Scenario: The following figure shows the federal funds market. Assume that the market of reserves is in equilibrium at $500 billion in reserves and a 3 percent federal funds rate.

-Refer to the scenario above.If the Fed completes an open market purchase of bonds that changes the quantity of reserves by $400 billion,then the federal funds rate will ________.

Question

Scenario: The following figure shows the federal funds market. Assume that the market of reserves is in equilibrium at $500 billion in reserves and a 3 percent federal funds rate.
 
-Refer to the scenario above.If the Fed completes an open market purchase of bonds that changes the quantity of reserves by $400 billion,then the federal funds rate will ________.

Quizplus · Accepted Answer

An open market purchase of bonds will increase the supply of reserves in the market, shifting the supply curve to the right, and bringing the market out of equilibrium. The new equilibrium federal funds rate will be lower than 3 percent, and the magnitude of the change will depend on the size of the shift in the supply curve. Since the quantity of reserves increases by $400 billion, the supply curve will shift to the right by $400 billion, and the new equilibrium federal funds rate will decrease. Using the Taylor rule, which relates the federal funds rate to economic conditions, a $400 billion increase in reserves would suggest a 2 percent decrease in the federal funds rate. Therefore, the correct answer is C, decrease by 2 percent.

Scenario: the Following Figure Shows the Federal Funds Market