Question

In the market for reserves, suppose the initial equilibrium level of the federal funds rate is equal to the interest rate paid on excess reserves, i.e., the supply curve intersects with demand curve in its horizontal part, what happens to federal funds rate when there is an open market purchase of government securities,? Use demand and supply model to illustrate the impact. Label your figure carefully.

Answer 1

The above diagram shows that initial equilibrium in the market for reserves occur at point E1. In the above case the supply curve of reserves intersects with demand curve of reserves in its horizontal part and federal funds rate is equal to the interest rate paid on excess reserves. When there is open market purchase of government securities then supply curve of reserves will shift rightwards to R2 and the new equilibrium occurs at point E2 where federal funds rate remains constant because federal funds rate cannot fall below the interest rate paid on reserves.