Thursday, July 9, 2009

the conduct of monetary policy

Let's now consider how it does so. We need to look more specifically at the institutional structure of the banking system and role of the fed in that institutional structure.
Think back to our discussion of the banking system. Banks take in deposits; make loans, and any other financial assets, keeping a certain percentage of reserves for those transactions. Those reserve are IOUs of the fed-either vault cash or deposits at the fed. Vault cash, deposits of the fed, plus currency in circulation make up the monetary base. The monetary base held at banks serves as legal reserves of the banking system. By controlling the monetary base, the fed can influence the amount of money in the economy and activities banks.
The actual tools monetary policy will affect the amount reserves in the system. In turn, the amount of reserves in the system will affect the interest rate. Other things equal, as reserves decline, the interest rate will rise; and as reserves increase, the interest rate will decline. So monetary policy will also be associated with interest rates.

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