Question

Using the supply and demand analysis of the market for reserves, indicate what happens to the federal funds rate (the cash rate in Australia), borrowed reserves, and nonborrowed reserves in the following situations holding everything else constant.
(a) The Fed (central bank) raises the target federal funds rate.
(b) The Fed (central bank) raises the interest rate on reserves above the current equilibrium federal funds rate (the cash rate).

Answer 1

( a ) Cash rate is the benchmark interest rate used by the Central Bank of Australia to make policy changes in the economy.

( a ) When the central bank of Australia raises the target federal funds rate, in this case, cash rate, it becomes costly or expensive for banks to use overnight loan facility for liquidity as the banks would need to pay higher interest rate than before. This would decrease the supply of money in the economy. It would also lead to increase in non-borrowed reserves as many people, firms or businesses may find it profitable to deposit money with the banks to earn higher interest rate. Borrowed reserves would remain the same as before.

( b ) When the central bank raises the interest rate on reserves above the current equilibrium federal funds rate, many institutions such as banks, businesses and people would deposit their money with the central bank in order to earn higher earnings through increased interest rate. This would increase the reserves of the central bank.