The January 22, 2008 press release of the FOMC (http://www.federalreserve.gov/ne

Question

The January 22, 2008 press release of the FOMC (http://www.federalreserve.gov/newsevents/press/monetary/20080122b.htm) states that the FOMC “decided to lower its target for the federal funds rate by 75 basis points to 312 percent.” The press release goes on to say that “In a related action the Board of Governors approved a 75- basis point decrease in the discount rate to 4 percent.”

(a) Use a supply-and-demand graph of the federal funds market to show the equilibrium federal funds rate and the discount rate before the policy action of January 22, 2008, when the federal funds rate was 414 percent and the discount rate was 434 percent.

(b) Use your graph to show how the Fed would lower the federal funds rate by 75 basis points (34 percent). Show in your graph the 75-basis point decrease in the discount rate. What policy action would the Fed use to lower the federal funds rate by 75 basis points?

Explanation / Answer

Ans.Federal fund rate can be determined by the intersection point between demand and supply curve of the Fed market as follows:
Quantity of demand: is the total reserve on the basis of the price that is the federal funds rate – interest rate in the federal funds market.
Reserves = required reserves + excess reserves
Where excess reserves are insurance against deposit outflows and the cost of holding these is the interest rate that could have been earned. Therefore if federal funds rate decreases then the opportunity cost of holding excess reserves falls and quantity of reserves demanded rises, therefore we have a downward sloping demand curve.
When the federal funds rate is above the rate paid on excess reserves, , as the federal funds rate decreases, excess reserves, , as the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises thenthe downward sloping demand curve that becomes flat (infinitely elastic) at (infinitely elastic).
Quantity of supply:
Quantity of supply = non-borrowed + borrowed reserves
On the basis of the price that is the federal funds rate and the cost of borrowing from the Fed is the discount rate, and borrowing from the Fed is a substitute for borrowing from other banks (in federal funds market)
If iff < id, then banks will not borrow from the Fed and borrowed reserves are zero then the supply curve will be vertical.
As iff rises above id, banks will borrow more and more at id, and re-lend at iff then the supply curve is horizontal (perfectly elastic) at id
Therefore at the equilibrium quantity of reserves and federal funds rate occurs at the intersection of the demand curve and supply curve.

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