Question

1) For the each of the following, use the supply and demand of reserves to make the necessary changes and indicate what happens to the market (effective) federal funds rate.

a. Holiday shopping season causes banks to increases holdings of excess reserves. The Fed decides not to react.

b. Holiday shopping season causes banks to increases holdings of excess reserves. The Fed decides to react to keep the federal funds rate at the target. t —

c. Board of Governors reduces reserve requirements and directs NY Fed to offset it with open market operations.

d. FOMC raises the target federal funds rate and NY Fed conducts necessary operations to achieve it.

e. Fed decides to raise interest rate on reserve balances above the current equilibrium federal funds rate.

Answer 1

1. The supply and demand of reserves is shown below in graph, where S_R is the supply of reserves, D_R is demand for reserves, i_d is the discount rate, i_ff is the target federal funds rate, i_rb is the interest on reserve balances, R is the equilibrium quantity of reserves.

a. Holiday shopping season increases the demand for reserves ,thus shifting demand curve to D_R¹ and the federal funds rate also rises to i_ff¹. As Fed does not react, R does not change.

b. With holiday shopping season, when Fed reacts to keep the federal funds rate at the target, it undertakes open market operations and increases money supply due to which supply of reserves increases and supply curve shifts to S_R¹ and i_ff¹ reduces and returns back to i_ff.

c. When board of Governors reduces the reserve requirement,this shifts the demand curve left to D_R¹ and i_ff reduces to i_ff¹, In order to offset it, Fed decreases the money supply,thus shifting supply curve left to S_R¹ and this restores the federal funds rate back to i_ff.

d. FOMC raises the target federal funds rate. So,new target federal funds rate is i_ff¹. In order to achieve this, Fed decreases money supply and supply curve shifts left to S_R¹ achieving the new target federal funds rate.

e. Fed raises interest rate on reserve balances, thus, i_rb rises to i_rb¹. This shifts only the horizontal portion of demand curve upwards and having no effect on equilibrium R and i_ff.