Tools of Monetary Policy
Copyright 2014 Diane S. Docking
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Learning Objectives

Understand the monetary policy tools
used by the Fed.
Copyright 2014 by Diane Scott Docking
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The Federal Reserve and the Money
Supply

The 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.
Copyright 2014 Diane S. Docking
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Tools of Monetary Policy
Tools of
Monetary
Policy
Copyright 2014 Diane S. Docking
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Copyright 2014 Diane S. Docking
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Changing the Required
Reserve Ratio
Copyright 2014 Diane S. Docking
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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.”
Copyright 2014 Diane S. Docking
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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 tool
1. Raising causes liquidity problems for banks
2. Makes liquidity management unnecessarily difficult
Copyright 2014 Diane S. Docking
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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
Copyright 2014 Diane S. Docking
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Changing the
Discount Rate
Copyright 2014 Diane S. Docking
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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).
Copyright 2014 Diane S. Docking
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Open Market Operations
Copyright 2014 Diane S. Docking
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Open Market Operations


Open 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
Copyright 2014 Diane S. Docking
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Example: Deposit Creation Using
Required Reserve Ratio & Open
Market Operations by Fed
See Example reading
Copyright 2014 Diane S. Docking
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Deposit Creation
The maximum number of dollars in new deposits that
result from the Fed’s action is:
TD  k  initialinfusion
or
TD  k  initialcontraction
where k is called the “deposit multiplier” and rr is
the “required reserve ratio”.
1
k
rr
Copyright 2014 Diane S. Docking
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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.
Copyright 2014 Diane S. Docking
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Deposit Creation in the Banking System

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 ___________
Copyright 2014 Diane S. Docking
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Deposit Creation in the Banking System
If e  0 and c  0, then the deposit
multiplier is:
1
k =
rr + e + c
Copyright 2014 Diane S. Docking
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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?
 1 
TD  
  $20 million  $200 million
 0.10 
TD new  2 billion  200 million  $2.2 billion
Copyright 2014 by Diane Scott Docking
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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?
Initial infusion  1% of $2 billion  $20 million
 1 

  ($20 million)  $222 million
 0.09 
TD new  $2 billion  222 million  $2,222,000,000
Copyright 2014 by Diane Scott Docking
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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?
Copyright 2014 Diane S. Docking
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