Unit 4 Notes - March 21st, 2016

Tools of Monetary Policy

Reserve Requirement

·         Reserve Requirement: Only a small % of your bank deposit is in the safe. The rest of your money has been loaned out. [Fractional Reserve Banking]

·         The FED sets the amount banks must hold.

·         Reserve Requirement is the % of deposits that banks must hold in reserve and NOT loan out.

·         When the FED increases Money Supply, it increases the amount of money held in bank deposits.

·         If there is a Recession, what should the FED do to the RR?

o   Decrease it

§  Banks hold less money and more ER

§  Banks create money by loaning

§  Money Supply increases, Interest Rates fall, AD increases

·         If there is Inflation, what should the FED do to the RR?

o   Increase it

§  Banks hold more money and less ER

§  Banks create less money

§  Money Supply decreases, Interest Rates go up, AD decreases

Discount Rate

·         Discount Rate: The interest rate that the FED charges commercial banks.

·         Example: If Banks of America need $10 million, they borrow it from the US Treasury but must pay it back with interest.

·         To Increase MS, FED should Decrease the Discount Rate (Easy Money Policy)

·         To Decrease MS, FED should Increase the Discount Rate (Tight Money Policy)

Open Market Operations

·         Open Market Operations: FED buys/sells government bonds [securities]

·         Most important and widely used Monetary Policy

·         To Increase MS, FED should Buy government securities.

·         To Decrease MS, FED should Sell government securities.

Monetary Policy	Expansionary (Easy Money) (Recession)	Contractionary (Tight Money) (Inflation)
OMO	Buy Bonds	Sell Bonds
Discount Rate	Decrease	Increase
RR	Decrease	Increase
Loans, AD, GDP, MS	Increase	Decrease
Interest Rate	Decrease	Increase

Federal Fund Rate: FDIC member banks loan each other overnight funds [from bank to bank].

Prime Rate: Interest Rate that banks give to their most credit worthy customers.