Question

The Fed can change the discount rate directly and the federal funds rate indirectly. Explain.

Short answer

The Federal Reserve alters the discount rate by setting it directly, thereby changing the cost of borrowing for commercial banks. On the other hand, the federal funds rate is controlled indirectly through open market operations. Buying of government securities increases the money supply and reduces the federal funds rate due to a surplus of money, whereas selling securities reduces the money supply, increasing the federal funds rate.

Step-by-step solution

Understanding of the Discount rate

The discount rate is the interest rate that the Federal Reserve charges commercial banks for loans. The Federal Reserve can directly change this rate. When the Federal Reserve wants to promote lending, it lowers the discount rate. This makes borrowing cheaper for commercial banks, who then lowers the rates they offer to their customers, hence encouraging borrowing. If the Federal Reserve wants to limit lending and decrease the money supply, it increases the discount rate, consequently making loans more expensive for commercial banks.

Understanding of the Federal Funds Rate

The federal funds rate, on the other hand, is the interest rate that banks charge each other for overnight loans. Although the Federal Reserve does not directly set this rate, it’s influenced by the Federal Reserve through open market operations.

Influence on the Federal Funds Rate

Open market operations refer to the buying and selling of government securities by the Federal Reserve. When the Federal Reserve buys securities, it injects money into the banking system, increasing the amount of funds banks have available to lend. Consequently, this drives the federal funds rate down as there is now a surplus of money. Conversely, if the Federal Reserve sells securities, it pulls money out of the banking system, reducing the amount of money banks have to lend, which subsequently pushes the federal funds rate up. In this way, the Federal Reserve indirectly adjusts the federal funds rate.