University of Central Florida (UCF) ECO3223 Midterm 3 Practice Exam

When demand for reserves increases in the federal funds market while the market federal funds rate is at the target rate, it is likely that the market federal funds rate will rise. The reasoning behind this is grounded in basic supply and demand principles.

As banks demand more reserves, they are willing to pay a higher rate to secure those reserves. If the supply of reserves remains constant while demand is increasing, the competition among banks to borrow reserves will drive up the price of those reserves, which is reflected in the market federal funds rate. Consequently, banks will be paying more to borrow reserves, leading to an increase in the market federal funds rate.

This increase continues until the Federal Reserve intervenes by adjusting the supply of reserves through open market operations or other monetary policy tools to restore the balance and bring the federal funds rate back to the target rate. Therefore, this dynamic illustrates the responsiveness of interest rates to changes in demand for reserves within the constraints of the federal funds market.