Tools of Monetary Policy

• Reserve Requirement 
• Fractional reserve systems 
• The Fed sets the amount that the banks must hold 
• The reserve requirement (reserve ratio) is the percent of deposits that banks must hold in reserve ( the percent they can not loan out) 
• Using Reserve Requirement 
• Recession, what should the FED do to the reserve requirement 
• Decrease the reserve ration 
• 1. Banks hold less money and have more excess reserves 
• Banks create more money by loaning out excess 
• Money supply increases, interest rates fall, AD goes up
• Opposite during Inflation Times 
• Open Market Operation
• When the FED buys or sells government bonds (secretes)
• This is the most important and widely used monetary policy 
• If FED buys bonds- it takes bonds out of the economy and replaces them with money; MS increases
• If the FED sells bonds- it takes money and gives the security to the investors; MS decrease 
• Discount Rate
• There are many different interest rates, but they tend to all rise and fall together 
• The Discount Rate is the interest rate that the fED charges commercial banks for short-term loans 
• Federal Funds Rate 
• The Federal Funds rate is the interest rate that banks charge one another for overnight loans