Monetary Policy and the Market for Reserves 1 Consider a recently founded economy, Del Griffith Park, whose politicians are debating economic policies to implement. They are first considering whether or not to found a central bank and issue their own currency. Right now, they use US dollars for all their transactions and thus are subject to monetary policy dictated by the Federal Reserve. Banks in this economy like to hold reserves when interest rates are low, and dislike holding reserves when interest rates are high, and can borrow and lend with US banks at the US Federal Funds Rate. The government of Del Griffith Park issues debt to finance its operations that is indexed to the US federal funds rate. a (2 points) Draw the supply and demand curves in the market for reserves. Be sure to label the axes correctly! Then explain why each curve has the shape that it does, i.e., why the demand curve is downward sloping, etc. b (1 point) Suppose the Federal Reserve decides that after years of low interest rates, they would like to increase the federal funds rate. What is the effect on the Del Griffith Park government? c (2 points) The government decides they should implement their own central bank. This new central bank has established a market for reserves and can perfectly dictate the level of reserves in the economy, but does not offer discount loans nor interest paid on reserves. Suppose that banks are suddenly worried about the stability of the Del Griffith Park Dollar and demand falls to where the interest rate is zero. Show this in a graph. Describe and show what the central bank can do to return the economy to the original interest rate on a second graph. d (2 point) Now suppose that this new central bank decides to offer interest on reserves at some fixed interest rate. Consider the shocks described in part (c), but show what happens to interest rates and quantity of reserves when this new policy tool is implemented. e (2 point) There is one bank in the economy, the Del Griffith Banking and Shower Curtain Rings, with the following balance sheet. Assets Liabilities Reserves: $60B Deposits: $600B Mortgage-Backed Securities: $500B Repos: $100B Corporate Bonds: $200B Bank Capital: $60B When the economy enters the downturn, depositors worry that they will be unable to withdraw their money. All of the bank's depositors show up and demand the bank return their deposits. If the bank is unable to cover all of their deposits with their cash on hand, they can sell their Mortgage Backed Securities at 75% value and their Corporate Bonds at 90% of their value. Show what happens to this bank if bank managers try to limit any losses to the smallest amount possible. f (2 point) These same politicians are considering implementing deposit insurance to prevent the effects of this downturn. Show in the same table what happens to the bank's assets and liabilities when deposit insurance is available to depositors. However, the deposit insurance requires insurance fee. If the case (c) will happen with probability 0.5, how much is the maximum insurance fee which is acceptable for the bank