Question

B5. (10 marks) Using the supply and demand analysis of the market for reserves, indicate what happens to the federal funds rate (the cash rate in Australia), borrowed reserves, and nonborrowed reserves, holding everything else constant, under the following situations. (a) The economy is surprisingly strong, leading to an increase in the amount of checkable deposits (5 marks) (b) Banks expect an unusually large increase in withdrawals from checking deposit unts the future (5 marks)

Answer 1

Using the supply and demand analysis of the market for reserves

In case of federal funds rate:

a.) When there is a rise in checkable deposition, it leads to a rise in required reserves at any given interest rate, and thus shifts the demand curve to the right. If the federal funds rate is initially below the deduction rate, this then lead-in to a rise in the federal funds.If the federal funds rate is initially at the discount rate, then the federal funds rate will just remain at the discount rate, but borrowed reserves will increase.

b.) If banks expect that an unusually large increase in withdrawals will occur in the future, they will try to hold more and increasing amounts of reserves today, that means the demand for reserves will increase at any given interest rate.

In case of borrowed reserves:

a.) It will lead to no change in borrowed reserves if the federal funds rate increases and the borrowed funds will increase if the federal funds rate remain constant.

b.) It will try to clench on its non borrowed reserves as well. Thus it will try to increase the demand for reserves.

In case of non-borrowed funds:

a.) It will lead to no change in non borrowed funds.

b.)It will lead to increase in non borrowed funds.