Unit 4 day 4

Three Tools of Monetary Policy

Reserve requirement-

• Only small % of bank deposit is safe. Rest is loaned out. “Fractional Reserve Banking”

• FED sets amount that banks must hold

• The reserve ratio is % of the deposits banks must hold

• When FED increases money supply, it increases money held in bank deposits 

If there is a recession, what should FED do to the reserve requirement?

• Decrease reserve ratio

•  Banks hold less $, more ER

•  Banks create money by loaning out ER

• Money supply increases, interest fall, AD ^

If there is inflation, what should FED do to RR?
   -Increase RR
    -Banks hold $, less ER
  -  Banks create less money
   - MS decreases, Interest up, AD down
The Discount Rate

•    Interest rate that the FED charges commercial banks

****Ex. If bank needs 10 mil, the borrow from US treasury(FED controls) but they must pay back with interest
-To increase MS, FED decreases Discount rate(Easy money policy)
-To Decrease MS, FED increases discount rate(Tight money policy)
Open Market Operations(OMO)

•    FED buys/sells govt bonds(securities)

•    Most important and widely used monetary policy

•    To increase MS, FED buys Govt securities

•    To decrease MS, FED sells govt securities

Federal Funds Rate
   FDIC member banks loan each other overnight funds instead of FED.
Prime Rate

• Interest rates banks give to their most creditworthy customers