Question

Applying Economic Concepts In 2005 , the Fed set the discount rate for banks in good financial condition at 1 percent above the targeted FFR. a. Would these banks be more likely to borrow short-term funds from another bank or from the Fed? Why? b. How does this policy help keep the federal funds rate close to the target set by the Fed?

Short answer

a. Banks would borrow from another bank. b. This keeps the FFR close to the target.

Step-by-step solution

Understanding the Discount Rate

In 2005, the Federal Reserve (the Fed) set the discount rate at 1% above the targeted federal funds rate (FFR). The discount rate is the interest rate that banks are charged when they borrow short-term funds directly from the Fed.

Comparing Borrowing Options

When banks in good financial condition need short-term funds, they can either borrow from other banks in the federal funds market or borrow from the Fed at the discount rate. Since the discount rate is set higher than the targeted FFR (by 1%), borrowing between banks is typically cheaper.

Deciding Where to Borrow (Part a)

Given that the discount rate is 1% higher than the FFR, banks are more likely to borrow from another bank because it is less expensive compared to borrowing from the Fed.

Examining Impact on Federal Funds Rate (Part b)

The policy of setting the discount rate higher than the FFR encourages banks to lend to each other rather than relying on the Fed. This discouragement of borrowing from the Fed helps maintain the demand for funds in the interbank market and keeps the federal funds rate close to the target set by the Fed.

Key concepts

Discount Rate

The discount rate is a vital component of the Federal Reserve's toolkit. It is the interest rate that banks must pay when they borrow funds directly from the Federal Reserve's lending window. This rate acts as a baseline to guide other interest rates in the economy and is typically higher than the federal funds rate. In the example from 2005, the discount rate was set at 1% above the targeted federal funds rate, signaling a strategic move by the Federal Reserve to influence banks' borrowing behavior.
This higher rate encourages banks to seek cheaper borrowing options, typically from other banks, making it an effective tool in monetary policy to manage the economy's liquidity. By adjusting the discount rate, the Federal Reserve can influence the cost of borrowing money in the short term, impacting the overall economic activity.

Federal Funds Rate

The federal funds rate (FFR) is another cornerstone of monetary policy. It is the interest rate at which banks lend reserve balances to other banks overnight. Unlike the discount rate, the FFR is determined by the market but is influenced by the Federal Reserve through open market operations.
This rate is crucial because it affects the economy by influencing other interest rates, such as those for mortgages, loans, and savings. In 2005, the Fed's decision to set the discount rate higher than the FFR encouraged banks to prefer interbank loans over borrowing directly from the Fed. This approach maintains banks' liquidity without the need for significant intervention by the Federal Reserve, ensuring the FFR stays close to the Fed’s target, stabilizing the financial system.

Monetary Policy

Monetary policy refers to the actions taken by a central bank, like the Federal Reserve, to control money supply and achieve macroeconomic goals such as controlling inflation, managing employment levels, and maintaining financial market stability. Tools of monetary policy include interest rates, reserve requirements, and open market operations.
The relationship between the discount rate and the federal funds rate is a key element of monetary policy. By setting the discount rate above the federal funds rate, the Fed can steer banks towards borrowing from each other, ensuring that more lending occurs in the interbank market. This strategy helps manage liquidity, interest rates, and ultimately, economic health.

• Interest rates: Manipulating the cost of borrowing and lending.
• Reserve requirements: Dictating the amount of funds banks must hold in reserve.
• Open market operations: Buying and selling government securities to expand or contract the money supply.

Interbank Loans

Interbank loans are short-term loans made between banks, and they play a critical role in maintaining liquidity in the banking system. These loans allow banks with excess reserves to lend to those facing a shortfall, balancing their daily needs for reserves.
By encouraging banks to borrow from each other rather than directly from the Fed, as seen with the higher discount rate, these loans help maintain a stable and well-functioning financial system. This dynamic ensures that the federal funds market remains active and the federal funds rate stays in line with the central bank's targets, promoting price stability and consistent money flow in the economy.

• Encourages bank cooperation and sharing of resources.
• Promotes efficient allocation of reserves across the banking system.
• Supports the achievement of monetary policy objectives.