Tools of Monetary Policy & 3 Shifters of MS (04/03/17

The FED adjusting the money supply by changing any one of the following:

1. Reserve Requirement
2. Open Market Operation 
3. Discount Rate

Reserve Requirement

In the Reserve Requirement the FED sells the amount that banks must hold. 

The reserve requirement (reserve ratio) is the percent of deposits that banks must hold in reserve (the  percent they can NOT loan out)

If there is a recession what should the FED do to reserve requirement?

Decrease the Reserve Ratio

1. Banks hold less money and have more excess reserves
2. Banks create more money by loaning out excess
3. Money supply increases, interest rates fall, AD goes up. RR↓ MS↑ i↓ I↑ AD↑

If there is inflation what should the FED do to the reserve requirement?

Increase the Reserve Ratio

1. Banks holds more money and have less excess reserves
2. Banks create less money
3. Money supply decreases, interest rates up, AD down. RR↑MS↓ i↑I ↓AD↓

Open Market Operation 

• Open money operation is 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 bonds out of the economy and replaces them with money. MS↑
• If the FED SELLS bonds it takes money and gives the securities to the investor. MS↓
• It also depends on whether or not the Purchase (or sale) is from a bank or from the nonbank pubilic

Discount Rate

The Discount Rate is the interest rate that the FED charges 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.

When they say the FED has "raised rates" they will charge us more to take out a loan.

The Prime Rate 

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