Question

Using the money-supply demand diagram, illustrate:a) Lowering reserve requirements.b) Lowering the federal funds rate.c) Open market sale.

Answer 1

a) Reserve requirement is the amount of money which every bank has to keep with the Fed. Lowering reserve requirement means banks have to keep less money with the Fed and now they are able to lend more money in the economy. This causes rightward shift of MS curve.

b) Federal funds rate is the interest rate at which one bank lends its reserve balance to other bank overnight. Decrease in federal funds rate means increase in lending of reserves and thus increase in money supply which causes rightward shift of MS curve.

c) Open market operation is the sale and purchase of government securities by the Fed in order to control the supply of money in the economy. Sale of government securities reduces the money holding of banks and thus reduces money supply. Open market sale shifts MS curve leftwards.