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reserve and it is on deposit with the Federal Reserve. Bank A would like to loan out all of its cash (after all, that is generally how banks make money) but it can only work with the $2 million that is not in reserve. Now the Fed decides to loosen the Monetary Policy, meaning that it makes more cash available to the public. In order for the Fed to achieve this it can take any or all of the following steps:

• Increase Bank A’s reserves for example by $0.5 million (possibly by buying Treasury Bonds from Bank A), giving Bank A an extra $0.5 million to loan out.
• Decrease Bank A’s reserve requirement to $0.5 million from $1 million, thereby allowing Bank A to withdraw $0.5 million from its reserves.
• Lower the discount rate allowing Bank A to borrow money (perhaps as much as $0.5 million) inexpensively.

Conversely to the above example, the Fed can tighten its Monetary Policy by taking steps opposite of those mentioned above. In that case cash flows out of the economy, leaving Bank A with less money.

Interest Rates

All this loosening and tightening of the Monetary Policy is done with one goal in mind; adjusting the interest rates. Interest rates are continuously monitored and adjusted to maintain a healthy economy and battle inflation. More on this later.

Interest rate is the price one must pay to borrow money. In effect, interest rates are the price of buying money. Think of it this way.When you buy a house, one of the first things you do is to secure a mortgage with a bank. After the price of the house has been agreed upon between …