Suppose the Federal Reserve did not pay interest on excess reserves. How would the reserve demand curve?
A. Demand curve slope down
B. Demand turns flat
C. Demand turns
D. Reserve Supply is vertical at the point
E. Reserve supply becomes horizontal
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The demand would go down. Banks can now keep money in excess reserves and there is an advantage. They get paid interest. However, if there was no advantage, the banks would only be keeping excess reserves for other reasons, such as a safety net. There would be no extra benefit to keeping an extra reserve. The money would not be working for the bank. It would be better to put it somewhere and put it to work, so that it can earn interest.
Demand curves essentially always slope down, so that should not change. What should happen is that the banks' demand for reserves will drop. The banks will not get any benefit for holding excess reserves so they will not want to hold them. This will move the banks' demand curve for reserves to the left.
The demand curve will definitely begin to slope down, as this is something we would naturally expect to happen as banks, who are looking to make profit from the stock that they hold, would suddenly find reserves very unprofitable because of the interest they are no longer receiving for it and therefore they would want to get rid of them.
The reserve demand curve would slope downwards. Banks would keep as little excess reserves as possible while ensuring that they are ready for any emergency. The funds freed would be lent out even if the rates of interest they receive move to lower levels as the borrowers notice that the lenders are now eager to lend more money.
I'll play devil's advocate and say that demand would remain flat; even though the banks could now lend out their money instead of keeping it for the interest payments, they would still want to keep current levels stable in case of inflation, runs, or other sudden need. Invested money cannot be liquidated quickly, but reserve money can.
As pohnpei and justaguide say, the demand curve is downward sloping as the relationship between Price and Quantity of a good (in this case bank reserves) at various prices is measured. When factors other than price (in this case interest rate charged for borrowing) affect the demand curve, the affecting influence is seen in a shift of the position of the curve on the graph. Favorable influences shift the curve to the right, while unfavorable influences shift it to the left. Since the withdrawal of interest paid on reserves would be an unfavorable influence (from the point of view of the bankers), the downward sloping demand curve would shift to the left, as pohnpei said, but the demand would not be flat.
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