Leading up to and during the Lehman Brothers collapse, overnight lending markets became quite volatile, as shown by the figure below.

a) (10 points for correct and completely labeled diagram)On your exam sheet, draw a reserve market diagram depicting points A, B, and C. Assume that the Fed held reserve supply constant and that the volatility in the effective federal funds rate originated from the volatility in reserve demand. Note, this is the period before the Fed obtained the authority to pay interest on reserves

b) (10 points) In hindsight the Fed could have done a better job in terms of hitting their federal funds target = 2%.Explain in words what they should have done to avoid point B and what they should have done differently to avoid point C. Note that we are still in the period before the Fed obtained the authority to pay interest on reserves.

c) (10 points) Draw a reserve market diagram depicting your answer for part b) above. Be sure to label points A, Band C. Note that we are still in the periodbeforethe Fed obtained the authority to pay interest on reserves.

d) (20 points total: 10 points for complete and correctly labeled diagram and 10 points for explanation) Now let's pretend that we were in a new regime (as they are now) where the Fed sets the interest rate they pay on reserves at 25 basis points below the federal funds target and the discount rate set 25 basis points above the federal funds target.In the space below,redraw the reserve market diagram accounting for this new regime.Make sure you label points A, B, and C under this new and current regime.Explain in detailas to why the implied (actual) funds rate is different in this new regime relative to the old regime as in 1.a).

Effective Federal Funds Rate (DFF) Federal Funds Target Rate (DISCONTINUED SERIES) (DFEDTAR) 3.0 2.8 - - B 2.5- A 2.0 FF Target 1.5 - (Percent) 1.0 75 - - Actual FF Rate 0.5 0.0 2008-07 2008-08 2008-09 2008-10 2008-11 2008-12 2009-01 Shaded areas indicate US recessions. FRED 2013 research.stlouisfed.org OF EDTAR