Question

Why a decrease in the discount rate does not normally lead to an increase in borrowed reserves and hence, a change in the federal funds rate? Use the supply and demand analysis of the market for reserves to explain.

Answer 1

Solution-

In most cases, the discount rate is set far enough above the fed funds target rate such that, evenif there was a reduction in the discount rate with no change in the target fed funds rate, theequilibrium rate would still be below the discount rate, thus banks would still be better offborrowing at the market rate rather than the discount rate. In other words, even if the discountrate decreases, the amount of borrowed reserves may not change since the equilibrium willstill fall below the discount rate, as shown in the graph below.