Introduction

Several changes in the early 1940s economic environment affected the relationship between the public, the Fed, and the Treasury. Most important, government financing requirements increased throughout most of the decade (see figure 7.1). Also, after 1940 the rate of gold inflow into the United States slowed markedly. This created a situation where the government's desired rate of money production generally exceeded the amount that the Treasury could produce on the basis of its gold purchases. The 1930s arrangement giving the Treasury sole rights to produce new money no longer was satisfactory. The task now facing the general government was how to supplement the Treasury's money production without reintroducing the seigniorage incentive problem emphasized in the previous chapter.

The solution took the form of an interest rate control program. In April 1942 the United States Treasury and the Federal Reserve agreed to control nominal interest rates on short-term and long-term government securities. With respect to short-term securities, the Fed announced that it would buy at a rate of 3/8 percent all 3-month Treasury bills presented by the public. Later, in August 1942 the Fed also announced that the original seller of a Treasury bill would be able to repurchase the bill at the 3/8 percent rate. As a result, the rate on 3-month Treasury bills was constant from 1943 to the end of the bill rate policy in July 1947.

The agreement on longer-term securities did not take the form of a rigid promise to buy and resell securities at fixed rates. Of particular interest, the Fed agreed to support 25-year government bond prices at a level consistent with a 2.5 percent interest rate ceiling.