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that the relationship grew less exact,
and the responsiveness of borrowing to
the rate spread apparently declined.
Billions of dollars
These changes were probably a result
4 (a) 1975-79, by reserve statement periods
of increased uncertainty about Federal
3
Reserve policy and about future federal
funds-discount rate spreads," Banks
2
tend to be more cautious about using
their discount-window privileges (resulting in the flatter slope) and are more
prone
to error (resulting in increased
OL-~
__ ~~~~~L--L
__ ~~~
variability), the less certain they are
4r-~~~~--------------~-.
about future rate spreads.
(b) 1979-82, by reserve statement periods
When monetary policy procedures
3
were modified in 1982, insulating the
federal funds rate and borrowing from
2
"eo:. • •
the vagaries of weekly money supply
growth, the reliability in the borrowing
0 0: ::_::: •. :.-0::: ~:::: ..:
1
relationship increased, and borrowing
.' ':.
became more responsive to changes
in the rate spread. Yet, while chart 4c
clearly shows this, it also reveals that
4~~~~~--------------~-'
(c) 1982-85, by reserve statement periods
the relationship was nonetheless flatter
and more scattered between 1982 to 1985
than it was between 1975 and 1979.
A number of factors may account for
this. First, the federal funds-discount
rate spread remained more volatile
than it was during the 1975 to 1979
period. Second, there may have been
some lingering uncertainty from previPercent
SOURCE: Board of Governors of the Federal Reserve
ous operating procedures. The shift in
System.
procedures in late 1982 was gradual,
and banks were slow to realize how
Chart 4

The Borrowing Function

eo

0"

.:

0°

•••

: ••

;;

"0"

•.••:

°

0:.

°0.:.

°0

••.•••

Washington, DC: Board of Governors of the Federal Reserve System, August 1982. This linear
regression model was estimated for illustrative
purposes only. It was not intended to scientifically
model the borrowing function, which would require better specification and more sophisticated
estimation techniques.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

6. Several economists have advanced this hypothesis. See Peter Keir, "Impact of Discount Policy
Procedures on the Effectiveness of Reserve Targeting;' Federal Reserve Staff Study- Volume J
New Monetary Control Procedures, Board of Governors of the Federal Reserve System, February
1981; D. H. Resler et al. (August 1982); and Marvin

Federal Reserve operations were being
conducted. Finally, even though current procedures tend to smooth the
federal funds rate, they nevertheless
retain the structure of the 1979 to 1982
procedures (that is, biweekly nonborrowed reserve objectives are sought
that force target amounts of borrowing
into the discount window). The federal
funds rate is freer to move with market forces than under federal funds targeting, leading to greater uncertainty
about future rate spreads.
Summary
In the clean world of textbook models,
individual banks' demand functions for
borrowed reserves result in an upward
sloping reserve supply relation, commonly referred to as the borrowing
function. This can be used by the Federal Reserve in its attempt to successfully implement monetary policy. Observation, however, reveals that the relationship is, by no means, exact. It has
often been volatile, and both the volatility and slope of the relationship appear
to have changed from time to time,
particularly with respect to different
operating procedures. How much these
factors affect the outcome of monetary policy is a matter of debate.

Goodfriend, "Discount Window Borrowing, Monetary Policy, and the Post-October, 1979 Federal
Reserve Operating Procedure;' Journal of Monetary Economics, vol. 12, no. 3 (September 1983),
pp.343-56.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Federal Reserve Bank of Cleveland

ISSN 042R- 1276

ECONOMIC
COMMENTARY
One of the functions of the Federal
Reserve System is to provide loans to
depository institutions (generally, banks)
in each district through what is figuratively known as the "discount window."
These loans help banks to overcome
temporary liquidity problems, to adjust
their investment portfolios to sudden
changes, and to handle emergency situations when other sources of credit
are unavailable.
The discount window also plays an
important role, however, as a monetary
policy instrument. In this capacity, monetary policymakers rely on a systematic relationship observed between the
volume of borrowing at the discount
window and the difference (spread)
between the federal funds rate and the
discount rate. The federal funds rate
is the rate charged for loans in the interbank market for bank reserves, while
the discount rate is the rate charged for
borrowing reserves at Federal Reserve
Banks. In general, greater or lesser
amounts of borrowing tend to be associated with wider or narrower spreads
between the federal funds rate and
the discount rate.
In this Economic Commentary, we
explore how borrowing and the spread
interact, review the monetary policy
role of this relationship, and discuss
some changes in this relationship that
have taken place in recent years.
The Anatomy of Borrowing

Federal Reserve loans fall into three categories. Loans that allow depositories

Address Correction
Requested:
Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

November 1, 1985

Richard L. Mugel is an economic analyst at the
Federal Reserve Bank of Cleveland.
The views expressed herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Reserve
Borrowings
and the
Money Market
by Richard L. Mugel

Table 1 Discount Window Administration
Size of bank
(domestic deposits)

Consecutive
weeks
borrowing

Numerical Guidelines

Weeks of borrowing within:
13 weeks

26 weeks

Under $200 million

4-5

6-7

7-8

$200 million - $1 billion
$1 billion - $3 billion
More than $3 billion

3-4
2-3
1-2

5-6
4-5
3-4

7-8
6-7
4-5

Borrowing as
a percent of
domestic
deposits

2.0
2.0
1.5
1.0

SOURCE: Board of Governors of the Federal Reserve System.

to adjust their portfolios to unanticipated
deposit and loan activity are called adjustment credit. Seasonal credit loans
allow certain institutions (farm banks,
for example), special access to the window to fund seasonal activities, such
as planting and harvesting. This credit
program exists for those institutions
that do not have ready access to alternative funding in the national money
markets. The extended credit program is
designed to fulfull longer-term needs
resulting from prolonged cash flow problems of depository institutions.'
Loans are granted at each of the 12
Federal Reserve district banks. While
loans are approved at the discretion of
each bank, the extension of discountwindow credit is not arbitrary. Borrowing is guided by Federal Reserve Regulation A, issued under the authority of
the Federal Reserve Act, as amended
by the Monetary Control Act of 1980.
According to the guidelines, banks
must have an appropriate reason for
borrowing and must have sought alternative sources of funding first. Appropriate reasons for borrowing include
(1) liquidity needs arising from unanticipated deposit or loan activity, (2) the

avoidance of overdrafts in reserve accounts and, (3) liquidity needs arising
from outside forces, such as wire transfer failures.
Inappropriate reasons include borrowing to take advantage of a favorable
spread between the discount rate and
rates on other sources of funds, or for
supporting loan and investment activity.2 In addition, the Federal Reserve
sets guidelines pertaining to the appropriate amount, frequency, and duration
of discount-window borrowing for banks
of different size (see table 1).
In spite of these regulations, casual
observation reveals that the volume
of adjustment and seasonal borrowing
at the discount window is quite sensitive to movements in money market
interest rates, suggesting that depositories, as a matter of policy, consider
favorable rate spreads in their borrowing decisions. A positive relationship
between borrowing and the spread of
the funds rate over the discount rate is
not by itself at odds with discountwindow guidelines. It is, in fact, perfectly consistent with the behavior
predicted by economic theory.

1. Because of the special circumstances under
which it is typically issued, the volume of extended
credit borrowing tends to be relatively insensitive to changes in short-term interest rates and
is, therefore, excluded from most expressions of
the borrowing function.

2. For more information on Regulation A and
discount window guidelines, see The Federal Reserve Discount Window, Board of Governors of the
Federal Reserve System, October 1980.

Understanding the
Borrowing Relationship
Traditionally, economists have advanced
two theories to explain banks' behavior at the discount window: the profit
theory and the need theory.' According
to the profit theory, depository institutions borrow at the discount window,
and repay those loans, whenever it is
profitable. The need theory states that
institutions are naturally reluctant to
increase their indebtedness at Federal
Reserve Banks and will borrow only
when they have to.
Neither of these hypotheses, however,
offers a complete explanation. Taken
together, both the need and the profit
theories of borrowing are able to explain
the discount-window behavior of depository institutions and to account for
the observed relationship between borrowing at the discount window and
the spread between the federal funds
rate and the discount rate. The most
common approach to understanding
the borrowing relationship begins with
the standard microeconomic assumption that banks seek to maximize their
profits. Consequently, they make calculated decisions, weighing the perceived
cost of a particular activity against its
expected benefits.
The discount rate, however, does
not adequately depict the actual cost of
discount-window borrowing. Depositories also have to consider the opportunity cost of borrowing. Federal Reserve
regulations limit the use of discountwindow credit and limit the volume,
frequency, and duration of borrowing.
Byapplying for a discount-window loan
today, therefore, a bank may lose easy
access to the window at a later date.
Such a lost opportunity would be costly
if, for example, in the near future the
federal funds rate were to rise well above
the discount rate. Many institutions
may not be willing to take the risk of
threatening their future opportunity to
borrow, unless a favorable gap between
the federal funds rate and the discount
rate presents itself.

3. See Robert C. Turner, Member-Bank Borrowing.
Columbus, OH: Ohio State University, 1938.

Chart 1

Borrowing and the Rate Spread

Percent

Billions of dollars
Federal fundsdiscount rate spread

1985 0.0
SOURCE: Board of Governors of the Federal Reserve System.

As a consequence, banks must consider past borrowing, future rate spreads
and expected future needs in their current borrowing decisions. This concept
can be understood by means of the following analogy: imagine a bank that has
a limited number of tickets to the discount window for use during a specified
period. Since it can't predict its future
need to borrow, the bank will conserve
its tickets, using them when it is to
its greatest advantage. This approach
is consistent with the profit theory of
borrowing.
In addition to opportunity cost, there
are other considerations that encourage banks to seek alternative funding
before turning to the discount window.
A bank may be reluctant, for example, to risk facing reprimands from Federal Reserve discount-window officers
should its reason for borrowing be considered inappropriate. Inappropriate
and excessive loan requests may jeopardize future access to the window and
invite greater scrutiny from federal regulators. Banks also may wish to avoid
borrowing at the window because, were
it to become known in the market, it
might be interpreted as a sign of weakness that would increase the costs of
borrowing in the market. (Even though
the names of borrowing institutions
are not disclosed by Federal Reserve
Banks, banks nevertheless fear discovery.) Because of these risks, depositories

generally try to avoid borrowing at the
discount window. As a result, they are
willing to pay a higher price for money
from alternative sources and, before
borrowing, will search out these alternatives first. Significantly higher premiums in the marketplace, however,
induce banks to overcome their reluctance to borrow from the System; guided
by the profit motive, they will come
to the discount window.
The theoretical foundation upon
which the borrowing function rests,
therefore, is the microeconomic behavior of individual banks. Considering all
costs-explicit
and implicit-in their
decision to borrow, banks seek to maximize profits. The result is a positive
relationship between the volume of
borrowing at the discount window and
the Federal funds-discount rate spread.
This relationship can be exploited by
the Federal Reserve in its conduct of
monetary policy. By regulating the
supply of non borrowed reserves, the
System is able to determine reserve
market pressures and to influence the
aggregate level of borrowing.
The Borrowing Relationship
and Monetary Policy
Federal Reserve policymakers seek
to foster conditions that are expected

to promote price stability and economic
growth. The System uses bank reserves
as a tool, controlling at anyone time
either the quantity of reserves or their
price (the federal funds rate). Prior to
1979, the Federal Reserve placed greater
emphasis on levels of the federal funds
rate that were thought to be consistent with desired money supply growth.
The relationship between borrowing
and the federal funds rate took on a more
important role after October 1979, when
the Federal Reserve sought to gain better control over money supply growth by
focusing more closely on the quantity
of bank reserves in its operating strategy. Despite changes in procedures and
strategies since 1979, the importance
of the borrowing relationship to monetary policy has persisted.
Chart 2
Percent

~

---------------Rate spread

rd

_

Discount window
borrowing

~
Nonborrowed
reserves

Dollars
Total
reserves

Under non borrowed reserves targeting, the procedure employed between
1979 and 1982, target paths for nonborrowed reserves (reserves supplied
through open-market operations) were
set to produce a federal funds rate and
a level of total reserves thought to be
consistent with a desired growth in the
money supply. Any excess of reserve
demand above the amount supplied
though open-market operations had
to be met at the discount window, resulting in a widening of the spread
between the federal funds rate and the
discount rate.
In late 1982, procedures guiding
open-market operations were modified
because the usefulness of Ml as a guide

4. In daily and weekly practice, the borrowed and
non borrowed reserve procedures look identical:
reserves are supplied or withdrawn in order to
maintain a non borrowed reserve objective. The
difference is in the calculation of that objective.
The non borrowed reserves procedure derived the
objective from a target for total reserves, with an
allowance for borrowing. The borrowed reserves

for monetary policy operations diminished as the introduction of new deposit
instruments altered the relationship
between Ml and economic activity.
Under the newer procedure, known as
borrowed reserves targeting, the System seeks target levels of adjustment and
seasonal borrowing that are expected
to produce a desired degree of reserve
pressure, allowing non borrowed reserves
to vary with changes in reserve demand:' Unlike non borrowed reserves
targeting, deviations in reserve demand
from reserve supply, as a rule, are met
through open-market operations, not
borrowing, and consequently do not
automatically lead to higher levels of
borrowing and tighter reserve market
conditions. This approach to interweek
variations in reserve demand, has tended
to moderate the intensity of fluctuations in the federal funds rate.
In both non borrowed and borrowed
reserve targeting, the System has relied
on an upward sloping reserve supply
curve, which means that more reserves
are supplied at greater federal fundsdiscount rate spreads (see chart 2). Because depositories tend to seek other
sources of funds before turning to the
discount window, pressure in the money
market drives short-term interest rates,
particularly the federal funds rate,
higher which, in turn, induces banks
to overcome their reluctance to borrow
at the discount window.
Observing the Borrowing Function
While there might appear to be a simple
and precise relationship between borrowing and the rate spread, this is really
not the case. Chart 3, which shows adjustment and seasonal borrowing plotted
against the federal funds-discount rate
spread between 1975 and 1985, reveals
both a clear relationship and yet a wide
dispersion of plotted values. Linear regression estimates of the borrowing
function, using the spread as an explanatory variable, over a sample from 1975
to 1985, explain 80 percent of the variation of borrowing, but show a standard
error of $313 million>

procedure subtracts a target for borrowed reserves
from the estimated total reserve needs of the
banking system.

Chart 3

The Borrowing Function

Billions of dollars

4~~~~--------------~---.
1975-85, by reserve statement periods
3

- . -.
_

Percent
SOURCE: Board of Governors of the Federal Reserve
System.

Several factors may explain the
short-run variability in the borrowingspread relationship. Some are predictable and can be modeled. These include
expectations of future interest rates
and seasonal events, such as ends of
quarters, holidays, and tax dates. The
other category includes chance factors,
such as wire transfer failures, deposit
and loan fluctuations, random fluctuations in banks' attitudes toward the
discount window and management of
reserve balances, and the degree of
uncertainty about Federal Reserve policy and future rate spreads.
A closer look at the borrowing relationship reveals noticeable changes in
the slope and reliability of the borrowing relationship over time, particularly
with respect to different Federal Reserve operating procedures. The slope
of the borrowing relation indicates the
responsiveness of borrowing to the federal funds-discount rate spread. Steeper
slopes indicate greater responsiveness
of borrowing to the spread. The scatter
of plotted values on the other hand, gives
a clue about the reliability of the borrowing relationship, how likely it is
that a given spread will produce a predictable level of borrowing.
Chart 4a shows that between 1975
and 1979, when the Federal Reserve was
targeting the federal funds rate, the
borrowing relationship was relatively
reliable, and borrowing was highly
responsive to changes in the rate spread.
Under non borrowed reserve targeting
(chart 4b), the scatter of points indicates
5. The borrowing function was estimated using
weekly and biweekly (reserve statement period)
data between 1975 and April 1985, using a static
coefficients model of the form discussed in D. H.
Resler et al., "Detecting and Estimating Changing
Economic Relationships: The Case of Discount
Window Borrowings;' Special Studies Paper 165,

Understanding the
Borrowing Relationship
Traditionally, economists have advanced
two theories to explain banks' behavior at the discount window: the profit
theory and the need theory.' According
to the profit theory, depository institutions borrow at the discount window,
and repay those loans, whenever it is
profitable. The need theory states that
institutions are naturally reluctant to
increase their indebtedness at Federal
Reserve Banks and will borrow only
when they have to.
Neither of these hypotheses, however,
offers a complete explanation. Taken
together, both the need and the profit
theories of borrowing are able to explain
the discount-window behavior of depository institutions and to account for
the observed relationship between borrowing at the discount window and
the spread between the federal funds
rate and the discount rate. The most
common approach to understanding
the borrowing relationship begins with
the standard microeconomic assumption that banks seek to maximize their
profits. Consequently, they make calculated decisions, weighing the perceived
cost of a particular activity against its
expected benefits.
The discount rate, however, does
not adequately depict the actual cost of
discount-window borrowing. Depositories also have to consider the opportunity cost of borrowing. Federal Reserve
regulations limit the use of discountwindow credit and limit the volume,
frequency, and duration of borrowing.
Byapplying for a discount-window loan
today, therefore, a bank may lose easy
access to the window at a later date.
Such a lost opportunity would be costly
if, for example, in the near future the
federal funds rate were to rise well above
the discount rate. Many institutions
may not be willing to take the risk of
threatening their future opportunity to
borrow, unless a favorable gap between
the federal funds rate and the discount
rate presents itself.

3. See Robert C. Turner, Member-Bank Borrowing.
Columbus, OH: Ohio State University, 1938.

Chart 1

Borrowing and the Rate Spread

Percent

Billions of dollars
Federal fundsdiscount rate spread

1985 0.0
SOURCE: Board of Governors of the Federal Reserve System.

As a consequence, banks must consider past borrowing, future rate spreads
and expected future needs in their current borrowing decisions. This concept
can be understood by means of the following analogy: imagine a bank that has
a limited number of tickets to the discount window for use during a specified
period. Since it can't predict its future
need to borrow, the bank will conserve
its tickets, using them when it is to
its greatest advantage. This approach
is consistent with the profit theory of
borrowing.
In addition to opportunity cost, there
are other considerations that encourage banks to seek alternative funding
before turning to the discount window.
A bank may be reluctant, for example, to risk facing reprimands from Federal Reserve discount-window officers
should its reason for borrowing be considered inappropriate. Inappropriate
and excessive loan requests may jeopardize future access to the window and
invite greater scrutiny from federal regulators. Banks also may wish to avoid
borrowing at the window because, were
it to become known in the market, it
might be interpreted as a sign of weakness that would increase the costs of
borrowing in the market. (Even though
the names of borrowing institutions
are not disclosed by Federal Reserve
Banks, banks nevertheless fear discovery.) Because of these risks, depositories

generally try to avoid borrowing at the
discount window. As a result, they are
willing to pay a higher price for money
from alternative sources and, before
borrowing, will search out these alternatives first. Significantly higher premiums in the marketplace, however,
induce banks to overcome their reluctance to borrow from the System; guided
by the profit motive, they will come
to the discount window.
The theoretical foundation upon
which the borrowing function rests,
therefore, is the microeconomic behavior of individual banks. Considering all
costs-explicit
and implicit-in their
decision to borrow, banks seek to maximize profits. The result is a positive
relationship between the volume of
borrowing at the discount window and
the Federal funds-discount rate spread.
This relationship can be exploited by
the Federal Reserve in its conduct of
monetary policy. By regulating the
supply of non borrowed reserves, the
System is able to determine reserve
market pressures and to influence the
aggregate level of borrowing.
The Borrowing Relationship
and Monetary Policy
Federal Reserve policymakers seek
to foster conditions that are expected

to promote price stability and economic
growth. The System uses bank reserves
as a tool, controlling at anyone time
either the quantity of reserves or their
price (the federal funds rate). Prior to
1979, the Federal Reserve placed greater
emphasis on levels of the federal funds
rate that were thought to be consistent with desired money supply growth.
The relationship between borrowing
and the federal funds rate took on a more
important role after October 1979, when
the Federal Reserve sought to gain better control over money supply growth by
focusing more closely on the quantity
of bank reserves in its operating strategy. Despite changes in procedures and
strategies since 1979, the importance
of the borrowing relationship to monetary policy has persisted.
Chart 2
Percent

~

---------------Rate spread

rd

_

Discount window
borrowing

~
Nonborrowed
reserves

Dollars
Total
reserves

Under non borrowed reserves targeting, the procedure employed between
1979 and 1982, target paths for nonborrowed reserves (reserves supplied
through open-market operations) were
set to produce a federal funds rate and
a level of total reserves thought to be
consistent with a desired growth in the
money supply. Any excess of reserve
demand above the amount supplied
though open-market operations had
to be met at the discount window, resulting in a widening of the spread
between the federal funds rate and the
discount rate.
In late 1982, procedures guiding
open-market operations were modified
because the usefulness of Ml as a guide

4. In daily and weekly practice, the borrowed and
non borrowed reserve procedures look identical:
reserves are supplied or withdrawn in order to
maintain a non borrowed reserve objective. The
difference is in the calculation of that objective.
The non borrowed reserves procedure derived the
objective from a target for total reserves, with an
allowance for borrowing. The borrowed reserves

for monetary policy operations diminished as the introduction of new deposit
instruments altered the relationship
between Ml and economic activity.
Under the newer procedure, known as
borrowed reserves targeting, the System seeks target levels of adjustment and
seasonal borrowing that are expected
to produce a desired degree of reserve
pressure, allowing non borrowed reserves
to vary with changes in reserve demand:' Unlike non borrowed reserves
targeting, deviations in reserve demand
from reserve supply, as a rule, are met
through open-market operations, not
borrowing, and consequently do not
automatically lead to higher levels of
borrowing and tighter reserve market
conditions. This approach to interweek
variations in reserve demand, has tended
to moderate the intensity of fluctuations in the federal funds rate.
In both non borrowed and borrowed
reserve targeting, the System has relied
on an upward sloping reserve supply
curve, which means that more reserves
are supplied at greater federal fundsdiscount rate spreads (see chart 2). Because depositories tend to seek other
sources of funds before turning to the
discount window, pressure in the money
market drives short-term interest rates,
particularly the federal funds rate,
higher which, in turn, induces banks
to overcome their reluctance to borrow
at the discount window.
Observing the Borrowing Function
While there might appear to be a simple
and precise relationship between borrowing and the rate spread, this is really
not the case. Chart 3, which shows adjustment and seasonal borrowing plotted
against the federal funds-discount rate
spread between 1975 and 1985, reveals
both a clear relationship and yet a wide
dispersion of plotted values. Linear regression estimates of the borrowing
function, using the spread as an explanatory variable, over a sample from 1975
to 1985, explain 80 percent of the variation of borrowing, but show a standard
error of $313 million>

procedure subtracts a target for borrowed reserves
from the estimated total reserve needs of the
banking system.

Chart 3

The Borrowing Function

Billions of dollars

4~~~~--------------~---.
1975-85, by reserve statement periods
3

- . -.
_

Percent
SOURCE: Board of Governors of the Federal Reserve
System.

Several factors may explain the
short-run variability in the borrowingspread relationship. Some are predictable and can be modeled. These include
expectations of future interest rates
and seasonal events, such as ends of
quarters, holidays, and tax dates. The
other category includes chance factors,
such as wire transfer failures, deposit
and loan fluctuations, random fluctuations in banks' attitudes toward the
discount window and management of
reserve balances, and the degree of
uncertainty about Federal Reserve policy and future rate spreads.
A closer look at the borrowing relationship reveals noticeable changes in
the slope and reliability of the borrowing relationship over time, particularly
with respect to different Federal Reserve operating procedures. The slope
of the borrowing relation indicates the
responsiveness of borrowing to the federal funds-discount rate spread. Steeper
slopes indicate greater responsiveness
of borrowing to the spread. The scatter
of plotted values on the other hand, gives
a clue about the reliability of the borrowing relationship, how likely it is
that a given spread will produce a predictable level of borrowing.
Chart 4a shows that between 1975
and 1979, when the Federal Reserve was
targeting the federal funds rate, the
borrowing relationship was relatively
reliable, and borrowing was highly
responsive to changes in the rate spread.
Under non borrowed reserve targeting
(chart 4b), the scatter of points indicates
5. The borrowing function was estimated using
weekly and biweekly (reserve statement period)
data between 1975 and April 1985, using a static
coefficients model of the form discussed in D. H.
Resler et al., "Detecting and Estimating Changing
Economic Relationships: The Case of Discount
Window Borrowings;' Special Studies Paper 165,

that the relationship grew less exact,
and the responsiveness of borrowing to
the rate spread apparently declined.
Billions of dollars
These changes were probably a result
4 (a) 1975-79, by reserve statement periods
of increased uncertainty about Federal
3
Reserve policy and about future federal
funds-discount rate spreads," Banks
2
tend to be more cautious about using
their discount-window privileges (resulting in the flatter slope) and are more
prone
to error (resulting in increased
OL-~
__ ~~~~~L--L
__ ~~~
variability), the less certain they are
4r-~~~~--------------~-.
about future rate spreads.
(b) 1979-82, by reserve statement periods
When monetary policy procedures
3
were modified in 1982, insulating the
federal funds rate and borrowing from
2
"eo:. • •
the vagaries of weekly money supply
growth, the reliability in the borrowing
0 0: ::_::: •. :.-0::: ~:::: ..:
1
relationship increased, and borrowing
.' ':.
became more responsive to changes
in the rate spread. Yet, while chart 4c
clearly shows this, it also reveals that
4~~~~~--------------~-'
(c) 1982-85, by reserve statement periods
the relationship was nonetheless flatter
and more scattered between 1982 to 1985
than it was between 1975 and 1979.
A number of factors may account for
this. First, the federal funds-discount
rate spread remained more volatile
than it was during the 1975 to 1979
period. Second, there may have been
some lingering uncertainty from previPercent
SOURCE: Board of Governors of the Federal Reserve
ous operating procedures. The shift in
System.
procedures in late 1982 was gradual,
and banks were slow to realize how
Chart 4

The Borrowing Function

eo

0"

.:

0°

•••

: ••

;;

"0"

•.••:

°

0:.

°0.:.

°0

••.•••

Washington, DC: Board of Governors of the Federal Reserve System, August 1982. This linear
regression model was estimated for illustrative
purposes only. It was not intended to scientifically
model the borrowing function, which would require better specification and more sophisticated
estimation techniques.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

6. Several economists have advanced this hypothesis. See Peter Keir, "Impact of Discount Policy
Procedures on the Effectiveness of Reserve Targeting;' Federal Reserve Staff Study- Volume J
New Monetary Control Procedures, Board of Governors of the Federal Reserve System, February
1981; D. H. Resler et al. (August 1982); and Marvin

Federal Reserve operations were being
conducted. Finally, even though current procedures tend to smooth the
federal funds rate, they nevertheless
retain the structure of the 1979 to 1982
procedures (that is, biweekly nonborrowed reserve objectives are sought
that force target amounts of borrowing
into the discount window). The federal
funds rate is freer to move with market forces than under federal funds targeting, leading to greater uncertainty
about future rate spreads.
Summary
In the clean world of textbook models,
individual banks' demand functions for
borrowed reserves result in an upward
sloping reserve supply relation, commonly referred to as the borrowing
function. This can be used by the Federal Reserve in its attempt to successfully implement monetary policy. Observation, however, reveals that the relationship is, by no means, exact. It has
often been volatile, and both the volatility and slope of the relationship appear
to have changed from time to time,
particularly with respect to different
operating procedures. How much these
factors affect the outcome of monetary policy is a matter of debate.

Goodfriend, "Discount Window Borrowing, Monetary Policy, and the Post-October, 1979 Federal
Reserve Operating Procedure;' Journal of Monetary Economics, vol. 12, no. 3 (September 1983),
pp.343-56.

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Permit No. 385

Federal Reserve Bank of Cleveland

ISSN 042R- 1276

ECONOMIC
COMMENTARY
One of the functions of the Federal
Reserve System is to provide loans to
depository institutions (generally, banks)
in each district through what is figuratively known as the "discount window."
These loans help banks to overcome
temporary liquidity problems, to adjust
their investment portfolios to sudden
changes, and to handle emergency situations when other sources of credit
are unavailable.
The discount window also plays an
important role, however, as a monetary
policy instrument. In this capacity, monetary policymakers rely on a systematic relationship observed between the
volume of borrowing at the discount
window and the difference (spread)
between the federal funds rate and the
discount rate. The federal funds rate
is the rate charged for loans in the interbank market for bank reserves, while
the discount rate is the rate charged for
borrowing reserves at Federal Reserve
Banks. In general, greater or lesser
amounts of borrowing tend to be associated with wider or narrower spreads
between the federal funds rate and
the discount rate.
In this Economic Commentary, we
explore how borrowing and the spread
interact, review the monetary policy
role of this relationship, and discuss
some changes in this relationship that
have taken place in recent years.
The Anatomy of Borrowing

Federal Reserve loans fall into three categories. Loans that allow depositories

Address Correction
Requested:
Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

November 1, 1985

Richard L. Mugel is an economic analyst at the
Federal Reserve Bank of Cleveland.
The views expressed herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Reserve
Borrowings
and the
Money Market
by Richard L. Mugel

Table 1 Discount Window Administration
Size of bank
(domestic deposits)

Consecutive
weeks
borrowing

Numerical Guidelines

Weeks of borrowing within:
13 weeks

26 weeks

Under $200 million

4-5

6-7

7-8

$200 million - $1 billion
$1 billion - $3 billion
More than $3 billion

3-4
2-3
1-2

5-6
4-5
3-4

7-8
6-7
4-5

Borrowing as
a percent of
domestic
deposits

2.0
2.0
1.5
1.0

SOURCE: Board of Governors of the Federal Reserve System.

to adjust their portfolios to unanticipated
deposit and loan activity are called adjustment credit. Seasonal credit loans
allow certain institutions (farm banks,
for example), special access to the window to fund seasonal activities, such
as planting and harvesting. This credit
program exists for those institutions
that do not have ready access to alternative funding in the national money
markets. The extended credit program is
designed to fulfull longer-term needs
resulting from prolonged cash flow problems of depository institutions.'
Loans are granted at each of the 12
Federal Reserve district banks. While
loans are approved at the discretion of
each bank, the extension of discountwindow credit is not arbitrary. Borrowing is guided by Federal Reserve Regulation A, issued under the authority of
the Federal Reserve Act, as amended
by the Monetary Control Act of 1980.
According to the guidelines, banks
must have an appropriate reason for
borrowing and must have sought alternative sources of funding first. Appropriate reasons for borrowing include
(1) liquidity needs arising from unanticipated deposit or loan activity, (2) the

avoidance of overdrafts in reserve accounts and, (3) liquidity needs arising
from outside forces, such as wire transfer failures.
Inappropriate reasons include borrowing to take advantage of a favorable
spread between the discount rate and
rates on other sources of funds, or for
supporting loan and investment activity.2 In addition, the Federal Reserve
sets guidelines pertaining to the appropriate amount, frequency, and duration
of discount-window borrowing for banks
of different size (see table 1).
In spite of these regulations, casual
observation reveals that the volume
of adjustment and seasonal borrowing
at the discount window is quite sensitive to movements in money market
interest rates, suggesting that depositories, as a matter of policy, consider
favorable rate spreads in their borrowing decisions. A positive relationship
between borrowing and the spread of
the funds rate over the discount rate is
not by itself at odds with discountwindow guidelines. It is, in fact, perfectly consistent with the behavior
predicted by economic theory.

1. Because of the special circumstances under
which it is typically issued, the volume of extended
credit borrowing tends to be relatively insensitive to changes in short-term interest rates and
is, therefore, excluded from most expressions of
the borrowing function.

2. For more information on Regulation A and
discount window guidelines, see The Federal Reserve Discount Window, Board of Governors of the
Federal Reserve System, October 1980.