Question

In the market for reserves, assume that banks just borrow from other banks, but not from the federal reserve system. What happens to the federal funds rate when discount rates are lowered? Is the Federal Reserve Bank able to control the federal funds rate here? Draw the graph and explain in simple terms.

Answer 1

The market for reserves shows the demand and supply for reserves, the intersection of which yields the equilibrium quantities of reserves, and the equilibrium interest rate. Now, as the banks only borrow from other banks, this interest rate is basically the fed funds rate.

The fed funds rate is that rate of interest which the banks need to pay when they borrow from one another.

The discount rate, on the other hand, is that interest rate that a bank needs to pay when they borrow money from the Federal Reserve.

So, when the discount rate is lowered, banks will prefer to borrow money from the Fed Reserve instead of borrowing from other banks. So, this will reduce the demand of reserves from the banks market. So, it will lead to a fall in the fed funds rate.

The Federal Funds rate can't be controlled directly and they cant mandate a specific fed funds rate. However, they can lower the fed funds rate by either reducing the discount rate, as they do here, or by implementing an expansionary monetary policy. The higher the money supply causes higher inflation, pushing down the feds fund rate.

Take a look at the adjoined fig.