Macroeconomics
Monetary Policy in Ample Reserves Banking Systems TheFedusesmonetarypolicytools toguide thefederalfundsrate. Theequilibriumfederalfundsrate and quantity of reserves are determined at the intersection of D R and S R . However, if S R intersects with D R at the last flat part of D R (where reserves are ample), the three traditional tools of monetary policy (OMOs, discount rate, and rr) would not be effective because a change in reserves or money supply doesnotaffectinterestrates (referbacktotable2tounderstand why) . Inthiscase,theFedapplies anexpansionarymonetarypolicybyreducingIOR toreduceinterestrate, increase investment and aggregate demand, and hence, stimulate the economy (D R2 to D R1 on the diagram below ). A contractionary monetary policy , on the other hand, would consist of increasing IOR to increase interest rate, reduce investment and aggregate demand, and contract the economy (D R1 to D R2) .
Monetary Policy in Limited Reserves Banking Systems In a banking system operating with limited reserves at thedownward-slopingpartofD R , achangein money supply does affect the federal funds rate . An expansionary monetary policy in this case is illustratedbyashiftoftheS R curvetotheright(highermoneysupply),which reducesthefederalfunds rate,nominalinterestrate,andhence,increasesinvestmentandaggregatedemand (S R ₁toS R ₂inthe diagrambelow). Acontractionarymonetarypolicy ,ontheotherhand,consistsofashiftoftheS R curve totheleft(lowermoneysupply),which raisesthefederalfundsrate,nominalinterestrate,andhence, reduces investment and aggregate demand (S R ₂ to S R ₁).
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