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

Question

BlackTom AI · Accepted Answer

Banks must hold a larger fraction of deposits as reserves, so raising the reserve requirement increases the quantity of reserves that banks need to hold. Key concepts: the federal funds market clears at an interest rate between the discount rate (the central bank’s lending rate, acting as an upper bound) and the interest on excess reserves (IOER, acting as a lower bound). The federal funds rate is determined by supply and demand for reserves among banks when the market rate lies inside this corridor.

Step-by-step reasoning:
1. Starting position: the federal funds rate (ffr) is between the discount rate and IOER, so banks actively trade reserves in the federal funds market and the market rate is set by equilibrium between reserve supply and reserve demand.
2. Increase in the reserve requirement forces banks to convert some previously excess reserves into required reserves. Required reserves are not lendable in the federal funds market, so the amount of lendable (excess) reserves falls.
3. This is a leftward shift (decrease) in the supply of lendable reserves, or equivalently a rightward shift (increase) in effective demand for reserves (banks need to obtain more reserves to meet requirements).
4. With supply of lendable reserves lower and demand higher, the equilibrium federal funds rate rises (movement up along the supply curve or new intersection at a higher rate), provided the new equilibrium still lies inside the corridor.
5. If the ffr were already pinned at IOER (floor) or discount rate (ceiling), the result might differ, but the premise says the ffr is between those bounds, so the market-clearing rate responds.

Why the correct answer is A: the shortage of lendable reserves caused by higher requirements increases competition for reserves and pushes the federal funds rate up.

Why the other options are incorrect:
- B (no change): incorrect because ceteris paribus the reduced lendable reserves change equilibrium; only a compensating open-market operation by the central bank could offset it.
- C (decrease): wrong direction—reduced supply of lendable reserves raises, not lowers, the rate.
- D (eliminate the market): wrong; the market still functions, it simply adjusts the rate upward.

Conclusion: an increase in the reserve requirement raises the federal funds rate, confirming answer a.

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

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