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Prepared for the Steering Committee for the Fundamental Reappraisal ofthe
Discount Mechanism Appointed by
the Board of Governors of the Federal Reserve System

The following paper is one of a series prepared by the research staffs of the Board of Governors
of the Federal Reserve System and of the Federal Reserve Banks and by academic economists
in connection with the Fundamental Reappraisal of the Discount Mechanism.
The analyses and conclusions set forth are those of the author and do not necessarily indicate
concurrence by other members of the research staffs, by the Board of Governors, or by the Federal
Reserve Banks.






Major Issues and Related Findings


Borrowing and Monetary Restraint.............2
Determinants of Member Bank Borrowing . . . .
Non-Price Rationing .........................
Announcement Effects......................... 6
Proposals for Change......................... 7
Concluding Observations .....................

Discounting and Monetary Control


Borrowing and Monetary Restraint.............10
Determinants of Member Bank Borrowing . . . .
Interest Rates and Borrowing................. 13
Reluctance to Borrow......................... 18
Theoretical Reconciliation................... 19
Non-Price Rationing .........................
Announcement Effects......................... 23

Proposed Changes in the Discount Mechanism


Abolition of the Discount M e c h a n i s m ........ 25
Nondiscretionary Approach ...................
Discretionary Approach....................... 3 3
Tobin's P r o p o s a l s ................... .. . . . 34



February 20,


Project #9

A Review of Recent Academic Literature
on the Discount Mechanism

David M. Jones


A Review of Recent Academic Literature
on the Discount Mechanism


After approximately two decades of disuse, the Treasury-Federal
Reserve Accord of 1951 prompted renewed interest in the nature and effective­
ness of the discount mechanism.

Analysis since the Accord has been devoted

in large part to the unresolved controversy over the nature of the relation­
ship between discounting and monetary control.
The scope of this paper will be confined to that post-Accord
academic literature which bears directly on the implications of discounting
for monetary control.

Special emphasis will be placed on the determinants

of member bank borrowing, including a review of the major issues and related
empirical findings.

The responsiveness of borrowing to interest rate move­

ments is of particular concern in this regard.

An effort will also be made

to cover in some detail the wide range of proposed changes in the current
discounting arrangement.
The primary intent of this paper is to present the post-Accord
discounting literature in such a way as to highlight the major points of
emphasis in recent analysis.

Hopefully, information of this type can serve

as important background material for a reconsideration of the role of the
Federal Reserve discount mechanism.

The paper does not attempt to assess

the pros and cons of the many technical issues that are raised in the .litera­
ture .

- 2 II.

Major Issues and Related Findings

The fundamental issue raised by post-Accord literature dealing
with the Federal Reserve discount mechanism is that of whether this mechanism
operates to subvert or to supplement over-all monetary control.

Critics have

argued that the discount function as it currently operates is fundamentally
antagonistic to monetary management.

Related to this position, issues have

developed around a number of topics, namely:
during periods of restraint;



the effects of borrowing

the factors that determine borrowing;

(3 )

the significance of non-price rationing; and (k ) the announcement effects of
discount rate changes.

Borrowing and Monetary Restraint
On one hand, the discount mechanism may be viewed as a sort of
"safety valve" which cushions but does not offset the usually uneven impact
on individual banks of restrictive shifts in monetary policy.


reserves are allocated through the discount window directly to those banks
coming under greatest stress, and thus the System is free to act more
decisively than otherwise would be the case.
The case favoring the present discounting arrangement turns on the
contention that reserves supplied through the discount "window" are by nature
more restrictive in terms of credit and deposit expansion than reserves
supplied through other means.

Borrowing from the Federal Reserve is looked

upon as only a temporary source of funds for the individual bank, usually
requiring some form of asset adjustment in order to effect prompt repayment.
Thus, the larger the overall volume of borrowing relative to other sources of
reserves, the greater the restrictive impact on credit growth.

- 3 The academic critics of the existing discount mechanism have not
sought to directly refute the points raised above.

Their position is founded

instead upon the following three general considerations:

The initiative in using the discount mechanism rests with the

borrowing banks themselves rather than with those charged with the responsi­
bility for monetary control;

Member bank borrowing from the Federal Reserve adds to total

reserves, in contrast with the sale of Treasury bills or any other means of
reserve adjustment available to the banks; and

Member bank borrowing tends to rise during periods of monetary

restraint and fall during periods of monetary ease.
In essense, the critics hold that overall monetary control is
weakened to the extent that discounting counters the impact of Federal Reserve
System open market operations on the reserve base.

Working in the context

of models linking bank reserves to the money supply, and the money supply to
real economic activity, some economists have argued that borrowing accentuates
cyclical swings.

Determinants of Member Bank Borrowing
With discounting at the banks' own initiative and, therefore, difficult
to predict, post-Accord inquiry has focused on the determinants of member
bank demand for borrowed reserves.

To what extent are bank borrowing

decisions influenced by profitability considerations?
so-called "tradition against borrowing?"

How strong is the

These questions are remnants of the old




need vs. profitability issue which was debated at length in the 1920's and
The "need" concept has never been clearly defined by its advocates,
but according to common interpretation banks that borrow out of "need" do so
only to meet temporary, unexpected reserve deficiencies.

At the same time,

the needy banks supposedly make every effort to repay these debts as quickly
as possible.

This view of borrowing behavior presumes a strong traditional

reluctance on the part of banks to be in debt to the Federal Reserve.
On the other hand, the strict version of the "profitability" thesis
posits that banks will borrow whenever additional funds can be invested in
earning assets carrying yields higher than the discount rate.

In short, banks

borrow out of a calculated effort to profit from rate differentials, rather
than simply in response to the unpredictable swings in market factors that
produce temporary reserve deficits.
Expressed in these terms, "need" and "profitability" appear to be
conflicting motives.

In effect, the borrowing-out-of-"need" proponents

postulated an interest-insensitive bank borrowings demand function, while the

See for example, W. Randolph Burgess, The Reserve Banks and the Money
Market, rev. ed. (New York: Harper and Brothers, 1936); Lauchlin Currie, The
Supply and Control of Money in the United States, rev. ed. (Cambridge: Harvard
University Press, 1935); Charles 0. Hardy, Credit Policies of the Federal
Reserve System (Washington; Brookings Institution, 1932); Seymour E. Harris,
Twenty Years of Federal Reserve Policy (Cambridge: Harvard University Press,
1933); Winfield W. Rjefler, Money Rates and Money Markets in the United States
(New York: Harper and Brothers, 1930); and Robert C. Turner, Mem.ber-Ba.nk
Borrowing (Columbus: Ohio State University Press, 1938)* For an excellent
discussion of the points raised in these earlier writings, see A. James Meigs
Free Reserves and the Money Supply (Chicago: University of Chicago Press,
1962), pp. 6-3 1 .

- 5 -

"profitability" school visualized a functional relationship in which
borrowings were interest-sensitive.
One of the few important contributions of the post-Accord
discounting literature has been that of the theoretical resolution of the
"need" vs. "profitability" issue.

But even this accomplishment rests in

large part on a modified concept of profitability which dates back to
Turner1s work in the 1930's. The argument runs roughly as follows: given
a reserve deficiency or the need to borrow— whether the cause is an un­
expected surge in required reserves, or a sudden cash drain, or some other
reserve absorbing factor— the extent to which a bank makes use of the
discount window for its reserve adjustment depends upon the relative costs
of borrowing and other means of replenishing reserves.

For example, the

higher the Treasury bill rate (i.e., the higher the opportunity cost of
running down bill holdings) relative to the discount rate, the greater the
"profitability" of borrowing to meet a given reserve deficit.

Thus, a

reluctant bank that borrows only to meet its immediate "needs" can be, at
the same time, sensitive to the rate differentials between its alternative
sources of short-term funds.

Using this modified concept of profitability,

it has been demonstrated with some rigor that it is possible to integrate,
into a consistent theory, bank reluctance to be in debt to the Federal
Reserve and the profit incentive for such borrowing.
During periods of monetary restraint, the discount rate tends to
lag behind rising market rates on alternative sources of funds and borrowings

Conversely, the discount rate remains above falling market rates on

the same sources of funds during periods of monetary ease and borrowings

- 6 -

This fact represents one basis of the contention that borrowings tend to
accentuate cyclical swings.

Non-Price Rationing
The attitude of banks toward the non-price terms applied at the discount
window has an important bearing on their borrowing decisions.
terms appear to be quite difficult to administer.

Yet, these

A wide variation in

non-price terms, between the various Federal Reserve districts and/or over
time can serve to diminish significantly the predictability of borrowings.
It is difficult, if not impossible, to separate the relative effects of non­
price rationing from effects of bank reluctance to borrow.

It has been

argued that these two factors have a mutually reinforcing effect on bank

But there has been very little in the literature on this subject.

Generally, there seems to beadissatisfaction with non-price rationing,
explicitly on the grounds that the price mechanism would operate more

Announcement Effects
A major source of contention in the literature has been the question
of whether discretionary changes in the discount rate have undesired effects
on expectations.

On one hand, it is argued that one must make inconsistent

assumptions about the behavior of lenders and borrowers in order for the
announcement feature of discount rate changes not to have unintended effects.
It has also been argued that, at best, the announcement effects will be
There are, however, those who see some merit in announcement

They argue that discretionary discount rate changes have two basic


First, the changes are widely publicized and especially useful

as a universal means of signalling the intent, for example, to s e n a balance
of payments drain.

Secondly, discount rate adjustments, as the only major

monetary instrument having no direct reserve effects, can play a unique and
often helpful role as an index of the course of policy.

Proposals for Change
Proposals for changing the discount mechanism have run the gamut from
abolishing it all together, to allegedly making it the most powerful tool
of monetary policy.

Elimination of the discretionary aspect of discount

window administration is the object of nearly all the proposed modifications
in the mechanism.
A plan frequently advanced would eliminate discretionary discount
rate changes by "tying" the discount rate to the market rate on some alter­
native source of ready funds. This type of arrangement

usually involves

setting the discount rate high enough above the anchor rate to make it a
"penalty" rate.

Most advocates of such a scheme would rely on the price

mechanism alone to allocate Federal Reserve credit ana to keep borrowing in
check, discarding the present borrowing "privilege" with its non-price
connotations in favor of granting banks the "right" to borrow.

There has been

controversy, however, on the appropriate market rate.
A somewhat more radical plan calls for the payment of interest at
the discount rate on member bank excess reserves.

Through discount rate

adjustments, the Federal Reserve would then have direct control over the
opportunity cost of bank lending.

Under such an arrangement, banks would

be tempted to increase their excess reserves and reduce their holdings of

short-term Government securities.

The discount rate -would take on sharply

increased importance among the major instruments of monetary policy.
There are, in addition, those who -would abolish the discount

Two basic reasons for suoh a move have been advanced.


by doing away with borrowing at the banks1 own initiative the Federal Reserve
would greatly improve its control over total reserves.

Secondly, it has

been argued that the discounting function is no longer necessary in view of
the substantial postwar growth in bank holdings of short-term Government
securities which can be used to make the necessary adjustments in reserve

Needless to say, the latter argument is of diminished relevance

under circumstances in which bank holdings of short-term Governments are
It has also been proposed, however, that the discounting terms
should be fully discretionary.

The basic contention is that the discretionary

approach entails the power not only to control total borrowing, but also
makes possible the selective control of bank lending practices.

Concluding Observations
Although most of the major issues raised in the course of the academic
dialogue on discounting remain unresolved, it is possible to draw some
general conclusions.

Discounting does not, for example, appear to weaken

monetary control to any significant extent during periods of monetary restraint.
Indeed, the discount mechanism is, for the most part, a useful complement to
open jnarket operations.

In particular, shifts in monetary policy are, as

argued by those favoring the current arrangement, cushioned by the provision
of temporary reserves through the discount window to those banks coming

- 9 -

under the greatest stress.

At the same time, borrowed reserves have less

expansive implications for credit and deposit growth than a corresponding
amount of reserves supplied through other means.
On the other hand, regardless of how limiting the effect of
borrowed reserves on credit growth may be, the fact remains that monetary
control is rendered less precise under conditions in which banks 'b-orrow at
their own initiative.

Hopefully, the predictability of borrowing can be

improved by reliable quantitative measurements of the relative effects of
interest rates and other factors that influence borrowing decisions.
With regard to discount window administration and general supply
considerations, there is almost unanimous agreement among economists on the
desirability of complete reliance on the price mechanism to control borrowing.
But regardless of how appealing the "tied" rate plans may be, there has been
no final agreement on the market rate to which the discount rate Should be
linked nor on the appropriate spread to be maintained.

While experience

suggests that there should be some substantial revisions in the present
non-price discounting guidelines, it seems, nevertheless, that both non-price
and price terms will continue to be necessary to insure effective monetary
Finally, the predominant view in the literature is that under
present circumstances discount rate changes will have, at best, ambiguous
announcement effects.

At the same time, those who fear that discount rate

changes will have adverse effects on expectations may have over-rated their
case a bit.

In particular, it is not likely that discount rate changes alone,

whatever may be their effects on expectations, dominate the behavior of borrowers

- 10 -

and lenders.

Indeed, these rate adjustments are only one of many factors

that influence expectations about the course of monetary policy and future
economic conditions.


Discounting and Monetary Control

Borrowing and Monetary Restraint
As noted above, the assumption is frequently made by those favoring
the current discount procedures that borrowed reserves are less expansive
in terms of credit growth than a corresponding amount of reserves provided
through open market operations.


It is argued that banks will seek to

extinguish their borrowed reserves promptly, usually through some form of
asset adjustment,

In Roosa's words:

"In the American setting the fact that banks borrow
only as a privilege means that even though any
individual bank can temporarily, in effect, cause
the creation of reserves by borrowing at the discount
window, that same bank simultaneously takes on an
obligation to find ways of extinguishing those reserves—
the more promptly the better, in order to preserve its
privilege for use again when unexpected reserve drains
occur. Thus, as a general rule, the larger the aggregate
volume of bank borrowing from the Federal Reserve, the
greater will be the effort going on, through the banking
system, to limit credits and bring rese^rves into balance
with the requirements against deposits."3
The fact that Roosa casts his discussion in terms of the actions
of an individual bank is not to deny that a high or rising volume of

See for example, Board of Governors of the Federal Reserve System,
and the United States Treasury, The Federal Reserve and the Treasury: Answers
to Questions from the Commission~on Money and Credit (Englewood Cliffs, New
Jersey: Prentice-Hall, Inc., 1963), p. 118.
Robert V. Roosa, "Credit Policy at the Discount Window:
Quarterly Journal of Economics, LXXIII (May, 1959) 5 p. 33^.


- 11 borrowings for the banking system as a whole may persist for long periods as,
for example, when an increasing number of banks turn to the discount window
for temporary reserve relief*

But the key point is that aggregate borrowed

reserves have a restrictive impact on credit expansion and the higher the
level of such borrowing, the greater the restriction involved.
Apart from the special nature of borrowed reserves, Samuelson has
argued that the tendency for borrowings to partially offset the reserve
effects of open market operations actually strengthens monetary policy.


observes that:
"While it is true that discounting often acts counter to
open-market operations, there is no evidence that a unit
change in open-market operations induces an opposing change
in discounting large enough to reverse or substantially wipe
out the original effect. So it is not really difficult for
the planners of open-market operations to take all this into
account; and precisely because they know that the discount
window provides an escape valve, they can be more courageous
in the use of open-market operations.
Among the critics of the existing discounting arrangement, Milton
Friedman looks upon borrowing with somewhat more alarm.

He contends that

with discounting at the banks* own initiative, the System is unable to exert
direct control over monetary expansion.^
Warren Smith, another academic critic of the existing discount
mechanism, asserts that those who emphasize the restrictive nature of
borrowed reserves overlook the all-important fact that member bank borrowing
adds to total reserves.

1 .. .Therefore.. .borrowing constitutes an offset to

b. Paul A. Samuelson, "Reflections on Monetary Policy," Review of
Economics and Statistics, XLII (August, i960), p. 266.

Milton Friedman, A Program for Monetary Stability (New York:
University Press, 1959)> p. 38.


- 12 the restraint that brought it about to the extent that the supply of reserves
is thereby increased."
Finally, the pro-cyclical fluctuations in borrowings have been
criticized by Aschheim,


and Brunner and Meltzer


among others.

In this

regard, Aschheim observes that "...however strong the commercial bank
tradition and however potent the Federal Reserve policy, they have not stood
in the way of cyclical fluctuations in the volume of rediscounting....'


Brummer and Meltzer go into somewhat more detail on this matter:
"The administration of the discount window contributed both
in the twenties and the fifties to the cyclical variability
of the money supply. -^The discount rate typically lags behind
the movements of the market rates. A cyclical upswing,
generated or reinforced by non-monetary factors, pushes market
rates ahead of the discount rate, and induces banks to expand
their borrowing.
The rising volume of discounts and advances
increases the [reserve] base and consequently, increases the
money supply. A reverse operation occurs in a downswing.
The cyclical variability of the money supply is thus ampli­
fied by the operation of the discount window.

Determinants of Member Bank Borrowing
Most of the post-Accord dialogue on the factors that influence borrowing
decisions has been conditioned by the need vs. profitability issue that was

6. Warren L. Smith, "The Discount Rate as a Credit Control Weapon,"
Journal of Political Economy, LXVI (April, 1958), p. 172.
7. Joseph Aschheim, Techniques of Monetary Control (Baltimore:
Hopkins Press, 1961).


8. U.S. House, Subcommittee on Domestic Finance, An Alternative Approach
to the Monetary Mechanism, by Karl Brunner and Alan H. Meltzer, 88th Congress,
2nd Session, August 17, 1964.

Techniques of Monetary Control, op. cit., p. 91.
An Alternative Approach to the Monetary Mechanism, op. cit., p. 89.

- 13 -

debated extensively in the 1920's and 1930's.

Recent attempts have been

made to isolate and quantify the impact of interest rates on borrowing, and
general comments on the sensitivity of borrowing to rate movements are
abundant in the literature.

Somewhat less attention has been devoted to

the question of bank reluctance to borrow.

One of the more interesting

contributions in the post-Accord literature is a theoretical reconciliation
of these two motives.

Interest Rates and Borrowing. Many of those who feel that the present
discount mechanism weakens monetary control are alarmed by evidence suggesting
that borrowings are sensitive to interest rates and therefore work systematically
against open market operations.

Although the extent to which borrowings respond

to rate movements is clearly an empirical question, the evidence is scanty.
Typical of the casual observation in this area is the following:

"No doubt

it is true that banks are reluctant to borrow, but like many ordinary persons,
bankers allow their reluctance to be overcome by more attractive alternatives.""*’’
Aschheim theorizes in a similar vein:
"The Federal Reserve prefers to state that in time of mone­
tary tightness there is a great 'need' on the part of member
banks for rediscounting. Economically, the more informative
formulation, however, is that in times of monetary tightness
it is more profitable for banks to borrow from the Federal
Reserve than in other periods."^
Warren Smith is somewhat more specific about the way in which he
feels that interest rates influence borrowing decisions, but he too stays

11. Earl Rolph, "Discussion," American Economic Review, Papers and
Proceedings, XLV (May, 1955)> pp. ^13-^+i

Techniques of Monetary Control, op. cit., p. 91*

- Ik primarily in the realm of supposition in observing that while bank demand
for readily available funds to satisfy the kind of urgent needs that
commonly induce banks to borrow at the discount window is probably quite
interest-insensitive, the extent to which banks actually turn to the Federal
Reserve to satisfy these needs rather than relying on other sources may be
significantly affected by rate movements.
"In most cases, banks have a choice of obtaining additional
funds by borrowing at the Federal Reserve or by liquidating
secondary reserves or other investment securities. Surely,
the major factor influencing the choice will be the relevant
cost of funds obtained by the various methods, and this
depends chiefly on the relation between the discount rate and
the expected yield on assets that the bank may consider
liquidating. 3
Meigs, who actually focuses on bank demand for free reserves
(excess reserves less borrowing), concludes that "aggregate member bank
borrowing is indeed influenced by the net yields obtainable on borrowed
funds, within a considerable part of the range of interest rates and other
conditions observed."


In this connection Meigs makes the point that the

hypothesis that member bank borrowing is not responsive to changes in market
interest rates cannot be confirmed solely by demonstrating that banks are
reluctant to borrow.

Rather, the characteristics of the demand schedule

must be determined by direct empirical observation of borrowing and interest
More recently, de Leeuw has concluded from empirical bank borrowings
demand estimates (based on quarterly data for the 195^-62 period) that the


"The Discount Rate as a Credit-Control Weapon," op. cit., p. 172.


Free Reserves and the Money Supply, op. cit., p. 89 .

- 15 -

response of borrowings to the differential between the discount rate and the
yield on 3“m°nth Treasury bills is "moderate/* with implied long-run elastici­
ties with respect to the discount rate and the yield on Treasury bills of -0.7
and +0.5, respectively.*^

De Leeuw uses a stock-adjustment formulation of the

borrowings demand function in deriving these results.

According to the stock-

adjustment principle, changes in bank borrowings in any given period are a func­
tion of the discrepancy between the desired level of borrowings in that period
and the actual level of borrowings in the preceding period.

De Leeuw posits that

desired amounts of borrowing are dependent, in turn, upon the differential
between the Treasury bill and discount rates, the Treasury bill rate level,
and the net inflow of bank funds (i.e., changes in private demand deposits plus
Federal Government demand deposits plus private time deposits less member bank
required reserves less holdings of loans and other private securities).
In an empirical study patterned closely after de Leeuw1s work,
Stephen Goldfeld has estimated borrowing demand functions for city and country
banks, separately.-^

He found the short-run elasticity of changes in

15. Frank de Leeuw, nA Model of Financial Behavior," in The Brookings
Quarterly Econometric Model of the United States, (eds.) James S. Duesenberry,
Gary Fromm, Lawrence R. Klein, and Edwin Kuh (Chicago: Rand, McNally and
Company, 1965 ) PP* 512-513•
16. Stephen M. Goldfeld, Commercial Bank Behavior and Economic Activity,
(Amsterdam: North Holland Publishing”Company, 1966 )
. Goldfeldfs short-run
elasticities were calculated by

where B represents bank borrowing and r is the

relevant interest rate. Note that the relevant mean used was that of the
level of borrowing, B. The mean of the flow variable cannot be used because
it could well be zero in some cases. The long-run elasticities were obtained
by setting the borrowings flow, AB, equal to zero, solving for the steady-state
B, and differentiating as above.

- 16 borrowings with respect to the discount rate to be -0.875 for country banks
and -0.979 for city banks.

Comparable elasticities with respect to the

Treasury bill rate were +O.785 and h-0.877 for country and city banks, respec­

Goldfeld's long-run elasticity estimates for these variables were

substantially higher than de Leeuw's and, surprisingly, were higher for
country banks than for city banks.

Specifically, the long-run elasticity

of borrowings with respect to the discount rate were -2.926 and -2.382 for
country and city banks, respectively.

The Treasury bill rate elasticities

were +2.625 for country banks and +2.134 for city banks.
In yet another empirical study, Goldfeld and Kane have disaggregated
further by deriving borrowings demand estimates for four separate classes of
member banks. 1

Another distinguishing feature of this study is that the

empirical demand estimates are based on weekly borrowings data.

From a demand

function relating borrowings to the Treasury bill-discount rate differential,
lagged borrowings, and changes in nonborrcwed reserves, Goldfeld and Kane
calculated implicit short-run elasticities with respect to the bill rate of

.56 for New York City banks, .08 for Chicago banks, .15 for other Reserve
city banks, .21 for country banks, and similarly, .21 for total member banks.
Goldfeld and Kane note that the long-run elasticity of borrowings with respect
to the Treasury bill rate ranged from 2.8 to 3*9 for the various groups of
member banks, and are thus generally consistent with Goldfeld's quarterly

(Comparable elasticity estimates for the discount rate were not

presented in this article.)

Stephen M. Goldfeld and Edward J. I&ne, "The Determinants of Member
Bank Borrowing: An Econometric Study," Journal of Finance, XXI (September,
1966 ), pp. 499-51^.

- 17 -

The Federal Reserve System has not always been completely clear on
the importance it attributes to interest rate considerations in bank borrowing

The following is among its pronouncements on the subject:
"Banks are generally reluctant to become indebted to the
Federal Reserve except for very short periods, and when
in debt feel constrained to liquidate assets. The deterrents
to borrowing are greatly weakened if market yields on
securities owned become and remain substantially higher than
the discount rate."*^

Going into greater detail on the relationship between borrowings, market rates,
and the discount rate under conditions of monetary restraint, the System has
commented that:
" is of prime importance that the general reluctance
of banks to borrow at the Federal Reserve be reinforced
by a discount rate with real deterrent power at times when
a tempering of bank credit growth is in the public interest.
In other words, in order to make the discount mechanism an
effective supplement to open market operations the Federal
Reserve is obliged to maintain discount rates not markedly
lower than market yields on the most readily available
alternative source of bank reserves, Treasury bills. If the
Federal Reserve in these circumstances did not adjust its
discount rates to keep them 1 in touch* with market rates,
the task of administering the discount window to prevent
excessive credit expansion would become very difficult."^9
On the other hand, the System has more recently concluded that a comparison
of the costs of alternative sources of ready funds with changing amounts of
borrowed funds "does not suggest that there is a powerful borrowing response
to Changing cost considerations0

18. U.S. Congress, Joint Economic Committee, Employment Growth and Price
Levels, Hearings, "Part U--The Influence on Prices of Changes in the Effective
Supply of Money," 86th Congress, 1 st Sess ion (May 25-28, 1959), p. 755.

Ibid., p. 756

The Federal Reserve and The Treasury: Answers to Questions from
the Commission on Money and Credit, op. cit., p. 134.

- 18 Reluctance to Borrow, Attempts to discern the nature of the tradition
against borrowing date back to the need vs. profitability discussions of
the 1920's.

Bank reluctance to borrow is commonly associated with the notion

that since banks are already "in debt" to their depositors with repayment due
in many cases on demand, it is imprudent to incur additional debt that is
of a prior claim nature.


Continued borrowing has been viewed as a confession

either of weakened condition or of poor management.


There is general agree­

ment that the reluctance to borrow varies markedly in intensity among banks.
Nevertheless, it has been argued that "in most cases" bank reluctance to
borrow is "a deterrent sufficiently strong to prevent excessive use of dis23
At first glance, the premium in excess of the discount rate that
banks have paid for Federal funds might be construed as a manifestation of
bank reluctance to borrow from the Federal Reserve.

In fact, however, the

larger banks that are primarily responsible for bidding up the Federal funds
rate are almost certainly not insensitive to rates as the traditional meaning
of reluctance would imply.

Rather, these banks might be viewed as adding

an implicit cost factor to the discount rate in order to take account of
scrutiny by the discount authorities.

Under such circumstances, the effective

cost of borrowing to these large banks will exceed the published discount
rate and the Federal funds premium may be largely illusory.


Ibid. , p. 129.


"Credit Policy at the Discount Window," op. cit., p. 213.

23. The Federal Reserve and the Treasury: Answers to Questions from the
Commission on Money and Credit, op. cit., p. 13 O.

- 19 -

Theoretical Reconciliation.

Polakoff has demonstrated that it is

possible to integrate into a consistent theory bank reluctance to be in
debt to the Federal Reserve and the profit incentive for such borrowing.


The key assumption in Polakoff's theoretical scheme is that there is a
"reluctance elasticity" on the part of member banks when borrowing from the
Federal Reserve, which means that not only is there a reluctance to borrow
at all times but that this reluctance increases as the volume of discounting

Viewing member bank borrowing decisions in the context of a "pre­

ference" system, Polakoff reasons that as borrowings rise in response to an
increasing differential between the yield on Treasury bills and the discount
rate, the disutility of borrowing relative to the utility of profit will
eventually become so great that member banks will no longer borrow.


argues, in effect, that the banks* marginal propensity to borrow falls as
the spread between the bill and the discount rates widens.
To test his hypothesis, Polakoff relates (in scatter diagrams) both
weekly and monthly data on member bank borrowings to specific spreads between
the bill and discount rates over the July 1953-December 1958 period.


concludes that "the expansion paths of borrowings suggested by the various
scatter diagrams are all consistent with the theoretical results deduced from
the integration hypothesis.

These empirical findings are not, however,

2b. Murray E. Polakoff, "Reluctance Elasticity, Least Cost, and Member
Bank Borrowing: A Suggested Integration," Journal of Finance, XV (March,
i960), pp. 1 -18 .

Ibid., p. 18. In a more recent article, Polakoff has fitted a
quadratic function to his empirical data and offered this as further proof
of his theoretical scheme. See: Murray E. Polakoff, "Federal Reserve
Discount Policy and Its Critics," in Banking and Monetary Studies, (ed.) Deane
Carson (Homewood, Illinois: Richard D. Irwin, Inc., 19^3)> PP* 205-207.




supported by Goldfeld's results from quarterly data for the somewhat longer

1950-III— 1962-11 period.

Taking account of the impact of loan demand and

reserve availability on borrowing behavior (something which Polakoff failed
to do) Goldfeld tests specifically for the relationship between borrowings
and the rate spread postulated by Polakoff.

He finds that while borrowings

are in general interest-sensitive, there is no tendency for the marginal

propensity to borrow to fall as the rate differential widens.

Non-Price Rationing
The guiding principles of Regulation A (as amended in 1955) have been
interpreted and applied only with considerable difficulty.

The appropriate­

ness of borrowing under these non-price terms turns on the intent of the

A bank is not, for example, to willfully borrow in order to profit

from rate differentials.

But this is basically a subjective determination

and the uses to which borrowed reserves are put are quite difficult, if not
impossible, to pinpoint.
Distinctions between appropriate and inappropriate borrowing can be
quite fine, as evidenced by the following case cited by a former Federal
Reserve discount officer:

Commercial Bank Behavior and Economic Activity, op. cit., pp. 150-151.
In their more recent test using weekly data covering the July 1953-December 1963
period, Goldfeld and Kane come up with what they consider to be "limited support"
for the relationship between borrowings and rates hypothesized by Polakoff. See
"The Determinants of Member-Bank Borrowing: An Econometric Study," op. cit.,
p. 513. The evidence offered by Goldfeld and Kane in support of the Polakoff
hypothesis has recently been brought into question by Polakoff, himself, and
Silber in "Reluctance and Member-Bank Borrowing: Additional Evidence," Journal
of Finance, XXII (March, 1967)* pp. 88-92. Polakoff and Silber argue that high
colinearity in Goldfeld and Kane's observations bearing on Polakoff's hypothesis
"sheds serious doubt on the validity of these results." In place of Goldfeld
and Kane's analysis Polakoff and Silber present their own evidence which is
interpreted as verifying the operation of the "reluctance/surveillance" motive
in periods of "tight" money.

- 21 -

"...if a bank borrowed temporarily to meet a commitment
to make a loan to a business concern at k per cent, with
reasonable expectations of having funds at hand shortly
to pay out, the bank would not be borrowing to earn a rate
differential even though it was borrowing at the lower rate
(in one market) and re-lending at a higher rate (in another
With regard to the stability of discounting terms over time,
Professor Whittlesey has set out to correct what he terms a "common mis­
conception" that non-price discount window standards are adjusted to changing
business conditions.

He contends


"The fact is that neither the way

in which the discount window is administered nor the standards by which member
bank borrowing is judged are modified to conform to over-all monetary policy."
Roosa is of a similar opinion:
"Insofar as human frailties permit, it is always the same
[discount] window, open in the same way at all times for
borrowers of the same circumstances. What makes the impact
of these continuous standards seem to vary is that the
circumstances of the banks themselves change."^9
The relative importance of discount window administration and the
tradition against borrowing in borrowing decisions has been a point of

Professor Whittlesey argues, for example, that the administra­

tion of the discount window is not a significant feature of over-all credit
control but merely acts in an indirect and admonitory manner " keep alive
and reinforce the tradition against borrowing, without which discount policy
as presently conducted could quickly break down."

According to Whittlesey,

27. George W. McKinney, Jr., The Federal Reserve Discount Window (New
Brunswick: Rutgers University Pres¥, i960), pp. 106-107.
28. Charles R. Whittlesey, "Credit Policy at the Discount Window,"
Quarterly Journal of Economics, LXXIII (May, 1959), p. 209.
Comment," op. cit. , p. 33 U.


"Credit Policy at the Discount Window:


"Credit Policy at the Discount Window," op. cit. , p. 216.


- 22 "...the privilege of borrowing, despite conventional statements to the contrary,
is, in practice, tantamount to a right....
Roosa, for one, does not appear to be convinced that discount
window administration does in fact play so unimportant a role in borrowing

Without attempting to determine precisely where the influence

of discount window surveillance begins and the influence of the traditional
reluctance to borrow runs out, he contends that "both are certainly present;
and whenever the check imposed by tradition might begin to falter, the
limits imposed by surveillance would begin to take hold.”3^
Finally, the difficulties in administering the provisions of
Regulation A may have contributed to inter-Federal Reserve District variations
in non-price terms.

This is contended in a recent study of the relationship

between borrowed reserves and total reserves in the various Federal Reserve

The evidence provided, however, cannot be considered conclusive.’
The dominant view in the literature is that there should be greater

reliance on the price mechanism and less on non-price rationing in the
allocation of Federal Reserve credit through the discount window.

As will be

seen in a subsequent section of this paper, proposals by Aschheim, Brunner
and Meltzer, and Tobin all call explicitly for an "open" discount window where
banks have the right to borrow all they wish at the existing discount rate.


Ibid., pp. 214-215.


"Credit Policy at the Discount Window:

Comment," op. cit., p.

336 .

33* See, David T. Lapkin and Ralph W. Pfouts, "Administration of the
Discount Function," National Banking Review, III (December, 1965 ), pp. 179l86; and Jimmie R. Monhollon and James Parthemos, "Administration of the
Discount Function: A Comment," National Banking Review, IV (September, 1966),
pp. 89-92.

- 23 Announcement Effects
There has recently been a growing concern with the impact of discount
rate policies on expectations.

Apparently not everyone agrees with

C.E. Walker's observation that changes in the discount rate are "a simple and
easily understandable technique for informing the market of monetary
authorities' views on the economic and credit situation."^
According to Kareken, some asymmetrical assumptions about the
behavior of lenders and borrowers are necessary in order to argue that the
"announcement effects" of discount rate adjustments are necessarily

In particular, lenders must be expected to interpret an

increase in the discount rate as a sign that tighter credit conditions
lie ahead and react with a more conservative lending policy; while borrowers,
o n the other hand, must take the discount rate rise as signaling the end of
good times and cut back their spending plans and loan demands accordingly.


Samuelson is not so sure that the borrowers will in fact react in
such a manner.

He reasons that:

3^. C. E. Walker, "Discount Policy in the Light of Recent Experience,"
Journal of Finance, XII (May, 1957)> P» 229.
John H. Kareken, "Federal Reserve System Discount Policy: An
Appraisal," Baixca Nazionale Del Lavoro Quarterly Review, No. k& (March, 1959),
p. 109.
In a more recent article, Warren Smith has expressed these conditions
under which announcement effects can be assumed to be stabilizing in Hicksian
terms. That is, lenders must have elastic expectations about future interest
rate movements while borrowers act on inelastic expectations. See Warren L.
Smith, "The Instruments of General Monetary Control," National Banking Revi^*,
I (September, 1963 ), pp. 61 -63 .




"Today, financial men know that the Federal Reserve leans
against the breeze,' tightening money when it thinks the
forces of expansion are strong and easing money when
deflation seems a threat. Therefore it is rational for an
investor to say, 'Aha!, the "Fed" is raising interest rates;
they must know that the current outlook is very bullish,
and if that is going to be so, I'd better expand my opera­
tions.' Conclusion: Announcement effects are often
Taking a position similar to Samuelson's, Warren Smith concludes that, "the
effects of discount rate increases on business expectations are likely to be
destabilizing [i.e., optimistic] or at best, neutral," but hastens to add
that he believes such effects to be "rarely of major importance" because the
discount rate is only one of many kinds of information which go into the
formulation of business expectations.


According to Smith, changes in the discount rate also induce shifts
in expectations about monetary policy and bring on related "unsteadiness" in
market rates.

Failure to increase the discount rate when the Treasury bill

rate rises to or above its level, may, for example, trigger a decline in
interest rates, especially if current business indicators point £ven slightly

In attempting to smooth such a swing, the System might bring about

tighter monetary conditions than would otherwise be desirable.


control may also be undermined, Smith argues, when a technical increase in
the discount rate, to bring it in line with market rates, is interpreted as
a sign of tighter monetary policy ahead, causing a sharp rise in rates.
Appropriate action by the monetary authorities in this case might result in
a relaxation of restrictive policies, before it is deemed appropriate on
general grounds.

36 . "Recent American Monetary Controversy," op. cit., p. 10, n. 1.
37. "The Discount Rate as a Credit Control Weapon," op. dit. , p. 17*+. A
similar argument is advanced by Smith in "The Instruments of General Credit
Control," op. cit. , pp. 63-6^.

- 25 -

Still another expression of concern with announcement effects is
offered by Culbertson who observes that the November 1957 discount rate
reduction in particular "precipitated the most extraordinary bull market in
bonds, a development that would have been most untimely had recession not
been in the offering.

The [November 1957] discount rate reduction seems to

have served waiting debt speculators in the capacity of a starter's gun, and
thus, to have contributed unduly to the speculative flavor of the bond
On the other hand, the System has observed that discretionary dis­
count rate changes are a useful complement to the other major tools of
credit policy because they are probably the most widely publicized step that
a central bank can take--and yet they have no direct effect on the available
supply of bank reserves.



Proposed Changes in the Discount Mechanism

The critics of the present discounting arrangement have offered
alternative proposals that range from abolishing the practice to making it
the most powerful tool in the central banker's kit.

Abolition of the Discount Mechanism
Perhaps the most adamant advocate of abolishing discounting is Milton
Friedman, who argues that since member banks discount at their own initiative,

38 . John M. Culbertson, "Timing Changes in Monetary Policy," Journal
of Finance, XIV (May, 1959)> pp. 157-158.
39. The Federal Reserve and the Treasury: Answers to Questions from
the Commission on Money and Credit, op. cit., p. i 4 j!

- 26 the Federal Reserve System cannot determine the amount of money it creates
either through the discount window or by a combination of discounting and
open market operations.^®

Regarding discount rate policy in particular,

Friedman is highly critical of those .who have looked to the level of the
discount rate rather than its position relative to other rates as an indica­
tion of the tone of monetary policy.

Under a discretionary discount rate

policy, an unchanged rate is, according to Friedman, accompanied by unintended
shifts between monetary tightness and ease as market rates change relative
to the discount rate.

Moreover, the occasional but usually substantial

changes in the discount rate are viewed as a source of general instability.
Friedman sums up his feelings as follows:
"...rediscounting should be eliminated. The Federal Reserve
would then no longer have to announce a discount rate or to
change it; it would then have direct control over the amount
of high-powered money it created; it would not be a source of
instability alike by its occasional changes in the discount
rate and by the unintended changes in the 'tightness' or
'ease' of policy associated with an unchanged rate, nor would it
be misled by these unintended changes; and it would be less
subject to being diverted from its main task by the attention
devoted to the 'credit' effects of its p o l i c y . " 4 l
One vital qualification is, however, added by Friedman to his argu­
ment for total abolishment.

He reasons that since required reserves are

calculated after the fact, some discrepancies between required and actual
reserves are unavoidable.

As an alternative to the current charge of the

discount rate plus two percentage points on realized reserve deficits,
Friedman offers a fixed rate of "fine" that "...should be large enough


A Program for Monetary Stability, op. cit., p. 38 .


Ibid., p. 44.

- 27 -

to make it well above likely market rates of interest.

The fine would then

become the equivalent of a truly 'penalty' discount rate...[but]
collateral, or eligibility requirements, or the like would be involved."


Apparently, Friedman was not aware of how much this one qualification
weakens his solution.

As Ahearn has pointed out, this qualification would

replace the discount mechanism with an "overdraft system" under which
everything would depend on the height of the penalty rate.

If market rates

of interest moved up, the penalty rate might have to be adjusted upward to
keep it a penalty, which means in essence, that the discount mechanism would
have crept back under another name.
Professor Kareken also views the abolition of discounting as a
possible alternative to the present system.


He reasons that in view of

the growth in public debt— and especially, the expansion in the stock of
Treasury bills--during and after World War II, there is no longer any need
for discounting in order to make reserve adjustments.

With the closing down

of discount facilities, banks short of reserves would, according to Kareken,
be forced to sell short-term Governments.

But those banks with reserve

excesses would have a strong incentive to retain their Treasury obligations,
and perhaps to acquire more.
Ahearn contends that this analysis is faulty because Kareken1s
assumption that Governments sold by reserve deficient banks will be bought up


Ibid., p. i 5

J 3 Daniel S. Ahearn, Federal Reserve Policy Reappraised, 1951-1959
(New York: Columbia University Press, 19&3)> P- 1**0.
W*. "Federal Reserve System Discount Policy:
pp. 1 1 1 -1 1 2 .

An Appraisal," dp. cit.,




by other banks, ignores the fact that broad swings in reserve positions
affect nearly all banks in roughly the same way at about the same time.
If bank reserve positions were tightening, Ahearn asserts, it would actually
be rational for excess reserve banks to husband their reserves and, indeed,
to sell Governments in anticipation, before reserve positions tightened
further and depressed security prices lower.


In the light of more recent

developments, there is, of course, the additional argument that bank holdings
of short-term Governments might drop so low as to limit this means of
reserve adjustment.

Nondiscretionary Approach
A general dissatisfaction with the discretionary features of discount
policy is reflected in nearly all of the suggested modifications in this

The proposals along this line rest on the assumption that "pro­

fitability" considerations do, in fact, bear heavily on borrowing decisions.
The central feature of the proposed nondiscretionary discounting arrangements
is a discount rate that is "tied" to the Treasury bill rate or some other
money market rate that is relevant to borrowing decisions.
ment is apparently motivated in large part by the desire to:

Such an arrange­
(l) stabilize

the rate differentials that influence borrowing decisions, thus hopefully
stabilizing the borrowing aggregate, and (2 ) eliminate the threat of adverse
announcement effects stemming from discretionary discount rate changes. When
coupled with a penalty rate concept, this system establishes a basis for relying
entirely on the price mechanism for the allocation of credit at the discount


Federal Reserve Policy Reappraised, 1951-1959, op. cit., p. 140, n. 51

- 29 The practical problem of how high to set the "penalty" rate is an
important one.

If the rate is set too high, borrowing from the Federal Reserve

Banks might cease to be a practical alternative for banks unexpectedly in need
of reserves.

Many regard this lender-of-last-resort

function as an important

central bank responsibility, however, and the adverse effect on the attractive­
ness of membership in the System is also a consideration.

On the other hand,

if the penalty rate is set too low, the volume of borrowing might become

A perhaps even more thorny problem is created by the fact that

market interest rates do not move in perfect tandem with each other.


if the discount rate were tied to some particular rate, movements of other
market rates relative to the chosen rate could result in continued interest
rate-induced instability in the aggregate volume of borrowing.
The choice of the market rate to which the discount rate would be
tied and the size of the differential to be used hinges in significant part
on the question of whether banks balance borrowings against rates on other
sources of readily available funds or whether borrowings are related to the
rate that banks can earn on loans.

A penalty discount rate that is effective

under conditions in which borrowings are balanced against rates on marginal
assets (i.e., Treasury bills) may not inhibit, borrowing decisions that are
related to the higher return on earning assets.
Moreover, even if the discount window authorities effectively pre­
clude borrowing to lend at a profit tinder the terms of Regulation A, a given
penalty rate may become ineffective as banks shift from one short-term source
of funds to another.

If, for example, the discount rate is set at some

specified margin above the Treasury bill rate, but if, in fact, a substantial
number of banks turn to other sources of short-term funds such as CD's, the
discount rate may lose its initial penalty properties.

- 30 -

Warren Smith has observed that on practical grounds, the discount
rate should exceed the Treasury bill rate by a margin that is sufficient to
discourage "unnecessary borrowing" without imposing too heavy a penalty on
banks that are "forced" to borrow because they lack salable securities.


this basis, he determines that the discount rate should be set a full 1 per
cent or more above the Treasury bill rate.


Smith has been careful to distinguish between his penalty rate
system in which the ui§e of the discount window is penalized in cost terms
relative to other sources of short-term funds, and the British scheme,
where the penalty rate is related to the return on earning assets— which
happens in the case of the British discount houses to be almost exclusively
Treasury bills.

The British penalty rate concept is held to be impracticable

in the United States "because there are several thousand member banks able
to borrow directly from the Federal Reserve and invest their funds in a
broad range of assets carrying widely varying interest rates.
In another "tied" discount rate plan, Ahearn proposes that the
discount rate be anchored to the bill rate but that the Federal Reserve be

46. "The Discount Rate as a Credit Control Weapo'n," op. cit., p. 176.
More recently, however, Smith has voiced reservations about using the Treasury
bill rate as an anchor rate. At a May, 1966 Federal Reserve seminar on the
discount mechanism, he noted that in the last few years, many banks have come
to use CD's rather than Treasury bills in their reserve adjustments. At the
same time, Smith indicated that he has become less certain of the appropriate
penalty rate spread.
"There is a fuzziness about what a penalty rate is here. Does
it have to be sort of higher than any rate that any bank can
earn on an asset, at one extreme, or does it have just to be a
little bit above the lowest rate [at which] any bank can turn
out any asset, at the other extreme? It's probably somewhere
in between."

Ibid., p. 171, n. 3 .

- 31 -

allowed to vary the differential in accordance with monetary policy aims.
"This would retain needed flexibility in the relation of the discount rate
to other money market rates but also minimize the possibility of market
misinterpretation of the meaning of discount rate changes."


Brunner and

Meltzer also call for an arrangement in which the discount rate would always
exceed the bill rate, but not necessarily by a fixed margin.

They envision

a "market determined [discount] rate" and suggest that the discount window
should be kept "open" at the penalty rate.


Precisely how the penalty rate

would be determined is not, however, spelled out.
Aschheim presents a plan in which the discount rate is tied to the
rate on Federal funds instead of the Treasury bill rate because Federal funds
are held to be the closest substitute for reserve accommodation from the
Federal Reserve.

As did Brunner and Meltzer, Aschheim also envisions (but

fails to spell out) a penalty-rate scheme in which "the 'principles of
prudent discounting' that are currently applicable to the System's rediscount
facility could be dispensed with."


Aschheim concludes:

" market operations are feasible, nonpenal
rediscounting is--in effect— an escape mechanism for
commercial banks seeking to overcome the constraint of
restrictive open-market policy. Last-resort reserve
accommodation via a penalty rate eliminates this escape
mechanism while retaining the safety valve of central-bank
lending to member banks at the latter's initiative. Thus, in
monetary systems possessing the institutional setting for
open-market operations, penalty-rate rediscounting enhances
the effectiveness of central bank control."51


Federal Reserve Policy Reappraised, 1951~1959> op. cit., p. l44.


An Alternative Approach to the Monetary Mechanism, op. cit. , pp. 89-90.


Techniques of Monetary Control, op. cit., p. 94.


Ibid., p. 98.

- 32 -

Some technical difficulties appear to exist, however, in attempting
to tie the discount rate to the funds rate where there is unlimited resort
to the "window."

The pre-determined and fixed penalty spread would have to

be added to some past value of the funds rate to determine the current
discount rate, say the average effective funds rate for the preceding week.
The balance of supply and demand in the funds market is very shiftable,
however, and the rate tends to be quite unstable.

As long as the current

funds rate remained below the current week's discount rate, borrowings would
probably be very low.

If the current funds rate should rise to the discount

rate, however, banks would be indifferent between the funds market and the
"window" as a source of reserves, the funds rate would rise no further, and
borrowings could rise indefinately until the demand for reserves was satisfied
at the existing discount rate.

Thus, it would appear that considerable

instability in the volume of borrowings would be re-introduced.
In summary, those advocating a nondiscretionary discount mechanism
would attempt to minimize the variability in borrowings by fixing the
differential between rates pertinent to the borrowing decision and to hold
down the average level of borrowings by setting the discount rate at a
penalty level.


Some interesting variants of the "tied" rate scheme were offered
at the recent Federal Reserve seminar referred to in footnote 46
above. It was proposed, for example, that the discount rate should be linked
to the Federal funds rate but that the spread should increase with both the
size and duration of an individual bank's borrowing from the Federal Reserve.
Another plan called for a given bank to pay a borrowing rate which is fixed
in relation to its return per dollar of loans and investments, on the grounds
that since the most efficient bankers constitute the hard core of borrowers,
a single penalty discount rate for the system as a whole might have perverse
affects by penalizing least those that tend to borrow the most. For an
excellent summary of the dialogue and proposals at the May, 1966 seminar on
discounting, see: Priscilla Ormsby, "Summary of Issues Raised at the Academic
Seminar on Discounting," May 11, 1966.

- 33 -

Discretionary Approach
As an alternative to his proposal for abolishing discounting, Kareken
suggests that the discretionary features of discounting be strengthened.


In his view, there is no basis for thinking that non-price rationing is in
principle any less effective than price rationing in curbing unwanted expan­
sions of Federal Reserve credit.

Indeed, the discretionary approach entails

the power not only to control total indebtedness, but also to selectively
control bank lending practices.
The selective control of bank lending is considered to be a means
of influencing two factors of "special significance" in the contemporary
inflationary process— namely, inventory speculation and money wage pressures.
To the extent that funds needed to finance an inventory buildup or an increase
in corporate transactions balances (in order to make larger wage payments)
must be limited by member banks that make use of the discount window, the
inventory and wage sources of inflationary pressure would be blunted.
Karaken notes that his plan would require the establishment of
appropriate non-price eligibility conditions such as a maximum figure for
the ratio of loans to total loans and investments.

In addition, and in marked

contrast to most of the proposed modifications in discounting, it would be
necessary to keep the discount rate below the penalty level.

"If banks are

to avail themselves of the System's discount facilities and thereby to submit
to the regulation of their activities it must in some sense be profitable for
them to do so."


Aschheim indicates general disapproval of this scheme by

asking the obvious:

53. "Federal Reserve System Discount Policy:
pp. 119 -120 .

Ibid., p. 121.

An Appraisal," op. cit. ,

- 3^ "If the purpose is selective lending control, why confine it
to those banks that choose to subject themselves to it? If
many banks choose to shun the discount window to avoid centralbank regulation of their lending practices, how far down shall
the discount rate go or how watered down shall the selective
lending control be in the effort to lure more banks to the dis­
count window?"55

Tobin's Proposals
Professor Tobin advocates a radical departure from the current dis­
counting arrangement- which would make the discount rate "the most powerful
tool in the central bankers' kit."


He makes two basic proposals:


The Federal Reserve Banks should pay interest at the
discount rate on member bank reserve balances in
excess of requirements;

(2 )

Banks should be released from the prohibition of
interest payments on demand deposits and from the
ceilings on interest rates on time and savings

According to Tobin, the purpose of the first proposal is to tighten
the control of the Federal Reserve over the opportunity cost of bank lending.
By raising the discount rate, the Federal Reserve would "clearly, directly,
and quickly" make lending less attractive to all banks, regardless of whether
they are in debt to the Federal Reserve or not.

The discount rate would

become a floor to the rate on Treasury bills and similar short-term paper
that banks might hold as secondary reserves.


Techniques of Monetary Control, op. cit., pp. 96-97.

56 . James Tobin, "Towards Improving the Efficiency of the Monetary
Mechanism," Review of Economics and Statistics, XLII (August, i960), p. 2f9.

Ibid., pp. 277-278.

- 35 -

The purpose of the second proposal is to tighten the Federal Reservefs
control over the opportunity cost that bank depositors charge against any
alternative investment of funds.

,The rate that banks pay depositors will

be closely geared to the discount rate since a bank will always be able to
earn a fraction of the discount rate (one minus the required reserve ratio) on

a new deposit.""

Among the advantages claimed by Tobin for the second pro­

posal, are the elimination of the "unproductive efforts" devoted to economizing
cash in periods of high interest rates, and the replacement of the existing
"wasteful and imperfect" non-price competition with price competition.


to pay depositors interest than to seek their patronage by organ music, free
silverware, and plush

s u r r o u n d i n g s . "59

Another important feature of Tobin's plan is that the Federal Reserve
would make a perfect Federal funds market at the discount rate.

Among the

implications forseen by Tobin for his proposals are that much of the short-term
Government debt would be transferred to the Federal Reserve from banks and
corporations, leaving them to hold excess reserves and bank deposits, respectively.
Also, Tobin suspects that monetary control under his system may require much
wider fluctuations in discount rates and connected short-term interest rates
"than we have yet had the courage to try."


By way of criticism of the Tobin scheme, Ahearn points out that the
potential for inflationary enlargement of the reserve base would be enormous;


Ibid., p. 278




Ibid., p. 279.




yet the only administrative defense against member bank borrowing would be
the power to raise the discount rate.


The problem would be compounded by

the difficulties in carrying out offsetting open-market operations under
conditions of dried up public short-term Government security holdings.



Federal Reserve Policy Reappraised, 1951-1959, op. cit., p. 133-

62. This point is made by Jonathan Levin in "Professor Tobin on the
Monetary Mechanism," internal Federal Reserve Bank of New York memorandum,
September 8, i960, p. 5 .

Ahearn, Daniel S., Federal Reserve Policy Reappraised, 1951-1959 (New York:
Columbia University Press, 1963).
Alhadeff, David A., "Monetary Policy and the Treasury Bill Market," American
Economic Review, XLII (June, 1952), pp. 326-346.
Aschheim, Joseph, Techniques of Monetary Control (Baltimore:
Press, l96l).

Johns Hopkins

Board of Governors of the Federal Reserve System, Annual Report, 1952, 1953>
, "Excess Profits Taxes of Commercial Banks," Federal Reserve Bullein,
XXXVII (June, 1952), pp. 602-619.
_____, "Interest Rates and Monetary Policy," by Stephen H. Axilrod and Ralph
A. Young, Federal Reserve Bulletin, XLVIII (September, 1962 ), pp. IIIO-II37 .
_____, "Regulation A— Effective February 15, 1955," Federal Reserve Bulletin,
XLI (January, 1955), pp. 9-l4.
_____, and the United States Treasury, The Federal Reserve and the Treasury:
Answers to Questions from the Commission on Money and Credit (Englewood
Cliffs, N. J.: Prentice-Hall Inc., 1963).
Burgess, W. Randolph, The Reserve Banks and the Money Market, rev. ed. (New
York: Harper and Brothers, 1936).
Carr, Hobart C., "Federal Funds," in Money Market Essays (New York:
Reserve Bank of New York, 1952), pp. 13-l6.


Culbertson, John M., "Timing Changes in Monetary Policy," Journal of Finance,
XIV (May, 1959), pp. 145-160.
Currie, Lauchlin, The Supply and Control of Money in the United States, rev. ed.
(Cambridge: Harvard University Press, 1935).
de Leeuw, Frank, "A Model of Financial Behavior," in The Brookings Quarterly
Econometric Model of the United States, (eds.), James S. Duesenberry; Gary
Fromm; Lawrence R. Klein; and Edwin Kuh (Chicago: Rand, McNally and Com­
pany, 1965), PP. 465-530.
Deming, Frederick W., A Theoretical and Empirical Examination of a Commercial
Bank's Decision to Borrow from the Federal Reserve, unpublished Ph. D.
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