Question

Why is it that a decrease in the discount rate does not normally lead to an increase in borrowed reserves (discount loans)? Use the supply and demand analysis of the market for reserves to explain.

Answer 1

With a decrease in discount rates, there will be typically a higher demand for more money and more borrowing. This will lead to a rise in the money supply. With the rise in the money supply, liquidity will increase. As a result the interest rates will fall.

So even though the banks can borrow at a lower rate from the Fed, they are giving out the money as loans at a lower rate than normal. So the difference between the interest rate and the discount rate is used by the banks to make their earnings. Since this difference remains constant (as both the interest rate and the discount rate falls), so the banks have no additional incentive to borrow more money. Thus borrowed reserves do not necessarily increase with a decrease in the discount rate,

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