I got this question wrong:

Which of the following best describes the relationship between bank reserves, the federal funds rate, and a decrease in interest rates for consumers and business?

The answer is: If the FOMC uses monetary policy to increase the amount of reserves in the banking system, the federal funds rate will decrease, which will result in generally lower interest rates.

I put: If the FOMC uses monetary policy to decrease the amount of reserves in the banking system; the federal funds rate will decrease, which will result in generally lower interest rates.

Why is my answer wrong? Because I though that when the FOMC decreases the required reserves, the banks have more money to loan out. So know the federal funds rate goes down since other banks also have more money to loan out, hence, a lower interest rate. Please explain to me where my understanding went wrong!! I have a test coming up and I thought I understood this and now I'm freaking out!! Thanks for you help!

I understand your confusion, and I'm here to help clarify the concept for you. Let's break it down step by step:

1. The Federal Open Market Committee (FOMC) is responsible for setting monetary policy, which includes determining the level of bank reserves in the banking system.

2. When the FOMC uses monetary policy to increase the amount of reserves in the banking system, it typically does so by purchasing government securities from banks. This injection of reserves increases the overall amount of money available for lending by banks.

3. When banks have more reserves available to lend, they are more willing to loan money to other banks through the federal funds market. This increased supply of loanable funds in the federal funds market tends to drive down the federal funds rate.

4. Lowering the federal funds rate has a domino effect on other interest rates. As the federal funds rate decreases, banks also lower the interest rates they charge each other for short-term borrowing. This ultimately leads to a decrease in interest rates for consumers and businesses in the broader economy.

Now, let's analyze why your answer is incorrect:

You mentioned that when the FOMC decreases the required reserves, banks have more money to lend out. While it is true that banks have more money to lend out, a decrease in the required reserves would not directly lead to a decrease in the federal funds rate.

The required reserves are the minimum amount of reserves that banks must hold against their deposits. By reducing the required reserves, banks are not necessarily injecting more reserves into the banking system as a whole. Instead, they are simply able to hold a smaller portion of their deposits as reserves.

Therefore, reducing the required reserves does not increase the overall supply of reserves in the banking system, which is what would be required to drive down the federal funds rate.

In summary, the correct answer is that if the FOMC uses monetary policy to increase the amount of reserves in the banking system, the federal funds rate will decrease, resulting in generally lower interest rates. Lowering the required reserves alone would not directly lead to a decrease in the federal funds rate and lower interest rates.