Question

In the market for reserves, suppose the initial equilibrium level of the federal funds

rate is between the discount rate and the interest rate paid on excess reserves,

what happens to the federal funds rate when there is an increase in the reserve requirement?

Using demand and supply model to illustrate the impact. Label your figure carefully.

Answer 1

Demand Rd1 and Supply Rs1 of reserves intersect at E. This determines the initial equilibrium level of the federal funds rate which lies is between the discount rate id1 and the interest rate paid on excess reserves.

Now when there is an increase in the reserve requirement, banks will have fewer excess reserves so they demand more reserves. This shifts the demand for reserves from Rd1 to Rd2. Since supply is fixed this ultimately results in increasing the federal fund rate from iff1 to iff2. The new equilibrium is at F