Monetary Policy Assignment

Loanable Funds Market

• The private sector supply and demand of loans 
• This market brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects) 
• This market shows the effect on REAL INTEREST RATE 
• Demand- Inverse relationship between real interest rate and quantity loans demanded 
• Supply - Direct relationship between real interest rate and quantity loans supplied 
• This in NOT the same as the money market (supply is not vertical)
• Prime Rate -Intrest rate that banks charge their most credit worth customers 

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 

Money Creation

• A single bank can create money by the amount of its excess reserves 
• The banking system as a whole can create money by a multiple of the excess receivers 

• MM x ER= Expansion of money 

• Money Multiplier = 1/rr

New vs Existing $ 

• If the initial deposit in a bank comes from the FED or bank purchase of bond or other money out of circulation (buried treasure), the deposits immediately increases the money supply 
• The deposit then leads to further expansion of the money supply through the money creation process 
• Total change in MS if initial deposit is new $= Deposit + $ created by banking system 
• If a deposit in the bank is existing $ (already counted in M1), deposition the amount does NOT change the MS immediately because it is already counted
• Existing currency deposited into a checking account changes only the composition of the money supply from coins/paper $ to checking account deposit 
• Total change in the MS if deposits is existing $ = banking system c

Fractional Reserve System

Fractional Reserve System
The process in which banks hold a small portion of their deposits in reserves and they loan out the excess.
Demand Deposits
Created through the Fractional Reserve System
Required Reserves
Cash that banks keep on hand
Total Reserves (TR) or Actual Reserves (AR)
*Required Reserves (RR) + Excess Reserves (ER)

Money Market

• Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded 
• When the interest rate increases, the quantity demanded of money falls because individuals would prefer to have interest earring instead of borrowed liabilities
• When interest rates decrease, the money quantity demanded increase. There is no incentive to convert cash into interest earning assets 
• Money demand is downward sloping 
• Money Demand Shifters 
• Change inn price levels 
• Change in income 
• Changes in taxation that affects investment 
• Increasing the Money Supply 
• If the FED increase the money supply, a temporary surplus of money will occurs at 5% interest. 

The Federal Reserve Bank

Nickname: The FED

The Central Bank 

Job: The promote economic growth  and maximum employment