Question

In a recent meeting (January 16, 2020) of the Federal Open Market Committee (FOMC), the Federal Reserve eliminated the reserve requirement on deposits and other reserve items at banks and other depository institutions up to $16.9 million and reduced the reserve ratio to 3% on amounts $16.9 to $127.5 million.

What is likely to happen to interest rates in the economy as a consequence? Use the loanable funds theory of interest rate to justify answer.

Answer 1

If the Federal Reserve decides to lower the reserve ratio through an expansionary monetary policy, commercial banks are required to keep less cash on hand and are able to increase the number of loans to give consumers and businesses. This increases the money supply, economic growth and the rate of inflation. Hence it decreses te interest rates in the economy and make money supply available at cheaper rates.

Loanable funds theory:

Loanable funds is the sum total of all the money people and entities in an economy have decided to save and lend out to borrowers as an investment rather than use for personal consumption. The theory of loanable funds uses a classical market analysis to describe the supply, demand, and interest rates for loans in the market for loanable funds.

The law of supply and demand is applicable in the market for loanable funds. You can consider the interest rate a lender earns, or a borrower must pay, as the price for the loan. Supply, as we have stated above, is simply the amount of savings in the market that provides the money to fund the loans. Demand is the level of investment seeking financing. As the interest rate on loanable funds increases, it becomes more expensive to borrow, and the quantity of funds demanded will decrease. On the other hand, as the interest rate for loanable funds increase, the supply of loanable funds also increases because higher interests rates makes saving more financially attractive.