Economics Online Tutor
Changes in the reserve requirement
The reserve requirement is defined and explained in the section on banking.
When the reserve requirement increases, excess reserves decrease. This decreases the amount of
reserves available for banks to loan out. This in turn decreases the ability of individual commercial
banks to create new money. This decreases the amount of money subject to the deposit expansion
When the reserve requirement decreases, excess reserves increase, new money created from bank
loans increases, and the amount of money subject to the deposit expansion multiplier increases.
Changes in the discount rate
The discount rate affects the money supply in the same way that the federal funds rate does. The
difference is that the federal funds rate is a market interest rate that banks use to borrow funds from
each other, while the discount rate is an interest rate that the Fed sets for funds that banks borrow
directly from the Fed.
The discount rate is slightly higher than the federal funds rate. The Fed actually uses two different
discount rates. It charges a lower rate to banks in good financial condition (banks with high credit
ratings). This lower discount rate is the lowest interest rate that the Fed has direct control over.
Liquidity Trap: a theory that expansionary monetary policy may be ineffective
after a certain point:
The liquidity trap theory states that when nominal interest rates are close to zero, monetary policy tools
are ineffective in lowering them further.
This can become an issue during times of expected deflation.
When the economy is in a recession, without the presence of a liquidity trap, monetary policy can be
used in order to try to increase private business investment. The cost of investment is interest, and an
increase in investment spending can increase output, jobs, and income.
Monetary policy during recessionary times would involve lowering interest rates.
However, if prices are expected to fall, then the nominal interest rate is lower than the real interest rate
[nominal rate = real rate plus expected inflation, with expected inflation negative]. The lower limit for
nominal interest rates is zero (because if the nominal interest rate were less than zero, it would mean
that creditors would be paying debtors for the use of the creditors' money, which wouldn't make sense).
So nominal rates cannot fall below zero. With expected deflation, and nominal interest rates lower than
real interest rates, there would exist a real interest rate that cannot be reduced with the use of monetary
When interest rates cannot be lowered using monetary policy, then monetary policy cannot be effective
in increasing investment, output, jobs, and income.
This is the liquidity trap.
Monetary policy is an alternative to discretionary fiscal policy for governments to
influence real output and price levels. In the United States, monetary policy is
conducted independently from fiscal policy.
Much disagreement exists among economists as to the relative effectiveness of
monetary vs fiscal policy, the relative effectiveness of specific policy tools, and
the wisdom of using these tools in the first place. These different opinions are
the reason why different economics schools of thought exist. These different
opinions also constitute a sizable portion of different political positions.
Different countries have different monetary & banking systems. The discussion
in this section will be limited to the tools of monetary policy within the United
States' Federal Reserve System (the Fed).
This discussion requires prior knowledge of topics covered in the section
The Fed has a degree of power to control the money supply in the economy. The
level of the money supply influences the level of real GDP as well as the price
The tools that the Fed uses to control the money supply are: open market
operations, changes in the reserve requirement, and changes in the discount
bonds" in this
discussion of open
refers to Treasury
include Treasury Bills,
which are short term
mature in less than
one year; Treasury
Notes, which are
bonds that generally
mature within one to
ten years; and
which are long term
bonds that generally
mature in twenty to
Treasury Bills pay no
they are issued at a
discount from par
value, and pay the full
par value upon
Treasury Notes and
Treasury Bonds pay
interest based on a
stated percentage of
par value once every
six months. The full
par value is paid
Open market operations
The main tool used by the Fed to control the money supply is open market
operations. This tool involves the Fed buying or selling government bonds on
the open market.
If the Fed wants to increase the money supply, it will buy government bonds on
the open market.
When the Fed buys bonds, the money paid for the bonds is deposited into the
accounts of brokers at various commercial banks. These deposits become new
additions to the money supply and new excess reserves for the banks to lend
out. This makes the amount spent on the purchase of bonds subject to the
Banks sometimes borrow overnight funds from each other in order to cover
deficiencies in reserves caused by unexpected withdrawals. The rate that they
charge each other is called the federal funds rate. With an increase in excess
reserves in the banking system caused by the Fed buying bonds, the cost of
borrowing for banks becomes lower. This lowers the federal funds rate. A lower
federal funds rate decreases bank costs, and banks can charge lower interest
rates to their borrowing customers. This in turn lowers the cost of private
business investment, resulting in more investment spending in the economy.
If the Fed wants to decrease the money supply, the opposite occurs. The Fed
sells bonds, and the money it receives from the proceeds is deducted from the
broker accounts. This decreases the money supply, excess reserves, and the
amount of reserves subject to the money multiplier. This also increases the
federal funds rate and commercial interest rates, decreasing investment
The Fed compares the federal funds rate to a target rate in order to determine
when to engage in open market operations.
Open market operations can also influence long term bond rates to move in the
same direction as the overnight (short term) federal funds rate. When the Fed
buys bonds, its actions increase the demand for bonds. With the laws of supply
& demand in effect, an increase in the demand for bonds will increase the prices
of bonds on the open market. An increase in the prices of bonds will decrease
their yields, or interest rates. When the Fed sells bonds, it increases the supply
of bonds. This decreases the prices of bonds, increasing their interest rates.
The Fed is able to influence bond rates because of market power. Transactions
by the Fed can be a relatively large portion of the overall bond market. In
addition, the Fed makes open market decisions without regard for any profit
motive, but competes in the bond market with investors who are guided by
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