Monetary Policy ToolsChapter 16 Section 3

Money Creation

• Department of Treasury is in charge of manufacturing money • Federal Reserve is in charge of putting money into

circulation • Process of putting money into circulation is

referred to as money creation• Multiplier effect: for every 1 dollar change in fiscal

policy creates greater than 1 dollar change in the economy money creation works in the same way

Money creation- Banks

• Money creation doesn’t mean printing money• Banks create money by going about their business • When ever you deposit money into your account,

that is money creation

Money creation- Banks

• Banks will also make money by charging interest- amount they are allowed to lend is determined by the RRR• RRR: calculated by the ratio of reserves to deposits • Example: if you deposit $1000 and the RRR is 10%,

they can lend out $900

Money multiplier

• Process will continue until the loan amount (new money created) is very small

• Money multiplier: formula to see how much new money will be created from each demand deposit

• Initial cash deposit x (1/RRR)

• In the real world: people hold on to some money and the banks keep excess reserves

Reserve Requirements

• A reduction of the RRR frees up reserves for banks- give more loans and increase money multiplier (money supply grows)

• Increase in RRR- banks hold more money and money supply shrinks

• This process can be disruptive to banking system

• The Fed will rarely change reserve requirements

Discount Rate

• Interest rate the Fed Reserve charges on loans to financial intuitions• Changes in the discount rate affect the prime rate• Prime rate: interest banks charge on short-term

loans • Reducing the discount rate: banks can lend more• Increase the discount rate: shrinks the money

supply

Open Market Operations

• Most important monetary policy

• Buying and selling of governments securities

• Bond purchases: Fed will buy bonds to increase money supply

• Bond sales: Fed will sell bonds to decrease money supply