Question

1. What are the assumptions behind the Pure (Unbiased) Expectations Theory and to what conclusion do those assumptions lead?

2. What is the difference (in words, not numbers) between the Federal Funds market and the market for Discount Window loans?

Answer 1

Ans1_Assumptions of the Unbiased Expectation theory:-
The pure expectations theory rests upon important assumptions about investors and markets.
-Investors are indifferent between owning a single long-term security or a series of short-term securities over the same period. Thus maturity alone does not affect investor’s choice of investments.
-All investors hold common expectations about the course of short-term rates.
-On average, investors are able to predict rates accurately. Their expectations aboutfuture rates are unbiased in the statistical sense - they are neither consistently low nor consistently high.
-There are no taxes, information costs, or transaction costs in the financial markets.Investors are free to exchange securities of varying maturities quickly and without penalty.

The main implication of the pure expectations theory from these assumptions is that; for a given holding period, the average expected annual yields on all combinations of maturities will be equal.

Ans 2_The Fed Funds Rate and the Discount Rate are both important monetary policy tools that the Fed can adjust to have an effect on the money supply. The difference is that the discount rate is the interest rate that a bank must pay when they borrow money from the Fed, while the Fed Funds Rate is the rate that banks must pay when they borrow from one another. The Fed directly decides what the Discount Rate is based on the current state of the economy. The Fed Funds Rate, on the other hand, is determined by the demand and supply of loanable funds on the open market. The Fed sets a target for the Fed Funds Rate and then will buy or sell Treasury bills in order to indirectly affect the rate until that target rate is reached.
Before open market operations (buying and selling Treasury bills to alter the Fed Funds Rate) the discount rate was the primary tool used to expand or contract the money supply. Nowadays the Fed primarily uses the Fed Funds Rate, and many businesses pay significant attention to what target the Fed announces. In addition, adjusting the Fed Funds Rate gives the Fed far more flexibility and power in its monetary policy than does the discount rate because the Fed can precisely control how much in T-bills to purchase, while the Fed cannot precisely control how much banks borrow from the Fed.