Question

4. Graphically explain how the discount rate and the interest on reserve together limit the fluctuation of the Federal Funs rate.

Answer 1

Fed Funds rate is the interest rate at which depository institution (banks and credit credit unions) lend reserve balances to other depository institutions (DI) overnight on an uncollateralized basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. These reserve balances are kept to meet the required reserve ration decided by fed.

Fed funds rate is decided by Fed Open Market Committee and the transactions for funds for overnight basis happens between various DI at Fed funds effective rate (FEER). This rate is maket determined rate and to avoid fluctuations Fed uses discount window and interest on reserve as its tool.

Discount Window : At this rate funds will be provided by Fed directly to banks and this rate is generally higher than fed funds rate. Therefore if one DI is not able to get funds in the market due to higher FEER, it can go to Fed and borrow at discount window rate. As this can be seen in the graph below, discount window effectively keeps a cap over FEER and therefore reduces fluctuations.

Interest on reserve (IOR) : This is the rate of interest which Fed pay to DI for keeping funds with it. The other component of IOR is Interest on Excess Reserves (IOER), which is the interest paid on those balances that are above the level of reserves the DI is required to hold. Paying IOER reduces the incentive for DIs to lend at rates much below IOER, providing the Federal Reserve additional control over the FFER. As this can be seen in the graph, Discount window keeps a check on the lower bound of Fed funds rate, as DI's does not have to lend at FEER (in case if drops) and they can go to Fed for lending excess reserves.

These tools both have the ability to reduce volatility in Fed funds rate thereby keeping this in control of Fed.

This relationship is presented below in diagram where Discount window is acting as cap and IOR is acting as support.

Please Like and Support!!.

Thanks!!