Question

1. Using the demand and supply for loanable funds and the AD-AS model, illustrate what happens when the Federal Reserve decides to lower the reserve requirement.

Answer 1

Every comkercial bank has to keep a certain percentage of their deposits as reserves with the central bank, so when the central bank decreases teh reserve ration the commercial banks have more excess reserves so they can lend out more money and this is an increase in the supply of loanable funds. The market for the loanable funds is shown in the left panel, initial the market is an equilibrium with interest rate of 'r' and quantity at 'Q'. When the Fed decreases the reserve ration it increases the supply of loanable funds so the supply of loanble funds shifts to the right. The increase in the supply of loanbale funds decreases the interest rates and inrease the supply of money.

The interest rate is the cost of borrowing , since there is a decrease in the cost of borrowing it would lead to an increase in the consumption and spending activities in the economy. Since the consumption and spending are the components of aggregate demand , the agggregate demand will increase and the AD curve shifts to the right. (Right side). The increase in the aggregate demand increase both real GDP and the price level.