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Section 3 Monetary Policy Tools

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Objectives

After studying this section you will be able to:

1. Describe the process of money creation.
2. Explain how the Federal Reserve uses reserve requirements, interest rates, and open market operations to implement U.S. monetary policy.
3. Understand why some monetary policy tools are favored over others.

Section Focus

Banks create money in their day-today operations. The Federal Reserve uses the tools of monetary policy to control the amount of money in circulation.

Key Terms

• money creation
• required reserve ratio (RRR)
• money multiplier formula
• excess reserves
• prime rate
• open market operations

In early 2001, when it appeared that economic growth was slowing, the Fed began reducing interest rates. The September 11 terrorist attacks further increased the need for such changes in economic policy. By early 2003, the Fed had cut interest rates 13 times, to 45-year lows. By reducing the cost of borrowing, the Fed hoped to encourage consumers to spend more money and stimulate economic growth. In this section you will see why the Fed uses these tactics to influence economic growth.

Money Creation

The Department of the Treasury is responsible for manufacturing money. The Federal Reserve is responsible for putting dollars into circulation. How does this money get into the economy? The process is called money creation, and it is carried out by the Fed and by banks all around the country. Recall from Chapter 15 the multiplier effect of government spending. The multiplier effect in fiscal policy holds that every one dollar change in fiscal policy creates a change greater than one dollar in the economy. The process of money creation works in much the same way.

How Banks Create Money

Money creation does not mean the printing of money. Banks create money not by printing it, but by simply going about their business.

For example, suppose you take out a loan of $1,000. You decide to deposit the money in a checking account. Once you have deposited the money, you now have a balance of $1,000. Since demand deposit account balances, such as your checking account, are included in M1, the money supply has now increased by $1,000. The process of money creation begins here.

The daily activities of banks and their customers create money through the multiplier effect.

Banks make money by charging interest on loans. Your bank will lend part of the $1,000 that you deposited. The amount that the bank is allowed to lend is determined by the required reserve ratio (RRR)—the fraction of the deposit that must be kept on reserve. This is calculated as the ratio of reserves to deposits. The RRR is the fraction of deposits that banks are required to keep in reserve. The required reserve ratio, which is established by the Federal Reserve, ensures that banks will have enough funds to supply customers' withdrawal needs.

Suppose in our example that the RRR is 0.1, or 10 percent. This means that of your $1,000 demand deposit balance, the bank is allowed to lend $900.

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