Question

The cost to a member bank of borrowing from the Federal Reserve is measured by the a. reserve requirement. b. price of securities in the open market. c. discount rate. d. yield on government bonds.

Short answer

The cost to a member bank of borrowing from the Federal Reserve is measured by the discount rate. This is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's discount window. Hence, the correct answer is c. Discount rate.

Step-by-step solution

Identify the Correct Term

Among the four given options, the correct term that measures the cost to a member bank of borrowing from the Federal Reserve is the discount rate. Typically, when member banks can't meet their reserve requirement or are short on reserves, they can borrow from the Federal Reserve's discount window. The interest rate charged for these loans is the discount rate. Therefore, it is the discount rate that directly measures the cost of borrowing for member banks. The higher the discount rate, the higher is the cost of borrowing for banks and vice-versa. In other words, the discount rate is a key policy tool used by the Federal Reserve to influence the cost of borrowing and thus influence the levels of economic activity. So, the correct answer is c. Discount rate.

Key concepts

Federal Reserve Borrowing

Understanding the Federal Reserve borrowing process is crucial for economics students, as it plays a significant role in shaping monetary policy and financial stability in the United States. When it comes to Federal Reserve borrowing, 'the discount rate' is the term that steals the spotlight.

The Federal Reserve, also known as the Fed, provides short-term loans to financial institutions through what is known as the discount window. To borrow from the discount window, member banks must pay interest on these loans, and this interest rate is referred to as the discount rate.

An increase in the discount rate makes borrowing more expensive for banks, which can lead to higher interest rates for loans and credit extended to businesses and consumers. Conversely, a lower discount rate can encourage borrowing and lead to lower interest rates, thus promoting more economic activity. In short, the discount rate is a tool that the Fed uses to help regulate the economy's money supply, and indirectly, economic activities.

Reserve Requirement

The reserve requirement is another concept that plays a pivotal role in ensuring the stability of the banking system and influencing the country's monetary policy. It refers to the minimum fraction of deposits that each bank must hold in reserve, either in their vaults or at the Federal Reserve.

Banks can typically meet these reserve requirements through their regular operations. However, there are times when they fall short due to various reasons such as an unexpected withdrawal surge or other financial commitments. In such situations, banks may need to borrow funds to meet their reserve requirement, which triggers interactions with the discount window and the associated discount rate.

The reserve requirement is determined by the Fed and can be adjusted as part of the monetary policy to control the amount of funds in the banking system. Lowering the reserve requirement frees up funds for banks to loan out, potentially boosting economic growth, while increasing the requirement can help cool down an overheated economy.

Economic Activity

Economic activity encompasses all the actions that relate to the production, distribution, and consumption of goods and services within an economy. It is the heart of any country's prosperity and reflects the overall health of its economy.

Several factors can influence economic activity, and among those are the policies set by the Federal Reserve, including the discount rate and reserve requirements. By manipulating these levers, the Fed can either stimulate or slow down economic activity depending on the current economic climate.

For instance, during periods of sluggish economic performance, the Federal Reserve might lower the discount rate, making it cheaper for banks to borrow money. This action would typically lead to banks reducing their own interest rates for loans, thereby encouraging individuals and businesses to borrow, invest, and spend more, thus invigorating economic activity. On the other hand, to combat inflation, the Fed can do the opposite by increasing rates, making borrowing more expensive and thus slowing down the economy.