MONUMENTOS a GENERALIDADES

Since the early 1970s, the Federal Reserve has used several different procedures to control the growth rate of the money supply.6 _{In these procedures, there is an important distinction between borrowed reserves and} nonborrowed reserves. Borrowed reserves come from the discount window, while nonborrowed reserves are supplied by Fed open market operations. The Fed can directly control nonborrowed reserves, but the demand for borrowed reserves is related to the spread between the funds rate and the discount rate. During the 1970s, the Fed followed a policy of targeting the federal funds rate at a level it believed to be consistent with the level of money stock desired. It conducted open market operations in order to keep the funds rate within a narrow range, which in turn was selected to realize the money growth objective set by the Federal Open Market Committee. Under this practice of pegging the fed funds rate in the short run, changes in the discount rate affected only the spread between the two rates and therefore the division of total reserves between borrowed and nonborrowed reserves. For example, if the Fed raised the discount rate while the federal funds rate remained above the discount rate, borrowing reserves from the Fed would become relatively less attractive than going into the federal funds market. This would decrease the quantity demanded of borrowed

6 _{These procedures are described in more detail by Gilbert (1985) and Broaddus and Cook (1983) and are analyzed along with} other possible operating procedures in Goodfriend (1982).

reserves but would increase demand for their substitute, nonborrowed reserves, thereby tending to put upward pressure on the funds rate. Given the policy of pegging the funds rate, however, the Fed would increase the supply of nonborrowed reserves by purchasing securities through open market operations. The result would be the same federal funds rate and total reserves as before, but more nonborrowed relative to borrowed reserves.7

On October 6, 1979, the Federal Reserve moved from federal funds rate targeting to nonborrowed reserves targeting. Under the prevailing system of lagged reserve requirements, required reserves were taken as given since they were determined on the basis of bank deposits held two weeks earlier. Consequently, once the Fed decided on a target for nonborrowed reserves, a level of borrowed reserves was also implied. Again assuming discount rates below the federal funds rate, an increase in the discount rate would decrease the spread between the federal funds rate and the discount rate. Since this would decrease the incentive to borrow, demand would increase for nonborrowed reserves in the federal funds market. Under the new procedure the target for nonborrowed reserves was fixed, however, so the Fed would not inject new reserves into the market. Consequently, the demand shift would cause the funds rate to increase until the original spread between it and the discount rate returned. The upshot here is that, since discount rate changes generally affected the federal funds rate, the direct role of discount rate changes in the operating procedures increased after October 1979.

In October 1982, the Federal Reserve moved to a system of targeting borrowed reserves. Under this procedure the Federal Open Market Committee periodically specifies a desired degree of "reserve restraint." More restraint means a higher level of borrowing. Open market operations are conducted to provide the level of nonborrowed reserves consistent with the desired level of borrowed reserves and the demand for total reserves. A discount rate increase under this procedure initially shrinks the spread between the federal funds rate and discount rate, and shifts demand toward nonborrowed reserves. In order to preserve the targeted borrowing level, the funds rate changes by about the same amount as the discount rate so that the original spread is retained. As a result, discount rate changes under borrowed reserves targeting affect the funds rate the same as under nonborrowed reserves targeting.

In the late 1980s and early 1990s, the Federal Reserve partially reverted to the operating procedures it had used in the 1970s, as it began to place less weight on achieving a particular level of borrowed reserves and greater weight on keeping the funds rate in a fairly narrow range. In this period the link between the discount and funds rates weakened somewhat. At times, changes in the discount rate were

7 _{Although under this procedure discount rate changes did not directly affect the funds rate, some discount rate changes signaled} subsequent funds rate changes. See Cook and Hahn (1988).

followed by smaller changes in the funds rate, as some of the effect on the funds rate was offset by a change in the borrowed reserves target.

REFERENCES

Bagehot, Walter. Lombard Street: A Description of the Money Market. New York: E. P. Dutton and Company, 1921. Board of Governors of the Federal Reserve System. The Federal Reserve Discount Window. Washington: Board of

Governors, 1990.

Broaddus, Alfred, and Timothy Cook. "The Relationship between the Discount Rate and the Federal Funds Rate under the Federal Reserve's Post-October 6, 1979 Operating Procedure," Federal Reserve Bank of Richmond

Economic Review, vol. 69 (January/February 1983), pp. 12-15.

Cook, Timothy, and Thomas Hahn. "The Information Content of Discount Rate Announcements and Their Effect on Market Interest Rates," Journal of Money, Credit, and Banking, vol. 20 (May 1988), pp. 167-80.

Gilbert, R. Alton. "Operating Procedures for Conducting Monetary Policy," Federal Reserve Bank of St. Louis Review, vol. 67 (February 1985), pp. 13-21.

Goodfriend, Marvin. "A Model of Money Stock Determination with Loan Demand and a Banking System Balance Sheet Constraint," Federal Reserve Bank of Richmond Economic Review, vol. 68 (January/February 1982), pp. 3-16.

Gorton, Gary. "Private Clearinghouses and the Origins of Central Banking," Federal Reserve Bank of Philadelphia

Business Review, January/February 1984, pp. 3-12.

Humphrey, Thomas M. "The Real Bills Doctrine," Federal Reserve Bank of Richmond Economic Review, vol. 68 (September/October 1982), pp. 3-13, reprinted in Thomas M. Humphrey, Essays on Inflation, 5th ed. Richmond: Federal Reserve Bank of Richmond, 1986, pp. 80-90.

________, and Robert E. Keleher. "The Lender of Last Resort: A Historical Perspective," Cato Journal, vol. 4 (Spring/Summer 1984), pp. 275-318.

Peristiani, Stavros. "Permanent and Transient Influences on the Reluctance to Borrow at the Discount Window," Research Paper No. 9115, Federal Reserve Bank of New York, May 1991.

Thornton, Henry. An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. London: George Allen & Unwin, 1939, reprinted Fairfield, N.J.: August M. Kelley, 1978.

The information in this chapter was last updated in 1993. Since the money market evolves very rapidly, recent developments may have superseded some of the content of this chapter.

Federal Reserve Bank of Richmond Richmond, Virginia

1998

Chapter 4