Introduction to Finance



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R.Miltcher - Introduction to Finance

dynamic actions 
Fed actions 
that stimulate or repress economic 
activity or the level of prices


4.4 Monetary Policy Functions and Instruments
87
The basic policy instruments of the Fed that allow it to increase or decrease the money 
supply are, as follows:
• Changing reserve requirements
• Changing the discount rate
• Conducting open-market operations
In recent years, the Fed has also engaged in a nontraditional monetary policy:
• Quantitative easing
We will fi rst cover the traditional policy instruments and then discuss the use of quantitative 
easing.
The Fed sets reserve requirements for depository institutions (i.e., banks), sets the interest 
rate at which to lend to banks, and executes open-market operations. By setting reserve 
requirements, the Fed establishes the maximum amount of deposits the banking system can 
support with a given level of reserves. The amount of reserves can be aff ected directly through 
open-market operations, thereby causing a contraction or expansion of deposits by the bank-
ing system. Discount or interest rate policy on loans to banks also aff ects the availability of 
reserves to banks and infl uences the way they adjust to changes in their reserve positions. Thus 
the Fed has a set of tools that, together, enables it to infl uence the size of the money supply to 
attain the Fed’s broader economic objectives.
Reserve Requirements
The banking system of the United States is a 
fractional reserve system
because banks are 
required by the Fed to hold reserves equal to a specifi ed percentage of their deposits. 
Bank 
reserves
are defi ned as vault cash and deposits held at the Reserve Banks. 
Required reserves 
are the minimum amount of bank reserves that must be held by banks. The 

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