Suppose the Fed's Open-Market Desk thinks the downward-sloping portion of the demand for reserves is given by the equation
D = 28 ? (3 ×i),where i is the federal funds rate in percent and D is expressed in billions of dollars. Suppose the Fed is currently supplying $26.5 billion in nonborrowed reserves. There are no secondary or seasonal credit discount loans. The primary credit discount rate is currently set at 2 percent and the interest rate on reserves is 0.30 percent. The Fed's target for the federal funds rate is 1 percent.
a.Does the Desk need to change the supply of reserves in the market? How much does it need to add or withdraw from the market? After carrying out its daily actions, what will be the equilibrium amount of reserves and discount loans? b.Suppose the demand curve for reserves shifts to D = 35 ? (3 ×i). The Fed does not realize that the demand curve has shifted, so it keeps the supply of nonborrowed reserves at the level you determined in part a. Calculate the equilibrium federal funds rate, reserves, and the amount of primary credit discount loans.
What will be an ideal response?
| a. | First, find out if S = D at federal funds rate below discount rate and equal to target federal funds rate. |
| S = D: 26.5 = 28 ? 3i so 3i = 1.5, so i = 0.5. This is below the discount rate, but also below the target for the federal funds rate. | |
| Second, calculate what nonborrowed reserves (NBR) should be to get federal funds rate equal to target of 1 percent: S = D = 28 ? (3 × 1) = 25. Since supply is now 26.5, Fed must use open-market sales to withdraw 1.5 billion in reserves from the market. Then the federal funds rate will be 1 percent, reserves will equal 25 billion, and there will be no primary credit discount loans. | |
| b. | The shift in the demand curve changes the equilibrium point. |
| First, find out if S = D at federal funds rate below discount rate. | |
| S = D: 25 = 35 ? 3i so 3i = 10, so i = 3.33. This is above the discount rate, so the federal funds rate must equal the discount rate of 2 percent. | |
| The demand for reserves is now 35 ? 3i = 35 ? (3 × 2) = 29, which equals the equilibrium quantity of reserves; because the supply of nonborrowed reserves is 25, primary credit discount loans equal 4. |
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