Question

Explain how the Fed uses open market operations and discount lending to affect the fed funds rate and reserves in the banking system?

Answer 1

By purchasing or selling securities in open market operation FED can opt for expansionary or contractionary monetary policy.The fed can buy securities from the the banks through open market operations to reduce liquidity in the system and this raises the interest rate in the economy as supply of funds reduces in the system. The OMO is a tool to reduce liquidity and supply of funds and hence raising the interest rates.
When Fed buys securities from the market the cash will be released into the economy this reduces the reserves in the banking systems and the fed funds rate decreases.When Fed sells security cash will be bought from the economy, the fed rate will increase and reserves in the banking system will increase.

When discount rate decreases by the fed then the fed rate decreases and decrease in reserve in bank system and when discount rate increase the bank reserves increases and fed funds rate increases. This is because discount rate affects the entire economy and bank rates also increase. This reduces liquidity in the system.