2. Since Summer 2007 when the current great recession started, the Fed has lower
ID: 1098149 • Letter: 2
Question
2. Since Summer 2007 when the current great recession started, the Fed has lowered the discount rate from 6.25 percent to 0.75 percent. During the same period, the Fed also lowered the federal funds rate target to 0.15 percent from a high of 5.30 percent. Following the week of August 15, 2011, when the stock markets around the world declined significantly, the Fed announced that it will keep interest rates at low level until 2014. Indeed, as of August 23, 2013, the discount rate is still 0.75 percent, while the targeted federal funds rate is between 0.0 and 0.25 percent. Mr. Bernanke also added that his policy will calm markets as it removes uncertainties about monetary policy in order to maintain
Explanation / Answer
a) The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility--the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.
Under the primary credit program, loans are extended for a very short term (usually overnight) to depository institutions in generally sound financial condition. Depository institutions that are not eligible for primary credit may apply for secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties. Seasonal credit is extended to relatively small depository institutions that have recurring intra-year fluctuations in funding needs, such as banks in agricultural or seasonal resort communities.
The discount rate charged for primary credit (the primary credit rate) is set above the usual level of short-term market interest rates. (Because primary credit is the Federal Reserve's main discount window program, the Federal Reserve at times uses the term "discount rate" to mean the primary credit rate.) The discount rate on secondary credit is above the rate on primary credit. The discount rate for seasonal credit is an average of selected market rates. Discount rates are established by each Reserve Bank's board of directors, subject to the review and determination of the Board of Governors of the Federal Reserve System. The discount rates for the three lending programs are the same across all Reserve Banks except on days around a change in the rate.
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b) Fed funds are the loans that banks make to each other to meet the reserve requirement set by the Federal Reserve. These loans are usually overnight, since the reserve requirement needs to be met at the end of each day.
Banks that have reserves in excess of the requirement loan them to banks that are short. The loan is then placed in a Federal Reserve Bank to meet the reserve requirement. The interest rate on the loan is usually pretty close to the target set by the FOMC at its monthly meeting. This is known as the Fed funds rate.
The reserve requirement is set by the Federal Reserve to control the amount of money available to lend, also known as liquidity. This is to keep banks from lending out all their money, which they would like to do. The Fed requires that a certain percentage of the bank's deposits be reserved, or set aside, each night each night. The banks can meet the requirement with cash held in their vaults, or with deposits at their local Federal Reserve bank.
The Fed funds rate target is the interest charged for Fed funds loans. Both the Fed funds rate and the reserve requirement are methods of implementing monetary policy. If the Fed funds rate and reserve requirements are high, this is known as contractionary monetary policy, which decreases liquidity and prevents inflation.
At the directive of the FOMC, the trading desk at the New York Fed ("the Desk") adjusts the level of reserve balances in the banking system through open market operations. In fact, the directive for implementation of U.S. monetary policy from the FOMC to the New York Fed states that theDesk should "create conditions in reserve markets" that will encourage fed funds to trade at a particular level. In formulating monetary policy, the FOMC sets a target level or range for the fed funds rate appropriate for the desired level of monetary policy accommodation. When rates approach zero, the FOMC may utilize other indicators of the stance of monetary policy in addition to the fed funds target. It is important to remember that actual fed funds rates are determined by market participants, based on market conditions.
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d)
Mr. Bernanke inflation is controllable
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