AP, IB, and College Microeconomic and Macroeconomic Principles 

8 key questions about monetary policy answered

Monetary Policy Tools

Updated 4/24/2018 Jacob Reed
1. What is monetary policy?

Monetary policy is how the Federal Reserve (central bank of the United States) works to achieve the macroeconomic goals of full employment, price stability, and growth.  The tools of monetary policy include open market operations, the discount rate, and the reserve requirement.

Pile of Money

Open market operations include just 2 things: buying and selling government bonds (securities). You could see questions on your exams asking about open market policies or open market actions. These questions are about buying or selling bonds. These questions are not asking about discount rates or reserve requirements. 

The reserve requirement (or required reserve ratio) is the percentage of demand deposits (or checkable deposits) which cannot be loaned out. If the reserve requirement is 10% and a customer makes a $1000 deposit, the bank may loan out $900 of excess reserves while keeping $100 of required reserves on hand.

The discount rate is the interest rate banks are charged when they borrow money from the Federal Reserve (the Fed). If banks do not have enough money to cover the required reserves, they may borrow money from the Fed and pay the discount rate for the short-term (overnight) loan.

The discount rate is the only interest rate the Fed controls directly.  All 3 tools are used to target other interest rates; like the federal funds rate, which is the interest rate banks charge each other. The Fed targets other interest rates by changing the reserves on banks’ balance sheets. Changing reserves impacts how much money banks have available to loan out and that impacts the interest rates in the rest of the economy. 

2. What is expansionary monetary policy?

Expansionary monetary policy uses one or more of the tools above to increase reserves in the banking system. This lowers interest rates and increases the quantity of investment and interest rate sensitive consumer spending in the economy. This increases GDP and with it employment. Expansionary monetary policy is used to fight the economic problem of unemployment.

To expand the economy and fight unemployment, monetary policy tools can be used in the following ways:
Open Market Operations: Buy bonds to increase bank reserves.

Reserve Requirement: Decrease the reserve requirement to increase excess reserves and  increase the money multiplier.
Discount Rate: Decrease the discount rate to encourage banks to loan out more of their reserves as a penalty for loaning out too much will be lower.

3. What is contractionary monetary policy?

Contractionary monetary policy is used to fight the economic problem of inflation. The Fed will use the tools above to decrease the bank reserves which will raise interest rates. Increasing interest rates decrease the quantity of investment and interest rate sensitive consumer spending.  This decreases the price level and eases inflationary pressures.

To slow the economy and fight inflation, monetary policy tools can be used in the following ways:

  • Open Market Operations: Sell Bonds to decrease bank reserves.
  • Reserve Requirement: Increase the reserve requirement to decrease excess reserves and decrease the money multiplier.
  • Discount Rate: Increase the discount rate to discourage banks from loaning as much of their reserves as a penalty for loaning out to much will be higher.

4. What is the money multiplier?

The actions of the Federal Reserve have a small immediate impact on bank reserves but that effect multiplies throughout the banking system. Money is created every time a loan is made and money is destroyed every time a loan is paid back. The money multiplier tells us how much new money, loans, or deposits can be created by increasing a bank’s reserves.

When a deposit is made in a bank, some of that money is loaned out (excess reserves) and some of it stays with the bank (required reserves). If the Federal Reserve has a Reserve Requirement of 10% and a customer makes a demand deposit of $1000, the bank can loan out $900 worth of excess reserves while keeping $100 in required reserves. The $900 loan (newly created money) can be deposited in a checking account. Now the bank can loan out $810 while $90 is kept in reserves. When that loan is redeposited, $729 can be loaned out while $81 is kept in reserves. As this process of loaning and re-depositing continues, each loan is newly created money.

The formula for the money multiplier:

  • Multiplier is 1 divided by the reserve requirement (1/RR)

Formula for the expansion of money:

  • Maximum Loan, Deposit, or Money Creation = Excess Reserves x Money Multiplier

A 10% reserve requirement would mean the multiplier is 10 (1/.10 = 10). To find the maximum amount of money the banking system can create from the original $1000 deposit (from the example above), multiply the money multiplier times the excess reserves. That original deposit can cause the creation of $9000 ($900 of excess reserves times the money multiplier of 10) worth of new money. Since the new money is all created through loans and the original deposit was not a loan, $9000 is also the amount of loan creation the banking system could create.

To figure out how many dollars’ worth of demand deposits this $1000 deposit could create again multiply the excess reserves by the multiplier to get $9000 worth of deposits. Since the original $1000 was also a deposit, it must be added in; bringing the total deposit creation to $10,000.

If, instead of a customer deposit, the Federal Reserve bought $1000 worth of bonds from a bond dealer (on the open market), things would work a little differently. The bond dealer will deposit the newly created money into their bank account and the excess reserves can be loaned out.  The maximum dollar value of loans would be $9000 ($900 of excess reserves times the money multiplier of 10). Since the original bond purchase was new money (the Fed creates new money when they buy bonds) and a fully deposited by the bond dealer, to find the maximum money creation or deposit creation you would need to add the original bond purchase to the $9000 of loans. As a result, the maximum money creation and deposit creation from the Fed’s purchase would be $10,000. 

The trick for all questions like this is to remember that money, loan, and deposit creation can be figured out by multiplying the excess reserves by the money multiplier. Then, look at the original amount and determine if it should be added in as well.

Note: This all works in reverse too. Actions of the Federal Reserve can shrink the money supply as well.

5. Why will the actual amount of money creation be less than the money multiplier predicts?

The money multiplier is about maximum changes in the banking system. It assumes banks always loan out excess reserves, money is always redeposited into a bank, and consumers do not hold cash. Since those assumptions are far from the reality, the actual changes in the banking system will be much less than the money multiplier indicates. 

6. How does monetary policy impact the money market?

As we see above, the actions of the Federal Reserve dramatically increase and decrease the supply of money. The Fed unilaterally controls the money supply which allows it to target interest rates like the Federal Funds Rate. Expansionary monetary policy shifts the money supply to the right and contractionary monetary policy shifts it to the left. Shifting the supply curve in the money market changes the equilibrium interest rate.  

7. How does monetary policy impact AS/AD?

Changes in interest rates impact the quantity of investment and interest rate sensitive spending in the economy. Those changes shift the aggregate demand curve in the AS/AD model. Expansionary monetary policy shifts AD to the right, which increases real GDP (decreasing unemployment) and increasing the price level. Contractionary monetary policy shifts AD to the left which decreases real GDP and decreases the price level.

8. How does monetary policy impact the growth rate?

Since the interest rate directly impacts the quantity of investment and gross investment includes purchases of physical capital, interest rates can impact the growth rate of the economy. Higher interest rates tend to decrease investment and with it the growth rate. Lower interest rates tend to increase investment and the growth rate. 

Up Next: 
Review Games: Money MultiplierFiscal Policy/Monetary Policy Sorting
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 Bank Balance Sheets

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