MONETARY TOOLS

1) Reserve requirement

    -Only a small percent of your bank deposit is in the safe. The rest of the money has been loaned out. This      is called "Fractional Reserve Banking". The FED sets the amount that the banks must hold. The                   RR(reserve ratio) is the % of deposits that banks must hold and not loan out.
  -When the FED increases money supply(MS), it increases the amount of money held in bank deposits.

If there is a recession, the FED should decrease the RR:

1) Banks hold less money and have more excess reserves.
2) Banks create more money by loaning out excess reserves.
3) MS increases, interest rates fall, AD goes up.

If there is inflation, FED should increase the RR:

1) Banks should hold more money and have less ER.
2) Banks create less money.
3) MS decreases, interest rates up, D down.

2) Discount rate

    -This is the interest rates that FED charges commercial banks.
    -To increase the MS, the FED should decrease the discount rate (easy money policy).
    -To decrease MS, the FED should increase the discount rate (tight money supply).
    -Only member banks are entitled to the discount rate.

3) Open market operations

    -The FED buys/sells government bonds(securities),
    -This is the most important and widely used monetary policy.
    -To increase the MS, the FED buy government securities.
    -To decrease the MS, the FED sell government securities.
    -Buying bonds = bigger MS, selling bonds = smaller MS.

Federal funds rate

-This is where FDIC member banks loan each other overnight funds.

Prime rate

-This is the interest rate that banks charge their most credit worthy customer.

When a customer deposits or withdraws cash from their demand deposit account, it has no effect on money supply. It only changes:

1) The composition of money
2) Excess reserves.
3) Required reserves.

Single bank

-Loan from your excess reserves (ER).

Banking system

-ER * multiplier (total money supply).

Anytime the FED buys or sells bonds, ER is created.