Question 2. Assume that the banking sector is described as follows:
D = d0 d1(i iD) (1)
L = d0 + l1(i iL) (2)
where L stands for bank loans, D stands for bank deposits, iL the loan rate, iD deposit rate and i is the
market interest rate. For convenience assume that the constant is d0 in both equations. Also assume that
banks do not have operating costs and are not required to hold reserves.
(a) Calculate the competitive equilibrium. Illustrate the equilibrium in a diagram.
(b) How do your results from the previous question change when the government sets deposit rates equal
to iD = a, with a < iL? Provide intuition.
(c) Now instead suppose that government introduces a mandatory reserve ratio, r, such that R = rD.
How do your results change compared to (a)? What are the implications of such a reserve ratio policy
on interest rates, deposits and loans? Provide intuition.
(d) Sometimes, it is suggested that the reserve ratio policy can be an alternative to targeting interest rates
or monetary aggregates. Can this be an e ective policy to stabilise output and in
ation
uctuations?
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