Chapter 15 Monetary Policy

1. Chapter 15MonetaryPolicy Tools 2 and 3

2. 2nd Tool: Reserve Ratio • Manipulation of the Reserve Ratio can influence the ability of commercial banks to lend money.

3. TOOLS OF MONETARY POLICY The Reserve Ratio • Raising the Reserve Ratio • Banks must hold more reserves • Banks decrease lending • Money supply decreases • Lowering the Reserve Ratio • Banks may hold less reserves • Banks increase lending • Money supply increases

4. Raising the Reserve Ratio: • When the reserve ratio is raised, banks are required to have larger reserves. • This diminishes their ability to create money by lending. • They have to hold more in reserves and there have less to lend. • Banks could have lower checkable deposits and at the same time, increase reserves. • To reduce checkable deposits, the bank could let outstanding loans mature and be repaid, and not extend new credit. • Also, to increase reserves, the bank might sell some of its bonds. This would increase the banks reserves • This reduces the supply of money.

5. Lowering the Reserve Ratio: • When the reserve ratio is lowered, banks lending ability increases. • Lowering the reserve ratio, transforms required reserves into excess reserves, and enhances the ability of banks to create new money by lending. • Changing the reserve ratio affects the money creating ability in two ways: • Changes the amount of excess reserves. • It changes the size of the monetary multiplier. • Raising the reserve ration forces banks to reduce the amount of checkable deposits they create through lending.

6. Reserve Ratio Key Points • A powerful technique of monetary control • It is infrequently used • Last such change was in 1992 (the Fed lowered the reserve ratio from 12% to 10%)‏

7. 3rd Tool of Fed: Discount Rate • Commercial Banks sometimes must borrow money from the Federal Reserve Bank (e.g. unexpected and immediate needs for funds). • When a commercial bank borrows from the Fed, it gives the Fed a promissory note (an IOU) drawn against itself and secured by acceptable collateral (typically U.S. Government Securities). • The Fed charges interest on the loans it makes to Commercial banks • The interest rate the Fed charges is called the Discount Rate. • The Promissory note is an asset to the Fed and a Liability to the Commercial Bank.

8. 3rd Tool of Fed: Discount Rate • A loan to a commercial bank from the Fed, increases the borrowing bank’s reserves. • Since no required reserves need be kept against loan from the Fed, all new reserves acquired by borrowing from the Fed, are excess Reserves.

9. Discount Rate Key Points: • Borrowing from the Fed by Commercial banks, increases the reserves of the Commercial Banks and enhances their ability to extend credit. • The Fed has the power to set the Discount Rate that it charges banks. • From the viewpoint of the Commercial Bank, the discount rate is a cost of acquiring reserves. • Lowering the discount rate encourages commercial banks to obtain additional reserves from the Fed.

10. Discount Rate Key Points (cont.): • When the commercial banks lend the money obtained from the loan from the Fed, it increases the money supply. • When the Fed increases the discount rate, it discourages commercial banks from borrowing from the fed. • The Fed may raise the discount rate when it wants to restrict the money supply.

11. TOOLS OF MONETARY POLICY • Easy Money Policy • Buy Securities • Decrease Reserve Ratio • Lower Discount Rate

12. TOOLS OF MONETARY POLICY • Tight Money Policy • Sell Securities • Increase Reserve Ratio • Raise Discount Rate

13. Expansionary or Easy Money Policy • The Fed takes steps to increase excess reserves, which lowers the interest rate and increases investment which, in turn, increases GDP by a multiple amount

14. Contractionary or Tight Money Policy • Excess reserves fall, which raises interest rate, which decreases investment, which, in turn, decreases GDP by a multiple amount of the change in investment