Question

Suppose the amount of borrowed reserves rises suddenly from zero. With what tool of monetary policy could the Federal Reserve respond if it wants to keep the federal funds rate below the discount rate? Please precisely defend your reasoning.

Answer 1

Borrowed reserve is fund borrowed from central bank by member banks to maintain the necessary statutory ratios.

Borrowed reserves indicate a tight credit environment relative to the demand for loans and rising interest rates. Alternatively, should there is an excess of reserves in the banking system, then there will be positive Borrowed Reserves. Increase in Borrowed reserves indicate high demand for loan in the market and leading to Increase in rate. Hence, following measures can be adopted by Central Bank to keep the federal rate below discount rate-

a. Increase in liquidity by reducing key reserve requirements.

b. Buy back of Govt Bond from market infusing the liquidity

c. Open market operations by Central Bank