3-21-16

Monetary Policy

Jesse Le deposits $1,000 in cash into Happy Bank. The reserve requirement is 20%. Happy Bank has no excess reserves.

1.What is the immediate effect on the money supply?

There is no immediate change, only the composition of the money changes.

2.What is the maximum increase on the MS that can be made by Happy Bank?

($1,000*.20)=$200

$1,000-$200=$800

3. What is the maximum effect on the MS by the entire banking system?

1/.20=5

5*$800=$4,000

4. Why won’t the MS be increased by its theoretical maximum amount?

Due to there being no excess reserves there can be no lending and no money made.

3 Rules of Monetary Policy

1. The Reserve Requirement

-Only a small percent of your money deposit 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 (reserve ratio) is the % of deposits that banks must hold in reserve and not loan out.

-When the FED increases the money supply it increases the amount of money held in bank deposits.

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

Decrease the Reserve  Ratio

Banks hold less money and have more excess reserves

Banks create more money by loaning out excess

Money supply increases, interest rates fall, AD goes up

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

Increase the Reserve Ratio

Banks hold more money and have less excess reserves

Banks create less money

Money supply decreases, interest rates up, AD goes down

2. The Discount Rate

-The Discount Rate is the interest rate that the FED charges commercial banks.

Ex. If Banks of America needs $10 million, they borrow it from the U.S. Treasury (which the FED controls) but they must pay it back with interest.

-To increase the Money supply, the FED should decrease the Discount Rate (Easy Money Policy)

-To decrease the Money supply, the FED should increase the Discount Rate (Tight Money Policy)

3. Open Market Operations (OMO)

The FED buys/sells government bonds (securities).

This is the most important and widely used monetary policy

To increase the Money supply, the FED should Buy government securities.

To decrease the Money supply, the FED should Sell government securities

	Easy Money (Recession)	Tight Money (Inflation)
Monetary Policy	Expansionary	Contractionary
OMO	Buy Bonds	Sell Bonds
Discount Rate	Decrease	Increase
Reserve Requirement	Decrease	Increase
Loans	Increase	Decrease
AD	Increase	Decrease
DP	Increase	Decrease
MS	Increase	Decrease
I	Decrease	Increase

Federal Fund Rate- This is where FDIC member banks loan each other overnight funds.

Prime Rate- It is the Interest Rate that Banks give to their most creditworthy customers.

Money Supply and Bank Reserves are the same federal funds rate will be opposite