Let’s use the model of the supply and demand for bank reserves to explain how the Federal Reserve can change aggregate demand in the short run. Remember that the Federal Reserve controls the supply of bank reserves, but private banks create demand for bank reserves.
a. After a meeting, the Federal Reserves Open Market Committee votes to cut interest rates from 2% to 1.5%. How will they make this happen: Will they increase the supply of reserves or decrease the supply?
b. As a result of your answer to part a, will banks usually lend more money in response, or will they lend less money? Will this tend to increase the nation’s money supply, lower it, or will it have no net effect on the money supply?
c. Will this typically increase aggregate demand or lower it?