Kenneth R. Szulczyk
The Federal Funds MarketFigure 3. The Federal Reserve uses the discount rate to increase money supply
The Fed could use the discount rate for expansionary monetary policy. For instance, the Fed
decreases the discount rate, depicted in Figure 3. Then the banks borrow cheaply from the Fed,
boosting the reserves in the banking system. Thus, banks have more reserves to lend. Supply
function for the federal funds market increases and shifts rightward. Consequently, the interest
rate for federal funds fall and both the monetary base and money supply expand.
Contractionary monetary policy works similarly to expansionary monetary policy. Figure 4
shows the Federal Funds Market. Market interest rate is i while the equilibrium reserves are
R. For example, the Fed raises the discount rate. Banks borrow less from the Fed because loans
have greater interest rates. Thus, banks have fewer reserves, causing reserves in the banking
system to fall. Consequently, the banks have fewer reserves to lend, shifting the supply for
Federal Funds leftward. Interest rate rise while both the monetary base and money supply
shrink.
The Fed can grant adjustment, seasonal, or extended credits. Adjustment credit is a short-
term loan to help banks, experiencing short-term liquidity problems. Seasonal credit is a loan to
help small banks, located in agriculture areas or tourist destinations. These areas experience
wide fluctuations in income because farmers harvest crops once or twice a year, and tourists
visit an area during high season. Finally, the Fed could grant an extended credit. For instance, a
large bank is on the verge of bankruptcy and has severe liquidity problems. Thus, the Fed grants
a long-term loan to this bank, preventing a bank failure.
The Fed along with FDIC could extend loans to restore the financial health of the bank. For
example, Continental Illinois Bank, the 8th largest U.S. bank, failed during the 1970s because it
granted too many bad loans. The FDIC purchased 80% of the bank’s stock and elected new
management. Thus, the U.S. government nationalized the bank because the bank became too big
to fail while the Fed provided $3.5 billion in loans to the FDIC. During the 2008 Financial