Reference no: EM133303590

Consider a recently founded economy, Del Griffith Park, whose politicians are debating economic policies to implement. They are first considering whether or not to found a central bank and issue their own currency. Right now, they use US dollars for all their transactions and thus are subject to monetary policy dictated by the Federal Reserve. Banks in this economy like to hold reserves when interest rates are low, and dislike holding reserves when interest rates are high, and can borrow and lend with US banks at the US Federal Funds Rate.

Quetion 1. The government decides they should implement their own central bank. This new central bank has established a market for reserves and can perfectly dictate the level of reserves in the economy, but does not offer discount loans nor interest paid on reserves. Suppose that banks are suddenly worried about the stability of the Del Griffith Park Dollar and demand falls to where the interest rate is zero. Show this in a graph. Describe and show what the central bank can do to return the economy to the original interest rate on a second graph.

Question 2. Now suppose that this new central bank decides to offer interest on reserves at some fixed interest rate. Consider the shocks described in part (c), but show what happens to interest rates and quantity of reserves when this new policy tool is implemented.