Tools of Monetary Policy

1. Reserve Requirement
 -only a small percent of your bank deposit is in the safe. The rest of your money has been loaned out "Fractional Banking "
- FED set the amount that banks must hold
- Reserve Requirement (reserve ratio) is the % of deposits that banks must hold in reserve and not loaned out

• When the FED incr money supply it increase the amount of mkney held in bank deposits

If recession , FED should decrease reserve ratio 

  1) Banks held less money and have more excess

  2) Banks create more money by loaning out excess

  3) Money supply increase interest rates fall,  AD increase

If inflation, FED should increase Reserve Ratio

1) Banks held more money and have less excess

2) Banks create less money

3) Money supply decrease, interest rate increase, AD decrease

2) The Discount Rate

- interest rate FED charge commercial banks

Ex: if Bank of America needs $10 mil, they borrows it from the U.S Treasury which FED controls but they must pay it back with interest

To increase money supply the FED should decrease the Discount Rate (Easy money policy)

To decrease money supply the FED should increase the Discount Rate (Tight money policy)

*FDIC banks are the only ones using Discount Rate. They do not want it.

3) Open Market Operations

• FED buys/ sells government bonds (securities)
• The is the most important and widely used monetary policy

To increase money supply, FED should buy government securities

To decrease money supply, FED should sell government securities 

Buying bonds means bigger money supply 

Selling bonds means smaller money supply

Federal Funds Rate

* FDIC membe banks loan each other overnight funds (Banks to Bank)

Prime Rate 

*Interest Rate that banks charge their most credit worthy customers

When a customer deposits cash or withdraws cash from their demand deposig acct. It has no effect on money supply

Single Bank - Loan money from Excess Reserves

Banking System - ER x multiplier x Total money supply

When the FED buys or sells bonds, ER is create

It only changes:

1)Composition of money

2) Excess Reserves

3) Required Reserves

Monetary Policy

What Banks Do

A bank is a financial intermediary
-Use liquid assets (ie banks deposits) to finance the investments of borrowers
* Process is known as fractional reserves banking
- A system in which in whicb depository institutions hold liquid assets less than the amount of deposits
- Can take the form of
  1. Currency in bank vaults
  2. Bank Reserves - deposits held at the federal reserve

T Account- banking sheet to measure banks liabilities versus their assets
-Items whicht the bank holds legal chain
-The use of funds by financial intermediaries liabilities (Amount owed)
- The legal claims against banks
- The amounts of funds for financial intermediaries
12 district federal reserve banks
- Quasi owned (owned by members)
-Not directly owner by fed
-people sit on the board who are elected by prez


Function of Fed
*Issues currency to population
* Sets Reserve Requirement and holds reserves of banks
*Lends money to bank and charge interest
*Check clearing service for banks
*Act as personal bank for governments
*Supervise member banks
*Control money supply in economy

Functions of the Federal Reserve

Time Value of Money

Is a dollar today worth more than a dollar tomorrow"
- Yes because of inflation and opportunity cost.
V=future value of $
p=present value of $
r= real interest rate (nominal rate-inflation rate) expressed as a decimal
n=years
k=number of times interest is credited per year

Simple Interest Formula

• v= (1+r)^n x p

Compound Interest Formula

• V= 91+r/k)^nk x p

Calculate future value of money

Step 1:Calculate the real interest rate

          r% = I% - pie%

Step 2 : Use the simple interest formula to calculate the future value of the $

v = (1 + r )^n x p

Demand for money has an inverse relationship with nominal interest rate and the quantity of money demanded

1. What happens to the quantity demanded of money when interest rates increase?

 - Quantity demanded falls because individuals prefer to have interest earning assets instead of borrowed liabilities.

     2. What happens to the quantity demanded when interest rates decrease?

  - Quantity demanded increases. There is no incentive to convert cash into interest earning assets.

Money Demanded Shifters

1. Changes in price level
2. Changes in income
3. Changes in taxation that affect investment

Increasing Money Supply

If Fed increases the money supply, a temporary surplus of money will occur at 5% interest. Surplus will cause interest rates to all to 2%

Increasing money-> Decreasing interest rate -> Increasing investment-> Increase in AD

If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The shortage will cause interest rates to rise to 10%

Decrease money supply -> Increase interest rate-> Decrease investment -> Decrease AD

Financial Sector

Financial Assets                                                                          

-Stocks and Bonds   

whose benefit to the owner

depends upon

the issuer of the asset

meeting certain oblogations

Financial Liablities

- Liabilities incurred by the issuer of a financial asset to stand behind the issued asset

Interest rate:  price paid for the use of a financial asset

Stocks

- Financial asset that conveys ownership in a corporation

Bonds

- Promise to pay a certain amount of money plus interest in the future

Monetary Policy Video

https://www.youtube.com/watch?v=AOyhmSNBqII
https://www.youtube.com/watch?v=tPq5nSE_H48