When the fraction of deposits banks hold as reserves decreases, interest rates fall and bond prices rise.

Question

Quizplus · Accepted Answer

When banks hold a smaller fraction of deposits as reserves, they have more funds available to lend, which increases the supply of loanable funds. This leads to lower interest rates. Lower interest rates, in turn, increase the price of existing bonds, which pay fixed interest rates, because new bonds are issued at the now lower prevailing interest rates, making the older, higher-yielding bonds more valuable.

When the Fraction of Deposits Banks Hold as Reserves Decreases