4.6 part 1 - Monetary Policy - SCARCE Reserves (Money Market Graph)

3 Economic Goals of a Country

1. Limit inflation (stable prices)

2. limit unemployment (or full employment)

3. promote economic growth (increase RGDP)

Scarce Reserves System

= Fractional Banking System

• uses money market graph to explain how FED changes interest rates

• central bank targets commercial banks’ policy rate through changes in Money Supply

Money Market Graph

• explains how the FED changes interest rates

• Central Bank targets commercial banks’ policy rate (Federal Funds Rate) through changes in Money Supply

2 Options if Commercial Banks aren’t at Reserve Requirement Rate

1. Federal Funds Rate

2. Discount Rate

Federal Funds Rate (Policy Rate)

_____ is what commercial banks charge when they lend out excess reserves to other banks overnight to make Reserve Requirement

Discount Rate

____ is what the FED charges when they lend money to commercial banks for overnight loans to make Reserve Requirement

• one of 3 monetary policy tools in scarce reserves system

  • Increase Disc. Rate = MS← = AD←

  • Decrease Disc. Rate = MS→ = AD→

3 Monetary Policy Tools in Scarce Reserves System

1. Discount Rates

2. Reserve Requirement

3. Open Market Operations ***

Reserve Requirement

% of demand deposits that banks cannot loan out

one of 3 monetary policy tools in scarce reserves system

• Increase RR = MS← = AD←

• Decrease RR = MS→ = AD→

Open Market Operations

FED buys/sells gov bonds (securities) to commercial banks

MOST EFFECTIVE monetary policy by fed in scarce reserves system

• Sell Securities = MS← = AD←

• Buy Securities = MS→ = AD→

“Sell Small, Buy Big”

Scarce Reserves Contractionary Policy

• fight inflation

• Raise discount rate

• Raise reserve requirement

• Open Market SALE of gov bonds

MS← = ir→ = AD←

Scarce Reserves Expansionary Policy

• fight unemployment

• Lower discount rate

• Lower reserve requirement

• Open Market PURCHASE of gov bonds

MS→ = ir← = AD→