HW 11 Solution - Econ 201 HW 11 35 1 If equilibrium real...

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Econ 201 HW 11 35 1. If equilibrium real GDP is less than full employment real GDP, what should the Fed do (4) If equilibrium real GDP is less than potential, the Fed needs to increase the money supply. (a) About the discount rate? Lower the discount rate (b) The reserve requirement? Reduce the reserve requirement (c) With bonds? Buy bonds (d) About interest payments the Fed offers on bank reserves? (Assume the Fed currently pays interest on bank reserves.) Stop or reduce paying interest on bank reserves. 2. Explain how and why each of your answers in the previous question will affect the federal funds rate? (4) a. Lowering the discount rate gives banks access to cheaper funds from the Fed. But banks care more about lending to other banks than the Fed cares about lending to banks. This is because banks are motivated by profits where the Fed isn’t. So banks will respond to this competition by lowering the federal funds rate to make profitable loans to other banks. b. Reducing the reserve requirement allows banks to loan more of their deposits to each other. Since more funds are available, banks will charge lower interest rates to one another (lower fed funds rate). At this point, they can charge a lower rate and make greater profits on volume of loans. c. By buying bonds, the Fed releases cash into the economy in exchange for bonds.
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