Wednesday, February 6, 2013

Why Are Federal Funds Better Than Discount Rates?

The interest paid on required reserves and excess reserves is the same.  The spreads between the discount rate and the fed funds rate is not the same.
Excess reserve rate-Discount Window Rate spread (blue); excess reserve rate-Fed funds rate spread (red); excess reserves (green).
For a bank, borrowing money from the lender-of-last-resort (the Federal Reserve) is less profitable than borrowing from a primary dealer.  So, if you are a primary dealer, holding excess reserves and lending amongst other primary dealers is a good option.  This makes it easier for banks to sell and forget (quantitative easing) than to enter into a bond with the Federal Reserve.
The Fed has taken on many mandates from congress and the president since its inception.  It is now the lender-of-last-resort, inflation/price-control warden, employment creator, money supply master, central banker to central banks, and of course (through open market operations) the interest rate trend-setter.
M2 money supply (blue), unemployment (red), fed funds (green), primary window rate (orange), and inflation (purple).
The Federal Reserve sure has a lot to keep itself busy.

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