Money MultiplierObjectives:

1. Determine the maximum potential extent to which the money supply will change following a Federal Reserve purchase or sale of government securities.

2. Discuss the ways in which the Federal Reserve conducts monetary policy.

Money Multiplier

• Say: • A bank’s reserves are $100.

• The required reserve ratio is 10%.

• How much can that bank’s deposits be?

• $1000!

• Ten times as much as their reserves.

• Are you sensing a multiplier?

• Money Multiplier = 1/Req. Res. Ratio

Money Multiplier II• The Money Multiplier tells us:

• For each dollar the Fed increases reserves by, how much can deposits, and so the money supply, increase

• If the Required Reserve Ratio is 20%• the money multiplier is 5

• each dollar the Fed injects into the system can cause deposits to increase by $5.

Money Multiplier III• In the real world, the money multiplier is

smaller, because:• People keep cash on hand!• Banks keep excess reserves above zero!• The more of either that happens, the smaller

the impact of an increase in reserves on the money supply!

Monetary Policy Tools• The Federal Reserve has three tools for

conducting monetary policy1. The Required Reserve Ratio

2. The Discount Rate– The rate that the Fed charges to banks for

overnight loans to cover reserve requirements

– If the bank can’t get any on the fed funds market

– The Fed frowns on too many visits to the “Discount Window”

3. Open Market Operations– Buying and selling bonds and other government

securities