One way this is accomplished is through the discount mechanism, by which the Fed lends reserves, temporarily, to the banks. The Fed charges an interest rate, called the discount rate, on such loans. In other words, banks faced with reserve deficits can temporarily borrow reserves from their regional Federal Reserve bank at a price (the discount rate).
Say that a bank in Cucamonga, California, has a reserve deficiency of $1,000 (it needs $1,000 more reserves than it has). Rather than take the drastic step of calling in loans, and preferring not to sell securities, it can borrow the reserves it needs from the Federal Reserve Bank of San Francisco at the prevailing discount rate.
When a manufacturer borrows from a bank, the manufacturer receives a brand-new deposit at the bank. A bank is in the same position relative to the Federal Reserve: When it borrows from its friendly neighborhood Federal Reserve bank, it receives a brand-new deposit at the Fed which increases its legal reserves. The ability to borrow these reserves-to discount from the Fed- means that when it is faced with a reserve deficiency the Cucamonga bank does not have to call in loans or sell securities, and thus the money supply can remain unchanged.
The Federal Reserve tries to influence the willingness of banks to borrow reserves by changing the interest rate it charges on such loans (the discount rate). A lower discount rate will make the borrowing of reserves more attractive to banks, and a higher discount rate will make it less attractive.
The effectiveness of the discount mechanism as a means of injecting or withdrawing reserves is limited by the fact that the initiative for borrowing from the Fed rests not with the Fed but with the banks. Banks will want to borrow reserves only when they need them. If they already have ample reserves, there is no reason for them to borrow more, no matter how low the discount rate.
The Banking Act of 1980 expanded access to borrowing from the Federal Reserve to all depository institutions that have to hold reserves-which means nonmember as well as member commercial banks and also thrift institutions. Previously, only member banks had access to discounting-the discount window-although in emergencies others could sometimes use it, too. Now, however, nonmember banks and thrift institutions have the same access to borrowing from the Federal Reserve that member banks have, and on exactly the same terms.
It has been recognized for a long time that discount policy has two dimensions: The first is price, the discount rate, the rate of interest the Federal Reserve charges financial institutions when they borrow from the Fed. The second dimension has to do with the quantity of Federal Reserve lending, including Federal Reserve surveillance over the amount that each institution borrows and the reasons why it borrows. Let us examine quantity first and price second.
Historically, the primary function of a central bank has been to stand ready to supply funds-promptly and in abundance-whenever the economy is in danger of coming apart at the seams because of a shortage of cash. While that is no longer its sole function, it is still one of its most important. The central bank is the ultimate source of liquidity in the economy, because with its power over bank reserves it can increase (or decrease) the ability of the banking system to create money. Since no one else can do the job, it is the central bank that must be responsible for supplying funds promptly on those rare but crucial occasions when liquidity shortages threaten economic stability: “financial panics,” the history books call them. Because of this responsibility, the central bank has traditionally been called the lender of last resort.
The discount facilities instituted by the passage of the Federal Reserve Act in 1913 were supposed to provide a vehicle through which the Federal Reserve could quickly inject funds precisely where needed in order to stop a panic from spreading. Banks threatened with cash drains could borrow what they needed from the Fed-the lender of last resort. Thus they could get more reserves without any other bank losing them and thereby prevent an infection from becoming a plague.
In the ordinary course of events, however, bank use of the discount facility is rather routine, not at all panic-oriented, with banks borrowing here and there to make short-run adjustments in their reserves with no fuss or bother. A bank may find itself with an unexpected reserve deficit, for example, and need to borrow a few million to tide itself over the weekend.
The Fed has always stressed that ordinary run-of-the-mill borrowing of this sort (as contrasted with crisis situations) should not be used too often to get banks out of reserve difficulties. Banks should run their affairs so they do not have to rely on the Fed to bail them out every few weeks. Or, as the Federal Reserve usually puts it, discounting is considered a privilege, not a right, and privileges should not be abused. Federal Reserve surveillance enforces the “privilege, not a right” concept by checking up on banks that borrow too much or too frequently. A bank is supposed to borrow only because of need, and not go out and make a profit on the deal.
In particular, the Fed is sensitive to the possibility that banks may borrow from it and then turn around and use the money to purchase higher-yielding securities. The Fed does not want a bank borrowing from it at a 6 percent discount rate and then using the funds to buy a short-term security yielding 8 percent. Nor does the Fed like it when a bank borrows from it too often, in effect using the discount facility as a more or less permanent source of funds.
One Fed method of preventing “abuse” of the discount facility is to tighten surveillance procedures: It checks up on why banks are borrowing and what they are doing with the money. Another way is simply to raise the price of borrowing-which brings us to the discount rate itself.