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Interest Rates & Interest Rates & Monetary PolicyMonetary PolicyChapter 16Chapter 16

Learning Targets:Learning Targets:

16.116.1

I can determine the equilibrium interest I can determine the equilibrium interest rate in the market for money.rate in the market for money.

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Interest RatesInterest Rates

Fed’s primary influence is on the money supply Fed’s primary influence is on the money supply & interest rates& interest rates

InterestInterest- price paid for the use of money.- price paid for the use of money. Price that borrowers need to pay lenders for Price that borrowers need to pay lenders for

transferring purchasing power to the futuretransferring purchasing power to the future

There is a wide variety of US interest rates that vary There is a wide variety of US interest rates that vary by purpose, size, risk, maturity, & taxabilityby purpose, size, risk, maturity, & taxability

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Demand for MoneyDemand for Money

Transactions demandTransactions demand

Asset demandAsset demand

Total money demandTotal money demand

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Transactions demand (DTransactions demand (Dtt))

Demand for money as a medium of exchangeDemand for money as a medium of exchange

People hold money because it is convenient for buying People hold money because it is convenient for buying goods & servicesgoods & services

Level of nominal GDP is the main determinant of the Level of nominal GDP is the main determinant of the amount of money demanded for transactionsamount of money demanded for transactions

Direct relationship between transaction demand for $ & Direct relationship between transaction demand for $ & nominal GDP (will shift the total money demand curve)nominal GDP (will shift the total money demand curve)

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Asset demand (DAsset demand (Daa))

People hold their financial assets in many People hold their financial assets in many forms (i.e. stocks, bonds, or money)forms (i.e. stocks, bonds, or money)

Money is the most liquid of all assets & is Money is the most liquid of all assets & is immediately usable for buying other assetsimmediately usable for buying other assets

Disadvantage of money – does not earn interestDisadvantage of money – does not earn interest

Inverse relationship between amt. of money Inverse relationship between amt. of money demand & rate of interestdemand & rate of interest

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Total Money Demand (DTotal Money Demand (Dmm))

Sum of asset demand & transactions Sum of asset demand & transactions demanddemand

Represents the total amount of money Represents the total amount of money the public wants to hold, both for the public wants to hold, both for transactions and as an asset, at each transactions and as an asset, at each possible interest ratepossible interest rate

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Equilibrium interest rate Equilibrium interest rate (Learning Target)(Learning Target)

Intersection of supply & demand curve Intersection of supply & demand curve for moneyfor money

Equilibrium “price” is the interest rateEquilibrium “price” is the interest rate Changes in demand or supply affect the Changes in demand or supply affect the

interest rateinterest rate We are most interested in supply of moneyWe are most interested in supply of money

Increase in supply…lowers int. rateIncrease in supply…lowers int. rate Decrease in supply…increase int. rateDecrease in supply…increase int. rate

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Interest rates & bond Interest rates & bond pricesprices

These are closely related (inverse These are closely related (inverse relationship)relationship)

Learning Targets:Learning Targets:

16.216.2

I can explain the goals and tools of I can explain the goals and tools of monetary policy.monetary policy.

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Consolidation Balance Sheet Consolidation Balance Sheet of Federal Reserve Banksof Federal Reserve Banks

AssetsAssets Two main assets of Federal Reserve BanksTwo main assets of Federal Reserve Banks

SecuritiesSecurities Loans to Commercial BanksLoans to Commercial Banks

LiabilitiesLiabilities Reserves of Commercial BanksReserves of Commercial Banks Treasury DepositsTreasury Deposits Federal Reserve Notes OutstandingFederal Reserve Notes Outstanding

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Tools of Monetary PolicyTools of Monetary Policy

1.1. Open-Market OperationsOpen-Market Operations

2.2. The Reserve RatioThe Reserve Ratio

3.3. The Discount RateThe Discount Rate

4.4. Term Auction FacilityTerm Auction Facility

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Open-Market OperationsOpen-Market Operations

Consists of buying of government bonds from, Consists of buying of government bonds from, or the selling of government bonds to, or the selling of government bonds to, commercial banks & the general publiccommercial banks & the general public

Most important instrument for influencing the Most important instrument for influencing the money supplymoney supply

U.S. government issued bonds to finance past U.S. government issued bonds to finance past budget deficitsbudget deficits

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Buying securitiesBuying securities

From commercial banksFrom commercial banks From the publicFrom the public

In both cases, the reserves of commercial banks will In both cases, the reserves of commercial banks will increase but also increases checkable deposits increase but also increases checkable deposits when sellers (public) place Fed’s check into their when sellers (public) place Fed’s check into their personal checking acct.personal checking acct.

Increases lending ability of banksIncreases lending ability of banks

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Selling securitiesSelling securities

To commercial banks To commercial banks To the publicTo the public

In both cases, the reserves of commercial In both cases, the reserves of commercial banks are reducedbanks are reduced

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Reserve RatioReserve Ratio

The Fed can manipulate the reserve ratio in The Fed can manipulate the reserve ratio in order to influence the ability of commercial order to influence the ability of commercial banks to lendbanks to lend

Raising the reserve ratioRaising the reserve ratio Two consequences Two consequences

Lowering the reserve ratioLowering the reserve ratio Excess reserves would rise & enhances the ability Excess reserves would rise & enhances the ability

of banks to create new money by lendingof banks to create new money by lending

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Effects of changes in reserve ratio Effects of changes in reserve ratio on lending ability of on lending ability of commercial bankscommercial banks

Reserve Reserve RatioRatio

Checkable Checkable DepositsDeposits

Actual Actual ReservesReserves

Required Required ReservesReserves

Excess Excess ReservesReserves

Money-Money-Creating Creating Potential Potential of Single of Single

BankBank

1010 $20,000$20,000 $5000$5000 20002000 30003000 30003000

2020 ““ ““ 40004000 10001000 10001000

2525 ““ ““ 50005000 00 00

3030 ““ ““ 60006000 -1000-1000 -1000-1000

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Discount rateDiscount rate

When a commercial bank borrows, it gives the When a commercial bank borrows, it gives the Federal Reserve Bank a promissory note (IOU) Federal Reserve Bank a promissory note (IOU) drawn against itself and secured by acceptable drawn against itself and secured by acceptable collateralcollateral

The Fed charges interest on loans they grant The Fed charges interest on loans they grant to commercial banks (discount rate)to commercial banks (discount rate)

Borrowing from the Fed increases the reserves Borrowing from the Fed increases the reserves of the commercial banks which enhances their of the commercial banks which enhances their ability to extend creditability to extend credit

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Discount Rate (cont)Discount Rate (cont)

The Fed has the power to set the The Fed has the power to set the discount rate at which commercial banks discount rate at which commercial banks borrow from themborrow from them

From the commercial banks’ point of From the commercial banks’ point of view, the discount rate is a cost of view, the discount rate is a cost of acquiring reservesacquiring reserves

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Relative importanceRelative importance

Of the three instruments of monetary Of the three instruments of monetary control, buying & selling securities in the control, buying & selling securities in the open market is the most importantopen market is the most important

It’s flexible (can occur daily)It’s flexible (can occur daily) Impact on reserves is promptImpact on reserves is prompt

16.3 Learning Targets:16.3 Learning Targets:

I can explain the Federal funds rate and I can explain the Federal funds rate and how the Fed controls it.how the Fed controls it.

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Targeting the Federal Targeting the Federal funds ratefunds rate

Federal Funds rateFederal Funds rate

Rate of interest that banks charge one Rate of interest that banks charge one another on overnight loans made from another on overnight loans made from temporary excess reservestemporary excess reserves

Some banks have excess reserves while Some banks have excess reserves while others have deficiencies…they loan to each others have deficiencies…they loan to each other to meet their reserve requirementsother to meet their reserve requirements

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Term Auction FacilityTerm Auction Facility

Fourth Fed tool for altering bank reservesFourth Fed tool for altering bank reserves

Introduced in 12/07 in response to Introduced in 12/07 in response to mortgage debt crisismortgage debt crisis

Fed holds two auctions per month at Fed holds two auctions per month at which banks bid for the right to borrow which banks bid for the right to borrow reserves for 28-day periodsreserves for 28-day periods

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Expansionary monetary Expansionary monetary policypolicy

Easy money policyEasy money policy

Lower the interest rate to bolster Lower the interest rate to bolster borrowing & spendingborrowing & spending

This will increase AD & expand outputThis will increase AD & expand output

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Prime interest ratePrime interest rate

Benchmark interest rate used by banks as a Benchmark interest rate used by banks as a reference point for a wide range of interest reference point for a wide range of interest rates charged on loans to businesses & rates charged on loans to businesses & individuals.individuals.

Higher than federal funds rate because prime Higher than federal funds rate because prime rate involves longer, more risky loans than rate involves longer, more risky loans than overnight loans between banksovernight loans between banks

They do closely track one another thoughThey do closely track one another though

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Restrictive monetary Restrictive monetary policypolicy

• Called “tight” money policyCalled “tight” money policy

• Used during inflation. Used during inflation.

• Int rate goes up which will reduce borrowing Int rate goes up which will reduce borrowing and spendingand spending

• Slows economy down and holds down price-Slows economy down and holds down price-level increaseslevel increases

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Taylor ruleTaylor rule

Assumes that the Fed has a 2 percent “target Assumes that the Fed has a 2 percent “target inflation rate” that it is willing to tolerateinflation rate” that it is willing to tolerate

FOMC follows three rules when setting its FOMC follows three rules when setting its target for Federal Funds rate (pg. 320)target for Federal Funds rate (pg. 320)

Fed has no official allegiance to Taylor ruleFed has no official allegiance to Taylor rule

They change Fed Funds rate to any level it They change Fed Funds rate to any level it deems appropriatedeems appropriate

16.4 Learning Targets:16.4 Learning Targets:

I can explain the effectiveness of I can explain the effectiveness of monetary policy as well as its monetary policy as well as its shortcomings.shortcomings.

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Monetary policy, real Monetary policy, real GDP, & the price levelGDP, & the price level

Cause-effect chainCause-effect chain

Market for moneyMarket for money

Demand & supply curves for money are brought Demand & supply curves for money are brought togethertogether

Money supply curves (vertical line representing Money supply curves (vertical line representing some fixed amount of money determined by Fed)some fixed amount of money determined by Fed)

Equilibrium interest rate – S & D curves intersectEquilibrium interest rate – S & D curves intersect

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InvestmentInvestment

Inverse relationship between interest rate Inverse relationship between interest rate & amount of investment spending (key & amount of investment spending (key graph p. 322)graph p. 322)

Changes in interest rate mainly affect the Changes in interest rate mainly affect the investment component of total spendinginvestment component of total spending

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Equilibrium GDPEquilibrium GDP

Investment spending is one of the Investment spending is one of the determinants of ADdeterminants of AD

The greater the investment spending, the The greater the investment spending, the farther to the right lies the AD curvefarther to the right lies the AD curve

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Effects of an expansionary Effects of an expansionary Monetary PolicyMonetary Policy

Intended outcome will be an increase in excess Intended outcome will be an increase in excess reserves in the commercial banking system & a reserves in the commercial banking system & a decline in the Federal Funds Ratedecline in the Federal Funds Rate

Banks earn profits by lendingBanks earn profits by lending

Nation’s money supply will riseNation’s money supply will rise Lowers interest rate, increases investment, Lowers interest rate, increases investment,

aggregate demand, & equilbrium GDPaggregate demand, & equilbrium GDP

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Effects of a Restrictive Effects of a Restrictive monetary policymonetary policy

Inflation is a problem so restrictive monetary policy is Inflation is a problem so restrictive monetary policy is usedused

Actions taken:Actions taken: Sell government securities to banks & publicSell government securities to banks & public Increase the legal reserve ratioIncrease the legal reserve ratio Increase the discount rateIncrease the discount rate Decrease the amount of reserves auctioned off under term Decrease the amount of reserves auctioned off under term

auction facilityauction facility

Higher interest rate will discourage investment, lower Higher interest rate will discourage investment, lower AD, & restrain demand-pull inflationAD, & restrain demand-pull inflation

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Monetary Policy: Monetary Policy: Evaluation & IssuesEvaluation & Issues

Advantages over fiscal policyAdvantages over fiscal policy

1.1. Speed & flexibilitySpeed & flexibility Can be quickly altered (securities can be bought & sold Can be quickly altered (securities can be bought & sold

on a daily basis which affects the money supply & on a daily basis which affects the money supply & interest rates almost immediately)interest rates almost immediately)

2.2. Isolation from political pressureIsolation from political pressure Members of Fed BOG serve 14-year termsMembers of Fed BOG serve 14-year terms Isolated from lobbying & political pressureIsolated from lobbying & political pressure

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Recent U.S. Monetary Recent U.S. Monetary PolicyPolicy

In early 1990’s, Fed’s expansionary In early 1990’s, Fed’s expansionary monetary policy helped economy recover monetary policy helped economy recover from recessionfrom recession

To counter potential inflation during that To counter potential inflation during that strong expansion (1990’s), Fed reduced strong expansion (1990’s), Fed reduced reserves in banking system to raise the reserves in banking system to raise the interest rateinterest rate

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Problems & Problems & ComplicationsComplications

LagsLags Monetary policy faces a recognition & Monetary policy faces a recognition &

operational lagoperational lag

Cyclical asymmetryCyclical asymmetry Less reliable in pushing the economy from a Less reliable in pushing the economy from a

severe recessionsevere recession