3/31/17: Tools of Monetary Policy

• Tools of Monetary Policy
1. Open market operation
2. Reserve requirement 

• The Reserve Requirement
• The FED sets the amount that banks must hold
• Reserve ratio is the percent of deposit that banks must hold in reserve (% they can NOT loan out)

• Money Multiplier
• If triple R is .2, MM= 5
• Used to find change in money supply, change in DD.

• Using Reserve Requirement
• For Recessions
• Decrease the reserve ratio
1. Banks hold less money & have more excess reserves.
2. Banks create more money by loaning out excess.
3. Money supply increases, interest rates fall, AD goes up.
• RR down, MS up, I up, i down, AD up
• For Inflation
• Increase the reserve ratio
1. Banks hold more money & have less excess reserves.
2. Banks create less money.
3. Money supply decreases, interest rates up, AD down.
1. RR up, MS down, I down, i up, AD down

• Open Market Operations (OMO)
• FED buys or sells government bonds (securities)
• This is the most important & widely used monetary policy.
• If the  FED buys bonds: it takes bonds out of the economy & replaces them with money.
• MS up
• If the FED sells bonds: it takes money & gives the security to the investor.
• MS down

• The Discount Rate
• The discount rate is the interest rate that the FED charges commercial banks for short term loans.
• Federal Funds Rate
• The federal funds rate is the interest rate that banks charge one another for overnight loans.