Question

Explain/Discuss the following concepts:

- The discount rate and the federal funds rate

Answer 1

Discount Rates

The “discount rate” or “primary credit rate” is the interest rate the Federal Reserve sets and offers to member banks and thrifts that need to borrow money in order to prevent their reserves from dipping below the legally required minimum.This situation can arise if a bank lends too much and/or has too many withdrawals on a given day. Money is borrowed overnight via the “discount window.”As a rule of thumb, the higher the discount rate, the higher mortgage interest rates will be. The two tend to correlate over time, though not as strongly as the 10-year bond yield due to its longer maturity.When the discount rate goes up, the prime rate goes up as well, which can slow the demand for new loans and cool the housing market.

Fedral fund rate

The “federal funds rate” is the interest rate banks charge one another for overnight use of excess reserves. Put simply, banks can avoid borrowing directly from the Federal Reserve (via the discount window) by borrowing from one another instead.The Federal Reserve doesn’t actually set the federal funds rate, but rather sets a “target rate” and works to keep it in a given range by buying or selling government bonds.The Fed uses the federal funds rate to control the supply of available funds, essentially controlling inflation. If the federal funds rate is low, banks will be keen to borrow from one another, using the reserves to grant more loans, which in turn feeds the economy.If the Fed feels the need to slow things down, they will simply raise the target for the federal funds rate, which will curtail borrowing among banks and reduce the amount of new loans issued to businesses and consumers.