Unit IV: Monetary Policy

Monetary policy is always conducted by the Fed and only affects AD through investment spending.

In open market operations, the Fed can either buy bonds, which increases the money supply, or sell bonds, which decreases the money supply.

The discount rate is used when FDIC member banks and other eligible institutions may borrow short-term loans from the Fed (banks borrow from the Fed).

The federal funds rate is used when FDIC member banks loan each other overnight funds (banks borrow from each other).

Reserve requirement is a certain amount of reserves that banks must keep in the vault.

The prime rate is the interest rate that banks charge to do their most creditworthy customers.

If the Fed wants to fight a recession, it will enact expansionary monetary policy to increase the money supply by using one or more of the following tools:

• Buying bonds in open market operations
• when the Fed buys bonds, a demand deposit (DD) is created
• banks can make more loans after they've set aside the required reserve
• the money supply is increased
• as a result of buying bonds, the price of bonds increases and the nominal interest rate decreases
• Lowering the discount rate 
• when the discount rate is lower, banks can borrow funds from the Fed at a lower cost
• they can make more loans and money supply is increased
• Lowering the reserve requirement ratio
• when the reserve requirement is lower, banks have more excess reserves to make loans and money supply is increased
• Lowering the federal funds rate

If the Fed wants to fight inflation, it will enact contractionary monetary policy to decrease the money supply by using one or more of the following tools:

• Selling bonds in open market operations
• when the Fed sells bonds, buyers use their funds from a demand deposit
• banks have fewer excess reserves to lend money and the money supply is decreased
• as a result of selling bonds, the price of bonds decreases and the nominal interest rate increases
• Raising the discount rate
• when the discount rate is higher, banks will borrow less at a higher cost
• they make fewer loans and money supply is decreased
• Raising the reserve requirement ratio
• when the required reserves are higher, banks have fewer excess reserves to make loans and money supply is decreased
• Raising the federal funds rate

For more information, please refer to this video on Khan Academy:

Monetary policy tools: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap-financial-sector/monetary-policy-apmacro/v/monetary-policy-tools-ap-macroeconomics-khan-academy?modal=1