Question

Using supply and demand analysis of the market for reserves, show and explain what happens to the federal funds rate under the following situations:

a. The Fed reduces reserve requirements

b. A switch occurs from deposits into currency

c. Banks expect a large increase in withdrawals from checking accounts

d. The Fed conducts an open market sale of securities

Answer 1

Before answering the questions let us understand the basic dynamics of why Federal Funds rate go up and dwon. It all depends on the demand and supply of the market of reserves. So when Fed need more funds with them, they increase the rate of interest so more people start putting funds in deposits. However, in the case when Fed has excessive money in deposits, they lower the interest rates so people take money off deposits or alternatively they are willing to take more loans because of lower interest rates, it works like any normal demand supply matrix.

Given the above understanding let's evaluate each of the scenarios:

(a) Federal funds rate rates will fall because in this case Fed reduces reserve requirements, with this it means that they need less funds with them to be kept as reserves, if they need less funds than what they have they will want people to withdraw the money and to do so they will reduce the interest rates so less people put money in deposits with banks or other scenario can be people want to take loans because of lower interest rates.

(b) Federal funds rate rates will increase. This scenario states people opt for keeping more currency than deposits. In this case, Fed would want more reserve funds as more people are taking out money from the banks, so it will increase interest rates to motivate people to keep more deposits than currency.

(c) Federal funds rate rates will increase. Again in this case banks are anticipating that a large number of withdrawls will happen from the accounts. Fed hence would have shortfall of reserve funds as more people will be taking out money from the banks, so it will increase interest rates to motivate people to keep more deposits than currency and to demotivate withdrawls.

(d) Federal funds rate rates will fall because in this case Fed will expect a good amount of money from the open market sale of securities and hence would not want any excessive money in reserves with it.

if they need less funds than what they have they will want people to withdraw the money and to do so they will reduce the interest rates so less people put money in deposits with banks or other scenario can be people want to take loans because of lower interest rates.