Monetary Policy

Monetary Policy

3 Tools of Monetary Policy

1. Reserve Requirement 

•     - Only small % of deposit is in the safe. The rest is loaned out. Fractional Reserve Banking
•     - RR is % deposits that must not be loaned out
•     - If fed increases money supply it increases money held in bank deposits 
• - During recession, fed decreases RR to increase money supply, decrease interest, increasing AD
• - During inflation, fed increases RR, decreasing money supply, increasing interest, and decreasing AD
• . Discount Rate
• - interest rate Fed charges commercial banks
• - To increase money supply, decrease discount rate (easy money)
• - To decrease money supply, fed increases discount rate (tight money)
• . Open Market Operations (OMO)
• - Fed buys and sells bonds
• - Most widely used monetary policy
• - To increase money supply, Fed buys securities (bonds)
• - To decrease money supply, Fed sells bonds

Expansionary (recession) v. Contractionary (inflation) Policy

Expansionary 

- Buy Bonds (omo)

- Decrease Discount Rate

- Decrease RR

- MS Increase

- AD increase

- GDP increase

- interest decrease

- Loans increase

Contractionary

- Sell bonds

- Increase discount rate

- RR increase

- MS decreases 

- AD decrease

- GDP decrease

- Interest increase

- Loans decrease

Federal Fund Rate - FDIC member banks make overnight loans to other 

banks

Prime Rate - interest rate banks charge to most credit worthy customers