Question

1. Answer all of the following questions regarding the Money Supply and Reserves.
   1. Briefly explain, using arguments developed in the course, why the Fed does NOT have complete control over the money supply.
   2. Use the Market for Reserves framework to analyze each of the following scenarios. Treat each scenario separately (i.e. draw a separate fully-labeled graph for each in order to get full credit). Assume that the market is initially in equilibrium. Important: Make sure that your graphs clearly show changes in the equilibrium federal funds rate, changes in the equilibrium level of reserves, and any shifts in the demand or supply curves. Explain in one sentence what your graph is showing.
      1. Commercial banks decrease their demand for reserves.
      2. The Fed sells Treasury bills to commercial banks.

Answer 1

A. The money supply in the economy is equal to the monetary multiplier times the monetary base. The monetary base is sum of reserves and currency in the country. While the Fed has complete control over monetary base, it cannot control money supply.

The Fed cannot control the amount of currency held by households, it can influence it using interest rates but cannot directly control it. Additionally, the Fed cannot determine how much banks would lend. Here again, the Fed can influence banks decisions using its monetary tools but cannot directly decide how much banks lend. Thus, these actions of households and banks influence the monetary multiplier and deters complete control of Fed on money supply.

B. The demand for reserves is a downward sloping curve. Like everything else, if the price of reserves /federal funds rate rises, demand for reserves would fall.

The supply curve for reserves is an upside down L shaped curve which becomes elastic at the discount rate. If the federal funds rate ever exceeded the discount rate, banks’ demand for Fed discount loans would too high because of a clear arbitrage opportunity would exist: borrow at the discount rate and relend at the higher market rate. Below that point, the reserve supply curve is vertical (perfectly inelastic) at whatever quantity the Fed wants to supply via open market operations.

The intersection of the demand and supply curves of reserves produce equilibrium federal funds rate.