Unit 4

1. The Reserve Requirement
• Only a small percent of your bank deposit is in the safe. The rest of your money has been loaned out. This is called "Fraction Reserve Banking."
• The FED sets the amount that banks must hold.
• The reserve requirement (reserve ratio) is the percent of deposits that banks must hold in reserve and NOT loan out.
1. If there is a recession, what should the FED do to the reserve requirement?
• Decrease the Reserve Ratio
1. Banks hold less money and have more excess reserves.
2. Banks create more money by loaning out excess.
3. Money supply increases, interest rate fall, AD goes up
2. If there is inflation, what should the FED do to the reserve requirement?
• Increase the Reserve Ratio
1. Banks hold more money and have less excess reserves.
2. Banks create less money by loaning out.
3. Money supply decreases, interest rate rise, AD goes down.
2. The Discount Rate
• The Discount Rate is the interest rate that the FED charges commercial banks.
• To increase the money supply, the FED should decrease the Discount Rate (Easy Money Policy)
• To decrease the money supply, the FED should increase the Discount Rate (Tight Money Policy)
3. Open Market Operations
• The FED buys/sells government bonds (securities)
• This is the most important and widely used monetary policy
• To increase the money supply, the FED should buy government securities.
• To decrease the money supply, the FED should sell government securities.

	Easy Money	Tight Money
Monetary Policy	Expansionary	Contractionary
Open Market Operation	Buy bonds	Sell bonds
Discount Rate	Decrease	Increase
Reserve Requirement	Decrease	Increase

Federal Funds Rate: this is where FDIC member banks loan each other overnight funds.

Prime Rate: the interest rate that banks charge their most credit and worthy customer.