Learning ObjectivesUnderstand the monetary policy
tools used by the Fed.
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The Federal Reserve and the Money SupplyThe Federal Reserve controls the
Money Supply by controlling the amount of transaction deposits in the banking system.◦If the Fed wishes to increase
(decrease) the Money Supply, it increases (decreases) deposits.
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How Fed Controls Money Supply via Required Reserve Ratio
Banks must maintain reserves as percent of deposits
Reserves kept as deposits in Fed (plus vault cash)
Fed controls level of deposits by setting the “required reserve ratio.”
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Reserve Requirements
A decrease in RR → increase in Supply of Loanable Funds (LF) → decrease in Interest rates (assuming demand stays constant).
An increase in RR → decrease in Supply of Loanable Funds (LF) → increase in Interest rates (assuming demand stays constant).
• Rarely used as a tool1. Raising causes liquidity problems for banks2. Makes liquidity management unnecessarily difficult
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Reserve Requirements
Advantages◦ 1. Powerful effect
Disadvantages◦ 1. Small changes have very large
effect on Ms
◦ 2. Raising causes liquidity problems for banks
◦ 3. Frequent changes cause uncertainty for banks
◦ 4. Tax on banks
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Changing the Discount Rate
A decrease in DR → increase in borrowing by banks →increase in Supply of Loanable Funds (LF) → decrease in Interest rates (assuming demand stays constant).
An increase in DR → decrease in borrowing by banks → decrease in Supply of Loanable Funds (LF) → increase in Interest rates (assuming demand stays constant).
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Open Market OperationsOpen market operations involve the purchase or
sale of government securities based on FOMC directives sent to N.Y. Fed Trading Desk
Open market purchase of government securities: ◦ Fed purchase of securities results in an injection of
additional funds into the bank system Increases supply of federal funds, which Lowers federal funds rate, which leads to Lower rates spread to other money market securities
◦ More funds available for money market and bank lending◦ Increase bank deposits and bank reserves, money market
liquidity and, in time…◦ Increases the money supply
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Example: Deposit Creation Using Required Reserve Ratio & Open Market Operations by Fed
See Example reading
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Deposit CreationThe maximum number of dollars in new
deposits that result from the Fed’s action is:
where k is called the “deposit multiplier” and rr is the “required reserve ratio”.
ontractioncinitialkTDor
infusioninitialkTD
rrk
1
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Deposit Creation in the Banking System
The lower the required reserve ratio, the greater the deposit multiplier and its effect on deposits.
This model of multiple deposit creation ignores the fact that: ◦ The public may desire to hold money in the
form of ____________ instead of transaction deposits
◦ The bank may choose to hold ______________ and not loan out all of the money.
◦ If this is the case, then the deposit multiplier is smaller than if excess reserves = 0 and currency = 0.
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Deposit Creation in the Banking System
Excess Reserves = ER = e x TD ; where e = percentage of transaction deposits held as excess reserves; i.e., e = $E/$TD
Level of Currency = C = c x TD ; where c = percentage of transaction deposits held as currency; i.e., c = $C/$TD
“e” and “c” are referred to as ___________
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Deposit Creation in the Banking System
k = 1
rr + e + c
If e 0 and c 0, then the deposit multiplier is:
Monetary Policy
Suppose reserves are $2 billion and the Fed increases reserves by 1% or $20 million when bank reserve requirements are 10%.
What is the predicted increase in bank deposits?
Suppose reserves are $2 billion and the Fed increases reserves by 1% or $20 million when bank reserve requirements are 10%.
What is the predicted increase in bank deposits?
billion $2.2million 200billion 2TD
million $200million $200.10
1 TD
new
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Monetary Policy
Suppose that instead of changing the $2 billion in reserves the Fed reduces the reserve requirement from 10% to 9%.What is the predicted increase in bank deposits?
Suppose that instead of changing the $2 billion in reserves the Fed reduces the reserve requirement from 10% to 9%.What is the predicted increase in bank deposits?
000,000,222,2$million 222billion $2TD
million $222 million) $20(0.09
1
million $20 billion $2 of 1% infusion Initial
new
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