Key Principles & Tools of Monetary Policy

A single bank can create money (through loans) by the amount of excess reserves

The banking system as a whole can create money by a multiple of the initial excess reserves

Cash is existing money that increase bank reserves, but it does not create an immediate change in MS

FED purchase of a bond from the public is new money that increases bank reserves and causes an immediate change in MS

Bank purchase of a bond from the public is new money that increases bank reserves and causes and immediate change in MS

Factors that weaken the effectiveness of the deposit multiplier

• If banks fail to loan out all of their ER the FED has to change the multiplier
• If bank customers take their loans in cash rather than in new checking account deposits
• Demand for money has an inverse relationship between the nominal interest rates and the quantity of money demanded

What happens to the quantity demanded of money when interest rates increase? Decreases

What happens to the quantity demanded when interest rates decrease? Increase

Money demand Shifters

• Change in price level
• Change in income
• Change in taxation that affects investment

Functions of the FED

1. It issues paper currency
2. Sets reserve requirements and holds reserves of banks
3. It lends money to banks and charges them interest
4. They are in check clearing service for the banks
5. It acts as a personal bank for the government
6. Supervises member banks
7. Controls the money supply in the economy

In an open market operation you can either buy bonds (increase money supply) or sell bonds (decrease money supply)

The discount rate and the reserve requirement both decrease in an expansionary policy

The discount rate and the reserve requirement both increase in an contractionary policy

Federal Fund rate- it is the investment rate that commercial banks can charge other commercial banks for overnight loans

Prime rate- the interest rate that is given to a bank's most credit-worthy customer