How does an open-market purchase by the Fed affect the level of bank reserves and the interest rate? Illustrate the interest rate effect by drawing the appropriate graph.

What will be an ideal response?

When the Fed buys government securities from banks it pays for the securities by increasing the reserves of the banks at the Fed. Banks have more reserves and, therefore, more excess reserves since there has been no corresponding increase in deposit liabilities. This increase in excess reserves allows banks to increase their lending, which will increase the money supply. The increase in the money supply will shift the money supply schedule outward and cause a decrease in the level of equilibrium interest rates. Panel (a) of Figure 29-4 in the text is the appropriate graph to illustrate the effects of an expansionary monetary policy on interest rates.