Chapter 18, Problem 1LO

To determine

How monetary policy affects the equilibrium federal funds rate.

Concept Introduction:

Reserves: These are the liquid assets which are kept by commercial banks, government to meet the emergency demand.

Federal fund rate: It is the rate at which the depository institutions lend funds to other depository institutions, overnight.

Open market operations: These are conducted by the central bank, which involves buying and selling of bonds in the open market.

Explanation of Solution

The market for reserves is depicted in the diagram. The reserve demand is downward sloping which indicates that as the interest rates (federal fund rates) goes down, the demand for reserves increases because now the cost of borrowing will be less. However, the supply for reserves is vertical curve which implies that the supply of reserves is governed by the Federal Reserve (Central Bank).

The intersection of the supply and demand curve is the equilibrium fund rate or interest rate. When the Fed makes open market purchases, the supply of reserves shifts right, lowering the interest rates (or federal fund rate), keeping other things constant. When it sells, it moves the reserve supply curve left, increasing the interest rates (or federal fund rate), keeping other things constant.