Question

Write a one-paragraph response. Discuss and distinguish between the federal funds rate and the discount rate. Assume that banks are hesitant to borrow from the Fed, which of these two rates would be higher?

Answer 1

In the US, commercial banks need to maintain some minimum balance as reserve requirements set by the Federal Reserve. This is done to ensure that banks have adequate funds to meet potential withdrawals. However, some banks fall short of their daily reserve requirement and to meet the shortfall the banks can either borrow from other commercial banks with surplus fund or from the Federal Reserve.

The rate at which a commercial bank borrows fund from other banks to meet its overnight funds requirement is called the federal funds rate. On the other hand, the rate at which a commercial bank borrows from the Federal Reserve to meet its overnight funds requirement is called the discount rate.

So, if banks are hesitant to borrow from the Federal Reserve then it means that the discount rate is higher than the federal funds rate.