Monetary Policy Instrument #2: the federal funds rate (and the discount rate)

Monetary Policy Instrument #2: the discount rate and the federal funds rate

The discount rate is the interest rate charged by the Fed on loans to commercial banks. These loans are called discount loans. The federal funds rate is the interest rate charged on loans from commercial banks to other commercial banks. The federal funds rate is one half of a percentage point less than the discount rate.

Lowering the discount and federal funds rates increases the money supply (expansionary monetary policy).
· If the Fed decreases the discount and federal funds rates, banks will be more willing to risk putting themselves in a position where they would need to borrow from the Fed to meet the required reserve ratio.
· Consequently, banks will keep fewer excess reserves and loan out more money than they would if the discount rate were higher.
· More loans mean the money supply is larger.
· A larger money supply means interest rates decrease.
· Lower interest rates encourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Increased investment (I) & consumption spending (C) mean increased aggregate demand. (AD = C + I + G + X - M)
Raising the discount and federal funds rates reduces the money supply (contractionary monetary policy).
· If the Fed increases the discount and federal funds rates, banks will be reluctant to risk putting themselves in a position where they would need to borrow from the Fed to meet the required reserve ratio.
· Consequently, banks will keep more excess reserves and not loan out as much as they would if the discount rate were lower.
· Fewer loans mean the money supply is smaller.
· A smaller money supply means interest rates increase.
· Higher interest rates discourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Reduced investment (I) & consumption spending (C) mean reduced aggregate demand. (AD = C + I + G + X - M)