Monetary Policy Tools Chapter 16 Section 3Chapter 16 Section 3

Money Creation Department of Treasury is in charge of manufacturing money Department of Treasury is in charge of manufacturing money Federal Reserve is in charge of putting money into circulation Federal Reserve is in charge of putting money into circulation Process of putting money into circulation is referred to as money creation Process of putting money into circulation is referred to as money creation Multiplier effect: for every 1 dollar change in fiscal policy creates greater than 1 dollar change in the economy  money creation works in the same way Multiplier effect: for every 1 dollar change in fiscal policy creates greater than 1 dollar change in the economy  money creation works in the same way

Money creation- Banks Money creation doesn’t mean printing money Money creation doesn’t mean printing money Banks create money by going about their business Banks create money by going about their business When ever you deposit money into your account, that is money creation When ever you deposit money into your account, that is money creation

Money creation- Banks Banks will also make money by charging interest- amount they are allowed to lend is determined by the RRR Banks will also make money by charging interest- amount they are allowed to lend is determined by the RRR RRR: calculated by the ratio of reserves to deposits RRR: calculated by the ratio of reserves to deposits Example: if you deposit $1000 and the RRR is 10%, they can lend out $900 Example: if you deposit $1000 and the RRR is 10%, they can lend out $900

Money multiplier Process will continue until the loan amount (new money created) is very small Process will continue until the loan amount (new money created) is very small Money multiplier: formula to see how much new money will be created from each demand deposit Money multiplier: formula to see how much new money will be created from each demand deposit Initial cash deposit x (1/RRR) Initial cash deposit x (1/RRR) In the real world: people hold on to some money and the banks keep excess reserves In the real world: people hold on to some money and the banks keep excess reserves

Reserve Requirements A reduction of the RRR frees up reserves for banks- give more loans and increase money multiplier (money supply grows) A reduction of the RRR frees up reserves for banks- give more loans and increase money multiplier (money supply grows) Increase in RRR- banks hold more money and money supply shrinks Increase in RRR- banks hold more money and money supply shrinks This process can be disruptive to banking system This process can be disruptive to banking system The Fed will rarely change reserve requirements The Fed will rarely change reserve requirements

Discount Rate Interest rate the Fed Reserve charges on loans to financial intuitions Interest rate the Fed Reserve charges on loans to financial intuitions Changes in the discount rate affect the prime rate Changes in the discount rate affect the prime rate Prime rate: interest banks charge on short-term loans Prime rate: interest banks charge on short-term loans Reducing the discount rate: banks can lend more Reducing the discount rate: banks can lend more Increase the discount rate: shrinks the money supply Increase the discount rate: shrinks the money supply

Open Market Operations Most important monetary policy Most important monetary policy Buying and selling of governments securities Buying and selling of governments securities Bond purchases: Fed will buy bonds to increase money supply Bond purchases: Fed will buy bonds to increase money supply Bond sales: Fed will sell bonds to decrease money supply Bond sales: Fed will sell bonds to decrease money supply