Complete Question:
If reserve demand is volatile, in order for the central bank to keep interest rates from being volatile, it must:
a. Target the quantity of reserves.
b. Set targets for both interest rates and the quantity of reserves.
c. Not target the interest rates.
d. Let the quantity of reserves fluctuate.
Answer:
d. Let the quantity of reserves fluctuate.
Explanation:
Volatility in reserve demand is offset by the central bank allowing the quantity of reserves to fluctuate in line with demand. By manipulating and adjusting the reserve levels, a central bank can prevent volatile fluctuations in currency. It does this by affecting the exchange rate and increasing the demand for and value of the country's own currency. By varying the reserve requirements, the liquidity position of the banks and hence their ability to lend are affected as an anti-inflationary measure with reduction of potential credit expansion.
