Question

Assume federal funds rate is greater than the interest rate paid on reserves. What happens to the federal funds rate when the Fed increases the interest rate on reserves? Draw the graphand explain.

Answer 1

Federal Funds Rate :-The federal funds rate means to the interest rate that banks impose on other banks for granting to them surplus cash from their reserve balances on an overnight basis. By law, banks must keep a reserve equal to a fix percentage of their deposits in an account at a Federal Reserve bank. Any money in their reserve that greater the essential level is available for granting to other banks that might have a shortfall.

Interest on reserves (IOR) is the rate at which the Federal Reserve Banks give interest on reserve balances, which are balances taken by DIs at their local Reserve Banks.

When the FED increases the interest on reserves, the federal funds rate will increase. A higher fed funds rate means banks are little able to borrow money to keep their reserves at the required level. As a result, they give little money out. The money they do give will be at a higher rate because they are borrowing money at a over rate.

Diagram:-