Economics Micro & Macro (CliffsAP)

The power of the multiplier depends on two factors. First, when a bank holds onto excess reserves, it is not fully maxi-
mizing its ability to create new money. Second, for the multiplier to be fully effective, consumers must deposit all of
the money borrowed into another account. If consumers do not elect to deposit all of the borrowed money into another
account, there will be less money for banks to lend.

Tools of Monetary Policy

The following tools are used by the Federal Reserve to aid the economy in times of macroeconomic instability. It is
important to remember that these tools do not fix problems; rather, they provide a blueprint for supply and demand to
follow.

Reserve Requirement

The Fed requires banks to hold a fraction of their transaction deposits in their vaults. Transaction deposits are

checking accounts and other deposits that can be used for consumption.

Discount Rate

When a bank needs more reserves (money to keep on hand or lend out), it typically borrows from other banks in

what is called the federal funds market, so named because money is being lent from one bank’s account with

the Fed to another bank’s account with the Fed. For example, if Bulldog National Bank has $1 million in excess

reserves, it can lend money to another bank. When a bank borrows money in the federal funds market, it pays an

interest rate called the federal funds rate.

There are times when banks borrow directly from the Federal Reserve. When they do, the Fed charges what is

called the discount rate. The discount rate is changed periodically by the Fed to control the money supply.

When the Fed raises the discount rate, it is trying to discourage other banks from borrowing money and thereby

restricts the money supply. When the Fed lowers the discount rate, the expansion of the money supply is made

easier for banks because the Fed is encouraging banks to borrow.

It is important to remember that the discount rate is relatively stable, and it remains this way for months at a

time.

Open Market Operations

Open market operationsare the buying and selling of U.S. government bonds. This tool is the most effective

way in which the Federal Reserve controls the money supply. The FOMC is in charge of open market opera-

tions, and it can regulate the money supply through buying and selling government bonds. Suppose the FOMC

wants to stimulate growth in the economy and increase bank reserves. The committee can elect to buy govern-

ment bonds, which will increase the money supply. By buying bonds, the Fed is giving money to the economy

in exchange for a bond. In actuality, the Fed is paying banks for bonds, and this increases the banks’ reserves.

With more reserves, banks can lend out more money to consumers.

If the Fed wants to decrease the money supply, it sells bonds. With this strategy, the Fed takes money away from

banks in exchange for bonds. This reduces the amount of money that banks can loan out, thereby making it

more difficult for consumers to obtain loans.

A simple way to remember the effects on the money supply this process has is to remember the following

acronym:

Buying

Gives

Selling

Takes

Part II: Macroeconomics