UNIT 4: 3 Tools of Monetary Policy

(3/21/16)

3 TOOLS OF MONETARY POLICY:

#1 The Reserve Requirement
- holding a % back.
- only a small percent of your bank deposit is in the safe. The rest of your $ 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 reserve and NOT loan out.
*FED increases money supply increases amount of money held in bank deposits

1. If there is a recession, what should the FED do to the reserve requirement?
- Decrease the Reserve Ratio
1) banks hold less money & have more excess reserves.
2)banks create more money by loaning out excess.
3) MS increases, interest rate decreases, AD increases.

2. If there is inflation, what should the FED do to the reserve requirement?
- Increase the Reserve Ratio
1) banks hold more money & less excess reserves.
2) banks create less money.
3) MS decreases, interest rates increasem AD decreases.

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

- to increase the MS, the FED should decrease the Discount Rate (Easy).
- to decrese the MS, the FED should increase the Discount Rate (Tight).

#3 Open Market Operations (OMO)
- The FED buys/sells government bonds (securities).
- This is the MOST IMPORTANT and widely used.
- to increase MS, FED buy gov. securities.
- to decrease MS, FED sell gov. securities.

*Federal Funds Rate - where FDIC member banks loan eachother overnight funds.
                                   ex./ Wells Fargo borrow from Chase.

*Prime Rate - interest rate that banks give to their most credit worthy customers.