Here is another realistic scenario. Consider the above graph that shows demand for excess reserves by the banking system as a whole. The discount rate is 4.5 percent and the Fed pays an interest of 1.50 percent on excess reserves. Currently banks as a whole are holding an excess reserve of $70 billion. Suppose that as a result of a long and deep recession (such as the one occurred in 2007-08), the Fed has been increasing the supply of reserves in order to reduce the fed funds rate. As a result, currently the supply of reserves stands at $110 billion. The Fed wants to reduce the fed funds rate further to only 0.50 percent. Can it accomplish this goal through an additional open market purchase? If the Fed increases the supply of reserves by an additional $20 billion, the equilibrium fed funds rate will equal percent. It seems that, to reduce the equilibrium fed funds rate to 1.00 percent, the Fed has to reduce the interest it pays on bank reserves. If the Fed reduces the interest it pays on reserves to 0.50 percent, the equilibrium federal funds rate will equal percent but it has to supply additional reserves of market operations. billion dollars to commercial banks through open

7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% LL 2.0% 1.5% 1.0% 0.5% 0.0% $0 $10 $20 $30 $40 $50 $60 $70 $80 $90 $100 $110 $120 $130 $140 $150 $160 Bank Excess Reserves ($Billion) The model of the federal funds market that we have learned is sometimes called the corridor model. This is because, in this model the equilibrium fed funds rate fluctuates between the discount rate and the interest on reserves. This gives the Fed a tool to control the fluctuations in the equilibrium fed funds rate. Let's see how. Assume that the supply of federal funds equals $70 billion. Suppose that currently the discount rate is 4.5 percent and the interest on reserves equals 1.5 percent. In this case, if demand for reserves increases by $40 billion dollars, the equilibrium fed funds rate will increase to percent, and if it decreases by $40 billion, the equilibrium fed funds rate will decrease to percent. Now suppose the Fed wants to reduce the fluctuations in the equilibrium fed funds rate. So it…

7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% LL 2.0% 1.5% 1.0% 0.5% 0.0% $0 $10 $20 $30 $40 $50 $60 $70 $80 $90 $100 $110 $120 $130 $140 $150 $160 Bank Excess Reserves ($Billion) Consider the above graph that shows demand for excess reserves by the banking system as a whole. The discount rate is 4.5 percent and the Fed pays an interest of 1.50 percent on excess reserves. Currently banks as a whole are holding an excess reserve of $70 billion. This means that the equilibrium fed funds rate is 0.03 percent. Suppose that demand for excess reserves by the banking system increases by $20 billion (banks collectively want to hold $20 billion more excess reserves). In that case, the equilibrium fed funds rate will increase to 0.02 percent. Suppose that demand for excess reserves by the banking system increases by another $20 billion (now demand has increased by a total of $40 billion). In that case, the equilibrium fed funds rate will increase to 0.01 percent. Federal Funds Rate

Round Deposits Required Reserves of 20% Excess Reserves New Loans 50% of loan proceeds are held as currency in circulation by people Loan proceeds redeposited 1 $500 $100.00 $400.00 $400.00 $200.00 $200.00 2 $200 $40 $160 $160 $80 $80 3 $80 $16 $64 $64 $32 $32 4 $32 $6.40 $25.60 $25.60 $12.80 $12.80 5 $12.80 $2.56 $10.24 $10.24 $5.12 $5.12 6 $5.12 $1.02 $4.10 $4.10 $2.05 $2.05 7 $2.05 $.41 $1.64 $1.64 $.82 $.82 8 $.82 $.16 $.66 $.66 $.33 $.33 9 $.33 $.07 $.26 $.26 $.13 $.13 10 $.13 $.03 $.10 $.10 $.05 $.05 Totals $833.25 $166.65 $666.60 $666.60 $333.30 $333.30   Calculate the new money supply.   Calculate the money multiplier.

The following financial statement is for the current year. From the past, you know that 10% of fixed-rate mortgages prepay each year. You also estimate that 10% of checkable deposits and 20% of savings accounts are rate sensitive. Second National Bank Assets Liabilities Reserves $ 1,500,000 Checkable Deposits $ 15,000,000 Securities Money Market Deposits $ 5,500,000  1 Year $ 6,000,000 Savings Accounts $ 8,000,000 1 to 2 Years $ 8,000,000 CDs  2 years $ 12,000,000 Variables-rate $ 15,000,000 Residential Mortgages  1 Year $ 22,000,000 Variables-rate $ 7,000,000 1 to 2 Years $ 5,000,000 Fixed-rate $ 13,000,000  2 years $ 2,500,000 Commercial Loans Fed Funds $ 5,000,000  1 Year $ 1,500,000 Borrowings 1 to 2 Years $ 18,500,000  1 Year $ 12,000,000  2 years $ 30,000,000 1 to 2 Years $ 3,000,000 Buildings, etc. $ 2,500,000  2 years $ 2,000,000 Bank Capital $ 5,000,000 Total $100,000,000 Total $100,000,000 (a) What is the current Income GAP for Second National Bank?  (b) What will…

Table 14.1: FIRST COMMERCIAL BANK Asset Liabilities Total Reserves: S150,000 $100,000 $1,000,000 $200,000 Deposits Net Worth Required Reserves Excess Reserves ? ? Loans $1,200,000 Total $1,200,000 Total 14. Refer to Table 13.1. First Commercial Bank's total loans equal S a) 1,050,000 b) 1,200,000 c) 1,150,000 d) 1,250,000

Fed Funds Rate 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 0$ $50 $100 $150 $200 $250 $300 $350 $400 $450 $500 $550 $600 $650 $700 $750 $800 Federal Funds ($Billions) Consider the above graph that shows demand for excess reserves by the banking system as a whole. Currently banks as a whole are holding an excess reserve of $350 billion. The graph indicates that the Fed is paying percent interest on bank excess reserves and that the equilibrium fed funds rate is percent. If the Fed reduces the interest on bank reserves to one percent, the equilibrium fed funds rate will equal percent.

Deposit Reserve Requirement Money Multiplier Potential Money Creation $1,000 10% From above   $1,000 20% From above   $1,000 25% From above   With a deposit of $1,000 and the reserve requirement of 10% what is the potential money creation? Group of answer choices $5,000 none of the above $10,000 $4,000

Table 13.1: FIRST COMMERCIAL BANK Asset Liabilities S150,000 S100,000 Total Reserves: $1,000,000 $200,000 Deposits Net Worth Required Reserves ? Excess Reserves ? Loans $1,200,000 Total $1,200,000 Total 15. Refer to Table 13. 1. First Commercial bank's excess reserves equal $ a) 150,000 b) 250,000 c) 100,000 d) 50,000

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