Academic journal article Economic Inquiry

Discount Window Borrowing and Federal Reserve Operating Regimes

Academic journal article Economic Inquiry

Discount Window Borrowing and Federal Reserve Operating Regimes

Article excerpt

I. INTRODUCTION

The borrowing behavior of banks at the Federal Reserve's discount window is a component of most models of the monetary sector, including the model used by the Federal Reserve.(1) As several researchers have noted,(2) however, the policy importance of accurate predictions of borrowing behavior depends on the Federal Reserve's short-run operating procedure. If the Federal Reserve uses a Federal funds rate target to control money growth, as it did in the 1970s, inaccurate predictions of borrowing behavior have no effect on money supply growth. If the Federal Reserve uses a nonborrowed reserves target, as is usually assumed for the October 1979 to October 1982 period, or a borrowed reserves target, as was used after October 1982, then poor predictions of bank borrowing are a potentially significant source of errors in controlling money.(3) Given the importance of accurate borrowing predictions to monetary control under current short-run operating procedures, admissions by the Federal Reserve that its borrowing equation poorly explains recent borrowing behavior are cause for concern.(4)

Part of the problem may lie with inadequate allowance for differences in bank borrowing behavior under different operating procedures. The choice of operating procedure determines not only the importance of accurate borrowing predictions, but also affects borrowing behavior by affecting the stochastic process characterizing the spread between the Federal funds rate and the discount rate.(5) The standard model for aggregate borrowing, typified by Goldfeld and Kane |1966~, assumes a positive relationship between borrowing and the spread. The optimizing model of individual bank borrowing decisions of Goodfriend |1983~, used by Cosimano |1988~ and Dotsey |1989~, among others, suggests that borrowing also depends negatively on banks' expectations about future levels of the spread. Specifically, Goodfriend's model of risk-neutral banks predicts a larger impact on borrowing of a spread change that banks expect to be temporary than one that banks expect to be more persistent. To the extent that banks predict future spreads using an autoregressive model, changes in the stochastic process characterizing the spread should change the impact realizations of the spread have on borrowing.(6) Moreover, if banks are risk-averse, changes in the operating procedures that produce less predictable spreads may affect both banks' borrowing and excess reserve behavior.(7)

Because the spread's stochastic behavior depends on the Federal Reserve's operating procedure, borrowing behavior, in turn, should depend on the Federal Reserve's operating procedure. Consequently, the Federal Reserve should not assume that the borrowing equation in its model is invariant to changes in operating procedure. As Goodfriend notes, such an assumption is another example of the Lucas critique. Bryant |1983~ and Dutkowsky and Foote |1988~ show that borrowing equations estimated during the period when the Federal Reserve targeted the Federal funds rate produce poor forecasts of borrowing after the regime change of 6 October 1979. These papers do not, however, provide evidence on how the borrowing equation changed after October 1979. One purpose of this paper is to investigate whether bank borrowing behavior changed with changes in Federal Reserve operating procedures, leading to estimated borrowing equations that differ significantly under different operating procedures.

In addition to the changes in operating procedures, the Federal Reserve also changed the reserve accounting rules in February 1984, replacing lagged reserve accounting with contemporaneous reserve accounting. Although the effect of this switch on bank reserve management is difficult to predict, the increased uncertainty about reserve needs and the decrease in information about the aggregate demand for reserves make it plausible that banks became more conservative, affecting their excess reserve behavior and their discount window borrowing. …

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