Question

Using the supply and demand analysis of the market for reserves, indicate how the following situations would affect central bank interest rates and economies in general.

a. The central bank eliminates interest paid on excess reserve.

b. The central bank introduces special interest rates (lower than usual) for commercial banks and sets special auctions.

c. The central bank conducts an open market sale of certain securities.

d. The central bank sets negative interest rates on bank deposits.

e. The central bank increases reserve requirements.

Short answer

The effect on the interest rate and the economy is as follows:

a. Lending would increase causing an increase in the money supply.

b. Lending would increase causing an increase in the money supply.

c. Money supply would be reduced.

d. Spending would increase causing an increase in aggregate demand.

e. Money supply would be reduced.

Step-by-step solution

Concept Introduction

A central bank is an apex monetary authority in the economy. It performs several functions such as lender to the government. and lender to commercial banks. The central bank is also responsible for issuing currency and formulating monetary policy.

Explanation (part-a) 

If interest on the excess reserve is removed, commercial banks would have no profits from keeping the reserve. So, they would increase lending. This increase in lending would further contribute to a rise in the money supply.

Explanation (part-b) 

If the central bank reduces the interest rate for commercial banks, borrowing from the central bank would become cheaper for these banks. This would cause an increase in borrowing from the central bank' and lending to the public. Consequently, the money supply would increase

Explanation (part c)

In an open market sale, the central bank would sell securities to commercial banks and other institutions. In turn, it would receive payments from such institutions. This would reduce the money supply in the economy as money would go to the central bank.

Explanation (part-d) 

A negative interest rate means that the depositors would have to pay the commercial banks for keeping deposits. As this is not profitable for depositors, it would encourage them to spend money instead of keeping it in deposits.

Explanation (part e) 

When the Federal Reserve increases the reserve rate, the amount of money that banks are required to hold for possible future use increases. This would reduce lending by commercial banks. Consequently, the money supply would decline.