Question

Using the graph of demand and supply of reserves, show what happens to the equilibrium federal funds rate when the Fed buys up bonds from the banking system (Open Market Operations). Assume prior to the OMOs, all banks just borrow from the other banks, not from the Fed. Draw the graph and explain what happens to the federal funds rate.

Answer 1

As a part of expansionary monetary policy when the Fed buys government securities in the open market, it deposits the payments into the bank accounts .These deposits increases the reserves available with the commercial banks and now they have more money available to lend in the market .To lend money in the market and attract the borrowers, the banks decreases the federal funds rate which is the rate banks charge each other for overnight loans.

We can see in the above figure when supply of money in the market increases it leads to change in equilibrium point from point A to point B whereby the quantity of loanable funds increases from Q1 to Q2 and the Federal fund rates declines from I1 to I2.