HOW THE FEDERAL RESERVE DECIDES HOW MUCH MONEY TO PUT INTO THE ECONOMY WASHINGTON, May 4 — Only one thing is entirely agreed, accepted and understood about the somewhat mysterious and often controversial subject of the Government's monetary policy, which is conducted by the semi-independent Federal Reserve Board. This is that the Fed, as it is commonly known, can create money out of thin air by writing a check on itself without any deposits to back that check. It can do so in unlimited amounts. And only it can do so—the Treasury cannot. Yesterday, Arthur F. Burns, chairman of the Federal Reserve Board, disclosed to Congress the Fed's intentions and targets for creation of money in the year ahead. But he gave his targets in the form of range, not a precise number, and he is the first to admit that he and his colleagues are not at all certain what exactly is the "right" amount of money to create for the good of the nation's economy. The Government's "printing press" is literally in the Bureau of Engraving and Printing, which turns out currency notes in amounts that depend on the public's demand for them. But the true printing press is a little known man named Alan R. Holmes who sits in an office in the Federal Reserve Bank of New York and decides every day, under instructions and guidelines from a powerful body of the Federal Reserve known as the Open Market Committee, how much money to create. ORDERS SECURITIES Mr. Holmes creates money by placing an order in the money market for Treasury bills or other Government securities. He pays for them by writing a check on the Federal Reserve Bank of New York. If the order is for $100 million, an additional $100 million in cash suddenly flows into the economy, possessed originally by the people who sold the Government securities to the Fed. Mr. Holmes can "extinguish" money, too. If he places a sell order in the market, the Fed sells securities to a money market dealer or bank and gets a check in payment. The amount of money in that check essentially vanishes. The buyer of the securities from the Fed has less cash but the Fed, in effect, tears up the check. How much money Mr. Holmes creates makes a good deal of difference to the performance of the economy—the rate of inflation, the expansion of production and jobs, interest rates and indeed general well-being—because the amount of money affects how rapidly the wheels of the economy turn. But what Mr. Holmes does is cause of controversy because the creation of additional money is also linked by economists to inflation. Friedrich Hayek, the Pulitzer Prize-winning Austrian economist, asserts unequivocally that "inflation is at all monetary phenomenon." Mr. Hayek has innumerable followers. While other economists think his view is a little oversimplified, nearly all of them agree that "money matters." What is more, the check that Mr. Holmes writes is only the beginning of the process of creating money. That initial $100 million starts a process by which the nation's money supply—currency plus deposits in banks—will grow not by $100 million but by some multiple of that amount. It is at this point that things begin to get a little more complicated. In brief, the "multiplier" effect arises from the way the nation's—any advanced nation's—banking system works. It is called a "fractional reserve" system and it works this way: Suppose that Salomon Brothers receives Mr. Holmes's check on the Federal Reserve Bank of New York and deposits it in Citibank, where deposits are now higher by $100 million. Under the Fed's "reserve requirement" regulations, which are crucial to the multiplier process, Citibank must deposit about $15 million of this in its "reserve" account at the Fed. But then it can, and does, lend the remaining $85 million to, say, the United States Steel Corporation, which needs money to pay wages while it waits for its inventories of steel to be bought. U.S. Steel gets the money from Citibank and deposits it at the Pittsburgh National Bank, and the multiplying process goes on. Pittsburgh National puts about $13 million in its reserve account at the Fed and uses the remaining $72 million to buy notes of the city of Boston, which deposits this income in the First National Bank of Boston. At this point Mr. Holmes's original $100 million has already become $257 million, as follows: H Salomon Brothers has $100 million more cash (but correspondingly less in Treasury bills). f U.S. Steel has $85 million more cash (but a debt to Citibank). H Boston has $72 million more cash (but a debt to Pittsburgh National). The process continues until, with a 15 percent reserve requirement, Mr. Holmes's original check for $100 million eventually adds more than $600 million to the total of bank deposits in the nation, the nation's money supply. And that money, obviously, can be and is sent to (sic). Sometimes more spending is desirable to bring forth production and add to jobs, but by no means always. The more money there is in circulation, the easier it is for sellers to raise prices, whether to cover higher wages and other costs or to increase profits, because customers around the nation have more to spend. When prices go up all over, this is inflation. But it is impossible to know precisely just how much money is enough or how much is too much at any given time. But there is obviously a point of "too much," as all of history teaches. For policy makers, there are the two following questions: H What targets for Mr. Holmes should the Open Market Committee, which consists of seven members of the Federal Reserve Board and the presidents of five of the twelve regional Federal Reserve banks, establish? The relationship of the money supply to the economy at large, including inflation, is by no means clear, even to the experts. K Because Mr. Holmes's buying and selling affects short-term interest rates as well as the money supply, which should he concentrate on? At bottom, the nation's central bank is controversial, and frequently unpopular, because it is a "naysayer." Whenever inflation rears its head, the job of the Fed is to slow the creation of money and, for a while at least, that often means higher interest rates and sometimes a cutback in production and a loss of jobs. SWITCHING OF FUNDS The right policy will always be a matter of judgment. But at the moment the problem of setting the target for Mr. Holmes is complicated by what Mr. Burns calls the "new financial technology," such as those little electronic "tellers" that many banks now make available to their depositors. Among other services, they permit immediate switching of funds from savings to checking accounts by the push of a button and even payment of some bills, such as utilities bills, directly out of savings. The "money supply" as long defined meant currency plus checking accounts (known in the jargon as Ml). There were fairly well-established relationships between the growth of Ml and the overall courage of the economy, including the rate of inflation. But now that people, and business, too, have learned to use savings accounts as almost the equivalent of checking accounts, those relationships have gone awry. "Our equations are all fouled up," a high Federal Reserve official concedes. The report of the Open Market Committee on its meeting of last January disclosed that the panel, puzzled by a slow growth in money but a rapid growth in the economy, threw up its hands and simply gave Mr. Holmes an unusually wide "target range" for money growth in the period immediately ahead. This meant that he was not to take any special action to create or extinguish money as long as M1 growth stayed within a very wide band. M2, which includes savings accounts. But Mr. Holmes cannot tell when he writes one of his checks how much of the ultimate deposits will be in checking or savings accounts. Thus his art will always be imprecise and his results subject to criticism. At present, the Fed does not know whether Ml or M2 is the more important measure, though in the end it controls the growth of both. The interest rate problem is a different one. When Mr. Holmes intervenes in the market to buy or sell Government securities, he not only changes the amount of money in the economy but, unavoidably, also affects what are called "money market interest rates"—the rate on very short-term instruments such as Treasury bills. RATE ON BANK LOANS The impact of his intervention decisions shows up first in the most sensitive and closely watched of all rates, called the "Federal funds" rate, which is the interest rate charged on loans from one bank to another. In daily operations some banks wind up short of their required reserve deposits with the Federal Reserve and some have an excess, and this gives rise to overnight loans from one bank to another. Eventually, a rising prime rate brings along with it higher interest rates to ordinary consumers and other borrowers. Sometimes, as occurred last week, Mr. Holmes is instructed to intervene in such a way as to "nudge up" the Federal funds rate himself, as a signal that the Federal Reserve feels the money supply is growing too rapidly. In either case, whether he "lets" the rate go up or pushes it up himself, the result is higher interest rates. And these days that often means a quick drop in the stock market, as happened in the last few days. Every time Mr. Holmes writes a check he adds to bank reserves and makes the Federal funds interest rates "easier"—that is, lower or less likely to rise. DISCUSSION 1. Explain how the Federal Reserve System is actually creating money when Alan Holmes places an order in the money market for Treasury bills or other government securities. How will this money supply change affect employment and output? 2. The article refers to "the multiplier." Is this the same multiplier that we talked about in Chapter 9? If not, what is it? 3. Who actually decides to expand the money supply—the Treasury, Alan Holmes, The Open Market Committee, or the Board of Governors of the Federal Reserve Board.

HOW THE FEDERAL RESERVE DECIDES HOW MUCH MONEY TO PUT INTO THE ECONOMY

WASHINGTON, May 4 — Only one thing is entirely agreed, accepted and understood about the somewhat mysterious and often controversial subject of the Government's monetary policy, which is conducted by the semi-independent Federal Reserve Board. This is that the Fed, as it is commonly known, can create money out of thin air by writing a check on itself without any deposits to back that check. It can do so in unlimited amounts. And only it can do so—the Treasury cannot. Yesterday, Arthur F. Burns, chairman of the Federal Reserve Board, disclosed to Congress the Fed's intentions and targets for creation of money in the year ahead. But he gave his targets in the form of range, not a precise number, and he is the first to admit that he and his colleagues are not at all certain what exactly is the "right" amount of money to create for the good of the nation's economy. The Government's "printing press" is literally in the Bureau of Engraving and Printing, which turns out currency notes in amounts that depend on the public's demand for them. But the true printing press is a little known man named Alan R. Holmes who sits in an office in the Federal Reserve Bank of New York and decides every day, under instructions and guidelines from a powerful body of the Federal Reserve known as the Open Market Committee, how much money to create.

ORDERS SECURITIES

Mr. Holmes creates money by placing an order in the money market for Treasury bills or other Government securities. He pays for them by writing a check on the Federal Reserve Bank of New York. If the order is for $100 million, an additional $100 million in cash suddenly flows into the economy, possessed originally by the people who sold the Government securities to the Fed. Mr. Holmes can "extinguish" money, too. If he places a sell order in the market, the Fed sells securities to a money market dealer or bank and gets a check in payment. The amount of money in that check essentially vanishes. The buyer of the securities from the Fed has less cash but the Fed, in effect, tears up the check. How much money Mr. Holmes creates makes a good deal of difference to the performance of the economy—the rate of inflation, the expansion of production and jobs, interest rates and indeed general well-being—because the amount of money affects how rapidly the wheels of the economy turn. But what Mr. Holmes does is cause of controversy because the creation of additional money is also linked by economists to inflation. Friedrich Hayek, the Pulitzer Prize-winning Austrian economist, asserts unequivocally that "inflation is at all monetary phenomenon." Mr. Hayek has innumerable followers. While other economists think his view is a little oversimplified, nearly all of them agree that "money matters." What is more, the check that Mr. Holmes writes is only the beginning of the process of creating money. That initial $100 million starts a process by which the nation's money supply—currency plus deposits in banks—will grow not by $100 million but by some multiple of that amount. It is at this point that things begin to get a little more complicated. In brief, the "multiplier" effect arises from the way the nation's—any advanced nation's—banking system works. It is called a "fractional reserve" system and it works this way: Suppose that Salomon Brothers receives Mr. Holmes's check on the Federal Reserve Bank of New York and deposits it in Citibank, where deposits are now higher by $100 million. Under the Fed's "reserve requirement" regulations, which are crucial to the multiplier process, Citibank must deposit about $15 million of this in its "reserve" account at the Fed. But then it can, and does, lend the remaining $85 million to, say, the United States Steel Corporation, which needs money to pay wages while it waits for its inventories of steel to be bought. U.S. Steel gets the money from Citibank and deposits it at the Pittsburgh National Bank, and the multiplying process goes on. Pittsburgh National puts about $13 million in its reserve account at the Fed and uses the remaining $72 million to buy notes of the city of Boston, which deposits this income in the First National Bank of Boston. At this point Mr. Holmes's original $100 million has already become $257 million, as follows: H Salomon Brothers has $100 million more cash (but correspondingly less in Treasury bills). f U.S. Steel has $85 million more cash (but a debt to Citibank). H Boston has $72 million more cash (but a debt to Pittsburgh National). The process continues until, with a 15 percent reserve requirement, Mr. Holmes's original check for $100 million eventually adds more than $600 million to the total of bank deposits in the nation, the nation's money supply. And that money, obviously, can be and is sent to (sic). Sometimes more spending is desirable to bring forth production and add to jobs, but by no means always. The more money there is in circulation, the easier it is for sellers to raise prices, whether to cover higher wages and other costs or to increase profits, because customers around the nation have more to spend. When prices go up all over, this is inflation. But it is impossible to know precisely just how much money is enough or how much is too much at any given time. But there is obviously a point of "too much," as all of history teaches. For policy makers, there are the two following questions: H What targets for Mr. Holmes should the Open Market Committee, which consists of seven members of the Federal Reserve Board and the presidents of five of the twelve regional Federal Reserve banks, establish? The relationship of the money supply to the economy at large, including inflation, is by no means clear, even to the experts. K Because Mr. Holmes's buying and selling affects short-term interest rates as well as the money supply, which should he concentrate on? At bottom, the nation's central bank is controversial, and frequently unpopular, because it is a "naysayer." Whenever inflation rears its head, the job of the Fed is to slow the creation of money and, for a while at least, that often means higher interest rates and sometimes a cutback in production and a loss of jobs.

SWITCHING OF FUNDS

The right policy will always be a matter of judgment. But at the moment the problem of setting the target for Mr. Holmes is complicated by what Mr. Burns calls the "new financial technology," such as those little electronic "tellers" that many banks now make available to their depositors. Among other services, they permit immediate switching of funds from savings to checking accounts by the push of a button and even payment of some bills, such as utilities bills, directly out of savings. The "money supply" as long defined meant currency plus checking accounts (known in the jargon as Ml). There were fairly well-established relationships between the growth of Ml and the overall courage of the economy, including the rate of inflation. But now that people, and business, too, have learned to use savings accounts as almost the equivalent of checking accounts, those relationships have gone awry. "Our equations are all fouled up," a high Federal Reserve official concedes. The report of the Open Market Committee on its meeting of last January disclosed that the panel, puzzled by a slow growth in money but a rapid growth in the economy, threw up its hands and simply gave Mr. Holmes an unusually wide "target range" for money growth in the period immediately ahead. This meant that he was not to take any special action to create or extinguish money as long as M1 growth stayed within a very wide band.

M2, which includes savings accounts. But Mr. Holmes cannot tell when he writes one of his checks how much of the ultimate deposits will be in checking or savings accounts. Thus his art will always be imprecise and his results subject to criticism. At present, the Fed does not know whether Ml or M2 is the more important measure, though in the end it controls the growth of both. The interest rate problem is a different one. When Mr. Holmes intervenes in the market to buy or sell Government securities, he not only changes the amount of money in the economy but, unavoidably, also affects what are called "money market interest rates"—the rate on very short-term instruments such as Treasury bills.

RATE ON BANK LOANS

The impact of his intervention decisions shows up first in the most sensitive and closely watched of all rates, called the "Federal funds" rate, which is the interest rate charged on loans from one bank to another. In daily operations some banks wind up short of their required reserve deposits with the Federal Reserve and some have an excess, and this gives rise to overnight loans from one bank to another. Eventually, a rising prime rate brings along with it higher interest rates to ordinary consumers and other borrowers. Sometimes, as occurred last week, Mr. Holmes is instructed to intervene in such a way as to "nudge up" the Federal funds rate himself, as a signal that the Federal Reserve feels the money supply is growing too rapidly. In either case, whether he "lets" the rate go up or pushes it up himself, the result is higher interest rates. And these days that often means a quick drop in the stock market, as happened in the last few days. Every time Mr. Holmes writes a check he adds to bank reserves and makes the Federal funds interest rates "easier"—that is, lower or less likely to rise.

DISCUSSION

1. Explain how the Federal Reserve System is actually creating money when Alan Holmes places an order in the money market for Treasury bills or other government securities. How will this money supply change affect employment and output?

2. The article refers to "the multiplier." Is this the same multiplier that we talked about in Chapter 9? If not, what is it?

3. Who actually decides to expand the money supply—the Treasury, Alan Holmes, The Open Market Committee, or the Board of Governors of the Federal Reserve Board.