A decrease in the discount rate will:

Question

BlackTom AI · Accepted Answer

A lower discount rate lowers banks’ cost of borrowing from the Federal Reserve, which tends to push the federal funds rate down.

1. Relevant knowledge points and concepts
- Discount rate: the interest rate the Fed charges commercial banks for borrowing at the discount window.
- Federal funds rate: the overnight interbank lending rate that the Fed targets as its primary policy instrument.
- Reserve supply and demand: banks obtain reserves either from each other in the federal funds market or from the Fed; changes in relative costs shift borrowing behavior and the supply of reserves in the interbank market.
- Policy signaling: a change in the discount rate signals the Fed’s stance and affects expectations about the target federal funds rate.

2. Step-by-step reasoning
- Step 1: Lowering the discount rate makes direct borrowing from the Fed cheaper for banks.
- Step 2: Some banks that previously borrowed in the federal funds market at a higher rate will substitute toward borrowing from the Fed, reducing demand for funds in the federal funds market.
- Step 3: Additionally, increased discount-window borrowing increases the total reserves in the banking system, effectively shifting the supply of reserves rightward.
- Step 4: With lower demand for interbank funds and a larger supply of reserves, the equilibrium federal funds rate falls.

3. Intermediate logical steps (no numerical calculations needed)
- Before: r_ff (federal funds rate) > r_discount (previously), banks borrow in funds market.
- After discount cut: r_discount decreases → banks substitute toward Fed borrowing and reserves increase → supply ↑ and demand ↓ in funds market → r_ff decreases.

4. Why the correct answer is correct
Because a lower discount rate reduces banks’ marginal cost of obtaining reserves and increases reserve availability, market forces lower the equilibrium federal funds rate. The Fed also signals easier monetary policy, reinforcing downward pressure on the fed funds rate.

5. Why other options are incorrect
- b (eliminate borrowing from the Fed): incorrect — lowering the rate encourages, not eliminates, borrowing from the Fed.
- c (increase the federal funds rate): incorrect — cheaper Fed borrowing and greater reserves reduce, not raise, the fed funds rate.
- d (not affect the federal funds rate): incorrect — the discount rate influences reserve flows and expectations, so it typically affects the federal funds rate.

6. Conclusion
Therefore, a decrease in the discount rate will decrease the federal funds rate, matching answer a.

A decrease in the discount rate will:Single choice

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