanent resources of the 5S) after they are allocated to, or otherwise ac<uired by, the 7nited States Treasury. 5S) operations are conducted through The )ederal 2eserve %ank of &ew York in its capacity as fiscal agent for the Treasury conducts 5S) operations. The &ew York )ed, e1ecutes foreign operations on behalf of the )ederal 2eserve System and the Treasury. It s natural that they administer 5S) provisions. In this capacity, the &ew York )ederal 2eserve %ank acts as an intermediary for the parties involved when the 5S) provides shortDterm financing to foreign governments. 0owever, it neither guarantees, nor profits from, the loans.

Throughout each day, the &ew York )ed s foreign e1change trading desk provides current information on market conditions to the Treasury. )or intervention purposes, and on an as needed basis, the trading desk buys or sells foreign currencies on behalf of the Treasury, through the 5S). Treasury Department and )ederal 2eserve foreign e1change operations are closely coordinated and many times are conducted Eointly. !lthough, there have been noticeable times when they were not conducted Eointly. This generally happens when there is a policy split between the two agencies. The )ederal 2eserve participates in the 5S) with its own funds. The Treasury reimburses the &ew York )ederal 2eserve %ank for e1penses incurred in carrying out Treasury actions. The )ederal 2eserve occasionally engages in OwarehousingO transactions with the 5S). Warehousing a transaction involves the sale of foreign currencies by the 5S) to the )ederal 2eserve for dollars while simultaneously arranging to repurchase them. 2epurchase usually occurs within one year. The dollars are immediately credited to the Treasury s account at the &ew York )ederal 2eserve %ank, and the )ederal 2eserve invests the warehoused foreign currency. 0owever, this currency is kept separate from the )ed s regular accounts. While invested it earns a market rate of return. !ccording to the )ed, any effect warehousing has on domestic bank reserves is offset by open market operations. 5S) accounts and activities are subEect to ;ongressional oversight. 9onthly reports on 7.S. intervention activities and a monthly financial statement of the 5S) are provided to ;ongress on a confidential basis. This is not usually public information. The &ew York )ederal 2eserve %ank makes a publicly available <uarterly report to ;ongress. It is prepared by the manager of foreign operations. The 5S) was structured to be selfDfinancing. The original ;ongressional appropriation and retained earnings, which are held in both dollars and foreign currency, are the resources for the )und. The 8old 2eserve !ct of +3F/ initially funded the 5S) with resources resulting from the devaluation of the dollar, in terms of gold. *4 billion of the resulting valuation gain was appropriated by ;ongress to the 5S). Gater, *+.- billion of that was used to fulfill the initial 7.S. <uota subscription to the I9). Securities issued by foreign governments are what the &ew York )ed invests 5S) foreign currency balances. This is because these instruments yield marketDrelated rates of return and have a high degree of li<uidity and credit <uality. In addition to interest earned on assets, the 5S) s balance sheet includes gains or losses on e1change operations as well as interest earned on assets. The Strate$y o# Monetary Policy This essay was originally published by the )ederal 2eserve %ank of 9inneapolis. !nd we thank them for graciously allowing us to reproduce it on our web site. OThe 2egionO, September +33: %y !lan S. %linder, Iice ;hairman, %oard of 8overnors of the )ederal 2eserve System Iice ;hairman %linder delivered these remarks before the 9innesota 9eeting, a business forum, in Bune in 9inneapolis, 9innesota. 9onetary policy is much in the news these days. It seems it always has been as long as I ve been at the )ed. %ut lately it s not because of anything we ve done' monetary policy has done nothing since )eb. +. 2ather, what s changed dramatically is the market chatter and speculation about what the )ed might do in the near term future. I m afraid the speculation changes more oftenDDand more dramaticallyDD than the policy. So, today, I d like to turn away from the fi1ation on the )ed s shortDrun tactics and talk more generally about the strategy of monetary policy. Specifically, I d like to address three <uestions. )irst, what are the goals and obEectives of monetary policyDDwhat is it trying to accomplish, and whyL Second, what are the instruments at our disposal in achieving those goals, and why do we choose the ones we chooseL !nd finally, but importantly, how and when do we use those instrumentsL That s the timing of monetary policy, by which I mean something bigger than tactics but smaller than strategy. In the process of talking about those three issues, I will touch upon several controversial <uestions about monetary policy. These are live <uestions, not dead ones. The goals of monetary policy Get me start with the goals. The )ederal 2eserve fre<uently is said to be an OindependentO agency. !nd it is an independent agency' this is very important to our effectiveness. %ut people often misunderstand what independence means. The independence of the )ed means, to me, two things. )irst, that we have very broad latitude to pursue our goals as we see fit' we decide what to do in pursuit of those goals. Second, it means that once our monetary policy decisions are made, they cannot be reversed by anybody in the 7.S. governmentDD e1cept under e1treme circumstances. #;ongress would have to pass a law limiting the power of the )ed.$ %ut although we are free to choose the means by which we achieve our goals, the goals themselves are given to us by statute, by the 7.S. ;ongress. !nd that is how it should be in

a democracy. ;ongress writes the goals into the )ederal 2eserve !ct and directs us to pursue those goals, giving us <uite broad latitude in how to do it. What are those goalsL The )ederal 2eserve !ct tells us to pursue both Oma1imum employmentO and Ostable prices.O There has been considerable controversyDDand it s flaring up again nowDDover the dual obEectives of ma1imum employment and stable prices. #!ctually, the !ct specifies a third goalDDOmoderate longDterm interest ratesODDbut this is likely a corollary of price stability.$ An the one hand, some have been critici(ing the )ed over the last +6 months for tightening monetary policy to fight an inflation that some people say doesn t e1ist. Waving swords at dragons, so to speak. An the other hand, there are those who would like us to focus entirely on only one obEectiveDD fighting inflationDDand forget about employment altogether. To do that, of course, the law would have to be changed. This issue is controversial. 9y personal view is that a dual obEective is not only feasible but desirable. The )ederal 2eserve is the ultimate determinant of the average level of prices in the economy' that is our proper, overriding, longDterm goal. %ut monetary policy does affect employment in the short run #an important <ualifying phrase$, and !mericans do care about gyrations in employment. If they didn t, nobody would fret much about recessionsDD which are, after all, transitory events. So, to me, the conclusion follows readily" We control an instrument that influences employment in the short run' !mericans care deeply about employment' and it is therefore appropriate for ;ongress to order the )ederal 2eserve to pay attention to employment, too. )urthermore, and importantly, the two goals do not conflict in the long run because the longDrun effects of monetary policy on employment are negligible. In the long run, the very nature of our economy means that only the priceDstability goal can be operative. %ut in the short run, both obEectives can beDDand in my view, should beDD operative. 0owever, I caution you again that this is a controversial issue and there are people who would argue the other side. &ow these two obEectivesDDma1imum employment and stable pricesDD are not wellDdefined goals. They are not the e<uivalent of telling a truck driver" 8o out in the truck and drive from 9inneapolis to ;hicago at :>.: miles per hour. The instructions we have from ;ongress are much vaguer than that. So how do we make them more concreteL This is another aspect of the independence of the )ed" We must interpret what those phrases mean. I personally interpret Oma1imum employmentO to mean that we should try to hold the unemployment rate as low as possible without pushing it below what economists call the natural rate or the fullD employment rate. Why stop thereL Why not push the unemployment rate lower stillL !fter all, if we are pursuing ma1imum employment, we still haven t achieved it at a natural rate of between :.: percent and 6 percent. The answer is that pushing unemployment below that level would cause inflation to rise and thereby run afoul of our other obEectiveDDstable prices, which is our only obEective in the long run. That second obEectiveDDstable pricesDDalso is not well defined. ;ongress has not told us to hold the consumer price inde1 #;@I$ at ,., percent growth, nor to target the producer price inde1, nor the 8D@ #gross domestic product$ deflator, nor to pursue any other number. So what does Ostable pricesO meanL I think there is a strong consensus that it does not mean literally hitting (ero in the measured ;@I inflation rate because there are wellDknown biases in the inde1, biases that convince most scholars that increases in the true cost of living are smaller than measured increases in the ;@I. 0ow much smaller is e1tremely controversial, and nobody has a really good fi1 on it. %ut virtually everyone who has thought about this matter at all deeply believes there is some upward bias in the ;@I. So we should be shooting not for literally (ero inflation in the ;@I, but for something like (ero OtrueO inflation, whatever that means numerically. The definition I ve long used for price stability is a situation where ordinary people in their ordinary course of business are not thinking and worrying about inflation. !s you well know, back in the late +3>,s and early +3-,s everybody in business in !merica was thinking about inflation. &ow people are thinking about inflation a lot less. Some are' but I think a fair assessment must be that we are now close to functional price stability, though probably not <uite there yet. The point of the )ederal 2eserve !ct assigning us the goal of price stability is that, until we reach that obEectiveDDwherever it is, inflation should be kept on a longDrun downward track. To me, that is the operational meaning of the goal of price stability right now. This does not mean that inflation every year must be lower than the year before, but it does mean that the trend should be downward. In that regard, )igure +, #printed in the maga(ine$ a graph of the rate of change of the ;@I in the 7nited States from +36, to +33/, is instructive. The solid line is the change in the ;@I stripped of its food and energy componentsDDthe soDcalled OcoreO inflation rate. The thin line is the change in the overall ;@I, including food and energy prices. Gooking at this graph, by the way, tells you why economists focus on the core ;@I. Aver long periods of time, they tell you e1actly the same thing. %ut over short periods, the ;@I, because of its very volatile food and energy prices, bounces around in a way that sometimes causes confusion. The message of this chart is simple. )or about +/ years, from +366 to +3-,, inflation trended upward. There were plenty of gyrations, with a peak in the Iietnam War period #+366D63$, then a fall during the price controls of the &i1on administration #+3>+D>F$, then a surge in late +3>F when A@5; hit the first time, and so on. %ut the broad historical story from +366 to +3-, is one of rising inflation, which is to say that the )ederal 2eserve was failing to meet its goal of promoting price stability. I should point out that that was not the only thing that was going wrong in this period, and nobody should put the entire blame on the )ederal 2eserve. %ut part of the blame must be on the )ederal 2eserve, for it was our statutory responsibility and it was not met. Then from +3-, to +33/DDanother period of +/ yearsDDyou see a clear success story. Inflation started above +F percent and then tumbled down #e1cluding an aberration in +3-F$ to about /.: percent, where it lingered from about +3-/ to about +33,, before rising a little and then

falling again. %ut the capsule history of the period from +3-, to now is clearly one of falling inflation. That signifies the success of the )ederal 2eserve s antiDinflation policyDDalmost a complete reversal of the previous period s failure. We are now almostDDbut not <uiteDDback to the inflation rates of the early and mid +36,s. The instruments of monetary policy So those are goals of )ederal 2eserve policy" 9a1imi(e employment, which I interpret as holding the unemployment rate as low as you can without going beyond the natural rate, and keep inflation on a downward track until you achieve price stability. 0ow do we try to do thisL What are the instrumentsL )undamentally, the )ederal 2eserve controls only one thing. That s a sobering thought, actually, when you think about how much attention is paid to the )ederal 2eserve throughout the financial world. %ut we control only one thing" the volume of bank reserves held by 7.S. banks. We have a few other small weapons, but that s the only important one we have. To control bank reserves, we buy or sell Treasury bills in the open market, thereby either taking reserves away from banks or giving banks reserves. An that, there is basically no choice. Where we have a choice is the following. If we want, we can use this one instrument to control some measure of the money supplyDD9+, 94 or any other 9 that we can invent. #!nd, indeed, in the +3>,s the )ed did Eust that by creating many measures of money.$ We can control any measure of the money supply, although somewhat imprecisely, for there is no meaningful definition of money that we can control with perfect precision. &onetheless, within some tolerable limits, we can control any monetary aggregateDDe1cept when things go badly wrong. !lternatively, we can control shortDterm interest rates with very great precisionDDespecially the federal funds rate, which is the rate banks pay to borrow reserves overnight. That s the choice. We can target bank reserves' we can target some definition of the money stock' or we can target shortDterm interest rates, especially the federal funds rate. %ut, whatever we do, we have Eust one instrument. Get me make a small digression at this point. There is a common error, repeated time and time again even by people who are presumably knowledgeable about the subEect, that because the )ederal 2eserve only has one instrument at its disposal, it can pursue only one goal. This is simply wrong. Suppose someone told you that you have a budget of *+,, per week, and you are to pursue two goals" clothe yourself and feed yourself. Is there anybody that thinks it is impossible to further both those goalsL !s everybody knows, you would take your *+,, and balance the two goals by spending some of it on clothes and some on food. Your actual choice would depend on the terms of the tradeoffDDthat is, the prices of food and clothingDDand on how you value the two goods. Af course, you can t spend your entire *+,, on food and then spend it again on clothing. Similarly, the )ederal 2eserve has one instrument and two shortD term goals, and we must trade off one goal against the other. The terms of the shortDrun tradeoff between furthering the employment goal and furthering the priceDstability goal is called the O@hillips curve.O Together with the @hillips curve, Eudgments about the relative importance of the two goalsDDin the short runDDlead to decisions. Af course, the )ed s problem in the long run does differ from the problem faced by a consumer deciding how to spend *+,,. In the long run, we can only affect inflation, which is an important aspect of this problem. %ut it does not mean that we can t pursue two goals in the short run. 0aving made that digression, let me return to the main theme. I ve said that the )ed has one instrumentDDbe it reserves, money or a shortD term rate of interest. Which choice is bestL This is a very longDrunning controversy of monetary theory and policy. !t various times in the last F, years or so, the )ed has done each of those. There are periods when it has focused on bank reserves, on various definitions of money, and on shortDterm interest rates. That already suggests that there may not be one obviously correct answer for all places and times. In the notDtooDrecent past, the )ederal 2eserve has targeted money growth rates. !nd I think that, if a strategy like that were workable, there would be real advantages to it. I see two. )irst, it is often said that the money supply, being tied to the price level in the long run, provides the economy with a Onominal anchorODDthe assurance that the price level will not Eust run away from us, either up or down #though the usual concern is up$. 9oney potentially gives us a longDrun anchor on the price level in a way that interest rates do not. Second, and getting a little ahead of a point I want to make later about the lags in monetary policy, if a moneyDtargeting strategy actually works, you get a preview of the subse<uent effects of monetary policy pretty <uickly. &ot long after the )ederal 2eserve moves bank reserves, we see the effect on the money supply. !nd, if that was a reliable guide to the ultimate effects on the economy, it would provide a valuable preview of where we are going. It s like seeing the ninth inning of a baseball game while you re still in the first inning. 7nfortunately, in recent years the relationship between the various measures of the money supplyDDpick any one of themDDand things that really matter to us, like inflation and employment, has pretty much disappeared. !s a result of that, the )ed has essentially abandoned any focus at all on any of the monetary aggregates, and moved to shortDterm interest rates. That was by necessity, not choice. The money targeting rule was simply not going to work, and there really was no alternative. So that left shortDterm interest rates, specifically the federal funds rate. Gags in monetary policy

That brings me to the last, and <uite important, aspect of strategyDD the timing of monetary policy. The simplest statement to make about the lags in monetary policy is" They are long. If you remember that one thing, you ve gone a long way toward understanding the actual implementation of monetary policy. )igure 4 #printed in the maga(ine$ shows one estimate of these lags. I want to emphasi(e that it is only one estimate out of many models we maintain at the )ederal 2eserve. In the private sector, in the universities and so on there are many more models. They don t all give the same answer' but, <ualitatively, almost all look pretty much like this chart. It shows the estimated effect of a specific tightening of monetary policy" a + percentage point increase in the federal funds rate, maintained for two years and then taken away. The upper panel shows the effect on the level of 8D@, and the lower panel shows the effect on inflation as measured by the ;@I. Gooking first at the top panel, the tighter monetary policy starts to have some effect on 8D@ right away, but it is very small. Then the effect builds, with the peak effect occurring between eight and +4 <uarters out. Then the effect starts to dissipate, and about 4, <uartersDDfive yearsDDafter the tightening of monetary policy there is essentially no trace left on 8D@. That s what I meant earlier when I said that we do not have any effect on employment in the long run. !gain, I should emphasi(e that this is the result from one particular model, and others will give answers that are <uantitatively different but <ualitatively similar. Gook now at the second panel, which shows the effect of a monetary tightening on inflation. If there were no effect on inflation, of course, the )ederal 2eserve would never tighten policy. )or about si1 <uarters or so, there is essentially no effect on inflation. %ut then the effect starts to build, and it peaks, in this model, after about +/ or +: <uartersDDthree and oneDhalf to four yearsT That s a long time. In particular, notice that it comes after the peak effect on 8D@. So the lag from monetary policy to output #or employment$ is very long, and the lag to inflation is even longer. Why should this process take so long in a fle1ible market economyL !fter all, we communicate our actions to the money market immediately, and shortDterm interest rates move within minutes, if not seconds. So why should the effects of monetary policy take so long to reach the economyL Well, part of the answer is that some of it does hit right away. %ut not much. The long lags start to make sense if you think about the main channels through which )ederal 2eserve policy works. 0igher interest rates have their biggest effects on housing, on consumer durables like automobiles and on business investment in e<uipment and factories. Think about the channels that have to be followed after the federal funds rate moves. )irst, nobody e1cept banks care about the federal funds rate per se. That rate has to affect interest rates that matter to people or to businessesDDlike rates for home mortgages, automobile loans and corporate bonds. That reaction can take a while, although sometimes it happens <uite fast, as in +33/. Second, people must react to changes in interest rates' and, on most days, most people are doing something other than thinking about interest rates. ;onsumers have other things to do with their lives, and business people have other things to do with their businesses. They have personnel decisions, things to buy, things to sell and so on. %ut, at some point, interest rate increases get to be front and center in their minds, and they begin to think about changing their plans. They may think about that a short time or a long time. Third, if they decide to change their plans, they must give instructions and have those instructions e1ecuted. In a small business, that happens fairly <uickly. %ut in a big business it may take a long time. They have layers of management and committees which must give concrete content to the phrase" Owe want to change our plans.O !nd finally, in many cases, there is a further lag between the time of e1ecution of the plan and actual e1penditures. Suppose lower interest rates induce a company to decide to build a new factory. Well, that could take two years, and for the first si1 months very little money will be spent. So, for all of these reasons, there are long lags, and the strongest effects on the economy may not be felt until one, two or even three years after the monetary policy action. These long lags have very important implications for the strategy of monetary policy. 9ost obviously, to make any kind of intelligent decision today, we need some sort of picture of the state of the economy one, two and three years aheadDDno matter how indistinct. 0ow do you get such a pictureL )irst of all, you need forecasts of where the economy would be with unchanged policy. Second, you need some sort of a theory of cause and effect, a theory that says" If the )ed does this, then these things will happen. Third, you need some statistical evidence to fill the theory with numbers. It is not enough to say" If we raise the federal funds rate, 8D@ growth will slow. 0ow muchL WhenL ! theory doesn t answer <uestions like that. 0a(ards lurk in all of these thingsDDforecasts, theory and statistical evidence. )orecasts are not very good. They are at best mediocre when you look one year ahead, and they are not very good at all further ahead than that. So we really don t have the kind of forecasting accuracy that we would like. Second, the theories or monetary policy are not that strong, and are much in dispute. 5conomics is not physics. !nd I don t even mean sophisticated physics, where they argue about esoteric theories' I mean simple &ewtonian physics. We simply do not have theories as tight as physicists do. )inally, the statistical evidence is much weaker than we would like. Gots of people might dispute the graphs I ve shown in )igure 4, and many could produce a model with different numbers. &obody really knows whose numbers are correct. )urthermore, monetary policy is not like pressing a fi1ed se<uence of keys on your computer, which will give you the same outcome every single time. The graphs I ve shown you represent a statistical average over a long period of history. Some monetary policy episodes had bigger effects and some had smaller, and there is no way of knowing whether the ne1t episode will have an effect larger or smaller than average.

What to doL So what is a poor central banker to doL When you look at this set of difficultiesDDforecasts are not very good, theories and statistical evidence are much in disputeDDit is tempting to say" Why don t we Eust wait and see what happensL If inflation starts rising, hit the economy with higher interest rates. If unemployment starts rising, do the reverse. I call this the %unker 0ill strategy" Wait until you see the whites of their eyes and then fire. Why don t we do thatL The answer is very simple" The %unker 0ill strategy will fail. It is sure to lead you into error because by the time you see the whites of their eyes, they ve already shot you right through the heart. The graphs we Eust saw show that it takes one to two years until policy has a large effect on output and two to three years until it has a large effect on the inflation rate. If the whites of their eyes are showing inflation, you re about two and a half years too late. !nd if those whites are showing unemployment, you re about one and a half years too late. To have any hope for success in monetary policy, you need to act preemptively against either a rise in inflation or rising unemployment. Instead of using the %unker 0ill strategy, we must use what I call the Ostitch in timeO strategy. You try to save nine by stitching in time, in either direction. 7nfortunately, actually to use such a strategy in practice, you have to use forecasts, knowing that they may be wrong. You have to base your thinking on some kind of a monetary theory, even though that theory might be wrong. !nd you have to attach numbers to the theory, knowing that your numbers might be wrong, and that all you ve got is a statistical average anyway. We at the )ed have all these fallible tools, and no choice but to use them. It s a tough world, but that s the way it is. What can you do to try to guard against failureL There are two principles that monetary policy makers need to keep in mind. )irst of all, be cautious. Don t oversteer the ship. If you yank the steering wheel really hard, a year later you may find yourself on the rocks. Second, you must have a longDrun strategy in mind. The )ederal Apen 9arket ;ommittee meets eight times a year. You can t be thinking only about what s going to happen in the ne1t si1 or seven weeks' that s basically irrelevant to the monetary policy decision. You must think about a longDterm strategy, e1ecute the first step of that strategy, and then watch. You must be fle1ible and prepared to modify or even abandon your strategy if things look to be going wrong. @eople often misunderstand and think that we can t have a longDrun strategy because of all these uncertainties and because the world is constantly changing. That is <uite wrong. You must have a longDrun strategy, but you must be willing to modify it as new information becomes available. ;an this stitchDinDtime strategy lead you into error anywayL You bet it canT %ut the other strategyDDthe %unker 0ill strategyDDis sure to lead you into error. !nd that makes it, to me, a very easy choice.

Perspectives on +ederal ,eserve 2ndependence ! Chan$in$ Structure #or Chan$in$ Ti es This paper was written in +3>6. 0owever, the reader will find that the issues it discusses are as relevant today as they were then. It provides useful insights into the nature, importance, and structure of the )ed and why it is so important that the )ed stay independent and free from shortDterm political manipulations. This paper was originally published by the )ederal 2eserve %ank of 9inneapolis. !nd we thank them for graciously allowing us to reproduce it on our web site. @erspectives on )ed Independence, +3>6 !nnual 2eport essay %y %ruce P. 9acGaury @resident To provide for the establishment of )ederal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the 7nited States, and for other purposes. 0ow Structure !ffects the )unction of 9onetary @olicy Aur 4,,th year, perhaps more than most years, has generated its share of <uestions about monetary policy and about the role of the )ederal 2eserve System D the nation s central bank D in solving our economic problems. Aver the past few years, the dual problems of inflation and unemployment have been especially ve1ing. !nd <uestions about how effectively our money managers are responding to such problems reflect the urgency and comple1ity of the inflation=unemployment dilemma.

These <uestions also reflect increasing reliance on monetary policy D managing the supply of money and credit D as a means of assuring national economic health. That emphasis has grown as we have had to cope with large deficits and difficult economic events such as the energy crisis, fluctuating foreign currencies, and continuing @ostDIietnam adEustments. The focus on monetary policy has generated <uestions not only about policy actions, but about the structure and power relationships of the )ederal 2eserve System D <uestions about its Oindependence.O Differences of opinion over monetary policy actions are to be e1pected, regardless of how the System is structured. 8iven the limits of human wisdom and the incomplete state of our economic knowledge, such differences are normal and inherent. That there is such disagreement does not mean the procedures are wrong or the structure inappropriate. If, on the other hand, the structural makeDup of the System, or its procedures, tends to inhibit development and implementation of good policy decisions, then we can try to improve those structure and procedures. Since our world is changing and issues seem to be getting more comple1, it would be surprising if some adEustments in the mechanisms for monetary management might not prove useful. It s against this background that the various proposals to change the structure and limit the OindependenceO of the )ederal 2eserve System deserve to be discussed. The Semantics of )ed Independence Uuite probably the term OindependenceO has been overDused. It was a key concept in the design of our central banking system D but in a relative sense, not as an absolute. What does OindependenceO meanL Is the )ederal 2eserve accountableL Is it responsive to changing national prioritiesL )irst, let s be clear on what independence does not mean. It does not mean decisions and actions made without accountDability. %y law and by established procedures, the System is clearly accountable to congress D not only for its monetary policy actions, but also for its regulatory responsibilities and for services to banks and to the public. &or does independence mean that monetary policy actions should be free from public discussion and criticism D by members of congress, by professional economists in and out of government, by financial, business, and community leaders, and by informed citi(ens. &or does it mean that the )ed is independent of the government. !lthough closely interfaced with commercial banking, the )ed is clearly a public institution, functioning within a discipline of responsibility to the OpublicDinterest.O It has a degree of independence within the government D which is <uite different from being independent of government. Thus, the )ederal 2eserve System is more appropriately thought of as being OinsulatedO from, rather than independent of, politicalD government and bankingDspecial interest pressures. Through their +/Dyear terms and staggered appointments, for e1ample, members of the %oard of 8overnors are insulated from being dependent on or beholden to the current administration or party in power. In this and in other ways, then, the monetary process is insulated D but not isolated D from these influences. In a functional sense, the insulated structure enables monetary policy makers to look beyond shortDterm pressures and political e1pedients whenever the longDterm goals of sustainable growth and stable prices may re<uire OunpopularO policy actions. 9onetary Eudgments must be able to weigh as obEectively as possible the merit of shortDterm e1pedients against longDterm conse<uences D in the onDgoing public interest. 9onetary @ower... 9onetary decisions have special importance because of their impact on all other aspects of our economic life. In a very real way, the power to create money also carries the power to destroy its value. @ushed to e1tremes of misEudgment or illadvised action, misuse of monetary power can erode values and destroy the economic fabric of the society it servesDby inflation, boomDbust depression, immoderate stimulus, or by e1cessive restraint. ... !nd Its Gimits While monetary policymakers have great potential power over the economy, there is misunderstanding about the practical limits of such power. Typically, monetary policy can restrain credit e1pansion more effectively than it can stimulate borrowing. It can control the supply of money, but not the demand for it. It can influence interest rates, but not control them. The central bank can influence only a few of several factors that determine the course and vigor of economic performance. The problems are comple1 and constantly changing, our knowledge is never complete, and mechanisms for avoiding harmful policy sideDeffects are not ade<uately developed. )inally, the ultimate effects of monetary actions are not precisely known until months later, if at all.

Thus, Eust as responsible monetary policy must avoid e1treme actions D which on balance may be more harmful then helpful to the economy D so must the public be restrained in its e1pectations as to what monetary policy alone, however well managed, can accomplish. The Gawmakers 2ole @oliticians, the elected representatives who make our laws and determine public policy, are themselves subEect to pressures inherent in our structure of government. They are e1pected to respond to the desires and needs of their constituents. !nd constituent e1pectations tend not to be tempered by such realities as cost and resource limits. In short, politicians are under pressure to accomplish more than available resources permit. That can mean attempting more than we can afford or are willing to pay for. @ut another way" it is easier to vote for needed programs than for increased ta1es. Such pressures probably give our national policies and goals an inflationary tilt. This is especially true in a democracy where the powers delegated to our elected officials must be affirmed by Oback homeO constituents every two, four or si1 years. The need for our elected representatives to be responsive and Otuned inO to their constituents is a vital function in our political process. It provides important guarantees to citi(ens. %ut it may also limit the e1tent to which elected representatives can afford to consider the longDterm merits of policies. @olicy actions that may lead to defeat in the ne1t election, however valid, are not likely to be seen as attractive options. %alanced policy therefore re<uires an institutional structure that insulates monetary policymakers from such shortDterm pressures D which is to say, one that also insulates elected officials from the negative electoral conse<uences of policy decisions that may be essential but unpopular. Abviously, not all policy decisions pose this type of conflict. &ot all elected officials yield to shortDrun pressures or would need to. In any case, the merits of a given policy are seldom unambiguous. %ut the conse<uences of persistently e1pansive monetary policy are too severe to risk procedures that compound a bias in favor of shortDrun options and produce shortDsighted results. Ather 9oney 0istorically, we have used a variety of mechanisms to manage money D a stock of silver and gold bullion or currency backed by metals. These mechanisms regulated the money supply according to irrelevant changes in our stock of metals and offered little or no consideration of actual needs of the economy, shortD or longDterm. Aur own history, and the e1periences of other nations, are replete with e1amples of runDaway inflation and economic chaos that developed because the lure of superficial solutions outweighed responsible but less popular policy actions. Aut of long e1perience, our monetary system has evolved so that the supply of money and credit are OmanagedO at levels intended to be most conducive to stability, growth, and a high level of production and employment in our national economy. That responsibility re<uires not only a high degree of technical knowledge about the economy and the interaction of its different elements and forces but also re<uires obEective, OindependentO Eudgments about the best monetary adEustments to help achieve those national goals. 0istory of 2eforms Aver the years the )ederal 2eserve System has proved remarkably adaptable to changing needs. %oth policies and procedures have been altered when the need for change became clear D sometimes by statutes or amendment to the )ederal 2eserve !ct, often by policy and administrative implementation within the authority of the !ct. The )ederal 2eserve System was barely in operation when it became apparent that purchases of government securities, now the main mechanism for influencing the money supply, added to bank reserves and thus became an une1pected mechanism for effecting monetary e1pansion. The %anking !cts of +3FF and +3F: reaffirmed and strengthened the )ederal 2eserve s independence from the e1ecutive branch D they removed the comptroller of the currency and the Secretary of the Treasury from the )ederal 2eserve %oard D and affirmed its independent budget and income procedures. They delegated to the )ed the power to control stock margin re<uirements and to regulate savings interest rates. World War II saw the central bank directly supporting the financing of unprecedented war e1penditures with subse<uent moneti(ation of that debt after the war. In the famous OaccordO of +3:+, after lengthy debate both public and within government, it was agreed that the )ederal 2eserve would no longer support #by its purchases of government securities$ the artificially low interest rates and par values for financing government debt. Thus ended the domination of monetary policy by the Treasury s needs to finance its massive warDborn debt. The 5mployment !ct of +3/6 affirmed Oma1imum employmentO as one of the goals of )ederal 2eserve policy, establishing formally that monetary policy has a responsibility to support and help implement national obEectives. In more recent developments, congress has delegated additional authority to the )ed under the consumer @rotection !ct to regulate OTruth in Gending,O O5<ual ;redit ApportunityO and other consumer interests.

Aver the years, it became clear that monetary policy had to be uniform throughout the nation, that regional variations were not possible. Yet the concept of a OfederalO system, with input from various regional perspectives, was important in the policy process. The establishment of the soDcalled )ederal Apen 9arket ;ommittee #)A9;$, combining the %oard of 8overnors and five )ederal 2eserve %ank presidents as the maEor policyDmaking body, represented a maEor structural innovation that accommodated the needed change. Independent... )rom Whom 2epresentative ;arter 8lass and his congressional contemporaries worked out the remarkably durable provisions of the )ederal 2eserve !ct within the conte1t of our federal system of structural checks and balances. The terms of the seven )ederal 2eserve %oard members #+/ yearsDDoriginally %oard terms were +, years, changed to +4 years in +3FF and to +/ years in +3F:$ are not so long or unchangeable as the lifeDtime appointments of Eustices to the Supreme ;ourt, but are long enough to make the partisan political prospects of a ne1t election substantially irrelevant. 7ltimately the System is accountable to congress, not the e1ecutive branch, even though 2eserve %oard members and the chairman are presidentDappointed. The authority and delegated policy powers are subEect to review by the congress not the president, the Treasury Department, nor by banks or other interests. %ecause the )ederal 2eserve System finances its operations from internally generated income, it does not depend on congressional budget appropriations. This is an essential element of Oinsulation,O since the power to appropriate budgets is the power to control. This principle was reaffirmed in the %anking !ct of +3F: and again in the 8overnment ;orporation ;ontrol !ct of +3:/. The check and balance structure e1tends in other ways. Directors of regional banks are re<uired to represent borrowers and the general public as well as banks and lenders. The regional structure itself ensures the representation of varied regional interests in economic research and policy formulation, as well as directly on the )A9;. 9embers of the %oard of 8overnors must themselves be geographically representative. )inally, an important element of insulation results from the ability to have policy deliberations conducted in a manner and climate that ensures ma1imum candor by all staff and officials involved. !lternative policies cannot be discussed fully and realistically without such candor. @ressures for 2eform @ressures for reform of the )ederal 2eserve System stem from three kinds of concerns" #a$ disagreement with monetary policy, #b$ disagreement with how the System functions in a procedural conte1t, and #c$ disagreement as to its accountability D to ;ongress, to the e1ecutive branch, to the public. Disagreements over monetary policy are inherent. Pnowledgeable monetary e1perts and economic professionals can and often do disagree over appropriate action, timing, methods of implementation and degree of emphasis. Typically, there is more disagreement over the precise degree of restraint or stimulus than over the direction of policy, whether restraint or stimulus. %ut disagreement over policy is normally healthy disagreement. It does not in itself Eustify reform unless policies are clearly bad, and clearly bad for reasons of structural dysfunction. ;ritics of monetary policy often cite the need to coordinate monetary with other national economic policies" the various agencies of government should not work at OcrossDpurposes.O Working at crossD purposes can be wasteful and inefficient. It may be an indication of bad policy on the part of one agency or on the part of all. %ut agreedDupon policy obEectives often conflict in implementationDas when we seek more Ogood thingsO than limited resources can provide, or when lower interest rates also mean more inflation. The populist goals of readily available credit at low interest on the one hand, and the dangers of rising prices, inflation and subse<uent recession on the other, are the classic issues of monetary=economic policy debate, about which there is not only honest argument but also inherent conflict. !t times, rapid increases in federal e1penditures D and deficits D have forced overDreliance on monetary restraint to curtail inflation. In the conte1t of checks and balances, it can be prudent to have a system where not all agencies or branches of government are re<uired to arrive at the same Eudgment concerning the nation s economic needs and prospects. Ather criticisms stem from the fact that the )ederal 2eserve System, as our central bank, is institutionally related to banking D especially member banks. 9ember banks elect si1 of the nine directors of each regional )ederal 2eserve %ank. !nd each member bank owns nominal stock in its district )ederal 2eserve %ank. %oards of regional )ederal 2eserve %anks have been, de facto, largely representative of banking, financial and business interests D more or less by deliberate policy. 7nderstandably, the boards of regional 2eserve %anks must include knowledgeable banking and business leaders, since one of the regional %ank s maEor functions is to work Eointly with and through member commercial banks in providing financial services to business, government, agriculture and the district economy. In practice, this has meant that they have not been specifically representative of the interests of consumers, organi(ed labor, minorities, or women D however those interests may be defined. %ut this is in process of change. 2ecent @roposals

Several suggestions for reform of the )ederal 2eserve System have been proposed, some of which seem acceptable, even if not offering substantive improvements. ;ollectively, they might enhance the public s understanding of the )ederal 2eserve as a public institution and its functioning as the Osupreme courtO of monetary policy. !mong the recent proposals are" The term of the chairman of the )ederal 2eserve %oard should be coterminous with the president s. Some have suggested that a si1 or twelveDmonth overlap would be wise and in the interest of stability, allowing a new president to be deliberate in selecting a new chairman. Athers note that the current procedure has not caused problems and may have merits worth preserving. There should be broader representation among district %ank directors. This proposal seems desirable and in keeping with a legitimate concern for the interests of consumers and minorities. 0istorically, educators and farmerDranchers have been well represented on the 9inneapolis %ank s %oard of Directors. 51panding the number of board members DD a proposal that was made last year DD would make it possible to add persons with a broader range of backgrounds and e1perience without losing the contributions of present representation. The member bank stock arrangement should be eliminated. This suggestion would seem to have little material effect. It may now be regarded as an incidental aspect of membership, thought useful at the time the )ederal 2eserve !ct was enacted. It is not an essential mechanism for )ederal 2eserve membership, but a useful one and certainly not harmful in symboli(ing the stake and the participation that commercial banking has in the central bank process. In contrast, the issue of )ederal 2eserve membership is of maEor significance. %oth e<uity and efficiency re<uire that competing financial institutions be subEect to broadly similar reserve re<uirements. This issue becomes more important as other nonDbank financial institutions #such as savings and loans$ e1pand their role. There should be fuller discussions on policy deliberations and more immediate reporting of )A9; policy decisions and plans. This recommendation has much broader significance. 9ore public knowledge and discussion of )ederal 2eserve policy would lead to a more informed public and more sophisticated understanding of the issues. ;learly a desirable result. !t the same time, reforms should not destroy the freedom of policy makers to e1plore and discuss all policy options without the inhibiting influence of e1posure to public misinterpretation or criticism during the formulative process. There should be full and fre<uent reporting to ;ongress of policy actions and e1pectations. This proposal would seem to be helpful to all concerned. The current procedure of regularly reporting to ;ongress on the OtargetsO of monetary growth has been generally constructive. Time and e1perience with this procedure may suggest whether more detailed reporting would be useful. Insulation ... how it works %eing Oindependent withinO the government means a monetary function that is insulated from, yet fully aware of, other essential needs such as national defense, foreign policy and trade, resource development, housing, and employment. ;onstructive policy derives from a structure which can be both coordinative and independent, within government and also beyond government. It will be helpful, then, to e1amine such cooperative=independent relationships between the )ederal 2eserve System and the other elements with which it must coordinate. These include" The e1ecutive branch, including the president and his advisors, the Treasury Department and other agencies. The ;ongress. %anking and private financial institutions. Structural relationships within the )ederal 2eserve System itself. With The 51ecutive %ranch Independence from the e1ecutive branch of government was a main concern during the development of the )ederal 2eserve System, as it has been since. Yet it is essential that the monetary function work in cooperation with the president and his economic advisors and with the maEor agencies of the e1ecutive branch, principally the Treasury Department. 8iven the power and influence of the presidency, that office can e1ert strong pressure and influence on any agency. %y and large, presidents have been careful not to abuse this power, respecting the need for an independent monetary authority. )ollowing World War II it appears that @resident Truman did, for a time, support the Treasury Department in its need to finance the public debt and approved the then subordinate role of the )ederal 2eserve System in supporting that effort. When this impasse was resolved, the )ederal 2eserve s responsibility and accountability for monetary actions were restored. Since then, the OindependentO relationship between the two agencies has functioned well.

There are any number of linkages between the )ederal 2eserve and the economic agencies of the e1ecutive branch. They are formal and informal and they function at both the policy and staff levels. The chairman of the %oard of 8overnors, for e1ample, Eoins the Secretary of the Treasury, the chairman of the ;ouncil of 5conomic !dvisors, and the director of the Affice of 9anagement and %udget in meetings of the soDcalled Uuadriad. When the )ederal Apen 9arket ;ommittee takes policy actions which it believes to be in the best interest of the nation, it does so with full knowledge of the administration s plans and obEectives. ... !nd the Treasury The central bank is in constant contact with the Treasury Department which, among other things, is responsible for the management of the public debt and its various cash accounts. @rior to the e1istence of the )ederal 2eserve System, the Treasury actually carried out many monetary functions. !nd even since, the Treasury has often been deeply involved in monetary functions, especially during the earlier years. !t the beginning of World War II, it appeared desirable that the Treasury be able to issue debt at relatively low interest cost and also on a basis that assured purchasers that securities would be marketable at near face value. %ecause of the urgency of this need, the policy was agreed to and continued after the war until +3:+. During this period, the Treasury was, in effect, deciding the monetary policy of the country as it made its decisions as to how much debt needed to be funded. %ecause the central bank supported the market for government securities, it was forced to purchase amounts of securities necessary to maintain low interest rates and the par value of securities. Thus, as the Treasury issued additional debt, the central bank was forced to ac<uire part of that debt. This process resulted in direct addition to bank reserves. )ollowing the +3:+ accord between the Treasury and the )ederal 2eserve System, the central bank was no longer re<uired to support the securities market at any particular level. In effect, the accord established that the central bank would act independently and e1ercise its own Eudgment as to the most appropriate monetary policy. %ut it would also work closely with the Treasury and would be fully informed of and sympathetic to the Treasury s needs in managing and financing the public debt. In fact, in special circumstances the )ederal 2eserve would support financing if unusual conditions in the market caused an issue to be poorly accepted by private investors. The Treasury and the central bank also work closely in the Treasury s management of its substantial cash payments and withdrawals of Treasury Ta1 and Goan account balances deposited in commercial banks, since these cash flows affect bank reserves. With the ;ongress ! second maEor relationship, of course, is with the ;ongress D the branch of government that specifically delegated, in the form of the )ederal 2eserve !ct, the responsibility for managing monetary policy in the interests of the nation. !t the same time, ;ongress retained responsibility for the ta1ing and spending decisions of the federal government. When the balance between spending and ta1ation results in government deficits, the Treasury has to issue additional public debt. In a monetary sense, the failure to ta1 ade<uately to cover the e1penditures of the )ederal government is an invitation for Oprinting moneyO through the issuance of federal debt. Depending on the phase of the business cycle, this tends to increase the money supply and, without offsetting action by the central bank, can result in an inflationary rise in prices. The result is Ohidden ta1ationO D which takes away from ta1payers in the form of lower purchasing power #higher prices$ what they would have paid in additional ta1es had the e1pended funds been obtained through that source. Thus there is an important linkage between the ta1ing and spending powers of ;ongress and the monetary powers as delegated to the )ederal 2eserve System. In principle, it is the Eob of ;ongress and the e1ecutive branch Eointly to define the economic policy obEectives of our national government, and to support those obEectives with appropriate fiscal measures. Then the central bank can coordinate monetary policy in a manner which serves those national obEectives. When fiscal policy does not match spending appropriately to ta1 revenues, then the monetary authority is faced with a difficult choice" #a$ how severely should it restrain the inflationary forces that may develop, and #b$ to what e1tent should it permit inflationary forces to have their effect in higher pricesL When the failure to provide appropriate ta1 revenues generates acute forces of inflation, then even the best compromise may re<uire severe monetary restraint. This has the effect of appearing to be at crossDpurposes with congressional intent and can also produce severe disruptions in some areas of the private sector such as housing. Thus, the ;ongress and the )ederal 2eserve System may not always appear to agree in their policy actions, but they have a substantial common interest in coordinating such policies. 9onetary policy can be less e1treme when fiscal policy is doing Oits share.O !nother reason for delegating the monetary responsibility to an authority not directly a part of the government is the high degree of technical e1pertise re<uired to analy(e economic data, trends, and other information related to appropriate monetary decisions. While the )ederal 2eserve has been called the monetary OagentO of ;ongress and is subEect to its ultimate control, its special responsibilities re<uire a separation in carrying out its uni<ue functions. ;ongress cannot effectively legislate dayDtoDday monetary decisions, nor even provide operating mandates.

In the dialogue between the ;ongress and the central bank, both the intent of the national policy and the rationale for appropriate monetary policy must be communicated. To accomplish this, the )ederal 2eserve System reports regularly to the ;ongress with regard to its conduct of monetary policy. Aver the years, e1haustive hearings have been held by the Senate and 0ouse banking committees regarding the functions and procedures of the )ederal 2eserve System. The Boint 5conomic ;ommittee and other committees of ;ongress fre<uently call on )ederal 2eserve representatives to discuss both policy and operational matters. With %anking ! third area of independence relates to commercial banking and other private financial institutions. It was no accident that the )ederal 2eserve System was structured to include direct representation from commercial banking, for without a sound banking system monetary policy could not operate. When the central bank takes action to restrict or e1pand the money supply, the multipliers set in motion are leveraged through the banking systemDoften to the discomfort of bankers themselves. When monetary policy is restrictive, the restrictive action takes place at the loan desks of commercial banks where, with greater demand for funds and limited money to lend because of the restrictive policy, bankers are forced to decline some loans that both they and their customers might otherwise consider prudent. Thus is e1pansion of the money supply restrained. !ll national banks and many stateDchartered banks are members of the )ederal 2eserve System. It is essential that the maEority of bank deposits in the country be subEect to )ederal 2eserve re<uirements in order that the reserve mechanisms for controlling the money supply can function well and e<uitably. In addition, the central bank is charged to perform other services for member banks such as supplying coin and currency, clearing checks, transferring funds, and making loans to member banks under special circumstances. These services re<uire direct working relationships with commercial banks. The )ederal 2eserve s supervisory role #and also the central bank s ultimate role as the lender of last resort$ reflects both the public need and the monetary need for sound banking. Through all these close ties and relationships, it is essential that the central bank deal Oat arm s lengthO with commercial banking in general and that it not be dominated or made subservient to banking interests. This also has been a maEor concern of ;ongress over the years and is a concern that is reflected in its design of the )ederal 2eserve !ct. It is one of the reasons why the )ederal 2eserve s bank supervision and regulatory functions are structurally accountable to the )ederal 2eserve %oard rather than to regional bank boards. Within Itself Ane other area in which separateness and independence have significant meaning is within the )ederal 2eserve System itself. !s originally conceived, the regional )ederal 2eserve %anks were largely autonomous" a federation of regional institutions made up the )ederal 2eserve System. !s time and e1perience brought changes, it became necessary to coordinate monetary policy on the national level, while continuing to perform central bank services for member banks, including the discount #lending$ function at the regional level. 2egional )ederal 2eserve banks are regularly e1amined by the %oard of 8overnors to confirm the internal <uality and integrity of each %ank s operations and also to ensure that regional %anks are complying with all statutory regulatory re<uirements of the System. !n important feature within the )ederal 2eserve is that the chairman of the %oard of 8overnors, though spokesman for both the sevenDman %oard and the )ederal Apen 9arket ;ommittee, does not have independent authority. 0e cannot establish policy himself nor control policy decisions. 0e is subEect to and limited by the maEority vote of the councils of which he is part. Thus, there e1ists within the System itself checks and balances which limit the authority and the power of its different elements. These relationships are significant when structural changes are under consideration. @erspectives on Independence Aur central bank structure D functioning in an environment reasonably insulated from the dayDtoDday pressures of partisan politics and shortD term e1pediency D was born out of decades of e1perience with boom=bust recessions, financial panics, and monetary instability. Aver the years, the System and its vital monetary function have been under constant scrutiny and review by ;ongress, by professional economists, by banks and financial e1perts as well as by the public. 0earings by Senate and 0ouse banking committees on )ederal 2eserve responsibilities and procedures have been e1haustive. Such studies have produced innumerable changes in responsibilities, authority and procedures. It is through such efforts that our monetary mechanisms have kept pace with the changing needs of the times. While many problems persist, it is also true that over the past three decades D and despite some pretty difficult times D recessions have been moderate, and severe panics and disruptions have been largely avoided. Whether the proposals currently suggested are useful remains to be seen. %ut the role of the )ederal 2eserve System in carrying out the e1acting responsibilities of managing the nation s monetary policy re<uires the best structural and procedural framework possible to do that Eob. The record suggests that a degree of OindependenceO is essential for effective e1ecution of its monetary role. There is a recogni(ed need

for professionalism in analysis and formulation of policy D free of partisan=e1pediency considerations and free of distraction from other responsibilities. 7rgent and changing economic needs call for fre<uent review, evaluation, and suggestions for reform D relying on the tested lessons of past e1perience as we learn to understand and cope with new changes. ! System that provides responsible policy must serve the broad public interest, remaining obEective and removed from special interest, yet ultimately accountable to and in dialogue with the realities of changing times, human values, and economic conditions. Q 2obert W. Worcester, vice president at the )ederal 2eserve %ank of 9inneapolis, provided valuable assistance in preparing this te1t for publication. Central Bankin$3 Then and *o. B. !lfred %roaddus Br. @resident )ederal 2eserve %ank of 2ichmond This article is e1cerpted from an address given to the Woodrow Wilson )orum sponsored by the Woodrow Wilson %irthplace )oundation, Staunton, Ia., !pril 4, +33F. 9arvin 8oodfriend, senior vice president and director of research at the 2ichmond )ed, contributed substantially to the preparation of the article. The theme of this conference is O)acing 5conomic Issues" ;linton and Wilson.O !nd this is a <uite appropriate theme, because there are obvious parallels. @resident ;linton and the country face pressing economic problems today ... @resident Wilson also faced substantial economic challenges in his administrations. Ane of @resident Wilson s greatest achievementsDDwhich occurred in his first year in officeDD was his orchestration of the difficult compromise, among a number of powerful and conflicting groups in the country, that culminated in passage of the )ederal 2eserve !ct in December +3+F and the creation of our central bank, including its regional arms, the )ederal 2eserve banks, the following year. !gainst this background, what I would like to do this morning is to tell you a story" an historical story, if I may, which seems appropriate in this setting. It is the story of the )ederal 2eserve, inflation, deflation and the relationship between the three. @robably everyone here knows that the )ed is supposed to maintain the purchasing power of the !merican dollar and to prevent inflation. It is also supposed to prevent deflation, which is not much on people s minds today, but was at times in Wilson s day and certainly in the +3F,s. !nother way of saying this is that the )ed is supposed to keep the aggregate level of pricesDDnot the individual prices of particular goods and services, but the aggregate price levelDDreasonably stable over time. ! stable price level by definition implies the absence of both persistent inflation and persistent deflation. That the )ed is in some sense responsible for stabili(ing the price level presupposes some benefit from doing so. !s many of you know, there has been far less than complete agreement in the 7nited States, both in the distant past and more recently, on the desirability of priceD level stabilityDDparticularly the desirability of controlling inflation. Some people, especially those who borrow money regularly, benefit from inflation, at least temporarily and partially. %ut I think it s fair to say that a maEority of !mericans value a stable price level and a sound dollar, even if they don t think about it a lot. In general they don t want the fre<uently high and typically variable inflation rates that have plagued so many other countries in the past and now. !mericans sense that stable prices and stable money prevent the arbitrary redistributions of real income and wealth that accompany inflation and weaken societies. They sense also that stable prices and stable money eliminate the confusion, uncertainty, risk and inefficiency that inflation introduces into the nation s free market system. &ow while most !mericans believe that the )ed is supposed to OfightO inflation and deflation in some general sense, they are also aware that the fight has been an uneven one and by no means fully successful in all periods of our history. An the contrary, the country went through a cataclysmic deflation in the +3F,s. Subse<uently it went through a substantial inflation in the late +3>,s and early +3-,sDDnot as traumatic and damaging as the e1perience in the F,s, but a very bad timenonetheless. What s the problemL Why hasn t the )ed done a better EobL I am going to argue today that one reasonDDand maybe the main reasonDDis that the )ed does not now have, and it never has had, a clear congressional mandate to stabili(e the price level. ;onse<uently, the )ed s success in stabili(ing the price level in at least some periods of its history has been and continues to be a function largely of" prevailing general economic conditions the strength of the )ederal 2eserve s leaders oldDfashioned luck. The implication, of course, is that something probably should be done to strengthen the )ed s hand so that its performance would be less dependent on fortuitous circumstances. !nd let me make it clear that I personally feel strongly that something should be done. I am well aware that in today s relatively low inflation climate, many people do not see this as a pressing issue, such as the federal budget deficit or health care reform, that re<uires immediate attention. I disagree for reasons I hope to make clear in the remainder of my comments. ...

The 8old Standard and @rice Stability %efore the )edaral 2eserve !s I suggested a minute ago, the )ederal 2eserve was established in +3+/ to remedy banking and currency problems that had been recurring since the ;ivil War. The country had no central bank during this period, which is known to economic historians as the &ational %anking 5ra. The 7nited States left the gold standard to help finance the ;ivil War, but returned to it in +->3. Thereafter, monetary conditions were largely governed by the flow of gold to and from the 7nited States as part of the international balance of payments adEustment mechanism under the international gold standard. 7nder the gold standard, the national money supply was closely linked to the nation s stock of monetary gold, which included gold coin, Treasury currency backed by gold and gold reserves held by banks. When the country ran a balance of trade surplus, for e1ample, the e1cess of foreign receipts over e1penditures was received in gold. The gold inflow set in train a multiple e1pansion of deposits that increased the money supply. The increase in the money supply then increased domestic demand for goods and services and put upward pressure on domestic prices. The reverse occurred when the country ran a trade deficit. )or our purposes, the point is that under a gold standard without a central bank, the nation s stock of money was automatically regulated by conditions in world markets. This system had good features and notDsoDgood features. An the good side, the gold standard did keep the aggregate price level under control over the very long run. The aggregate level of prices in +3+/, for e1ample, was not very different from the level F, years before in the early +--,s. %y comparison, the price level rose 4>, percent between +36, and +3-:. So the gold standard provided an anchor for the price level over the long runDDthat is, it provided a means of stabili(ing the price level over the long run. 9oreover, it was a credible anchor' the public understood the mechanism and knew it worked. %ut the gold standard had significant limitations in the short and intermediate terms. )irst, while the gold standard anchored the price level over the very long run, it nonetheless allowed it to drift upward and downward by significant amounts over fairly long periods. )or e1ample, slow growth in the world gold supply caused the price level to decline at over + percent per year from +->3 to +-3>, which provoked William Bennings %ryan s famous plea not to crucify mankind on a cross of gold. Subse<uently, new gold discoveries and improved mining techni<ues caused the metal s supply to increase rapidly in the late +-3,s and early +3,,s. ;onse<uently, the price level rose at over 4 percent per year from about +-3> to +3+/. ! second limitation was that the strict discipline of the gold standard did not allow the money supply to increase rapidly in response to domestic disturbances such as a banking panic or a stock market crash. ShortDterm Interest 2ate %ehavior %efore the )ederal 2eserve Get me e1pand Eust a little on that last point and shift the focus temporarily from prices to interest rates, since it was really a concern about financial problems and sharp interest rate movements under the gold standard that led to the )ederal 2eserve !ct. %ecause the nation s monetary gold stock was relatively unresponsive to domestic economic conditions in the short run, the &ational %anking 5ra was characteri(ed by considerable shortDterm interest rate variability. Sudden sustained shortDterm interest rate spikes of over +, percentage points occurred on eight occasions during this period. Some, though not all, of these spikes were associated with banking panics, which involved a loss of confidence in the banking system and a rush to convert bank deposits into currency. Since banks held only a fractional reserve of coin and currency in their vaults, Obank runsO generated a scramble for li<uidity that could not be satisfied in the short run. 9aEor banking panics occurred in +->F, +--/, +-3,, +-3F and +3,>. In addition to the recurring interest rate spikes, there was a pronounced seasonal pattern in shortDterm interest rates. This pattern resulted from the relatively strong demand for currency during the fall harvest and ;hristmas holiday seasons. It was e1acerbated by the reserve re<uirement provisions of the &ational %ank !ct, which led to a phenomenon known as OpyramidingODDthe concentration of reserves in bigD city banks. The practice of counting correspondent balances as legal reserves, combined with the payment of interest on interbank balances, caused reserves to concentrate in the larger cities, especially in &ew York. The withdrawal of interbank balances in peak agricultural and holiday periods tended to e1acerbate seasonal pressures on the banking system. ;onse<uently, shortD term interest rates varied seasonally by as much as 6 percentage points over the course of a year. The )edaral 2eserve s 9andate in +3+/ This background information is essential in understanding what @resident Wilson and the ;ongress had in mind when they passed the )ederal 2eserve !ct. The )ederal 2eserve was established in +3+/ in large part to alleviate the two main problems of the &ational %anking 5ra" #+$ recurrent interest rate spikes associated with li<uidity crises and banking panics, and #4$ interest rate seasonals e1acerbated by reserve pyramiding. Specifically, as stated in its preamble, the purposes of the )ederal 2eserve !ct were Oto provide for the establishment of )ederal 2eserve banks, to furnish an elastic currency, to afford means of rediscounting paper, to establish a more effective supervision of banking in the 7nited States, and for other purposes.O 7nder the !ct, +4 )ederal 2eserve banks #including ours in 2ichmond$ were established around the country as depositories for the re<uired reserves that previously had been held at correspondent banks in &ew York ;ity and elsewhere. %y re<uiring that private banks hold reserves directly in a )ederal 2eserve bank, the act eliminated reserve pyramiding and eased the seasonal strain on the banking system. The most important power given the new central bank, however, was the authority to issue currency and to create bank reserves at least partly independently of the nation s monetary gold reserves. The )ed could create currency and reserves as long as the )ederal 2eserve banks kept a minimum /, percent gold reserve against )ederal 2eserve notes, which were paper currency, and a F: percent gold reserve

against deposits held by private banks at )ederal 2eserve banks. These minimum gold reserve ratios made the )ed respect the discipline of the gold standard' however, the monetary gold stock was so large during the )ed s early years that these re<uirements were not Obinding.O In other words, they did not constrain the volume of )ederal 2eserve notes that could be issued nor the volume of bank reserve deposits that could be created by 2eserve bank discount window lending. The power to create currency and bank reserves enabled the )ed to do what it had been established to do" eliminate both the seasonal in interest rates and the periodic spikes in rates that had plagued the country during the &ational %anking 5ra. @rice Stability in the )ed s 5arly Years The 51pectation !s we have Eust seen, the new central bank was well e<uipped to deal with both seasonal and special li<uidity pressures and their effects on interest rates. %ut we need now to shift our focus back to the price level and ask" What did the )ederal 2eserve System and its ability to create currency and bank reserves imply for the stability of the price levelDDthat is, the stability of the purchasing power of moneyL The answer is that it was taken for granted that the minimum gold reserve ratio under the gold standard would continue to provide what economists call a nominal anchor for the monetary system, which is a fancy way of saying that it would provide for a reasonably stable price level over time. #!s a footnote, I should point out here that the framers of the )ederal 2eserve !ct apparently did not give much attention to the intermediate drift of the price level upward and downward which, as I mentioned earlier, can and did occur under the gold standard.$ The clear presumption underlying the !ct was that the new central bank would concern itself mainly with making li<uidity available on a timely basis to smooth shortDterm movements in interest rates. !ny discretionary inEection of currency or bank reserves for this purpose, however, was e1pected to be only temporary, so that the nation s money supply and price level would, over the long term, be governed by the nation s stock of monetary gold, much as it had been before the establishment of the )ed. 8iven this presumptionDDand this is a crucially important point about the history of central banking in the 7nited StatesDDthe )ederal 2eserve !ct did not include a mandate for price stability because everyone e1pected that the price level in fact would be stable over time as long as the )ederal 2eserve respected its minimum gold reserve ratio. The gold standard would guarantee price stability and the new central bank could focus on stabili(ing the banking system and interest rates. &o separate mandate to resist inflation or deflation was needed. )ederal 2eserve @olicy In the !ftermath of World War I This was the e1pectation. Get me turn now to the reality of the early years of the )edDDmore specifically, the period between +3+/ and +343. The presumptions about the gold standard and priceDlevel stability implicit in the )ederal 2eserve !ct were tested swiftly and severely during these years. In one of the great ironies of monetary history, by the time the )ederal 2eserve banks actually opened for business in +3+/, the outbreak of World War I in 5urope had brought about widespread suspensions of national commitments to maintain the fi1ed currency price of gold. %ecause the 7nited States remained neutral until +3+>, it was able to remain on the gold standard throughout the war, and, although it embargoed gold e1ports, it continued to fi1 the dollar price of gold at *4,.6> per ounce. !s it turned out, 7nited States participation in the war and the large federal deficits that accompanied itDDyes, there were deficits back then tooDDoccasioned the first maEor use of the fledgling central bank s power to create currency and bank reserves. 9ost of the federal deficit was covered by sales of 7.S. government bonds to the public. The additional supply of bonds, naturally, put upward pressure on interest rates, which would have greatly increased the cost of financing the war had the pressures been allowed to persist. ;onse<uently, the 2eserve banks held shortDterm interest rates down by keeping their discount rates low and accommodating credit demand at these ratesDD which they were able to do because of the e1cess gold reserves I mentioned earlier. The discount window lending by )ederal 2eserve banks, in turn, increased the supply of bank reserves and caused the 7.S. money supply to rise. &ow, as you are no doubt aware, rapid money growth produces inflation over time. ;onse<uently, the highly accommodative monetary policy during the war caused the 7.S. price level appro1imately to double. !lthough the war ended in +3+-, )ederal 2eserve policy remained accommodative in +3+3 in an effort to cushion the negative economic impact of demobili(ation. The continued rapid growth in )ederal 2eserve notes and in bank reserves that resulted from this policy, along with the lifting of the wartime gold embargo that allowed gold to flow abroad again, finally mopped up the e1cess gold and caused the )ederal 2eserve s gold reserve ratio to become binding in midD +34,, toward the end of @resident Wilson s second term. !t this point, the )ed finally had to confront the constraints of the gold standard, and it responded affirmatively and aggressively. )aced with the need to defend its gold reserve ratio, the )ed raised its discount rate from / percent to > percent in +34,, a near doubling. In today s terminology this constituted a sharp OtighteningO of monetary policy, and it was strong medicine. The deflationary impact was swift and e1traordinary. @rices fell precipitously, and by Bune +34+ about half of the earlier wartime increase in the price level had been reversed. 7nfortunately, the sharp decline in the price level was accompanied by a severe economic contraction and rising unemployment lasting from early +34, to midD+34+. %ut by acting as it did, the )ed essentially validated the implicit assumption underlying the )ederal 2eserve !ctDDthat the country would remain on the gold standard, which would maintain a stable price level over the long run if not the shorter run. To use some current Eargon, the )ed attained credibility for its commitment to the gold standard and price stability by its stiff tightening of policy in +34,. !s a postscript, many monetary historians would argue that the )ed could have achieved greater credibility with less economic disruption if it had tightened policy sooner. 2egrettably, the cost of failure to resist inflation promptly and decisively when it arises is a lesson the nation has had to learn repeatedly. @rice Stability in the +34,s

!fter validating the country s commitment to the gold standard in the early 4,s, and once it had obtained a cushion of gold reserves above its legal minimum, the )ed began to use its monetary policy powers to achieve a greater degree of shortDterm priceDlevel stability. 7nder the able leadership of %enEamin Strong, governor of the )ederal 2eserve %ank of &ew York, the )ed deliberately began to offset the effect of temporary gold inflows on the 7.S. money supply by selling e<uivalent amounts of securities from its portfolio. Gikewise, temporary shortD term outflows of gold were offset by security purchases. Such Osterili(ationO insulated the 7.S. economy from the money supply and aggregate demand instability that gold flows would have caused had they been allowed to affect currency and bank reserves. !ggregate economic conditions were favorable during most of the period from +344 to +343, in my view, partly because the )ed recently had won at least belated credibility for its commitment to price stability by defending the gold reserve ratio in +34, and +34+, partly because of Strong s e1traordinarily skillful discretionary containment of inflation, and partly because of the absence of severe economic shocks. 7nfortunately, at the end of the decade, these foundations began to crumble. !fter having been partially restored in the 4,s, the international gold standard became increasingly fragile and deflationary. 9oreover, 8overnor Strong died an untimely death in +34-, which robbed the )ed of strong leadership. Thus the )edDDbereft of any e1plicit price stability mandateDDwas simply unable to maintain a discretionary monetary policy aimed at price stability. The conse<uence was a F, percent decline in prices in the early +3F,s and the most terrible economic depression in !merican history. ... While what happened during the Depression decade of the +3F,s obviously is very important in 7.S. monetary history, I must move on now from the OthenO part of my talk to the concluding OnowO part. We shall see that at least some of the deficiencies in the institutional structure of !merican monetary policymaking that e1isted in +343 still e1ist, and that they present some risks, although the risks are different from those of the earlier period. Inflation in the +3>,s and +3-,s We pick up our story a halfDcentury later in the midD+3>,s. !t the time, inflation had been rising slowly but steadily since the early +36,s. The 7.S. dollar and, through it, the world s other maEor currencies, had been linked to gold under an arrangement known as the %retton Woods System after the town in &ew 0ampshire where the agreement had been forged at the end of World War II. 7nder the arrangement, the 7.S. had pledged to maintain convertibility of the dollar into gold at *F: per ounce. %ut when e1cessively accommodative monetary policy and gold outflows caused the )ederal 2eserve s then 4: percent gold reserve ratio to become binding in the midD 6,s, in sharp contrast to the )ed s behavior in +34, and +34+, the gold reserve re<uirement was eliminated. !fter some attempts to repair the %retton Woods System, it finally collapsed in +3>F. The year +3>F is generally remembered as the year of the first oil price shock, but it was also a watershed in 7.S. monetary history. %efore +3>F there was a sense that both the domestic and international monetary systems should retain at least some link to gold, even though the country had not really permitted the gold standard rules to constrain monetary policy for some time. Since +3>F, however, there has been a generalDD although not universalDDbelief that the gold standard is a thing of the past. ;onse<uently, for the last 4, years the )ed has lacked even the weak %retton Woods commitment to gold that would have anchored the price level at least over the very long run and helped it deliver price stability. Since the )ederal 2eserve was originally designed to operate in an institutional environment with at least some such commitment, one might have e1pected ;ongress, as a matter of logic, to give the )ed an e1plicit price stability mandate when the %retton Woods System fell apart. 7nfortunately, no clear mandate has been forthcoming, although ;ongressman Stephen &eal of &orth ;arolina introduced an amendment to the )ederal 2eserve !ct in +3-3 and has reintroduced it every year since that would provide such a mandate. The &eal !mendment #sometimes referred to as the O(ero inflation amendmentO$ would re<uire the )ed, over a period of time, to eliminate inflation as a significant factor in economic and business decisions. The )ed supports this amendment, and I personally believe its passage would benefit the !merican economy enormously. !s you probably know, ;ongress did pass legislation in the late +3>,s that re<uires the )ed to set and report targets for the growth of the 7.S. money supply. 9any people, including your speaker, were hopeful at the time that this legislation would yield more stable and nonD inflationary money growth rates, and, hence, a more stable price level. %ut, frankly, it did not work well in this period. !s measured by the ;onsumer @rice Inde1, the inflation rate rose from /.3 percent in +3>6 to +F.F percent in +3>3 and +4.: percent in +3-,. To be sure, the higher inflation partly reflected the continued sharp increases in oil prices in this period. %ut it is also true that money supply growth e1ceeded its targets almost continuously throughout the late +3>,s. This performance created doubts about the )ed s commitment to the targets, which encouraged inflationary priceD and wageD setting behavior even before the oil price shock. ;ongress willingness to accept the inflationary money growth rates, and its failure to mandate the )ederal 2eserve to stabili(e prices, further undermined the public s confidence that inflation would be resisted. In short, by the late +3>,s the )ed had little if any credibility as an inflation fighter or as a defender of the purchasing power of the dollar. !ggressive Inflatopn )ighting in the +3-,s %y the time @aul Iolcker became )ederal 2eserve chairman in !ugust +3>3, the inflation outlook had begun to deteriorate rapidly. The widely publici(ed announcement on Act. 6, +3>3, of the )ederal 2eserve s intention to control money growth more closely inaugurated a period of aggressive inflation fighting. The announcement signaled financial markets and the country that the )ed was prepared to take responsibility for delivering low inflation, even without an e1plicit mandate for price stability from ;ongress. %ut the announcement was Eust the beginning. %ecause the )ed s credibility as an inflation fighter had been so badly compromised, the System had to follow the announcement with strong actions to demonstrate its intent, much as the )ed had had to do in the early +34,s. !nd

strong action was taken in the form of a severe tightening of policy that took shortDterm interest rates from around ++ percent in late +3>3 to +> percent by !pril +3-, and ultimately to around 4, percent by early +3-+. This was the sharpest tightening the )ederal 2eserve had ever engineered in so short a time. The action succeeded in bringing inflation down to around / percent in +3-4. In addition, in a manner similar to the early +34,s, it greatly enhanced the )ed s credibility as a defender of the purchasing power of the dollar, althoughDDin another parallel to the 4,sDDit was accompanied by a sharp and costly contraction. This credibility, combined with #in yet another parallel to the 4,s$ the able leadership of ;hairman Iolcker and his successor, !lan 8reenspan, has enabled the )ed to maintain the low inflation rate in subse<uent years and, indeed, to reduce it somewhat further to a trend rate currently of appro1imately F percent. Implications of the @arralells %etween the 4,s and the -,s !s we have seen, )ederal 2eserve policy in the early +3-,s had much in common with that of the +34,s. %oth decades opened with periods of e1ceedingly tight monetary policy in response to earlier accelerations of inflation, and the restrictive policies succeeded in bringing inflation sharply downward in both periods. %eyond this, the )ed s strong actions in each instance conferred upon it an enhanced credibility that helped keep inflation low for the remainder of the decade. 9oreover, unusually capable central bankers in both periods took advantage of this credibility to pursue price stability with essentially discretionary actions, even though Strong was acting within the overall framework of the gold standard in the earlier period. There is one final, less comforting comparison between the two periods, however, that needs to be drawn. !s I have indicated, the )ed entered the +3F,s without %enEamin Strong, with an eroding and e1ceedingly deflationary gold standard, and with no alternative, e1plicit price stability mandate. ;urrently, the )ed is moving toward the end of this century and the beginning of the ne1t in a stronger and <ualitatively different condition. Inflation, rather than deflation, is the current concern. 5conomic conditions are more tran<uil now than they were at the end of +343, despite the many problems we still face. )urther, in my opinion the )ed currently enEoys energetic and very capable leadership. 0owever, as in +343, there is no clear mandate for the )ed to pursue priceD level stability. This makes many of us who work at the )ed uneasy, and it e1plains why the )ederal 2eserve supports ;ongressman &eal s amendment, which, as I noted earlier, would provide us with such a mandate. In short, ladies and gentlemen, under present institutional arrangements surrounding the conduct of !merican monetary policy, maintenance of a sound dollar in the longerDterm future will re<uire continued strong leadership at the )ed, an absence of maEor destabili(ing economic shocks like the oil shocks of the +3>,s and, ultimately, a measure of good luck. The continuation of all these circumstances indefinitely would be fortuitous. I don t feel very comfortable in this situation, and you shouldn t feel comfortable eitherDD especially the younger people in the audience. This economic issue may seem less immediate and pressing than some of the others you ve faced over the last day and a half. %ut I can assure you that it is no less important. We need to resolve it promptly. 4o. the +ederal ,eserve is !udited !ll )ederal 2eserve %anks and branches, like commercial depository institutions, are audited and e1amined regularly. Internal audits are conducted by a permanent audit staff at each 2eserve %ank. 5ach audit staff is headed by a general auditor who reports directly to the %ank s board of directors. In addition, the )ederal 2eserve %oard s Division of )ederal 2eserve %ank Aperations and @ayment Systems conducts annual e1aminations of each 2eserve %ank and its branches. @rocedures used by the %oard s e1aminers are periodically surveyed and appraised by a private certified public accounting firm. The %oard is audited by the staff of the Inspector 8eneral s Affice and e1amined by a private ;@! firm. Aperations at each )ederal 2eserve %ank also are subEect to periodic review by the 8eneral !ccounting Affice #8!A$, the audit arm of the 7.S. ;ongress. 0owever, 8!A auditors are restricted by law from reviewing monetary policy operations and transactions carried out by the )ederal 2eserve on behalf of foreign central banks. The scope and fre<uency of audits are based on the specific risk factors inherent in each %ank s operations, including the nature of the activities it conducts, the prevailing level of controls surrounding these activities and the <uality and e1perience of the individuals assigned to the operation. Internal audits at each 2eserve %ank primarily involve verification of assets, liabilities and items held in custody. !uditors check either for the physical presence of these items or for the timely and accurate reporting of their movement. !n evaluation of the ade<uacy of controls throughout the %ank and compliance with prescribed procedures is also included. !udits are performed periodically in order to determine if the auditors perceptions of prevailing risk levels and operating conditions since the last review remain valid. @eriodic audits also help to determine whether previously identified problems and issues were ade<uately addressed and remediated, and to ascertain whether new problems or issues have emerged. !lthough auditing procedures differ among the +4 2eserve %anks, their emphases are broadly similar. !t the )ederal 2eserve %ank of &ew York, the auditing department reviews the fiscal, and accounting areas, and all of the service and professional operations #which include legal, bank supervision and regulation, and research and statistics$. !uditors assigned to the 5ast 2utherford Aperations ;enter #52A;$ review the cash processing operations. !n auditor at the %uffalo %ranch reviews activities there. !uditors also compile information concerning holdings and balances for accounts maintained by the %ank for depository institutions and certify their accuracy for bank e1aminers and public accountants.

Together with two nonDaudit groups, the auditing department controls activities in the %ank s gold vault, which stores about oneDthird of the world s official gold stock. !uditors monitor all gold transactions, both deposits and withdrawals, and independently verify accounting records and balances pertaining to gold being held in custody by the %ank. The %ank s audit analysis department speciali(es in audits of centrali(ed electronic data processing operations, automated systems under development and the check and electronic payments area. These audits consist of reviews of the %ank s data centers, with primary emphasis on environmental software products, including data base systems, operating systems, and data communications systems. !uditors evaluate the strength of internal controls and security of each environmental software product as well as the procedures and controls put in place by the organi(ational unit responsible for it. !udits of automated systems under development similarly concentrate on the ade<uacy of controls and security. These audits are intended to ensure that appropriate checks and balances are in place during automated processing steps. !udit teams check the accuracy of records pertaining to transactions that flow through the system and certify that systems under development are fully and ade<uately tested prior to being placed into production.

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