March 31, 2017

Tools of monetary policy

• 1) reserve requirement
• 2) open market operation
• 3) discount rate

Reserve requirement

• Only a small percent of money is in the safe
• The rest is loaned out
• Set amount bank must hold for lending ability
• If there is a recession, the FED should decrease the reserve ratio
• Banks hold less money and have more excess reserves
• Banks create more money by loaning out excess
• Money supply increases, interest rates fall,  AD goes up
• If there is an inflation, the FED should increase the reserve ratio
• Banks hold more money and have less excess reserves
• Banks create less money
• Money supply decreases, interest rates rise, and AD goes down

Monetary multiplier

• Find change in money supply,

Open market operations

• When the FED buys or sells government bonds (securities)
• This is the most important and widely used monetary policy
• If the FED buys bonds - it takes bounds out of the economy and replaces them with money
• If the FED sells bonds - it takes money and gives the security to the investor
• The effect of the open market ops are enhanced by the multiplier - if banks don't loan that money or people hold the cash, it becomes ineffective

The discount rate

• There are many different interest rates, but they tend to all rise and fall together