(3) On March 15, 2020, the Federal Reserve lowered its target for the federal funds rate...

(3) On March 15, 2020, the Federal Reserve lowered its target for the federal funds rate to a range of 0% to 0.25%. Please answer the following questions:

(a) What is the difference between the federal funds rate and the discount rate? Which does the Federal Reserve actually control?

(b) Why does a lower federal funds rate incentivize lending and why might that be a goal that the Federal Reserve currently has?

Solutions

Expert Solution

a) The Fed funds rate is the rate of interest which banks pay when they borrow from one another (banks and depository institutions). The discount rate is the interest rate which the banks pay when it borrows funds from the Federal Reserve. The Fed directly controls the discount rate by changing it according to the state of the economy. On the other hand, Fed has a target for Fed funds rate and uses open market operations to hit the target.

b) A lower fed funds rate means that there is monetary easing. Since banks' costs have declined, they are incentivized to reduce the cost for the borrowers by reducing the interest rates on its credit to the borrowers. This leads to an increase in aggregate demand and output and inflation. Lower fed funds rate is a goal right now because the US (and the world) is fighting one of the most important economic downturns in recent history created by COVID-19 pandemic. The income levels of people have fallen and unemployment has risen sharply. There is a big negative supply and consequent demand shock. Lower interest rates help ease some of the liquidity constarints from borrowers and pumo demand.

Rahul Sunny answered 1 month ago

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