Question

Suppose that the current i_ff is less than i_d but greater than i_or. If the Federal Reserve Bank raises the discount rate, then the equilibrium interest rate in the federal funds market will . . . (Please Explain Answer)

increase

decrease

not change

none of the above

Answer 1

Option 1

The discount rate is the interest rate charged by the Fed to lent money to other commercial banks. The federal funds rate is the inter bank rate which is used to borrow money from between commercial banks.

Commercial banks need to maintain certain money as reserves with Fed, and the remaining money can be used to lend to other banks at fed funds rate. So, when the discount rate is increased, commercial banks would borrow less money from fed hence the supply of currency reduces which increases the equilibrium interest rate in the fed funds market.