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New credit program at the discount window.

CASE DESCRIPTION

The primary subject matter of this case concerns the effect of the new credit program at the discount window on the behavior of the federal funds rate. The objective is to teach students how the basic demand-and-supply framework is employed to analyze the conduct of monetary policy in the reserve market. This case would be appropriate for a money and banking class, a monetary economics class, a financial economics class, an intermediate or an advance macroeconomic theory class. Level of difficulty could be at three or four. The case is designed to be discussed in one and one-half hours and should take students less than three hours of outside preparation.

CASE SYNOPSIS

The Federal Reserve employs three monetary policy tools: the required reserves, the open market operation (which affects the federal funds rate) and the discount policy. Traditionally (i.e., before January 9, 2003), the Fed set the discount rate below the targeted market federal funds rate, but prohibited banks from using the discount window. As a result, the volume of outstanding discount loans was normally small even though the discount rate is cheaper than the federal funds rate.

On January 9, 2003, the Federal Reserve introduced new lending programs, which are different from their predecessors in several aspects. The most significant changes are (1) the discount rates are now set above the prevailing federal funds rate, and (2) banks face very few restrictions on their use of primary credit. The proposal to make such changes is based on the following beliefs. First, it will eliminate the existing incentive for banks to borrow from the window to exploit the positive spread, and hence reduce the administration necessary for each discount loan. Second, as a result, it should help encourage banks to turn to the discount window only when the reserve markets tighten significantly and thereby the window serves as the last resort and a backup source of liquidity for individual depository institutions. Third, the discount rate will become an improved safety valve for releasing significant market pressures.

INSTRUCTORS' NOTES

The case introduces students to the application of the basic demand-and-supply framework to the analysis of conduct of monetary policy, in particular, the new credit program at the discount window adopted in January 2003 by the Federal Reserve System. Concepts involved in the case include demand and supply, reserve markets, discount rate, federal funds rate, discount window, interest rate stability, and monetary policy.

CASE QUESTIONS AND ANSWERS

1. In the reserve market, how do the Fed's restrictions on discount loans affect the supply curve? More specifically, what happens to the supply curve if the terms become more or less restrictive?

The Fed can change the monetary base by using two monetary policy tools: (1) open market operations that determine the nonborrowed monetary base (Rn); and (2) discount policy that includes the discount rate and the terms on the restrictions. So, in general, the supply curve in the reserve market is kinked at the discount rate with two segments: the lower part is vertical, indicating the nonborrowed monetary base, whereas the upper part is determined by the terms specified in the discount policy. A steeper upper segment indicates more restrictive terms specified in the discount policy (panel (a) in Figure 1), and a flatter upper part reflects looser requirements for discount loans (panel (b) in Figure 1). As an extreme case, when all strings are taken away, the supply curve becomes L-shaped, see panel (c), Figure 1.

[FIGURE 1 OMITTED]

2. Why was the volume of discount loans relatively small even when the discount rate was set below the targeted federal funds rate (before January 2003)? What are the main costs under such a discount policy?

Traditionally (before January 9, 2003), the discount rate (iD) was set below the targeted federal funds rate (iff), but the terms specified in the discount policy were very restrictive. Hence, even though banks had an incentive to borrow from the discount window, they were simply not allowed to do so. As shown in Figure 2 below, the volume of discount loans remained small, since (iff--iD) was usually set pretty small and the supply curve is very steep.

[FIGURE 2 OMITTED]

The main costs when the discount rate is set below the prevailing federal funds rate are transaction costs in administration. When the discount rate is below the federal funds rate, banks do have an incentive to borrow from the discount window so as to make some profit from re-lending the funds to the reserve market. If everyone could do it, then the discount window would no longer serve as the last resort for urgent funds. Very demanding restrictions that the Fed put on the discount loans essentially behave like credit rationing. The approval or disapproval of an application involves high administrative costs such as credit checking, proof of exhaustive sources from other opportunities, paper work, etc. As a result, banks are discouraged and may choose not to borrow from discount windows even when they really need to borrow for urgent cases. Thus the traditional restrictive discount policy would negatively influence the intended primary function of the discount window as the lender of last resort.

3. Before January 9, 2003, the discount rate was set below the federal funds rate. From then on, the Fed set the discount rate above the federal funds rate. Given a relatively stable demand on the same day in the reserve market, how did the Fed accomplish such a change if the federal funds rate were targeted unchanged? Are any other policy tool(s) involved?

The discount rate can be set administratively, while the federal funds rate can only be targeted indirectly through open market operations. The following figure shows how open market purchases must be done so as to keep iff unchanged wile the (new) discount rate (iD1) is reset above it.

[FIGURE 3 OMITTED]

4. When the discount rate is set above the targeted federal funds rate, do you expect the aggregate volume of discount loans (primary credit) to be high or low? Why? What is the difference between your answer here and that in question 2?

When the discount rate is set above the prevailing market interest rate, the volume of discount loans would be very low, unless the demand for reserves rises unexpectedly. However, unlike the answer given in question #2, the small volume of discount loans is not because the Fed does not lend at the low discount rate; rather, it is because banks have no incentive to borrow at a rate higher than what they can borrow from the federal funds market.

5. Compare the policies before and after January 9, 2003. Which policy makes the discount window serve as a better marginal source of reserves for the overall banking system? Why?

The new policy serves as a better marginal source of reserves than the old one. First of all, it is incentive compatible--only those banks that really need urgent funds for liquidity purposes would come to borrow from the discount window, simply because it is more expensive than the federal funds rate. Consequently, it costs much less than in the old program to help make the discount window the last resort for banks that really need urgent funds but cannot get them in the market. To set the "price" low and to refuse to sell by rationing would increase administrative costs by screening and monitoring potential borrowers. By setting the discount rate above the targeted federal funds rate, as long as the market rate does not rocket and touch the "ceiling", in theory, a bank comes to the discount window only when it cannot easily find the source of funds in the market.

On the other hand, from banks' perspective, to set the discount rate above the federal funds rate and to take the strings away can help make the discount loans really serve as the last resort much better than otherwise. When the discount rate is set below the market interest rate, if a bank comes to the window for a discount loan, it may negatively signal its financial weakness: either it cannot afford to pay a higher interest rate prevailing in the market, or it has exhausted all other possible sources. So, to reach the window could damage the bank's market value. Rather, if the Fed has authorized in advance a group of banks to be qualified for borrowing from the discount window, a bank would go to the window whenever it needs urgent funds but cannot get them easily from the market. In this scenario, to borrow from the discount window actually positively signals its financial strength, since at least it belongs to a pre-qualified group by the standard of the Fed. This way, the discount window can really serve as the last resort for urgent funds at much lower administrative costs.

6. Under the new policy, what is the most important point for the discount window credit to act as a short-run safety valve for the overall banking system by making additional reserves available, and for the discount rate act as a rate ceiling even if demand for reserve may sometimes rocket unexpectedly?

Discount window credit acts as a short-run safety valve only if the restrictions are completely taken away as shown in Figure 4, panel (a). If there is any restriction on the application for the discount loan, panel (b) may prevail. In that case, the discount rate as a cap may be broken and hence the discount window may not act well as the short-run safety valve.

[FIGURE 4 OMITTED]

REFERENCES

Hubbard, R. G. (2001). Money, the financial system and the economy, 4th edition, Addison Wesley

Madigan, B. F. & W. R. Nelson. (2002). Proposed revision to the Federal Reserve's discount window lending programs, Federal Reserve Bulletin, July, 2002, 314-319 (http://www.federalreserve.gov/pubs/bulletin/2002/0702lead.pdf)

Mishkin, F. S. (2004). The economics of money, banking and financial markets, 7th edition, Pearson Addison Wesley

Stevens, E. (2003). The New Discount Window, Economic Commentary, Federal Reserve Bank of Cleveland, May 15, 2003 (http://www.clevelandfed.org/Research/com2003/0515.pdf)

Amanda S. King, Georgia Southern University Darrell Parker, Georgia Southern University Bill Z. Yang, Georgia Southern University
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Title Annotation:CASE NOTES
Author:King, Amanda S.; Parker, Darrell; Yang, Bill Z.
Publication:Journal of the International Academy for Case Studies
Article Type:Case study
Geographic Code:1USA
Date:Mar 1, 2005
Words:1700
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