POLICIES TO RESTRAIN
AGGREGATE DEMAND

If the Fed wants to restrain aggregate demand, it can sell bonds in the open market or raise required reserves to reduce excess reserves. Since the commercial banks typically operate with small excess reserves (because they earn no interest on such idle funds), either action can have a direct and powerful restrictive effect on the extension of bank credit. The Fed can also raise the rediscount rate, which makes it more expensive for commercial banks to borrow additional reserves when they run tight. This is a less powerful restraint, since banks are still able to borrow addi-, tional reserves if they are willing to pay the higher rate. But the rediscount rate is widely viewed as an indicator of the Fed’s general attitude on credit conditions, and thus has an important symbolic, psychological impact. The Fed has plenty of powers to restrain aggregate demand if it wants to use them.

The Impact of Monetary Restriction

When the economy is expanding, a growing money stock is needed. Businesses need more for “working capital” to finance larger inventories, to meet higher payrolls, to buy more materials. They need more to finance fixed investment in machinery, equipment, and buildings. Although expanding sales provide some of the funds needed, typically businesses must turn to banks for additional funds to expand. Consumers too need more money to finance the higher volume of transactions. These facts can be summed up in the demand-for-money function indicated above; the public desires to hold more money as the level of income and wealth rises. And the basic source of more money for the system is bank lending, which in turn rests on the availability of more reserves provided by the Fed. Note, therefore, that in a growing economy, if the Fed merely does nothing to provide additional reserves, this policy of inaction implies a gradual tightening of the money markets and a rise in interest rates, since demand for M rises but supply does not.

What do the banks do when their excess reserves are squeezed? They often raise their interest rates—the prices they charge on credit. Alternativcly, banks often “ration” credit to their customers before they raise interest rates. Instead of using higher rates to eliminate the customers least willing to pay more for money, they allocate their scarce credit to their oldest and best customers. They consider this sound long-run policy, just as many businesses don’t try to squeeze the last penny out of good customers in periods of tem porary shortages. Either way, tight money tends to check the upswing.

Bankers hate to impose credit rationing on good customers. Instead, they often sell off part of their government securities and use the funds to meet customers’ loan demands. But such switches from government securities to loans are limited by the volume of securities the banks already have and by falling government bond prices if many banks try to sell simultaneously. Bankers may also get new reserves by borrowing at the Fed. But the Fed canclose this loophole by raising the rediscount rate and frowning on rediscounting. Thus, banks may partially escape Federal Reserve pressure, but the possibilities are limited as long as the Fed keeps the pressure on.

When credit becomes tighter and interest rates rise, businesses and consumers try to avoid the pinch by economizing on money balances— that is, by reducing their money balances to the barest minimum needed to carry on their trans- actions and meet precautionary needs. The same amount of money thus does more work; V is speeded up, and the restraint of tighter money is partially avoided. The higher interest rates are forced by the credit squeeze, the greater is the inducement to convert “idle” money balances into interest-yielding securities and savings deposits. These shifts make previously idle money available for active use.

FIG. 12—1 As interest rates rise, the turn-
over of demand deposits goes up. It pays
people to economize on the use of money
and to reduce their idle balances. (Source:
Federal Reserve Board.)

Figure 12-1 shows this effect clearly. The dot for each year shows the average interest rate on “prime” short-term loans and the average turn over (or velocity) of demand deposits at some 400 city banks outside New York City (which is eliminated to avoid the huge volume of stockmarket transactions there). Velocity varies directly with interest rates. For example, note the low interest rates and velocity during the depression years. These velocity figures include many transactions not contained in the g.n.p. accounts, and thus are only a very imperfect approximation to changes in income velocity. But in some respects they are more interesting, since they show what happens to the total use of demand deposits when interest rates rise or fall. If we plot income velocity against interest rates for the same years, the same general relationship is revealed.

But there are limits on how far working cash balances can be reduced. The public and the banks can avoid the pressure of Federal Reserve restraint temporarily, but only temporarily if the authorities make money tighter and tighter. The rise in V introduces a buffer against the impact of tighter money. It should be clear, however, that the Fed can ultimately have as strong an impact as it wishes, by raising reserve requirements sharply and by selling a large enough volume of government securities.

Don’t jump from this fact to the conclusion that the job of the Federal Reserve is easy. Its power to check economic expansion is enormous, but overly drastic action may throw the baby out with the bathwater. The Fed’s job is to check the inflation and level off the boom, not to plunge the economy into depression. Tightening up credit just enough to level off consumption and investment, or to keep their growth at just the right rate, is a difficult and delicate task.