One morning the Open Market Account Manager at the New York Federal Reserve Bank observes that...

One morning the Open Market Account Manager at the New York Federal Reserve Bank observes that the equilibrium (market) federal funds rate is 3.25%. Suppose the target federal funds rate is 2.5%. What does this indicate about total reserves in the banking system? What would the Account Manager decide to do (open market purchase or open market sale)? Draw a reserves market diagram to explain your answer. Label the diagram(s) neatly and show all the changes clearly.

Expert Solution

The federal fund rate is the interest rate at which banks lend to other banks (and other depository institutions) overnight. It can be seen as a type of cost to borrowing from a different bank.

The Open Market Account Manager at the New York Federal Reserve Bank observed that the equilibrium federal funds rate is 3.25%, much higher than the targetted federal funds rate of 2.5%. This means that the total reserves held by the banking system are higher (by 0.75%) than the targeted amount. To reduce the reserves held by banks, the Account Manager will choose to open market purchase and increase the money supply (as there will be more money in people's hands) in the market from Q₀ to Q₁. This will lead to a fall in interest rate as the quantity of money rises from r₀ to the targetted r₁ rate.

The graph below indicates the above change.

Rahul Sunny answered 2 years ago

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