Question

Assume that the required reserve ratio is 20 percent. If the public withdraws $100 million of their currency holdings from their checking accounts, what happens to the federal funds rate? Use the demand and supply analysis of the market for reserves to explain your answer. Include the relevant graph and a brief explanation.

Answer 1

If the Public withdraws $100 billion from their currency holdings, then this will lead to an increase in the liquid money supply in the economy, thereby leading to inflationary problems in the economy. To tackle this, the Fed will either decide to carry out open market operations and sell government-approved bonds in the markets, or it will increase the bank interest rates in order to induce savings. In the given question, the Fed can either reduce its monetary base or can increase its required reserve ratio. It should be noted that even a small increase in the required reserves ratio could lead to a huge change in money supply in the economy, and thus the Fed should use this tool very carefully.