(1) Changes in banks’ required reserve ratio (RRR) — The required reserve ratio (RRR) is now 10% of banks’ checking deposits. — It was lowered from 12% in early 1990's. — The RRR on savings account, CD’s, and money-market deposit accounts is zero. — Changes in the RRR have large effects on money supply: increasing RRR causes a decrease in banks’ excess reserves and a decrease in the money multiplier (1/RRR), so the money supply decreases by a lot. –> Because this tool’s effects are so powerful as to preclude “fine tuning” (making small changes in monetary policy as needed), it is rarely used.(2) Changes in the discount rate – The Fed controls the discount rate, i.e. the interest rate at which it loans money to banks. – When the Fed lowers the discount rate, bank reserves will increase, because banks will take advantage of the lower rates by borrowing more reserves from the Fed (and then loaning those reserves out). – Although the Fed is officially a “lender of last resort” to banks, to be used only when banks are in desperate situations, when it lowers the discount rate it is generally signaling a relaxation of that rule, i.e. an increased willingness to make ordinary loans to banks in order to expand the volume of money and credit.
* (3) Open market operations (OMO) — In OMO, the Fed buys or sells bonds, usually from the banks, in order to affect the level of bank reserves and the federal funds rate (the interest rate at which commercial banks loan each other money, usually in the form of reserves, on an overnight basis). In turn, the money supply and other interest rates will be affected, too. -- OMO is the Fed’s most important and most-used policy tool. – How OMO works: when the Fed buys or sells securities (government bonds) from banks, it makes or collects the payment for those bonds by crediting or debiting the banks’ reserve accounts at the Fed and thereby changing the level of bank reserves, which changes the money supply in the same direction. These operations are carried out solely by the regional Fed bank of New York. -- Expansionary monetary policy calls for open-market purchases: Fed buys securities, pays by crediting banks’ reserve accounts --> money supply expands, interest rates fall. -- Contractionary monetary policy: open-market sales:
Fed sells securities, collects payment by debiting banks’ reserve accounts --> money supply shrinks, interest rates rise. -- The Fed uses OMO to affect the federal funds rate. Open-market purchases and sales by the Fed affect the federal funds rate because they affect the supply of bank reserves. An increase in the supply of bank reserves (expansionary OMO) reduces the federal funds rate; a decrease in the supply of bank reserves (contractionary OMO) increases the federal funds rate. -- Imagine (or, better yet, draw) a supply-and-demand diagram of the federal funds market, with the quantity of bank reserves on the horizontal axis, the interest rate (price) on borrowed bank reserves on the vertical axis, an upward-sloping supply curve, and a downward sloping demand curve. If the Fed makes an open-market purchase of a security from a bank, for example, it pays for the security by crediting the bank’s reserve account at the Fed; thus it is adding to the total supply of reserves. That addition corresponds to an outward shift of the supply curve of federal funds, which will cause the interest rate on reserves (i.e., the federal funds rate, or the “price” of borrowing reserves) to fall.
II. AN EXAMPLE OF MULTIPLE DEPOSIT CREATION
Let us consider an example of an expansionary monetary policy move by the Fed. Suppose that the Fed conducts expansionary OMO by making an open-market purchase of securities. Specifically, the Fed buys $100 in securities from the First National Bank. (The required reserve ratio, RRR, for checking deposits is 10%. We will assume that First National and all other banks initially have zero excess reserves. Also assume that all loans get redeposited into checking accounts at First National.) The Fed pays for the securities by crediting First National’s reserve account at the Fed with $100. We would like to know: What is the ultimate change in the money supply, after the entire chain of deposit creation has run its course?
Fast-forwarding a bit, we can answer that question right now, because we know the initial change in reserves (+$100) and can compute the money multiplier (1/RRR = 1/.10 = 10). The ultimate change in the money supply will be: {increase in money supply} = {increase in reserves} * {money multiplier} = ($100) * (10) = $1000.
To see just how we got from an initial increase in reserves of $100 to a cumulative increase in the money supply of $1000, we can look at the changes in First National’s balance sheet. The initial change in First National’s balance sheet is:
