the equilibrium in federal fund market by the interaction between supply and demand on reserve . ..

1. Why banks demand reserves?
• Banks have a legal obligation to hold a required reserve.
• To hold excess reserve to meet short-term liquidity needs.

2. Before we go, Some needed definitions
• Federal fund market: a market in which supply and demand on reserves
interacts.
• Federal fund rate (𝑖 𝑓𝑓): interest rate that banks charge each other on very
short term loans, determined by the demand and supply for reserve in the
federal fund market.
• Discount rate (𝑖 𝑑): the interest rate that the central bank charges on
discount loans for the commercial banks.
• Interest on reserve balance (𝑖 𝑟𝑏): the interest rate which paid by the central
bank for commercial banks reserves.
• Federal fund rate target: a mission for the central bank to direct 𝑖 𝑓𝑓 into
targeted level.

3. 𝑖 𝑟𝑏
i
R
The interaction between Demand and supply on the federal fund market…
D
- As any other types of loans, we expect that there is a negative
Relationship between the quantity of demanded reserve (R) and
The federal fund rate ( ).
- For that, the first part of demand curve for reserve D is downward
Slopping.( )
𝑖 𝑓𝑓
- The second part of demand curve for reserve is going to be perfectly
elastic or completely horizontal, this case happens when ( ) reach
the level of , if is below banks will borrow from each other
and deposit those loans at the central bank in order to gain arbitrage
profits, the competition between commercial banks will increase the
demand on loans from each other, then the arbitrage profits will be
eliminated.
𝑖 𝑓𝑓
𝑖 𝑟𝑏 𝑖 𝑓𝑓 𝑖 𝑟𝑏
The demand curve

4. 𝑖 𝑓𝑓
∗
𝑖 𝑑
𝑖 𝑟𝑏
i
R
The interaction between Demand and supply on the federal fund market…
𝑅∗
S
- The vertical portion of the supply curve S reflects the assumption that
the fed can set a certain amount of reserve at whatever level in interest.
- At that case, the supply curve is completely inelastic until we reach 𝑖 𝑑
- The is considered as a ceiling on the federal fund rate because banks
will not pay a higher interest rate to borrow from each others than
at that level the supply curve is going to be perfectly elastic.
𝑖 𝑑
𝑖 𝑑
The supply curve
Equilibrium in federal fund market
- The equilibrium federal fund rate and equilibrium reserve occur at
the intersection of D & S curves at the point E=( , )𝑖 𝑓𝑓
∗
𝑅∗
D