How Fed actions affect reserves in the banking system

• Every bank have to keep reserves at some ratio(eg. 10% of total reserve) in addition to buy asset or make a loan, which is required by Fed
• Fed has 2 main tools to affect reserve liquidity. They are...
  • Open market operations: Fed buys assets(bonds/security) from bank(Primary dealer) and keep the payment in the Fed's balance sheet liability as reserve for the bank which banks can withdraw this reserve anytime they want: So the reserve liquidity is increased.
  • Discount loans: when Fed lets the bank borrow the discount loan, reserve liquidity in financial market increased, because bank get more reserve.

The market for reserves and the federal funds rate

• Fed tried to influence the federal fund rate directly by those two prior methods(Open market operations, discount loans)

Demand and supply in the market for reserves

• When demand and supply for the reserves reach equilibrium, the resulting rate is the federal funds rate(i_ff), the interest rate charged on the loans of these reserves.

• Demand curve

  • Reserve demand is influenced by two factors
    • Required reserve demand : determined by Fed
    • Excess reserve demand : the additional reserve bank choose to hold. It is the insurance of deposit outflows.
      • The opportunity cost for holding the excess reserve demand calculated by
        = the interest rate that bank can get from lending - the interest rate earned on reserve at Fed(i_oer)
        • If Fed fund rate decreases, the raid paid on excess reserve(i_oer) isn't changed, the opportunity cost on holding is lower which will increase excess reserve demand

    • R^d is slope down because when fed fund rate(i_ff) is lower toward i_oer, demand increases.