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Econ%2B310%2BW2010%2BHW4%2BAnswers+_1_

Econ%2B310%2BW2010%2BHW4%2BAnswers+_1_ - Econ 310 Homework...

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Econ 310 Homework Assignment 4 Answer Key Question Seventeen Describe the model we use for determination of the Federal Funds Rate. Specifically: (a) What are “Federal Funds”, and where do they come from? Federal funds are essentially bank reserves, held by the banking system in deposit accounts at the Federal Reserve. The quantity of federal funds available in the market is controlled by the Fed, through open market sales and purchases, or through the issue of discount loans. (b) How does demand for federal funds depend on the federal funds rate? Why? The federal funds rate is the rate at which banks can lend excess reserves to other banks overnight. As a result, it is the opportunity cost of holding excess reserves. As the federal funds rate rises, the opportunity cost of holding excess reserves also rises, and each bank will respond by reducing demand for federal funds. (c) Describe the supply curve for federal funds. Why does it have this shape? The supply curve looks like an inverted L. At all federal funds rates below the discount rate, the supply of federal funds is invariant to the interest rate and is fixed at the quantity of non-borrowed reserves. This is because a bank that wishes to borrow money will never borrow from the Fed at the discount rate if it can borrow from another bank at a lower federal funds rate. Therefore, no discount loans will be made when the federal funds rate is below the discount rate. This means that the total quantity of reserves in the system is equal to the quantity of non-borrowed reserves, and is unchanging: that quantity is simply redistributed amongst the banks through the borrowing and lending process. If the federal funds rate were equal to the discount rate, however, supply of federal funds to the market would be infinite. This is because the Fed stands ready to lend arbitrarily large amounts to the banking system at the discount rate. The effect of the discount rate, then, is to place a ceiling on the federal funds rate. It will never make sense to observe a federal funds rate above the discount rate, as banks would prefer to borrow from the Fed at the lower discount rate rather than borrow from another bank at the higher federal funds rate. Now describe the effects of the following Fed actions in the federal funds market (d) The Fed makes an open market sale of securities to the banking sector. The sale of securities means that the quantity of non-borrowed reserves will fall. The supply of federal funds contracts, and at the original federal funds rate there is excess demand. Banks will
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express their willingness to pay higher prices to fill their demands for excess reserves, and the federal funds rate will rise. (e) The Fed increases the discount rate. If the federal funds rate is less than the discount rate then there is no discount lending taking place.
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