Question

Suppose the amount of borrowed reserves rises suddenly from zero. With what tool of monetary policy could the federal reserve respond if it wants to keep the federal funds rate below the discount rate? Defend your reasoning?

Answer 1

The Fed has four tools to achieve the monetary policy goals: reserve requirements, discount rate, interest on reserves and open market operations. In my opinion when the amount of borrowed reserves suddenly increases from zero Fed should use it's tool of fixing the interest on reserves. Discount rate refers to the rate of interest that the Reserve Banks charge commercial banks for short-term loans. Lowering the discount rate will be expansionary and should be opted by Fedas it has influence on other rates of interest. The lower rates will encourage spending and lending by businesses and consumers. In a similar approach, an increase in the discount rate will be contractionary because the rate of discount has influence on the other interest rates. The higher rates will discourage spending and lending by businesses and consumers.