Chapter 15.3, Problem 1R

To determine

To explain: The significance of discount rate, price rate, federal funds rate, open market operations.

Explanation of Solution

The main objective of the central bank is to run the economy steady and smooth by avoiding inflation and recession in the economy. In order to avoid such an economic downturn, the central bank use various tools such as discount rate, price rate, etc.

The discount rate is the rate that is charged by the Fed on the loan offered to commercial banks. The discount rate is used to slow or fasten the money supply in the economy. To fasten the money supply in the economy, the Fed reduces the discount rate or vice versa. While the prime rate is the interest rate that is charged by the commercial banks to its best business customers. So, in order to reduce the money supply, banks increase the prime rate that discourages the businesses to take the loan for their new projects. While in the case of the federal funds rate, the Fed increases the rate so that borrowing of loans from other banks becomes costly and it will reduce the lending capacity of banks. Moreover, open market operation is the major tool to stimulate the money supply by sell and purchase of securities and bonds. When the Fed wants to reduce the money supply then it sells the securities in the market and when it wants to increase the money supply then it purchases the securities in the market.