Compare and contrast the federal funds rate, the discount rate, and the prime rate.(4 points)

Question

short answer

Answer 1

1. Definition:

   • Federal Funds Rate: The interest rate at which banks lend reserves to each other overnight. It is influenced by the Federal Reserve's monetary policy.
   • Discount Rate: The interest rate charged by the Federal Reserve to banks for short-term loans from its discount window.
   • Prime Rate: The interest rate that commercial banks charge their most creditworthy customers, typically used as a benchmark for various loans.

2. Purpose:

   • Federal Funds Rate: A tool for the Federal Reserve to manage monetary policy and influence overall economic activity.
   • Discount Rate: Provides liquidity to banks and regulates the money supply by offering a safety net for banks in need of immediate funds.
   • Prime Rate: Reflects the credit risk associated with lending and serves as a reference point for consumer and business loans.

3. Market Influence:

   • Federal Funds Rate: Changes directly affect other interest rates in the economy, including those on loans and deposits.
   • Discount Rate: Primarily impacts the banks' willingness to borrow from the Fed, influencing availability of credit in the economy indirectly.
   • Prime Rate: Changes often follow movements in the federal funds rate, impacting borrowers' loan interest rates.

4. Measurement:

   • Federal Funds Rate: A market-driven rate that fluctuates based on supply and demand for reserves.
   • Discount Rate: Set by the Federal Reserve and remains constant until adjusted by the central bank.
   • Prime Rate: Generally established as a fixed percentage above the federal funds rate, subject to change when banks modify their lending practices.