Question

a. Suppose the Fed increases the interest rate that it pays on reserves. Show with a diagram how that would affect the Fed Funds market. Explain.

b. What happens to the money supply (say M1) as a result of this action? Explain.

Diagrams are mandatory

Answer 1

a. Fed Funds market is a market when banks trade their reserves. Banks with excess reserves loan out to other banks who have shortage of reserves. The price of the trade is the interest rate at which reserves are lended out. The Fed by increasing the interest it pays on excess reserves (IOER) incentivizes commercial banks (Depository Institutions) to not lend out reserves at any rate below the IOER set by the Fed. Thus supply of excess reserves reduces at lower interest rates - implying that the supply curve shifts to the left. This increases the Fed Funds rate and reduces quantity of reserves available in the Fed Funds market.

b. Money supply is the total quantity of money in the economy. M1 is a narrow definition of money supply. M1 = currency in circulation + checkable deposits + traveller's checks. The reduced supply of reserves decreases currency in circulation by primarily reduced quantity of reserves available for loaning out. Various depository institutions would have to take loans from other DI's at higher rates - thus quantity of reserves demanded decreases and so other commercial bank have less to loan out. Thus currency in circulation falls. There is a decrease in money supply (which would increase commercial interest rate).