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Question
The fact that the Fed is willing to pay interest on reserves gives the Fed another mechanism for affecting the money supply and the amount of reserves that banks hold. How might a very low interest rate paid on reserves increase the money supply? (Hint: Consider the possible uses of excess reserves.)Answer
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Suppose that a risk-neutral investor has a choice between buying a one-year bond paying 5 percent today, a two- year bond paying 4 percent today, a three-year bond paying 8 percent today, or a four-year bond paying 2 percent today, if a one-year bond purchased one year from now is expected to have an interest rate of 6 percent, a one-year bond purchased two years from now is expected to have an interest rate of 7 percent, and a one-year bond purchased three years from now is expected to have an interest rate of 8 percent. Explain with the help of suitable calculations, which of the following would the investor decide to do?a. The investor will purchase a one-year bond today, followed by three successive one-year bonds. b. The investor will purchase a two-year bond today, followed by two successive one-year bonds. c. The investor will purchase a three-year bond today, followed by a one-year bond.d. The investor will purchase a four-year bond today.
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