Tools of Monetary Policy- How the Fed Influences Change in Our Economy

Tools of monetary policy help to put money back into the economy in the United States. One of the first tools that are used by banks is creating money. Banks do not just print money but also create money by giving out loans to customers. For instance if you take out a loan of two thousand dollars and you decide to deposit the money into a checking account. The bank will take that two thousand dollars and loan a portion of it out to a consumer. The amount that the bank can loan out is determined by the required reserve ratio. The money that is loaned then retains interest making both you and the bank money. The required reserve ratio is a fraction of the deposit that must be kept on reserve just in case you want to make a withdrawal from the bank. Otherwise if they did not keep this certain amount of your money on hand they would go bankrupt because then when people made withdrawals the bank would have to make loans to pay you back the money which would end up as a loss to them. Another process of monetary policy is the money multiplier. This is the money that the bank makes and that you make when they keep taking loans and they keep loaning them out to make a profit. The money multiplier formula is calculated as one divided by the required reserve ratio. The money multiplier tells us how much the money supply will increase after an initial cash deposit to the banking system. To make this process seem simpler lets say for instance that you deposit one thousand dollars into your local bank. Nine hundred of that thousand dollars is then loaned out to another customer and the bank holds onto nine hundred dollars. That nine hundred dollars is then deposited into a bank where ninety of the nine hundred is taken out to hold on reserve and the other eight hundred and ten is loaned out. If you add up all of the money that has been loaned out you will realize that the money supply has increase by two thousand seven hundred and ten. Sometimes banks hold excess reserves so that the demands of the customer who made that first deposit will be made. This shows you that loans are one of the biggest factors when it comes to the economy and its banking system.

One of the simplest tools of monetary policy that the Fed uses to adjust the amount of reserves in the banking system is to change the required reserve ration. Though it is the easiest for the Fed to use it is the least used method. By reducing the RRR it frees up reserves for banks, allowing then to make more loans. By allowing banks to make more loans it also helps to increase the money multiplier. Both of these would cause a substantial increase in the money supply held by the banks around the United States. The Fed can also use this process in reverse by hiring the RRR. This hick in the RRR would cause money held by the banks to increase but even the smallest rise in the RRR would cause banks around the country to take out considerable amounts of loans so that they could hold the minimum amount of money needed for the RRR.

Another key tool of monetary policy is the discount rate. The discount rate is the interest rate that the Federal Reserve charges on loans to financial institutions. Banks barrow from the Fed to maintain reserves at the required level. Changes in the discount rate can affect the prime rate. The prime rate is he rate of interest banks charge on short term loans to their best customers which are usually large companies with good credit ratings. The Fed uses this method if they want, for instance the banks that they loan the money out to, to make more loans. With a lower discount rate banks can reduce their excess reserves by lending them out. Then they wont have to worry about their reserves falling to low. The banks then can add to their reserves by borrowing from the Fed at a low rate. These new loans that the banks make will then increase the money supply in our economy. The opposite of this can also be said if the Fed decides to increase the discount rate. If the Fed decides that they want to reduce he money supply, it will increase the discount rate. By increasing the discount rate it cause banks to not want to borrow from the Fed. This will cause banks to hold more excess reserves to keep from falling below their required levels. This makes it so that the banks cannot make as many loans out to customers causing a decrease in the amount of money that is created by banks.

Out of all of these monetary policy tools the most important tool is open market operations. Open market operations are the buying and selling of government securities to alter the supply of money. Out of all of the monetary policies this one is used by far the most. When the Federal Open Market Committee chooses to increase the money supply it orders the trading desk at the Federal Reserve Bank of New York to purchase a certain quantity of government securities on the open market. The Federal Reserve Bank buys these securities with a check draen on Federal Reserve funds. The seller of that bond then deposits that money from that bond sales in its bank. With this technique funds enter the banking system setting in motion the money creation process. If the FOMC decides that they want to do the exact opposite and decrease the money supply it will make an open market bond sale. The Fed sells government securities back to bond dealers, receiving from them checks drawn on their own bank accounts. Once the Fed has processed these checks, the money is out of circulation. Banks then reduce their outstanding loans in order to keep reserves in the banking system.