As an example of this mechanism, consider the following crude model of the federal funds market
shown in Figure 3.
If a bank did need additional funds, it could obtain reserves through an overnight loan in the federal funds market
, where banks with extra reserves lend to other banks.
Similarly, larger institutions appear to be relatively more active than the smaller ones on the supply side of the money market (that is, lending in the federal funds market
and entering into reverse repurchase agreements).
The Federal Open Market Committee establishes the target rate for trading in the Federal funds market
Repos also help the Fed to implement its federal funds rate target, because for banks overnight Treasury repos are a relatively close substitute for borrowing in the federal funds market
The effects of these events can be seen in the trends of not only the federal funds market
, but also the repo, commercial paper, Libor, and Eurodollar markets.
If banks couldn't earn at least as much trading in the federal funds market
as what they were earning on their reserves balances, their incentive to supply funds into that market would not exist.
Our results are highly consistent with the predictions of our 2008 study--that is, the revised discount window is effective and plays an essential role in moderating volatility in the federal funds market
Gara Afonso and Anna Kovner, Federal Reserve Bank of New York, and Antoinette Schoar, MIT and NBER, "Stressed, not Frozen: The Federal Funds Market
in the Financial Crisis"
For much of the week of September 15, which was the day that investment bank Lehman Brothers filed for bankruptcy, pressures in the federal funds market
caused the actual daily average federal funds rate to be above the FOMC's then 2 percent target rate.
Through 2007 the fear became widespread that many banks might fail, and interbank lending rates spiked to levels well above those in the federal funds market
However, unlike the answer given in question #2, the small volume of discount loans is not because the Fed does not lend at the low discount rate; rather, it is because banks have no incentive to borrow at a rate higher than what they can borrow from the federal funds market