Question

Let’s use the model of the supply and demand for bank reserves to explain how the Federal Reserve can change aggregate demand in the short run. Remember that the Federal Reserve controls the supply of bank reserves, but private banks create demand for bank reserves.

a. After a meeting, the Federal Reserve’s Open Market Committee votes to cut interest rates from 2% to 1.5%. How will they make this happen: Will they increase the supply of reserves or decrease the supply?
b. As a result of your answer to part a, will banks usually lend more money in response, or will they lend less money? Will this tend to increase the nation’s money supply, lower it, or will it have no net effect on the money supply?
c. Will this typically increase aggregate demand or lower it?

Answer 1

A) To cut the interest rate from 2% to 1.5%, the Federal Reserve needs to increase the money supply. The Open Market Committee will have to sell US Treasury security bonds in order to increase the money supply. This in turn will increase commercial bank's reserves, who in turn, will lower their interest rates in other to get rid of excess reserves.

B) Banks will lend more money because they now have excess reserves. It will increase the nation's money supply because banks create money when they make loans.

C) This will typically increase aggregate demand because a lower interest rate and cheaper loans result in a higher demand for financial securities. Firms will take more loans, they will use this loans for investments, and this investments will in turn increase production. Increased production means a higher supply of goods and services at a better price, and consumers will take advantage of it.