Macroeconomics
Equilibriuminthereservemarketisdeterminedwherethesupplyofreservesandthedemandfor reserves are equal. The supply of reserves curve (S R ) is vertical because itiscontrolledbytheFed, hence,itis constant .However,thedemandforreservescurve(D R ),which representsthedemandfor reserves by banks is divided into three parts : 1. Middle Part (in Blue): This downward-sloping part of the D R curve illustrates the inverse relationship between the federal funds rate and the quantity demanded of reserves. This is justifed by the factthatwhenthefederalfundsrateishigh,bankswouldratherlendouttheir funds to other banks at high rates instead of depositing them at the Fed and earningnoora lowerrateofreturn.However,ifbankscan’tearnthatmuchmoneybylendingwhenthefederal funds rate is low, they would rather deposit them with the Fed. 2. Top Part(inOrange): Ifabankreallyneedstoborrowmoney,itcanalsoborrowfromtheFed insteadofotherbanks.Rememberthatthediscountrateistheinterestratepaidbybankswhen borrowingmoneyfromtheFed. Supposethatthefederalfundsrateis8%,whereasthediscount rateis6%.ThismeansthatitwouldbecheaperforbankstoborrowfromtheFedratherthanfrom eachother. Thiseffectivelysetsacaponthefederalfundsrateatthediscountrate,causingthe demand curve to be horizontal at the discount rate. 3. Bottom Part (in Black): This part of the graph represents a low federal funds rate at which bankslendtoeachother.However,theyhaveanotheroptiontoconsider.Ifbankscanearnmore interestonreserves(IOR)bydepositingtheirmoneywiththeFedthanbylendingtoeachother and receiving the federalfundsrate,theywouldpreferkeepingtheirmoneywiththeFed.This effectivelysetsaflooronthefederalfundsrateattheIOR,causingD R tobecomehorizontal. For instance,ifthefederalfundsrateis2%andIORis3%,bankswouldratherdeposittheirfundsat the Fed and earn 3%. The frst two parts of the D R curve imply the existenceoflimitedreserves,whereasthelastpart indicates ample reserves.
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