Question

1. I'm looking for some help explaining the following things, I appreciate any guidance:
   1. The relationship between the discount rate and Federal Funds rate and the interest rate on reserves.
   2. In respect to the above 3 rates, what condition has to exist for open market operations to have an affect on the federal funds rate?
   3. What condition has to exist for a change in the discount rate to have an affect on the federal funds rate?

Thanks!

Answer 1

A) When money is deposited in a bank, it overturns and lends to it. However, the Fed asks the bank to keep a certain percentage of these deposits as a reserve, in case the depositors want to withdraw from the bank. When a bank has excess reserves, they are called federal funds because they are deposited in regional banks of the Federal Reserve. Sometimes a bank wants to lend more money than it has, so it borrows it from a bank that has excess reserves. When a bank borrows money from another bank, the imputed rate is the Federal funds rate. while, sometimes, because of the unusually high demand for loans or a sudden demand for withdrawals, the amount of the reserve available to the bank is less than the required percentage. When this happens, the bank first tries to borrow from other banks, then borrow Eurodollars and then borrow using repurchase agreements (which are government-guaranteed loans) from federal bank. The rate that the Fed charges them is the discount rate.

The relationship between the three terms given is that the Federal Reserve influences the direction of interest rates in two ways:

1. By increasing or decreasing the discount rate.
2. By indirectly influencing the direction of the federal funds rate

B) In the United States, the federal funds rate is the interest rate at which banks borrow overnight to meet their reserve requirements. This is the rate of interest that the Federal Reserve targets when it manages OMOs. The short-term interest rates offered by banks are based on federal funds rates. The Fed can therefore indirectly affect the interest rates faced by consumers and businesses through the sale and purchase of securities.

The federal funds rate is determined by the supply of money, which is controlled by the Fed. The Fed seeks to establish macroeconomic stability through monetary policy.

C) The Fed can adjust the discount rate independently of the fed funds rate. The discount rate is generally higher than the federal funds rate. It is therefore used as a last resort by banks that need to borrow.