Tool of Monetary Policy

1. The Reserve Requirement

•   Only a small percent of your bank deposits is in the safe. The rest of your money has been loaned out. This is called Fractional Reserve Banking.

•   FED sets amount that banks must hold.

•   The RR is the percent 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.

1. Decreasing 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

2. Increasing Reserve Ratio

•   Banks hold more money and have less excess reserves

•   Banks create less money

•   Money supply decreases, interest rates increase, AD goes down

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

To increase the money supply, the FED should decrease the discount rate. (Easy money supply)

To decrease money supply, the FED should increase the discount rate. (Tight money supply)

3. Open Market Operations

•   The FED buys/sells government bonds. (securities)

•   To increase money supply, the FED should buy government securities.

•   To decrease money supply, the FED should sell government securities.