Monetary Policy

Monetary Policy Tools

★Money Creation

●How banks create money

■banks expand the money supply by

making loans

How it works:
➔money is deposited in a bank

➔after meeting the reserve requirement,

money is loaned out by banks
➔this money is spent, deposited, and

loaned out again
➔and so on and so on…

★Tools of the Fed and Monetary Policy

●Reserve requirement—the amount of money

banks cannot loan out and must be held in
reserve

■most powerful tool
■changes money supply drastically
■reserve rate increases, money supply

decreases

■reserve rate decreases, money supply

increases

Multiple Choice

What is the reserve requirement?

• The amount of money banks owe the government

• The amount of money banks have to hold

• The amount of money banks can borrow

• The amount of money banks can invest

●Discount rate

■interest rate the Fed charges to

commercial banks (discount rate)

■they increase the rate, then pass it

on to people borrowing (cover the
spread [prime rate])

■useful tool for “fine tuning”
■gives incentives for borrowing (or

not) money

Multiple Choice

What is the "discount rate"

• Interest rate the Fed charges commercial banks

• The rate of inflation

• The rate of return on investments

• The rate of exchange between two currencies

●Open market operations

■most utilized and important tool
■buying and selling government

securities and bonds

■if the fed buys bonds—money

supply increases

■if the fed sells bonds—money

supply decreases

■this can change the money supply

quickly

●Directions of the Fed depends on its

objectives:

■tight money policy—used to control

inflation

■easy money policy—used to

control recession

★Monetary Policy

●Deals with changes in the money

supply

●All three previously mentioned ways

are used

●Usually counter-cyclical

■reverses current economic trends
■why? (for stability)
■usually better for the economy