Question

4. Utilizing the market for reserves and assuming that initially the federal funds rate is 1 percentage point below the discount rate but 1 percentage point above the interest rate paid on reserves,

a. Show what would happen to the federal funds rate if the FED decreased the discount rate by 0.5 percent

b. Show what would happen to the federal funds rate if the FED increased the interest rate paid on reserves by 0.5 percent

Answer 1

(a) Discount rate represent the cost of borrowing money from FED for the banks. If the FED decreased the discount rate by 0.5 percent, it would be less expensive for banks to borrow money from the Federal Reserve. As a result, they can subsequently charge less interest on their own loans given to customers. This expansionary monetary policy decision by the FED thus will have a ripple effect on the demand for loanable funds in the economy. Cheaper access to credit will encourage businesses to invest, households to invest and consume, thus, the economy will get a push forward spurting both production and consumption

(b) If the FED increased the interest rate paid on reserves by 0.5 percent, there is an incentive to save more. Since savings represent a preference for future consumption over present consumption, the current consumption in the economy will lower a bit, however, savings will go up. The increase in interest rate by FED might have been decided to suck excess liquidity from the economy as higher interest rate would incentivize people to park their funds with banks or other financial institutions.  To ensure that more savings translate into more funds availale for investors, federal funds rate might go down to ensure that investors can raise loans and channleize those savings to productive activity in the economy.