If the federal funds rate is between the discount rate and interest on excess reserves, a decline in the reserve requirement:

Question

BlackTom AI · Accepted Answer

The federal funds rate is bounded above by the discount rate and below by the interest paid on excess reserves (IOR), so banks will not pay more than the discount window rate to obtain reserves and will not lend federal funds for less than IOR.

Relevant concepts:
- Reserve requirement: fraction of deposits banks must hold as reserves.
- Excess reserves: reserves held beyond required amounts.
- Federal funds market: banks with excess reserves lend to banks short of reserves; the market interest rate is the federal funds rate.
- Supply–demand for reserves: more excess reserves → supply of funds in the fed funds market increases → rate falls (subject to the IOR floor and discount-rate ceiling).

Step-by-step reasoning:
1. A decline in the reserve requirement lowers the required-reserves target: required reserves = reserve requirement × deposits. For a given deposit level, required reserves fall.
2. Required reserves fall → banks suddenly have higher excess reserves (actual reserves unchanged immediately) because required portion decreased.
3. Higher excess reserves mean more banks are willing to lend in the federal funds market, shifting the supply curve for reserves to the right.
4. With increased supply of lendable reserves, the market-clearing federal funds rate falls (downward pressure on price of borrowing overnight funds).
5. Because the rate originally lay between the discount rate and IOR, the rate can decline but will be prevented from falling below IOR (banks prefer holding IOR over lending at a lower rate). The net effect is a decrease in the federal funds rate toward, but not below, IOR.

Why the other options are wrong:
- (a) Increase: increased excess reserves increase supply, not demand, so rate falls, not rises.
- (b) Eliminate market: a change in requirements changes supply but does not remove the market.
- (c) No change: there is a clear supply shift so the rate changes unless offset by other actions, which are not given.

Conclusion: Therefore, a decline in the reserve requirement will decrease the federal funds rate — answer d, which matches the provided answer.

If the federal funds rate is between the discount rate and interest on excess reserves, a decline in the reserve requirement:Single choice

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