Question

For each of the scenarios below, explain the shift(s) in:

 Demand :

 Supply :

 Federal Funds Rate (FFR) :

 Money Supply (MS) :

a) The Fed increases reserve requirements.

b) The Fed conducts an open market purchase.

c) The Fed lowers the discount rate below the current equilibrium federal funds rate.

d) The Fed reduces reserve requirements and sterilizes this by conducting an open market sale of securities. (The term “sterilize” means to leave the Federal Funds Rate (FFR) unchanged)

Answer 1

a.) When Fed increases the reserve requirement: -

• Demand – Increase in reserve requirement will lead to reduction of money supply as well as consumer spending in the economy, which ultimately causes Decrease in the demand.
• Supply – Increase in reserve requirement will also cause reduction in price levels and money available in the economy, which ultimately Reduces the supply as well.
• Federal Funds Rates – When Fed increases the reserve requirement, the banks have less money to lend which leads to Rise in the Federal Funds rates.
• Money Supply – Increase in the reserve requirement causes decrease in the money supply, as the banks have less money that can be lend.

b.) The Fed conducts an open market purchase: -

• Demand – Conduct of open market purchase by Fed will lead to increase in the money supply as well as consumer spending in the economy, which ultimately causes increase in the Demand in the market.
• Supply – this will also cause rise in the price levels and flow of the money, leading to increase in the supply as well.
• Federal Funds Rates – As this open market operation increase the money available for loan, it Reduces the interest rates.
• Money Supply – When Fed conducts an open market purchase, it increases the funds available to banks for lending. Thus, it increases the Money supply.

c.)The Fed lowers the discount rate below the current equilibrium federal funds rate.

• Demand – when fed reduces the discount rate, it increases the flow of the money in the market which leads to increase in the demand in the market.
• Supply – reducing the discount rate will also cause increase in price levels and supply of money in economy and also increase in the supply.
• Federal Fund Rates – change in discount rates affects directly the federal funds rates. With decrease in the discount rate, federal funds rate also decreases.
• Money supply – Reduction in discount rate makes loans cheaper, which increase the money supply in the economy.

d.) The Fed reduces reserve requirements and sterilizes this by conducting an open market sale of securities.

• When Fed reduces reserve requirement, it causes Increase in Demand and supply of goods in the market as well as money supply in the economy. Also, it Decreases the Federal funds rate.

• However, when Fed conducts open market sale of securities, it will Decrease the demand & supply of goods and also Money supply in economy. But will increase the Federal funds rates.

Thus, when Fed reduces reserve requirements and sterilizes this by conducting an open market sale of securities, the effects of both these independent Monetary policies would be nullified and it will not affect Demand & Supply of the goods or Money supply or Federal funds rates.