S_DReserves - to other banks since they could earn more by...

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SUPPLY AND DEMAND FOR BANK RESERVES The supply is vertical up to the discount rate. That is, The Fed controls the total amount of (non- borrowed) bank reserves (regardless of the Fed Funds rate) through open market operations. However, under the current discount lending policies, banks can borrow as much as they want if they pay the discount rate (.75% currently) – set as the fed funds rate target + ½ % roughly. So the supply of reserves becomes horizontal at the discount rate since the fed funds rate would never rise about this (since banks could borrow cheaper from the fed’s discount window) and since banks can borrow as much as they wish at the discount rate. The demand for reserves is downward sloping since at lower market fed funds rates, banks would be willing and anxious to borrow more from other banks to use to make more profitable loans. However, at a fed funds rate below what the Fed pays banks on their excess reserves, banks would stop lending reserves
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Unformatted text preview: to other banks since they could earn more by holding them (and get paid interest by the Fed). The point of the Fed supplying as much reserves as demanded by the banking system at the discount rate, and paying interest as a rate below the target fed funds rate, is to allow the Fed to control the Fed Funds rate maximum and minimum levels. In normal times, the market fed funds rate will equal the feds target, somewhere in the vertical portion of the supply curve. In an emergency (a large shift to the right in the demand for reserves), when the market fed funds rate shoots up, above the target, it wont go above the discount rate. And in a period (like now) when the supply of reserves has grown dramatically (S shifts to right), it allows the Fed to control a minimum Fed funds rate (the rate they pay on reserves)...
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