Question

5. Use the federal funds market to graph each of the following scenarios (each on a separate graph) and described what is happening.

a. Suppose that the Federal Reserve decides to increase its target for the Federal Funds rate from 2% to 2.25% while also increasing the discount rate from 2.5% to 2.75%. Show how the Federal Reserve can use open market operations to do this (state what they will do with open market operations).

b. Suppose that banks increase their demand for reserves. Show how the Fed can offset this change through open market operations in order to keep the federal funds rate at the target rate. Describe the open market operations used.

c. Suppose that the Federal Reserve decides to decrease the required reserve ratio but does not want the increase to impact the target for the federal funds rate. Show how the Federal Reserve can use open market operations to accomplish this policy. Describe the open market operation being used

Answer 1

(a)

The increase in the discount rate is shown by the fact that the horizontal section of the supply curve has risen from 2.50% to 2.75%. The Fed has conducted an open market operation of government securities to decrease reserve stock in such a manner that the supply curve moves from S1 to S2 to intersect the demand curve at 2.25 % instead of 2.00% resulting in the needed rise in the Federal Funds rate.

(b)

As the Fed raises the demand for the reserves the demand curve shifts rightward. Fed should undertake an open market operation (purchase) of government securities. This leads to shifts in the supply curve such that the new demand curve intersect supply curve at 2.25%.

(c)  

An increase in the required reserve will lead to rightward shift of the demand curve. To keep the Federal rate same the Fed will undertake an open market purchase of government securities so that the supply curve shift rightward. So the new supply curve will intersects at 2.25%.