5.00% 4.50% 4.00% 3.50% 3.00% 2.50% Fed Funds Rate 2.00% 1.50% 1.00% 0.50%% 0.00% 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Bank Reserves ($Billion) Assume that currently the supply of reserves in the banking system is $130 billion and the Fed is paying 1.00 percent interest on reserves. Now the Fed is worried that the low fed funds rate could cause inflation. Why? Because a low fed funds rate will cause all the other interest rates to be low through arbitrage. This will encourage firms and households to borrow money from banks to buy plants, equipment, homes, and cars. The increase in demand for these things will push up their prices. How could the Fed cool off the demand for goods and services in order to reduce the possibility of inflation? If it reduces the supply of reserves by $10 billion through an open market purchase, the equilibrium fed funds rate will equal percent. If it increases the interest on reserves to 2.00 percent, the equilibrium fed funds rate will equal percent