1. Define the Federal Funds Rate. Who sets the Federal Funds Rate? How does the Federal Funds Rate differ from the Discount Rate? Which is generally higher? Why do banks generally hesitate to borrow from the lowest possible rate?

The Federal Funds Rate is the interest rate banks charge each other for overnight loans of excess reserves. Banks with excess reserves can increase their bottom line by loaning them to banks that need reserves to meet their own reserve requirement. The fed funds rate is actually a market-determined rate, but one that is influenced by the Fed. When the Fed announces that they will increase the discount rate, they are signaling a tighter monetary policy. They back up the announcement by reducing reserves through open market operations, thus reducing the supply of reserves and increasing the fed funds rate. The federal funds rate differs from the discount rate in that the fed funds rate is set in the market and is the cost of one bank borrowing excess reserves from another. The discount rate, set by the Fed, is the cost of bank borrowing directly from the Fed. Even though the discount rate tends to run a bit lower than the fed funds rate, commercial banks prefer to borrow the overnight funds from each other to keep from signaling to the Fed that they cannot meet their reserve requirements.

2. Discuss the notion of a “supply shock” and its impact on prices.

A “supply shock” is an interruption in the supply of a commodity such as energy. In terms of an aggregate supply and aggregate demand analysis, the supply curve shifts to the left as a result of higher energy costs to producers and prices rise. When prices rise for this reason the associated inflation is termed “cost-push inflation.”

3. Use the notion of the business cycle to discuss economic activity in a recession.

The Open Market Committee (FMOC) is made up of the seven members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and four of the remaining presidents of the Federal Reserve Banks, rotating on a 1-year basis. The FMOC meets regularly to buy and sell government securities in the open market in order to maintain key interest rates. As this relates to the current article, the FOMC will insure that the Federal Funds Rate increase by selling securities. (Note that the seven members of the Board of Governors are appointed by the President for a term of 14 years.)

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