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