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Central banks wield powerful tools to steer the economy. They buy and sell securities, adjust reserve requirements, and set discount rates to influence money supply and interest rates. These actions can stimulate growth during recessions or cool down overheating economies.

Banks play a crucial role in this system. Their balance sheets, consisting of assets like loans and liabilities like deposits, determine their lending capacity. By managing reserves and assessing loan risks, banks act as intermediaries between central bank policies and the broader economy.

Central Bank Monetary Policy Tools

Open Market Operations

Top images from around the web for Open Market Operations
Top images from around the web for Open Market Operations
  • Open market operations involve the central bank buying or selling government securities (Treasury bills, bonds, notes) in the open market to influence money supply and interest rates
  • Buying securities injects money into the economy, increases the money supply, and puts downward pressure on interest rates by increasing the supply of loanable funds
  • Selling securities removes money from the economy, decreases the money supply, and puts upward pressure on interest rates by decreasing the supply of loanable funds
  • Expansionary monetary policy involves buying securities to increase money supply, lower interest rates, and stimulate borrowing and spending (during a recession)
  • Contractionary monetary policy involves selling securities to decrease money supply, raise interest rates, and reduce borrowing and spending to combat inflation (during an economic boom)

Reserve Requirements and Discount Rate

  • Reserve requirements set the minimum fraction of deposits that banks must hold as reserves (vault cash, deposits at the Fed), limiting the amount they can lend out
  • Lowering reserve requirements allows banks to lend more, increasing the money supply and putting downward pressure on interest rates (expansionary policy)
  • Raising reserve requirements forces banks to lend less, decreasing the money supply and putting upward pressure on interest rates (contractionary policy)
  • The discount rate is the interest rate the Fed charges on loans to banks (discount window lending)
  • Lowering the discount rate makes borrowing from the Fed more attractive, increases lending and money supply, and puts downward pressure on other interest rates (expansionary policy)
  • Raising the discount rate makes borrowing from the Fed less attractive, decreases lending and money supply, and puts upward pressure on other interest rates (contractionary policy)

Bank Balance Sheets and Lending

Bank Balance Sheets

  • Assets include reserves (vault cash, deposits at the Fed), loans (mortgages, business loans, consumer loans), and securities (government bonds, corporate bonds)
  • Required reserves == reserve requirement ×\times deposits, excess reserves == total reserves - required reserves
  • Liabilities include deposits (checking accounts, savings accounts, CDs) and borrowings (loans from other banks, the Fed)
  • Bank capital is the difference between assets and liabilities, acting as a buffer against losses (loan defaults, investment losses)
  • Factors affecting lending include reserve requirements (higher requirements mean less lending capacity), demand for loans (more demand means more loans if excess reserves are available), and perceived risk of loans (riskier loans require higher interest rates or may be denied)

Key Terms to Review (19)

Ample Reserve Environments: Ample reserve environments refer to situations where a central bank has provided the banking system with an abundant supply of reserves, typically in excess of the minimum reserve requirements. This abundant reserve supply allows banks to easily meet their reserve requirements and have additional funds available for lending and other financial activities.
Bank Reserves: Bank reserves refer to the cash and other liquid assets that banks are required to hold on hand to meet their deposit and withdrawal obligations. These reserves serve as a buffer to ensure banks can meet customer demands and maintain financial stability.
Contractionary Monetary Policy: Contractionary monetary policy refers to actions taken by a central bank to reduce the money supply and tighten credit conditions in an economy. This is done with the goal of slowing down economic growth, controlling inflation, and maintaining price stability.
Discount Rate: The discount rate is the interest rate used by central banks, such as the Federal Reserve, to set the cost of borrowing money for commercial banks and other financial institutions. It is a key tool used in the execution of monetary policy and can have significant impacts on economic activity, inflation, and the overall financial system.
Expansionary Monetary Policy: Expansionary monetary policy refers to the actions taken by a central bank to increase the money supply and stimulate economic growth. This policy aims to lower interest rates, encourage borrowing and spending, and promote investment and employment within an economy.
Federal Funds Rate: The federal funds rate is the interest rate at which depository institutions (such as banks) lend reserve balances to other depository institutions overnight on an uncollateralized basis. It is a key monetary policy tool used by the Federal Reserve to influence the overall level of interest rates and economic activity.
Forward Guidance: Forward guidance refers to the communication strategy used by central banks to provide information about the likely future path of monetary policy. It aims to influence public expectations about the future course of interest rates and other policy instruments in order to shape economic outcomes.
Inflation Targeting: Inflation targeting is a monetary policy framework where a central bank aims to maintain the rate of inflation within a specific target range, typically around 2% annually. This approach is used by many central banks to achieve price stability and guide economic expectations.
Interest on Reserves: Interest on reserves refers to the interest paid by the central bank to commercial banks on the reserves they hold with the central bank. This is a key tool used by central banks, such as the Federal Reserve, to influence monetary policy and the overall banking system.
Limited Reserve Environments: A limited reserve environment refers to a financial system where banks and other financial institutions are required to hold a certain minimum amount of reserves, typically in the form of cash or deposits with the central bank, in relation to the amount of loans and deposits they have. This reserve requirement is designed to ensure the stability and liquidity of the financial system.
Liquidity Trap: A liquidity trap is a situation in which interest rates are extremely low, and monetary policy becomes ineffective at stimulating the economy. This occurs when individuals and businesses prefer to hold cash rather than invest or spend, leading to a lack of demand and a stagnant economy.
Monetary Base: The monetary base, also known as high-powered money or central bank money, refers to the total amount of currency and reserve balances held by the public and banks. It represents the most liquid and fundamental form of money in an economy, serving as the foundation for the broader money supply.
Money Supply: The money supply refers to the total amount of money available in an economy at a given time. It encompasses various forms of liquid assets that can be easily used as a medium of exchange, including currency, deposits, and other highly liquid instruments. The money supply is a crucial economic indicator that influences economic activity, inflation, and the effectiveness of monetary policy.
Open Market Operations: Open market operations refer to the process by which a central bank, such as the Federal Reserve, buys and sells government securities (typically Treasury bonds) in the open market to influence the money supply and interest rates in an economy. This is a key tool used by central banks to implement monetary policy and achieve macroeconomic objectives.
Primary Dealers: Primary dealers are a group of financial institutions that have a direct trading relationship with a central bank, such as the Federal Reserve. They are authorized to buy and sell government securities, acting as market makers to facilitate the central bank's execution of monetary policy.
Quantitative Easing: Quantitative easing (QE) is an unconventional monetary policy tool used by central banks to stimulate the economy. It involves the central bank purchasing large quantities of assets, typically government bonds and other securities, from financial institutions in order to inject liquidity into the financial system and lower long-term interest rates. This is done with the aim of encouraging economic growth, boosting employment, and maintaining price stability.
Reserve Requirements: Reserve requirements are regulations that mandate the minimum amount of reserves a bank must hold against its deposits. These reserves can be in the form of cash, deposits with the central bank, or other highly liquid assets. Reserve requirements are a key tool used by central banks to influence the money supply and control inflation.
Treasury Bills: Treasury bills, or T-bills, are short-term debt securities issued by the U.S. government to raise funds. They are considered one of the safest investments due to the full faith and credit of the U.S. government backing them, and they play a crucial role in the measurement of money supply and the execution of monetary policy.
Treasury Bonds: Treasury bonds are debt securities issued by the United States government to finance its operations and borrowing needs. They are considered one of the safest investments due to the full faith and credit of the U.S. government backing them, and they play a crucial role in the execution of monetary policy, government spending, and the broader economy.
Ample Reserve Environments
See definition

Ample reserve environments refer to situations where a central bank has provided the banking system with an abundant supply of reserves, typically in excess of the minimum reserve requirements. This abundant reserve supply allows banks to easily meet their reserve requirements and have additional funds available for lending and other financial activities.

Term 1 of 19

Key Terms to Review (19)

Ample Reserve Environments
See definition

Ample reserve environments refer to situations where a central bank has provided the banking system with an abundant supply of reserves, typically in excess of the minimum reserve requirements. This abundant reserve supply allows banks to easily meet their reserve requirements and have additional funds available for lending and other financial activities.

Term 1 of 19

Ample Reserve Environments
See definition

Ample reserve environments refer to situations where a central bank has provided the banking system with an abundant supply of reserves, typically in excess of the minimum reserve requirements. This abundant reserve supply allows banks to easily meet their reserve requirements and have additional funds available for lending and other financial activities.

Term 1 of 19



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AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.
Glossary
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