PS4 solutions - Department of Economics U.C Berkeley Problem Set#4 Suggested Solutions Fall 2014 Economics 1 Page 1 PROBLEM SET#4 Suggested Solutions

PS4 solutions - Department of Economics U.C Berkeley...

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Department of Economics Fall 2014 U.C. Berkeley Economics 1 Problem Set #4 Suggested Solutions Page 1 PROBLEM SET #4 Suggested Solutions NOTE: If your total of the PS1+PS2+PS3 scores + iclicker points put you pretty close to the maximum of 40 points, your GSI looked over your PS4 quickly and gave it a  (check or check-plus) rather than a specific score and set your total of problem set+iclicker to the max of 40. In that case, you want to read through the solutions carefully and compare your answers with what’s here because you won’t see any of those lovely “Please see solutions” stamps on your returned PS. If your total of the first three problem set scores + iclicker points put you more than 5 points away from the max of 40 points, your GSI graded your PS 4 as per usual and you have a point score at the top of your returned problem set. 1. (2 points total) a. What is the Federal Funds rate? The Federal Funds rate is the interest rate banks charge each other for overnight loans of reserves. U.S. banks are required to maintain reserves equal to 10 percent of their total deposits. (See ) Banks that are unable to meet their reserve requirement are able, however, to borrow from banks with excess reserves (they can also borrow from the Fed at a higher rate.) The Federal Funds rate is determined in the market by changes in the supply of and demand for federal funds. The difference between a bank’s total reserves and its required reserves are the bank’s “excess reserves.” Banks that have excess reserves make up the supply of federal funds. Banks whose total reserves are less than required make up the demand for federal funds. Like any market, the market for federal funds will clear at an equilibrium price where the supply of federal funds meets the demand for federal funds. This equilibrium price is called the “Federal Funds rate.” The Fed is able to manipulate this market by increasing or decreasing the amount of reserves in the banking system. Increasing the amount of reserves means than fewer banks will need to borrow in order to meet their reserve requirement, which will decrease the demand for federal funds. More reserves in the system also means that more banks will have excess reserves to lend, increasing the supply of federal funds. The net effect is that the federal funds rate will fall. Alternatively, if the Fed decreases the amount of reserves, more banks will need to borrow in order to meet their reserve requirements, increasing the demand for federal funds. At the same time, fewer banks will have excess reserves to lend, decreasing the supply of federal funds. The increase in demand & decrease in supply have the same effect: both serve to increase the price of federal funds, that is, the federal funds rate.
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