Microsoft Word - Money, Banking, and Int Finance(scribd).docx

Money, Banking, and International Finance

Crisis, the Fed had granted up to $2 trillion in loans to prevent some of the largest banks and
financial companies in the United States from failing.

The Federal Funds Market

Figure 4. The Federal Reserve uses the discount rate to decrease money supply

Banks can abuse the discount window. For example, a bank could borrow funds from the
Fed at 2% and lend these funds out at 5%, earning 3% interest on the Fed loans. The Fed
counters this problem by investigating and auditing the bank more, ensuring the bank is
complying with regulations. Moreover, the Fed can impose fines or publicly criticize the bank.
A bank borrowing from the Fed indicates financial weakness. Finally, the Fed may stop lending
to the bank because borrowing from the Fed is a privilege and not a right! Many economists
argue the Fed should set the discount rate greater than a comparable short-term interest rate.
That way, borrowing from the Fed becomes a penalty because a bank borrows at a higher
interest rate than the market. The European Central Bank uses the penalty interest rate to prevent
its banks from abusing its loans.
The Fed implemented the Term Auction Facility (TAF) Program after the 2008 Financial
Crisis. Fed specifies the total amount of discount loans that it is willing to provide to the banks
while the banks competitively bid for these funds. Then the Fed uses the bidding process to set
the interest rate for loans.
Fed’s discount policy provides four benefits to the banking system. First, the Fed is the
“lender of the last resort.” If a bank has trouble with liquidity or needs reserves, and it cannot
borrow from other banks, subsequently, the Fed is the last place to go to ask for a loan. Second,
the Fed creates the announcement effect, when the discount rate unexpectedly changes. Rate
change provides information to the financial markets because the Fed conducts monetary policy
secretly. For example, the Fed raises the discount rate. Press, politicians, and financial analysts
think the Fed is tightening monetary policy, i.e. contracting the money supply. Third, the Fed
uses moral suasion, which means the Fed uses its power to persuade depository institutions to do