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

The position of the demand curve for reserves will depend on banks’ lending
opportunities and on the general volume of transactions. Suppose, for example, that
a new technological innovation causes firms to want to invest more money in new
equipment. To finance this investment, firms try to borrow more from banks. As
the quantity of bank loans demanded increases, interest rates on bank loans will
rise. Any bank that was holding excess reserves will have a greater incentive to
make additional loans because the interest that can be earned has risen (recall that
reserves earn no interest). Other banks may not have an excess of reserves, but to
take advantage of the higher returns on loans, they will try to borrow additional
reserves in the federal funds market. Consequently, the demand curve for reserves
shifts to the right.
Changes in the volume of transactions through the banking system also can shift
the reserve demand curve. For example, as real incomes rise, the dollar volume of
transactions in the economy will rise. Banks hold reserves because they cannot predict
perfectly their daily flow of deposits and withdrawals. As these flows become
larger, banks will need to hold additional reserves.
THE SUPPLY OF RESERVES
The supply of reserves arises from two sources. First, some banks have borrowed
reserves from the Fed. These reserves are called borrowed reserves. As the federal
funds rate increases, it becomes more expensive to obtain funds from other banks
in the federal funds market, and banks instead borrow more from the Fed. If the
discount rate is increased, borrowing from the Fed becomes more expensive and
borrowed reserves fall. Such borrowing is not the main source of reserves, however.
In 2000, borrowed reserves accounted for only $400 million out of a total stock of
reserves equal to about $40 billion. The difference between total reserves and
borrowed reserves is called nonborrowed reserves. The supply of nonborrowed
reserves is under the Fed’s immediate control, and it is by adjusting the supply of
nonborrowed reserves that the Fed affects the funds rate.
OPEN MARKET OPERATIONS
In Chapter 28, we saw that open market operations are the Fed’s most important
tool for influencing the economy. Whenever the Fed buys government securities
from the private sector in an open market purchase, it pays for them by simply
creating nonborrowed reserves; whenever it sells government securities to the
private sector, the level of nonborrowed reserves held by the banking sector is
reduced. If the Fed wishes to increase nonborrowed reserves, it undertakes an
open market purchase. If it wants to reduce nonborrowed reserves, it undertakes
an open market sale.
Through these open market operations, the Fed can control the total supply of
reserves. For example, suppose banks increase their borrowing from the Fed so that
the level of borrowed reserves rises. The Fed can sell government securities to
reduce the supply of nonborrowed reserves if it wants to keep total reserves from
THE FEDERAL FUNDS MARKET ∂ 719