The Market for Reserves

Demand for Reserves ffr Reserves 0 When the federal funds rate is high, the opportunity cost of holding excess reserves is also high. Banks demand fewer excess reserves. When the federal funds rate is low, the opportunity cost of holding excess reserves is also low. Banks demand more excess reserves. Demand Q 1 Q 2 ff 2 ff 1

Supply of Reserves ffr Reserves 0 Supply ff 2 ff 1 Q 1 Q 2 When the federal funds rate is high, banks borrow more from the Fed, causing reserves to rise. When the federal funds rate is low, banks borrow less from the Fed, causing reserves to fall.

Market Equilibrium ffr Reserves 0 Supply ff eq Q eq Demand Market equilibrium occurs where the demand for reserves equals the supply of reserves.

ffr Reserves 0 S1S1 ff 1 Q1Q1 D Expansionary Open Market Operations S2S2 ff 2 Q2Q2 Expansionary open market operations increase the amount of reserves supplied to the banking system. The supply curve shifts to the right. The federal funds rate falls.

ffr Reserves 0 S1S1 ff 2 Q1Q1 D Contractionary Open Market Operations S2S2 ff 1 Q2Q2 Contractionary open market operations decrease the amount of reserves supplied to the banking system. The supply curve shifts to the left. The federal funds rate rises.

ffr Reserves 0 S1S1 ff 1 Q1Q1 D Expansionary Discount Lending S2S2 ff 2 Q2Q2 Expansionary discount lending increases the amount of reserves supplied to the banking system. The supply curve shifts to the right. The federal funds rate falls.

ffr Reserves 0 S1S1 ff 2 Q1Q1 D Contractionary Discount Lending S2S2 ff 1 Q2Q2 Contractionary discount lending decreases the amount of reserves supplied to the banking system. The supply curve shifts to the left. The federal funds rate rises.

Increase in Reserve Requirements ffr Reserves 0 S ff 1 Q1Q1 D1D1 When reserve requirements increase, banks must hold more reserves. The demand for reserves rises. The federal funds rate increases. D2D2 Q2Q2 ff 2

Decrease in Reserve Requirements ffr Reserves 0 S ff 1 Q2Q2 D2D2 When reserve requirements decrease, banks may hold fewer reserves. The demand for reserves falls. The federal funds rate decreases. D1D1 Q1Q1 ff 2