Chapter 8 - Chapter 8 Conduct of Monetary Policy Monetary...

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Chapter 8: Conduct of Monetary Policy Monetary policy affects interest rates and the money supply which, in turn, has great influence over economic activity. The Fed has three instruments to implement monetary policy: (1) Open Market Operations; (2) Discount lending and Discount Rate; and (3) Reserve Requirement. To understand how the Fed affects the important variables – interest rate and money supply -- in the economy, one should understand the Fed’s balance sheet. When the Fed conducts policy, it does so through changes in its balance sheet: Assets and Liabilities. In a very simplified form, the balance sheet of the System looks as follows Fed Assets Liabilities Government Securities Currency in circulation Discount Loans (zeros) Reserves Note: in the subsequent discussion, the term bank applies to all depository institutions . The most important asset is US Treasuries. Discount loans are loans the Fed makes to banks. The rate the Fed charges on these loans is called the discount rate. Currency in circulation (which excludes currency held in banks) is an important liability of the Fed. Currency held in banks is also a liability of the Fed but is counted as part of reserves. All banks have an account at the Fed in which they hold deposits. These deposits plus currency that are physically held by banks themselves (called “vault cash”) constitute reserves. - There are 2 categories of reserves: o Required reserves are those the Fed requires banks to hold (currently 10% -- called reserve ratio --of checkable deposits). The fed does NOT pay interest on required reserves, although the Fed will start paying interest on them starting in 2011 o Excess reserves are those reserves that exceed the required level. They are held to provide cash to depositors on demand.
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Chapter 8 - Chapter 8 Conduct of Monetary Policy Monetary...

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