Monetary Policy ToolsChapter 16 Section 3 and 4

RRR – required reserve ration◦ Cash deposit x (1/RRR) = the money multiplier◦ Simplest way to change M2◦ Increase Reserves = Decrease in money supply◦ Decrease Reserves = Increase in money supply◦ Rarely used in today’s economy

Money Creation

This is the interest rate that the Fed charges on loans to financial institutions. ◦ Usually will set a “target level” for loans to be set

at. ◦ Prime rate – rate of short-term loans to their best

customers◦ Increase IR = less M2◦ Decrease IR = more M2

The Discount Rate

Buying and selling bonds◦ the most important

and most used monetary policy tool

◦ Can be done smoothly and on an ongoing basis

Open Market Operations

Money supply increase – interest rates decrease

Money supply decreases – interest rates increase

How Monetary Policy Works

When policy is made, it must be made at the correct time of the business cycle or adverse effects can take place.

Inside lag – the time it takes to implement monetary policy

Outside lag – the time it takes for monetary policy to have an effect

Is it better left alone?

The Problem of Timing