If the Fed conducts an open market purchase, the federal funds rate will:

Question

BlackTom AI · Accepted Answer

An open market purchase increases bank reserves, so the supply of reserves in the federal funds market rises and the overnight interbank interest rate (the federal funds rate) falls. 1) Relevant knowledge points and concepts - The federal funds market is where banks with excess reserves lend overnight to banks with reserve shortfalls; the federal funds rate is the market-clearing (equilibrium) interest rate for those loans. - An open market purchase means the Fed buys government securities from banks or the public, paying by crediting bank reserves—this increases the monetary base and the supply of reserves. - Price formation: with a fixed demand for reserves at each interest rate, an increase in supply lowers the equilibrium price (the interest rate). 2) Step-by-step reasoning - Start: initial supply of reserves S1 and demand for reserves D determine initial federal funds rate r1. - The Fed conducts an open market purchase → reserves held by banks increase. - Supply curve shifts right from S1 to S2 (S2 > S1) while demand D is unchanged in the short run. - New intersection of S2 and D occurs at a lower interest rate r2 (r2 < r1). - Therefore the federal funds rate falls. 3) (Conceptual) intermediate steps - S1 ∩ D → r1 - Open market purchase → S2 (S2 = S1 + ΔR, ΔR > 0) - S2 ∩ D → r2 where r2 < r1 4) Why the correct answer is correct Because increasing reserve supply lowers the “price” of overnight funds in a competitive interbank market, the federal funds rate declines following an open market purchase. 5) Why the other choices are incorrect - a. remain unchanged: incorrect because supply changed; equilibrium interest changes unless demand perfectly offsets it. - b. become zero: incorrect; the rate falls but not necessarily to zero (other frictions and policy tools like IOER/standing facilities typically prevent a zero rate). - c. rise: incorrect because a larger supply of reserves puts downward pressure on the rate, not upward. Conclusion: The federal funds rate will fall, matching the provided answer (d. fall).

If the Fed conducts an open market purchase, the federal funds rate will:Single choice

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