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The discount window is an instrument of monetary policy (usually controlled by central banks) that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions.
The Federal Reserve and other central banks maintain discount windows, referring to the loans they make at an administered discount rate to commercial banks and other deposit-taking firms. Discount window borrowing tends to be short-termusually overnightand collateralized.
By law, depository institutions that maintain reservable transaction accounts or nonpersonal time deposits (as defined in Regulation D) may establish borrowing privileges at the Discount Window. Eligibility to borrow is not dependent on or related to the use of Federal Reserve priced services.
Banks borrow at the discount window when they are experiencing short-term liquidity shortfalls and need a quick cash infusion. Banks generally prefer to borrow from other banks, since the rate is cheaper and the loans do not require collateral.
By law, depository institutions that maintain reservable transaction accounts or nonpersonal time deposits (as defined in the Boards Regulation D) may establish borrowing privileges at the Discount Window. Eligibility to borrow is not dependent on or related to the use of Federal Reserve priced services.
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In the model, when a bank has access to the interbank market, discount window loans are never used to respond to shocks because their penalty rate makes them more costly. In other words, banks use the discount window only if they can no longer access the interbank market after a liquidity shock occurs.
By providing ready access to funding, the discount window helps depository institutions manage their liquidity risks efficiently and avoid actions that have negative consequences for their customers, such as withdrawing credit during times of market stress.
Because the discount window attracts inferior risks (which is the source of stigma), it helps to mitigate the adverse selection problem in the market for private credit. As a result, interest rates can decrease and more of the low-risk firms are able (and willing) to receive external funding and invest.

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