Consider the market for reserves. The initial supply and demand for reserves RES^s and RES₀^D are as drawn in the figure below (solid lines), for the initial level of non-borrowed reserves NBR₀, discount rate i_DL and interest on reserves i_res,0.

Point 0 identifies the initial equilibrium federal funds rate i_FF,0 and level of total reserves RES₀

a) Explain why the supply curve becomes horizontal at i_DL.

Decrease in Demand for Reserves: Suppose from now on that banks decide to increase their loans and hence the demand for reserves decreases. This corresponds to the shift of the RES^D to the dashed curve in the figure on the left (RES₁^D). In this case, the new equilibrium would be at point 1. However, the Fed wants to keep i_FF at exactly its original level i_FF,0.

b) Suppose the Fed does not want to change the discount rate i_DL. Explain how the Fed can achieve its goal via Open Market Operation or changing the interest rate on reserves. Qualitatively, draw in the figure how each instrument would change either the supply or the demand for reserves. Explain carefully how each instrument shifts the curves.

c) Compare the total reserves and the NBR (which case har more NBR relative to the total reserves) under the 2 possible cases your described in part (b).

d) If in the scenario above, the Fed decides to use only Open Market Operations to keep the federal funds rate at i_FF,0, what does the change in NBR imply about the size of the Feds holdings of Treasury bonds (or other asses used in IMOs) and about the size of the Feds balance sheet?

RES IDL RES, Aft0 FRES ARES, O NBRO Reserves RES IDL RES, Aft0 FRES ARES, O NBRO Reserves