An analysis of primary principles of the monetary policy in economics

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An analysis of primary principles of the monetary policy in economics

This lack of DW borrowing has been widely attributed to stigma —concerns that, if discount borrowing were detected, depositors, creditors, and analysts could interpret it as a sign of financial weakness.

In this post, we review the history of the DW up untilwhen the current DW regime was established, and argue that some past policies may have inadvertently contributed to a reluctance to borrow from the DW that persists to this day.

At that time, there were no open market operations the buying and selling of government securities in the open market to conduct monetary policy. Instead, the Fed adjusted the money supply by lending directly to banks through the DW.

During these initial years, the DW was used extensively, and there appears to have been no mention of stigma attached to DW borrowing.

Time Series Analysis for Business Forecasting

From the late s, the DW gradually fell into disuse as the Fed began to take a dim view of DW borrowing and adopted a stance against the practice. The Fed observed that banks were becoming habitual borrowers from the DWand it was concerned that an overreliance on DW borrowings would weaken banks and make them more prone to failure.

Moreover, the Fed had switched to open market operations as its primary tool for conducting monetary policy. Accordingly, it viewed the DW as playing a more subordinate role by providing limited amounts of short-term credit to banks, to meet emergency needs, for example.

Although it discouraged DW borrowing, the Fed generally kept the DW rate below the market ratein part because the Fed lacked independence from the Treasury and was obliged to keep the DW rate below the market rate to help the federal government finance its deficits at low rates.

The Treasury—Federal Reserve Accord of freed the Fed from pressure from the Treasury, but the Fed continued to maintain the DW rate below the market rate despite recommendations to the contrary. It did so because it believed that banks that legitimately needed DW funds should not face a punitive rate.

Between the late s and the s, the Fed adopted and amended numerous restrictions on DW borrowing. Whenever DW borrowings increased, the Fed tightened the restrictions to suppress borrowing. Inthe Fed added the requirement that, prior to accessing the DW, banks must demonstrate that they have exhausted private sources of funding.

In the early s, following another period of elevated DW borrowings, the Fed levied a surcharge on frequent borrowings by large banks to augment the administrative restrictions. These policies appeared to have been effective, as DW borrowings adjusted for the size of the banking sector remained low after the s, except for occasional minor spikes see chart below.

In particular, the requirements that a borrower had to satisfy the Fed that it had a legitimate reason to borrow from the DW and that it had exhausted private sources of funding likely contributed to DW stigma.

Trade 40-0

Indeed, these requirements may have led market participants to presume that if a bank was borrowing from the DW, it must be in trouble, even if, in fact, the bank was borrowing to address a temporary funding shortfall or to meet reserve requirements. Another important factor that may have contributed to DW stigma was that, initially, the Fed lacked an official stance on DW lending to failing or insolvent institutions.

Indeed, until the FDIC Improvement Act ofwhich restricted Fed lending to undercapitalized banks, the Fed occasionally lent to banks that turned out to be insolvent. When the DW loan became publicit further increased stigma in a way that administrative restrictions alone were not able to achieve.

The incident helped reinforce a perceived link between recourse to the DW and financial problems, which made solvent banks reluctant to access the DW for fear that they might be considered insolvent.

Macro Selections

Only financially strong and well-capitalized banks are allowed to borrow at the PCF. The rate charged is a penalty rate above the target range for the fed funds rate rather than a subsidized rate, as in the pastas seen in the DW rate chart.

The Secondary Credit Facility was also created at this time, as a facility for weaker institutions that do not satisfy the criteria for Primary Credit—reinforcing the idea that borrowing from the PCF does not necessarily reflect a solvency problem.

By lending freely, central banks create an expectation that they will be available to provide as much liquidity as is needed during a crisis and alleviate the high demand for liquidity that triggers most crises.

By charging a penalty rate, they ensure that banks borrow as a last resort. A plausible explanation for the persistence of DW stigma is that the old policies left lasting perceptions of the DW, which, among other factors, may have dissuaded banks from readily using it to this day.

An analysis of primary principles of the monetary policy in economics

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