CHAPTER 15
MONETARY
POLICY
Tools 2 and 3
2nd Tool: Reserve Ratio

Manipulation of the Reserve Ratio can influence the ability of
commercial banks to lend money.
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
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.
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.
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%)
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.
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.
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.
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.
TOOLS OF MONETARY POLICY
Easy Money Policy
• Buy Securities
• Decrease Reserve Ratio
• Lower Discount Rate
TOOLS OF MONETARY POLICY
Tight Money Policy
• Sell Securities
• Increase Reserve Ratio
• Raise Discount Rate
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
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