Tools of Monetary Policy and 3 Shifts of Money Supply

The Fed adjusting the money supply by changing any one of the following

1. Setting reserve requirements
2. Lending Money to Banks
• Discount rate
3. Open Market Operations
• Buying and selling bonds

The reserve requirement

• Only a small percent of your money is in the safe the rest  of your money has been loaned out. This is called "fractional reserve banking"
• The FED sets the amount that banks must hold. The reserve requirement is the percent of deposits that banks must hold in reserve.

Using Reserve requirement

• If there is a recession, what should the FED do to the reserve requirement?
• Decrease the reserve ratio
1. Banks hold less money and have more excess reserve.
2. Banks create more by loaning out excess
3. Money supply increases, interest rates decrease, AD goes up
• If there is inflation, what should the FED do to the reserve requirement?
1. Increase the reserve ratio
2. Banks hold more money and have less excess reserves
3. Banks create less money
4. Money supply decreases, interest rate increases, AD decreases

Open Market Operations

• Open market operations is when the FED buys or sells govt. bonds
• This is the most important and widely used monetary policy.
• If the FED buys bonds it takes bonds out of the economy and replaces them with money.
• If the FED sells bonds it takes the money and gives the security to teh investor.

The Discount rate

• There are many different interest rates, but they tend to all rise and fall together.
• The discount rate is the interest rate that the FED charger commercial banks for short term loans.

Federal Funds Rate

• The federal funds rate is the interest rate that banks charge one another for overnight loans as reserves.

Prime rate

• It is the interest rate that banks charge their most credit worthy customers.