Question

10. The discount rate and the federal funds rate The discount rate is the interest rate on loans that the Federal Reserve makes to banks. Banks occasionally borrow from the Federal Reserve when they find themselves short on reserves. A lower discount rate banks' incentives to borrow reserves from the Federal Reserve, thereby the quantity of reserves in the banking system and causing the money supply to ipply to . The federal funds rate is the interest rate that banks charge one another for short-term (typically overnight) loans. When the Federal Reserve uses open-market operations to sell government bonds, the quantity of reserves in the banking system , banks' need to borrow from each other , and the federal funds rate

Answer 1

A lower discount rate will increase bank's incentive to borrow from Fed as it is now less costly to borrow loans. Banks will borrow loans and thereby there will be increase in the quantity of reserves. This will increase the money supply. Explanation: A lower discount rate will provide more incentive to borrow from reserves which leads to increase in the quantity of reserves that helps in money creation and which further tends to increase in money supply. When Fed conducts open-market operations to sell government bonds, the quantity of reserves in the baking system decreases. Thus, banks' need to borrow from each other rises, and the federal funds rate increases. Explanation: When Fed sells the government bonds, then the reserves in the banks decline and money creation is decline. As there are low reserves, banks need to borrow from other banks which lead to increase in the funds rate.