Unit IV: Three Tools of Monetary Policy

Only a small percentage of your bank deposit is in the safe. The rest of your money has been loaned out. This is called “Fractional Reserve Banking”. The FED sets the amount that banks must hold. The reserve requirement (reserve ratio) is the % of deposits that banks must hold in the reserve and not loan out.

When the Fed increases the money supply it increases the amount of money held in bank deposits.

1.    If there is a recession, what should the FED do the reserve requirement?

Decrease the Reserve Ratio

                               I.            Banks hold less money and have more excess reserves

                            II.            Bank create money by loaning out excess

                         III.            Money supply increases, interest rates fall, AD increases

2.    If there is inflation, what should the to the reserve requirement?

Increase the Reserve Ratio

                               I.            Banks hold more money and have less ER

                            II.            Banks create less money

                         III.            Money supply decreases, interest rates go up, AD down

#2 Discount Rate- The discount rate is the interest rate that the FED charges commercial banks.

Example: If the Banks of America needs $10 billion, they borrow it form the U.S. Treasury (which the FED controls) but they must pay it back with interest.

To increase the money supply, the FED should decrease the Discount Rate (Easy Money Policy).

To decrease the money supply, the FED should increase the Discount Rate (Tight Money Policy).

#3 OMO (Open Market Operations)

-The FED (Federal Reserve) buys/ sell government bonds (securities)

- This is the most important and widely used monetary policy.

To increase the money supply, the Fed should buy government securities.

To decrease the money supply, the FED should sell government securities.

Monetary Policy	Expansionary (Easy Money)	Contractionary (Tight Money)
OMO (Open Market Operations)	Buys Bonds	Sell bonds
Discount Rate	Down	Up
Reserve Requirement	Down	Up
	AD up GDP up Loans up MS up “i” down	AD down GDP down Loan down MS down “i” up

Federal Fund Rate- This is where FDIC member banks loan each other overnight funds, so instead of borrowing from the FED they can borrowing from each other.

Ex: Wells Fargo borrows from Chase

Prime Rate in the interest rate that banks gives to their most credit worthy customers.