Posted: July 25th, 2021

Suppose, one morning, the Open Market Trading Desk drastically under-estimates the demand for reserves when deciding the quantity of reserves to supply to the market. Use the graph of the Market for Bank Reserves to show why the market federal funds rate will not exceed the discount rate regardless of how large the gap between estimated and actual reserve demand.

1. Use the following Taylor rule to calculate what would happen to the real interest rate if inflation increased by 3 percentage points.

Target federal funds rate = 2 + current inflation + ½(inflation gap) +½(output gap)

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