Q. Suppose the Fed lowers the interest rate paid on reserves. Draw the money supply /...

Q. Suppose the Fed lowers the interest rate paid on reserves. Draw the money supply / money demand graph, starting from the initial equilibrium, then show clearly the impact on the real interest rate and the quantity of money. Use good labels.

Expert Solution

Question

It has been stated that Fed has lowered the interest rate paid on reserves.

This reduction in interest rate paid on reserves by Fed will induce the banks to keep less reserves with Fed and to lend more.

As banks will lend more, the money supply in the economy will increase.

This increase in the money supply will shift the money supply curve to the right.

Following is the required figure -

The above figure shows that the increase in the money supply has shifted the money supply curve to the right from MS to MS1.

This has resulted in a decrease in the real interest rate (from r to r1) and an increase in the quantity of money (from M to M1).

Thus,

When the Fed lowers the interest rate paid on reserves then the real interest rate decreases and the quantity of money increases.

Rahul Sunny answered 8 months ago

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