THREE TOOLS OF MONETARY POLICY
1.
The
Reserve Requirement:
-
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 percentage of deposits
that banks must hold in reserve and NOT loan out.
-
When the FED increases the money supply
it increases the amount of money held in bank deposits.
·
If there is a recession, what should the
FED do to the reserve requirement? Steps:
Decrease the Reserve
ratio
1.
Banks hold less money and have more
excess reserves.
2.
Banks create more money by loaning
out excess.
3.
Money supply increases, interest
rates fall, AD goes up.
·
if there is inflation, what should the
FED do to the reserve requirement?
Funds Increase the
Reserve ratio
1.
Banks hold more money and have less
excess reserves.
2.
Banks create less money.
3.
Money supply decreases, interest
rates go up, AD down.
2.
The
Discount Rate
-
The discount rate is the interest rate
that the FED charges commercial banks. For example, if bank of America needs
$10 million, they borrow it from the US 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.
Open
Market Operations
-
The FED buys/sells 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 (bonds).
-
Ø Federal funds rate.
This is where FDIC member banks,
loan each other overnight loans.
Ø Prime rate
Interest rate that banks give to
their most credit worthy customers.
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