Unit 7 Macroeconomics:Taxes, Fiscal, and Monetary Policies

Chapters 16.3

EconomicsMr. Biggs

Monetary Policy Tools

Money CreationThe Department of the Treasury is responsible for manufacturing money.The Federal Reserve is responsible for putting dollars into circulation.Money creation - The process by which money enters into circulation.

How Banks Create MoneyMoney creation does not mean the printing of money.Banks create money by simply going about their business.For example, if you take out a loan for $1,000 and then deposit the $1,000, you have increased the money supply by $1,000 because demand deposit account balances are included in M1.

Using the fractional reserve banking system, banks make money by charging interest on loans.Required reserve ratio (RRR) - Ratio of reserves to deposits required by the Federal Reserve.

The Money MultiplierThe money creation process will continue until the loan amount becomes very small.Money multiplier formula - The amount of new money that will be created with each demand deposit.

In the real world, people hold some cash outside the banking system, meaning that some funds leak out of the money multiplier process.Also, banks sometimes hold excess reserves which are also a leaks.Excess reserves - Reserves greater than the required amount.

Reserve RequirementsThe simplest way for the Fed to adjust the amount of reserves in the banking system is to change the required reserve ratio (RRR).

Reducing Reserve RequirementsA decrease in the RRR would free up money for banks to make more loans and would also increase the money multiplier. This causes the money supply to increase.

Increasing Reserve RequirementsA slight increase in RRR would force banks to hold more money in reserve.This causes the money supply to contract.This is an effective but disruptive strategy and is not used very often.

Discount RateThe discount rate is the interest rate that the Federal Reserve charges on loans to financial institutions.Changes in the discount rate affects the cost of borrowing from the Fed and if it costs banks more to borrow from the Fed, they will raise their prime rate.Prime rate - Rate of interest banks charge on short-term loans to their best customers.

Reducing the Discount RateA decrease in the discount rate makes banks more willing to borrow from the Fed.This causes banks to increase lending, causing the money supply to expand.

Increasing the Discount RateAn increase in the discount rate makes banks less willing to borrow from the Fed.This causes banks to reduce lending in order to build reserves, causing the money supply to contract.

Open Market OperationsFederal Open Market Operations are by far the most-used monetary policy tool.Open market operations - The buying and selling of government securities to alter the money supply.

Bond PurchasesThe Fed’s (FOMC) purchase of treasury bonds increases reserves in the banking system.This causes banks to increase lending, causing the money supply to expand.

Bond SalesThrough treasury bond sales, the Fed removes reserves from the banking system.This causes banks to reduce lending, causing the money supply to contract.

Using Monetary Policy ToolsOpen market operations are the most used of the Federal Reserve’s monetary policy tools.The Fed changes the discount rate less frequently.Open market operations or changes in the discount rate do not disrupt financial institutions like changing the reserve requirement.Today, the Fed does not change reserve requirements to conduct monetary policy.

The End