Question

A. What are excess reserves? What are the factors that determine how much a bank would like to hold in excess reserves? Briefly explain.

B> 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.

Answer 1

A)

Basically, these excess reserves are capital reserves held by banks in an excess amount of what is required by creditors or internal accounts in banks. So basic factors that determine how much a bank would like to hold in excess reserves are-

• As an extra measure of safety in case of sudden loan loss or bulk cash withdrawals by account holders.
• As a buffer in times of economic uncertainty.
• Moreover, central banks in a country pay the bank an interest rate while lending based on excess reserves, so to improve the entity's credit rating, these reserves are held.
• These reserves affect the bank's balance sheet, by reducing the liabilities but no change in assets.

B)

Here,

It is basically an interbank market, the federal bank only influences this market equlibrium.

So if reserve demand rises , then this case will arise where the market rate is higher than target rate

From the below graph,

where,

This will make,

So, if demand increases(), that is market rate increases and supply is the same, there be a volatile interest rate that is more fluctuation and unstable that will make the economy slow as people will hold money.

So in order to overcome this problem,

The account manager will try to keep the interest rate constant as if it not done will make the economy volatile and as soon as supply increases (), the market rate will come down to the target rate again and people will save more after seeing a low rate.