State whether the following statement is true or false AND explain why: "An increase in the...

State whether the following statement is true or false AND explain why: "An increase in the interest rate paid on excess reserves will always cause an increase in the federal reserve funds rate."

Solutions

Expert Solution

Banks will have an incentive to supply their excess reserves to federal funds market only when federal funds rate is greater than the interest rate paid on excess reserves by Fed otherwise they will keep their excess reserves with Fed.

So, if there is an increase in interest rate paid on excess reserves then such increase can cause an increase in the federal reserve funds rate only if, after increase, the interest rate paid on excess reserves becomes greater than the federal reserve funds rate because now federal reserve funds rate has to be increased so as to induce banks to supply their excess reserves to federal reserve funds market.

On the other hand, if after increase, the interest rate paid on excess reserves is still less than the federal reserve funds rate then federal reserve funds rate does not have to increase so as to induce banks to supply their excess reserves to federal reserve funds market.

Thus,

An increase in the interest rate paid on excess reserves will not always cause an increase in the federal reserve funds rate.

Hence, the given statement is False.

Rahul Sunny answered 1 year ago

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