FEDERAL RESERVE SYSTEM POLICIES AND THEIR EFFECTS ON THE BANKING SYSTEM*

Abstract

IN RECENT YEARS Federal Reserve policies have aimed primarily at keeping the net reserve position of the banking system within a range considered suitable to the degree of credit restraint or ease desired by the Federal Open Market Committee. The managers of the open-market account maintain estimates of the effect non-managed factors will have on bank reserves, and then, taking these factors into account, aim at a predetermined level of free reserves. A model is developed to explain Federal Reserve behavior in setting target levels of free reserves. Free reserves are made a function of five indicators observed by the Federal Reserve. These variables representing the broad aims of the monetary authorities include measures of the growth in output, level of unemployment, price changes, and short-term capital outflow. Movements in these variables are able to explain almost 91 per cent of the variation in free reserves. Tradeoffs between different variables are considered by examining their impact on the target level of free reserves. Although each is important, the coefficients indicate the Federal Reserve has been particularly sensitive to increases in the wholesale price index for industrial products. The model suggests that there may be a sizable lag between changes in the economic indicators and a shift in Federal Reserve policies. If the Federal Reserve aims at target levels of free reserves, the effectiveness of monetary policies will depend on the reaction of the banking system to variations in free reserves. To test this reaction, an excess-demand model for free reserves is developed to explain the growth in member-bank loans and investments. The growth in member-bank credit is made proportional to the difference between the actual level of free reserves and the level desired by the banking system. Actual free reserves are taken to be the level desired by the Fed. The level of free reserves banks are willing to hold is a function of several variables, but during normal times the most important appears to be variations in the demand for loans. Interest and discount rates, surprisingly, have little influence that is not already explained by variations in loan demands. Within the range of variation permitted between the bill and discount rates during the postwar period, the desired level of free reserves appears quite interestinelastic. The regressions indicate that variations in free reserves have a pronounced effect on loan and investment expansion. In the same quarter, loans and investments will increase or decrease by over three times the initial change in actual or desired free reserves. If free reserves are maintained at this new level, the growth will be repeated each quarter. The level and direction of movements in free reserves are often taken as indicators of Federal Reserve policies. Since the desired level of free reserves will change with variations in the intensity of loan demands, a given level of free reserves will not always be associated with the same degree of credit expansion or contraction. The amplitude of cyclical fluctuations in desired free reserves has, however, been con-