What happens to the bank lending, supply of money, and aggregate demand if the Federal Reserve increases discount rate to 3.5% and why?
The discount rate is the interest rate that a central bank, such as the Federal Reserve in the United States, charges commercial banks to borrow funds from it. A change in the discount rate can have several effects on the economy.
1. Bank Lending: When the Federal Reserve increases the discount rate, it becomes more expensive for commercial banks to borrow money from the central bank. As a result, banks are likely to reduce their borrowing from the Fed. This reduction in borrowing may lead to a decrease in the availability of funds for lending to businesses and individuals. Therefore, an increase in the discount rate generally leads to a decrease in bank lending.
2. Supply of Money: The discount rate is just one tool that the Federal Reserve uses to control the money supply. By increasing the discount rate, the central bank discourages banks from borrowing money and subsequently reduces the amount of money available in the economy. This action can lead to a decrease in the supply of money. With less money available, people and businesses may have limited access to credit, which can impact consumption and investment decisions.
3. Aggregate Demand: The effect on aggregate demand depends on how the increase in the discount rate influences other interest rates in the economy. When the discount rate increases, it can influence other interest rates, including rates for mortgages, auto loans, and business loans. If these rates also increase, it can lead to higher borrowing costs for consumers and businesses, which may result in a decrease in spending and investment. Consequently, a decrease in spending can lead to a decrease in aggregate demand.
In summary, an increase in the discount rate can reduce bank lending, decrease the supply of money, and potentially lower aggregate demand due to higher borrowing costs for consumers and businesses.