Question

Utilizing the market for reserves and assuming that initially the federal funds rate is 0.5 percentage point below the discount rate but 0.5 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 0.3 percent

b. Show what would happen to the federal funds rate if the FED increased the interest rate paid on reserves by 0.75 percent

Answer 1

When the Fed reduces the discount rate, surplus reserves of commercial banks in the entire economy will be increased and money supplies expanded. In the other hand, as the Fed increases the discount rate, surplus funds in business banks will decrease and the volume of capital will be contracted.

a. The discount rate reflects the cost to the banks of borrowing FED capital. If the FED reduced the rate of discount by 0.3%, the banks 'borrowing from the Federal Reserve would be less costly. As a consequence, they will charge less interest on customers 'own loans. This expansionary FED decision on monetary policy would thus have a wavering impact on the economy's demand for loanable funds. Cheaper credit access would enable companies to invest, households to invest and consume and thus improve production and consumption.

b. Raises are made to save money as the FED raises the interest rate charged on reserves by 0.75%. As the future demand is compared to the present demand, savings in the current economy will, however, be decreased somewhat. FED may have wanted to drain excess liquidity from the economy because the higher rate of interest would allow people to park their assets with banks or other financial institutions. Federal funds can be reduced to allow investors to receive credit and canalis the saving into productive investment in the economy in order to ensure that saving results are translated into more funds available to investors.