Question

The Fed can change the discount rate directly and the federal funds rate indirectly. Explain.

What does it mean to say the Fed serves as the lender of last resort?

The Fed has announced a new, lower target for the federal funds rate; in other words the Fed wants to lower the federal funds rate from its present level. What does setting a lower target for the federal funds rate have to do with open market operations?

If reserves increase by $2 million and the required reserve ratio is 10 percent, what is the change in the money supply? Make sure and show your work and explain the process.

Define discount rate and federal funds rate.

Answer 1

1. The Fed can change the discount rate directly, since it is the rate that it uses to loan money to banks. The Fed controls the federal funds rate indirectly through open market operations.

2. In the United States, the Federal Reserve serves as the lender of last resort to those institutions that cannot obtain credit elsewhere and the collapse of which would have serious implications for the economy. The Federal Reserve has the authority and financial resources to act as ‘lender of last resort’ by extending credit to depository institutions or to other entities in unusual circumstances involving a national or regional emergency, where failure to obtain credit would have a severe adverse impact on the economy.

3. Setting a lower target for the federal funds rate means that the Fed will have to buy securities in an open market operation. This increases the supply of reserves in the banking system, causing the federal funds rate to fall (towards the lower target rate)

4. If reserve increase by $2 million and the required reserve ratio is 10 percent.

Multiplier = 1/0.10 = 10

If reserve increase by $2 million, the change in the money supply is $2 million* 10 = 20 million.

5. The federal funds rate is the interest rate that banks charge one another for borrowing funds. The Fed changes the federal funds rate by changing the amount of reserves in the banking system. More specifically, if the Fed wants to lower the federal funds rate they will need to exert downward pressure on this rate in the federal funds market. They can do this by conducting an open market purchase.

the discount rate is the interest rate that the Fed charges banks that borrow funds from them. The discount rate is the rate that the Fed can change by issuing an order.