[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

then understand how the Fed is able to influence the market to make sure the
equilibrium level of the federal funds rate is kept close to the target established by
the FOMC.
FEDERAL FUNDS RATE (i)
Figure 32.2
RESERVES (R )
Reserve
demand
THE DEMAND FOR RESERVES
Banks hold reserves for two reasons. First, they must satisfy the legal reserve requirement
imposed by the Fed. Second, even if reserve requirements were zero (as they
are in some countries), banks need to hold some reserves to meet their daily transaction
needs. Deposits and withdrawals cannot be predicted perfectly each day,
so a bank must make sure it has enough cash on hand in case withdrawals happen
to exceed deposits. Similarly, when Desktop Publishing writes a check to
ComputerAmerica on its account at BankNational and ComputerAmerica deposits
that check into its account with BankUSA, BankNational must have enough reserves
to transfer to BankUSA to cover the check. Of course, BankNational will receive
funds as it collects on checks it has received in deposits that are from accounts in other
banks, but the daily balance of payments and receipts is unpredictable. BankNational
needs to ensure that it has access to reserves to make certain it can always settle its
account. The reserves a bank holds over and above its required reserves are called
excess reserves. Because reserves do not earn interest, banks try to keep excess
reserves to a minimum. In 2000, for example, required reserves totaled $40 billion,
while excess reserves were only just over $1 billion.
What happens if a bank discovers that it does not have enough
reserves to meet its needs? It has two options. It can try to borrow
reserves from the Fed. If the Fed agrees to lend reserves to the bank,
the interest rate on the loan is called the discount rate. Unlike interest
rates on other types of loans, the discount rate is not determined by
Reserve
demand
with higher
deposits
THE DEMAND FOR RESERVES IN THE
FEDERAL FUNDS MARKET
When the federal funds rate increases, it becomes
more expensive to borrow reserves from other banks.
Banks will turn to other sources (such as the Fed) or
adjust their balance sheets to reduce the likelihood
that they will need to borrow in the funds market.
conditions of demand and supply; the Fed simply sets it. In some countries,
the discount rate is linked directly to market-determined rates of
interest. If the discount rate is increased, banks find it more expensive
to borrow from the Fed.
The second option a bank has is to borrow reserves from another
bank. Just as some banks find themselves short of reserves, other banks
may find they have larger reserve holdings than they need. Since the Fed
does not pay interest to banks on reserve account balances, and vault
cash similarly earns the bank no interest, a bank with more reserves
than it needs will want to lend them out in the federal funds market. In
this way, it can earn the federal funds interest rate on its extra reserves.
The federal funds rate adjusts to balance supply and demand in the
federal funds market.
The quantity of federal funds demanded will fall if the federal funds
rate increases. A higher federal funds rate makes it more costly to borrow
reserves from other banks. Each bank has an incentive to take extra
care to ensure that it does not run short of reserves. Figure 32.2 shows
the demand for federal funds as a downward-sloping function of the
funds rate.
718 ∂ CHAPTER 32 THE FEDERAL RESERVE AND INTEREST RATES