Macroeconomics
Since in such banking systems, the tools of traditional monetary policy, such as OMOs, have limited effectiveness in influencing interest rates, the central bank will adjust the IOR to stimulate or slow down the economy. How the interest on reserves works: ➔ When the Fed increases the IOR, banks are more encouraged to keep additional deposits within the Fed. ➔ As more reserves are held with the Fed, banks’ lending ability decreases. ➔ This reduces investment and aggregatedemandsincefrms’andhouseholds’needfor borrowing is not always met. ➔ The opposite of these steps applies when the Fed reduces IOR instead. Therefore,increasingIORispartofacontractionarymonetarypolicy,whereasdecreasingIORispartof an expansionary monetary policy. The Reserve Requirement (rr) AsexplainedinSectionEofthischapter,thefractional-reservebankingsystemcontrolshowbankslend andultimatelycreatemoneyinaneconomy.Oneofthecornerstonesofthissystemisbanks’reserves. Therefore, toimpactmoneysupply,acentralbankcanalsoinfluencereservesthroughtherequired reserve ratio or reserve requirement (rr) . However, this is a tool mainlyusedinbankingsystemswithlimitedreservesduetothemultiplier effect thatimpactsmoneysupply.Recallthat inanamplereservesbankingsystem ,moneysupplyhas no signifcant effect on interest rate; therefore, the use ofthemultipliertochangemoneysupplyis dropped . Using this tool, the Fed indirectly impacts money supply by targeting the monetary base through changing reserves. How the required reserve works: ➔ When the Fed changes the rr, reserves are affected. ➔ Sincereservesareacomponentofthemonetarybase(MB=cashandcoinsincirculation+bank reserves), a change in reserves changes the MB. ➔ If the Fed knows the money multiplier in the economy, it can deduce the change in money supply following the change in rr by using Ms = MB × MM. A decrease in the required reserve is an expansionary monetary policy tool that results in the following effects: rr ↓ → deposits ↑ → monetary base↑ → loans ↑ → moneysupply ↑
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