Consider the US economy in the last couple years, in particular before the current crisis impacted the economy. An important issue in the last couple years was the possible scenarios and escape paths for the FED from quantitative easing

a. Because the economy was heating up, banks begin to reduce the ratio of reserves relative to deposits (i.e. they lend out a larger fraction of their deposits.) Describe and illustrate how this will affect (i) the money supply and (ii) aggregate demand (if at all).

b. Assuming no policy intervention, describe what happens to inflation and output in the short and in the long run.

c. Suppose that the FEDs objective is to stabilize the price level at the level prior to the economy heating up. Should it intervene in response to banks changing their lending decisions? How could the FED intervene via open market operations?

d. In conjunction with open market operations, the FED decides to change the amount of interest it pays on reserves. How would it want to change the interest rate it pays on reserves? How would this affect banks' lending decisions? Would this affect the monetary base or the money multiplier?