#7 (20 points) a) In Ben S, Bernanke’s book: “The Courage to Act” he writes of when overnight lending markets first began becoming tight. It was on August 9, 2007 when BNP Paribus ( a bank in France) suspended withdrawals from its sub-prime funds. News from European markets arrives in early morning and short term financial markets in the US were feeling the brunt. That morning, Ben Bernanke emailed Brian Madigan (a Penn Stater) to instruct the New York Fed to purchase large quantities of Treasury Securities on the open market. The New York Fed ended up purchasing $24 Billion in Treasury securities that morning. The target for the Federal Funds rate at this time was 5 1/4 %.
a) (10 points) Draw a Reserve Market Diagram depicting the state of affairs on August 8, the day before the shock, assuming the Fed was hitting their target exactly. Now depict the shock and the reaction of the New York Fed assuming that they purchased just enough securities to get the federal funds rate back to target. What would determine how many securities that the New York Fed would have to purchase to bring the federal funds rate back to target?
b) (10 points) Let’s pretend that the exact same shock occurs but that we are in a world where there is about $2.6 trillion in excess reserves (this is the current number as of Oct. 2015) and that the Fed is paying 5 1/4% for holding these excess reserves. Redraw the reserve market diagram as above locating point A. Now, given this new regime, show point B and explain exactly what is going on here. Does Brian Madigan have to instruct the New York Fed to purchase large quantities of Treasury Securities on the open market? Why or why not? Explain.