All else constant, a rise in market interest rates leads to (less borrowing = b/

Question

All else constant, a rise in market interest rates leads to (less borrowing = b/c the cost to borrow is more?) Why is this questions answer A) a rise in discount borrowing and a rise in the money supply?

If it is going to cost more capital for people to borrow then why would banks borrow more (from the central bank). I would think that people don't want loans so there is no need for commercial banks and thrifts to borrow from the federal reserve when the demand for loans decreases.

I believe the answer should be a decrease in discount borrowing (b/c the market rates are going up -> discount rate goes up) then there is less borrowing from the commercial banks and people thus there is less supply of money.

Explanation / Answer

The answer will be a rise in discount borrowing and a rise in the money supply. This is so because

An interest rate is the cost of borrowing money. Among the many industries affected by fluctuations in interest rates, real estate and banking are perhaps the most directly impacted. When interest rates increase, borrowing becomes more expensive, dampening consumer demand for mortgages and other loan products and negatively affecting residential real estate prices. Rising interest rates can also lead to increased default rates, as holders of adjustable rate debt find themselves faced with higher payments. Vendors of mortgage backed securities, which consist of bundled mortgages, will see their ability to monetize the securities lessens as a result of the deterioration of the quality of the underlying asset.

At any given time, there are a number of interest rates available in the economy. Interest rates vary across the size, risk, duration, and liquidity of an investment. The interest rates for various durations of investments (short- to long-term) are called the Yield Curve.

Why Interest Rates Rise and Fall.

There are two main determinants of interest rates - the Supply and Demand for Money:

Changes in Money Demand alter the Interest Rate.

The opposite side of the Money Supply is Money Demand. Because money is perfectly liquid, it is easily converted into other goods. Thus, during certain situations, it is preferable to hold more dollars (instead of say stocks) since there is little risk of them falling in value and they are easily converted into other goods. In particular, the demand for money rises when: consumer spending rises, uncertainty rises, there are higher costs in buying and selling other assets, expectation of a future stronger dollar, increased demand for reserves from central banks (both foreign and domestic), and a rise in foreign demand for US goods and investments. Each of these aspects push up the demand for US dollars while the reverse decreases the demand for dollars. A rising demand for money, all else constant, will raise interest rates while the converse is also true. The opposite can also happen during times when the market becomes averse to riskier assets because investors will move into the dollar and U.S. debt in a search for safety. The demand for money, combined with the Supply of Money determine interest rates. This framework for understanding interest rates its known as the Liquidity Preference Framework, with the Liquidity Preference Curve being the Demand for Money curve. Since currency is the most liquid store of value, its demand demonstrates the demand, or preference, for liquidity.

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