March 31, 2017

3 Tools of Monetary Policy 

3 Tools of Monetary Policy

1. Reserve Requirement
2. Open Market Operations (OMO)
3. Discount Rate

Reserve Requirement

• The FED sets the amount that banks must hold
• Bank deposits when someone (public or private) deposits money in the bank
• Banks keep some of the money in reserves and loans out their excess reserves
• The loan eventually becomes despots for another bank that will loan out their excess reserves
• The reserve requirement (reserve ratio) is the percent of deposits that the bank cannot loan out
• If there is a recession, the bank should:
• Decrease RR
• Banks hold less money and have more excess reserves
• Banks create more money by loaning out excess
• Money supply increases, Interest Rates Fall, Aggregate Demand Increases
• If there is an inflation, the bank should
• Increase RR
• Banks hold more money and have less ER
• Banks create less money
• Money Supply decreases, Interest Rates increase, Aggregate Demand decreases

Open Market Operations

• When the FED buys or sells government bonds (securities) 
• Most important/widely used monetary policy
• If the FED buys bonds ---> takes bonds out of economy and replaces them with money 

If the bank buys bonds, the money supply increases

If the bank sells bonds, the money supply decreases

• Effect is enhanced by multiplier, but if banks don't loan it out or people store it, it becomes effective.

The Discount Rate

• The interest rate that the FED charges commercial banks for short term loans

The Federal Fund Rate

• The interest rate that banks charge one another for overnight loans