Question

5. Using a supply and demand graph of the market for money, show the effects on the nominal interest rate if the Fed takes the following monetary policy actions: (LO2, LO3) a. The Fed lowers the discount rate and increases dis- count lending. b. The Fed increases the reserve requirements for com- mercial banks. c. The Fed conducts open market sales of government bonds to the public. d. The Fed decreases the reserve requirements for como mercial banks.

Answer 1

5 a. The graph below shows the affect of change in policy discount rate determined by FED. when FED lowers policy discount rate , it means more funds are available for lending so it increases discount lending for commercial banks.

d. If FED decreases the reserve requirements then commercial banks have to keep lesser deposits as reserves and makes more money available for lending . Thus it increases money supply and reduces interest rates.

In the graph for part a.) and d.) this is shown as increase in money supply causing nominal interest rates to fall.

b. If FED raises reserve requirments for commercial banks, it means commercial banks have to park higher amount from their customers deposits as reserves with FEd on a daily basis which will be unavailable for lending purposes. This reduces money supply and thereby raises nominal interest rates given other things constant.

c. When open market sales of government bonds are made to public, then it reduces money supply from the system, which raises interest rates and thus reduces demand for loans in the economy.

In the graph for part b.) and c.) this is shown as decrease in money supply causing nominal interest rates to rise.

Nominal Interest Rates Open market sales of Yout. Bonds and increase in reserve requirements contracts money supply. So it moves leftwards. MS MS 7 Quantity of Money