Question

1. Explain how the Fed decrease interest rates.

2. Describe the function of the “lender of the last resort” of the Fed. What’s the purpose of it?

Answer 1

1)The Federal reserve is the central banking system in United States .The Federal reserve raises or lowers the interest rates through its monetary policy arm Federal Open Market Committee .Open market operations(incentive provided to banks) are controlled by Federal open market Committee(FOMC). After a review of the available economic data the FOMC sets the target Fed Funds rate.Fed funds rate is the rate at which banks banks lend federal reserve funds to each other .The federal reserve often provide several incentives to the banks to meet the set target rate.Open Market operations is one such incentive.

If the federal reserve wants to lower the interest rates it replaces the securities in banks reserve and replaces them with credit.As a result of this the bank will have more than enough reserves to meet it's requirement.In an attempt to lend extra reserves to other banks the bank lowers its fed fund rate.This is how the Fed gets banks to lower the interest rates.

2)Lender of the last resort

Lender of last resort refers to an institution often the central bank in a respective country which can be approached by eligible banks and other financial institutions experiencing financial difficulty or are on the verge of collapse.In the US Federal Reserve serves as the Lender of Last resort.This particular function of the fed reserve serves the purpose of protecting the customer deposits in bank's that are on the verge of financial collapse.During financial crises customers of a bank may resort to panic withdrawing of their deposits(termed as bank run) .Such bank runs affect the liquidity of banks and have also resulted in the collapse of certain banks in the past .The Lender of last resort function of the federal reserve allows the fed reserve to injects funds into such banks thereby the banks can maintain their liquidity and prevent insolvency.