Unit 4 tools of monetary policy

March 10, 2016

Federal Reserve Bank (FED)

Functions of FED

•  Issue paper money
•  Sets reserve requirements and holds reserves of the bank
•  Lends money to banks and changes their interest
•  Check clearing service for bank
•  Acts as personal bank for government
•  Supervises member banks
• Control money supply

     The Reserve Requirement

•  Only a small % of your bank deposit is in the safe, the rest of your money has been loaned out (Fractional Reserve Banking)
•  FED sets the amount that banks must hold
•  Reserve Requirement (reserve ratio) is the percent of deposits that banks must hold in reserves and NOT loan out)
• When the FED increase the money supply it increases the amount of money held in banks deposits
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 If there is a recession, what should the FED do to the reserve requirement?

·         Decrease Ratio Rate

o   Banks hold less money and have more excess reserves

o   Banks create more money by loaning out excess

o   Money supply increases, interest rate, AD goes up

If there is in inflation, what should the FED do to the reserve requirement?

·         Increase ratio rate

o   Banks hold more money and have less excess reserves

o   Banks create less money

o   Money supply decreases, intrest rate go up, AD goes down

The Discount Rate

: The Discount Rate is the interest rate that the Fed charges commercial banks

 If Bank of America needs 10 billion dollars, they must pay it back with interest

·         To increase money supply, the FED should decrease the discount rate (Easy Money)

·         To decrease money supply, the FED should increase the discount rate (Tight Money)

     Open Market Operations (OMO)

: The FED 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

Federal Fund Rate: FDIC member banks make overnight loans to other banks

Prime Rate: Interest rate the banks charge to their most credit worthy customers

Monetary Policy	Easy Money (Expansionary/ Recession)	Tight Money (Contractionary, inflation)
OMO	Buy Bonds	Sell Bonds
Discount rate	Decrease	Increase
Reserve Requirement	Decrease	Increase
MS	Increase	Decrease
AD	Increase	Decrease
GDP	Increase	Decrease
Loans	Increase	Decrease
Interest Rates	Decrease	Increase