Question

5. The Fed raised the effective Federal Funds rate from around 0.15% in December 2015 to 2.40% in February 2019. For the sake of simplicity, we assume that the discount rate was 3% during the period. However, the Fed indeed paid interest on reserves in an ample reserve environment. Use the market for reserves to graphically show and explain how the monetary policy tool helps achieve a higher equilibrium Federal Funds rate in 2019.

Answer 1

The Federal Fund Rate Rise is a contractionary monetary policy device. With the rise in the Federal Funds rate, the reserves retained by the commercial bank decrease the overall demand for loans.

'a' is the initial point of equilibrium in the graph. As the levels of the Federal Funds increased from R1 to R2, the demand for reserves by commercial bakeries decreased.

There is a left-hand trend in the demand curve. As a result , economic growth is slowing and the availability of reserves in the economy is declining. The supply curve of reserves changes from S1 to S2. With the contractionary monetary policy, the new level of equilibrium is at point b of the lower availability of reserves in the economy.

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