Question

1) Suppose a bank receives a $1000 deposit. The required reserve ratio is 10%. The bank makes an $850 loan and holds $150 in reserves.

d. Demonstrate what happens in the market for Federal Funds graphically. Show how the federal funds rate and the quantity of federal funds changes. [10pts]

Answer 1

Reserve ratio = 10%

Say that the initial deposits is $1000 and every time bank lends loans, the borrower deposits the funds in his bank account.

Cycle	Deposits	Reserve (10%)	Loans
1	1000	150	850
2	850	85	765
3	765	76.5	688.5
etc...	etc...	etc...	etc...

This continues as more money is borrowed and deposited every time.

The point here, is to show that the amount of funds that is in circulation after each deposit and loan cycle reduces as there is a reserve requirement of 10% over every deposit made.

This reduces the availability of money supply in the economy.

In the above diagram, Money supply or the quantity of federal funds at a particular point in time is always constant, and thus it is a vertical straight line. As from each deposit and loan cycle, the quantity of federal funds is to reduce. As the availability of funds is lesser after each cycle, the interest rates or cost of borrowing of these funds increases.

Therefore the cost of borrowing or interest rate in the federal funds market increases as the supply of federal funds decreases after each deposit and loan cycle from the bank.