￼Matriculation Number 110004277
The Importance of The Discount Rate during Financial Crises and its Effectiveness in Targeting a Given Interbank Lending Rate
In this essay I will briefly describe supply and demand for reserves in the economy to provide some context to the discount window before discussing the implementation of the discount window during the financial crisis of 2007-8 and its overall importance making specific reference to the Federal Reserve and its effect on the interbank lending rate. Firstly, I will outline the market for reserves within the banking sector. Demand for reserves has a downward slope because as the federal funds rate, also known as the interbank overnight loan rate, falls, the opportunity cost of holding higher levels of excess reserves falls so demand for reserves subsequently rises. Supply however is of greater importance in terms of the interplay between discount rate and interbank rate, especially during a financial crisis. Supply is made up of two components; amount of reserves that are supplied by the fed’s open market operations, entitled non- borrowed reserves (NBRs) and borrowed reserves (BRs), direct borrowing from the fed, the cost of which is known as the discount rate. Because borrowing federal funds from other banks is a substitute for borrowing from the central banks (taking out discount loans), if the federal funds rate falls below the discount rate, then banks will not borrow from the fed and borrowed reserves will be zero. So as long as the interbank rate remains below discount rate, the supply will equal non- borrowed reserves so the supply curve will be vertical. The reserves market is where the interbank rate is determined through either discount loans or open market operations. I feel it is of great importance to emphasise the importance of the discount window and the reasons behind which it was brought into existence. It was initially expected to reduce bank panics by increasing availability of reserves...
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