Tools of Monetary Policy

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Tools of Monetary Policy

3 tools

1. Setting RR
2. lending $ to banks and thrifts
• Discount rate
3. Open Market Operations
• Buying and selling bonds

RR

• "fractional reserve system"
• The Fed sets the amount that bank must hold
• RR is % of deposit that banks must hold in reserve
• loan eventually becomes deposits for another bank that will loan out ER 
• If there is a recession fed actions on RR
• decrease reserve ratio
• Banks hold decrease money and have more ER
• Banks create more $ by loaning out excess
• money supply increases, interest falls, AD increases, RR decreases, MS increases, i increases, I increases, and AD increases
• If there is inflation fed actions on RR
• Increases reserve ratio
• Banks hold more money and have less excess reserve
• banks create less money
• RR increases, MS decreases, i increases, I decreases, AD increases
• OMO is when fed. buy or sell govt bonds
• this is most important and widely used monetary olicy
• of fed buys bonds it takes bonds out of the eco and replaces them with $
• If fed sell bonds it takes $ and give the security to the investor
• To increase MS fed should BUY govt securities
• to decrease MS fed should sell govt securities
• If fed buys bonds the DD X MM

Discount Rate

• interest rate that fed charges commercial banks for short term loans
• DD generally not used by the fed to affect monetary supply