Tools of Monetary Policy Copyright 2014 Diane S. Docking1.

Copyright 2014 Diane S. Docking 1

Tools of Monetary Policy

Learning ObjectivesUnderstand the monetary policy

tools used by the Fed.

Copyright 2014 by Diane Scott Docking 2


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.


Tools of Monetary Policy

Tools ofMonetary

Policy



Changing the Required Reserve Ratio


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.”

8Copyright 2014 Diane S. Docking

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


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


Changing the Discount Rate


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).


Open Market Operations


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


Example: Deposit Creation Using Required Reserve Ratio & Open Market Operations by Fed

See Example reading


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


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.



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 ___________



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


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



Example: Deposit and Reserve Contraction

Suppose the Treasury Decides to sell $1,000,000 worth of T-Bills.

How will this ultimately affect the banking system?

Tools of Monetary Policy Copyright 2014 Diane S. Docking1.

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