Question

1) Explain and demonstrate graphically how targeting the overnight rate can result in fluctuations in nonborrowed reserves.

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Answer 1

Overnight rate fluctuations in non borrowed reserves

The overnight interest rate is the rate on loans of reserves from one bank to another.

Equilibrium in the market for reserves

Equilibrium occurs at the intersection of the supply curve R^S and the demand curve R^d at a point 1 and an interest rate of i^*

Response to an open market operation

An open market purchase increases non borrowed reserves and hence the reserved supplied, and shifts the supply curve from R₁^s to R₂^s. in the first fig. the equilibrium moves from point 1 to point 2 , lowering the overnight rate from i¹ to i² . in the second fig. the equilibrium moves from point 1 to point 2 ,but the overnight rate remains unchanged, i¹=i²=i_d.